SEC initiates first-ever regulatory interest litigation against broker and staff

The U.S. Securities and Exchange Commission recently charged a broker and five of its registered representatives with violating Best Interest (“Reg. BI”) regulations related to recommendations and sales of an unrated debt security, high-risk and illiquid to retirees and other retail investors, many of whom had fixed-income securities and had moderate risk tolerance. The SEC alleges in the complaint that the broker failed to comply with Reg. BI Care and Compliance obligations and that the Registered Representatives have failed to comply with Reg. BI Care bond following the sale of $13.3 million of high-risk debt securities known as L bonds between July 2020 and April 2021. The charges in this case appear to stem from an investigation SEC’s underlying interest on the issuer, which has filed for bankruptcy. The SEC is seeking cease-and-desist injunctions, reimbursement of costs, and civil penalties against the company and its registered representatives.

Businesses comply with O. Reg. BI only if the four component obligations are met (disclosure, care, conflict and compliance) and the associated persons comply with their Reg. BI’s obligation if they meet the disclosure and due diligence obligations. According to the SEC, the defendants breached the duty of care because (i) the registered representatives failed to “exercise reasonable care, care and skill in understanding the risks , benefits and costs” associated with recommending the debt security; and (ii) the firm and its representatives have recommended the debt security to at least seven clients “without reasonable grounds to believe that the [] the bonds were in the best interest of their clients. The SEC also alleges that the company failed to comply with Reg. BI Compliance Obligation because it failed to “establish, maintain, and adequately enforce written policies and procedures reasonably designed to achieve compliance with [Reg. BI].”

Key points to remember

  1. President Gensler keeps his promise to ensure that “Regulation Best Interest keeps the promise of its name.” [1] But it’s certainly interesting to be first for the SEC, given that either the company chose not to settle, or the SEC preferred to litigate the case, perhaps to make a statement to the industry. .
  2. While the SEC alleged the failure of Reg. BI stream obligations, the complaint does not include an explicit discussion of the broker-dealer or registered representatives putting their interests ahead of those of their clients. While it can be inferred that the SEC views the alleged facts in this way, it is significant that the complaint does not openly state this, especially since it is the first enforcement action of case that the SEC brought as part of its landmark 2019 rulemaking. One explanation may be that the SEC considers evidence of failure to comply with duty of care so compelling that it is not necessary to prove that the Registered Representatives put their own interests first.
  3. The SEC’s expectations regarding the policies, procedures, controls, and training set forth in the complaint have generally been described in Reg. BI adopts the publication and follows SEC guidelines, so the complaint sheds no new light on the regulator’s views. However, the complaint reaffirms the expectations that the SEC and its staff have already conveyed to the industry. In particular, Reg. BI policies and procedures must, among other things, be (i) appropriate to business operations; (ii) provide advice regarding the applicability of firm policies, including compliance with the obligations of the components of O. Reg. BI; and (iii) clearly designate the responsibilities of registered representatives, supervisors and compliance personnel. Companies must provide their registered representatives, supervisors and compliance staff with training regarding Reg. BI, company policies and procedures related to its obligations, as well as product-level training (eg, risks, requirements, and reasonably available alternatives). Firms must also establish criteria or thresholds for clients to invest in high-risk securities.[2]

Deeper dive

Breach of custody obligation: In the opinion of the SEC, the company’s processes, procedures and controls failed to meet its regulatory obligation in the following ways:

  • The CCO conducted due 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 registered representatives, supervisors or compliance personnel of the company.
  • The company “has not set any criteria or thresholds for its customers to invest in the [] obligations” or “restrict the sale of [] bonds to clients with certain risk profiles or investment obligations”, although the prospectus for the bonds stated that they involve a “high degree of risk”, “may be considered speculative” and “are only suitable for customers with Resources.”
  • The company also did not require its registered representatives to undergo training for the specific junk bond, despite the fact that the security differed from previous debt securities offered by the company.
  • The company and its representatives have obtained disclosure forms, customer agreements and purchase forms specific to the obligations of its customers. However, the prudential review and approval was simply a check for completeness and a check that the bond investment did not exceed 10% of the client’s net worth, which the SEC did not consider adequate. .
  • The company’s compliance department performed a similar review to ensure no information was missing, forms were signed, and an explanation was provided if the purchase exceeded 10% of an individual’s net worth. customer. However, the “corporate compliance department failed to consider whether an investment was in the best interest of the client.”

