How a $1.3bn RIA beat the SEC in a 12b-1 fee trial

Spotty witnesses and the decision to marshall a massive legal entourage may have backfired on the regulator.

Last month, $1.3bn RIA CapWealth Advisors squared up in federal court against an intimidating opponent: the Securities and Exchange Commission (SEC). The regulator had accused the firm of fraud stemming from its collection of 12b-1 fees on sales of certain mutual fund share classes, while CapWealth execs countered that they had reduced their advisory fees to cover any 12b-1 fees charged to their clients.

The battle’s outcome was a surprising one.

To understand the context of the dispute and the stakes at hand, one must go back to February 2018, when the SEC launched its Share Class Selection Disclosure Initiative allowing RIAs to avoid financial penalties if they self-reported past 12b-1 fee-related Advisers Act violations and returned any excessive fees charged to their clients. Many RIAs who had collected 12b-1 fees in the past did just that, but some did not. The SEC worked to root out such offenders and continued its crusade against firms it deemed to be out of compliance even after the disclosure program officially ended in April 2020.

Most firms that found themselves the subject of an SEC complaint elected to settle with the regulator, figuring it would be cheaper, quieter and easier than going to trial. But a small contingent elected to fight back on principle, decrying the 12b-1 crackdown as a misguided ‘regulation by enforcement’ campaign.

One of these rebels was Ambassador Advisors, a biblically focused RIA that the SEC argued did not adequately disclose the conflicts of interest related to its collection of 12b-1 fees. Ambassador argued that it never actually violated any regulations and pushed for a jury trial, which finally unfolded over eight days in March. Few were surprised when the jury found in favor of the SEC, determining that Ambassador’s failure to disclose its collection of 12b-1 fees breached its fiduciary duty to clients. The judge ordered Ambassador and its three top executives to pay more than $2m in combined civil penalties, disgorgement and interest.

Similarly, CapWealth chief executive Tim Pagliara raised eyebrows in December 2020 when he initially proclaimed his plan to take the SEC to trial. The SEC had sought financial penalties against CapWealth, Pagliara and advisor Tim Murphy, as well as repayment of ill-gotten gains plus prejudgment interest. 

‘Principle is important, my integrity is not negotiable, and I will not settle with them. I will take this all the way to a jury trial, and it will be adjudicated by a jury of my peers, and that’s the only way I’m going to accept it,’ he told Citywire at the time, adding: ‘We do not negotiate with regulatory thugs that harass our clients.’

Watchers took Pagliara’s assertions with a grain of salt. Juries famously hate perceived financial wrongdoing, even if they don’t totally understand the minutiae of a case. And the SEC is a formidable plaintiff, with virtually bottomless pockets and a wealth of lawyers and paralegals it can call on for support.

But in late October, Pagliara was vindicated when ten jurors in US District Court for the Middle District of Tennessee found in CapWealth’s favor, determining that the firm’s collection of 12b-1 fees from advisory clients in the mid-2010s constituted neither fraud nor a violation of its fiduciary duty.

While the SEC declined Citywire’s multiple requests for comment on the trial, Pagliara (pictured) was willing to discuss the details of the case. In an interview, he explained how his firm managed to come out on top.

Witness trouble

According to Pagliara — who was represented at trial by Gino Bulso and Eric Smith of Bulso PLC — the SEC’s expert witness testimonies were conducted sloppily. The minute entries for each day of the trial are not public record, but Pagliara told Citywire that the SEC’s staff started off on the wrong foot with Chief District Judge Waverly Crenshaw, Jr.

‘When they put their first witness up on the stand, the judge had to dress them down because they were not following the rules of his court,’ he said. ‘They were introducing their witnesses and their credentials incorrectly.’ 

Pagliara said things reached a boiling point when the SEC called its in-house expert witness – an economist with the SEC’s office of litigation economics – to the stand.

‘He came back into court the next day and he said, “I’ve done some research on this overnight and I want to change a few of my answers.” My attorney was setting up and all of a sudden the judge said, “Ladies and gentlemen of the jury, I’m going to ask you to leave.” Well, the judge took over and it was tense. He almost held [the expert witness] in contempt of court.’

If Judge Crenshaw expressed frustration with the SEC’s attorneys or witnesses, the jury almost certainly picked up on that tension, even if they had been ordered out of the room during the worst of it.

