United States Securities and Exchange Commission v. Western International Securities, Inc.

Opinion

Case 2:22-cv-04119-ODW-AFM Document 71 Filed 03/13/23 Page 1 of 21 Page ID #:781

O 1

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8 United States District Court 9 Central District of California

11 UNITED STATES SECURITIES AND Case № 2:22-cv-04119-ODW (AFMx) EXCHANGE COMMISSION, 12 ORDER GRANTING IN PART AND Plaintiff, 13 DENYING IN PART PLAINTIFF’S v. MOTION TO STRIKE 14 AFFIRMATIVE DEFENSES [56] WESTERN INTERNATIONAL 15 SECURITIES, INC. et al.,

16 Defendants.

17 19 Plaintiff United States Securities and Exchange Commission (“SEC”) brings 20 suit against Defendant Western International Securities, Inc. (“Western”) and five of 21 its registered representatives for violating SEC Regulation Best Interest in connection 22 with recommending and brokering the purchase of high-risk, illiquid L Bonds for 23 Western’s retail investor clients. The SEC now moves to strike several of Defendants’ 24 affirmative defenses. (Mot. Strike (“Motion” or “Mot.”), ECF No. 56.) Having 25 carefully considered the papers filed in connection with the Motion, the Court deemed 26 the matter appropriate for decision without oral argument. Fed. R. Civ. P. 78; 27 C.D. Cal. L.R. 7-15. For the following reasons, the Court GRANTS IN PART AND 28 DENIES IN PART the SEC’s Motion. Case 2:22-cv-04119-ODW-AFM Document 71 Filed 03/13/23 Page 2 of 21 Page ID #:782

2 This matter concerns alleged violations by Western and five of its registered 3 representatives of Regulation Best Interest, Rule 15l-1(a) of the Securities Exchange 4 Act of 1934, 17 C.F.R. § 240.15l-1(a), in connection with offering L Bonds to 5 Western’s retail investor clients. (Compl. ¶ 6, ECF No. 1.) Western alleges that this 6 is the SEC’s first ever action to enforce Regulation Best Interest. (Western 7 Answer 63, ECF No. 45.) The Court begins by discussing the purpose of Regulation 8 Best Interest and the circumstances surrounding its adoption. 9 A. Regulation Best Interest 10 In 2010, Congress, by way of the Dodd-Frank Wall Street Reform and 11 Consumer Protection Act, directed the SEC to investigate and adopt new rules 12 regarding the appropriate standard of conduct to govern the relationship between 13 broker-dealers and their customers. Pub. L. No. 111-203, § 913, 124 Stat. 1376, 14 1824–30 (2010). Nearly a decade of public debate on the topic followed. XY Plan. 15 Network, LLC v. SEC, 963 F.3d 244, 250 (2d Cir. 2020) (noting SEC received “over 16 6,000 comment letters . . . and held a series of ‘investor roundtables’” to gather 17 feedback on the proposed rule (quoting Regulation Best Interest: The Broker-Dealer 18 Standard of Conduct, Exchange Act Release No. 34–86031 (June 5, 2019), 84 Fed. 19 Reg. 33,318, 33,320, 2019 WL 3043879 (July 12, 2019) (“Adopting Release”))). On 20 June 5, 2019, as a result of these efforts, the SEC adopted Regulation Best Interest. 21 17 C.F.R. § 240.15l-1; XY Plan., 963 F.3d at 249–50 (2d Cir. 2020) (discussing 22 history of Regulation Best Interest). 23 Regulation Best Interest establishes a standard of conduct for broker-dealers 24 and associated persons when they recommend securities transactions or investment 25 strategies to retail customers. Adopting Release, 84 Fed. Reg. at 33,318–19; (Compl. 26 ¶ 43). It does this by “enhanc[ing] the broker-dealer standard of conduct beyond 27 existing suitability obligations, and align[ing] the standard of conduct with retail 28 customers’ reasonable expectations.” Adopting Release, 84 Fed. Reg. at 33,318.

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1 Under Regulation Best Interest, broker-dealers must “[a]ct in the best interest of the 2 retail customer at the time the recommendation is made,” without placing the interest 3 of the broker-dealer ahead of the interest of the retail customer. Id. The “best 4 interest” standard is therefore more stringent than the previously applicable 5 “suitability” standard, which required broker-dealers to “have a reasonable basis to 6 believe that a recommended transaction or investment strategy involving a security or 7 securities is suitable for the customer.” FINRA Rule 2111(a); Adopting Release, 8 84 F.R. at 33,374 (discussing “existing suitability requirements” under FINRA Rule 9 2111). At the same time, the “best interest” standard is less stringent than the 10 fiduciary standard that applies to registered investment advisers. SEC v. Criterion 11 Wealth Mgmt. Servs., Inc., 599 F. Supp. 3d 932, 949 (C.D. Cal. 2022). 12 Regulation Best Interest consists of four component obligations: (1) the 13 Disclosure Obligation, (2) the Care Obligation, (3) the Conflict of Interest Obligation, 14 and (4) the Compliance Obligation. 17 C.F.R. 240.15l-1(a)(2)(i)-(iv); (Compl. ¶ 46). 15 This case involves alleged violations of the Care Obligation and the Compliance 16 Obligation. (See Compl. ¶¶ 47–52.) The Care Obligation requires a broker-dealer to 17 exercise reasonable diligence, care, and skill to, among other things, (1) understand 18 the risks associated with a particular securities transaction, and (2) have a reasonable 19 basis to believe that the recommended transaction is in the best interest of a retail 20 customer, given that customer’s specific investment profile and characteristics. 21 17 C.F.R. 240.15l-1(a)(2)(ii); (Compl. ¶¶ 47–49). The Compliance Obligation 22 requires a broker-dealer to establish, maintain, and enforce written policies and 23 procedures reasonably designed to achieve compliance with Regulation Best Interest. 24 17 C.F.R. 240.15l-1(a)(2)(iv); (Compl. ¶ 52). 25 In June 2019, the SEC issued a voluminous1 adopting release regarding 26 Regulation Best Interest. (Western Answer ¶ 5); see Adopting Release. The 27 28 1 The SEC avers that the Adopting Release is 175 pages, (Compl. ¶ 44), whereas Defendants assert that it is 770 pages, (Individual Defs. Opp’n 4, ECF No. 60; Western Answer ¶ 5.).

