Norwalk, Connecticut financial advisor John Davenport (CRD# 1448999) recently received an investor complaint alleging that his investment advice resulted in...Read More
What is reverse churning by an investment advisor?
Churning a brokerage account refers to the excessive buying and selling of securities by a broker for the primary purpose of generating commissions rather than acting in the best interest of the client.
Reverse churning is the opposite – where little to no trades are done in an account, but the client pays fees because they are being charged an annual fee instead of commissions. Reverse churning can only occur in fee-based accounts.
Reverse churning violates several securities industry rules and regulations. Below is a summary.
Firms are not permitted to reverse churn under SEC’s Regulation Best Interest (“Reg BI”) . On June 5, 2019, the SEC adopted Reg BI, 17 CFR § 240.15l-1, under the Securities Exchange Act of 1934. Reg BI established a “best interest” standard of conduct for brokerage and investment advisory firms and their associated persons when making recommendations to clients for securities accounts and transactions. The compliance date for Reg BI started June 30, 2020. Securities transactions advised on or after this date must be in the “best interest” of the customer and must not place the interests of the firm and the registered representative ahead of those of the customer. Regulation Best Interest: The Broker-Dealer Standard of Conduct, 17 CFR § 240.15l-1(a), 33318, 33328 (2019). The rule includes four component obligations: care, disclosure, conflict of interest, and compliance. The care obligation requires broker-dealers to:
exercise reasonable diligence, care, and skill to: (1) [u]nderstand the risks, rewards and costs of a recommendation; (2) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer, based on the retail customer’s investment profile, and that the recommendation does not place the broker-dealer’s interest ahead of the retail customer’s interest; and (3) have a reasonable basis to believe that a series of transactions is in the best interest of the retail customer and does not place the interest of the broker- dealer ahead of the retail customer’s interests.
Regulation Best Interest (“Reg BI”) essentially creates a fiduciary standard. The SEC makes that clear in Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors:
Both Regulation Best Interest (“Reg BI”) for broker-dealers and the fiduciary standard for investment advisers under the Investment Advisers Act (the “IA fiduciary standard”) are drawn from key fiduciary principles that include an obligation to act in the retail investor’s best interest and not to place their own interests ahead of the investor’s interest. Although the specific application of Reg BI and the IA fiduciary standard may differ in some respects and be triggered at different times, in the staff’s view, they generally yield substantially similar results in terms of the ultimate responsibilities owed to retail investors.
The same bulletin makes it clear that advisors must consider costs when recommending an account:
Are costs always a relevant factor to consider when making account recommendations?
Yes, you must always consider cost as a factor when making an account recommendation. While Reg BI and the IA fiduciary standard do not always obligate you to recommend the least expensive type of account, both require you to have a reasonable basis to believe that the account recommendation is in the retail investor’s best interest and does not place your or your firm’s interests ahead of the retail investor’s interest. As discussed further below, if you recommend a higher cost account, you must have a reasonable basis to believe the account recommendation is nonetheless in the retail investor’s best interest based on other factors and in light of the particular situation and needs of the retail investor. The Commission has pursued enforcement actions against investment advisers for recommending higher-cost products to clients when similar, lower-cost products were available.
FINRA has cautioned its members for years that fees associated with its customers’ accounts must be appropriate. In November 2003, FINRA released a Notice to Members stating, “[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.” See FINRA Notice to Members, 03-68. FINRA members were also directed to implement supervisory procedures to require periodic review of fee-based accounts to determine that they remained appropriate for customers.
FINRA and the SEC have become increasingly vocal and active in efforts to combat “reverse churning,” when an advisor charges a management fee on an account in which the advisor has conducted minimal to no trades. In September 2022, the SEC instituted cease-and-desist proceedings against brokerage firm Waddell & Reed, LLC, through which the firm agreed to pay $775,589 in restitution, interest, and a civil penalty for breaches of fiduciary duty for failing to follow its own policies designed to prevent reverse churning. See In the Matter of Waddell & Reed, LLC, Administrative Proceeding File No. 3-21107 (Sept. 19, 2022).
In the cease-and-desist proceedings, the SEC wrote:
An investment adviser’s fiduciary duty includes a duty of care. To fulfill this obligation, an adviser, among other things, must provide investment advice in the best interest of its client based on the client’s objectives, and must generally provide advice and monitoring over the entire course of the relationship.
Further, an investment adviser’s fiduciary duty applies to all investment advice the adviser provides to clients, including advice about account type. Advice about account type includes advice about whether to open or invest through a certain type of account, e.g., a commission-based brokerage account or a fee-based advisory account. As a general matter, an investment adviser’s duty to monitor extends to all personalized advice it provides to the client, including, for example, in an ongoing relationship, an evaluation of whether a client’s account or program type (for example, a wrap account) continues to be in the client’s best interest.
The SEC also found that Waddell & Reed’s reverse churning also violated Section 206(2) of the Advisers Act, which makes it unlawful for any investment adviser, directly or indirectly, to “engage in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”
If a firm engages in reverse churning, the firm can be held liable to the investor to pay back the fees improperly charged.