Most investors believe that their brokers will trade on their behalf with their best interests in mind. In fact, they’re required to in accordance with Regulation Best Interest, or Reg BI. In a nutshell, brokers must always use the investor’s best interest as their benchmark before making any recommendation. This includes vetting an investment and completing due diligence following their broker-dealer’s recommendations.
Unfortunately, not every broker follows that rule, nor any other rule, resulting in losses for the investor. One method is when a broker continually trades in an investor’s account, but the investor sees no reasonable gains. Sometimes, the excess trading is done on margin, leading to additional charges and risks. The investor loses money and pays increasing amounts of commissions, fees, and other expenses. This process is known as churning.
There are multiple types of churning that apply to different financial situations. In a brokerage account, it’s simply more frequent trading that generates more commissions, fees, and other expenses for the broker and their firm. This type of trading is not in the customer’s best interest, unnecessary, and usually leads to losses while the broker makes more fees. Churning may also lead to tax liabilities, even if the account is profitable.
A broker has a fiduciary duty to maintain credibility and trust with their investment clients. Churning and other similar activities violate that duty.
Is Churning Legal?
It’s both illegal and unethical, and a violation of SEC rules. Brokers who engage in churning may be sanctioned, including suspended or barred and handed large fines. They may also be ordered to repay the excess fees to their clients, known as “disgorgement.”
The broker’s income is primarily from commissions charged for making a customer’s buy and sell orders in the securities markets. The conundrum is that the broker only makes money when their customers buy or sell these securities. Broker-dealers offer incentives to brokers from time to time to encourage sales of specific securities.
There are three different regulations that govern churning:
- The SEC’s Rule 15c1-7. This rule categorizes broker activity as fraudulent if they take advantage of their discretionary power in a client’s account
- FINRA (Financial Industry Regulatory Authority) Rule 2111. This rule indicates that brokers and broker dealers must always consider the client’s best interest in any recommendations. They must have a reasonable basis to believe that a trade will be beneficial for the customer based on their investment objectives, liquidity needs, tax status, and risk tolerance.
- NYSE Rule 408(c).This rule forbids investment firms from lawfully permitting their brokers to churn accounts.
For a broker to proceed with a trade, it is essential that they possess a valid justification indicating that it will be advantageous for the customer, considering their investment objectives, liquidity requirements, tax status, and risk tolerance.
Types Of Churning
Brokers may churn annuities, mutual funds, stocks and bonds, and even life insurance policies. While stocks and bonds are the most frequently churned, others are not far behind.
Mutual funds are investments that are intended for holding long-term, rather than trading frequently. Brokers that switch or recommend switching prematurely are likely engaging in churning, especially if there increased fees involved.
Even with a higher rated “flat fee” brokerage account, a broker may do little to nothing just to receive their commission. These accounts are generally for customers who trade less frequently. This is known as “reverse churning.”
If you believe your account has been churned, you see excessive fees in your account, or there recurrent buying and selling of securities that are not in line with your investment objectives, we suggest speaking to one of our securities attorneys at Silver Law Group to discuss your accounts.
Mirsad Muharemovic Accused Of Churning
Former registered broker Mirsad A Muharemovic (CRD# 312259) worked for Arive Capital Markets of Coram, NY. From August of 2016 through March of 2019, he engaged in churning in the accounts of two of his elderly clients. These trades included the use of margin. He made unsuitable recommendations to both clients, and they routinely accepted these suggestions.
In the first client’s case, the account had to grow by over 54% just to break even. The client suffered losses of $185,966, and cost the client commissions, fees, and margin interest of an additional $137,305.
In the second client’s case, his two accounts suffered losses in two accounts that also included $74,338 in commissions, fees, and margin interest. The break-even point in the first account was over 74%, and break-even for the second account was just over 30%.
Following an investigation and disciplinary action, Muharemovic was ordered to pay fines and restitution to both clients for their losses. He was suspended indefinitely pending the payment of the fines and restitution.
Seeing and Preventing Churning
Churning may be difficult to uncover without frequent and thorough reviews of account activities. If a client’s investment objectives are hindered by excessive trading frequency, leading to increased commission costs without yielding observable results over time, the client may realize that the broker has engaged in overtrading and churning.
Another way to tell is when an account is paying more in fees than its earning on investments. Or if you receive notices every time you or your broker places a trade. If you’re receiving a large number of these letters, churning is a possibility.
One way to prevent a broker from engaging in churning is to not allow them to have discretionary permission for your accounts. This means that you must approve every recommendation and suggestion before they make a trade. But even that may not work.
Because even with approval, do you know what your broker is recommending, and why? If you routinely accept the broker’s recommendations without question, they will still be able to churn if you approve everything they suggest. They frequently offer explanations that sound perfectly reasonable, even though they’re not helping you, your investment objectives, and your portfolio. It’s up to you to do some review to learn if the trade would benefit your investments.
The flat-fee account, also called a “wrap around account,” is another option for thwarting attempts at churning. However, you’ll need to do your own due diligence on any of your broker’s recommendations, rather than just taking their advice without questions.
Did Your Broker Churn Your Account?
Silver Law Group represents investors in securities and investment fraud cases. Our lawyers are admitted to practice in New York and Florida and represent investors nationwide to help recover investment losses due to stockbroker misconduct. If you have any questions about how your account has been handled, call to speak with an experienced securities attorney. Most cases are handled on a contingent fee basis, meaning that you won’t owe us until we recover your money for you. Contact us today at (800) 975-4345 and let us know how we can help.