Additionally, Pagliara said the SEC called two former CapWealth clients as witnesses, hoping to show the jury who was impacted by the ‘excess’ 12b-1 fees. He said that this strategy backfired for the SEC and ultimately worked in CapWealth’s advantage. ‘One of them hadn’t been a client since 2015, this 80-year-old woman,’ he said. ‘They asked her:

“During your discussions with Mr. Pagliara … do you remember talking about 12b-1 fees?”

“No.”

“Do you remember talking about anything related to your advisory account?”

“No.”

“What do you remember?”

“I remember at one point there was not much cash left on the account.”

So, my attorney gets up and asks: “Did it surprise you that they brought you all the way from Lilburn, Ga., to testify about $76 in 12b-1 fees?”

“Yes.”

“Do you even know why you’re here?”

“No. No one ever explained it to me.”’

Were clients harmed?

Whether or not investors were harmed financially is largely irrelevant in CapWealth’s case and other 12b-1 cases.

Judge Crenshaw’s written instructions for the jury ahead of deliberations spelled this out: ‘The SEC does not need to prove, or offer any evidence, that any defendant intended to harm or actually harmed any client. … When you consider whether the defendants committed any of the violations alleged by the SEC, you should not consider or speculate about whether their conduct caused economic harm.’

Instead, the judge instructed the jury to determine whether the SEC proved its accusation that CapWealth violated the anti-fraud provision of the Advisers Act. To do so, the SEC needed to prove that CapWealth breached one of the fiduciary duties that it owed to its clients – either the duty of best interest or the duty to disclose conflicts of interest.

CapWealth’s position throughout the course of the dispute held that there was no conflict of interest because the firm discounted other fees, including its advisory fee, to offset the 12b-1 fees that it collected. Additionally, Pagliara testified that it was more tax efficient for certain clients to pay 12b-1 fees compared to higher advisory fees because 12b-1 fees are tax deductible while advisory fees are not. By leaving such clients in share classes that charged 12b-1 fees, the firm was indeed acting in its clients’ best interests, he said.

A memorandum opinion written by Judge Crenshaw in April said that if the jury finds Pagliara’s testimony to be true, ‘then Defendants had no conflict of interest. They would have received the same compensation regardless of the strategy they pursued—whether through 12b-1 fees or an enhanced advisory fee—and they simply chose the strategy most beneficial for each client.’ If there is no conflict of interest, the firm could not have breached its duty to disclose such a conflict.

As for the SEC’s accusation that CapWealth failed to establish adequate compliance policies, it could be argued that CapWealth’s reduction of advisory fees addressed the conflict of interest created by its collection of 12b-1 fees.

Evidently, ‘the jury believed in our credibility and how we priced our services,’ Pagliara told Citywire days after the jury found in his firm’s favor.

Location, location, location

Putting aside for a moment the legal arguments at play, a few intangibles likely worked in CapWealth’s favor throughout the trial.

Veteran securities attorney Bill Singer pointed out that the United States District Court for the Middle District of Tennessee is a ‘relatively favorable venue’ for CapWealth, which is based in Franklin, Tenn.

‘A jury in Tennessee is likely not populated with folks who have contacts to the same extent to Wall Street as in other larger jurisdictions, and, more to the point, one is likely to encounter more distrust of “big government” and the SEC,’ Singer explained. 

Making matters worse was the heavy artillery the SEC brought to the battle. Pagliara noted the SEC’s staff comprised eight attorneys and paralegals, plus its expert witnesses, including at least one full-time SEC employee – a troupe that could be seen as a waste of government resources, especially by more conservative jurors.

‘That’s a lot of government staffing going up against little old CapWealth,’ Singer said. ‘For reasons that often escape me, the SEC never quite appreciates the optics of having that many “feds” enter a courtroom.’

The price of victory

Singer sees the SEC’s defeat as an embarrassment and a detrimental precedent-setter for the regulator.

‘More defendants will now be emboldened to reject settlement offers and force the government to prove its case,’ he said.

Many such defendants will lose. But the SEC’s court-related expenses will likely skyrocket, which, for better or worse, may force it to be more selective in filing complaints against registered firms. Pagliara said CapWealth spent roughly $1.5m defending itself, while the SEC spent ‘over $4m’ in an effort to collect what he said ‘would’ve ultimately come down to about $16,000 in “excessive” 12b-1 fees.’ The SEC did not have to pay CapWealth’s legal fees. 

‘I’m a taxpayer, too,’ Pagliara said. ‘There was no proportionality whatsoever. This was wrong.’