SEC Brings First Ever Regulation Best Interest Litigation Against Broker-Dealer and Its Personnel

The U.S. Securities and Exchange Commission recently charged a broker-dealer and five of its registered representatives with violating Regulation Best Interest (“Reg. BI”) related to recommendations and sales of an unrated, high-risk, and illiquid debt security to retirees and other retail investors, many of whom were on fixed incomes and had moderate risk tolerances. The SEC alleges in the complaint that the broker-dealer failed to comply with the Reg. BI Care and Compliance obligations and that the registered representatives failed to comply with the Reg. BI Care obligation as a result of selling $13.3 million of high-risk debt securities known as L Bonds between July 2020 and April 2021. The charges in this case seem to stem from an underlying investigation by the SEC of the issuer, which filed for bankruptcy. The SEC is seeking cease-and-desist injunctions, disgorgement of fees, and civil penalties against the firm and its registered representatives.

Firms comply with Reg. BI only if all four component obligations are satisfied, (Disclosure, Care, Conflicts, and Compliance) and associated persons comply with their Reg. BI obligation if they satisfy the Disclosure and Care obligations. According to the SEC, the defendants failed to comply with the Care obligation because (i) the registered representatives did not “exercise reasonable diligence, care, and skill to understand the risks, rewards, and costs” associated with recommending the debt security; and (ii) the firm and its representatives recommended the debt security to at least seven customers “without a reasonable basis to believe the [] bonds were in their customers’ best interests.” The SEC also alleges that the firm failed to comply with the Reg. BI Compliance obligation because it did not adequately “establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with [Reg. BI]."

Key Takeaways

1. Chairman Gensler is keeping his promise to ensure that “Regulation Best Interest lives up to the promise of its name.” ^[1] But this is certainly an interesting one to be the first for the SEC, given that either the firm chose not to settle or the SEC preferred to litigate the matter, perhaps to make a statement to the industry. 
   
   
2. While the SEC alleged failure of particular Reg. BI component obligations, the complaint does not include an explicit discussion of the broker-dealer or the registered representatives placing their interests ahead of the interests of their customers. While one can infer that the SEC views the alleged facts that way, it is significant that the complaint does not overtly spell that out, especially given that this is the first substantive enforcement action the SEC has brought under its landmark 2019 rulemaking. One explanation may be that the SEC considers the evidence of failure to meet the Care obligation so persuasive that it is not necessary to prove the registered representatives put their own interests first. 
   
   
3. The SEC’s expectations related to policies, procedures, controls, and training set forth in the complaint generally were outlined in the Reg. BI adopting release and follow up guidance from the SEC, so the complaint does not shed any new light on the regulator’s views. However, the complaint does reaffirm the expectations the SEC and its staff have already conveyed to the industry. In particular, Reg. BI policies and procedures must, among other things, be (i) tailored to the firm’s business; (ii) provide guidance regarding enforceability of firm policies, including compliance with the component obligations of Reg. BI; and (iii) clearly designate responsibilities to registered representatives, supervisors, and compliance staff. Firms must provide their registered representatives, supervisors, and compliance staff, with training regarding Reg. BI, firm policies, and procedures related to its obligations, as well as product level education (e.g., risks, requirements, and reasonably available alternatives). Firms must also establish criteria or thresholds for customers to invest in high-risk securities.^[2]

Deeper Dive

Failure to Comply with the Care Obligation: In the SEC’s view, the firm’s processes, procedures, and controls fell short of its regulatory obligation in the following ways:

• The CCO conducted diligence on the bonds, but did not provide the due diligence report (which contained a detailed analysis of the risks and rewards of the bonds) to the firm’s registered representatives, supervisors, or compliance personnel. 
  
  
• The firm “did not set any criteria or thresholds for its customers to invest in the [] bonds” or “restrict the sale of the [] bonds to customers with certain risk profiles or investment obligations,” despite the fact that the prospectus for the bonds indicated that they involve a “high degree of risk,” “may be considered speculative,” and “were only suitable for customers with substantial financial resources.” 
  
  
• The firm also did not require its registered representatives to complete training for the specific high-risk bond, despite the fact that the security varied from previous debt securities offered by the firm. 
  
