Quick Answer
Fee-based and commission-based brokerage accounts create different conflicts of interest. Commission-based accounts risk churning, excessive trading to generate commissions, while fee-based accounts risk reverse churning, charging fees regardless of activity. Regulation Best Interest requires the compensation model to match the customer's actual trading frequency and needs.
How the broker-dealer gets paid affects the types of conflicts that can arise. Understanding these compensation models helps identify when an account type may be unsuitable for a particular customer.
Compensation Models Compared
| Feature | Fee-Based | Commission-Based |
|---|---|---|
| Compensation | Flat fee or percentage of assets under management (e.g., 1% annually) | Per-transaction commission |
| Best suited for | Active traders with frequent transactions | Buy-and-hold investors with infrequent trades |
| Potential conflict | Fees charged regardless of activity (reverse churning) | Incentive to encourage unnecessary trading (churning) |
| Regulation | SEC Regulation Best Interest (Reg BI) applies | SEC Regulation Best Interest (Reg BI) applies |
Churning vs. Reverse Churning
- Churning: Excessive trading in a commission-based account to generate commissions for the representative
- The rep benefits from more trades, so the conflict is over-trading
- Reverse churning: Charging ongoing fees in a fee-based account when the customer trades very infrequently
- The customer pays fees regardless of activity, so the conflict is paying for services not being used
Suitability Considerations
- A fee-based account is unsuitable for a customer who trades very infrequently; they would pay ongoing fees without enough activity to justify the cost
- A commission-based account is unsuitable for a very active trader; per-trade commissions would quickly exceed what a flat fee would cost
- Both account types are subject to SEC Regulation Best Interest (Reg BI), which requires broker-dealers to act in the customer's best interest
Exam Tip: Gotchas
The exam tests both traditional churning AND reverse churning. A fee-based account can be just as unsuitable as a commission-based account if it does not match the customer's trading activity level. Always match the compensation model to the customer's trading frequency.
What Should You Check on Exam Day?
- Can you explain the difference between churning and reverse churning?
- Do you know which account type is unsuitable for a very infrequent trader?
- Can you explain why a commission-based account can be unsuitable for a very active trader?
- Do you know which SEC regulation applies to both fee-based and commission-based accounts?
- Can you state how compensation is determined in a fee-based account versus a commission-based account?