Churning Woes in Investment Accounts Continue

August 27, 2018

With the advent of new technology being employed at almost all broker dealers, the potential for a financial advisor to engage in excessive or unauthorized trading or “churning” has been substantially reduced. Churning is simply excessive trading in a brokerage account in order for the broker or financial management team managing the investment account to generate greater commissions.
In brokerage customer accounts, or trading accounts in which the broker is paid only when trades are generated, churning or excessive fees has always been a concern. If a broker is only compensated when selling or purchasing securities, the potential for the broker to engage in fraud is compelling. The logic of a brokerage account, as opposed to a fee based account, is that the model is suitable for investors who have a set asset allocation with very little trading activity. As opposed to a monthly or yearly fee for managing assets, known as a fee-based account or wrap account, customers who have set investments in stocks or bonds will save money because there is very little trading activity.
Now with the advent of a very basic trading systems algorithm, broker dealers should be able to immediately register when churning occurs by cross checking the total customer’s assets under management against the trading activity in the account. If the trading activity in comparison to a customer’s assets reaches a certain threshold, known as the turnover ratio, the broker dealer should have alerts in place to identify the client, the broker or financial advisor, and inform the broker’s branch manager. The branch manager should then conduct a review of the trading activity as well as the client’s investment profile. If the trading abuse is occurring in an investment account belonging to a senior citizen, new FINRA Rule 4512 has mandated brokerage firms to create a trusted contact person. This trusted contact person should be notified in order to respond to any possible stockbroker fraud being committed in the investment account. FINRA Rule 2165 permits brokerage firms that have a reasonable basis to believe that stock broker fraud has occurred, to place a temporary hold on the “disbursement of funds.” These rules and cross checks should make it very difficult to engage in churning. But still, it occurs more frequently than most other forms of stock broker fraud.
In a recent New York Times article about a senior investor who had churning occur in her account, the stats provided by FINRA showed that in 2017, there were 166 cases of unauthorized trading and 142 customer complaints. The churning case noted in the Times article settled, as do many other customer disputes and so was not included in the FINRA statistics, meaning, in reality, the cases of excessive or unauthorized trading could be substantially higher.
The Times article discussed how the senior investor had Alzheimer’s and was being moved into a senior assisted living facility. It was at this juncture that a family member noticed brokerage statements showing a $100,000 loss in one month alone. After more diggingand hiring a securities attorney and forensic accountant, it was discovered that the account valued at $1.3 million had been charged $128,000 in commissions, nearly 10% of its value. In one month, the broker had sold two-thirds of the investment portfolio, generating sales commissions of $47,600. In addition, the monthly statements cited in the article showed the trades were “unsolicited”. When a trade is marked as unsolicited, this means it was entered at the direction of the customer. Finally, the trades of one stock were being broken up and entered into smaller batches in order for the broker to generate more commissions.
While this article was comprehensive, it failed to discuss key aspects of what must be considered in a churning case, or any stock broker fraud case for that matter. What were the client’s investment objectives and how was the new account form set up? If the client has objectives that expressly dictate short term trading with an aggressive risk tolerance and investment objectives that permit speculation, there will of course be a higher turnover ratio and greater trading activity in the account.
On August 14, 2018 InvestmentNews reported a FINRA panel awarded $5 million for churning. In the first sentence of the article, InvestmentNews reported the most material consideration of a churning case, that the investment objectives of the account were conservative. In that case, the investment account racked up $1.3 million in commissions against an investment portfolio valued at $1.5 million.
As with any other stockbroker fraud case, there are of course many other considerations that must be made before determining whether there is a valid case.
If you feel your investment account has been mismanaged or subject to churning, please contact the securities attorneys of Lubiner, Schmidt & Palumbo for a consultation.