reverse churning

A recent InvestmentNews article explored The Securities and Exchange Commission’s (SEC) attempts to prevent conflicts of interest at registered investment advisers, a breach of their fiduciary duties, by focusing on potential misuse of popular flat-fee wrap accounts. The use of these accounts have given rise to claims of “reverse churning.” As we previously reported, “churning” is excessive trading activity or in a brokerage account. Churning trading activity has no utility for the investor and is conducted solely to generate commissions for the broker. By contrast “reverse churning” is the practice of placing investors in advisory accounts or wrap programs that pay a fixed fee, such as 1-2% annually, but generate little or no activity to justify that fee. Such programs constitute a form of commission and fee “double-dipping” in order to collect additional fees.

The SEC is looking into the practice by which clients pay an annual or quarterly fee for wrap products that manage a portfolio of investments. Investment advisors who place clients in such programs already charge fees based on assets under management (AUM) and the money management charges for wrap products are in addition to the AUM fee. According to InvestmentNews, the assets under these arrangements totaled $3.5 trillion in 2013, a 25% increase from 2012. Included in these numbers include separately managed accounts, mutual fund advisory programs, exchange-traded-fund (ETF) advisory programs, unified managed accounts, and two types of brokerage-based managed accounts.

Reverse churning can occur under these arrangements if there’s too little trading in the accounts in order to justify the high fees. In August, the SEC’s scrutiny of these products came to the forefront with the agency’s victory in a court case that revolved in part around an adviser’s improperly placing his clients into wrap programs. A jury decided in the SEC’s favor against the advisory firm Benjamin Lee Grant that the SEC argued improperly induced clients to follow him when he left the broker-dealer Wedbush Morgan Securities to his advisory firm, Sage Advisory Group.

It is relatively easy to grasp the concept of excessive trading activity or “churning” in a brokerage account. Churning trading activity has no utility for the investor and is conducted solely to generate commissions for the broker. Churning involves both excessive purchases and sales of securities and the advisors control over the account. But regulators are also looking at another growing trend referred to as “reverse churning.” According to the Wall Street Journal (WSJ) the Securities and Exchange Commission (SEC) states that “reverse churning” is the practice of placing investors in advisory accounts that pay a fixed fee, such as 1-2% annually, but generate little or no activity to justify that fee. Regulators are watching for signs of “double-dipping” whereby advisers generate significant commissions in an investor’s brokerage account and then moves the client into an advisory account in order to collect additional fees.

As a background there are many standalone brokerage firms and investment advisor firms where the option does not exist for a client to be switched between types of accounts. However, there are also many dually registered firms which are both broker-dealers and investment advisers. These firms, and their financial advisors have tremendous influence over whether a customer establishes a brokerage or investment advisory account. In the WSJ, the SEC was quoted as saying that “This influence may create a risk that customers are placed in an inappropriate account type that increases revenue to the firm and may not provide a corresponding benefit to the customer.”

However, dumping a client account into an advisory account after the broker ceases trading is only one strategy that should be included in the category of “reverse churning.” There are many other creative ways that brokers can generate excessive commissions for themselves while providing no benefit to their clients. For example, if a broker recommends a tax deferred vehicle, such a as a variable annuity, in an IRA account there is no additional tax benefit for the client. While the recommendation would not result in excessive trading, the broker would earn a huge commission for an investment that cannot take advantage of one of its primary selling points.

Articles Tagged with reverse churning

SEC Cracks Down on Wrap Accounts to Prevent “Reverse Churning”

Regulators On the Look Out for “Reverse Churning”