And Now for the SEC’s First Substantive Reg BI Action

We have made it a point previously in this blog to track developments of the SEC’s Regulation Best Interest (Reg BI), even speculating more aggressive enforcement actions could be coming due to certain Reg BI deficiency letters sent to firms late last year. Since Reg BI went into effect in June 2020, however, many have waited with bated breath to see what enforcement of the regulation would look like in practice. While the SEC has pursued some cases regarding firms missing deadlines and omitting certain information in disclosure documents, it had taken no further action until June. On June 15, 2022 the SEC finally took its first substantive Reg BI action by filing a civil regulatory complaint in the U.S. District Court for the Central District of California against Western International Securities, Inc. and five of its brokers for allegedly selling a risky debt security, known as corporate L Bonds, to its retail customers. The Complaint invokes Section 15l-1(a) of the Securities and Exchange Act of 1934 — Regulation Best Interest — and seeks to enjoin the Defendants from the acts, practices and courses of business described in the Complaint.

Western and the Defendant brokers who were all independent contractors of Western sold L Bonds, which were offered by GWG Holdings, Inc. The Complaint alleges these L Bonds were “high risk, illiquid, and only suitable for customers with substantial financial resources.” Between July 2020 and April 2021, Western’s brokers recommended and sold approximately $13.3 million of its corporate L Bonds. Western received a commission of 3.25-5% of the value of each L Bond and its independent brokers received 85-90% of that commission with Western receiving the remaining approximate 10% of the commission. In addition, Western received .75% of the total value of each 2-year and 3-year L Bond it sold and 1% of the total value of every 5- and 7-year Bond it sold. The Defendant brokers received aggregate commissions each of between approximately $5,400 and $32,500 for the sales of the L Bonds during this time period. The SEC claims that Western and its brokers ran afoul of Reg BI by recommending L Bonds to retail customers without a reasonable basis to believe the investments were in those customers’ best interest. The SEC accused Western of 1) not meeting the Reg BI Care Obligation, which requires brokers to understand the risks, rewards and costs associated with the products before recommending them, and 2) not meeting the Reg BI Compliance Obligation, which requires creating, maintaining, and enforcing written policies and procedures that adhere to Reg BI. Western had conducted training of the brokers but the SEC alleges the training was not sufficient. It also had written supervisory procedures, but the SEC alleges those, too, were lacking as was supervision.

Western’s time to answer has been extended until September 14, 2022. Therefore, it is still early in this litigation. However, earlier this month, there was a FINRA action filed in Los Angeles against Western also alleging that Western failed to undertake reasonable due diligence before selling GWG L Bonds to its customers.

FINRA reports the top 15 categories of complaints filed in its forum. For the first time since June 30, 2020, when Reg BI became enforceable, Reg BI claims are among the top 12 categories of FINRA claims.

Some considered the June 2022 Western complaint to be Chairman Gary Gensler’s first step in making good on his promise to put some teeth into Reg BI, after over a year of failing to do much of anything. The Director of Investor Protection at the Consumer Federation of America, Micah Hauptman, called the SEC enforcement “welcome news” and said that the SEC is entering a “more aggressive enforcement of Reg BI” that will send a “powerful message to the brokerage industry that business as usual won’t be tolerated.” However, others, like the president of the Institute for the Fiduciary Standard, Knut Rostad, are not nearly as convinced. Mr. Rostad believes it was “not a Reg BI case,” but “a suitability case,” which was the Pre-Reg BI standard for brokers. The suitability standard requires that a broker make recommendations that are suitable based on a client’s personal situation, but the standard does not require the advice to be in the client’s best interest over and above that of the broker’s interest.

We believe Western is a Reg BI case. In Western, the clients were given disclosures and they made representations about their qualifications to own the L Bonds. Notwithstanding this, the SEC claims the disclosures made to the clients and representation from the clients still did not make the bonds in these seven clients’ best interest. Arguably even without Reg BI, the L Bonds would have been found unsuitable for these clients given their risk tolerances, age, sophistication, and retirement status. However, it is also clear that merely going through the disclosure motions without assessing the particular product for the particular client raises to the level of violating Reg BI. In fact, many of what Western is alleged to have lacked is what FINRA found lacking in its examination of broker-dealers in the 2022 Report on FINRA’s Examination and Risk Monitoring Program. Western is likely the bellwether of things to come for SEC enforcement of Reg BI and where the SEC goes, FINRA is sure to follow. Watching the Western case unfold should be illuminating.

This may be a good time to review the 2022 Report on FINRA’s Examination and Risk Monitoring Program and compare its findings to your training, supervision and WSPs. Enforcement is clearly the theme for 2022; therefore, if you have not yet done so, it is time to ensure your firm will meet the standard. We are happy to assist you in doing so.

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About the Author: Sandra D. Grannum

Sandra Dawn Grannum concentrates her practice on securities, broker/dealer arbitration, litigation, mediation and regulatory defense. She is co-chair of the Commercial Litigation Team.

Sandy has tried complex multimillion-dollar arbitrations before FINRA, AAA and JAMS across the country. She has represented brokerage firms, banks, clearing firms, and associated persons in over 60 arbitrations before the NASD and FINRA which have been tried through award. In addition, she has successfully pursued cases in state and federal courts and in adversarial proceedings before bankruptcy courts.

About the Author: Emmanuel L. Brown

Emmanuel L. Brown represents a range of clients involved in litigation. He assists at various stages of legal proceedings and trial preparation, including legal research, writing motions, and drafting other memoranda. Prior to joining the litigation group, Manny worked in the firm’s corporate and securities group for two years on matters related to finance, securities and mergers and acquisitions.

About the Author: Jamie L. Helman

Jamie L. Helman concentrates her practice on securities, broker-dealer arbitration, litigation, mediation, employment matters, and regulatory defense. She has experience first-chairing FINRA arbitrations, defended on-the-record testimony of broker-dealer employees before FINRA, and is presently involved in the representation of broker-dealers in several pending FINRA cases as well as regulatory matters.

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