Enforcement News: SEC Charges Registered Broker-Dealer and Five of Its Registered Representatives with Violating Best Interest Obligation Regulations

• Posted on: Jun 24 2022

By: Jeffrey M. Haber

On June 5, 2019, the Securities and Exchange Commission (“SEC” or the “Commission”) adopted “Regulation Best Interest” or “Reg BI”.¹ In connection with adoption of the regulation, the SEC issued a 175-page release in which it offered guidance on how the Commission interprets Reg BI.²

The regulation established a standard of conduct for broker-dealers and associated persons when they recommend securities transactions to retail customers. Reg BI is intended to enhance the broker-dealer standard of conduct beyond existing suitability obligations, by requiring broker-dealers to, among other things: act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker-dealer ahead of the interests of the retail customer; and address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest.

Reg BI is satisfied by compliance with four component obligations: (1) Disclosure Obligation, (2) Care Obligation, (3) Conflict of Interest Obligation, and (4) Compliance Obligation.

Under the Disclosure Obligation, before or at the time of the recommendation, a broker-dealer must disclose, in writing, all material facts about the scope and terms of its relationship with the customer. This includes a disclosure that the firm or representative is acting in a broker-dealer capacity; the material fees and costs the customer will incur; and the type and scope of the services to be provided, including any material limitations on the recommendations that could be made to the retail customer. Moreover, the broker-dealer must disclose all material facts relating to conflicts of interest associated with the recommendation that might incline a broker-dealer to make a recommendation that is not disinterested, including, for example, conflicts associated with proprietary products, payments from third parties, and compensation arrangements. 

The Care Obligation requires a broker, dealer, or associated person to exercise reasonable diligence, care, and skill to understand the potential risks, rewards, and costs associated with a recommendation of a securities transaction to a retail customer. The Adopting Release states that what constitutes reasonable diligence depends on, among other things, the complexity of, and risks associated with, the recommended security.

The Care Obligation also requires a broker, dealer, or associated person to exercise reasonable diligence, care, and skill to have a reasonable basis to believe that the recommendation is in the best interest of the particular retail customer, based on that customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation. 

The Adopting Release states that what is in the best interest of a retail customer depends on the facts and circumstances of the recommendation, including “matching” the recommended security to the retail customer’s investment profile. Where the “match” between the retail customer profile and the recommendation appears less reasonable, it is more important for the broker to establish that it had a reasonable belief that the recommendation was in the best interest of the retail customer. The Adopting Release also states that, in addition to “matching” the recommendation to the customer’s suitability profile, a registered representative should also exercise reasonable diligence, care, and skill to consider reasonably available alternatives.

Under the Conflict of Interest Obligation, a broker-dealer must establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with its recommendations to retail customers. These policies and procedures must be reasonably designed to identify all such conflicts and at a minimum disclose or eliminate them. Importantly, the policies and procedures must be reasonably designed to mitigate conflicts of interests that create an incentive for an associated person of the broker-dealer to place its interests or the interest of the firm ahead of the retail customer’s interest.

Moreover, when a broker-dealer places material limitations on recommendations that may be made to a retail customer (e.g., offering only proprietary or other limited range of products), the policies and procedures must be reasonably designed to disclose the limitations and associated conflicts and to prevent the limitations from causing the associated person or broker-dealer from placing the associated person’s or broker-dealer’s interests ahead of the customer’s interest. Finally, the policies and procedures must be reasonably designed to identify and eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.

The Compliance Obligation requires a broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI. According to the Adopting Release, a broker “should consider the nature of that firm’s operations and how to design such policies and procedures to prevent violations from occurring, detect violations that have occurred, and to correct promptly any violations that have occurred.”

In sum, Reg BI requires a broker, dealer, or associated person to act in the best interest of a retail customer when making a recommendation of a securities transaction (the “Best Interest Obligation”). Firms comply with the Best Interest Obligation if they comply with the foregoing four component obligations. Similarly, associated persons of broker-dealers comply with Reg BI’s Best Interest Obligation if they comply with the Disclosure Obligation and the Care Obligation.

In SEC v. Western International Securities, Inc., Case No. 2:22-cv-04119 (C.D. Cal.) (here), the SEC charged Western International Securities, Inc. (“Western”), a registered broker-dealer, and five of its registered representatives with violating the Best Interest Obligation when they recommended and sold an unrated, high-risk debt security known as L Bonds to retirees and other retail investors. These bonds were only suitable for customers with substantial financial resources. From July 2020 through April 2021, Western sold an aggregate of $13.3 million of L Bonds.³

The SEC alleged that, between July 2020 and April 2021, Western and the brokers recommended and sold L Bonds to retail customers, many of whom were on fixed incomes and had moderate risk tolerances, despite GWG’s warning that the L Bonds were high risk, illiquid, and only suitable for customers with substantial financial resources. According to the SEC, defendants failed to comply with Reg BI’s “Care Obligation” both because they did not exercise reasonable diligence, care, and skill to understand the risks, rewards, and costs associated with L Bonds, and also because they recommended L Bonds to at least seven particular customers without a reasonable basis to believe the bonds were in their customers’ best interests. 

The SEC also alleged that Western failed to comply with Reg BI’s “Compliance Obligation” because it did not adequately establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI.

Commenting on the filing, Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, stated: “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.”

“Reg BI is an essential tool for the protection of the best interests of retail investors,” said Regional Director, Daniel R. Gregus. “Protecting retail investors is one of the fundamental duties of the SEC, and a top priority of the Chicago Regional Office.”

The SEC’s press release announcing the filing of the complaint can be found here.

The SEC’s complaint against defendants can be found here.

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.

This article is for informational purposes and is not intended to be and should not be taken as legal advice.

Footnotes

1. The SEC set June 30, 2020 as the compliance date in order to give broker-dealers sufficient time to comply with Reg BI. On and after the compliance date, broker-dealers that provide recommendations of securities transactions or investment strategies that register with the Commission are required to comply with Reg BI as of the date of registration.
2. See Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 34-86031, 84 Fed. Reg. 33318 (July 12, 2019) (the “Adopting Release”) (here).
3. The L Bonds at issue paid fixed interest rates of between 5.50% and 8.50%, depending on the maturity period of the bond. The issuer, GWG Holdings, Inc., a publicly traded financial services company, offered maturity periods of two, three, five, or seven years.