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1 compliance date for Regulation Best Interest was set for June 30, 2020, more than a 2 year after the SEC adopted the Regulation, in order to provide an “opportunity for 3 broker-dealers to comply with [Regulation Best Interest], including by creating or 4 updating the necessary disclosures and . . . developing, updating or establishing their 5 policies and procedures and systems, as appropriate, to achieve compliance with 6 [Regulation Best Interest].” Id. at 33,400; (Western Answer ¶ 6). 7 B. L Bonds 8 With this action, the SEC alleges that Defendants violated Regulation Best 9 Interest when they recommended their retail investor clients invest in L Bonds. 10 L Bonds were high-risk, illiquid corporate bonds2 that paid fixed interest rates of 11 between 5.5% and 8.5% and were available with two-, three-, five-, or seven-year 12 maturity periods. (Compl. ¶ 7.) 13 L Bonds were offered by GWG Holdings, Inc. (Id.) GWG is a financial 14 services company whose business model prior to 2018 centered on acquiring life 15 insurance policies in the secondary market. (Id. ¶ 23.) This involved purchasing life 16 insurance policies from consumers who no longer wanted or needed their policies, 17 continuing to pay the premiums, and collecting the policy benefits upon the insured’s 18 death. (Id.) 19 In 2018 and 2019, GWG consummated a series of transactions with nonparty 20 Beneficient, resulting in a significant reorientation of GWG’s business model. (Id. 21 ¶ 24.) In particular, Beneficient became a wholly owned subsidiary of GWG, and 22 GWG stopped acquiring life insurance policies. (Id.) GWG now operates pursuant to 23 Beneficient’s business model, which is different. (Id. ¶¶ 24–25.) 24 Since GWG began offering L Bonds in 2012, it has offered L Bonds in a total 25 of four separate offerings. (Id. ¶¶ 26, 28.) The L Bonds relevant to this action are 26 from GWG’s fourth offering, which was an offering of up to $2 billion in L Bonds 27 2 “A corporate bond is a debt obligation, like an ‘IOU.’ Customers who buy corporate bonds are 28 lending money to the company issuing the bond. In return, the company promises to pay interest on the principal and to return the principal when the bond comes due, or ‘matures.’” (Compl. ¶ 27.)

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1 that began in June 2020. (Id. ¶ 28.) In connection with this offering, GWG issued a 2 forty-page prospectus that indicated that investing in L Bonds involves a “high degree 3 of risk, including the risk of losing “one’s entire investment[,]” and that “[i]nvesting 4 in L Bonds may be considered speculative.” (Id. ¶¶ 31, 33.) The prospectus further 5 indicated that, due to the lack of a secondary market for L Bonds, they “are only 6 suitable for persons with substantial financial resources and with no need for liquidity 7 in [the] investment.” (Id. ¶ 34.) 8 GWG’s largest tangible asset is its portfolio of life insurance policies, which as 9 of December 31, 2019, had a face value of approximately $2 billion and a fair value of 10 $796 million. (Id. ¶ 39.) However, L Bonds are not directly secured by GWG’s life 11 insurance portfolio. (Id.) Instead, they are primarily secured by GWG’s equity 12 ownership interests in certain GWG subsidiaries. (Id.) As a result, the claims of 13 L Bond holders to any of GWG’s assets, including its portfolio of life insurance 14 policies, are subordinate to the interests of GWG’s subsidiaries’ creditors. (Id.) This 15 is important because the fair value of GWG’s life insurance portfolio, less the amounts 16 GWG owes to its senior creditors, is insufficient to repay GWG’s outstanding L Bond 17 debt. (Id.) 18 In January 2022, GWG became unable to meet its obligations and suspended 19 further sales of L Bonds. (Id. ¶ 41.) On April 20, 2022, GWG filed for Chapter 11 20 bankruptcy. (Id. ¶ 42.) As a result, those who invested in L Bonds stand to lose a 21 significant amount of their principal. (See id. ¶ 84 (“[T]he value of GWG’s life 22 insurance portfolio was not sufficient to repay all of GWG’s outstanding debt.”).) 23 C. L Bond Purchases Recommended and Brokered by Western 24 The process by which Western recommended and executed the purchase of 25 L Bonds for its investor customers comprised several steps and included several 26 written forms. Taken together, the forms enabled Western to collect information 27 about the investor that might be pertinent to whether L Bonds were an appropriate 28 investment. Among other things, the customer would provide Western with the total

