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Robert Bloink and William H. Byrnes

Regulation and Compliance > Federal Regulation > SEC

SEC's First Reg BI Action Singles Out Individual Advisors

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What You Need to Know

  • The complaint in Western shows that firms should focus heavily on their supervisory policies and procedures.
  • Procedures should be tailored to the business and reasonably designed to comply with Reg BI standards.
  • Advisors should have all the information necessary to determine whether an investment is in a client’s best interest.

Regulation Best Interest, or Reg BI, as the rule is known, became effective as of June 2020. While the regulation has now been effective for some time, how the Securities and Exchange Commission would interpret and enforce the new rules remained largely unknown. 

Now, the SEC has charged Western International Securities Inc. (Western) and five of its investment advisors with violations of Reg BI. This initial enforcement action can serve as guidance as to how the SEC might interpret the regulation’s requirements going forward. Covered advisors and firms should also view the case as a warning that the SEC may be willing to enforce the regulation against individual investment advisors on a more widespread basis than initially expected.

Regulation Best Interest: Background

Regulation Best Interest establishes a standard of conduct that investment advisors and broker-dealers must adhere to in their dealings with retail investment customers. The rule applies to a variety of transactions involving securities and was expanded to include rollover transactions that involve recommendations with respect to potential securities transactions. 

Under Reg BI, certain broker-dealers and other investment advisors are now required to act in their clients’ best interests by eliminating conflicts of interest, disclosing conflicts on a new Form CRS and taking steps to mitigate the impact of those conflicts. Covered advisors must comply with four basic requirements: (1) the disclosure obligation, (2) the care obligation, (3) the conflict-of-interest obligation and (4) the compliance obligation.

SEC v. Western International Securities Inc.: The Facts

The crux of the SEC complaint is that Western recommended certain unrated, high-risk “L bonds” to clients without a reasonable basis for believing the investments were in the client’s best interest. The unrated bonds, or junk bonds, in question were offered by GWG Holdings Inc. (GWG) and were sold to clients in 2020 and 2021.

In the GWG disclosure materials, GWG clearly disclosed that the L bonds were risky, that the investment should be treated as speculative and that the bond offerings were suitable only for clients with substantial financial resources who would not need immediate access to the investments for liquidity purposes.

The SEC alleges that Western and the other related advisors failed to do their due diligence. For example, the SEC asserts that they did not know whether GWG was profitable or how the bonds themselves were collateralized. The complaint also alleges that the advisors sold the bonds to clients with relatively moderate to conservative risk tolerance, clients with limited resources and clients on fixed incomes who were looking to preserve capital in retirement.

The SEC also alleges that the firm’s required policies and procedures violated the Reg BI compliance obligation. The policies and procedures in question may have been copied substantially from the SEC’s model disclosures without being tailored to Western’s specific situation. For example, the policies did not contain guidance on how an advisor could determine whether an investment recommendation was in a client’s best interests or what it meant for an advisor to recommend alternative investment options.

Takeaways for Firms and Advisors

The Western complaint provides some insight for advisors and financial firms. While many questions remain, the SEC complaint focuses heavily on compliance issues. In other words, the complaint shows that firms should focus heavily on their supervisory policies and procedures.

Those policies and procedures should be tailored to the business and should be reasonably designed to comply with the Reg BI standards.

Firms should also focus on their due diligence procedures. Specifically, ongoing monitoring of investments should be designed to ensure that advisors have the full information necessary to determine whether an investment is in a client’s best interest. 

The SEC action itself requests permanent injunctions, civil penalties against both the firm and its registered representatives, as well as disgorgement of profits with prejudgment interest (the brokers received commissions of between $5,400 and $32,500 each and the firm received $187,000 in fees and commissions). 

Importantly, advisors should be aware that the SEC complaint does not specify whether the specific clients suffered any financial losses because of L bond purchases.

Conclusion

Some industry professionals have noted that the SEC enforcement action in Western would have been possible under the previous suitability regime. Still, the enforcement action shows that the SEC is willing to enforce Reg BI against both financial firms and individual brokers — so both should pay close attention to see how this initial case plays out.