Securities And Exchange Commission Brings Its First Enforcement Action Under Regulation Best Interest Thumbnail

Securities And Exchange Commission Brings Its First Enforcement Action Under Regulation Best Interest

Regulation Best Interest (“Reg BI”), which became effective in June 2020, imposes a higher, quasi-fiduciary standard on securities brokers and registered representatives when making recommendations to retail clients.[i]  At that time, commentators (including me) speculated that the SEC would bring enforcement actions to establish Reg BI’s parameters, such as, for example, what constitutes a “reasonable” effort to comply, as well as to highlight the seriousness of it.

The SEC has now filed the first of such actions.

On June 16, 2022, the SEC announced that their Chicago office had commenced a Reg BI enforcement action against Western International Securities, Inc. and five of its registered representatives. According to the SEC press release, the civil action—filed in the U.S. District Court for the Central District of California—alleges that the firm and its registered representatives recommended and sold “L Bonds” to their customers, that L Bonds were of high risk (unrated and issued by a company with a history of losses), illiquid (there being no trading market for them), and “only suitable for customers with substantial financial resources.”[ii]  The SEC’s complaint asserts that the clients to whom the bonds were sold had only moderate-conservative or moderate risk tolerances, non-speculative objectives, limited experience and financial resources, and some were even retired, such that the defendants violated Reg BI’s care obligation by recommending the L Bonds “without a reasonable basis to believe the bonds were in their customers best interest”.

The complaint also alleges that Western International violated Reg BI’s compliance obligation by not adequately establishing, maintaining, and enforcing written policies and procedures “reasonably designed to achieve compliance with Reg BI,” and violated Reg BI’s care obligation by not adequately assessing the risks of the bonds.

Western International and its representatives have denied wrongdoing, and stated in a press release that they take Reg BI seriously and intend to “actively defend” the lawsuit. However, such posturing is common at the start of SEC enforcement actions. If it turns out that the allegations are true, it would indicate that the SEC chose a reasonably clear case for its first Reg BI enforcement proceeding, and is not (at least not yet) going beyond its plain text to impose standards at the outer edges.

Predictably, there has also been an increase in FINRA customer arbitrations alleging Reg BI violations, according to statistics released by FINRA earlier this year.

The landscape has clearly changed in the world of sales of commission-based securities products, which was indeed the intent of Reg BI in the first place.

[i] See “SEC REGULATION BEST INTEREST IS NOW IN EFFECT”, Frantz Ward Client Alert July 8, 2020.  Reg BI replaced the prior suitability standard with the requirement that recommendations must be in the best interest of the client, and among other requirements imposed disclosure and due diligence, care, and skill obligations.
[ii] Seems a bit ironic that the SEC would reference suitability as a factor in determining what is in a client’s best interest” since Reg BI completely obviated the suitability standard. 

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