by Tanner Dowdy, Notes and Comments Editor, University of Cincinnati Law Review Vol. 91
Broker-dealers (“BDs”) make a percentage of money off each trade they execute for their clients.1James Fallows Tierney, Investment Games, 72 Duke L.J. (forthcoming 2022-23), 16-19 (last revised: Feb. 15, 2022). That is, brokers employ transaction based revenue models, whereby money is made whether or not the investor profits from the trade.2Id. Because BDs can make money without fear of capital loss on trades they recommend, they have an incentive to churn client orders.3Id. at 47. Churning is jargon for the recommendation and execution of trades without care for the client’s interests.4Id.
Retail investors are particularly susceptible to churning.5Id. That has never been truer than today, when, using a smartphone, a growing number of retail investors are interfacing with BDs directly through digital apps.6Id. The Securities and Exchange Commission (“SEC”) has the unenviable job of policing these new BD relationships to ensure retail clients are handled with the proper standard of care.7Id. at 40-51.
That is where Regulation Best Interest (“Reg BI”) comes in. Reg BI is the SEC’s latest attempt to redefine the requisite standard of care BDs must use when recommending securities to retail investors.8See Regulation Best Interest, 17 C.F.R. § 240 (2019). Generally, Reg BI requires BDs to “act in the best interest of the retail customer, at the time the recommendation is made, without placing the financial or other interest of the broker-dealer ahead of the interests of the retail customer.”9See Regulation Best Interest, 84 Fed. Reg. 33318. This standard became effective in late 2019.10Id. For over two years, the industry has waited for an enforcement action to clarify how this standard will look in practice.11See, e.g., id. The waiting is now over: On June 15, 2022, the SEC brought its first Reg BI enforcement action in SEC v. Western International.12Haimavathi Marlier et al., Top 5 SEC Enforcement Developments, Harvard L. Sch. F. on Corp. Governance (Apr. 28, 2022), https://corpgov.law.harvard.edu/2022/04/28/top-5-sec-enforcement-developments/.
This article is an introduction to the BD industry, Reg BI, and the Western International complaint. It will proceed as follows. Part II summarizes how BDs generally function in a capital market. Part II also provides a summary of Reg BI—why it was adopted and what it means. Part III then pivots to the complaint. And, though it remains unclear how the action will be decided, Part IV offers six takeaways from the complaint.
II. The Reg BI Story
A. The Function of Broker Dealers
BDs wear two hats in a capital market.13Joshua Kennon, What is a Broker-Dealer?, The Balance (Apr. 25, 2022), https://www.thebalance.com/what-is-a-broker-dealer-4067290. As brokers, they serve as agents; stewarding orders they receive to a public exchange (i.e., the NYSE) or a private over-the-counter (OTC) exchange.14Id. Once a broker places a trade on an exchange, the search for a counterparty begins.15Id. The end result is (hopefully) clearance—a counterparty is found, and the broker receives a cut from the transaction (through the bid-ask spread, commission, or markups).16Id. As dealers, BDs serve as principals; using their own inventory of securities to take the other side of the customer’s trade.17Jerry W. Markham, Regulating Broker-Dealer Investment Recommendations-Laying the Groundwork for the Next Financial Crisis, 13 Drexel L. Rev. 377, 383-84 (2021).
B. The Debate about Duties
From the Great Depression until now, considerable ink has been spilled in an attempt to determine the proper standard BDs should be held to when recommending securities.18Id. at 396-409. Before Reg BI, the Financial Industry Regulatory Authority (“FINRA”) imposed a suitability doctrine, which “required broker-dealers to have a reasonable basis for believing that any recommended security was suitable for the client, under the facts and circumstances.”19Tierney, supra note 1, at 45.
After the Financial Crisis, Dodd Frank authorized the SEC to create a committee to further study the conflicts of interest around BDs (the belief was that the suitability doctrine may have been too lax).20Markham, supra note 17, at 411. After review, the Committee recommended BDs be held to the fiduciary duties imposed upon Investment Advisers.21Id. The SEC rejected that recommendation, and, in place, created Reg BI.22Id. Reg BI was a cautious approach to build “a separate framework of enhanced duties for broker-dealers making investment recommendations to retail customers.”23Id. at 412.
