SEC Files First Reg BI Action Against Broker-Dealer

Seward & Kissel LLP

On June 15, 2022, the Securities and Exchange Commission (“SEC”) filed a complaint against California-based broker-dealer Western International Securities, Inc. (“Western”) alleging violations of Regulation Best Interest (“Reg BI”).1 This is the first enforcement action the SEC has brought under Reg BI, offering a view into how it intends to enforce the new measure.

Background

The SEC adopted Reg BI on June 5, 2019, as part of a package of rulemakings and interpretations focused on enhancing the quality and transparency of relationships between retail investors and their investment advisers and broker-dealers, including the new Form CRS Relationship Summary, a brief customer relationship summary providing for disclosure of information, among other things, about firms’ services, fees, conflicts of interest, and any legal disciplinary history.2 Reg BI requires broker-dealers to act in the best interest of retail customers3 when making recommendations involving securities transactions or investment strategies involving securities to retail customers.

In 2021, the SEC brought enforcement actions against 21 investment advisers and six broker-dealers who failed to timely provide to retail customers Form CRS. The SEC settled the 27 claims for a total of $910,092 in penalties. The complaint against Western, however, marks the first time the SEC has alleged a violation of Reg BI itself.

Reg BI imposes on broker-dealers obligations of “Disclosure,” “Care,” “Conflict of Interest,” and “Compliance.” As relevant here, the “Care” obligation requires a broker-dealer and its representatives recommending a securities transaction to exercise reasonable diligence, care, and skill to understand the potential associated risks, rewards, and costs. The broker-dealer and its representatives must have a reasonable basis to believe the recommendation is in the customer’s best interest, based on those factors and the customer’s investment profile. Under the Care obligation, the broker-dealer must effectively train its representatives about Reg BI’s standards, including the risks involved in particular investments. The “Compliance” obligation requires the broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI.

The Complaint

The complaint alleges that Western sold over $13 million in high-risk debt securities called “L Bonds” to customers whose risk profiles did not match the nature of the investment. The L Bonds were unrated corporate bonds offered by GWG Holdings Inc. (“GWG”), a publicly traded company based in Texas that had recently changed the focus of its business from acquiring life insurance policies on the secondary market to providing liquidity to holders of illiquid investments and alternative assets. GWG sold the L Bonds in a June 2020 offering, paying fixed interest rates between 5.5% and 8.5% with a minimum investment of $25,000. The bonds’ prospectus disclosed the risk of losing the entire investment in the speculative financial instruments and that the bonds were suitable only for individuals with substantial financial resources and no need for liquidity.

The SEC alleges that Western and five of its registered brokers violated the Care obligation of Reg BI by selling the L Bonds, without understanding the key risks of the bonds and GWG, to retail customers with moderate risk tolerances, many of whom were retirees. Additionally, the SEC alleges that Western violated the Compliance obligation of Reg BI because its written policies and procedures merely recited the objectives of Reg BI, without offering specific guidance to their brokers based on its operations. Western also allegedly had inadequate procedures for enforcing its Reg BI compliance policies.

The SEC is seeking permanent injunctions, civil penalties, and disgorgement with prejudgment interest from Western and the five brokers. The SEC alleges that in total, the brokers earned commissions between roughly $5,400 and $32,500 for the L Bond sales, and Western received approximately $187,000 in commissions and fees.

S&K Observations

Reg BI was intended to enhance the standard of conduct for broker-dealers beyond the “suitability” standard (under FINRA Rule 2111) to require that broker-dealers not put their financial interest before the interests of their retail customers. The SEC’s action against Western demonstrates that the SEC intends Reg BI to have teeth and may bring further clarity concerning broker-dealers’ obligations thereunder. In the meantime, what is clear is that to satisfy the Compliance obligation of Reg BI, a mere boilerplate recitation of the regulation itself will not suffice, and compliance policies and procedures should be tailored specifically to a broker-dealer’s operations. Firms should focus on training to help ensure that their brokers understand their retail customers’ risk profiles and investment objectives to satisfy the best interest requirements brokers have for each investment they recommend.

 

1 See https://www.sec.gov/litigation/complaints/2022/comp-pr2022-110.pdf.

2 See https://www.sewkis.com/practices/private-equity/publications/secs-new-rule-15l-1-regulation-best-interest-standard-of-conduct-requiring-broker-dealers-to-act-in-the-best-interest-of-retail-customers/.

3 Reg BI defines a retail customer as “a natural person, or the legal representative of such natural person, who: (A) receives a recommendation of any securities transaction or investment strategy involving securities from a broker-dealer; and (B) uses the recommendation primarily for personal, family, or household purposes.” Therefore, any natural person, regardless of status (for example as an accredited investor, qualified client or qualified purchaser) is a retail customer under Reg BI.”

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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