The SEC’s first enforcement action involving wealth managers’ care obligation to clients under Regulation Best Interest could trigger a lengthy court case and alarm bells across the industry.
Western International Securities, a subsidiary of Atria Wealth Solutions, is accused of selling $13.3 million worth of troubled alternative asset manager GWG Holdings’ L Bonds products between July 2020 and April 2021 without having a “reasonable basis” to believe the investments were in clients’ best interests, according to the SEC. In a civil case filed June 15 in Los Angeles federal court, the regulator accused Western International and five of its registered representatives with violating the 2-year-old Reg BI rule.
While this case follows 42 small settlements relating to Reg BI’s procedural obligation to file and display “customer relationship summary” documents, those matters technically charged the firms with infractions under the Investment Advisers Act and the Securities Exchange Act. Western International’s case marks the SEC’s first direct enforcement action under the controversial rule, which subjects wealth managers selling alternative products like the L Bonds to tougher scrutiny about how they fit clients’ needs. Investigators say that the “high-risk, illiquid investment” didn’t serve Western International clients’ best interests.
“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 complaint states. “The [reps] nevertheless recommended L Bonds to these seven customers without reasonable basis for doing so.”
With state regulators, the SEC itself and FINRA each reporting problems with certain aspects of the industry’s Reg BI compliance, wealth managers have been expressing concerns about the amount of potential enforcement actions to expect from SEC Chair Gary Gensler under from the Biden administration.
Western International’s case displays how the SEC’s enforcement staff is “expanding their view of investor protection through Best Interest,” according to Arbitration Insight’s Louis Straney, a former regulator who serves as an expert witness. High-yielding but illiquid investments often come with substantial risks based on issuers like GWG, which filed for bankruptcy protection in April and whose L Bonds have already been the subject of a number of arbitration cases.
“It’s really not a space for amateurs. It’s certainly an area that could attract people during times of relatively low interest rates and questionable returns in the equity markets,” said Straney, predicting that regulators’ next cases under Reg BI could take many forms. “There are plenty of areas for them to look at, but this is certainly one that should be a priority.”
While the case against Western International could have been brought under the previous suitability standard for brokerages prior to Reg BI or through other existing statutes against misrepresentations or omissions, it will remind wealth managers to “make sure that they have policies and procedures in place” at their own firms, said Brian Rubin, the head of law firm Eversheds Sutherland’s SEC, FINRA and state securities enforcement practice.
“It’s clear that the gloves are off and that the SEC will be enforcing Reg BI, and I anticipate FINRA will as well,” Rubin said. “In the future, we will see more cases in this space, and I think some of them will have more nuance.”
For its part, Western International is denying the SEC’s allegations. Private equity-backed Atria, which owns a half dozen midsize wealth managers, purchased Pasadena, California-based Western International in May 2020. Western International had more than 400 independent financial advisors with $13 billion in client assets at the time of the deal.
“The firm takes its clients’ best interests very seriously and believes it complied with Reg BI and the regulatory guidance available during the pertinent timeframe,” spokesman Julian Arenzon said in a statement. “The firm intends to actively defend the claims asserted by the SEC and will not provide additional comments on this pending litigation at this time.”
The enforcement action stemmed from an SEC examination of the firm. Western International had put policies in place for alternatives like GWG’s L Bonds, but they weren’t sufficient for Reg BI’s obligations, according to the SEC. The firm generated $187,000 in commissions and fees on the sales, investigators say. The five reps — Nancy Cole, Patrick Egan, Andy Gitipityapon, Steven Graham and Thomas Swan — received a combined $70,000, according to the complaint. The L Bonds they sold were corporate bonds paying fixed interest rates between 5.5% and 8.5% over maturity periods of two to seven years, the SEC says.
GWG has sold about $2 billion worth of L Bonds since it began doing so in 2012, with $453 million in volume during the manager’s fourth offering of the products beginning in June 2020, according to the SEC. Until 2018, GWG’s business model simply involved buying life insurance policies on the secondary market, according to the regulator. That year, it and another firm called Beneficient Company Group, L.P. began a series of transactions that made Beneficient a subsidiary of GWG and changed its business to a focus on “providing liquidity to owners of alternative assets and illiquid investments,” the SEC complaint states. Other than goodwill on its balance sheet, GWG’s “liabilities are well in excess of its assets,” according to the regulator.
Western International’s procedures failed its clients in the face of that risk, investigators say. The firm’s chief compliance officer performed due diligence on the fourth offering of the products, but the subsequent report never reached Western International’s reps, supervisors or even other members of the compliance team, according to the SEC. In addition, the firm didn’t place any restrictions on sales of the L Bonds such as prohibiting them to clients with certain risk profiles or investment objectives, the SEC says. The firm’s mandatory online training course about L Bonds didn’t extend to reps who had already taken it for earlier offerings, despite the change in the issuer’s business model since that time, according to the regulator.
The SEC complaint includes descriptions of each of the seven clients who purchased L Bonds through the Western International brokers. One of them was a 79-year-old former truck driver, another was a 54-year-old restaurant server and a third was a 75-year-old retiree, according to the regulator.
“These registered representatives recommended L Bonds to retail customers despite having an insufficient and sometimes erroneous understanding of the investment,” according to the document. “Each of the Registered Representative Defendants misunderstood important issues regarding GWG and L Bonds. … Each of these issues were disclosed by GWG in the 2020 prospectus and/or in its public filings.”
The regulator charged the five reps and Western International with violating Reg BI’s care obligations to clients and the firm with transgressing the rule’s compliance requirements for written policies and procedures in line with the guidelines. While the case makes no allegations about investment losses sustained by the firm’s clients, the SEC seeks disgorgement of “any unjust enrichment they received as a result of the misconduct” and payment of civil penalties.