C. The Impact of Reg BI
Reg BI “enhances the broker-dealer standard of conduct” towards retail customers.24Markham, supra note 17, at 426. To what point? It is not exactly clear. To use the SEC’s own words, Reg BI enhances BD standards “beyond existing suitability obligations.”25Id. Recall the suitability standard “required broker-dealers to have a reasonable basis for believing that any recommended security was suitable for the client, under the facts and circumstances.”26Tierney, supra note 1, at 45.
Now, under Reg BI, BDs must align their “standard of conduct with retail customers’ reasonable expectations.”27Markham, supra note 17, at 426. In addition, BDs will have to ensure quantitative suitability, which asks whether a series of transactions is “not excessive and is in the retail customer’s best interest . . . and does not take the financial or other interest of the broker . . . ahead of the interest of the retail customer.”28Tierney, supra note 1, at 45. That means the analysis is no longer about single trades in isolation: the amount of trades—even trades that would be compliant in isolation—must also match the client’s profile.29Id.
To be compliant with this standard, BDs must meet four obligations: (1) a disclosure obligation, (2) a care obligation, (3) a conflict of interest obligation, and (4) a compliance obligation.30Markham, supra note 17, at 416-17. Below, each are covered in turn.
- The Disclosure Obligation. This obligation requires that, before or contemporaneous with the recommendation of a security, BDs disclose in writing, “all material facts about the scope and terms of its relationship with the customer.”31Id. at 17. This would likely come in the form of a relationship summary.32Id.
- The Care Obligation. The care obligation is meant to ensure that broker dealers “exercise reasonable diligence, care, and skill” in making recommendations to retail customers.33Id. at 419. For BD representatives, the care calculus must center on the costs of a recommendation to a client, as well as the suitability of a series of recommended transactions.34Id. at 420 (emphasis added). Of course, cost is not the only factor representatives should consider.35Id. Other factors include volatility, liquidity, and firm reputation.36Id.
- The Conflict of Interest Obligation. To ensure that BDs disclose their conflicts of interest, BDs must “create and maintain written policies that identify all conflicts of interest associated with investment recommendations.”37Id. at 421. This would include conflicts that are typically found in commission based compensation models.38Id. Importantly, there are blanket prohibitions “directed at sales contests, bonuses, and other [employee] compensation based on production.”39Id. at 422.
- The Compliance Obligation. The compliance obligation requires broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI as a whole.40Id. at 423.
III. SEC v. Western International
A. The L Bonds
Western International is a BD owned by Atria Wealth Solutions.41Complaint at 4-5, SEC v. Western International Securities, Inc., et al., Case No. 2:22-cv-04119 (C.D.CA 2022). The complaint alleges that Western International solicited highly illiquid and unrated corporate bonds—“L Bonds”—to a group of unsuspecting retirees.42Id. The L Bonds were offered by GWG Holdings, Inc. (“GWG”), and, depending on their maturity period, offered between 5.5% and 8.5% interest for investors.43Id. at 7. Maturities on the L Bonds ranged from two to seven years.44Id. GWG used the L Bonds sold to finance its operations.45Id. at 6.
From 2012 to 2020, GWG offered L Bonds in four separate offerings.46Id. at 7. The 2020 L Bonds are the focus of the complaint.47Id. The story of GWG’s business model reveals why: Before 2018, GWG used various subsidiaries it owned to acquire life insurance policies on the secondary market.48Id. at 6. GWG would purchase policies from customers who no longer needed them, and once the policies were acquired, contribute their premiums until the death of the insured.49Id. They financed this operation through L Bonds sold through BDs like Western International.50Id.
That business model—soliciting L Bonds collateralized by life insurance policies—changed in 2018.51Id. In 2018, GWG executed a series of transactions that resulted in Beneficent Company Group, L.P. (“Beneficent”) becoming its wholly owned subsidiary.52Id. After this merger, GWG Holdings no longer bought life insurance on the secondary market.53Id. Rather, GWG adopted Beneficient’s business model: to provide liquidity to holders of illiquid assets through loans and other means.54Id.
After this drastic change in operations, Western International representatives sold retail customers $13.3 million worth of GWG L bonds between July 2020 and April 2021.55Id. at 11. Those sales were part of a larger $2 billion issuance that began in June of 2020.56Id. at 7. Remember that each L Bondholder now held an IOU: GWG owed those investors interest payments. If GWG failed to make the payments, the investors were entitled to recover the collateral underlying the bonds.
