Securities Lawyers Blog
It is relatively easy to grasp the concept of excessive trading activity or “churning” in a brokerage account. Churning trading activity has no utility for the investor and is conducted solely to generate commissions for the broker. Churning involves both excessive purchases and sales of securities and the advisors control over the account. But regulators are also looking at another growing trend referred to as “reverse churning.” According to the Wall Street Journal (WSJ) the Securities and Exchange Commission (SEC) states that “reverse churning” is the practice of placing investors in advisory accounts that pay a fixed fee, such as 1-2% annually, but generate little or no activity to justify that fee. Regulators are watching for signs of “double-dipping” whereby advisers generate significant commissions in an investor’s brokerage account and then moves the client into an advisory account in order to collect additional fees.
As a background there are many standalone brokerage firms and investment advisor firms where the option does not exist for a client to be switched between types of accounts. However, there are also many dually registered firms which are both broker-dealers and investment advisers. These firms, and their financial advisors have tremendous influence over whether a customer establishes a brokerage or investment advisory account. In the WSJ, the SEC was quoted as saying that “This influence may create a risk that customers are placed in an inappropriate account type that increases revenue to the firm and may not provide a corresponding benefit to the customer.”
However, dumping a client account into an advisory account after the broker ceases trading is only one strategy that should be included in the category of “reverse churning.” There are many other creative ways that brokers can generate excessive commissions for themselves while providing no benefit to their clients. For example, if a broker recommends a tax deferred vehicle, such a as a variable annuity, in an IRA account there is no additional tax benefit for the client. While the recommendation would not result in excessive trading, the broker would earn a huge commission for an investment that cannot take advantage of one of its primary selling points.
In addition, many brokerage firms have “active trading account” programs designed to lower commission costs for high frequency traders. But brokers who wish to churn these customers’ accounts are still finding creative ways around these programs in order generate excessive commissions. These brokers may trade high priced but low value options or purchase investment ineligible for the active trading platform. Investments such as structured products, ETFs, non-traded REITs, CMOs, certain types of notes, and other non-conventional investments have their own set commission structure outside of active trading programs. Brokers may gravitate to these investments in order to find a way around smaller stock commissions.
Finally, the rise of alternative investments in client investment advisory accounts should pose a red flag if these investments are included in the advisor’s assets under management for the purposes of determining fees. Many alternative investments are long-term holdings, that are illiquid, not properly priced by a trading market, and must be held for between five and ten years. It’s highly questionable what advisory services a client could benefit from if they hold illiquid and long-term investments in their account. Often times such investments cost 7-10% in commissions in fees just to be a part of. Thus, charging another 1-2% annually on top of the heavy startup costs makes no sense.
The attorneys at Gana Weinstein LLP are experienced in representing investors and determining if wrongful activity took place in their accounts. Our consultations are free of charge and the firm is only compensated if you recover.