The Securities and Exchange Commission (“SEC”) has moved into a new area of broker-dealer enforcement relating to suitability of securities transactions. Historically, SEC enforcement of broker-dealer misconduct involving suitability of trades centered on violations of Section 10(b) of the Securities Exchange Act of 1934 (“the Exchange Act”). Indeed, for decades, the SEC did not bring unsuitability actions in federal court without a federal fraud charge pursuant to Section 10(b). Proof of “scienter” or evil intent is required to support an SEC fraud claim. Conversely, if a 10(b) claim did not manifest itself during an SEC investigation, the SEC would refrain from bringing such an action or delegate the matter to other regulators such as the Financial Industry Regulatory Authority (“FINRA”).
However, the sands of change began to shift after the SEC drafted and adopted Regulation Best Interest (“Reg. BI”) in June 2019. Reg. BI established a new, heightened standard for the securities broker-dealer and their registered representative when selling securities through a broker-dealer. Whereas, prior to the adoption of Reg. BI, broker-dealers and their registered representatives were only required to have a reasonable basis that their recommendation was suitable, Reg. BI added many new conditions. It now requires the broker-dealer and its registered representatives also be able to demonstrate that the recommendation was in the best interest of the customer, without consideration of any competing interest by the selling broker-dealer or registered representative. In short, the recommendation must be viewed as being in the customers’ best interest based upon objective criteria. Indeed, Reg. BI’s criteria of best interest” standard is now defined in four separate rules. They are as follows:
Disclosure – A broker-dealer must disclose all material facts about the scope and terms of its relationship with the customer, including fees and costs the customer will incur, the type and scope of broker’s services, and any conflicts of interest the broker may have. Disclosure must be in writing at or before the time a recommendation is made.
Care – Requires a broker to exercise reasonable diligence, care and skill in making a recommendation. The Broker must understand the risks, rewards, and costs associated with a recommendation. The broker must then consider those risks, rewards and costs against the customer’s investment profile and have a reasonable basis to believe that a recommendation is in the customer’s best interest and does not place the broker’s interest ahead of the retail customer’s interest. A broker should consider reasonable alternatives offered by the broker.
Conflict of Interest – Establishing, maintaining, and enforcing policies and procedures reasonably designed to address conflicts of interest. These policies and procedures must be aimed at a minimum toward disclosing or eliminating such conflicts.
Compliance Obligation – Establishing, maintaining, and enforcing policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.
The SEC initially set a date by which Reg. BI would go into effect of June 30, 2020. This date came and went without much fanfare. The SEC remained largely quiet with no federal court enforcement actions against any alleged violators of Reg. BI. Many securities attorneys believed that FINRA, with its delegated authority from the SEC, would continue in its traditional role as the main enforcement regulator of suitability cases in general with the SEC only selecting those cases where there was a 10(b) violation. However, after some recent criticism and an in-session call in Congress to become more aggressive, SEC policy changed.
On June 15, 2022, the SEC filed its first ever federal court enforcement action alleging violations of Regulation BI. It was filed in federal court in the Central District of California, in Los Angeles against Western International Securities, Inc. (“Western”) a registered broker-dealer located in neighboring Pasadena. The SEC’s federal complaint not only named Western but five of its registered representatives. They were all charged with violations of Reg. BI in connection with the sale of over $13 million dollars of “L-Bonds” from the issuer, GWG Holdings, Inc. The SEC alleged in its federal complaint that these products were unsuitable as they were high risk and illiquid. Further, that defendants, including Western knew, or should have known these risks when they were recommended and sold to Western’s securities customers allegedly without regard for their risk tolerance and liquidity needs.
In connection with the sale of L-Bonds, the SEC’s federal complaint charges Western with an alleged failure to comply with Reg. BI’s second obligation (“Care”) and fourth obligation (‘Compliance”). Specifically, the SEC contends that that the procedures that Western had in place were inadequate, largely boilerplate and rarely followed. Additionally, the SEC alleges that Western securities allowed L- Bond transactions to be sold without a reasonable basis as to why these products were selected over other, less speculative investment options. Similarly, the SEC complaint charged the five individual representatives for providing unreasonable, vague, and unsatisfactory reasons why the speculative L-Bonds were sold to risk-averse customers.
Thus, the SEC’s first-ever federal action charging suitability-based violations under Reg. BI, confirms that the SEC has entered into an area of enforcement regulation previously occupied by FINRA and state regulators.
Suffice to say, we can expect more Reg. BI cases in the future. Stay tuned!