One of the enduring areas of difficulty and dispute in the securities industry is determining the scope of responsibility owed to an investor by the securities market intermediaries. There are at least three types of intermediaries, in theory, with different responsibilities linked to the function each type performs in investing. To purchase or sell a security, an investor needs a broker – someone who buys and sells securities for the investor’s account. Depending on the security and the market in which the purchase or sale will occur, the broker may need a dealer – a person engaged in the business of buying or selling securities for his or her own account. The clearest example of a dealer is the Specialist- a member firm of a stock exchange that maintains a book of the securities assigned to them. The growth of e-trading and the development of purchase and sale aggregators like Citadel Securities and Virtu America, LLC., has materially decreased the importance of Specialists. During my career, I represented a Specialist firm on the New York Stock Exchange (“NYSE”) that had some 10 securities assigned to it. Although the Specialist was obligated by NYSE rules to “maintain depth in the market” for each assigned security, it essentially bought and sold securities for its own account when it filled orders for brokers.

Separate and apart from brokers and dealers are investment advisers (both firms and the persons who work for the firms) who are engaged in the business of providing advice and making recommendations to investors for compensation. Investment advisers whose “stock in trade” is the quality of their advice have long been subject to the legal obligations of a fiduciary, i.e., to give honest advice and guidance to assist an investor in making an investment decision. That means the investment adviser must put the interests of the investor ahead of any interest the adviser may have. For example, an investment adviser may not recommend an investment that benefits the adviser (such as one where the adviser owns the same security) more than the interest of the investor client. But human nature does not necessarily align itself with the legal differences in the functions of intermediaries.

Many investors develop a relationship of reliance and trust in their brokers, looking to them for advice when buying or selling a security. In recognition of the normal evolution of relationships between investors and intermediaries, the securities industry, including its regulators – the U.S. Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”), as well as the stock exchanges – developed the concept of “suitability”; indeed, that concept is codified in FINRA Section 2111, which applies to essentially all broker/dealers. Suitability is an ethical and enforceable standard regarding investments when dealing with clients. The broker (and almost all brokers are broker/dealers) must ask: “is this investment appropriate for the client?” The broker must consider the client’s age, health, income, net worth, investment objectives, risk tolerance, and nature and diversity of other investments.

As the size of the U.S. capital markets grew exponentially after WWII, followed by the “back office” hurricanes of the 1960s and early 1970s, and then the “Dot Com” collapse of the Millenium and the Great Recession of 2007-2009, not to mention the frauds of Bernie Madoff, the SEC became more concerned that the suitability standard was too passive to control possible fraud or fleecing by broker/dealers, especially those with winning personalities and “silver tongues.” Movies like The Wolf of Wall Street (2013) captured the sense that too many investors were “sheep” and too many broker/dealers were “wolves” preying on the innocent. In response to these concerns, the SEC, on Apr. 18, 2018, promulgated new Regulation BI (for “Best Interest”), which requires more active restraints on the securities selling process. After a lengthy comment period with many letters from market participants objecting to parts or all of the proposed Regulation, the SEC, by a 3-1 vote (Commissioner Robert Jackson dissenting), adopted Regulation BI on June 5, 2019.

Commissioner Jackson cited the Congressional mandate in the Dodd-Frank Act, which he asserted in his June 5, 2019, Statement on Final Rules Governing Investment Advice, was to “put investors first.” Commissioner Jackson expressed grave concern that “[o]ur nation is facing a savings crisis,” noting that “half of America’s retirees …face the terrifying prospect of running out of money in retirement.” He wrote “…today’s rules retain a muddled standard that exposes millions of Americans to the costs of conflicted advice.” Concluding, he said:

We can and should say unequivocally that today’s rule sets a federal floor, not a ceiling, for investor protection. Our failure to do so invites extensive and expensive litigation over the scope of the rule.

In the Adopting Release, subsequent FAQs, and regulatory pronouncements, the Commission imposed substantial burdens on brokers in the name of protecting investors from broker “over-reach.” The commission implied that investors were not capable of making investment decisions on their own. But at the same time, the continuing need for clarifying guidance from the SEC and the recurring number of enforcement actions brought by the Commission demonstrated the accuracy of Commissioner Jackson’s characterization of Regulation BI as setting “a muddled standard.”

Indeed, one might accept Commissioner Jackson’s criticism and conclude that there was no real improvement to the lot of investors from the promulgation of Regulation BI and the hundreds of pages of SEC commentary on the Regulation and its applications. In fact, one leading national law firm has noted the ambiguities inherent in the text of the Regulation and concluded that brokers will only know the “Dos and Don’ts” AFTER being subject to SEC enforcement actions.

Regulation BI has four main provisions setting out what a broker (and, indeed, an investment adviser) must do:

1. A disclosure obligation – requiring the broker/dealer to disclose in writing all material facts about the scope and terms of his or its relationship with an investor client.
2. A care obligation – requiring the broker/dealer to exercise reasonable diligence, care and skill when making recommendations to retail clients.
3. A conflict-of-interest obligation – requiring the broker/dealer to establish, maintain and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with recommendations to retail clients.
4. A compliance obligation – requiring the broker/dealer to establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Regulation BI as a whole.

With the following as background, we can explore a recent pair of SEC enforcement actions invoking Regulation BI.

1842: two young New Yorkers, Herren and Lee, start a commission merchant house.

1873: it is joined by Henry Bell Laidlaw and becomes Laidlaw & Co.

