When I am engaged to defend a case, whether it’s a customer arbitration or a regulatory complaint, my clients typically get to the point, sooner or later, where they ask me two questions: (1) what do I think about their chances of winning, and (2) what’s it gonna cost me.  In many matters, the answer to the second question renders the answer to the first irrelevant.  If to take a case to trial would take many multiples of what it would cost to settle, most clients will opt, albeit reluctantly, to settle.

A recent decision in an SEC case highlights this situation extremely well.  In 2020, the SEC filed a complaint in federal court in Tennessee against CapWealth Advisors, its founder, Timothy Pagliara, and the firm’s managing director of wealth management, Timothy Murphy.  The complaint included the same group of charges that the SEC has brought against a number of advisors, basically alleging that the advisor failed to adequately disclose the conflict of interest created as a result of the advisor’s receipt of 12b-1 fees from the sale of certain mutual fund share classes (when other share classes, without 12b-1 fees, were available).  According to the SEC, this caused CapWealth’s customers to pay approximately $430,000 more in fees than they otherwise would have had to pay.

Notably, the SEC always frames these charges as a fraud case.  While most advisors – including some of my own clients – have chosen to settle – without any admission of liability – when faced with this situation, it remains that the findings baked into the settlement include the fraud finding.  As you would expect, that aspect of the settlement can make the deal difficult to swallow.  I mean, who wants to have to explain to clients, and prospective clients, that your settlement with the SEC includes a violation of some antifraud statute?

But, the fact is that nearly all advisors do settle, notwithstanding this issue, for the simple reason that the answer to the second question I identified above – the cost of defense – trumps the answer to the first question, i.e., is the case winnable.

In a break from the pack, these defendants essentially said, screw the cost of defense, we are going to fight the SEC, and dare the government to prove its case in court.

Well, sure enough, they beat the SEC.  The result?  No findings of any rule violations, including any fraud findings.  That would seem like an ideal outcome.

Or was it?  The problem:  according to public reports, it cost CapWealth $1.5 million in legal fees to obtain this result.  I have no idea how much the SEC would have agreed to settle for, but, based on settlements in other cases involving similar allegations, I would expect that there would have been some civil monetary penalty imposed and an obligation to disgorge the (supposed) excess fees that the SEC identified.  Would that have amounted to $1.5 million?  Perhaps not.

But, let’s presume, for the sake of discussion, anyway, that the total price tag for the settlement would have been half of the $1.5 million that CapWealth paid.  Would it be worth settling, despite the finding of fraud, if it would save you $750,000?  I expect that a lot of firms, perhaps most, would say, 100%, yes, I would settle to save that much money.

The point is simple:  the decision to settle or to fight is an expensive one.  Few firms, and even fewer individuals, have the luxury of ignoring the cost of defending a case when deciding how to respond to a complaint.  And that is just the sad reality of things.  Certainly, claimants’ counsel know this when they file arbitrations against BDs.  They know that no matter how baseless a claim may be, there is no easy, cheap way out for the BD.  And, because of this, many BDs will elect to settle – so-called “nuisance” settlements – simply to avoid the expenses associated with a vigorous defense.

Ultimately, I am not sure what the lesson here is.  One the one hand, I applaud Mr. Pagliara, Mr. Murphy and CapWealth for having the backbone, and the wallet, to fight the SEC (and I applaud the great job their counsel did).  On the other hand, I can only wonder whether, even given the outcome of the trial, they question their decision to do so, given the cost.[1]

[1] It is worth pointing out the defendants here benefitted from the fact that the SEC filed its complaint in court, rather than initiating an administrative proceeding.  Had the Division of Enforcement filed the latter, then the Division would have had the opportunity to file an appeal from the adverse decision to the SEC itself (where, if history teaches, the rejection of the charges by the court would have been reversed).  And that, of course, would have added even more to the defense costs.