SEC’s First Enforcement Case under Regulation Best Interest

By Alexandros Kazimirov

On March 13, 2023, Judge Wright issued an order granting in part and denying in part a motion to strike brought by the Securities & Exchange Commission (SEC) in the first case pertaining to the enforcement of Regulation Best Interest (Reg BI). Reg BI marks the departure from the former suitability rule to the new enhanced best interest rule. To this end, it is prudent to delineate the scope of enforcement the SEC is seeking under the new rule.

Summary of facts

The SEC v. Western International Securities, Inc., (Western) is a case in the Central District of California, first filed on June 15, 2022. The case scrutinizes the conduct of Pasadena-based advisory firm Western International Securities, Inc. and five of its registered representatives under the new best interest rule.

According to the complaint, Western’s brokers recommended the sale of debt securities called L Bonds, which had no market-out and were unrated to several retail customers. The issuer of these bonds had described the bonds as high-risk and speculative securities in the prospectus, but Western’s brokers recommended them to investors with a conservative risk tolerance, investment objectives that did not include speculation, limited investment experience and limited liquid net worth.

The SEC alleges that this disproportionate matching violates the obligation of care that the brokers owe to their clients. The brokers did not exercise the reasonable care and diligence to assess and tailor the securities to their customers’ risk-sensitive profiles, and had no reasonable basis to believe their recommendation was in their clients’ best interests.

Furthermore, the complaint also refers to Western’s inadequate compliance mechanism vis-a-vis the incorporation of the best interest rule into the firm’s practice. Namely, Western did not undertake any substantial effort of explaining to its broker-dealers how to be compliant with the principles under the new regulation.

The SEC is seeking permanent injunctions, disgorgement and prejudgment interest, and civil penalties against both Western and the broker-dealers involved.

Best Interest Rule

The literature on Reg BI mentions that the “SEC has no definition of ‘best interest’. Instead, whether a broker-dealer has acted in a retail customer’s best interest is based on an objective assessment of the facts and circumstances of how the broker- dealer has satisfied the four component obligations of Regulation Best Interest at the time the recommendation is made.”^[1]

Generally, for a dealer-broker who sells products to retail investors, the duty of good faith and fair dealing implies several things. First a broker must ascertain the nature of the product, which includes both its features and its purpose, such as the targeted clientele. Then the broker must lay the foundation, i.e. the reasonable basis, on which the product may be recommended to a client who is suitable for the purchase.

If the broker’s relationship predates the recommendation, the broker must have disclosed all material facts as to the relationship terms to the client. Last, the broker’s conduct must be consistent; it ought to be happening in a coherent and organized manner which adheres to the principles of the best interest rule. Therefore, when a broker acts as a diligent, loyal seller in good faith and the terms of the sale are reasonable, the broker has acted in the client’s best interest.

Specifically, Reg BI lays out four component obligations:

Disclosure obligation: a broker-dealer, before or at the time of the recom- mendation, must provide the retail customer, in writing, full and fair disclosure of all material facts as to the scope and terms of its relationship with the retail customer and all material facts relating to conflicts of interest that are associated with a recommendation. The SEC did not identify the duty of disclosure to be an issue in Western.

Care obligation: Reg BI’s care obligation requires a broker, dealer, or associated person of a broker or dealer, in making a recommendation of a securities transaction, to exercise reasonable diligence, care, and skill to (a) understand the potential risks, rewards, and costs associated with the recommendation and to (b) have a reasonable basis to believe the recommendation is in the best interests of that customer, based on the customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation.

This component includes a two-part test: first comprehension of the product that is sold (diligence) and second matching the product to the needs and profile of the client (proportionality). In Western, the SEC asserts that the brokers were unaware of the issuer’s transactions, whether there was collateral security for the L Bonds and lacked appreciation of the risk that a purchase of such securities entailed. For the SEC issues pertinent to the product’s collateral can hardly be seen as of secondary nature. In other words, Western’s brokers failed the first prong.

The complaint then addresses what the SEC’s claims to be a mismatch. Namely that the L Bonds were securities bearing substantial risk and were intended for clients with substantial financial resources and no need for liquidity. But Western’s clients did not meet such criteria. The customers were mostly risk averse retirees who allocated between a tenth and a third of their cash savings in L Bonds. Therefore, according to the SEC, Western’s brokers failed the second prong, too.

Conflict of interest obligation: a broker-dealer must establish, maintain and enforce policies and procedures reasonably designed to identify, monitor and mitigate (or eliminate, if possible) conflicts of interest. Conflict of interest is not an issue in Western.

Compliance obligation: a broker-dealer must establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with Reg BI.