The collateral underlying the 2020 L Bonds consisted primarily of the equity ownership GWG had in its subsidiaries after the merger—not the portfolio of life insurance GWG and its subsidiaries had on their balance sheets.57Id. at 16 (emphasis added). In other words, in the case of default, holders of the 2020 L Bonds were entitled to receive what remained of GWG once its senior creditors had been paid.58Id. As it turned out, the fair value of the insurance portfolio (the assets), minus the senior credit facility (the liabilities) left GWG with insufficient equity to repay holders of L bonds.59Id.
Did the clients have any idea about this change in the L Bonds in 2020? No, they did not. Unfortunately, the investors—and the Western representatives—were under the misimpression that, like the prior L Bonds issues, the 2020 L Bonds were collateralized by the life insurance policies GWG retained on its balance sheet.60Id. How could this misunderstanding happen? The answer: poor compliance procedures. A reading of the Western complaint demonstrates so much.
B. Western’s Liability
The SEC has emphasized that in assessing whether a BD has complied with Reg BI, a fact specific inquiry is required:
[W]hat is in the best interest of a retail customer depends on the facts and circumstances of the recommendation, including “matching” the recommended security to the retail customer’s investment profile. Where the “match” between the retail customer profile and the recommendation appears less reasonable, it is more important for the broker to establish that it had a reasonable belief that the recommendation was in the best interest of the retail customer.61Id. at 10-11.
Accordingly, to assess the compliance of Western International, one must look to when the L bonds were recommended and scrutinize how they were represented. The complaint highlights glaring deficiencies in due diligence, recommendation practices, and financial compensation.
i. Due Diligence
Western did very little to ensure that its representatives understood the danger of the L bonds.62Id. at 11-12. For instance, Western’s chief compliance officer did not provide a due diligence report to Western registered representatives, supervisors, or other compliance personnel.63Id. To make matters worse, Western established no criteria, thresholds, or investment restrictions for L Bond investors.64Id. And perhaps most alarming: after GWG merged with Beneficent, Western representatives were not required to take a course on the new L Bonds if they had completed the prior course.65Id. at 12.
ii. Recommendation Practices
One of Western’s clients was an elderly retired truck driver worth $300,000.66Id. at 17. He was convinced to invest $100,000 worth his money into L Bonds.67Id. The story is much the same for the other investors who fell prey: All were conservative investors who wished to retire with stability, while receiving an asset that would generate supplemental income.68Id. at 17-23.
What did Western do to vet the interests of these clients? Not much. Nowhere did disclosures made to clients explain why L Bonds met their risk profiles.69Id. 12-13. Rather, the client forms consisted of a single document, with the only information being (1) the proposed investment, and (2) the customer’s net worth.70Id. No substance was provided as to why L bonds were within the client’s best interests.71Id. at 25-27. At the end of the process, each form was signed by a Western supervisor.72Id. at 12-13. But all the supervisor was tasked with was ensuring the forms were properly filled out and that the investment did not exceed 10% of the customer’s net worth.73Id. If the investment was in excess of 10%, a mere explanation was required as to why the investment was being made.74Id.
iii. Financial Compensation
Upon closing a sale, Western representatives stood to make good money. Commission ranged between 3% and 5% of the bond’s value.75Id. at 13-14. And of the total commission available, representatives received approximately 90%.76Id. Put simply, thousands of dollars were at play on each bond the representatives sold.
IV. Lessons from Western International
Lesson one: Material business events matter. Training programs should be revamped every time a BD becomes aware that one of its issuers has undergone a material business change. What qualifies as a material business change is up to the compliance personnel, but a logical place to start would be any event defined as such in the issuing entity’s corporate articles. Compliance personnel should err on the side of caution. It is startling that Western representatives failed to know, much less understand the material changes to the bonds they were selling after the GWG merger.
Lesson two: Representatives should disclose, in writing, how the securities they sell align with the needs of the client. And, if the transaction amounts to a series of transactions, justification for the sale should be disclosed too. A quick rundown of Western’s clients demonstrates that they were risk averse and in need of an income supplement for retirement. In a nutshell, they were seeking a higher rate of interest than funds sitting on deposits at banks. None of Western’s victims were looking to speculate. The Western practice was to look at very surface level characteristics (net worth) and all but end the analysis there. To justify a recommendation, BD representatives should explain why the investment makes sense. Relying on a simple metric is not enough.