1878: the firm joins the NYSE, and Henry Bell’s son Charles Laidlaw becomes a Governor of the NYSE, serving for 13 years.

1880: the firm moves to new offices at 14 Wall Street (eventually the site of the Bankers’ Trust building and the original site of the New York Clearing House).

1901: the firm had added operations in Toronto and Montreal.

Through the 20^th century, the firm continued to grow, and after WWII, having obtained financial backing from Hambros, then the largest UK merchant bank, the firm opened a major office in London as well as expanding to Florida, Texas, and California.

The firm is now Laidlaw and Company (UK) LTD, a British corporation (“Laidlaw”) with headquarters in London and with its major U.S. branch on Fifth Avenue, New York City. Laidlaw has been registered as a “broker” with the SEC since July 26, 2002.

On Monday, Nov. 20, 2023, the Commission issued an Order Instituting Administrative and Cease-and-Desist Proceeding against Laidlaw (the “Order”) and, in a separate enforcement action, against Richard Michalski and Michael Murray, two of the company’s registered representatives (referred to hereafter as “M & M,” and the enforcement action as the “M&M Order”), for violations of the suitability standard and of Regulation BI in the course of serving as “broker” to retail investors. The Order asserts that from December 2016 to December 2018, M & M persuaded nine retail investors to engage in a strategy of in-and-out trading, “which …[M & M] had no reasonable basis to believe was suitable for any [investor] due to the high costs, in the form of commissions and fees, associated with the trading.”

According to the M&M Order, “[t]hat trading generated approximately $260,916.73 in commissions and fees, with $147,996.56 paid to Laidlaw, $88,506.00 to Michalski, and $24,414.17 to Murray. That trading strategy continued even after the adoption of Regulation BI with comparable generation of commissions and fees, as well as losses for two investors and small gains (totaling less than the commissions paid) for a third. It can hardly be surprising that the SEC found the trading both excessive and unsuitable for the investors even before Regulation BI was adopted.

Once the Regulation took effect, the Commission found the trading strategy was not in the “best interest” of the investors considering their investment profiles, and rather showed that the “brokers” put their own financial interests ahead of the interests of the retail investors. In addition, two other Laidlaw registered representatives, designated Numbers 3 and 4 in the Order, similarly engaged in convincing six retail investors to use in-and-out trades “that placed the broker’s interest in generating commissions and fees ahead of the customers’ interest in making a profit” regardless of whether the investors’ profiles indicated a high risk tolerance.

Once again, the strategy generated profits for Laidlaw and its representatives: a total of $445,860.30, of which Laidlaw received $242,615.69. The Order describes at length the written policies and procedures by which Laidlaw was to monitor the actions of its representatives, but also describes how Laidlaw failed to administer and enforce its own policies.

In a Nov. 20, 2023 Press Release (the “Press Release”) concerning the two enforcement actions, the SEC noted that in addition to its other shortcomings, Laidlaw “failed to consider the impact of the costs generated by the frequency of trading.” As a result, the Commission found that Laidlaw had violated its duty to supervise its representatives even before Regulation BI was adopted, and further, that it failed to meet both its Care Obligation and its Compliance Obligation under Regulation BI during the period after its adoption.

In the M&M Order, the Commission found M & M had violated two aspects of the Care Obligation under Regulation BI:

1. the quantitative aspect, because they had no reasonable basis to believe that the trading strategy they recommended was in the best interest of the retail investors (in light of the investors’ investment profiles), and
2. that M & M had no reasonable basis for recommendations that resulted in the lack of a reasonably diverse portfolio of holdings (the so-called “component” part of the Care Obligation).

More specifically, the SEC found that M & M, like Laidlaw, “failed to consider the impact of the costs generated by the frequency of the trading.” The Press Release notes that the violations asserted in the two Orders were discovered by Commission personnel from the Division of Examinations. Neither the Press Release nor the Order discloses what, if any, sanctions were imposed on representatives Number 3 and Number 4, or if none, why they were treated differently from M & M.

In the Order and the M & M Order the Commission imposed sanctions as follows:

Laidlaw –

1. cease and desist from further Regulation BI violations;
2. censured;
3. disgorgement of $547,712.36 plus interest of $51,844.22; and
4. payment of a civil penalty of $223,328.

M & M -

1. cease and desist from further violations of Regulation BI;
2. censured;

Michalski – suspended from association with any business in the securities industry for 6 months; disgorgement of $88,506 plus interest of $4,260.55; payment of a civil penalty of $44,253.

Murray – disgorgement of $24,414.17 plus interest of $1,143.91; payment of a civil penalty of $20,000.

Under both Orders, the disgorged amounts and the civil penalties were to be collected in a Fair Fund to be dispersed to the affected investors.

SOME OBSERVATIONS ON THE UTILITY OF REGULATIONS

As shown by the SEC action against Laidlaw, the Commission had and continues to have the authority to bring enforcement actions against “brokers” that recommend unsuitable investments – without any need for the hundreds of pages of a “muddled standard” that are Regulation BI and the administrative guidance and enforcement decisions invoking it. The only real benefit to investor protection may lie in the difference between the negative injunction “thou shalt not recommend an investment that is unsuitable” and the affirmative direction that “a recommendation must be in the best interest of the investor.”

One may well wonder whether the “brokers” that must do what the law requires or suffer adverse consequences are better motivated to deal fairly with retail investors, because they are to follow an affirmative direction. One suspects, considering the behavior detailed in the two Orders discussed here, that the change in language will not have a materially positive effect on people whose livelihoods depend on successfully selling investments to retail investors.