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1 amount of alternative or illiquid investments the customer held and the percentage of 2 the customer’s liquid net worth that would be invested in alternative or illiquid 3 investments after their L Bond purchase. (Id. ¶ 61.) The forms were then forwarded 4 to a Western supervisor for review; the chief responsibility of the supervisor (or the 5 supervisor’s delegate) was to ensure the forms were completely filled out and to verify 6 that the L Bond investment did not exceed 10% of the customer’s net worth. (Id. 7 ¶¶ 62–63.) Then, Western’s compliance department would conduct an additional 8 review to ensure that the forms were completely filled out and that an explanation was 9 provided if the L Bond purchase exceeded 10% of the customer’s net worth. (Id. 10 ¶ 64.) 11 Western received a commission of 3.25%–5% of the value of each L Bond, and 12 the majority of this commission went directly to the registered representative who 13 brokered the transaction. (Id. ¶ 65.) Between July 2020 and April 2021, the five 14 registered representative Defendants in this matter each sold between $184,500 and 15 $1,061,400 in L Bonds and each made corresponding commissions of between $5,397 16 and $32,424. (Id. ¶ 69.) 17 Prior to offering L Bonds to Western’s investor customers, Western’s Chief 18 Compliance Officer reviewed GWG’s most recent Form 10-K and a due diligence 19 report drafted by a third party. (Id. ¶ 55.) According to the Complaint, the Chief 20 Compliance Officer did not provide the Due Diligence Report to Western’s registered 21 representatives, supervisors, or other compliance personnel. (Id. ¶ 56.) Moreover, the 22 SEC alleges that, although Western’s registered representatives took an online training 23 course on L Bonds in the past, Western did not require them to take a second training 24 course regarding the fourth L Bond offering, despite the significant changes in 25 GWG’s business model that had taken place by that time. (Id. ¶¶ 58, 72.) 26 The SEC alleges further gaps in the knowledge and understanding Western’s 27 registered representatives possessed at the time they recommended L Bonds. Some 28 did not know that GWG’s business model had changed, (id. ¶¶ 76–80), some did not

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1 understand or acknowledge the high degree of risk associated with L Bonds, (id. 2 ¶¶ 81–83), some did not understand that the L Bonds were junior to the claims of 3 other creditors, (id. ¶¶ 84–85), and some did not know that Beneficient had a history 4 of operating losses, (id. ¶¶ 86–89). 5 The Complaint sets forth facts regarding eight of Western’s retail customers 6 whom the SEC alleges have been harmed by Defendants’ violations of Regulation 7 Best Interest. (Id. ¶¶ 90–137.) The profile of Customer A is illustrative. Customer A 8 was a 79-year-old truck driver with a moderate risk tolerance whose investment 9 objectives did not include speculation. (Id. ¶¶ 93–94.) At the time of his L Bond 10 purchase in November 2020, Customer A’s annual income was $35,000 and his liquid 11 net worth was $300,000. (Id.) Through Defendant Steven Graham, Customer A 12 purchased $100,000 in two-year L Bonds for his individual retirement account, 13 comprising 10% of his net worth and 33% of his liquid net worth. (Id. ¶¶ 93–95.) 14 D. The SEC’s Suit 15 On June 15, 2022, the SEC initiated this action against Western and five of its 16 registered representatives: Nancy Cole, Patrick Egan, Andy Gitipityapon, Steven 17 Graham, and Thomas Swan (the “Registered Representative Defendants”). The 18 SEC’s first claim is for violation of Regulation Best Interest and is asserted against all 19 Defendants. (Id. ¶¶ 149–154.) The SEC’s second claim is for control person liability 20 under section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a), based on the Registered 21 Representative Defendants’ violations of Regulation Best Interest, and is asserted 22 against Western. (Id. ¶¶ 155–158.) In addition to alleging that Defendants violated 23 Regulation Best Interest in recommending and brokering the purchase of L Bonds for 24 Western’s customers, the SEC also alleges that Western’s policies and procedures 25 were insufficient to ensure that the Registered Representative Defendants understood 26 the potential risks, rewards, and costs associated with L Bonds, or to ensure that 27 investing in L Bonds was in the best interest of a given customer. (Id. ¶¶ 138–148.) 28

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1 On September 14, 2022, all six Defendants answered the Complaint. (Answers, 2 ECF Nos. 43–48.) As is relevant here, Western asserted the affirmative defenses of 3 (1) lack of fair notice, (2) void for vagueness, (4) selective enforcement, (7) failure to 4 state a claim, and (8) reservation of rights, (Western Answer 62–64), and each 5 Registered Representative Defendant asserted the affirmative defenses of (1) failure to 6 state a claim, (3) due process, (4) void for vagueness, and (8) reservation of rights,3 7 (see, e.g., Graham Answer 22–23, ECF No. 43). On October 5, 2022, the SEC filed 8 the instant Motion, asking the Court to strike each of the foregoing affirmative 9 defenses. (See Mem. ISO Mot. (“Mem.”), ECF No. 57.) The Motion is fully briefed. 10 (Individual Defs. Opp’n, ECF No. 59; Western Opp’n, ECF No. 60; Reply Individual 11 Defs., ECF No. 62, Reply Western, ECF No. 63.) 13 Under Rule 12(f) of the Federal Rules of Civil Procedure, a court may strike an 14 affirmative defense if it is insufficient as a matter of law or if it is “redundant, 15 immaterial, impertinent, or scandalous.” Fed. R. Civ. P. 12(f). “To determine that a 16 defense is insufficient as a matter of law, the court must be convinced that there are no 17 questions of fact, that any questions of law are clear and not in dispute, and that under 18 no set of circumstances could the defense succeed.” Ganley v. County of San Mateo, 19 No. C06-3923 TEH, 2007 WL 902551, at *1 (N.D. Cal. Mar. 22, 2007) (internal 20 quotation marks omitted); SEC v. Sands, 902 F. Supp. 1149, 1165 (C.D. Cal. 1995). 21 The purpose of the motion to strike is “to avoid the expenditure of time and 22 money that must arise from litigating spurious issues by dispensing with those issues 23 prior to trial.” Whittlestone, Inc. v. Handi-Craft Co., 618 F.3d 970, 973 (9th Cir. 24 2010). That said, “[m]otions to strike are disfavored, in part because of the limited 25 importance of pleadings in federal practice.” McGhee v. Tesoro Refin. & Mktg. Co., 26 440 F. Supp. 3d 1062, 1067 (N.D. Cal. 2020) (citing Capella Photonics, Inc. v. Cisco 27 3 This affirmative defense is unnumbered in each of the Registered Representative Defendants’ 28 answers. The Court numbers this the eighth of the Registered Representative Defendants’ affirmative defenses.