  
• The firm and its representatives obtained disclosure forms, client agreements, and bond-specific purchase forms from its customers. However, the supervisory review and sign-off merely consisted of a completeness check and a verification that the bond investment did not exceed 10% of the customer’s net worth, which the SEC did not view as adequate. 
  
  
• The firm’s compliance department conducted a similar review to ensure no information was missing, the forms were signed, and an explanation was provided if the purchase exceeded 10% of a customer’s net worth. However, the firm’s “compliance department did not examine whether an investment was in the customer’s best interest.” 

In turn, the SEC believes that the registered representatives had an “insufficient, and sometimes erroneous, understanding of the investment” that they recommended to retail customers and that they also lacked an appreciation for the issuer’s business, the risks associated with the security, and the nature of collateral for the bond. In the SEC’s eyes, this ultimately resulted in a mismatch between the retail investors and the high-risk bonds.^[3]

Failure to Comply with the Compliance Obligation: The complaint highlights several deficiencies in the firm’s written policies and procedures related to Reg. BI, including that they:

• Merely recited the objectives of Reg. BI, without offering registered representatives specific guidance tailored to the firm’s operations;
  
  
• Substantially copied from the SEC’s Small Entity Compliance Guide and therefore contained general language and were not tailored to the firm’s business; 
  
  
• Were not reasonably designed to achieve compliance with the Reg. BI Care obligation requirement that registered representatives understand the potential risks, rewards, and costs associated with their recommendations;
  
  
• Had inadequate procedures to enforce the firm’s limited policies regarding compliance with the Care obligation (e.g., no explanation of what may or may not constitute a reasonably available alternative and no procedures or guidelines for registered representatives or supervisors to follow in determining how to comply with the requirement or specific guidance as to which investments are risky);
  
  
• Were so vague that they “caused confusion as to who… was responsible for reviewing transactions for suitability and compliance with Reg. BI’s Care obligation”; and
  
  
• Did not include guidance for (i) supervisory reviews as to whether a transaction was in a customer’s best interest for the purpose of complying with Reg. BI; or (ii) monitoring or enforcing the requirement that registered representatives review reasonably available alternatives to a recommended security.

The SEC also believes that the firm’s other policies and procedures were notably insufficient (e.g., no guidance for offerings where the issuer does not establish specific suitability standards, compliance personnel directed to follow-up with representatives and supervisors “only ‘where total invested amounts exceed 10% of the client’s net worth’”). 

The SEC also alleges that the firm failed to enforce the policies it did have to achieve compliance with the Reg. BI Care obligation, including its policy regarding training (or it “was enforced in such a way that it failed to ensure registered representatives adequately understood” the bonds), and did not require firm personnel, aside from the CCO, to review the due diligence report on the bonds. 

We expect this matter to be the tip of the iceberg for Reg. BI enforcement activity. The fact that the issuer of the L Bonds went into bankruptcy may have given this case more urgency, but other cases are likely to arise out of routine examinations of brokers. The L Bonds were sold by a network of brokers, so other brokers and registered representatives who sold the issuer’s L Bonds may be settling with the SEC or facing similar complaints if they sold to retail customers without adequately meeting their obligations under Reg. BI.

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[1] See Testimony Before the Subcommittee on Financial Services and General Government, U.S. House Appropriations Committee, SEC Chairman Gary Gensler, May 26, 2021 at https://www.sec.gov/news/testimony/gensler-2021-05-26.
[2] The Reg. BI adopting release further provides: “because these firm-wide threshold decisions have such a significant effect on the subsequent recommendations ultimately made to a retail customer, we are requiring disclosure of the material limitations on the securities or investment strategies involving securities that may be recommended—by the broker-dealer and its associated persons—as well as any associated conflicts of interest.” See Release No. 34-86031 at 180. 
[3] “The [Reg. BI] Adopting Release states that what is in the best interest of a retail customer depends on the facts and circumstances of the recommendation, including ‘matching’ the recommended security to the retail customer’s investment profile. Where the ‘match’ between the retail customer profile and the recommendation appears less reasonable, it is more important for the broker to establish that it had a reasonable belief that the recommendation was in the best interest of the retail customer. The Adopting Release also states that, in addition to ‘matching’ the recommendation to the customer’s suitability profile, a registered representative should also exercise reasonable diligence, care, and skill to consider reasonably available alternatives.” See Case No. 2:22-cv-04119 at 50 and 51.