Several weeks ago, the Securities and Exchange Commission charged Western International Securities and five of its brokers with violating the SEC’s Best Interest Rule. 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 those bonds to retail clients who had fixed incomes and had moderate risk tolerance. They reportedly did so despite the fact that the issuer, GWG Holdings Inc., said the L Bonds were high-risk, illiquid, and only suitable for clients with substantial financial resources. In a statement to PLANADVISER, Western International Securities said it believes it has complied with applicable laws and regulations and intends to actively defend itself against SEC claims.
In a new discussion on the matter, Issa Hanna, partner at Eversheds Sutherland, said the SEC’s Reg BI charges represent a watershed moment for the financial adviser industry. He also points out that advisers should prepare for the November enforcement of the SEC’s updated marketing rules.
The first BI regulatory enforcement action
“Nearly two years after the effective date of Reg BI, the SEC filed the first known enforcement action alleging violations of the Broker/Dealer Best Interests Conduct Standard,” Hanna says. “This is an important moment for the industry, partly because of the symbolism of the charges finally being brought under Reg BI, but also because of what we can get out of the situation.”
In Hanna’s analysis, the alleged wrongdoing in the case is significant enough that it likely would have been subject to the previous fitness standards which were superseded by Reg BI.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.
“Quite simply, the facts of the case are not good facts for the defense,” Hanna says. “This is a situation where, among a set of clients, people with conservative risk profiles who were close to retirement or who had very little room for error with their net worth would have been placed in a very risky investment.In my opinion, under the old fitness regime, the regulator would not have hesitated to take enforcement action like this.
Still, the first Reg BI case is significant, says Hanna, in large part because its language and approach helps demonstrate the SEC’s heightened expectations for the thinking companies should have about how they oversee their businesses. professionals and the recommendations they make. He says the case shows the importance of serious “compliance obligations” at the heart of Reg BI.
“In general, industry practitioners should not look at this matter and think, just because it has previously been presented as an adequacy issue, that the application of Reg BI is not serious,” says Hana. “You can’t assume the SEC isn’t holding people higher now just because it was the first case. It very well could have been a different case, which would have raised more eyebrows.
As for future areas of application for Reg BI, Hanna points to various compliance bulletins the SEC has issued this year, including one from March that directly addresses the topic of bearings in the best interests. He expects advisers will soon be targeted for insufficient oversight or unfair actions related to turnovers.
“The compliance bulletin shows that the SEC sets the bar quite high for determining whether a given rollover recommendation is in a client’s best interest or not, and how to manage potential conflicts of interest that arise from a rollover recommendation. turnover,” says Hanna. out. “It wouldn’t surprise me if the SEC followed up on these bulletins with a targeted application under Reg BI, alleging that the companies failed to prove that their recommendations are in fact in the best interests of customers.”
According to Hanna, there are other aspects of Reg BI that are “completely new ground” from a broker/dealer’s perspective, and these could also be the subject of a targeted application of Reg BI to the coming. Chief among them 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, certain general practices were encouraged to help brokers manage conflicts of interest, but there were never established industry standards regarding how these conflicts should be managed and disclosed,” says Hanna. “Now under Reg BI there are such standards, and they are very prescriptive. I think you could easily see a situation in the future where the SEC would declare, in a similar enforcement action, that brokerage firm A failed to meet its obligations to mitigate conflicts of interest in its activities of sale.
Another likelihood, Hanna says, is that the SEC could bring an action involving both a breach of the Reg BI duty of care and the separate conflict of interest duty.
“Suppose you have a product that is more expensive than another product available, but the company has created an economic incentive for the registered representative to recommend the more expensive product, while recommending the other product, the less expensive, wouldn’t confer the same benefit on the company representative,” says Hanna. “In that case, you arguably have both the duty of care and the duty of conflict of interest coming into play – and potentially two breaches.”
The Latest on the SEC’s Marketing Rule
Hanna says her clients are, understandably, concerned about Reg BI compliance, but in fact, the SEC’s marketing rule is taking the most oxygen at the moment. This rule stems from an SEC vote in December 2020 to finalize key reforms under the Investment Advisors Act to modernize the rules that govern investment advisor advertisements and payments to attorneys.
With its vote to finalize the new marketing standards, the SEC has set a final compliance date of November 4 this year. Since then, in anticipation of the compliance date, the SEC has removed or amended a significant number of no-action letters released under the former Publicity Rule and Fund Solicitation Rule.
According to Hanna, companies are now starting to make “very difficult decisions” about how they are going to approach some difficult issues raised by the rule changes. This is because marketing rules, while significantly expanded and matured with new opportunities for financial services firms to interact with the public, are not free for all. So while advisors may now be free to engage with their clients via social media, for example, they still need to be extra careful and document all of their processes and procedures.
“There are certain types of performance presentations that clients have struggled with, in particular,” says Hanna. “Answering the question of how to present performance information in a compliant manner is not an easy task. And once you have an answer in mind, it’s a lot of work to put pen to paper and actually develop the policies and procedures that you’re going to implement and enforce.
Hanna says that effort is complicated by the fact that the SEC has not, at least at this point, issued clear guidance on its expectations.
“The feeling in the industry is that they think the adoption version and the rule itself are enough to get people into compliance 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 relates to customer testimonials.
“From my perspective, the SEC is not really waiting or hoping to allow companies to start publishing testimonials without safeguards or limitations,” he warns. “Of course, they lifted the total ban on posting testimonials, but any testimonials you post must still follow the rules. For example, you are still prohibited from having a statement in an advertisement that creates a misleading inference , or to make a statement that is not “fair and balanced”.
Hanna says her feeling is that the SEC actually wanted there to be questions left unanswered about what is authorized marketing and what is not.
“My feeling is that everyone, thus far, is being cautious, and my instincts say the SEC intended it to be that 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.”