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1 Sys., Inc., 77 F. Supp. 3d 850, 858 (N.D. Cal. 2014)). Reflecting this disfavor, some 2 courts decline to strike affirmative defenses unless the plaintiff can show that it would 3 suffer prejudice were the court to allow the defenses to stand. In re Honest Co., Inc. 4 Secs. Litig., 343 F.R.D. 147, 151 (C.D. Cal. 2022). 5 “As with motions to dismiss under Rule 12(b)(6)” of the Federal Rules of Civil 6 Procedure, “the court must . . . freely grant leave to amend when necessary.” Id. 7 (citing Lee v. Hertz Corp., 330 F.R.D. 557, 560 (N.D. Cal. 2019)); Kohler v. Staples 8 the Office Superstore, LLC, 291 F.R.D. 464, 467 (S.D. Cal. 2013) (“Unless it would 9 prejudice the opposing party, courts freely grant leave to amend stricken pleadings.” 10 (citing Wyshak v. City Nat’l Bank, 607 F.2d 824, 826 (9th Cir. 1979))). 12 The Court first considers Western’s fair notice defense and the Registered 13 Representative Defendants’ due process defense together, because, for the purpose of 14 this analysis, these two affirmative defenses are substantially the same. (Mem. 5–9 15 (addressing these two affirmative defenses together); see Individual Defs. Opp’n 6 (“It 16 is clearly established, both by common sense and by precedent, that due process 17 requires fair notice of what conduct is prohibited . . . .” (quoting Newell v. Sauser, 18 79 F.3d 115, 117 (9th Cir. 1996))).) 19 A. Lack of Fair Notice (Western’s First Affirmative Defense)/Due Process 20 (Registered Representative Defendants’ Third Affirmative Defense) 21 The SEC moves to strike Western’s first affirmative defense (lack of fair 22 notice) and the Registered Representative Defendants’ third affirmative defense (due 23 process). “A fundamental principle in our legal system is that laws which regulate 24 persons or entities must give fair notice of conduct that is forbidden or required. This 25 requirement of clarity in regulation is essential to the protections provided by the Due 26 Process Clause of the Fifth Amendment.” FCC v. Fox Television Stations, Inc., 27 567 U.S. 239, 253 (2012) (citations omitted). In a fair notice challenge, a court 28 considers whether a law or regulation “fails to provide a person of ordinary

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1 intelligence fair notice of what is prohibited, or is so standardless that it authorizes or 2 encourages seriously discriminatory enforcement.” Id. (quoting United States v. 3 Williams, 553 U.S. 285, 304 (2008)); see United States v. Approximately 64,695 4 Pounds of Shark Fins, 520 F.3d 976, 980 (9th Cir. 2008) (“[I]n the absence of 5 notice—for example, where the regulation is not sufficiently clear to warn a party 6 about what is expected of it—an agency may not deprive a party of property by 7 imposing civil or criminal liability.” (quoting Trinity Broad. of Fla., Inc. v. Fed. 8 Commc’n Comm’n, 211 F.3d 618, 628 (D.C. Cir. 2000))). 9 A party may challenge “the application of a regulation in a particular 10 situation . . . on the ground that it does not give fair warning that the allegedly 11 violative conduct was prohibited.” Phelps Dodge Corp. v. Fed. Mine Safety & Health 12 Rev. Comm’n, 681 F.2d 1189, 1192 (9th Cir. 1982). The parties appear to agree that 13 Defendants’ challenge to Regulation Best Interest is this type of “as-applied” 14 challenge. (See Individual Defs. Opp’n 20–21 (analogizing to Fed. Trade Comm’n v. 15 LendingClub Corp., No. 18-cv-02454-JSC, 2020 WL 2838827 (N.D. Cal. June 1, 16 2020), and distinguishing SEC v. Am. Growth Funding II, LLC, No. 16cv00828 17 (KMW) (DF), 2016 WL 8314623 (S.D.N.Y. Dec. 30, 2016), on the basis that present 18 case is “an as applied affirmative defense based on due process violations”).) As 19 such, the Court must consider “whether the challenged statute is unconstitutionally 20 vague ‘as applied to the particular facts at issue’ such that the challenging party did 21 not have sufficient notice that his or her conduct would be a violation of the statute.” 22 Oracle USA, Inc. v. Rimini Street, Inc., 191 F. Supp. 3d 1134, 1148 (D. Nev. 2016) 23 (quoting Holder v. Humanitarian L. Project, 561 U.S. 1, 18 (2010)). “This 24 assessment cannot be conducted in the abstract . . . .” SEC v. Ripple Labs, Inc., 25 No. 20 Civ. 10832 (AT) (SN), 2022 WL 748150, at *4 (S.D.N.Y. March 11, 2022). 26 The SEC cites case law supporting its contention that Regulation Best Interest 27 and its Adopting Release, taken together, provided Defendants with fair notice and 28 due process. (Mem. 5–6.) The SEC urges the Court to conclude at this early stage

