Beware: Regulators won't take excuses for reverse-churning

Exam priorities and lawsuits are zeroing in on account switching

Apr 14, 2018 @ 6:00 am

With regulatorszeroing in on reverse-churning, and lawsuits popping up around the practice, advisers should be paying attention.

The concern stems from conflicts of interest that advisers face when deciding whether to move clients from commission-based accounts to often more expensive fee-based accounts (depending on how much trading occurs, which additional services are provided and how much the fee is). But some advisers have felt pushed in that direction regardless of the circumstances, especially in retirement accounts, because of the compliance demands of the Labor Department's fiduciary rule.

And there's the rub: If the transition to a fee-based account is not in a client's best interests, it shouldn't happen.

That leaves advisers and their firms with a few choices: Use the best-interest contract exemption to allow for the variable pay of commissions, change the commission structure to be level, or move a client into a fee-based account. The third choice is the easiest to execute.

But advisers had better be sure they can justify the higher fee if that's the route they go.

Why? Because regulators have rightly been focusing more on the movement between accounts and are eager to find instances of profiteering. Are clients being moved to fee accounts because it really is in their best interest or because it's an easier way for advisers to meet a regulatory requirement?

Red flag

Last October, the Consumer Federation of America sent letters to DOL Secretary Alexander Acosta, SEC Chairman Jay Clayton and Finra Chief Executive Robert Cook raising such concerns. The organization pointed to comment letters from industry groups and firms that some of them are moving clients to fee accounts to comply with the DOL rule even though those clients would be better off in commission accounts. There's a red flag.

In their exam priorities for this year, both the Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc. included a focus on account transitions.

The SEC said practices that result in investors paying inadequately disclosed fees — such as "advisers that changed the manner in which fees are charged from a commission on executed trades to a percentage of client assets under management" — would be examined. And Finra included guidance in its priorities warning dually registered advisers against any switch that "clearly disadvantages the customer."

This isn't the first time regulators have faced potential blowback from or inappropriate reactions to the DOL rule. In 2014, the SEC included parking clients in wrap accounts as an area of scrutiny.

As Blaine Aikin pointed out a few years ago in a column in InvestmentNews, "The first occurrences of reverse-churning came to light around 2005, when the SEC adopted an exemption permitting brokers to accept fee-based compensation. In a subsequent sweep of fee-based brokerage accounts by Finra, it found not only widespread absence of trading activity, but also double-dipping, in which brokers charged commissions for investment products that were subsequently placed in the fee-based accounts."

So whatever the fate of the Labor Department's fiduciary rule, securities regulators' attention to account switching is here to stay — as is their focus on fees in general. In an SEC risk alert last Thursday, the agency pointed to frequent compliance issues it found during exams, and among them was charging clients additional fees, such as brokerage fees, when the client had been placed in a wrap account.

Given that reality, advisers better be prepared to answer these questions the next time an examiner comes knocking: Which services are performed to justify the fees? What was the decision-making process used to determine whether a fee account was a better model for the client than a commission account?


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