As everyone is likely well aware, one of the principal changes that happened when FINRA retired the old suitability rule – NASD Rule 2310 – and replaced it with shiny new FINRA Rule 2111 back in 2012 was the broadening of the scope of the rule to encompass not just recommendations to buy or sell specific investments, but, as well, recommendations involving investment strategies (which could include a combination of securities and non-securities).  Despite that change, the overwhelming majority of suitability cases still focus on recommendations relating to specific investments.  Every once in a while, however, a case comes out that makes it abundantly clear that FINRA stands prepared to charge registered reps with making unsuitable strategy recommendations.  Richard Wesselt, who has been in the industry since 1992, learned this the hard way through an AWC that was published a week or so ago.

According to the facts of the case as recited in the AWC (which Mr. Wesselt accepted), Mr. Wesselt recommended an “unsuitable investment strategy to 78 customers.”  It was a three-step process, as follows:

Step 1: Mr. Wesselt recommended that the customers “liquidate their retirement savings, which they often held in qualified, tax-deferred accounts such as 401(k)s or IRAs.”  Hmm.  This already sounds troubling.

Step 2: Mr. Wesselt then recommended that the customers “purchase a variable annuity with funds liquidated from their retirement plans.”  Interestingly, Mr. Wesselt generally recommended that his customers “purchase an X, or bonus, share class variable annuity.”  According to the AWC, while such shares “add a cash bonus to the contract,” they also “typically have the longest surrender periods of any variable annuities offered in the marketplace and charge higher mortality and expense fees than other share classes.”  Mr. Wesselt also recommended that as part of the annuity purchase, the customers pay extra for “a guaranteed minimum withdrawal benefit rider, which allows lifetime withdrawals of a specified percentage once the customer reaches a specified age.”  By recommending both the X-share and the withdrawal rider, Mr. Wesselt managed to increase the customers’ fees for purchasing the variable annuity.  Getting worse, huh?

Step 3: Finally, after the variable annuity was issued, Mr. Wesselt recommended that his customers take early withdrawals, causing them not only to lose benefits they had paid for, but to incur surrender charges.  Many of withdrawals were large one-time withdrawals to purchase whole life insurance policies (notoriously expensive products that have super high commissions); others were used “to pay significant expenses, such as the purchase of a home or the settlement of a divorce.”  The purpose of the life insurance policy was to build cash value, part of what Mr. Wesselt dubbed “building your own bank” or, even more perplexing, “infinite banking.”

FINRA rightly takes the position that a variable annuity is a “complex” investment vehicle, with lots of moving parts.  Given that, it is essential that extra care be taken when recommending such products to ensure that customers understand how they work, how much they cost, how the RR is going to be compensated, etc.  Indeed, as you know, FINRA has a special suitability rule – Rule 2330 – just for annuities.[1]  Mr. Wesselt, sadly, seemed to go in the opposite direction, and hid vital disclosures from this customers, as he “typically had his customers sign blank or incomplete disclosure documents or had them sign those documents quickly in his presence.”  As a result of his sleight-of-hand, “his customers frequently did not understand the unique features and risks associated with these variable annuities and riders.”

No surprise, I suppose, that between the unsuitable recommendations and the paperwork trickery, FINRA had enough to permanently bar Mr. Wesselt.

But, what about Mr. Wesselt’s BD, The O.N. Equity Sales Company?  The AWC states that during the relevant period, Mr. Wesselt was one of the firm’s “top producers for variable annuity sales”; in fact, in 2016 he was the firm’s highest producer.  For the 78 customers alone who FINRA identified, Mr.  Wesselt earned $686,025 in commissions just on the sale of the variable annuities.  And that doesn’t include, I expect, the commissions he earned on the sale of the products in Step 1 of his plan, or the purchase of the whole life insurance in Step 3.  The point is, Mr. Wesselt should certainly have been the focus of a good bit of attention from the firm.  Yet, there is no indication that O.N. Equity noticed anything untoward.  (Similarly, there is no indication that the firm has been the subject of any action taken by FINRA, i.e., no Wells letter, no filed complaint and no settled case.)