In turn, the SEC believes that the Registered Representatives had an “insufficient, and sometimes erroneous, understanding of the investment” they were recommending to retail clients and that they also lacked an appreciation of the issuer’s business, the risks associated with the title and the nature of the security of the obligation. In the eyes of the SEC, this ultimately resulted in a mismatch between retail investors and junk bonds.[3]

Non-compliance with the obligation to comply: The complaint highlights several deficiencies in the company’s written policies and procedures relating to Reg. BI, including that they:

  • Simply cited the purposes of Reg. BI, without providing Registered Representatives with specific advice relevant to business operations;
  • Largely copied from the SEC’s Small Entity Compliance Guide and therefore contained general language and was not relevant to business operations;
  • Were not reasonably designed to comply with O. Reg. The requirement of BI Care’s obligation that registered representatives understand the potential risks, benefits and costs associated with their recommendations;
  • Had inadequate procedures to enforce the firm’s limited policies regarding compliance with the duty of care (for example, no explanation of what may or may not constitute a reasonably available alternative and no procedures or guidelines that registered representatives or supervisors must follow to determine how to comply with the obligation requirement or specific guidance as to which investments are risky);
  • Were so vague that they “created confusion as to who…was responsible for reviewing transactions to ensure they were appropriate and compliant with Reg. BI’s duty of vigilance”; and
  • Did not include guidance for (i) supervisory reviews to determine whether a transaction was in the best interest of a client for purposes of complying with Reg. BI; or (ii) monitoring or enforcing the requirement that Registered Representatives consider reasonably available alternatives in a recommended capacity.

The SEC also finds that the company’s other policies and procedures were particularly inadequate (for example, no guidelines for offerings when the issuer does not establish specific suitability standards, compliance staff tasked with monitoring representatives and supervisors “only when the total amounts invested exceed 10% of the client’s net worth”).

The SEC also alleges that the company failed to enforce policies available to it to comply with Reg. BI Care’s obligation, including its training policy (or it “was enforced in such a way that it failed to ensure that Registered Representatives correctly understood” the bonds), and did not require Not that firm staff, with the exception of the CCO, review the due diligence report on obligations.

We expect this case to be just the tip of the iceberg for Reg. BI application activity. The fact that the issuer of the L bonds went bankrupt may have made this matter more urgent, but other cases are likely to arise from routine broker reviews. The L bonds were sold by a network of brokers, so other brokers and registered representatives who sold the issuer’s L bonds may settle with the SEC or face similar complaints if they sell to retail customers without adequately fulfilling their obligations under Reg. BI.


[1] See testimony before the Subcommittee on Financial Services and General Government, US 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 the statement further provides: “Because these company-wide threshold decisions have such a significant effect on subsequent recommendations ultimately made to a retail client, we require disclosure of material limitations on securities or investment strategies involving securities that may be recommended — by the broker-dealer and its related persons — and any associated conflicts of interest See Release No. 34-86031 at 180.
[3] “The [Reg. BI] The adoption of the release states that what is in the best interests of a retail client depends on the facts and circumstances of the recommendation, including the “match” of the recommended security with the investment profile of the retail client . Where the “match” between the retail client’s profile and the recommendation appears less reasonable, it is more important for the broker to establish that they reasonably believed the recommendation was in the retail client’s best interest. The Adoption Release also states that in addition to “matching” the recommendation to the client’s suitability profile, a Registered Representative must also exercise reasonable diligence, care, and skill in considering reasonably available alternatives. See Case No. 2:22-cv-04119 at pp. 50 and 51.

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