RIA Compliance Blog
Earlier this month, the Securities and Exchange Commission filed its first-ever civil lawsuit seeking to enforce Regulation Best Interest. The case, filed in a federal district court in California, seeks permanent injunctions, disgorgement with prejudgment interest and civil penalties against broker-dealer Western International Securities Inc. and five of its registered representatives. Regulation Best Interest, also known as “Reg BI,” became effective in mid-2020, requiring broker-dealers and their associated persons to act in the best interest of their retail clients when making recommendations.
Reg BI does not apply to registered investment advisers, but, at the time of its adoption in 2019, the SEC issued guidance in which it affirmed and substantially clarified its view of what investment advisers must do to comply with their fiduciary obligations to their clients. Among those obligations is to act in the client’s best interests at all times. Both broker-dealers and investment advisers are required to deliver Client Relationship Summaries to their clients and prospective clients at various times. This document, among other things, describes conflicts of interests the firm has relating to the services it provides or the fees it receives.
The complaint alleges that Western sold approximately $13 million debt securities to at least seven retirees and other clients whose risk profiles didn’t match the investments. The debt securities in question, “L Bonds” issued by GWG Holdings Inc., are high-risk, unrated bonds, according to the complaint. The marketing material for the L Bonds, including the prospectus, stated they are high-risk investments that should only be purchased by investors who have sufficient resources to weather a steep decline in the value of the bonds. It further warned they are not suitable for customers who require liquidity in their portfolios.
The Commission alleges that the bonds were recommended and sold to the customers even though Western lacked a reasonable basis to conclude that the bonds were in the customers’ best interests. Specifically, the SEC alleges that the customers in question all had moderate risk tolerances, as opposed to the high risk tolerance suggested by the marketing material and the nature of the bonds.
The SEC further alleged that the representatives who sold the bonds did not themselves understand the key risks of investing in them. Therefore, neither the firm nor the individuals exercised the “reasonable diligence” nor the “reasonable care” required by Reg BI.
The SEC also cites Western for failing to comply with Reg BI’s requirement that firms establish and enforce written policies and procedures designed to achieve Reg BI compliance.
Although this is the SEC’s first legal action regarding Reg BI, the Financial Industry Regulatory Authority issued a report of its examination findings and risk monitoring guidance in February of this year, explaining in detail the types of deficiencies relating to Reg BI that its examiners were observing in their examinations of broker-dealers. Furthermore, in March of this year, the SEC issued a Staff Bulletin, in the form of questions and answers, describing detailed scenarios and what actions a broker-dealer or an investment adviser must take to comply with their respective best interest standards.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.