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1 that the fact that the SEC adopted Regulation Best Interest and issued an Adopting 2 Release a year before the Regulation went into effect means that Defendants had fair 3 notice as a matter of law. (Id. at 6.) 4 Western, for its part, argues that it “has alleged that the SEC’s Complaint 5 accuses [Western] of violating standards that the SEC did not articulate anywhere in 6 [Regulation Best Interest] or the adopting release.” (Western Opp’n 3 (citing Western 7 Answer ¶ 1).) In particular, Western alleges and argues that neither Regulation Best 8 Interest nor its Adopting Release require broker-dealers to take the specific actions the 9 SEC alleges were required in this case, such as sharing the L Bond due diligence 10 report with Western’s compliance personnel. (Western Opp’n 14; Western Answer 11 ¶ 31.) Western argues that the absence of the alleged requirements in the Adopting 12 Release is evidence that Western did not have fair notice that the alleged conduct was 13 required. (Western Opp’n 14.) The Registered Representative Defendants make a 14 similar argument. (Individual Defs. Opp’n 17 (“[T]he SEC Complaint in this case 15 alleges violations of [Regulation] Best Interest based on conduct that the Adopting 16 Release specifically permits or does not require at all.”).) 17 At this early stage of litigation, it is premature to conclude that, as a matter of 18 law, the SEC provided Defendants with fair notice and due process with respect to 19 Regulation Best Interest. Factually, Defendants’ as-applied fair notice/due process 20 defense to Regulation Best Interest is based on (1) the underlying facts about the 21 investment, and specifically the facts suggesting that L Bonds were an inappropriate 22 investment, (2) what Defendants actually did or did not do to satisfy the Care 23 Obligation and the Compliance Obligation. Both of these areas of inquiry are in 24 material factual dispute. (Western Answer ¶¶ 36–39 (denying SEC’s allegations that 25 GWG and Beneficient had poor financial histories); Gitipityapon Answer ¶ 98, ECF 26 No. 46 (denying SEC’s allegation that Gitipityapon “did not know how Beneficient 27 made its money or whether it was generating reviews and did nothing to determine if 28 it was”).) If the facts about the soundness of the investment and the facts about

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1 Defendants’ actions are both in dispute, then the legal question of whether Defendants 2 had fair notice that their actions violated a regulation under those facts is also in 3 dispute. Cf. Ripple Labs, 2022 WL 748150, at *4 (rejecting motion to strike’s 4 challenge to as-applied fair notice defense, noting that ruling on defense would require 5 court to first make the factual determination of “what Ripple did before assessing 6 whether the statute fairly apprised Ripple that its conduct was prohibited”). 7 Furthermore, the parties dispute which standard applies in determining how 8 specific Regulation Best Interest must be to provide fair notice and comport with due 9 process. The SEC argues that the test is “whether the defendant had fair notice of 10 what the statute itself requires,” (Mem. 5 (alterations and emphasis omitted)), and 11 Western argues that, given that Regulation Best Interest is a rule and not a statute, the 12 test is whether the rule provides “ascertainable certainty” of what it requires, (Western 13 Opp’n 11–12). This is a disputed issue of law that is material to the success of the fair 14 notice/due process defense. Thus, the Court does not find that the questions of law 15 raised by the fair notice/due process defenses are “clear and not in dispute” such that 16 under no set of circumstances could those defenses succeed. Ganley, 2007 WL 17 902551, at *1. 18 Finally, and more broadly, when a party challenges a regulation as applied, 19 courts must “make a careful inquiry to determine the reasonableness of the 20 administrative interpretation and application of the regulation.” Phelps Dodge, 21 681 F.2d at 1192. This is a mixed question of fact and law, and in most cases, 22 including this one, the court lacks sufficient information at the pleading stage to 23 conclude that this inquiry will, in all possible scenarios, resolve in favor of the 24 regulator. Instead, given that motions to strike require courts to “view the pleadings in 25 the light most favorable to the nonmoving party,” this particular issue often resolves 26 in favor of the defendant, as it does here. Ripple Labs, 2022 WL 748150, at *5 27 (enumerating cases cited by the SEC in which the court refused to strike a fair notice 28 affirmative defense at the pleading stage); see In re Honest Co., 343 F.R.D. at 150,

