SEC takes first substantive Reg BI enforcement action

Investor advocates differ on whether the case against brokers selling risky bonds — L bonds offered by GWG Holdings — fulfills Reg BI's investor-protection promises.

The Securities and Exchange Commission on Thursday took its first substantive enforcement action involving Regulation Best Interest when it charged a brokerage and five of its registered representatives with inappropriate sales of an unrated, risky debt security to retail customers.

The SEC filed a complaint in a U.S. District Court in the Central District of California against Western International Securities Inc. as well as brokers Nancy Cole, Patrick Egan, Andy Gitipityapon, Steven Graham and Thomas Swan.

The SEC alleged that between July 2020 and April 2021, the defendants recommended and sold approximately $13.3 million in corporate L Bonds. The brokers each received aggregate commissions of between $5,400 and $32,500, while the firm received approximately $187,000 in commission and fees.

The bonds, offered by GWG Holdings Inc., were “high risk, illiquid, and only suitable for customers with substantial financial resources,” the SEC complaint states. But the brokers sold the bonds to many customers who had moderate risk tolerances, little investment experience and limited liquid net worth, and were on fixed incomes or retired.

The SEC alleged that the brokers violated Reg BI, which prohibits them from putting their financial interests ahead of their customers’ interests. The agency said the brokers failed to meet Reg BI’s care obligation because they didn’t understand the risks and costs associated with the products and recommended them to customers without having a reasonable basis to believe they were in their customers’ best interests.

The SEC also alleged that the brokerage failed to satisfy Reg BI’s compliance obligation because it didn’t establish, maintain and enforce written policies and procedures to adhere to the measure.

The SEC is seeking an injunction, disgorgement, interest and civil penalties against the brokerage.

“Reg BI is clear: broker-dealers must act in the best interest of their customers,” SEC enforcement director Gurbir S. Grewal said in a statement. “When they fail to do so, as we allege happened here, they put retail investors at risk, and we’ll hold them accountable.”

Western International Securities maintains that it did nothing wrong and said it will fight the SEC’s charges.

“The firm takes its clients’ best interests very seriously and believes it complied with Reg BI and the regulatory guidance available during the pertinent timeframe,” Julian Arenzon, a spokesperson for Western International Securities, said in a statement. “The firm intends to actively defend the claims asserted by the SEC and will not provide additional comments on this pending litigation at this time.”

INVESTOR ADVOCATES SPLIT

Investor advocates have been waiting to see how the SEC would enforce Reg BI since the regulation went into force in June 2020. Until Thursday, the SEC had only pursued cases centering on firms missing deadlines and omitting information in disclosure documents related to Reg BI.

Investor advocates had differing opinions on whether the action against Western International Securities was an example of the SEC’s ensuring that the broker-dealer standard of conduct meets its investor protection promises.

Micah Hauptman, director of investor protection at the Consumer Federation of America, called the SEC’s action“welcome news.”

“I hope this means we’re turning a corner and entering a period of more aggressive enforcement of Reg BI,” he said. “This case does that.”

Hauptman said the charges against the brokerage demonstrate that Reg BI is imposing a higher obligation on brokers than the previous suitability standard that governed them.

“This enforcement action will send a powerful message to the brokerage industry that business as usual won’t be tolerated,” he said. “What may have been acceptable under suitability will not be acceptable under Reg BI. They have to make meaningful changes to their policies and procedures.”

But Knut Rostad, president of the Institute for the Fiduciary Standard. came to the opposite conclusion, saying the SEC’s action amounted to a typical kind of enforcement against a brokerage for allegedly harming customers.

“This is not a Reg BI case,” Rostad said. “This is a suitability case. The SEC did not need Reg BI for this enforcement action. If this is the case the SEC is going to parade around about Reg BI, those of us who were skeptical about Reg BI have been affirmed.”

GENSLER FOLLOW-THROUGH

A securities lawyer said the Reg BI case shows that the SEC is following through on Chairman Gary Gensler’s promise to put teeth in the regulation through enforcement.

“The Gensler administration is putting their money where their mouth is,” said Issa Hanna, a partner at Eversheds Sutherland. “They’ve been saying for some time they’re going to be enforcing Reg BI aggressively. This is an example of the SEC staying true to their word. They’re going to enforce Reg BI to the letter.”

But Tom Gorman, a partner at Dorsey & Whitney, said Thursday’s action is a traditional SEC effort against inappropriate sales of complex products with an overlay of Reg BI. It’s a case that centers on a “gatekeeper,” such as a broker, failing to protect clients from products that aren’t good for them.

“It’s a new use for Reg BI,” said Gorman, a former SEC senior trial counsel. “It’s part of the [gatekeeper] tradition. It’s a slightly different way than the enforcement program has been going.”

Rostad, however, will be looking for more from the SEC.

“If Reg BI is going to be what they say it is, they’ve got to proceed with cases that could not be handled by the suitability standard because there is a difference between suitability and best interest,” he said. “That’s what we’ve been told for four years.”