SEC Signals Enforcement Ramp-Up Coming for Conflicted Brokers

Stockbrokers who don’t act in the best interests of investors should expect securities regulators to start taking a tougher stance, as Wall Street’s top cop signals it’s ready to ramp up enforcement.

Regulation Best Interest, or Reg BI, raised the standard for brokers when it took effect several years ago, directing them to act in the “best interest” of their clients. The rule was part of a decade-long fight over protections for retail investors, including those saving money for college or retirement.

The Securities and Exchange Commission has taken a light touch since the rule took effect, bringing just one lawsuit over alleged violations of Reg BI. But a series of recent alerts from SEC staff suggest the grace period may soon be coming to a close.

“The next phase is enforcement,” Jay Gould of Baker Botts LLP said, adding that the “guidance is out there. You need to know about it, you need to act on it.”

‘Generational Shift’

Reg BI requires brokers to act in the best interest of their clients when recommending transactions or investment strategies. That includes exercising reasonable care when making recommendations to investors and disclosing, or eliminating, conflicts of interest. A divided SEC approved the rule in 2019, with supporters saying it would make the services that financial firms offer clients more transparent.

But there were uncertainties about what the “best interest” standard required.

The agency’s only Reg BI lawsuit to date came in June 2022 against Pasadena, Calif.-based Western Securities International Inc. The SEC accused the firm of not exercising reasonable diligence to understand the risks of certain bonds it sold to retail investors.

The case is ongoing in the US District Court for the Central District of California.

It appears the SEC has been giving brokers a chance to catch up with the “best interest” standard before cracking down with more enforcement actions, attorneys said.

“I think the SEC rightfully has been giving firms time to implement what was really a generational shift in the obligations they owe to customers,” McGuireWoods LLP attorney Brian Baltz said.

But that runway is shortening.

The SEC has in recent months issued a series of guidance bringing the regulation into sharper focus. The most recent update was published in late April and dealt with brokers’ “care obligations.”

The agency has also published a risk alert highlighting Reg BI-related deficiencies from its examinations. The SEC noted, among other things, that some brokers didn’t have policies or procedures designed to comply with their care obligations.

“It’s time to get your house in order,” Faegre Drinker Biddle & Reath LLP attorney Sandra Grannum said. “I do think that enforcement will be around the corner.”

Aligning Duties

The adoption of Reg BI came after a more stringent Obama-era proposal from the Labor Department was struck down in court.

The SEC’s rule was viewed at the time as a win for large Wall Street firms. Critics argued it didn’t go far enough to protect investors, while investment advisers said it imposed a lower standard for brokers.

But there has been a message to brokers in the SEC’s recent guidance, Gould said: “You have a greater duty than you may think.”

The SEC’s guidance more closely aligns the duties of brokers with the higher “fiduciary” duty that applies to investment advisers, attorneys said. The SEC in April said the tests for the two groups “generally yield substantially similar results” in terms of responsibilities owed to investors.

While the guidance isn’t binding, it signals what SEC staff expect from the industry.

Brokers have an obligation to understand the needs of investors, including their financial situation, and to consider the available alternatives, the SEC said in last month’s guidance. A product’s cost is a factor, the agency said.

Firms should also scrutinize whether a risky or complex product is in the investor’s best interest, and consider whether lower risk alternatives could achieve the same results for clients, the SEC said.

“By calling that out specifically, the staff is indicating that those areas will be a focus both in exams and potentially in enforcement matters to come,” Ropes & Gray LLP attorney Amy Jane Longo said.

Harmonizing the obligations of brokers and investment advisers makes sense, some say, as brokers become more like their counterparts.

But that means additional training for brokers who have worked under a lower standard. It also requires brokerage firms to have the right compliance systems in place, attorneys said.

While larger firms might have taken those measures already, some regional and smaller firms were waiting to see how the rule shakes out before building their systems, attorneys said. They’re now going to be in a position of playing catch-up.

“It feels to me the brokerage firms are making an earnest effort to get on board and to clean up anything that might look unacceptable to the SEC,” Grannum said. “It might just be a scramble to see who’s left standing when the music stops.”