Brokerage Firms Continue to Run Afoul of Longstanding Requirements For Fee-Based Accounts

by James J. Eccleston, Esq.

ee-based accounts have existed for more than a decade as an alternative to paying commissions for buying and selling securities. They have been popular and profitable, but soon will become subject to more stringent regulatory requirements as a result of a 2007 court decision that effectively makes such accounts investment advisory (fiduciary) accounts instead of (arguably more limited duty) brokerage accounts. As we wait to see whether brokerage firms will choose to continue to offer fee-based programs in this fiduciary context, we must be mindful of how poorly several brokerage firms have complied with the longstanding regulatory requirements for fee-based accounts. Let's review what brokerage firms have continued to do wrong, as reflected in several regulatory actions and pronouncements.

Fee-based accounts started to blossom in 1995, when securities regulators gave their blessing to them as a way to better align the interests of the customer and the brokerage firm, provided that the customer planned to engage in at least a moderate level of trading activity, and preferred consistent and explicit monthly or annual charges. The reasoning was that, by eliminating commissions, fee-based accounts would reduce the likelihood of abusive sales practices such as churning and high pressure sales tactics.

What followed was tremendous growth in fee-based accounts. However, in 2003, the National Association of Securities Dealers (NASD), now known as the Financial Industry Regulatory Authority (FINRA), warned its member firms that fee-based accounts are not always suitable for customers, and that firms must determine, both initially and on an ongoing basis, whether the customer would be better served in a commission-based account. NASD Notice to Members 03-68 points out that fee-based accounts should not be comprised mainly of bonds or mutual funds, and should not be recommended to "buy and hold" investors. In a "questions and answers" publication also released in 2003, the NASD notes "potential problems" that it was identifying in its examinations of brokerage firms. These potential problems included:

Customers may not receive adequate disclosure about the distinctions and features of fee-based versus commission-based accounts, including the fact that fees probably will be higher in a fee-based account if the trading activity is modest;

Training and education of brokers at some firms are minimal;

Firms do not always have systems in place reasonably to ensure that mutual funds and other similar products may be purchased outside a fee-based account yet shortly thereafter be switched into a fee-based account where the customer will have been charged both a sales load and an ongoing fee;

Documentation supporting the appropriateness of recommending a fee-based account for a particular customer may be non-existent or weak; and

Some firms may lack systems or procedures to ensure that fee-based accounts are appropriate for customers both initially and periodically thereafter.

Similar problems continued through September, 2004. In a speech delivered to the Securities Industry Association (now known as the Securities Industry and Financial Markets Association) discussing regulatory issues, Elisse Walter of the NASD highlighted the problem areas:

I wish that we could say that everything is fine in this area of the woods, but our examinations have found a number of problems, such as inadequate disclosure to customers about how fees work, poor training of reps in how to tell what kind of fee is appropriate, lack of systems to prevent mutual funds and other products that can be bought outside a fee based account from being put into a fee based account to incur both a load and a fee, weak documentation of the choice of account type, no broker assigned to some fee based accounts, and lack of periodic review of whether a fee based account is still appropriate.

The regulatory hammer next moved to well-publicized regulatory actions. The first occurred in April, 2005, when the NASD fined Raymond James & Associates $750,000 for fee-based account violations. The NASD also ordered the brokerage firm to pay restitution in the amount of $138,000 to 190 of its customers in the firm's "Passport" fee-based program because they had not placed a trade in their accounts in three years!

The Raymond James action merely was a "shot across the bow", however, compared to the next headline news. In August, 2005, the NASD ordered Morgan Stanley to pay over $6.1 million for fee-based account violations. $4.6 million of that sum was ordered as restitution to Morgan Stanley customers who held a "Choice" account. These customers - all 3,549 of them - conducted no trades in their Choice accounts for at least two consecutive years and/or had Choice accounts whose assets averaged below $25,000 for at least one full year (which subjected them to an onerous minimal annual fee of $1,000 per year).

Wachovia Securities made the news in June, 2007. The NASD fined Wachovia $2 million for fee-based account violations in its "Pilot Plus" accounts. Additionally, the NASD ordered the firm to identify and pay restitution to approximately 1,300 customers who inappropriately were allowed to continue maintaining fee-based accounts, or who inappropriately were charged account fees on Class A mutual fund share holdings for which they already had paid a sales load.

Last but not least, in September, 2007, the NASD (now known as FINRA) fined AXA Advisors $1.2 million. The firm additionally must pay a total of $2.6 million in restitution to approximately 1,800 customers. As recently as 2005, customers in AXA's CapAdvantage fee-based program suffered from AXA's failure to supervise. The affected customers included those who placed no trades for three years, as well as customers who were allowed to open fee-based accounts with low asset balances. One customer, for example, opened a fee-based account with just $2,000, and AXA Advisors assessed fees until the account was depleted of all funds!

Should firms choose to continue to offer fee-based accounts to their customers, it will be time for brokerage firms to comply with the longstanding requirements for fee-based accounts, as well as the more stringent (fiduciary) requirements coming soon!