The Securities and Exchange Commission (SEC) recently charged a California-based brokerage and five of its registered representatives with violating Regulation Best Interest (Reg BI). The case involves the sale of more than $13 million of high-risk L Bonds to retail investors between 2020 and 2021.
These recommendations violated Regulation Best Interest in several ways:
Let’s start with the Care Obligation. Reg BI’s Care Obligation requires a broker dealer when making a recommendation of a securities transaction, to exercise reasonable diligence, care, and skill to understand the potential risks, rewards, and costs associated with the recommendation. In this case, the firm and defendants failed to comply with this aspect of their Care Obligation, because they failed to do just that.
At the time they recommended L Bonds to retail customers, the representatives did not understand key risks associated with L Bonds and the firm. Reg BI’s Care Obligation also requires a broker to exercise reasonable diligence, care, and skill to have a reasonable basis to believe the recommendation is in the best interests of that customer, based on the customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation. The defendants failed to comply with this component of the Care Obligation as well, by recommending L Bonds to at least seven retail customers without a reasonable basis to believe L Bonds were in those customers’ best interests.
Among other things, these customers had moderate-conservative or moderate risk tolerances, investment objectives that did not include speculation, limited investment experience, limited liquid net worth, and/or they were retired. The representatives nevertheless recommended L Bonds to these seven customers without reasonable bases for doing so.
Additionally, Reg BI’s Compliance Obligation requires brokers or dealers to (a) establish, (b) maintain, and (c) enforce written policies and procedures reasonably designed to achieve compliance with Reg BI. The firm failed to comply with its Compliance Obligation. Its written policies and procedures were not reasonably designed as they merely recited the objectives of Reg BI, without offering representatives specific guidance tailored to its operations. The firm also had inadequate procedures for enforcing what limited policies it had regarding compliance with the Care Obligation of Reg BI.
Case In Point: A Customer Example
This lack of diligence was focalized when looking into why this particular product was recommended. One of the defendants recommended L Bonds to a retail customer who purchased $100,000 in two-year L Bonds in or around November 2020. This customer was a 79-year-old retired truck driver with a moderate risk tolerance whose investment objectives did not include speculation. This customer had limited general investment knowledge and limited knowledge of bonds. At the time of his L Bond purchase, his annual income was $35,000 and his liquid net worth was $300,000.
The L Bond investment comprised 10% of his net worth and 33% of his liquid net worth. He made his L Bond investment in his individual retirement account and planned to use the L Bond investment primarily for personal use. In the “rationale” section of the Client Disclosure Form for his L Bond investment, the defendant wrote, in full: “Customer is seeking a higher rate of interest from funds sitting in a bank savings at .05%. They will utilize the interest for supplemental income each month.”
Nowhere did the defendant document why he believed L Bonds specifically were in his best interest or why he chose to recommend L Bonds to the customer as opposed to the many other investments that offered greater than .05% interest rates. The defendant’s basis for believing that $100,000 L Bond purchase was in his best interest were unreasonable, vague, and generic. Neither the defendant’s supervisor, the supervisor’s delegate, nor the firm’s compliance department raised any questions or concerns with the customer’s L bond investment.
To read the complete SEC press release, “SEC Charges Firm and Five Brokers with Violations of Reg BI,” click here.