“Churning” is a well-known term in the brokerage world, referring to excessive trading of securities by brokers to earn commissions. On the flip side, there’s “reverse churning,” where minimal trading occurs in a client’s account, yet the client still incurs fees due to the broker’s annual charges. The legality of this practice is questionable, and in most cases, it’s not legal. This article will delve into the regulatory landscape surrounding reverse churning in brokerage accounts.
Understanding ‘Regulation Best Interest’ (Reg BI)
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The Securities and Exchange Commission (SEC) introduced Regulation Best Interest, or Reg BI, as part of the Securities Exchange Act of 1934. Implemented in June 2019, Reg BI requires that all securities transactions from June 30, 2020, onwards must prioritize the client’s best interest over those of the firm or the advisor.
Reg BI establishes four fundamental obligations:
- Care: Broker-dealers must thoroughly evaluate the risks, rewards, and costs of a recommendation and ensure it aligns with the customer’s investment profile without placing their interests above the customer’s.
- Disclosure: Full transparency in business practices is essential.
- Conflict of Interest: Advisors should avoid situations where personal gain could supersede the customer’s interests.
- Compliance: Strict adherence to regulatory guidelines is mandatory.
The Fiduciary Standard and Reg BI
Reg BI effectively sets a fiduciary standard for broker-dealers, aligning it with the fiduciary principles also applicable to investment advisors. This standard compels brokers to prioritize the interests of retail investors and to avoid favoring their own or their firm’s interests. Brokers must justify any recommendation of a more expensive account over a cheaper alternative, proving that it serves the retail investor’s best interest.
FINRA’s Guidelines on Fees
The Financial Industry Regulatory Authority (FINRA) has been clear: all customer account fees must be justifiable and fair. A 2003 FINRA Notice to Members reiterated that placing a customer in a fee structure that is costlier than a comparable alternative violates the principles of fair and equitable trade.
The SEC and FINRA Tackle ‘Reverse Churning’
Both the SEC and FINRA are actively confronting “reverse churning,” where advisors charge account management fees without performing significant trading activities. A notable enforcement action in this regard was against Waddell & Reed, LLC. The SEC charged the firm with breaching fiduciary duty by allowing reverse churning, leading to a settlement of $775,589 in damages, interest, and civil penalties.
The SEC’s message is clear: advisors have a continuous fiduciary duty to provide care and advice in the client’s best interest, which includes periodically evaluating if the account type remains suitable for the client.
Implications and Legal Recourse
The SEC underscores that fiduciary duty encompasses all investment advice, including recommendations on account types. Firms engaged in reverse churning may face the liability of reimbursing wrongly charged fees to investors.
At Haselkorn & Thibaut, we understand the complexities of navigating regulatory requirements and compliance. For issues related to reverse churning or other investment irregularities, clients are encouraged to reach out to us at 1-800-856-3352 for expert guidance. Let our expertise guide you through these intricate financial regulations.
