In the wake of a big market correction, prepare for a deluge of clients to file claims with allegations slamming advisors for reverse churning. That’s the forecast according to lawyers representing litigants on both sides of such cases.
“There will be a tsunami of investor complaints related to reverse churning when the market crashes,” says Andrew Stoltmann, a Chicago-based lawyer and president of the Public Investors Arbitration Bar Association.
Reverse churning allegations surface in lawsuits and Finra complaints filed by investors against their advisors in the wake of their portfolio’s loss of value and as part of breach of fiduciary or breach of contract claims. The allegations typically entail a financial advisor placing a client’s funds in a fee-generating account, but then simply collecting the fee, rather than offering advice, trading or engaging in any meaningful account activity.
Since the most recent past dramatic market correction in 2008, fee-based accounts have grown in popularity among all financial advisory channels — broker/dealers and independent RIAs. The growth in those accounts has set the stage -- if client portfolios again take such a hit as they did in 2008 and 2009 -- for reverse churning allegations to ensue.
“Fee-based accounts have been profitable for advisors. An account that might not have traded much, now generates a steady revenue,” says J. Bradley Bennett, a partner at law firm Baker Botts in Washington, D.C. who served from 2011 to 2017 as Finra’s executive vice president and chief of enforcement, and currently defends financial advisors and their firms.
But if the markets crash, that revenue generation without account activity could leave advisors susceptible to reverse churning claims. Under such a scenario, clients may claim they previously paid less for better performance under a commission-based compensation scheme, Bennett says.
When the market crashes, clients will have “assumed that for that management fee a broker is going to properly diversify and select asset allocations to protect them against declining markets,” Stoltmann says. “If you are paying one to two percent a year in fees, you expect that of a broker,” Stoltmann adds.
Realistically though, the high-profile plaintiff lawyer knows winning damage awards in litigation with such allegations will be no cakewalk for disgruntled investors. “If we see these claims en masse, brokerage firms will sharpen their defenses,” Stoltmann says.
“That’s so unfortunate,” says Danny Sarch about the potential for a rise in reverse churning allegations. A recruiter and president of White Plains, N.Y.-based Leitner Sarch Consultants, Sarch argues that most advisory and broker-dealer firms “have tried very hard to make it very clear you are paying for advice, not for trades or some promise of precise performance.”
But Sarch too predicts that if clients “don’t understand what they are paying for,” reverse churning allegations could surface. That is why firm managers stress advisors engage in extensive notetaking during client meetings, thus documenting having told their clients what services they should expect in return for fees paid based on assets under management, Sarch says.
Already, though, some investors have made reverse churning allegations against their former advisors.
Philip Vujanov, an attorney at Cleveland-based law firm ChapmanAlbin, has two such pending cases: one in Alabama and one in Michigan. In both cases, his clients have made reverse churning allegations after a fee-based advisory firm recommended they invest in illiquid products, an annuity and non-traded REITS.
“I don’t think there would been enough to bring a claim based just on reverse churning,” if the accounts had not lost value as a result of the REIT and annuity recommendations, and the advisors had not inflated the REITs’ values for years and charged fees based on those erroneously big numbers, Vujanov says.
Moreover, he too stresses that if advisors keep clear documentation that a client’s stated investment objective was to protect principal, lack of trading activity would not be enough to support any reverse churning allegations.
Jane Stafford of the Stafford Law Firm in Prairie Village, Kan., also represents investors who have alleged their former advisors engaged in reverse churning. She’s ready to pursue such claims, despite the targeted advisory firms’ defenses.
“Just because they say they have a defense doesn’t mean it is a defense,” Stafford says.
If advisors see the value of assets “going down,” they should not “just sit down and watch it go down,” she says. Firms purportedly provide “investment advisory services,” which means they should be engaged in “constant monitoring of accounts,” Stafford says.
“Trades should be made with some frequency. There should be some level of activity on any account,” she adds.