Overview:

While a stockbroker need not have done anything illegal or unethical if a client or customer loses money, issues arise in cases of unauthorized Trading, unsuitable investments (i.e., securities selected do not meet the investor’s objectives), and churning the investor’s account. In its ordinary meaning, “churning” is the practice of a broker or brokerage firm executing trades with a customer’s investment account solely to generate commission. It happens when a broker buys and sells securities in a customer’s account in excess of what is needed to meet the customer’s investment objectives.

Churning may destroy the net value of an investment account in a short period of time by generating a large number of commissions. This has a two-fold negative impact on the investor’s financial future: first, because the broker’s investments are not prudent, and second, because the investor is paying more in commissions than he should. The practice occurs when a broker exercises control on investment decisions of a customer’s account through using a formal and legal agreement.

It stems from the inherent conflict of interest that exists between the commission broker and his or her customer. Brokerage firms promote themselves as trustworthy advisors for people with funds to invest but may lack the necessary expertise and formulate a required investment strategy. A huge portion of the income of a broker comes from commissions charged for buying and selling orders in the securities markets. The broker gets little to no money until the customer buys and sells shares, they cause their customers to execute trades purely for their own benefit– that is, causing their customers to trade only to obtain a commission with little to no benefit to the client.

Types of Churning

Following are the types of churning fraud:

i. High Turnover Ratio: (a.k.a Excessive Trading):

Overtrading arises when a broker buys and sells stocks on behalf of a customer for the sole purpose of increasing commissions. Customers will notice that their broker has been overtrading when the trades become counterproductive to their investment objectives, and driving commission costs consistently higher without observable results over time, investors will notice that their broker has been overtrading.

ii. In-and-Out Trading (a.k.a “Wash” Transactions):

Wash trading is a practice in which a trader buys and sells security with the intent of providing the market with misleading information. It is a fictitious trade in which a transaction gives the impression of authentic purchases and sales, but the trades were entered without the intent to take a genuine market position or execute genuine transactions subject to market risk or price competition.

iii. Mutual Fund Churning:

Buying and selling mutual funds often is referred to as churning the mutual fund portfolio. This is the polar opposite of the recommended investment strategy, which is to make investments and stay invested for the long run. Generally, customers churn their investments because their mutual fund agent/advisor advises them to do so; the agent might also pay them a percentage of the commission earned as an incentive to encourage them to churn.

Identifying Dishonest Brokers Involved in Churning

a) After each transaction, brokerage firms are required to send in confirmations. There should not be much Trading in the account unless one is an active trader. Usually, buy and hold strategies are the safest way to go for cautious long-term investors. So, if there are confirmations once or twice a week, or 10 times or more a month, it might be a sign that the broker is trading in the customer’s account too much.

b) A declining account value despite an upward moving market, or declining faster than a downward moving market, is another clue or indicator. Unnecessary commissions will deplete an account’s value and cause it to underperform the market. As a result, high losses may be the best clue that the account is being overrated.

c) Dividend selling occurs when a broker tries to persuade a buyer that buying a specific investment, such as stocks or mutual funds, would be profitable due to an upcoming dividend. In reality, the broker is trying to earn commissions by selling a client for a quick profit.

Applicable Law on Churning

As mentioned above, churning is highly illegal and unethical. It is a violation of Securities Exchange Commission (SEC) Rule 15c1-7 as well as other aspects of securities laws. Acts of the agent or the dealer that have a significant impact on the investor’s account are defined in Section 15c as manipulative or fraudulent device, deceptive or contrivance. As a result of this process, the agent gains discretionary control to trade in excess quantity or frequency, depending on the account’s financial situation. Second, it includes all actions by the broker in which the discretionary power vested requires the agent to record the investor’s name, the price and amount of the security in place, as well as the time and also the date of transaction.

According to FINRA Rule 2111, the broker must substantiate a reasonable basis to believe that a suggested transaction or investment strategy involving a security or securities is appropriate and suitable for the customer, on the basis of the required information obtained through the brokerage firm or broker to determine the customer’s investment profile.

Moreover, Rule 408 of the New York Stock Exchange mentions that the NYSE rules are based on the principle that a member of an organization who exercises influence over the account must first receive written consent from the required investor. At the time of entry into the records, any order entered by the member must be regarded as discretionary. The individual who is assigned with such responsibility under Rule 342(b)(1) is to oversee and review these accounts and provide a written statement for the supervisory procedures.

Ultimately, the disadvantages of churning the portfolio regularly are undeniable. It is the customer’s responsibility to not be swayed by the broker's' motivated’ sales tactics, and he must make an informed investment decision. To know more about the steps that you could take to avoid any kind of fraudulent, capital legal team of Fotis International to assist and guide.