But no court has agreed so far, and lawyers calculate slim odds for such petitions to succeed.
Andrew Stoltmann, a Chicago-based plaintiff lawyer and a director and past president of the Public Investors Arbitration Bar Association, says he typically doesn’t represent claimants in reverse churning cases because of limited monetary gains and certain obstacles.
The damages in such cases — where clients complain they were placed in fee-based accounts even if they were buy-and-hold investors — might arguably be only the difference between 1% and 2% in fees, Stoltmann says. That would bring too skimpy a payoff to plaintiff lawyers, who usually work on contingencies and get paid only if they win a case, he says.
“We’ve had the widespread adoption of a buy-and-hold strategy by so many investors that parasitic brokers have realized the only way they can make money is to put these folks [into] advisory fee accounts and hold their investments. They are taking 1% and 2% [of client assets as fees] when they should be taking virtually nothing,” he says.
Besides, it’s hard to persuade courts that there are common claims since each investor may have entered an advisory fee arrangement under individual circumstances, he says.
“This reverse churning falls into the black hole. It is activity that is not allowed,” but the plaintiff bar has too little incentive to chase it, Stoltmann says.
So far, a court has issued an opinion only in the case against Edward Jones.
In November 2019, U.S. District Judge John Mendez of the United States District Court for the Eastern District of California wrote in his ruling tossing the investors’ lawsuit that they had “received documents: expressly outlining the schedule of fees for [Edward Jones'] Advisory Programs, providing a specific estimate of the recipient’s anticipated yearly fees, and conceding that [the programs] could ‘be more expensive than other investment choices over the long term.’”
Those Edward Jones disclosures “fatally undermine” the investors’ allegations, Mendez concluded.
The complaining investors haven’t given up. They want to appeal Mendez’s ruling and are scheduled to file their opening brief with the Ninth Circuit Court of Appeals in March.
Still pending before a trial court is the proposed class action filed last month by an investor against Raymond James.
In that lawsuit, the investor, Kimberly Nguyen alleges Raymond James engaged in negligence, breached its fiduciary duties, and violated Finra’s rules on suitability and supervision. She alleges she opened a commission-based account with Raymond James in June 2015 and was advised to switch to a fee-based account in January 2016. As result, Nguyen allegedly paid more than $7,400 in fee-based account fees between 2016 and 2018 — “substantially more” than a “buy-and-hold” investor would have paid in a commission-based account, her complaint alleges. Fee-based accounts are not suitable for certain client types, Nguyen’s complaint argues.
May be better off complaining to regulators
Stoltmann says regulators might prove more effective at addressing reverse churning allegations than the courts.
“It’s teed up perfectly for regulators to handle it,” he says.
Finra dinged a broker-dealer based on reverse churning allegations, but that enforcement action happened more than a decade ago. In 2009, the self-regulator fined Robert W. Baird & Co. more than $500,000 for fee-based account breakpoint violations. About 154 of the firm’s customers “either paid fees in fee-based accounts without generating activity or paid fees higher than those indicated on the Baird fee schedule,” Finra said at the time. Baird settled but denied any wrongdoing.
Bradley Bennett, a lawyer and former head of Finra enforcement, argues that reverse churning allegations will only stick if a specific pattern unfolds: The broker-dealer initially offers clients commission-based trades, then moves them to fee-based accounts only after trading slows or ceases, he says.
Under those circumstances, regulators could argue broker-dealers are “maximizing the amount of money” they earn rather than looking out for the client’s interest.
But the federal government’s policies under the Obama administration present a ripe defense for broker-dealers facing reverse churning claims, based on allegations that they moved clients en masse to advisory fee accounts, Bennett says. And that’s a consequence of the Department of Labor’s fiduciary rule, he notes, which has since been vacated.
“The firms are going to say, ‘I followed the law and fully explained it to the client,’” Bennett says.
Jason Haselkorn of Haselkorn & Thibaut, a Florida-based securities and investment fraud law firm, usually represents clients complaining of reverse churning.
“Anytime that a client is being overcharged, it’s obviously something that will bother the client … [and] should bother the firm and the financial advisor working for the firm,” Haselkorn says. “At the same time, we’re not talking about the type of case where clients [are] going to lose tens of thousands or hundreds of thousands of dollars out of the principal in the account. It’s like a slow bleed.”
Although he represents plaintiffs, Haselkorn acknowledges reverse churning could be either strategic or accidental.
But he has a warning for investors: Evaluate “how much effort is really being put in by the firm or by the advisor to monitor the activities [of their account] on a quarterly basis or to provide investment services and advice on an annual basis.”
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