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Stockbroker Misuse of Fee- Based Accounts Replaces Churning as a Leading Fraudulent Practice
By Jacob H. Zamansky
WALL Street LAWYER
September 2005
Volume 9 / Number 4
© 2005 Legalworks, a Thomson business

Investor complaints about their brokers' misuse of "fee-based" investment accounts are on the rise as fee-based accounts become the product of choice at major Wall Street brokerage firms. Misuse of fee-based accounts by brokers appears to have replaced "churning" (excessive trading to generate commissions) as a leading fraudulent investor sales practice.

In the past ten years, major brokerage firms have employed a business strategy of moving accounts from "commission-based" (which charge a commission for each transaction) to "fee-based" (which impose an annual fee based on assets under management). The impetus for this change was competition from discount and on-line brokerage services, which charge much lower commissions. Enthusiasm for fee-based accounts also may be a response to investor concerns about churning in commission-based accounts. Whatever the cause, the major brokerage firms felt the need to promote fee-based accounts in order to keep their customers.

Assets in fee-based brokerage accounts reportedly grew to $270 billion at the end of 2004, more than doubling in five years. One study indicates that approximately 18% of brokerage assets at the five largest full service brokerage firms are currently in fee-based accounts, and the figure is expected to continue rising.'

Unfortunately for investors, there are substantial abuses of fee-based accounts, which have prompted securities regulators to take action. Rather than being "investor friendly" programs, fee-based accounts often impose disproportionate charges on investors who prefer to buy and hold securities rather than actively trade. In addition, as described below, the fee structure of these accounts gives brokers an incentive to engage in anti-investor sales practices. Many also provide little ongoing monitoring services to accounts that are not actively trading.

Brokerage Firm Marketing of Fee-Based Accounts
Each of the major brokerage firms now offers fee-based accounts to its clients using catchy sales and marketing practices. Morgan Stanley offers the "Choice Fee" program; Merrill Lynch offers the Merrill Lynch "Unlimited Advantage" fee- based program; and Salomon Smith Barney offers its clients the "Asset One" program. Each of these accounts generally impose a 1% to 2% annual fee for assets held in the account. For example, if a fee-based account has $1 million in assets, the firm will charge a $10,000 (or 1%) annual fee, which is usually paid on a quarterly basis by an automatic account deduction.

Misuse of fee-based accounts by brokers appears to have replaced "churning".., as a leading fraudulent investor sales practice.

Many firms compute the fee based on "total" or "gross" assets, which would include margin, option positions, and even mutual funds held in the account. Thus, brokers appear to have incentive to inflate gross assets by recommending transactions that are unsuitable for the customer. For example, with a $1 million account bearing a 1 % annual fee, a broker may encourage a client to "double up" on positions by borrowing $1 million on margin and buying $2 million worth of stock. That creates "gross assets" of $2 million, for an annual fee of $20,000 (as opposed to $10,000 if no margin were used).

Brokerage firms also have been inappropriately marketing fee-based accounts to "buy-and- hold" investors who build a portfolio, make few if any changes, and rarely trade. In so doing, brokerages end up charging fees to customers who would pay less if they were solely in a commission-based account.

Further, in recent decisions, securities arbitration panels have issued significant awards against "hit and run" brokers who open fee-based accounts for retirees, load them up with unsuitable high technology stocks, and never contact the clients while their accounts are deteriorating in value month after month.2 The evidence in these cases has revealed that, instead of servicing accounts, brokers spend most of their time prospecting for new accounts in order to build up a large base of "assets under management."3

Regulatory Action
Securities regulators for the last ten years have been examining brokerage firms' practices of making unsuitable recommendations of the use of fee-based accounts for retail investors. These examinations have culminated in recent regulatory actions and sanctions against major brokerage firms that improperly reconunend fee-based accounts and fail to supervise their employees' practices.

The fee structure of [fee-based] accounts gives brokers an incentive to engage in anti-investor sales practices.

In 1995, the Securities and Exchange Commission issued a report commonly known as the "Tully Report"4 on compensation practices in the retail brokerage industry. The Tully Report labeled fee-based programs a "best practice" because they purportedly align the interests of the broker/dealer and customer more closely than commission-based accounts, and reduce the likelihood of abusive sales practices such as churning, high pressure sales tactics, and unsuitable recommendations. The Tully Report noted that fee-based accounts are appropriate for investors who are building assets in their accounts, and may be appropriate for investors with moderate trading activity.

