SEC Brings Its First Regulation Best Interest Enforcement Action
On June 15, 2022, the Securities and Exchange Commission (“SEC”) filed a complaint in the U.S. District Court for the Central District of California against registered broker-dealer Western International Securities, Inc. (“Western”) and five of its registered representatives (the “Registered Representatives”), alleging that they had violated the Best Interest Obligation under Rule 15l-1(a) of the Securities Exchange Act of 1934 (“Regulation Best Interest” or “Reg BI”) in connection with their recommendations to retail customers to purchase certain unrated debt securities. This is the first action brought by the SEC to enforce Reg BI, and the litigation could lead to important legal rulings clarifying its scope.
Reg BI was enacted in June 2020 and established a “best interest” standard of conduct for broker-dealers and associated persons when they make recommendations to retail customers. It imposes four particular component obligations: a Disclosure Obligation, a Care Obligation, a Conflict of Interest Obligation, and a Compliance Obligation.
In its complaint, the SEC alleges that Western and the Registered Representatives sold an aggregate of $13.3 million of a particular type of debt security, called L Bonds, between July 2020 and April 2021 to retail customers. The SEC claims that these L Bonds, which were unrated corporate bonds, were “high risk, illiquid, and only suitable for customers with substantial financial resources.” Nevertheless, the SEC claims that the Registered Representatives recommended the L Bonds to retail customers who had (i) moderate-conservative or moderate risk tolerances, (ii) investment objectives that did not include speculation, (iii) limited investment experience, (iv) limited liquid net worth, and/or (v) were retired.
The SEC claims that the Registered Representatives violated Reg BI’s Care Obligation by failing to exercise reasonable diligence, care, and skill to understand the risks associated with L Bonds and recommending the L Bonds without a reasonable basis to believe the bonds were in the retail customers’ best interests. Additionally, the SEC claims that Western failed to comply with Reg BI’s Compliance Obligation because its written policies and procedures were not reasonably designed to comply with Reg BI. The SEC asserts that the policies and procedures merely recited Reg BI objectives without offering the Registered Representatives specific guidance tailored to Western’s operations. Specifically, the SEC’s complaint details how Western substantially copied from the SEC’s September 2019 Small Entity Compliance Guide but did not revise its policies and procedures during the time the Registered Representatives recommended L Bonds to its retail customers.
The SEC’s complaint is merely that, a complaint, and Western and the Representatives may have factual or legal defenses yet to be presented. But, regardless, the filing is a reminder that the SEC is seeking to police Reg BI and is continuing its focus on disclosures to retail customers.