United States Sec. & Exch. Comm'n v. W. Int'l Sec.

1

UNITED STATES SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. WESTERN INTERNATIONAL SECURITIES, INC. et al., Defendants.

No. 2:22-cv-04119-ODW (AFMx)

United States District Court, C.D. California

March 13, 2023

ORDER GRANTING IN PART AND DENYING IN PART PLAINTIFF'S MOTION TO STRIKE

AFFIRMATIVE DEFENSES [56]

OTIS D. WRIGHT, II UNITED STATES DISTRICT JUDGE

I. INTRODUCTION

Plaintiff United States Securities and Exchange Commission (“SEC”) brings suit against Defendant Western International Securities, Inc. (“Western”) and five of its registered representatives for violating SEC Regulation Best Interest in connection with recommending and brokering the purchase of high-risk, illiquid L Bonds for Western's retail investor clients. The SEC now moves to strike several of Defendants' affirmative defenses. (Mot Strike (“Motion” or “Mot.”), ECF No. 56.) Having carefully considered the papers filed in connection with the Motion, the Court deemed the matter appropriate for decision without oral argument. Fed.R.Civ.P. 78; C.D. Cal. L.R. 7-15. For the following reasons, the Court GRANTS IN PART AND DENIES IN PART the SEC's Motion.

II. BACKGROUND

This matter concerns alleged violations by Western and five of its registered representatives of Regulation Best Interest, Rule 15l-1(a) of the Securities Exchange Act of 1934, 17 C.F.R. § 240.15l-1(a), in connection with offering L Bonds to Western's retail investor clients. (Compl. ¶ 6, ECF No. 1.) Western alleges that this is the SEC's first ever action to enforce Regulation Best Interest. (Western Answer 63, ECF No. 45.) The Court begins by discussing the purpose of Regulation Best Interest and the circumstances surrounding its adoption.

A. Regulation Best Interest

In 2010, Congress, by way of the Dodd-Frank Wall Street Reform and Consumer Protection Act, directed the SEC to investigate and adopt new rules regarding the appropriate standard of conduct to govern the relationship between broker-dealers and their customers. Pub. L. No. 111-203, § 913, 124 Stat. 1376, 1824-30 (2010). Nearly a decade of public debate on the topic followed. XY Plan. Network, LLC v. SEC, 963 F.3d 244, 250 (2d Cir. 2020) (noting SEC received “over 6,000 comment letters . . . and held a series of ‘investor roundtables'” to gather feedback on the proposed rule (quoting Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 34-86031 (June 5, 2019), 84 Fed.Reg. 33,318, 33,320, 2019 WL 3043879 (July 12, 2019) (“Adopting Release”))). On June 5, 2019, as a result of these efforts, the SEC adopted Regulation Best Interest. 17 C.F.R. § 240.15l-1; XY Plan., 963 F.3d at 249-50 (2d Cir. 2020) (discussing history of Regulation Best Interest).

Regulation Best Interest establishes a standard of conduct for broker-dealers and associated persons when they recommend securities transactions or investment strategies to retail customers. Adopting Release, 84 Fed.Reg. at 33,318-19; (Compl. ¶ 43). It does this by “enhanc[ing] the broker-dealer standard of conduct beyond existing suitability obligations, and align[ing] the standard of conduct with retail customers' reasonable expectations.” Adopting Release, 84 Fed.Reg. at 33,318.

Under Regulation Best Interest, broker-dealers must “[a]ct in the best interest of the retail customer at the time the recommendation is made,” without placing the interest of the broker-dealer ahead of the interest of the retail customer. Id. The “best interest” standard is therefore more stringent than the previously applicable “suitability” standard, which required broker-dealers to “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer.” FINRA Rule 2111(a); Adopting Release, 84 F.R. at 33,374 (discussing “existing suitability requirements” under FINRA Rule 2111). At the same time, the “best interest” standard is less stringent than the fiduciary standard that applies to registered investment advisers. SEC v. Criterion Wealth Mgmt. Servs., Inc., 599 F.Supp.3d 932, 949 (C.D. Cal. 2022).

Regulation Best Interest consists of four component obligations: (1) the Disclosure Obligation, (2) the Care Obligation, (3) the Conflict of Interest Obligation, and (4) the Compliance Obligation. 17 C.F.R. 240.15l-1(a)(2)(i)-(iv); (Compl. ¶ 46). This case involves alleged violations of the Care Obligation and the Compliance Obligation. (See Compl. ¶¶ 47-52.) The Care Obligation requires a broker-dealer to exercise reasonable diligence, care, and skill to, among other things, (1) understand the risks associated with a particular securities transaction, and (2) have a reasonable basis to believe that the recommended transaction is in the best interest of a retail customer, given that customer's specific investment profile and characteristics. 17 C.F.R. 240.15l-1(a)(2)(ii); (Compl. ¶¶ 47-49). The Compliance Obligation requires a broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest. 17 C.F.R. 240.15l-1(a)(2)(iv); (Compl. ¶ 52).