And, look, I get two things.  First, I get that Mr. Wesselt made it appear that his clients actually signed all the necessary documents, but all that means is that as far as O.N. Equity knew the transactions were authorized; those signatures do not, however, establish that the transactions were suitable.  A customer cannot conclusively agree that a recommendation was suitable, as that is not something a customer is deemed capable of knowing.  That’s why Supplementary Material .02 to FINRA Rule 2111 explicitly states that “[a] member or associated person cannot disclaim any responsibilities under the suitability rule.”

Second, I get that the final step in the strategy – the purchase of the whole life insurance – did not take place at O.N. Equity, so the firm may not have known about it.  (I know this because O.N. Equity went to court to fight to keep complaints about the whole life insurance purchases out of four customer arbitrations that Mr. Wesselt’s conduct triggered.  According to the court’s decision determining that the insurance piece of the strategy was not subject to FINRA arbitration, “O.N. Equity is not in the business of selling life insurance, is not licensed to sell insurance, and does not appoint life insurance agents.”)  But, O.N. Equity certainly could have seen the early and sizable withdrawals from the recently purchased annuities across his customer accounts.

And when you look at the descriptions of what happened to the sample of Mr. Wesselt’s 78 customers described in the AWC, it makes you wonder how the firm could have missed these situations:

• In 2014, Customer 1 was 43 years old, with “substantial daycare expenses” and a 401(k) worth $220,000. He had her liquidate the 401(k), and used the proceeds to buy an X-share variable annuity.  He then had her withdraw $225,000 from the annuity to buy whole life insurance (that amount included surrender fees of $11,998 and tax withholding of $71,564).  The early withdrawals also caused her to incur a tax penalty.  Now she can’t afford her life insurance premiums, and her annuity, which held most of her retirement savings, is worth less than $10,000.

• Customer 3 was 59 years old in 2014 and nearing retirement. She approached Mr. Wesselt regarding the purchase of an apartment and assisting a child with student loan repayment.   Wesselt had her take $58,000 from her 401(k) and buy a variable annuity.  Six months later, he had her buy whole life insurance using her annual withdrawals from the annuity.  Each withdrawal was $16,840, which included $12,000 for the insurance premiums, $840 in surrender charges, and tax withholding of $4,000. Not surprisingly, because each withdrawal depleted the value of the annuity, this was sustainable for only three years.  By June 2017, the variable annuity had declined from its original value of $57,955 to $8,489.

• Customer 4 was 52 years old when she met with Mr. Wesselt in 2016. She needed to pay $40,000 as part of a divorce settlement, and wanted to help a child pay off student loans.  The only money she had available was her 401(k).   Wesselt had her roll her 401(k) into an X-share VA worth $133,144. Within three days, he recommended that she withdraw $63,697, which included $40,000 for the divorce settlement.  A week later, he had her withdraw another $55,323 from the variable annuity in order to pay for a new whole life policy.  In other words, in one week, her new annuity declined by 85% to $19,764, she paid $8,180 in surrender charges, and she was assessed a tax penalty for taking the early withdrawals.

Anyway, I didn’t mean to get hung up on O.N. Equity, but it does make me wonder how the firm has stayed clean throughout this.  The reason I found the AWC worth discussing is that, unlike probably 99% of suitability cases, this one focuses solely on the notion of an unsuitable strategy.  So, if anyone tries to tell you that Rule 2111 really didn’t change anything from old, reliable Rule 2310, feel free to laugh in their face as you share Mr. Wesselt’s sad tale.

[1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a “strategy,” as Rule 2111 does.  If you read Rule 2330, it only “applies to recommended purchases and exchanges of deferred variable annuities and recommended initial subaccount allocations,” i.e., actual transactions, not strategies.  Nevertheless, the AWC provides that Mr. Wesselt violated both Rule 2111 and Rule 2330(b).