Sec. & Exch. Comm'n v. Westport Capital Mkts. LLC.

• Citation: 408 F.Supp.3d 93
• Decision Date: 30 September 2019
• Docket Number: No. 3:17-cv-02064 (JAM),3:17-cv-02064 (JAM)
• Court: U.S. District Court — District of Connecticut
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. WESTPORT CAPITAL MARKETS LLC. et al., Defendants.

408 F.Supp.3d 93

SECURITIES AND EXCHANGE COMMISSION, Plaintiff,

v.WESTPORT CAPITAL MARKETS LLC. et al., Defendants.

No. 3:17-cv-02064 (JAM)

United States District Court, D. Connecticut.

Signed September 30, 2019

Michael Christopher Moran, Kathleen Burdette Shields, Securities & Exchange Commission, Boston, MA, John B. Hughes, U.S. Attorney's Office, New Haven, CT, for Plaintiff.

Richard Levan, Pro Hac Vice, Levan Legal LLC, Jon-Jorge Aras, Bala Cynwyd, PA, Brian E. Spears, Joseph W. Martini, Spears Manning & Martini LLC, Southport, CT, Robert S. Hoff, Wiggin & Dana LLP, Stamford, CT, for Defendants.

ORDER GRANTING IN PART AND DENYING IN PART SEC'S MOTION FOR SUMMARY JUDGMENT

Jeffrey Alker Meyer, United States District Judge

The Investment Advisers Act of 1940 was enacted "to achieve a high standard of business ethics in the securities industry." SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. 180, 186, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963). To this end, the Act imposes on investment advisers "an affirmative duty of utmost good faith, and full and fair disclosure of all material facts" about their services to their clients. Id. at 194, 84 S.Ct. 275. In particular, investment advisers must tell their clients about "all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which [is] not disinterested." Id. at 191-92, 84 S.Ct. 275.

The Securities and Exchange Commission (SEC) has filed this action under the Investment Advisers Act against two defendants: an investment company named Westport Capital Markets, LLC, and its owner and chief executive officer Christopher E. McClure. According to the SEC, Westport and McClure failed to disclose a conflict of interest they had due to secret profits they earned from trading on securities in their clients' investment accounts.

The SEC has now moved for summary judgment. I will grant the SEC's motion in part and deny it in part. On the one hand, I conclude that genuine fact issues remain as to the SEC's claims that Westport and McClure intentionally or recklessly defrauded their clients and that they willfully made false statements to the SEC. On the other hand, I conclude that no genuine fact issue remains as to the SEC's claims that Westport and McClure negligently failed to disclose their conflicts of interest to their clients and that they failed to advise and obtain their clients' consent to transactions in which they sold securities to their clients as a principal and at a profit from their own account.

BACKGROUND

Westport is a financial investment company that serves a wide range of clients. McClure owns Westport, and he wears just about every hat of importance in the company: he is the president, chief executive officer, chief financial officer, and chief compliance officer. As the firm's chief compliance officer, McClure is responsible for the accuracy of the firm's financial reports and for understanding what goes into those reports. Doc. #58-1 at 1-3 (¶¶ 1-2, 4).¹

Westport is dually registered under the securities laws as both a broker-dealer and an investment adviser. When acting as a broker-dealer, Westport carries out its clients' trading orders and is compensated by means of sales commissions. But when acting as an investment adviser, Westport has discretion to decide what trades to make on its clients' behalf, and its clients pay a negotiated annual fee for Westport's services pegged to the size of the account. Doc. #58 at 1. The SEC regulates Westport in its capacity as an investment adviser, while the Financial Industry Regulatory Authority (FINRA) regulates Westport in its capacity as a broker-dealer. Doc. #58 at 1 n.2.

The trouble for Westport began in 2011 when it entered into arrangements to act as a "selling dealer" for initial or secondary syndicate offerings of securities on the public market. Westport would buy an allocation of newly-offered securities from an underwriter for its own account at a discounted "concession" price and then immediately resell these securities at the (invariably higher) "prevailing market" price to both its brokerage clients and its advisory clients. Over the years, Westport engaged in nearly 1,400 such purchase transactions on behalf of its advisory clients, and more than 1,000 of these transactions involved clients whose accounts McClure personally managed. Doc. #58-1 at 4-5, 10 (¶¶ 9-10, 22).