In June 2019, the SEC issued a voluminous^[1] adopting release regarding Regulation Best Interest. (Western Answer ¶ 5); see Adopting Release. The compliance date for Regulation Best Interest was set for June 30, 2020, more than a year after the SEC adopted the Regulation, in order to provide an “opportunity for broker-dealers to comply with [Regulation Best Interest], including by creating or updating the necessary disclosures and . . . developing, updating or establishing their policies and procedures and systems, as appropriate, to achieve compliance with [Regulation Best Interest].” Id. at 33,400; (Western Answer ¶ 6).

B. L Bonds

With this action, the SEC alleges that Defendants violated Regulation Best Interest when they recommended their retail investor clients invest in L Bonds. L Bonds were high-risk, illiquid corporate bonds^[2] that paid fixed interest rates of between 5.5% and 8.5% and were available with two-, three-, five-, or seven-year maturity periods. (Compl. ¶ 7.)

L Bonds were offered by GWG Holdings, Inc. (Id.) GWG is a financial services company whose business model prior to 2018 centered on acquiring life insurance policies in the secondary market. (Id. ¶ 23.) This involved purchasing life insurance policies from consumers who no longer wanted or needed their policies, continuing to pay the premiums, and collecting the policy benefits upon the insured's death. (Id.)

In 2018 and 2019, GWG consummated a series of transactions with nonparty Beneficient, resulting in a significant reorientation of GWG's business model. (Id. ¶ 24.) In particular, Beneficient became a wholly owned subsidiary of GWG, and GWG stopped acquiring life insurance policies. (Id.) GWG now operates pursuant to Beneficient's business model, which is different. (Id. ¶¶ 24-25.)

Since GWG began offering L Bonds in 2012, it has offered L Bonds in a total of four separate offerings. (Id. ¶¶ 26, 28.) The L Bonds relevant to this action are from GWG's fourth offering, which was an offering of up to $2 billion in L Bonds that began in June 2020. (Id. ¶ 28.) In connection with this offering, GWG issued a forty-page prospectus that indicated that investing in L Bonds involves a “high degree of risk, including the risk of losing “one's entire investment[,]” and that “[i]nvesting in L Bonds may be considered speculative.” (Id. ¶¶ 31, 33.) The prospectus further indicated that, due to the lack of a secondary market for L Bonds, they “are only suitable for persons with substantial financial resources and with no need for liquidity in [the] investment.” (Id. ¶ 34.)

GWG's largest tangible asset is its portfolio of life insurance policies, which as of December 31, 2019, had a face value of approximately $2 billion and a fair value of $796 million. (Id. ¶ 39.) However, L Bonds are not directly secured by GWG's life insurance portfolio. (Id.) Instead, they are primarily secured by GWG's equity ownership interests in certain GWG subsidiaries. (Id.) As a result, the claims of L Bond holders to any of GWG's assets, including its portfolio of life insurance policies, are subordinate to the interests of GWG's subsidiaries' creditors. (Id.) This is important because the fair value of GWG's life insurance portfolio, less the amounts GWG owes to its senior creditors, is insufficient to repay GWG's outstanding L Bond debt. (Id.)

In January 2022, GWG became unable to meet its obligations and suspended further sales of L Bonds. (Id. ¶ 41.) On April 20, 2022, GWG filed for Chapter 11 bankruptcy. (Id. ¶ 42.) As a result, those who invested in L Bonds stand to lose a significant amount of their principal. (See id. ¶ 84 (“[T]he value of GWG's life insurance portfolio was not sufficient to repay all of GWG's outstanding debt.”).)

C. L Bond Purchases Recommended and Brokered by Western

The process by which Western recommended and executed the purchase of L Bonds for its investor customers comprised several steps and included several written forms. Taken together, the forms enabled Western to collect information about the investor that might be pertinent to whether L Bonds were an appropriate investment. Among other things, the customer would provide Western with the total amount of alternative or illiquid investments the customer held and the percentage of the customer's liquid net worth that would be invested in alternative or illiquid investments after their L Bond purchase. (Id. ¶ 61.) The forms were then forwarded to a Western supervisor for review; the chief responsibility of the supervisor (or the supervisor's delegate) was to ensure the forms were completely filled out and to verify...