As an investor, you have enough to worry about without wondering if your stock broker or investment advisor is taking advantage of you. Unfortunately, this is a very real concern, as unscrupulous brokers and advisors will often use their control over investors’ funds to profit at their customers’ expense.
What Investors Need to Know About Churning
One way brokers and advisors do this is through “churning.” As the U.S. Securities and Exchange Commission (SEC) explains, churning involves a broker “engag[ing] in excessive buying and selling (i.e., trading) of securities in a customer’s account without considering the customer’s investment goals and primarily to generate commissions that benefit the broker.” Brokers and advisors who churn their customers’ accounts do so knowing that most investors don’t closely monitor the trading activity in their portfolios, and even if they do, they don’t know how to tell when trading volume crosses the line from proactive portfolio management to investment fraud.
So, what is churning?
When it comes to determining whether a broker or advisor is engaged in churning, there isn’t a magic number or a specific formula that the SEC and Financial Industry Regulatory Authority (FINRA) use. Instead, the first question is whether the broker’s or advisor’s trading volume is excessive in light of the specific customer’s investment profile as well as the consequences of the trades being conducted. If a broker’s or advisor’s trading activity is generating substantial commissions but also generating reasonable returns for the investor, then the broker’s or advisor’s activity is unlikely to be classified as churning.
However, if the broker or advisor is generating commissions at the customer’s expense, then his or her trading volume is more likely to be deemed excessive. As FINRA explains, brokers and advisors must have “a reasonable basis for believing that a series of transactions . . . is not excessive and unsuitable for the customer, even if the individual transactions are suitable when viewed in isolation.” If, under the circumstances, a broker’s or advisor’s trading activity is detrimental to an investor’s interests, his or her trading activity may be classified as churning.
As FINRA also notes, churning requires an element of intent: “Although the terms ‘churning’ and ‘excessive trading’ are often used interchangeably, churning requires scienter in order to prove a fraud, whereas ‘excessive trading,’ now known as quantitative suitability, does not.” In other words, to prove that a broker or advisor is engaged in churning (as opposed to merely excessive trading), it is also necessary to prove that the broker or advisor intentionally attempted to profit at the customer’s expense.
Churning vs. Excessive Trading (or Quantitative Unsuitability)
Ultimately, however, this is a distinction without a difference for most investors. FINRA’s Rules and federal securities laws prohibit both churning and excessive trading (which FINRA now refers to as quantitative unsuitability). One type of claim is based on intentional fraud, while the other is based on negligence. But, both intentional fraud and negligence justify claims for damages, and investors can pursue claims for both churning and quantitative unsuitability in FINRA arbitration.
Three Red Flags for Churning (and Excessive Trading) According to the SEC
As an investor, it isn’t always easy to know if your broker or advisor has your best interests in mind. This is especially true when it comes to evaluating whether your broker or advisor is executing trades for his or her benefit instead of yours. With this in mind, the SEC encourages investors to monitor for three signs of excessive trading—which may also be signs of intentional account churning:
- Unauthorized Trading – “Be alarmed if you become aware of trades in your account that you did not authorize your broker to make.” While this won’t serve as a red flag if your broker or advisor has discretion over your investments, if your broker or advisor doesn’t have discretion, he or she should only be making trades with your approval.
- Frequent Trading – “Be wary of frequent in-and-out purchases and sales of securities that don’t seem consistent with your investment goals and risk tolerance.” For most retail investors, long-term holdings are typically the best strategy. If your broker or advisor is executing frequent trades—especially for relatively low dollar amounts or without giving investments the opportunity to perform in line with an overall investment strategy—this could be a sign of excessive trading for the broker’s or advisor’s profit.
- Excessive Fees – “Be suspicious if the total amount of fees seems high or if one segment of your portfolio consistently generates high fees.” Some investment products offer higher fees than others. If your broker or advisor is making a high volume of trades with investment products that generate high fees, this may be a red flag as well. Overall excessive fees are also a red flag for fraud—especially when your portfolio is underperforming.
While unscrupulous brokers and advisors will often engage in all three of these practices, any one of them can be sufficient to warrant a claim for negligence or fraud. Investors who have concerns about unauthorized trading, frequent trading or excessive fees should not ignore them—but instead, discuss them with an experienced investment fraud lawyer promptly.
As an investor, you need to be your own ally. You need to be proactive about monitoring the activity in your portfolio, and you need to seek legal advice when you have concerns. If you have concerns, you are not alone. Excessive trading, churning and other forms of broker and advisor fraud are far too common, and many investors find themselves needing to pursue claims to recover fraudulent investment losses.
Discuss Your Situation with a Lawyer at Zamansky LLC
If you have concerns about excessive trading or churning in your investment portfolio, we strongly encourage you to speak with one of our lawyers promptly. Our lawyers can determine if your broker or advisor is engaging in fraud, and if so, we can take appropriate legal action on your behalf. To learn more in a free and confidential consultation, call 212-742-1414 or request an appointment online today.