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1 153 (“[V]iewing the motion in the light most favorable to Defendants, the Court is 2 unprepared at this point to conclude these defenses have ‘no possible bearing on the 3 subject matter of the litigation.’” (quoting In re New Century, 588 F. Supp. 2d 1206, 4 1220 (C.D. Cal. 2008))); cf. Cholakyan v. Mercedes-Benz USA, LLC, 796 F. Supp. 2d 5 1220, 1245 (C.D. Cal. 2011) (denying motion to strike class allegations as 6 “premature” where defendant had not answered and discovery had not begun). 7 The fact that the SEC does not cite any securities regulation cases where a 8 Court struck a fair notice/due process defense at the pleading stage confirms this 9 conclusion. The Registered Representative Defendants pointed out the lack of 10 precedent supporting striking these affirmative defenses, (Individual Defs. Opp’n 20 11 (“[T]he SEC has cited no caselaw where a court has stricken a fair notice affirmative 12 defense at the pleadings stage, and the Court is not persuaded that doing so is 13 appropriate here.” (quoting Ripple Labs, 2022 WL 748150, at *5))), and in neither of 14 its Reply briefs did the SEC rebut Defendants with relevant case law, (see generally 15 Reply Western, Reply Individual Defs.). 16 Defendants’ fair notice/due process defenses are colorable, such that it would 17 be premature and improper at this stage to deny Defendants the ability to pursue and 18 prove these defenses to the factfinder. Thus, the Court denies the SEC’s Motion with 19 respect to Western’s first affirmative defense (lack of fair notice) and the Registered 20 Representative Defendants’ third affirmative defense (due process). 21 B. Void for Vagueness (Western’s Second Affirmative Defense; Registered 22 Representative Defendants’ Fourth Affirmative Defense) 23 The SEC moves to strike Western’s second affirmative defense and the 24 Registered Representative Defendants’ fourth affirmative defense, both of which seek 25 to challenge Regulation Best Interest on the grounds that it is void for vagueness. “It 26 is a basic principle of due process that an enactment is void for vagueness if its 27 prohibitions are not clearly defined.” Grayned v. City of Rockford, 408 U.S. 104, 108 28 (1972); United States v. O’Rourke, 470 F. Supp. 2d 1049, 1062 (D. Ariz. 2007) (“A

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1 statute is void for vagueness when it does not sufficiently identify the conduct that is 2 prohibited.” (quoting United States v. Wunsch, 84 F.3d 1110, 1119 (9th Cir. 1995))). 3 “The void for vagueness doctrine reflects the principle that a statute which either 4 forbids or requires the doing of an act in terms so vague that persons of common 5 intelligence must necessarily guess at its meaning and differ as to its application, 6 violates the first essential of due process of law.” Stevens v. Optimum Health Inst.— 7 San Diego, 810 F. Supp. 2d 1074, 1098 (S.D. Cal. 2011) (quoting Roberts v. U.S. 8 Jaycees, 468 U.S. 609, 629 (1984)). Whether an enactment is void for vagueness may 9 depend in part on whether the regulator has taken inconsistent positions regarding the 10 regulation. Gay Men’s Health Crisis v. Sullivan, 733 F. Supp. 619, 641 11 (S.D.N.Y. 1989) (finding genuine dispute as to vagueness where regulator issued 12 allegedly confusing and erroneous announcement regarding interpretation of 13 regulation). 14 The SEC concedes that this defense “is simply another phrasing for the 15 affirmative defense of Due Process/ fair notice.” (Mem. 10 (citing Papachristou v. 16 City of Jacksonville, 405 U.S. 156, 162 (1972)); see Reply Individual Defs. 8.) This 17 concession is appropriate; if anything, the void for vagueness doctrine appears to be a 18 specific application of constitutional due process requirements, such that this defense 19 is simply a subset of Defendants’ fair notice/due process defenses. See Grayned, 20 408 U.S. at 108. As discussed above, the Court declines to strike the fair notice/due 21 process defenses. The Court likewise declines to strike the void for vagueness 22 defenses. 23 To the extent Defendants’ void for vagueness defenses are not a subset of their 24 fair notice/due process defenses—for example, if the void for vagueness defense is 25 meant as a facial, rather than as-applied, challenge to Regulation Best Interest—the 26 Court declines to strike the defenses. The Court cannot make such a determination 27 without the benefit of the full Regulation, the Adopting Release, and potentially other 28

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1 documents. Indeed, even the length of the Adopting Release is in dispute, and this 2 basic dispute cannot be resolved on the current record. 3 Finally, to the extent Defendants’ void for vagueness defenses may be 4 duplicative of their fair notice/due process defenses, the Court nevertheless declines to 5 strike them. The SEC shows no additional prejudice that would arise from allowing 6 Defendants to maintain a void for vagueness defense that does not already exist by 7 virtue of the lack of notice and due process defenses. If anything, the specificity of 8 this defense provides the SEC with additional notice regarding the nature of the 9 defense. The Court sees no basis for striking this defense at this stage of litigation, 10 and accordingly, the Court denies the SEC’s Motion with respect to Western’s second 11 affirmative defense and the Registered Representative Defendants’ fourth affirmative 12 defense (void for vagueness). 13 C. Selective Enforcement (Western’s Fourth Affirmative Defense) 14 The SEC moves to strike Western’s fourth affirmative defense of selective 15 enforcement. Defendants in a civil enforcement action may raise the defense of 16 selective enforcement as an “independent assertion” that the regulator has brought the 17 enforcement action “for reasons forbidden by the Constitution.” United States v. 18 McGraw-Hill Cos., Inc., No. 2:13-cv-00779-DOC (JCGx), 2014 WL 1647385, at *11 19 (C.D. Cal. Apr. 15, 2014) (quoting United States v. Armstrong, 517 U.S. 456, 463 20 (1996)). The requirements for such a defense “draw on ‘ordinary equal protection 21 standards.’” Armstrong, 517 U.S. at 465 (quoting Wayte v. United States, 470 U.S. 22 598, 608 (1985)). Selective enforcement generally requires a showing “(1) [t]hat 23 others are generally not prosecuted for the same conduct; and (2) [t]he decision to 24 prosecute this defendant was based upon impermissible grounds such as race, religion, 25 or the exercise of constitutional rights,” Church of Scientology of Cal. v. C.I.R., 26 823 F.2d 1310, 1320–21 (9th Cir. 1987) (line breaks omitted), “or that there was no 27 rational basis for the difference in treatment,” United States v. Gibson Wine Co., 28 No. 1:15-cv-1900-AWI-SKO, 2016 WL 1626988, at *7 (E.D. Cal. Apr. 25, 2016).

