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Reverse Churning Prioritization by SEC is Another Example of Regulatory Overreach

by Robert G. Yetman, Jr.

The Securities and Exchange Commission recently announced that “reverse churning” is among its Office of Compliance Inspections and Examinations’ (OCIE) priorities for 2016. Are you familiar with reverse churning?

You likely know about churning, which is the practice of executing trades in a securities account primarily for the purpose of generating sales commissions. As the definition implies, it is the province of commission-based compensation structures, rather than those that are fee-only in makeup (fee-based financial advisors can, potentially, engage in churning, as well). A managed account from which the advisor is compensated solely by a percentage-based fee assessed against assets under management does not, obviously, present a nefarious broker with an opportunity to churn…but some would say that reverse churning is the shoddy, fee-only adviser’s answer to that. That said, I see the “problem” of “reverse churning” as, largely, a regulatory contrivance designed to serve as an entrée for even more regulation and more fines…and simply another effort by regulators to become even more bloated at the expense of industry professionals.

With so-called reverse churning, the sin lies in the adviser’s lack of activity on behalf of the investment account, which is, obviously, the opposite of how churning works…but is typically relevant only to managed accounts wherein the sole compensation to the adviser comes in the form of a fee assessed against assets under management, and transaction-based commissions are not available. For example, let’s say you have $250,000 under management at XYZ Advisers, and you pay a 1% percent management fee annually, against assets under management, for the service. Let’s further say, for the sake of discussion, that the 1% is charged in the form of a fee of 25 basis points debited against total account value at the beginning of each quarter. Again, to keep things simple, let’s further declare that your account is at $250,000 when .25% is debited at the outset of a three-month period. You have just paid your adviser $625 for his services on behalf of your account for the quarter. The quarter comes and goes, and it turns out that your account was traded infrequently, or maybe not at all. The SEC might well say you might have an adviser guilty of reverse churning, because he collected your $625, but then made few, if any, trades during the covered period.

I’m not suggesting that an adviser who genuinely sits on your account and does nothing to justify his fee over an extended period (you pick the period…one quarter, six months, a year) is not a problem, but what I am saying is that it is generally a customer service problem, and not one that rises to the level of being a regulatory issue. Assuming a customer is receiving account statements no less than quarterly, and transactions statements as trades are being executed, then he is going to know whether his account is being traded, as well as if it is making money (and, more specifically, reflecting a positive alpha coefficient return, which means, in layman’s terms, outperforming the market index of which it is representative). If he has questions, he can pick up the phone and speak to his representative. If he likes the explanation, great; if not, he can fire his advisor and move on to someone else, or even take over management himself.

If you pay your lawn maintenance guy a flat fee each month to service your yard and you don’t see him as often as you should, what do you do? Your fire him; you don’t call the state attorney general’s office.

An important, related issue is the matter of whether the account is making money (or not losing as much in a down market – again, positive alpha) in spite of a dearth of active trading. The fact is that not trading an account is every bit as viable a management tactic as trading it, depending on a wide array of factors that include client-elected management style, market climate, and economic climate…the very same set of criteria that are used to determine when and how it should be traded into securities. Sometimes the smartest thing to do is sit tight. This can be particularly important in “regular” brokerage accounts that do not enjoy any kind of tax-preferred status, wherein trades can often result in adverse tax consequences for account owners.

An important caveat to the above is that an adviser must be able to clearly articulate why less activity, or even no activity, was the best approach to take with an account over an appropriately-considered interval. Nor will I say that there is no circumstance where an alleged case of reverse churning doesn’t warrant a look by a regulator. Broadly speaking, however, the aforementioned articulation is an explanation that an adviser should have to make only to a client, and not to a regulator. Additionally, the nature of the fee mechanism…a percentage of account value…in a managed account provides a natural incentive to the adviser so compensated to perform on behalf of the account in a way that it makes as much money as possible. However, even if he is not motivated on that basis to act appropriately, the client, again, has ample opportunity to address whatever problem he feels that poses directly with the adviser.

Financial services regulation continues down the unfortunate and intellectually dishonest path of deciding that consumers of financial services…adults who are otherwise permitted to breed, drive cars, choose leaders, consume alcohol, carry guns, and enjoy a host of other responsibilities befitting a grown-up population…should be regarded as five-year-old children the moment they open a brokerage account or buy a mutual fund. I say “intellectually dishonest” because I do not hold for a minute that regulators really believe, philosophically, that investors are incapable of handling issues like this on their own, in the fashion I suggested. However, it is in the selfish interests of regulators that they decide that as much as possible is a formal offense for which brokers and advisors can be sanctioned and, more importantly, fined, in order that financial advisers of all kinds can be further bullied into doing their part to help feed the very beasts that seek to devour them.

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