A Poor Fit for Investors?

April 28, 2005
By Aaron Pressman & Amy Borrus

Regulators are looking into how brokerage firms steer clients into fee-based accounts that are unsuitable for them.

Attorney Lawrence L. Klayman makes his living representing investors in arbitrations against their brokers. Over the past couple of years, he has won settlements in more than 400 cases in which brokers put their customers into accounts that carry an annual fee based on a percentage of assets instead of trading commissions.

Many were Microsoft (MSFT ) employees who were urged to exercise options and hold their stock in such accounts. Most didn’t make many trades and paid far more than they would have in a traditional account. “These fee-based accounts have been a gold mine for the plaintiffs’ bar,” says the Boca Raton (Fla.)-based Klayman.

APPROPRIATE SWITCHES? They’ve been a gold mine for brokerages, too. Since 1999, firms from Merrill Lynch (MER ) and UBS (UBS ) to Raymond James & Associates (RJF) have promoted the accounts, which offer free stock trading but charge usually between 1% and 1.5% of assets. Plenty of customers have switched.

At the end of last year investors had almost $270 billion in fee-based brokerage accounts, up 61% from the end of 2002, according to Boston research firm Cerulli Associates. That makes it one of the fastest growing segments of the $6 trillion full-service brokerage industry.

Industry spokesmen say the spate of arbitration is a reflection of a three-year bear market and that some settlements are reached simply to avoid costly legal battles. Fee-based accounts save money for investors who make an average number of trades, or more. Morgan Stanley (MWD ) says its customers have saved $2 billion in commissions over the past five years with the accounts. Many firms have implemented strict review procedures to ensure only appropriate clients are switched, says Michael Udoff, associate general counsel for trade group Securities Industry Assn.

PROBES AND ENFORCEMENTS. All the same, the industry’s self-regulatory bodies, NASD and the New York Stock Exchange, are starting to take an interest. On Apr. 27, NASD brought its first disciplinary action over fee-based accounts. Raymond James agreed to pay almost $1 million to settle allegations, which it did not admit nor deny, that it failed to determine that the accounts were inappropriate for many clients.

NASD contends the firm switched more than 2,900 customers who hadn’t made a single trade the previous year. Lack of adequate monitoring allowed 17% of customers in the firm’s fee-based accounts to make no trades in 2003, up from 14% in 2002, NASD says. Raymond James says it was “satisfied to have resolved this matter.” In the settlement, it agreed to discontinue offering fee-based brokerage accounts.

NASD has “a number” of further enforcement actions coming, say Robert R. Glauber, NASD chairman and chief executive. The Big Board may act, too, says Donald van Weezel, vice-president of the NYSE’s regulatory branch. The Securities & Exchange Commission has also conducted a review looking into fee-based accounts. So far, its probe has resulted in confidential warnings about possible compliance failures to an unspecified number of firms.

STEADIER REVENUE STREAM. Regulators have also found cases of double-dipping, in which brokers sell mutual funds that carry steep commission-like sales charges to clients with fee-based accounts. Also, some customers are misled by marketing materials into believing that they’ll get investment management or financial planning with these accounts, though those services cost extra. Says the NASD’s Glauber: “It’s absolutely important that an investor is well informed of the advantages and disadvantages of a fee-based account.”

The advantages to brokerages are clear enough. By persuading customers to pay annual fees instead of commissions, the firms get more stable and predictable income. “It’s a steadier stream of revenue that tempers the drop during stock market downturns,” says Lauren Smith, analyst at Keefe, Bruyette & Woods Inc.

Recurring fees helped Merrill Lynch’s brokerage unit report a 3% revenue increase in the first quarter of 2005 from the previous year, even as trading volume slipped. Investment management firms that charge asset-based fees don’t have as volatile swings in quarterly results and sell for higher price-earnings ratios, adds Smith.

CURBING THE CHURN. The move to asset-based fees was intended to generate fewer regulatory problems for brokers, not more. A 1995 task force on broker compensation headed by former Merrill Lynch Chairman Daniel P. Tully reported to the SEC that fee-based accounts would reduce complaints about churning — excessive trading done by brokers to generate commissions. The accounts did accomplish that goal. Churning complaints have dropped 43% over the past four years, according to NASD.

Still, regulators believe that brokers must tell customers about the possible drawbacks of fee-based accounts as well the advantages. The brokerage firms insist that they do so already. Merrill Lynch spokesman Erik Henderson says his firm is careful to offer fee-based accounts only when appropriate. “It’s always going to depend on what’s best for the client,” he says. UBS and Wachovia (WB ) say they monitor all fee accounts and, if necessary, move a customer to a more suitable account.

Last month the SEC ruled that brokers don’t have to comply with stricter investment adviser rules just because an account is charged fees and not commissions. Still, the agency initiated a 90-day study to see whether some other form of regulation is needed.

In theory, letting customers choose what kind of account they want is best — as long as brokers provide accurate information, says Barbara Black, director of research at the Pace Investor Rights Project of Pace University. But she’s worried that the current disclosures are inadequate. While regulators study the issue, fee-based accounts may keep both brokers and lawyers digging for gold.

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