In the first settlement of its kind, the NASD hit Raymond James with a $750,000 fine Wednesday for pushing fee-based brokerage accounts on the wrong kinds of clients. The NASD said Raymond James Financial is in the process of dissolving its fee-based brokerage business, a pricing plan that gave clients the option of paying a flat annual fee for a year’s worth of trades, rather than paying commissions on each transaction. The problem with the Raymond James fee-based Passport Brokerage and Ambassador programs, which together held $5.5 billion in assets at year-end 2004, according to the NASD, was that it was sold to clients who did not trade enough to justify the annual fees, which tend to range from 1.1% to 1.5%. The ruling was the result of an ongoing NASD investigation into fee-based brokerage accounts.
Raymond James says it will shut down the fee-based trading program by July, but stressed that it is not retreating from fee-based business. “To the contrary, we expect to maintain a leadership position in innovative asset management alternatives,” the company said in a statement. The firm says it plans to move clients who are in its fee-based brokerage accounts to fee-based advisory accounts or commission brokerage accounts “as appropriate.”
Raymond James’ decision to close its fee-based brokerage business “was a voluntary decision,” said Mark Barracca, associate corporate counsel for Raymond James. “It wasn’t requested by the NASD. The decision was made prior to the settlement,” he said. Because of a NASD notice to members issued in the fall of 2003, and a similar rule proposal from the NYSE requiring strict supervision of the accounts, Raymond James decided that the costs of maintaining those accounts didn’t justify their continuation, said Barracca. The firm also decided that it preferred to focus on its advisory relationship with clients rather than the frequency of their trading, he said.
The next question is how the settlement will affect other firms that offer fee-based brokerage accounts, including wirehouse giants Morgan Stanley, Merrill and Smith Barney. Although the NASD declined to comment on how many, a spokesman says, “a number of other firms are under active investigation.” The New York Stock Exchange’s enforcement division and the Securities and Exchange Commission are conducting their own investigations into abuses of the accounts.
Morgan Stanley is one those firms under investigation, according to disclosures in its annual report. Last November, the NASD notified Morgan Stanley that it was considering disciplinary action against the firm in connection with its investigation into fee-based brokerage accounts. “The potential disciplinary action, which would allege NASD Rule violations, concerns Morgan Stanley’s opening and maintenance of certain Choice [fee-based brokerage] accounts, the fees charged for certain such accounts and the content of certain Choice marketing materials,” Morgan Stanley disclosed.
With $33 billion in assets in its fee-based brokerage accounts at the end of last year, Morgan Stanley is the second largest player in the industry, according Cerulli Associates data. But Merrill Lynch is the top dog in the business, with $89.1 billion in assets in its “Unlimited Advantage” accounts and a third of the market. UBS, Wachovia, Smith Barney and Charles Schwab are also big players. Many of these firms have set up periodic reviews of their fee-based accounts in light of increased regulatory scrutiny, but it’s unlikely that they will follow Raymond James out of the business, industry watchers say.
“The other brokerage firms seem very much committed to those kinds of accounts,” said Barry Barbash, a partner in the Washington office of New York law firm Shearman & Sterling LLP. “And the action didn’t appear to raise structural problems about those kinds of accounts. It’s just a situation where they were used inappropriately with respect to certain clients,” he said.
Back in the fall of 2003, the NASD warned broker/dealers to determine whether fee-based brokerage accounts are appropriate before recommending them to clients and to engage in continued oversight. While fee-based brokerage accounts often make the most sense for investors who trade frequently, commission accounts tend to be more appropriate for buy-and-hold investors. Despite a poor market environment for frequent trading, industry assets have shot up since the end of 2002 from $167 billion to $269 billion, though growth slowed significantly in 2004 versus 2003.
The top firms launched fee-based brokerage accounts back in 1995, when the SEC said charging a fee based on assets under management would better align a broker’s interests with those of his clients. “Commission rates were getting crunched anyway, and firms looked at this as a more lucrative way to sell these services,” says Matt Schott, an analyst with Needham, Mass.-based Tower Group.
The move against Raymond James’ fee-based accounts comes just three weeks after the SEC extended the so-called Merrill Exemption, which allows retail brokers to call themselves financial advisors. “That rule did work in favor of these accounts, but as a general rule, it puts more scrutiny on fee-based accounts, and in particular, the kinds of services brokerages have been providing in these fee-based brokerage accounts,” says Barbash. “So the regulatory calculus might be different.”
Without the exemption, it was unclear whether brokers would be able to continue to offer fee-based brokerage accounts without being licensed as Registered Investment Advisers under the Investment Advisers Act of 1940. The exemption is based on the notion that the actual investing advice provided is “incidental to the delivery of securities transactions.”
The Financial Planning Assn., whose membership includes RIAs, and consumer protection groups had been pushing to end the exemption, because they say it encourages broker-dealers to engage in self-dealing with their clients without disclosing their conflicts of interest. Registered Investment Advisers have a “fiduciary” duty to place their clients interests first, whereas Registered Reps. are required to adhere to looser “suitability” requirements. Even as it extended the exemption, however, the SEC created a focus group to examine the kinds of protections afforded to investors by the different standards. In the meantime, the FPA announced on Thursday that it plans to pursue a lawsuit against the SEC in an effort to have the exemption withdrawn.
In its investigation of Raymond James, the NASD found that the firm recommended and opened thousands of fee-based brokerage accounts for investors who trade infrequently, and failed to supervise its fee-based brokerage business. Raymond James neither admitted nor denied the charges.
According to the NASD, between early 2001 and Dec. 31, 2003, Raymond James recommended and opened fee-based accounts for approximately 2,913 existing customers who had commission-based accounts for more than one year without executing a trade in the account. In addition, more than 13 percent of the customers in Raymond James’ Passport Brokerage accounts—the firms’ primary fee-based brokerage account—made no trades in their accounts in 2001. The percentage of Passport Brokerage accounts that made no trades increased to 14.2 percent in 2002 and 16.6 percent in 2003.
Raymond James also used advertising and sales literature that emphasized the benefits of fee-based accounts without adequately discussing the fees and restrictions associated with those accounts, the NASD said.
As part of the sanctions imposed by the NASD, if Raymond James doesn’t discontinue its fee-based brokerage business by July 1, 2005, the firm will have to retain an independent consultant to oversee the creation of a supervisory system for the fee-based brokerage business.