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1 Western does not allege or argue that the SEC’s decision to single it out was 2 based on Western’s status as a member of a protected class or in retaliation for 3 exercising its constitutional rights. Instead, Western alleges and argues that there is 4 no rational basis for the SEC’s decision to single it out. (Western Opp’n 18.) Equal 5 protection rights may be asserted by a “class of one” such as Western when the party 6 asserting the right “has been intentionally treated differently from others similarly 7 situated and that there is no rational basis for the difference in treatment.” Vill. of 8 Willowbrook v. Olech, 528 U.S. 562, 564 (2000) (holding that a lack of rational basis 9 for differential treatment can give rise to an equal protection claim). However, “some 10 forms of state action . . . by their nature involve discretionary decisionmaking based 11 on a vast array of subjective, individualized assessments.” Engquist v. Or. Dep’t of 12 Agric., 553 U.S. 591, 603 (2008). Thus, a claim that a government agency abused its 13 discretion in selectively enforcing a regulation against a class of one is generally 14 available only “in truly horrendous situations.” Baker v. Coxe, 230 F.3d 470, 474–75 15 (1st. Cir. 2000); see Alt. Cmty. Health Care Coop., Inc. v. Holder, No. 11cv2585– 16 DMS (BGS), 2011 WL 6216964, at *4 (S.D. Cal. Dec. 13, 2011) (“Selective 17 enforcement of valid laws, without more, does not make Defendants’ action irrational. 18 However, the absence of rational basis can be shown if enforcement is malicious, 19 irrational or plainly arbitrary.” (cleaned up)). 20 As a preliminary matter, the parties dispute whether the familiar Iqbal/Twombly 21 plausibility standard, or the less stringent “fair notice” standard, applies in 22 determining whether Western sufficiently pleads its selective enforcement defense. 23 (Mem. 3 (“Courts in this District are split on the whether to apply the Twombly and 24 Iqbal pleading requirements to affirmative defenses, but at a minimum fair notice is 25 required”); Western Opp’n 8 (“The plausibility standard of Twombly and Iqbal should 26 not apply to [Western’s] affirmative defenses.”).) The Court need not resolve this 27 legal issue because the defense fails under either standard. Western believes that the 28 mere fact that it is the subject of the SEC’s first-ever lawsuit to enforce Regulation

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1 Best Interest means that it is the victim of selective enforcement. (See Western 2 Answer 64 (“The SEC has elected not to enforce the same requirements against other 3 similarly situated broker-dealers, such as the approximately 145 broker-dealers 4 engaged to sell L Bonds offered by GWG under the SEC’s publicly stated 5 standards.”).) Western alleges that these 145 other broker-dealers sold L Bonds 6 through September 2021, (id. ¶ 27), and that, despite Regulation Best Interest having 7 been in effect for more than two years, Western is the only broker-dealer that the SEC 8 has sued in a federal court action alleging violation of Regulation Best Interest, (id. 9 ¶¶ 27, 30; Western Opp’n 19). 10 These facts are insufficient as a matter of law to support a selective enforcement 11 defense, and thus, the defense fails under both the Iqbal/Twombly plausibility standard 12 and the more relaxed fair notice standard. If merely enforcing a regulation for the first 13 time means a regulator is guilty of selective enforcement, then the regulator could 14 never successfully begin enforcing a new rule. Cf. Alt. Cmty. Health Care, 2011 WL 15 6216964, at *4 (“Selective enforcement of valid laws, without more, does not make 16 Defendants’ action irrational.”). Moreover, Congress has expressly granted the SEC 17 broad discretion in determining when to investigate and bring enforcement actions. 18 15 U.S.C. § 77t(a)–(b); see SEC v. Jerry T. O’Brien, Inc., 467 U.S. 735, 745 (1984) 19 (“Congress intended to vest the SEC with considerable discretion in determining when 20 and how to investigate possible violations of the statutes administered by the 21 Commission.”). Logically and practically, this necessarily includes discretion to bring 22 an action to enforce a regulation for the very first time. 23 On the facts of this case as alleged, the SEC has a simple and rational basis for 24 its “selective” enforcement, and that basis is that it has never enforced Regulation Best 25 Interest in court before, meaning that, by definition, someone must be the first subject 26 of an enforcement action. Western may be that someone, but that fact alone, without 27 more, does not entitle Western to a selective enforcement defense. See Engquist, 28 553 U.S. at 603 (“[A]llowing an equal protection claim on the ground that a

