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.