Several weeks ago, the Securities and Exchange Commission charged Western International Securities and five of its brokers with violating the SEC’s Regulation Best Interest. The charges stem from allegations that the firm recommended and sold unrated, high-risk debt securities known as L Bonds to retirees and other retail investors.
The SEC alleges that the firm’s brokers sold these bonds to retail customers who were on fixed incomes and had moderate risk tolerances. They allegedly did this despite the fact that the issuer, GWG Holdings Inc., stated that L bonds were high-risk, illiquid and only suitable for customers with substantial financial resources. In a statement to PLANADVISER, Western International Securities said it believes it complied with applicable laws and regulations, and that it intends to actively defend itself against the claims asserted by the SEC.
In a new discussion about the matter, Issa Hanna, a partner at Eversheds Sutherland, says the SEC’s Reg BI charges represent a watershed moment for the financial adviser industry. He also emphasizes that advisers must be getting ready for November enforcement of the SEC’s updated marketing rules.
The First Reg BI Enforcement Action
“Almost two years after Reg BI’s effective date, the SEC has brought the first known enforcement action alleging violations of the broker/dealer best interest standard of conduct,” Hanna says. “This is an important moment for the industry, in part because of the symbolism of charges finally being brought under Reg BI, but also because of what we can take away from the situation.”
In Hanna’s analysis, the alleged wrongdoing in the case is significant enough that it likely would have been brought under the prior suitability standards that were replaced by Reg BI. In other words, the SEC likely would have viewed the L bond investments in the case as unsuitable for the investors in question under the old rules.
“Simply, the facts of the case are not good facts for the defense,” Hanna says. “This is a situation where, across a set of clients, people with conservative risk profiles who were close to retirement or who had very little margin for error with their net worth were allegedly placed in a highly risky investment. In my opinion, under the old suitability regime, the regulator would not have hesitated to bring an enforcement action like this.”
Still, the first Reg BI case is meaningful, Hanna says, largely because its language and approach help to demonstrate the heightened expectations the SEC has when it comes to how thoughtful firms should be about how they supervise their professionals and the recommendations they make. He says the case shows the importance of the serious “compliance obligations” at the heart of Reg BI.
“In general, industry practitioners should not look at this case and think, just because it would have been brought previously as a suitability issue, that Reg BI enforcement is not big deal,” Hanna says. “You can’t assume the SEC isn’t holding people to a higher standard now just because this was the first case. It very well could have been a different case, one that would have raised more eyebrows.”
Looking to future Reg BI enforcement areas, Hanna points to various compliance bulletins the SEC has published this year, including one from March that speaks directly to the topic of best interest rollovers. He expects advisers could soon be targeted for insufficient oversight or disloyal actions related to rollovers.
“The compliance bulletin shows the SEC is setting the bar quite high in terms determining whether a given rollover recommendation is in a client’s best interest or not, and how to deal with the potential conflicts of interest that arise from a rollover recommendation,” Hanna points out. “It would not surprise me if the SEC followed up on those bulletins with targeted enforcement under Reg BI, alleging that firms have failed to prove their recommendations are in fact in the clients’ best interest.”
According to Hanna, there are other aspects of Reg BI that are “completely new ground” from the perspective of broker/dealers, and these, too, could be the subject of targeted Reg BI enforcement moving forward. Chief among these is the simple fact that Reg BI is a best interest standard that requires brokers to put their own financial interests behind those of clients.
“Previously, there were certain general practices that were encouraged to help brokers manage conflicts of interest, but there were never set industry standards related to how those conflicts must be managed and disclosed,” Hanna says. “Now, under Reg BI, there are such standards, and they are very prescriptive. I believe you could easily see a situation in the future where the SEC says, in a similar enforcement action, that Brokerage Firm A hasn’t met its conflict of interest mitigation obligations in its sales activities.”
Another likelihood, in Hanna’s view, is that the SEC could bring a case that involves both a violation of the Reg BI care obligation and the distinct conflict of interest obligation.
“Say you have a product that is more costly than another product that was available, but the firm created an economic incentive for the registered rep to recommend the more costly product, whereas the recommendation of the other, less expensive product, would not confer the same benefit on the firm’s representative,” Hanna says. “In that case, you arguably have both the care obligation and the conflict of interest obligation that come into play—and potentially two violations.”
The Latest on the SEC Marketing Rule
Hanna says his clients are, naturally, concerned about Reg BI compliance, but in fact the SEC’s marketing rule is taking up the most oxygen at the moment. This rule comes from a December 2020 SEC vote to finalize key reforms under the Investment Advisers Act to modernize the rules that govern investment adviser advertisements and payments to solicitors.
With its vote to finalize the new marketing standards, the SEC set a final compliance date of November 4 of this year. Since then, in anticipation of the compliance date, the SEC has withdrawn or modified a significant number of No-Action Letters published under the previous advertising rule and the cash solicitation rule.
According to Hanna, firms are now starting to make “very difficult judgement calls” regarding how they are going to approach certain tough issues raised by the rule changes. This is the case because the marketing rules, while meaningfully expanded and ripe with new opportunities for financial services firms to interact with the public, are no free-for-all. So, while advisers may now be free to engage with their clients via social media, for example, they must still tread very carefully and document all their processes and procedures.
“There are certain types of performance presentations that clients have been struggling with, in particular,” Hanna says. “Answering the question of how to present performance information in a compliant manner is no easy task. And once you have an answer in mind, it is a lot of work to then put pen to paper and actually develop the policies and procedures that you are going to implement and enforce.”
Hanna says this effort is complicated by the fact that the SEC has not, at least at this stage, published clear guidance about its expectations.
“The sense in the industry is that they think the adopting release and the rule itself are sufficient to allow people to comply with the new framework,” Hanna says.
Hanna suggests that there has actually been considerable misunderstanding in the industry regarding the part of the new advertising rules that speak to client testimonials.
“From my point of view, the SEC is not really expecting or hoping to allow firms to start publishing testimonials with no guardrails or limitations,” he warns. “Sure, they lifted the flat-out ban on publishing testimonials, but any testimonials you publish still have to follow the rules. For example, you are still prohibited from having a statement in an ad that creates a misleading inference, or of making a statement that isn’t ‘fair and balanced.’”
Hanna says his sense is that the SEC actually wanted there to be some questions left unanswered regarding what is permissible marketing and what is not.
“My sense is that everyone is, so far, erring on the side of caution, and my gut says the SEC wanted it to be this way,” he says. “If you don’t tell people where the bright red line is, a lot of people will draw the line very cautiously.”