However, the Tully Report acknowledged that fee-based programs may not fit the needs of all investors. For example, "small and low-activity accounts" may be better off financially with a commission-based program. These accounts might include those comprising mainly bonds or mutual funds, and also could contain individual equities where the customer has expressed a "buy and hold" preference or strategy.

In November 2003, after receiving numerous complaints from investors regarding abuse of fee- based compensation programs, the NASD issued Notice to Members (NTM) 03-68 on "Fee-Based Compensation."5 NTM 03-68 reminded NASD members that fee-based compensation programs must be appropriate for the individual investor:

It generally is inconsistent with just and equitable principles of trade . - . to place a customer in an account with a fee structure that reasonably can be expected to result in a greater cost than an alternative account offered by the member that provides the same services and benefits to the customer. Accordingly, before opening a fee-based account for a customer, members must have reasonable grounds to believe that such an account is appropriate for that particular customer. [M]embers should. . . consider whether the type of account is appropriate in light of the services provided, the projected cost to the customer, alternative fee structures that are available, and the customer's fee structure preferences. In addition, members should disclose to the customer all material components of the fee-based program, including. the fact that the program may cost more than paying for the services separately. (Emphasis added).

The New York Stock Exchange, apparently following the NASD's lead, issued new Rule 405A regarding "Non-Managed Fee-Based Account Programs" on July 26, 2005.6 Rule 405, known as the "know your customer rule," requires brokers to make certain disclosures to investors about fee-based programs and to monitor accounts on an ongoing basis. New NYSE Rule 405A enhances Rule 405 by requiring that, prior to opening a fee- based account, each customer must receive a disclosure document describing the types of fee- based programs available. The document must disclose, for each fee-based account, "sufficient information for the customer to make a reasonably informed determination as to whether the [fee- based] Program is appropriate to suit their anticipated needs." Specifically, disclosures must include "at a minimum: a description of the services provided, eligible assets, fees charged, and an explanation of how costs will be computed and/or the provision of cost estimates based on hypothetical portfolios, and conditions or restrictions imposed, and a summary of the Program's advantages and disadvantages."

NYSE Rule 405A also requires that NYSE members "establish and maintain systems and procedures adequate to monitor, on an ongoing basis, transactional activity by customers" in fee- based programs. These systems and procedures "must include specific written criteria for identifying customers whose level of activity may be inappropriate in the context" of the fee-based program.

[An] NASD. .investigation resulted in significant regulatory action against brokerage firms that were alleged to have abused investors by inappropriately recommending or maintaining fee-based accounts.

In April 2004, the NASD announced that it was investigating inappropriate sales of fee-based brokerage accounts to buy-and-hold investors and was "looking broadly" at the issue.7 The NASD's investigation resulted in significant regulatory action against brokerage firms that were alleged to have abused investors by inappropriately recommending or maintaining fee-based accounts.

In April 2005, the NASD fined Raymond James & Associates $750,000 and ordered the firm to pay $138,000 in restitution for fee-based account violations.8 Among the cited violations were over 2900 instances in which the firm recommended that customers who went more than one year without executing a trade in their commission-based accounts convert to fee-based accounts. (The mandated restitution is to reimburse fees paid by 190 of those customers who never executed a trade in their fee-based accounts.) The NASD also found that certain of Raymond James' sales literature regarding fee- based accounts was inaccurate and misleading because it "emphasized the benefits of fee-based accounts without adequately discussing the fees and restrictions associated with those accounts."

More recently, in August 2005, the NASD fined Morgan Stanley $1.5 million and ordered the firm to pay more than $4.6 million in restitution for failing to adequately supervise its fee- based brokerage business.9 The NASD's investigation showed that from January 2001 through December 2003, "Morgan Stanley failed to establish and maintain a supervisory system reasonably designed to review and monitor its fee- based brokerage business to determine whether Choice accounts remained appropriate for its Choice customers." More than 3500 Morgan Stanley customers will be receiving restitution. Some of those customers went more than two consecutive years without executing a transaction in their fee-based accounts Others had balances so low that the minimum annual account fee of $1,000 represented at least 4% of the assets in their accounts-a far higher percentage than the firm advertised.

Conclusion
It appears that regulators are now serious about curbing the sales practice abuses found where brokerage firms recommend fee-based accounts to "buy-and-hold" customers and other investors for whom fee-based accounts are inappropriate. Major brokerages also are being required by regulators to disclose fee-based compensation to investors and to actively m6nitor accounts to insure that the fee-based accounts are-and remain-appropriate for the customers who use them. Vigorous enforcement by regulators hopefully will curb fee-based account abuses.

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