FINRA Lawyer Blog
In April 2018, the SEC proposed a new regulation that would govern the standard of conduct that applies when broker-dealers make recommendations to retail customers. Specifically, the proposal sought to established an express best interest obligation that would require all broker-dealers and associated persons to act in the best interests of their retail customers at the time a recommendation is made without placing the financial or other interests of the broker-dealer or associated person ahead of the interests of the retail customer.
At the time, the Commission received over 6,000 comments on the proposed rule. Ultimately, in July 2019, the SEC adopted Rule 15l-1(a) of the Securities Exchange Act of 1934 (“Reg BI”). On June 15, 2022, the SEC filed the first complaint for a violation of Reg BI since it was enacted. The SEC filed a complaint against Western International Securities, Inc. (“Western”) and five of its registered representatives for violating Reg BI in connection with the sale of high risk, illiquid and unrated debt securities known as L Bonds issued by GWG Holdings, Inc. (“GWG”).
Compliance with Reg BI consists of four components: the Disclosure Obligation, the Care Obligation, Conflict of Interest Obligation, and the Compliance Obligation. Registered representatives must comply with the Disclosure Obligation and the Care Obligation, which include:
- The Disclosure Obligation requires a written disclosure to the customer at the time a recommendation is made of all the material facts relating to the investment including, among other things, all costs and fees that may apply to the customer’s account.
- The Care Obligation requires that the firm’s registered representatives exercise reasonable diligence, care, and skill to understand the product being recommended including risks, reward and costs.
- The Conflict of Interest Obligation requires a firm to identify and disclose all conflicts of interest that may exist in connection with a particular investment recommendation.
- The Compliance Obligation is the most straightforward of the four obligations as it simply requires a firm to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest
Between July 2020 and April 2021, Western’s registered representatives sold approximately $13.3 million L Bonds to their retail customers. The Commission’s complaint faults Western for not establishing any criteria or thresholds for a customers’ financial resources before investing in L Bonds. The Commission also noted that Western’s Chief Compliance Officer reviewed a due diligence report on the L Bonds but did not distribute the report to Western’s registered representatives. The most significant issue it seems from reading the SEC’s complaint is that the registered representatives did not understand the product. In particular, Western’s registered representatives actually took a training course on the L Bonds but were not aware of a significant change to GWG’s business model that made the 2020 issuance of L Bonds very different in terms of their risk profile from the L Bonds issued in previous tranches.
The SEC concluded that L Bonds might be appropriate for “certain customers willing to accept a substantial degree of risk” but the registered representatives recommended L Bonds to customers who did not fit that profile. This “mismatch” meant that the registered representatives did not “demonstrate reasonable diligence, care or skill in determining that the L Bonds were in their customer’s best interests.”
The SEC also found Western’s policies and procedures were insufficient with regard to Reg BI. Interestingly, Western’s procedures were “substantially copied” from a Small Entity Compliance Guide that was published by the SEC. As such, the SEC found the policy too generic and not tailored to Western’s business. The policy also lacked an enforcement mechanism. The SEC’s prayer for relief included a request for an injunction, disgorgement of commissions earned and a civil penalty in an unspecified amount.
Perhaps most significantly, despite the financial industries’ understandable interest in Reg BI, it is hard to discern a significant difference between the obligations of Reg BI and the existing suitability obligations that have existed for years under FINRA Rule 2111. The SEC recitation of alleged wrongdoing by Western and its employees could just have easily amounted to a finding that they sold L Bonds that were not suitable for their clients in violation of FINRA Rule 2111. Based upon the SEC first invocation of Reg BI, It is not clear what Reg BI adds to the existing regulatory enforcement scheme.
Herskovits PLLC has a nationwide practice defending against investigations and actions filed by the SEC. Feel free to call us for a consultation at (212) 897-5410.