While the Department of Labor has been hard at work attempting to memorialize the "fiduciary duty" between a financial advisor and his or her client, its 1000-plus page proposal has thrown the spotlight on a new watchword in financial regulation: reverse churning.
The Securities and Exchange Commission (SEC) and its regulatory arm, the Financial Industry Regulatory Authority (FINRA) have had their eye on reverse churning for several years now, but quietly. Possibly because the phenomenon of reverse churning gibes so well with the DOL's fiduciary rule and because advisory accounts are growing in the US, reverse churning has suddenly been thrust to center stage.
What Is Reverse Churning?
If you know what churning is - excessive trading by a broker to generate more fees - you can probably guess what reverse churning is. Reverse churning is misuse of higher-fee advisory accounts by financial advisors who get paid management fees but do little to nothing to earn them. While it is a passive act, it is every bit illegal as excessive churning.
Reverse churning first came to light in 2005, when the SEC and FINRA conducted a sweep of fee-based brokerage accounts and found widespread abuse. Regulators found not only churning but double-dipping - charging clients fees-per-trade while also charging them an ongoing management fee.
More recently, FINRA has focused its high beams on reverse churning. Early this year, the SEC fined three broker-dealers for failing to monitor wrap-fee accounts on quarterly-basis to prevent reverse churning. Edward Jones, meanwhile, faces a lawsuit by investors who say they were charged unnecessary fees when they were switched from commission-based to fee-based accounts.
Reverse Churning and the Fiduciary Relationship Between Broker and Investor
Since the DOL rules seeks to better align the interests of financial advisors and their clients, it is no surprise that reverse churning is suddenly getting extra attention from regulators. Like churning, reverse churning represents one of the more subtle and pernicious ways that brokers can take advantage of unwitting retail investors while lining their own pockets. Indeed, it can be harder for unsophisticated investors to detect or identify reverse churning, since it is rather easy for a broker to insist that any inactivity in the account could be attributed to a lack of attractive investment opportunities.
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