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Dual Registrant Failed to Convert Inactive Fee-Based Accounts to Brokerage


A large dual registrant agreed to pay over $15 Million in fines, disgorgement and penalties for failing to convert inactive fee-based advisory accounts into traditional brokerage accounts.  The firm had policies requiring its financial advisers to conduct ongoing suitability reviews and flag those accounts without significant trading activity during the prior 12 months.  According to the SEC, the FAs, without an imposed deadline, failed to respond to requests from the Compliance Department to complete the reviews.  As a result, over a 5-year period, the firm failed to properly review nearly 8,000 accounts.  Once the SEC began an investigation, the firm converted 1700 accounts to brokerage and closed an additional 2000 accounts.  The SEC faults the firm for failing to have specific escalation procedures when they failed to respond to compliance inquiries and for neglecting to impose deadlines.  The SEC also charged the firm with unsuitable UIT recommendations.

Dual registrants (and parent companies of dual registrants) have this unique suitability compliance obligation that overrides the specific compliance programs for the investment adviser and its broker-dealer affiliate. The firm must determine which product line – fee-based account or traditional brokerage – is suitable and then continuously monitor the accounts to avoid either churning or, as in this case, reverse churning (i.e. inactive fee-based accounts).   Many industry observers used to think that fee-based accounts would displace bad brokers who churned accounts.  We have now come full circle as the regulator targets reverse churning.

BD/RIA Knew about Flipping Transactions but Failed to Stop Them

A large bank-affiliated broker-dealer/adviser agreed to pay over $5.1 Million in disgorgement, interest and penalties for failing to stop its brokers from churning/flipping high-commission market-linked investment products.  The SEC alleges that the respondent knew that its brokers engaged in flipping transactions as far back as 2005 but took inadequate measures to stop the misconduct.  For several years, the firm relied on supervisor pre-approval but failed to provide supervisors adequate guidance or training, resulting in routine approvals.  The firm finally stopped the unlawful activity by implementing a centralized electronic supervisory pre-approval process.

OUR TAKE: The regulators will not give credit for “voodoo compliance” whereby a firm superficially creates a compliance infrastructure, but the designated policies and procedures fail to stop unlawful conduct.  Ad hoc supervisory reviews rarely serve as adequate tools to check brokers with a significant financial incentive.


FINRA Proposal Eliminates Control/Discretion Defense to Churning

FINRA has proposed changing the suitability standard so that brokers could have liability for excessive trading even if the broker did not exert control or discretion over the client’s account.  Current FINRA rules require a showing of control before FINRA could charge a broker with churning.  FINRA questions whether this control element puts a “heavy and unnecessary burden on customers by, in effect, asking them to admit that they lack sophistication or the ability to evaluate a broker’s recommendation.”  FINRA says that this control element may not be appropriate in light of the recently proposed SEC’s Regulation Best Interest.  FINRA would evaluate churning based on the total facts and circumstances including turnover rate (e.g. greater than 6), cost-to-equity ratio (e.g. greater than 20%), or the use of in-and-out trading.

OUR TAKE: Brokers, and their compliance officers, have long relied on the regulatory distinction between accounts over which they exercised discretion versus directed accounts.  This proposal eliminates that ostensible compliance bright line which really has very little meaning in the real world where retail clients rely on broker recommendations.  Acting in a client’s best interest should not depend on how much control a broker exercises.


SEC, Not FINRA, Brings Churning Case Against 2 Brokers

trust me


The SEC charged two brokers with churning and excessive trading in customer accounts.  The SEC accuses the brokers of engaging in excessive short-term trading that had little chance of benefiting customers after payment of fees.  Both brokers, who had significant disciplinary histories, used telemarketing and cold-calling to find clients who they pressured with pre-filled agreements and margin arrangements.  An SEC official commented, “This case marks another chapter in the SEC’s pursuit of brokers who deploy excessive trading as a strategy in customer accounts to enrich themselves at customers’ expense.”

OUR TAKE: It is very unusual for the SEC to bring suitability and churning cases against individual brokers.  These types of cases are usually FINRA’s jurisdiction.  Perhaps this is the beginning of the SEC moving to regulate retail brokers in response to the DoL fiduciary rule.