If you are a financial advisor, you need to be aware of reverse churning. This little-understood issue might even be a Black Swan for the wealth management industry. Reverse churning is so pernicious that it could ensnare many advisors in regulatory and legal difficulties simply for doing nothing.
What Is Reverse Churning?
The emerging risk of “reverse churning” essentially describes advisors who collect fees from their clients but do not do much of anything. The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) are increasingly paying attention to reverse churning – especially as the U.S. stock market keeps dancing around record highs. This interest guarantees that lawyers are prepping themselves for litigation. We know that major brokerage firms are preparing themselves by increasing litigation reserves.
Under regulations, financial advisors should do more than just make an initial allocation with a client’s money, especially into the popular fee-based accounts that have made idle client accounts into vehicles that now regularly pay advisors and their firms. If they do not do more than collect fees, advisors could be in big trouble and at risk of a reverse churning lawsuit.
“There will be a tsunami of investor complaints related to reverse churning when the market crashes,” Andrew Stoltmann, a lawyer who is president of the Public Investors Arbitration Bar Association, said in a recent interview. The group’s lawyers sue the securities industry.
What's Reverse Churning? – Discover how this new risk can harm your advising business and learn how to be one step ahead Click To Tweet
How to Fight Reverse Churning?
If the stock market experiences a sharp correction and investors with fee-based accounts lose loads of money, clients are expected to sue their advisors for not doing more to protect them.
Regulators, meanwhile, are already telegraphing that they expect advisors to closely monitor their accounts to determine if clients have been put into proper account structure. If a client trades a lot, perhaps they truly are best served with fee-based accounts that cover trading fees. But if a client rarely trades, perhaps paying for trades is better than the so-called wrapped-fee account. The regulatory review for reverse churning seems to largely revolve around how much money an advisor made versus client activity.
Already, some case law provides insights. Three American International Group advisory firms, for example, paid about $10 million to settle federal charges for unnecessary fees on at least 1,000 mutual fund clients. The SEC charged advisors for failing to monitor advisory accounts quarterly for inactivity, or “reverse churning.”
The SEC also reviewed the advisor’s compliance policies and procedures. The regulators found that the advisors were obligated to determine if fee-based advisory accounts remained in the best interest of clients.
These issues are complicated, but one way to simplify them is to have clients complete a digital risk questionnaire, and then analyze their portfolios to determine if their accounts reflect their risk tolerance.
This process creates an important interaction between advisors and clients, while creating a written trail for regulators.
Bottom line: Digital risk reviews help advisors create surfboards that they can use should market and regulatory forces coalesce into a tsunami of litigation and compliance reviews.