Compliance under the best interest rule provides that broker firms should undertake the effort of explaining the effect of the principles of the regulation to their brokers in practice, and pursue such an effort consistently. A firm should not just reiterate its commitment to Reg BI or merely restate SEC’s guidance which fails to reach its broker-dealers, as in Western.

The complaint alleges that Western had a dysfunctional best interest compliance policy. Western’s Chief Compliance Officer (CCO) prepared due diligence reports which were out of reach for the dealer-brokers, and the latter were untrained in the latest offering of L Bonds, class of 2020-2021. This reflects a bifurcated system of due diligence, which according to the SEC, appears to have been largely asynchronous between the firm and the representative brokers.

With the brokers having no access to due diligence reports, their under- standing of the potential risk margin was grossly inadequate for the purpose of recommending the securities to their clients. And with the firm not encou- raging its brokers to stay up-to-date with the issuer’s product, it facilitated the lack of appreciation of its brokers and the eventual mismatch with the retail investors.

FINRA’s Suitability Rule

The question then is whether the recommendation of the debt securities would be adequate under the previous suitability standard. The test requires a broker to reasonably believe that a recommendation would be a good fit for the client, based on previous due diligence of the client’s profile. The suitability test lays out three obligations:

Reasonable-basis suitability: the reasonable-basis obligation required broker-dealers (through reasonable diligence) to understand the risks and rewards involved with a particular investment and to have a reasonable basis to believe that an investment was suitable for at least some investors.

Customer-specific suitability: the customer-specific obligation required broker-dealers to have a reasonable basis to believe an investment was suitable for a specific customer based on that customer’s investment profile.

Quantitative suitability: the quantitative suitability obligation required broker- dealers to reasonably believe that a series of individually suitable recom- mendations, when considered in con- cert, would not become excessive and therefore unsuitable for an investor.

In Western, the SEC argues that the retail investors were not fairly sophisticated investors, who had moderate risk tole- rance. Some indicated that they wanted to “earn income safely without risking [the] principal.” The investors were pensioners who had allocated a substantial portion of their liquid net-worth to purchase the issuer’s L Bonds, and relied on their brokers’ judgment.

In forming such judgment, the brokers did not take into account (i) important transactions pertaining to the issuer, (ii) warnings about the high-risk nature of the product in the issuer’s prospectus, (iii) that L Bonds were not directly collateralized by life insurance policies held by the issuer, and (iv) training as to the particular features of the latest issue of L Bonds.

From the aforementioned facts, a reasonable broker could not have proceeded to match the L Bonds, as suitable products for Western’s clients. Where the match between the retail customer profile and the recommendation appears less reasonable, like in Western, it is more important for the broker to establish their reliance on a reasonable belief that the recommendation was in the best interest of the retail customer.

However, such reasonable belief cannot be inferred under any of the suitability obligations, because the SEC alleges that the brokers lacked rudimentary understanding of the product’s features to form the reasonable basis by which they could recommend it to their client. Furthermore, the description of the products in the issuer’s prospectus was opposite to the investment profile that the clients maintained with Western. If the clients were not the typical target of the debt securities, and the brokers knew that, they could not have reasonably found them to be suitable for their clients.

Finally, the unsuitable nature of the products would not be reversed if the sale was treated in the aggregate or otherwise. Therefore, the facts and circumstances of Western, as applied under the suitability obligations of reasonable-basis, customer- specific, and quantitative suitability do not arrive to a different conclusion than under the best interest rule.

Conclusion

In SEC v. Western International Securities, Inc., the standard of conduct under scrutiny is fairly consistent with the previous threshold of the suitability rule. Namely that the recommendation of a security to retail investors be a reasonably proportionate fit to the investor’s profile. In other words, the SEC has not materially expanded the reach of the best interest rule, so far.

An enforcement agency would still find the recommendations described in Western to be below the threshold set by the suitability requirements, previously held. However, despite the fact that there is no radical departure in scope from the former rule, the sharpest point of contention rests less on the conduct of the broker-dealers and more on the perceived shortcomings of Reg BI.

In Western, the defendants claimed the affirmative defense of lack of fair notice, which pertains to the definitional clarity of Reg BI and asks the court to consider “whether the challenged statute is unconstitutionally vague as applied to the particular facts at issue such that the challenging party did not have sufficient notice that his or her conduct would be a violation of the statute.” Judge Wright refrained from reaching a conclusion on the legal determination of fair notice before the factual dispute is resolved, citing the Ripple case. It is evident however, that this will be the main issue.

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[1] Christopher Schell, Yan Zhang and Derek Walters, The Structured Products Law Review, Fourth Edition, Nov 2022, at 62 .