Is your client in a wrap program, despite being a low-volume trader? Read about reverse churning

I work for a dual registered broker-dealer/investment advisor. Recently we underwent an examination and during the exit interview the examiner mentioned that he had some concerns over what he called “reverse churning.” I’m not sure I understand what he was getting at, since I always thought of churning as excessive trading. How can an account be traded too little? It almost sounds like the examiner wants the client to pay more. Can you help make sense of this for me?

I’ve seen “reverse churning” arise most often when a broker-dealer is acting in dual capacities as both a registered investment advisor and a broker-dealer in connection with wrap accounts. Generally speaking, a wrap fee program will charge a higher advisory fee to cover, or offset, the transaction charges that would otherwise be paid on a frequently traded account. The higher advisory fee is justified by the fact that the more frequent trades would have cost the client more if the client had to pay the commissions.

Conversely, a non-wrap account would normally be more appropriate for “buy and hold,” or less frequently traded accounts. Typically, the advisory fee charged in that case would be lower than in a wrap account because there would be fewer trades. The client benefits by paying the lower advisory fee even though he or she has to pay the commissions.

The “reverse churning” comes in when the client is in a wrap program despite being a low-volume trader. In that case, being charged the higher advisory fee would be seen as inappropriate since the non-wrap program would have been a better “deal” for the client. 

I’m thinking of leaving my broker-dealer, giving up my Series 7 license and becoming a registered investment adviser in my own business. However, I’m worried about giving up my commission income, since it’s pretty substantial and I’m not sure how the fee-only revenues will compare. Is there any way I can still keep at least my trailing commissions (12b-1 fees)?

Advisors with trailing revenues on commissioned investment products sold will lose this income if they move to an “RIA-only” model. When you do so, you are no longer registered with a broker-dealer and are restricted to receiving only “fee-based” compensation. Transaction-based compensation such as 12b-1 fees and commissions are not permitted.

However, under the so-called “hybrid model,” a financial advisor can be affiliated with a broker-dealer for the advisor’s commissionable business and would conduct fee-based business through his or her outside RIA. Under this model, registered investment advisors can retain the recurring revenue as compensation for products sold, and can also continue to receive commissions on future transactions.

Maintaining a broker-dealer affiliation allows you to receive commissions on such products as mutual funds and variable annuities. The broker-dealer affiliation also allows you to retain your Series 6 or Series 7 securities license.

There are several broker-dealers out there that allow this independent model and you should look into them to see if they might be a good fit for you. Note that your Series 7 license is good for two years after you terminate your arrangement with your broker-dealer.

Alan J. Foxman is a contributing writer for On Wall Street, an attorney with the law offices of Rita G. Dew and a senior consultant with National Compliance Services in Delray Beach, Fla. 

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