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High Risk, No Reward: SEC’s First Reg BI Enforcement Action

Brokers beware: Reg BI is dormant no longer. Last week, the Securities and Exchange Commission (“SEC”) filed its first enforcement action alleging violations of Regulation Best Interest” (“Reg BI”), charging Western International Securities Inc. (“Western”) and five of its registered representatives. The SEC’s complaint alleges that, between July 2020 and April 2021, Western sold $13.3 million in high-risk “L Bonds,” and that at least some of these bonds were sold to risk-averse customers for whom the bonds were not in their best interest. The SEC seeks an injunction preventing Western and its representatives from further violating Reg BI, disgorgement of profits generated from the allegedly improper transactions, and the imposition of civil penalties.

Regulation Best Interest

Reg BI, which went into effect in June 2020, prohibits brokers from placing their own financial interest ahead of that of their retail customers when making investment recommendations.  In short, Reg BI requires that retail customers’ interests always come first (the “Best Interest Obligation”). For firms, meeting the Best Interest Obligation requires complying with four component obligations: Disclosure, Care, Conflict of Interest, and Compliance. Individual registered representatives, too, are bound by the Disclosure and Care Obligations. As the SEC’s complaint explains, Reg BI requires ‘“matching’ the recommended security to the retail customer’s investment profile.”  In explaining the importance of Reg BI, SEC Regional Director Daniel R. Gregus explained, “[p]rotecting retail investors is one of the fundamental duties of the SEC.”  See SEC Press Release, “SEC Charges Firm and Five Brokers with Violations of Reg BI.”

Care Obligation

Under Reg BI, the Care Obligation requires that broker-dealers make investment recommendations with reasonable care and diligence, as well as with an understanding of the risks, rewards, and costs associated with each investment. Additionally, brokers-dealers must have a reasonable basis to believe that every recommendation is in the best interest of the customer based on the customer’s particular risk tolerance, investment experience, and investable assets, among other considerations. In order to comply with this obligation, broker-dealers must ensure they are adequately informed of the risks involved with each investment and must recommend investments to clients based on their individual investment goals and financial situations.

A firm breaches its Care Obligation when it fails to adequately train its representatives about Reg BI’s standards or the risks involved with a particular type of investment. As the risks associated with each investment change over time, the provision of ongoing training is required in order for a firm to meet its Care Obligation.

Compliance Obligation

Reg BI’s Compliance Obligation requires that broker-dealers establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with the regulation. A firm is expected to tailor policies and procedures to its particular business and should include methods of enforcement and supervision.

The June 16 complaint charges Western and five of its representatives – Nancy Cole, Patrick Egan, Andy Gitipityapon, Steven Graham, and Thomas Swan – with violations of Reg BI arising from the sale of high-risk, illiquid, and unrated securities. The complaint alleges that Western and its individual brokers allegedly sold these high-risk L Bonds to risk-averse clients on at least seven occasions, totaling approximately $13.3 million.

The L Bonds were issued by GWG Holdings, Inc. (“GWG”). The L Bonds, according to GWG’s 2020 Prospectus, were so speculative that they are “only suitable for those with substantial financial resources and no need for liquidity.” The SEC alleges that they were “high risk” and that Western knew these risks, failed to adequately train its representatives with regard to them, and approved transactions without adequately evaluating the risks to the individual customers.

The seven retail clients referenced in the complaint ranged from 54-79 years old and, according to the complaint, had “moderate-conservative or moderate risk tolerances, investment objectives that did not include speculation, limited investment experience, limited liquid net worth, and/or they were retired.” In each case, the L Bonds purchased by Western’s broker on his or her behalf constituted between 8 and 33% of the client’s investable assets. Despite many of the clients expressing an interest in protecting their principal, Western representatives sold the bonds to them, allegedly claiming that the investments were low-risk.  That alleged representation was false, and the sales of L Bonds generated large commissions and substantial fees for Western and its individual brokers.

The SEC has charged Western with failure to comply with the Compliance Obligation for failure to adequately maintain policies and procedures that ensure compliance with Reg BI. The complaint alleges that Western’s policies and procedures were “not reasonably designed to achieve compliance with Reg BI’s Care Obligation requirement that its registered representatives understand the potential risks, rewards, and costs associated with their recommendation of L Bonds.” Although Western had a system in place, the SEC argues that it was boilerplate and largely unenforced. In addition, the SEC seeks to impose liability on Western because it allowed these transactions without requiring a reasonable rationale for why L Bonds were chosen over other, less speculative investment options.

According to the SEC’s complaint, the five named Western representatives violated Reg BI by providing “unreasonable, vague, and generic” rationales for why they sold L Bonds to risk-averse clients. In the seven instances cited by the SEC, the clients are said to have had low risk tolerances, objectives that did not include speculation, limited investment experience, and/or limited liquid net worth. The SEC alleges that the each broker knew these characteristics and either knew the risks associated with L Bonds or sold the bonds without adequately educating themselves on the risks, both of which are actionable under Reg BI.  According to the complaint, “[g]iven the mismatch between these customers and the high-risk L Bonds, these Registered Representative Defendants did not demonstrate reasonable diligence, care, or skill in determining that the L Bonds were in their customers’ best interests” and therefore violated Reg BI.

Compliance with Reg BI

In May 2021, SEC Chair Gary Gensler promised to make Reg BI an effective SEC regulation. It is yet to be clear whether this enforcement action will be the first of few or of many, but it provides valuable insight into how the SEC may seek to enforce the Best Interest standard in the future. As Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, explained, “Reg BI is clear: broker-dealers must act in the best interest of their customers . . . When they fail to do so, as we allege happened here, they put retail investors at risk and we’ll hold them accountable.” 

Even after the filing of the Western enforcement action, it remains somewhat unclear how SEC’s enforcement of Reg BI differs from its longstanding “suitability” standard.  Nevertheless, in order to comply with Reg BI, it is clear that broker-dealers and their registered representatives must exercise diligence to understand their individual clients’ risk profiles and investment objectives, as well as to learn the risks associated with each investment they may recommend.  Broker-dealers should also take a hard look at their compliance policies and training programs and ensure that these policies are appropriately-tailored and effectively enforced.  Most importantly, broker-dealers and registered representatives must always ensure that the individual customer’s needs and interests are put first in making any investment recommendations, especially in cases where large commissions and fees will be generated for the brokers and firm.  Such transactions may catch the attention of regulators, and brokers need to be ready to provide reasoned, valid bases for their recommendations, focused first and foremost on the clients’ best interests.

Thanks to Mintz summer associate Andrew Bobbitt for his valuable contribution to this blog post.

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Pete S. Michaels

Member / Co-Chair, Financial Services Practice

Pete S. Michaels is a Mintz attorney who focuses his practice on securities litigation, regulatory proceedings involving financial service companies and products, and compliance matters. He represents financial services firms and insurance companies and their employees, directors, and officers.

Michael E. Pastore

Special Counsel

Michael E. Pastore is a Special Counsel who represents banks, financial services, and other companies in litigation and government proceedings involving consumer protection and other laws. He also handles arbitrations and guides clients through government and internal investigations.

Alyssa C. Scruggs