Lesson three: Explicitly reference Reg BI in compliance forms. None of Western’s disclosure documents mentioned Reg BI. It may be a good idea for BDs to have their forms reference Reg BI. By explicitly referencing Reg BI on the forms (or the Reg BI standard), representatives will be encouraged to explain how their solicitation is compliant.
Lesson four: Set investment caps for certain investors. Western did nothing to ensure that L Bonds were reaching the hands of only those investors who could tolerate risk. Indeed, “Western did not set any criteria or thresholds for its customers to invest in L Bonds.”77Id. at 12. Nor did Western “restrict the sale of L Bonds to customers with certain risk profiles or investment objectives.”78Id. Requiring BDs to tailor a bond prospectus to an investor’s objective is certainly a low bar to meet if the best interest of the investor is the goal. BDs should revisit their systems regarding client profiling to ensure that they are accurate, up to date, and reflective of the securities products they hold in accounts.
Lesson five: Where inconsistencies arise, managers need flexibility to respond. Following up on inconsistencies was only mandated where the investment exceeded 10% of the client’s net worth. Supervisors should be provided with more information and flexibility to question decisions.
Protecting retail investors is important for the health of financial markets. Therefore, any BD who recommends securities to retail investors should be held to a rigorous standard. But understanding and soliciting financial products is tough. For those who believe Reg BI could lead to excessive scrutiny, the Western International complaint should provide solace: The errors Western made were readily foreseeable and errors many BDs would have likely avoided.
Nevertheless, the six prescriptions provided in this comment remain pertinent for BDs to ponder. That is especially true today, as bond markets and interest rates continue to experience turmoil. If a deep recession is to unfold in 2022-2023, there is a high probability corporate restructuring will increase. If that happens, BDs should ensure that they are readying their representatives to understand any corporate bond and fixed income instruments they solicit.
- 1James Fallows Tierney, Investment Games, 72 Duke L.J. (forthcoming 2022-23), 16-19 (last revised: Feb. 15, 2022).
- 3Id. at 47.
- 7Id. at 40-51.
- 8See Regulation Best Interest, 17 C.F.R. § 240 (2019).
- 9See Regulation Best Interest, 84 Fed. Reg. 33318.
- 11See, e.g., id.
- 12Haimavathi Marlier et al., Top 5 SEC Enforcement Developments, Harvard L. Sch. F. on Corp. Governance (Apr. 28, 2022), https://corpgov.law.harvard.edu/2022/04/28/top-5-sec-enforcement-developments/.
- 13Joshua Kennon, What is a Broker-Dealer?, The Balance (Apr. 25, 2022), https://www.thebalance.com/what-is-a-broker-dealer-4067290.
- 17Jerry W. Markham, Regulating Broker-Dealer Investment Recommendations-Laying the Groundwork for the Next Financial Crisis, 13 Drexel L. Rev. 377, 383-84 (2021).
- 18Id. at 396-409.
- 19Tierney, supra note 1, at 45.
- 20Markham, supra note 17, at 411.
- 23Id. at 412.
- 24Markham, supra note 17, at 426.
- 26Tierney, supra note 1, at 45.
- 27Markham, supra note 17, at 426.
- 28Tierney, supra note 1, at 45.
- 30Markham, supra note 17, at 416-17.
- 31Id. at 17.
- 33Id. at 419.
- 34Id. at 420 (emphasis added).
- 37Id. at 421.
- 39Id. at 422.
- 40Id. at 423.
- 41Complaint at 4-5, SEC v. Western International Securities, Inc., et al., Case No. 2:22-cv-04119 (C.D.CA 2022).
- 43Id. at 7.
- 45Id. at 6.
- 46Id. at 7.
- 48Id. at 6.
- 55Id. at 11.
- 56Id. at 7.
- 57Id. at 16 (emphasis added).
- 61Id. at 10-11.
- 62Id. at 11-12.
- 65Id. at 12.
- 66Id. at 17.
- 68Id. at 17-23.
- 69Id. 12-13.
- 71Id. at 25-27.
- 72Id. at 12-13.
- 75Id. at 13-14.
- 77Id. at 12.