A couple of years ago, I blogged about the concept of “reverse churning,” i.e., putting a customer who trades only infrequently into a fee-based account, thus costing the customer a lot more than it would have cost that customer to be in a commission-based account. The reason this became a topic was, at the time, the advent of the Fiduciary Rule, and its focus on conflicts of interest, given how a commission-based account has an inherent conflict.
Well, the Fiduciary Rule has stalled on its way to implementation, as you are likely aware, and when and if it ever gets back on track remains to be seen. Putting aside the question of whether that is a good or a bad thing, it remains that the Fiduciary Rule, even in its nascent form, is still having a real impact on the way that broker-dealers operate, and the risks they are running for, in essence, trying to do the right thing. But, this isn’t a new phenomenon. Broker-dealers have found themselves in this pickle for over 25 years.
Travel back with me to the year 1995. At the request of then-Chairman of the SEC Arthur Levitt, the Committee on Compensation Practices was assembled, chaired by Daniel Tully, the CEO of Merrill Lynch, and assisted by such luminaries as Warren Buffet. The Committee issued the infamous Tully Report, designed to identify industry “best practices.” Among the best practices identified by the Committee was the use of fee-based accounts, which were thought to “eliminate the incentive of a commission broker to make trade recommendations designed principally to enrich himself through commissions”:
PAYMENT FOR CLIENT ASSETS IN AN ACCOUNT, REGARDLESS OF TRANSACTION ACTIVITY. In many cases the best advice an RR can give a client at a point in time is to “do nothing,” or to keep assets in the safety of a money market account. The RR’s reward for this advice is zero compensation. Some firms’ practice of basing a portion of RR compensation on CLIENT ASSETS IN AN ACCOUNT is seen as one way to reduce the temptation for income-seeking RR’s to create inappropriate trading activity in an account. Fee-based accounts may also be particularly appropriate for investors who prefer a consistent and explicit monthly or annual charge for services received, and whose level of trading activity is moderate.
Not surprisingly, many BDs, eager to please their regulators and to demonstrate their willingness to appear compliant, proceeded to adopt this as a best practice, and started encouraging clients to move to fee-based accounts.
Bad decision, as it turns out. Not long after the Tully Report was issued and extolled as the blueprint for modern compensation structures, NASD started to backtrack. In November 2003, NASD issued Notice to Member 03-68, questioning whether what the Tully Report characterized as a best practice was, in fact, a good idea after all:
The . . . “Tully Report” . . . labeled fee-based programs a “best practice” because they more closely align the interests of the broker/dealer and customer and reduce the likelihood of abusive sales practices such as churning, high-pressure sales tactics, and recommending unsuitable transactions. . . . On the other hand, the Tully Report acknowledged that fee-based programs may not fit the needs of certain investors. In this regard, commenters to the Tully Committee noted that accounts with low trading activity may be better off with a commission-based program. . . .
Based on that, NASD warned that “[i]t generally is inconsistent with just and equitable principles of trade – and therefore a violation of Rule 2110 – to place a customer in an account with a fee structure that reasonably can be expected to result in a greater cost than an alternative account offered by the member that provides the same services and benefits to the customer.”
Given these seemingly contradictory directions – it is a “best practice” to use fee-based accounts, but, if you do, you may be violating Rule 2110 – it is easy to see how BDs found themselves in a real predicament. I mean, even if they followed NASD’s advice, and “before opening a fee-based account for a customer” they took steps to ensure they had “reasonable grounds to believe that such an account is appropriate for that particular customer,” they still ran the real risk of being second-guessed by NASD. In fact, NASD, and later, FINRA, brought Enforcement actions for reverse-churning.
Today, 23 years after the Tully Report and 15 years after NTM 03-68, nothing has changed. BDs are still being second-guessed for doing what they have been told is the right thing to do. What made me reach this conclusion was the report I read last week of a class action lawsuit just filed against Edward Jones by four customers for an illegal “reverse churning scheme.” What makes this doubly troubling is that it seems clear the regulators themselves are potentially responsible for this lawsuit. Remember, both FINRA and the SEC identified reverse churning in their respective 2018 Exam Priorities letters published at the beginning of this year. The SEC said it was focusing on “advisers that changed the manner in which fees are charged from a commission on executed trades to a percentage of client assets under management.” FINRA used very similar language, identifying “situations in which registered representatives recommend a switch from a brokerage account to a [fee-based] investment adviser account where that switch clearly disadvantages the customer.”
Claimants’ counsel are attentive to statements like this, perhaps as they should be. If they come to the understanding that regulators are purportedly concerned about fee-based accounts, then by golly, that can only mean litigation on that subject will shortly ensue. Poor Edward Jones has just learned this unfortunate fact, the hard way. But, how can this be fair? How can doing what the regulators identified as a best practice simultaneously not be something that is in the customers’ best interest? Talk about being between a rock and a hard place.
The only way out of this trap is some serious documentation and disclosure. Go back to NTM 03-68, read what it says in terms of the steps that must be taken before recommending a fee-based account. Step one is figure out what a customer’s account is going to look like:
[M]embers should make reasonable efforts to obtain information about the customer’s financial status, investment objectives, trading history, size of portfolio, nature of securities held, and account diversification. With that and any other relevant information in hand, members should then consider whether the type of account is appropriate in light of the services provided, the projected cost to the customer, alternative fee structures that are available, and the customer’s fee structure preferences.
Once the decision is made as to the proper type of account, then step two is disclosure: “[M]embers should disclose to the customer all material components of the fee-based program, including the fee schedule, services provided, and the fact that the program may cost more than paying for the services separately.” This is very important because it shifts the burden to the customer to complain that the compensation arrangement was improper. 03-68 expressly identifies this safe harbor: “Absent inducement by the member, no liability under Rule 2110 (unless derivative of another rule violation) will attach to a member where it is disclosed to a customer that a potentially lower cost account is available, but the member can demonstrate that the customer nevertheless opted for a fee-based account for reasons other than pricing.”
Finally, step three is monitoring. Once a decision is made to put a customer in a particular type of account, that is not the end of the story, as that decision must be revisited to ensure it continues to make sense. In 03-68, NASD suggested that members conduct an annual review “of fee-based accounts to determine whether they remain appropriate.” If you don’t do these annual look-backs, you clearly run the risk that you will be asked by someone, perhaps a regulator, perhaps an arbitration panel, perhaps a judge, to justify a decision that may have been made years before but which no longer matches a customer’s needs.
 These concepts remain valid today. There is a Q&A currently on the FINRA website relating to fee-based accounts, and its content is largely drawn straight from NTM 03-68.