Churning

Churning is one of the most common malpractice allegations against brokers. It is an illegal action that may benefit a broker or financial advisor at the expense of the client’s finance.

Federal laws and industry rules prohibit churning. It also violates an advisor’s fiduciary duty because fiduciaries are expected to place their client’s interests above their own.

What Is Churning?

Typically, brokers earn a commission or other fees on each purchase or sale of securities executed on behalf of an investor. In some cases, brokers are incentivized to convince their clients to purchase certain stocks. For example, they may earn a 12% bonus if they buy a certain number of shares on behalf of their customers.

Therefore, in a bid to earn more commission, some brokers may excessively trade assets in a customer’s brokerage without any potential benefit to fulfill the customer’s investment goals.

This action will subsequently have two negative impacts on the investor’s portfolio;

• One, the investment made by the broker is not prudent, hence high risk, and could result in massive financial losses.
• Two, the investor will pay more commission than normal due to the excessive buying and selling activities.

It is also vital to note that sometimes, churning might be done with the investors’ best interest in mind. In such cases, the frequent commissions charged will be negligible compared to the portfolio gains.

Types of Churning

Aside from excessive trading of stocks, churning may also be unnecessary trading of mutual funds and annuities.

Mutual funds with an upfront load are intended to be a long-term investment. Fees are charged when an investor purchases shares for mutual funds with a front-end load. For a back-end load, fees are charged when the investor sells.

The sale or purchase of a mutual fund with upfront loads must be justifiable. Unnecessary sales to repurchase can result in churning.

Deferred annuities do not have an upfront fee but are subject to surrender charges as a penalty for early withdrawal. A financial advisor must diligently evaluate the situation before recommending the sale of the annuities before the maturity date.

Example of Churning

A remarkable case of churning cited by FINRA involves a Holocaust survivor. A broker was discovered to have churned the client’s account, causing a loss of over $700,000. At the same time, the broker made almost the exact amount in commissions from the trading.

How to Identify Churning in an Investment Portfolio

Bear in mind that most brokers are aware of the securities laws and their violations; hence they can be smart whenever they execute churning, making it tougher to detect.

However, watch out for these red flags:

• Unauthorized Trading: Raise an alarm if you discover your broker is executing certain trades without your authorization.
• Frequent Trading: This includes frequent trading of securities that do not align with your investment goals and risk tolerance.
• Excessive Fees: Be suspicious if the total fee seems high or if one segment of your portfolio consistently generates high fees.

How to Prevent Churning

You will likely be a churning victim if your broker has discretionary authority over your brokerage account. Maintaining full control such that no transaction is executed without your approval can help prevent churning.

A fee-based account instead of a commission-based one can also eliminate the incentives for churning, but it is more expensive to operate if you only have a few stocks.

Contact S.A. Law Group for a Free Consultation Today

For some investors, a high-volume trading strategy could be something they seek, but for others, it is a sign of excessive trading. Churning may not be discovered until the broker earnings compound and becomes noticeable.

Contact us today if you have discovered that your advisor or broker is engaged in churning.