It is obvious that broker-dealers and their registered representatives, as well as investment advisors, must be careful in making recommendations to their clients. But the rise of claims related to inaction in a client account should also give members of the securities industry cause for concern. In particular, the U.S. Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and other critics have begun to focus their attention on “reverse churning,” a claim arising from an allegation that a registered representative or investment advisor breaches a duty to his or her client by moving an under-traded account from a commission to a fee-based compensation structure solely for the purpose of generating revenue.
Traditionally, registered representative and investment advisors have had to be particularly careful in advising a client that a trade or transaction was suitable, an analysis dependent on the client’s investment objectives, age, other investments, time horizon, tax status, willingness to accept risk, and other factors. However, recent announcements by the SEC, combined with the seemingly inevitable move toward a unified fiduciary standard for broker-dealers and investment advisors,make it clear that members of the securities industry should be increasingly diligent in an effort to foreclose potential liability arising from inactivity in a client account.
Recent comments by regulatory officials confirm an increased interest in fee-based compensation structures for investment advisors. For example, on March 6, 2014, Andrew Bowden, Director of the SEC’s Office of Compliance Inspections and Examinations, spoke concerning actions involving conflicts of interest (in particular, the rise of fee-based advisory accounts at dual registrants) and the potential conflicts of interest arising from such compensation structures. With respect to fee-based advisory accounts, Bowden specifically addressed three situations about which the SEC is particularly concerned: (1) accounts in which securities are purchased and portfolios are designed in commission paying brokerage accounts and then transferred to a fee-based wrap account in which the same trades could have been initiated without paying commissions; (2) accounts that consist primarily of cash or cash equivalents that are transferred to fee-based wrap accounts in which the fees are higher but the investments do not change; and (3) accounts that are fee-based accounts in which few if any transactions are made.
Bowden’s speech came on the heels of a similar speech given by SEC Chairwoman Mary Jo White on October 22, 2013. In her speech, White specifically identified reverse churning as an area that the SEC was targeting through Risk Analysis Examination, or the use of quantitative analysis of trading activity by clearing firms or broker dealers over an extended period of time (one to two years) to identify problematic behavior.
In addition to the SEC’s expressed concerns about reverse churning, the dramatic increase in the amount of assets held in fee-based accounts, suggests an inevitable increase in the rise of reverse churning claims. Specifically, recent reports show that the assets in fee-based accounts grew 28.4% in 2009, 20.6% in 2010, 8.3% in 2011 and 18.5% in 2012.
In sum, the SEC’s growing interest in reverse churning, plus the increase in assets held in fee-based accounts, in conjunction with recent changes to the FINRA suitability rule, which now requires documentation of hold recommendations, and the potential expansion and harmonization of fiduciary duties, all suggest that claims for reverse churning are likely to increase.
Given the rise of reverse churning claims, broker-dealers, investment advisors, and their representatives should take action to address claims of reverse churning. First, firms should ensure that there is an adequate supervision system in place to guarantee that accounts are handled properly. Recent enforcement decisions by FINRA have made it clear that FINRA will hold firms accountable if there is no system in place for supervision. The same will likely be true in individual arbitrations. Second, representatives should take care to monitor their client’s accounts. Basic customer service going beyond the provision of statements, such as conversations or emails confirming the client’s wishes (and appropriate documentation of such conversations), is both prudent and necessary. Finally, decisions to hold or stand pat in any account, and decisions to move from commission-based accounts to fee-based accounts, should be documented carefully with an eye towards avoiding claims that the move was reverse churning.