In 2022, the SEC brought its first enforcement action centered on the alleged failure of a broker-dealer and its associated persons to comply with the Regulation Best Interest (“Reg BI”) “care obligation.” The SEC sought to use the case to impose a new standard of knowledge and education about investments upon investment professionals. The defendants fought back, notably securing victories in motions practice, prevailing over the government’s effort to strike affirmative defenses based on fair notice, vagueness, and due process. Along with some legal commentators, the defendants raised significant questions about the SEC’s claims, including whether Reg BI truly prohibited certain conduct cited in the complaint and whether Reg BI sufficiently articulates the specific requirements imposed by the obligations of reasonable diligence and care.
Now that case, SEC v. Western International Securities, et al(No. 2:22-cv-04119 in the U.S. District Court for the Central District of California) has settled, and last week the Court entered a consent Final Judgment that includes a permanent injunction, disgorgement of “net profits gained as a result of conduct alleged in the Complaint,” and a civil penalty. The dollar amounts are not overwhelming—$34,468 in disgorgement and a $160,000 civil penalty against the brokerage firm, and generally lesser amounts for its associated persons.
The legal challenges raised by defendants and commentators in this case may be raised again in response to future enforcement actions. But the SEC has now locked in its first set of final federal court orders enforcing Reg BI based on the aggressive interpretation it advanced in Western International. The SEC is likely to build on its approach, so a close read of the case has important lessons for both financial professionals and attorneys who represent them.
Background on SEC v. Western International
The SEC’s complaint focused on recommendations by broker representatives that retail customers invest in corporate bonds issued by GWG Holdings. The bonds were issued after significant changes to the company’s structure and business strategy. They were issued while the company itself was enduring a string of operating losses. And they were characterized as high risk by GWG itself. Eventually, GWG Holdings declared bankruptcy.
In the complaint, the SEC targeted a broker and its associated persons who had recommended the purchase of the bonds to their clients. The complaint included a searching analysis of the registered representatives’ reasons for their recommendations, along with prolonged criticisms of the broker’s efforts to train its representatives. The SEC Staff built its case around the assertion that efforts to educate the representatives about the bonds and the issuing company had fallen short. The SEC Staff admitted that, despite the ultimate failure of GWG, the bonds were a reasonable choice for some retail customers. But according to the SEC, the associated persons lacked sufficient knowledge and awareness of GWG’s business and the nature of the bonds to adequately assess their nature and risk, and thus to separate wheat from chaff.
Lesson One: The Training Record of Associated Persons Is Critical
In the Western International complaint, the SEC focused pages of attention on the content and timing of the training undertaken by the broker-dealer’s associated persons. The complaint made clear that “box checking” a training video will not suffice under Reg BI when an underlying investment goes wrong. The staff noted that “all of the Registered Representative Defendants took a training course on GWG L Bonds.” But, the complaint alleged, “four of them … took that training on a prior issuance of L Bonds, not those sold pursuant to the 2020 prospectus.” The complaint went on to note that “[a]lthough Western’s CCO received the [GWG] Due Diligence Report, the CCO did not share the report or its contents with Western’s registered representatives,” none of whom “received or reviewed” it.
Both the company and the underlying investment had changed by the time of the relevant investments. The SEC faulted both the broker-dealer and the representatives for failing to train regularly on all new iterations of the securities at issue.
In similar matters, counsel have noted the importance of documenting every aspect of the training record for representatives. More critically, a smart representative will not just keep up to speed on all available trainings for any security he recommends, but will also keep copious and detailed records of his or her educational process.
Lesson Two: Knowledge of the Business of the Issuing Company Is Essential
The SEC complaint hammered the representatives for their alleged limited understanding of the underlying business of GWG. Following a merger, GWG had changed its business strategy from “the business of purchasing life insurance policies on the secondary market” to “offering loans, other liquidity products, and related services to customers holding illiquid alternative assets.” The SEC lasered in on the allegation that the representatives “erroneously believed that GWG was continuing to invest in life insurance policies” or “did not know about the business combination.”
Based on experience of similar matters since the rollout of Reg BI, the SEC’s emphasis on a representative’s knowledge of the business model of an issuing company whose securities she recommends cannot be overstated. SEC Staff questioning on this point can be sharp and searching, testing years-old recollections. Representatives must be prepared to articulate the entirety of their knowledge and understanding. That means careful notation by an associated person of his or her assessment of the company behind the investment, made at the time he or she makes the recommendation, may provide valuable documentation should an investigation come to pass.
Lesson Three: Knowledge of the Investment Details Is Essential
The complaint applied the same exacting standard to the representatives’ knowledge about the investments themselves. The SEC alleged that the associated persons “failed to appreciate that the life insurance policies [held by GWG] did not collateralize the bonds,” meaning that “other creditors had first claim on those life insurance policies, not the L Bond investors.” The complaint further alleged that several representatives wrongly “describ[ed] them as relatively safe” instead of carrying the “high degree of risk” noted in the GWG prospectus.
The SEC regarded these allegations as damning. In their view, the absence of a detailed and nuanced understanding of even technical aspects of the bonds rendered suspect any judgment by the representatives that the securities were reasonable for particular investors.
This issue, like knowledge of the issuing company, is subject to sharp and exacting interrogation by the SEC. Representatives must be prepared to give a full account of what they understood about an investment when they recommended it.
Lesson Four: Preparation Is Key
These lessons lead to a more fundamental practice, key for counsel representing broker-dealers or associated persons called to testify before the SEC: Representatives and broker representatives must be very well-prepared. To be sure, they cannot invent historical knowledge about recommended securities, and counsel cannot participate in any such invention. False testimony is a crime; and, more prosaically, it is always likely that evidence from other sources will undermine any inaccurate, self-serving recollection.
But neither can broker-dealers or representatives walk into testimony with only loosely recalled facts. Counsel must prepare them by drilling down into the historical details of their assessment of the security at issue. That means analyzing what the representative knew about the business, the investment, and the customer; when and how he knew it; and the measures he really took to self-educate. Recourse to notes and correspondence contemporaneous with the relevant recommendation is important. That means representatives are wise to keep careful notes of their process for analysis and recommendations on an ongoing basis.
Before testimony, counsel for a broker or for a representative should drill the representative to the point where she can accurately and succinctly explain 100 percent — not 99 percent — of her real, historical recommendation rationale and its basis.
Lesson Five: The Rules Are Still in Flux
Despite this settlement and final judgment, the SEC’s interpretation of what is necessary for brokers and associated persons to discharge the care obligation in Reg BI cases is not yet authoritative. To avoid the Commission’s crosshairs, adherence to these lessons from this first big Reg BI case is wise. But in any contested proceeding, counsel should also keep in mind that, prior to settlement, the court in Western International gave significant runway to arguments based on fair notice, vagueness, and due process. Such arguments may even be expanded as deference to administrative interpretations narrows in the wake of Loper Bright Enterprises v. Raimondo and related new precedents. The entire case record in Western International is important reading for any counsel defending a Reg BI inquiry.
Craig M. Warner is a partner at Duane Morris in Dallas. He served as an assistant U.S. Attorney and a Navy Judge Advocate. He advises clients ranging from middle market companies to Fortune 500 corporations on how to manage active and potential litigation and investigations. The opinions expressed are those of the author and do not necessary reflect the views of his employer, its clients, or any of their affiliates. This article is for general informational purposes and is not intended to be and should not be taken as legal advice.