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1 [speeding] ticket was given to one person and not others, even if for no discernible or 2 articulable reason, would be incompatible with the discretion inherent in the 3 challenged action.”); see also Lozman v. City of Riviera Beach, 39 F. Supp. 3d 1392, 4 1416 (S.D. Fla. 2014) (“In the realm of . . . regulatory enforcement . . . an individual 5 generally has no right to have the law go unenforced against him simply because 6 others equally or more culpable than he have gone unpunished.”); Alt. Cmty. Health 7 Care, 2011 WL 6216964, at *4. Based on the facts and theory alleged, Western has 8 no colorable basis for arguing that it was “intentionally treated differently from others 9 similarly situated and that there is no rational basis for the difference in treatment.” 10 Olech, 528 U.S. at 564; Gibson Wine, 2016 WL 1626988, at *8 (striking selective 11 enforcement defense as insufficiently pleaded and noting defendant “offered no 12 explanation of any impermissible purpose for the different treatment”). 13 Moreover, were the Court to decline to strike this affirmative defense, the SEC 14 would be significantly prejudiced. Western explicitly states its intention to conduct 15 discovery on its selective enforcement defense, including discovery regarding the 16 SEC’s “investigation into other broker-dealers selling L Bonds.” (Western 17 Answer 64.) The SEC argues that it would be prejudiced by the selective enforcement 18 defense because “the discovery Western admits it will seek is irrelevant, improper, 19 and unduly burdensome.” (Reply Western 8–9 (citing cases).) The Court agrees that 20 these internal matters have nothing to do with the merits of the properly pleaded 21 claims and defenses in this case, and the SEC would suffer significant prejudice were 22 it “required to conduct expensive and potentially unnecessary and irrelevant 23 discovery” on a “legally unsustainable affirmative defense[].” Barnes v. AT&T 24 Pension Benefit Plan—Nonbargained Program, 718 F. Supp. 2d 1167, 1173 25 (N.D. Cal. 2010); see Am. Growth Funding II, 2016 WL 8314623, at *7 (disallowing 26 affirmative defenses that would otherwise “force the SEC to give attention to matters 27 collateral to its securities claims against Defendants”). Thus, even if prejudice is a 28

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1 prerequisite to striking the selective enforcement defense, striking the defense is 2 appropriate. 3 The Court grants the SEC’s motion with respect to Western’s fourth affirmative 4 defense (selective enforcement). Moreover, leave to amend this defense is denied. 5 The deficiency of the defense does not lie in the fact that Western fails to plead facts 6 in sufficient quantity or detail. Instead, Western’s theory underlying this defense is 7 legally insufficient. Of course, if the ordinary course of discovery reveals a material, 8 non-speculative basis for a selective enforcement defense, Western retains the right to 9 move for leave to amend, subject to the applicable rules and procedural safeguards. 10 D. Failure to State a Claim (Western’s Seventh Affirmative Defense; 11 Registered Representative Defendants’ First Affirmative Defense) and 12 Reservation of Rights (Western’s Eighth Affirmative Defense; Registered 13 Representative Defendants’ Eighth Affirmative Defense) 14 Finally, the SEC moves to strike Western’s seventh affirmative defense and the 15 Registered Representative Defendants’ first affirmative defense (failure to state a 16 claim), along with Western’s eighth affirmative defense and the Registered 17 Representative Defendants’ eighth affirmative defense (reservation of rights). 18 These last two challenges to the Answers make little to no difference in the 19 context of the bigger picture of this case. Although the parties argue alternatively that 20 “failure to state a claim” and “reservation of rights” are or are not an affirmative 21 defenses subject to being stricken, and cite cases where district courts did and did not 22 strike such defenses, no one suggests that the outcome of this rather academic inquiry 23 will have any material outcome on the proceedings—that is, that any party will be 24 prejudiced. See In re Honest Co., 343 F.R.D. at 151 (noting motions to strike are 25 “usually a waste of time and money without” a showing of prejudice (quoting Virginia 26 A. Phillips & Karen L. Stevenson, Rutter Group Practice Guide: Federal Civil 27 Procedure Before Trial § 9:376 (Cal. & 9th Cir. ed. Apr. 2022))). For example, no 28 party argues that the inclusion of “failure to state a claim” as an affirmative defense

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1 would allow a defendant to circumvent the procedural requirements of Rule 12(b)(6) 2 or 12(f) of the Federal Rules of Civil Procedure. Similarly, no party argues that the 3 inclusion of “reservation of rights” as an affirmative defense would allow a defendant 4 to amend their answer to add defenses at will and without regard for the requirements 5 of Rules 15(a)(2) and 16(b)(4) of the Federal Rules of Civil Procedure and the 6 operative Scheduling and Case Management Order. Therefore, and particularly in 7 light of the general disfavor federal courts regularly express for motions to strike, 8 McGhee, 440 F. Supp. 3d at 1067, the Court denies the SEC’s Motion with respect to 9 Western’s Seventh Affirmative Defense and the Registered Representative 10 Defendants’ First Affirmative Defense (failure to state a claim) and Western’s Eighth 11 Affirmative Defense and the Registered Representative Defendants’ Eighth 12 Affirmative Defense (reservation of rights). 13 E. Discovery 14 Given that the parties in their papers extensively addressed the effect of the 15 outcome of this Motion on discovery, the Court makes a final clarification. The 16 parties should understand that the denial of the Motion with respect to the fair notice, 17 due process, and void for vagueness defenses is without any prejudice to any 18 determination by this Court or the assigned Magistrate Judge that certain discovery is 19 or is not allowable or appropriate. Discovery always remains subject to the relevance 20 and proportionality requirements of Rule 26(b)(1) of the Federal Rules of Civil 21 Procedure, no matter what affirmative defenses are pleaded. By the same token, the 22 granting of the Motion with respect to the selective enforcement defense does not 23 mean that the Defendants are completely barred from any discovery that might relate 24 to other broker-dealers. Certain discovery may remain relevant after the disposition of 25 this Motion, and other discovery may not. 26 /// 27 /// 28 ///

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1 Vv. CONCLUSION 2 For the reasons discussed above, the Court GRANTS IN PART AND 3 || DENIES IN PART Plaintiffs Motion to Strike. (ECF No. 56.) The Court 4] STRIKES Western’s fourth affirmative defense of selective enforcement without 5 || leave to amend. The Court otherwise denies the Motion. 9 March 13, 2023 . 10 So 1 Sedla | OTIS D. GHT, I 3 UNITED STATES/DISTRICT JUDGE

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