McClure personally reviewed the trading in Westport's trading accounts on a daily basis, and the daily trading logs showed that the seller-dealer offerings were being sold from Westport's own account to advisory client accounts at a higher price than the discounted price that Westport had paid for them. Id. at 28-29 (¶ 57). The sales of these syndicated shares from Westport's account to advisory clients resulted in compensation of about $650,000 for Westport from 2012 to 2015, all of which was over and above the $1.7 million that Westport charged in advisory fees to those same clients. McClure personally received about $530,000 of this $650,000 from Westport clients he personally advised. Id. at 6 (¶ 12).

Westport also invested some of its advisory clients' money in mutual funds. Mutual funds have various share classes in which one can invest, and the most important classes for present purposes are "Class A shares," which carry a "12b-1 fee" that is paid by the mutual fund to broker-dealers like Westport, and "institutional class" or "adviser class" shares, which do not. Westport opted to purchase Class A shares for many of its clients between 2012 and 2017, allowing it to earn $105,968 in 12b-1 fees on top of its usual advisory fees and on top of the profits it earned from selling discounted syndicate shares to these advisory clients at the market rate. McClure personally received compensation from the 12b-1 fees that were attributable to his advisory clients' mutual fund investments. Id. at 12-15 (¶¶ 25-26, 28-30).

According to the SEC, Westport could have avoided the 12b-1 fees for $96,834 of the total $105,968 in fees by buying institutional class shares rather than Class A shares. Id. at 13 (¶ 29). But Westport and McClure dispute the degree to which they could feasibly have done so, alleging that Westport's trading platform allowed ready access to institutional class shares beginning only in March 2015, and that McClure bought institutional class shares for his clients whenever they were available, after Westport switched to a different trading platform. Id. at 13-21 (¶¶ 29-39).

The SEC points to two specific clients of McClure as examples of the defendants' behavior. The first example is Henry Atterbury III, who switched from a brokerage account to an advisory account after McClure suggested that he do so. McClure then bought syndicate shares for Atterbury's account from Westport's account to generate about $134,000 in compensation for Westport due to the difference between the price that Westport paid for the shares and the price that it resold the shares to Atterbury's account. All of this was on top of the $139,000 paid to Westport in quarterly advisory fees. Id. at 34-36 (¶¶ 67-69).

The second example is an account held for the executors of the estate of Sylvia Stein. After the executors accepted McClure's suggestion to convert the account from a brokerage account to an advisory account, McClure made purchases of syndicate shares in the manner described above to generate $87,000 in compensation for Westport—on top of the approximately $131,000 charged to the account in advisory fees. In addition, McClure bought mutual fund shares for the account, resulting in yet more compensation for Westport by means of 12b-1 fees. Id. at 36-41 (¶¶ 70-73).

The parties agree that all the transactions as described above took place. They also agree that it was a conflict of interest for Westport to be earning this additional compensation and that the Investment Advisers Act required that Westport disclose this conflict of interest to its advisory clients. Id. at 21, 30 (¶¶ 41, 61). But Westport or McClure never personally discussed with any of their advisory clients how they were generating additional compensation from transactions involving syndicate share sales or 12b-1 fees. Id. at 25, 29-30 (¶¶ 49, 60). Instead of pointing to any client-specific advisories, Westport and McClure contend that they satisfied their disclosure requirements by means of statements they made in certain Investment Adviser Brochures, known as "Forms ADV" that were signed by McClure and that Westport periodically sent to their clients as well as filed with the SEC. Ibid.²

Westport principally relies on the disclosure that it made in Item 5 of Part 2A of the Forms ADV that it sent to clients and filed with the SEC:

Where the firm is dually registered as an investment adviser and broker-dealer and licensed to sell various forms of insurance, firm personnel may receive additional commission-based compensation for their work on behalf of the firm. Sales of insurance, mutual funds, initial public offerings (to qualified clients), bonds, and other offerings may result in a commission which is paid in addition to the advisory fee.... Receipt of both commission and fee-based compensation create a conflict of interest, as this practice gives the firm and its supervised persons an incentive to recommend products based on the compensation received, rather than on a client's needs. The firm and its supervised persons have a fiduciary obligation to act in the best interest of the firm's clients. Further, clients should note that they are under no obligation to pursue such investment offerings through Westport. Questions regarding the firm's fees and/or its advisory/brokerage services may be addressed directly with the firm.

Doc. #47-34 at 3 (2013 Forms ADV); see also Docs. #47-32 to #47-39 (additional Forms ADV with the same or broadly similar language); Doc. #58-1 at 22-24 (¶¶ 43-44) (relying on and quoting portions of...