By my count, the Department of Labor's
1,000-plus page fiduciary rule makes only one obscure reference to “reverse churning.” But this subtle reference belies the issue's importance. The SEC and Finra have
had this regulatory matter on their radar for years. Now, under the new fiduciary rule, the DOL has reason to pay attention to the problem — and it's clear they will.
As the term suggests, reverse churning is the opposite of excessive trading in a brokerage account. Both are illegal practices designed to pad an unethical adviser's wallet. In a nutshell, reverse churning occurs when an adviser places client assets in an advisory account, charges an ongoing management fee, and gets paid for doing little or nothing thereafter.
The first occurrences of reverse churning came to light around 2005, when the SEC adopted an exemption permitting brokers to accept fee-based compensation. In a subsequent sweep of fee-based brokerage accounts by Finra, it found not only widespread absence of trading activity, but also double-dipping, in which brokers charged commissions for investment products that were subsequently placed in the fee-based accounts.
The Financial Planning Association successfully sued the SEC over this exemption for “fee-in-lieu-of-commissions” accounts, ending (in 2007) the ability of brokers to offer fee-based accounts without registering as fiduciary investment advisers. Nevertheless, reverse churning is still a concern.
Double-dipping by dually-registered advisers or providing fee-based accounts with little activity and few ongoing services provided by a fiduciary adviser can result in unreasonable compensation, which is a breach of the fiduciary duty of loyalty.
(More: The DOL fiduciary rule covered from every angle)
In recent years, the SEC has made reverse churning
an examination priority. Just this past March the SEC fined three AIG-owned broker-dealers for, among other things,
failing to monitor wrap-fee accounts on a quarterly basis to prevent reverse churning. The firms had compliance policies in place for that purpose, but on at least two occasions SEC examiners found the firms did not conduct their “inactive account review” on a timely basis.
Up until now, reverse churning has not been an issue for the DOL. Under ERISA, variable compensation represents a prohibited transaction for a fiduciary investment adviser and the only prohibited transaction exemptions (PTEs) to allow variable compensation were limited in scope.
But the new rule changes all of that, and the DOL can foresee a potential problem. For decades, brokers have been able to avoid fiduciary accountability due to a definitional loophole under the old rule which requires that advice be regular and the primary source of decision-making in order to trigger fiduciary status. That loophole has now been closed, laying the groundwork for brokerage accounts to be converted into fee-based advisory accounts as brokers seek to adapt to the new DOL rule.
The new rule favors level compensation to better align the interests of the client and adviser, but allows variable compensation under the new Best Interest Contract Exemption (BICE) to help mitigate the rule's impact on the broker-dealer business model. BICE is a new PTE that makes it possible, but painful, for brokers to continue to receive variable compensation if they acknowledge fiduciary status and follow a number of specific requirements to protect investor interests.
The onerous requirements of BICE are expected to prompt brokers-turned-advisers to shift from variable to level compensation arrangements. That's generally a good thing for investors if they receive services that justify the fees and if brokers don't seize the opportunity to create a double-dipping windfall simply by changing compensation arrangements for existing clients.
(Related read: The 2 sides of DOL fiduciary rule's BICE advisers must understand)
The DOL is rightfully most concerned about the possibility of reverse churning in IRAs. According to the Department, choosing to take a distribution or rollover assets from a 401(k) plan to an IRA is one of the most important financial decisions that a worker will make in his or her lifetime. For that reason, the DOL decided to extend its regulatory reach under the new rule to include advice on rollovers and on the assets held in IRAs.
Rollovers can present compensation conflicts for both brokers-turned-advisers and for advisers whose fees are level but whose compensation would increase when assets are rolled into an IRA.
The transition from variable to level compensation for existing clients creates the clear potential for double-dipping. IRA clients of brokers could have been paying commissions and 12b-1 fees for years. If the investments in the IRA are largely static and require little oversight, it may be better for the client if the assets stay where they are rather than shifting to a higher cost level-fee arrangement.
This would require the broker-turned-adviser to enter into a BICE arrangement with the client. To do otherwise would result in reverse churning. It is incumbent on the adviser to diligently assess what is best for the client and recommend the appropriate course of action. The DOL will want to see documentation of the decision-making process if they suspect reverse churning may be involved.
The conflict for a level-fee adviser is associated exclusively with the rollover recommendation, not with the form of compensation post-rollover. An increase in an adviser's compensation as a result of a rollover recommendation would constitute conflicted advice and give rise to a prohibited transaction, notwithstanding the fact that a level fee would be charged afterward. Recognizing that conflicts are minimized under level-fee arrangements, the DOL created a streamlined version of BICE to address this situation.
In order to meet the conditions of this streamlined BICE, also known as the level-to-level exemption, the adviser must document the reasons why the rollover is in the best interest of the client. The adviser also must describe the services that will be provided for the fee, in addition to other requirements.
The lessons here for fiduciary investment advisers seeking to comply with the rule and avoid reverse churning are straightforward. Advisers need to become well-versed on the conditions established in the DOL rule for rollover advice. They should conduct a thorough and objective assessment of the options available to investors seeking rollover advice and carefully document the basis for their decision-making, especially in regard to a recommendation to switch a client from a brokerage to an advisory account. And they must monitor any account for which they receive an ongoing management fee.
The DOL fiduciary rule
may put a significant dent in the rollover business of some brokers and advisers. However, a prudent and well-documented recommendation should comport well with the rule and help assure that clients' best interests are served.
Blaine F. Aikin is executive chairman of fi360 Inc.
