SEC Intensifies Scrutiny Of Fee-Based Accounts And Reverse Churning

The SEC is crunching a lot of data these days, and it apparently intends to use some of that data to identify "reverse churning." Reverse churning is the practice of placing a client who trades infrequently in a fee-based, rather than a commission-based, account. Chair Mary Jo White recently identified this as a problem that the SEC can detect through its quantitative analytics.

Based upon the SEC's and FINRA's past regulatory and enforcement focus in this area, we recommend that firms review their supervisory systems and procedures to ensure that they are adequate to identify possible instances of reverse churning before the regulators do. Evaluation of the appropriate use of fee-based accounts is very likely to be an SEC exam priority in the coming year.

THE SEC'S ENHANCED USE OF DATA

At the annual meeting of the National Society of Compliance Professionals (NSCP) in October, White reported that the SEC's examination program continues to improve the implementation of a risk-based strategy that focuses on entities and business practices that the SEC believes pose the greatest risks to investors and markets.1 She pointed to the Risk Analysis Examination (RAE), which uses quantitative analytics to examine clearing firms and large broker-dealers. She said that the examination staff may require such firms to download all transactions cleared by a firm over the prior year or two, and the RAE subjects the data to a broad range of queries designed to identify problematic behavior.

Chair White reported that in one recently completed exam, the RAE team collected and analyzed over 400 million transactions, and she stated that she expects that future exams will analyze more than twice that many. Armed with this data, the RAE team is - and has been - able to identify a wide range of problematic behaviors including reverse churning, as well as unsuitable recommendations, misrepresentations and inadequate supervision.

THE PROBLEM: REVERSE CHURNING

Fee-based accounts may be desirable when they align the interests of the client and the firm in building assets in an account. Fee-based accounts also may offer some clients a greater variety of services, such as long-term financial planning and money management. Conversely, in a transactional or commission-based account structure, brokers are incentivized to make trades, even at the expense of a client's best interests.

However, fee-based accounts (also known as asset-based, or "wrap-fee" accounts) also...