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COMPLY-U.S. regulator intensifies scrutiny of fee-based accounts

Dec 12 (Reuters) - The top U.S. securities regulator is stepping up scrutiny of “reverse churning,” a practice in which brokerage firms trade very infrequently in accounts they manage for fixed fees, according to an official.

The issue will be a priority in the U.S. Securities and Exchange Commission’s 2014 program for examining firms, said Andrew Bowden, director of the agency’s Office of Compliance Inspections and Examinations.

Regulators are growing more concerned as Wall Street firms migrate from commission-based accounts for clients, and instead charge annual fees for a broader menu of services, typically including long-term financial planning and money management, Bowden said in an interview.

But switching accounts may not be in every client’s best interest. Possible consequences include censures and fines. A massive data-mining effort by the SEC this year revealed instances of the problem, said Chairwoman Mary Jo White in October.

Assets in fee-based managed accounts at U.S. brokerages have been growing. They totaled $2.8 trillion in 2012, an 18.5 percent increase from $2.3 trillion in 2011, according to Cerulli Associates, a financial services industry research firm in Boston.

That trend will continue, said Scott Smith, a director at Cerulli. “There’s a recognition among broker dealers that this is a best practice for adviser revenue models moving forward,” he said. Firms bring in steady money from fee-based accounts, unlike commissions, which can be intermittent, said Smith. Fee-based services can also help firms stay ahead of possible new regulations - the so-called fiduciary standard - that could require higher ethical standards for brokers, Smith said.


Companies have been tinkering with their compensation plans to nudge brokers in a fee-based planning direction. For example, Bank of America’s Merrill Lynch unit announced a broker compensation plan last week that, in part, rewards brokers who attract trust assets, which advisers often manage through fee-based accounts. But moving some clients’ assets from a commission-based account could raise questions by regulators about whether the change is in a customer’s best interest.

To be sure, the expansion of brokerage services, such as long-term financial planning, can offer value to investors, Bowden said. Fee-based accounts can also save money for clients whose advisers must actively trade their portfolios to achieve investment goals. And the SEC does not yet have a handle on whether reverse churning is a widespread problem.

Still, there can be a risk to both the client and firm when moving assets to a fee-based account: the fees - typically an annual charge of between 1 and 3 percent of the value of an investor’s portfolio - can end up costing more than trading commissions in accounts that show little to no activity, said Bowden.

Some accounts may sit in cash-like investments, such as money market funds, to address planning goals of conservative investors who need quick access to the money, Bowden said. Those investors might save money in commission-based accounts, paying minimal or no fees.

The fees can add up, as demonstrated in this example from Paul Meyer, a principal at the Securities Litigation & Consulting Group Inc (SLCG) in Westlake Village, California: An investor with a $1 million portfolio trading $100,000 in securities per year who pays the equivalent of 1 percent in commissions would have nearly $1.47 million after five years, assuming an 8 percent return. The same investor, in a fee-based account who pays a fee of 1.5 percent of the portfolio, would have $1.37 million, or $100,000 less.


The SEC’s growing interest in reverse churning underscores the role of a tougher regulatory standard than brokerages have traditionally followed.

Firms and advisers who counsel clients via fee-based accounts typically must act as fiduciaries, or in their clients’ best interests. That is a more stringent standard than the one commission-based brokers must meet. They must recommend investments and strategies that are merely “suitable” based on factors such as a client’s risk tolerance or age.

Moving clients’ assets from the brokerage side of the business to a fee-based account in the investment advisory arm requires advisers to shift from a suitability to a fiduciary standard.

A fiduciary would have to justify the benefit of having a client pay a flat fee, despite little to no activity in the account, or holding cash investments for long periods of time, Bowden said. “I think that’s a tough question for a fiduciary to answer - how that arrangement is in a client’s best interest.”

Sometimes there is no good answer, said SLCG’s Meyer. While many advisers recommend infrequent trading as a sound financial strategy, some brokers take advantage of collecting a flat fee. “The broker, once he has the money under management, has no incremental financial incentive to pick up the phone and make recommendations,” he said.


Monitoring accounts for potential reverse churning has been a challenge for firms, said Todd Cipperman, a compliance consultant in Wayne, Pennsylvania. That is because it is more difficult to spot inactivity than it is to find excessive trades, he said.

Some compliance responsibilities also trickle down to advisers, said Francois Cooke, a managing director with ACA Compliance Group, a Washington-area firm that provides compliance consulting services to broker-dealers. Firms that must tell regulators why a fee-based account is appropriate for a client who does not trade often will look to the adviser for an answer, Cooke said.

Advisers overseeing fee-based accounts should review the activity every quarter, and no less than once a year, Cooke said. If the client buys and holds securities and does not require many support services, it could be time to rethink the fee arrangement, Cooke said.