Investor Protection Clinic - Student Blog

Watch Out for "Reverse Churning"

Investors should be careful if a broker asks them to trade their account too often.  The term “churning” describes misconduct when a broker-dealer pushes an investor to make excessive purchases and sales when the transactions offer little to no utility to the investor.   The key to “churning” is excessive trading conducted to generate commissions.   

Too little activity may also be a problem.  Regulators have also begun to focus on something called “reverse churning.”  According to the SEC, reverse churning is the practice of putting investors into accounts that pay financial firms fixed fees while requiring little to no work to earn that fee. 

In some instances, investors may find their accounts churned and then reverse-churned to maximize fees for financial intermediaries.  In these schemes, brokers-dealers first place commission generating trades with assets in a client’s brokerage accounts.  After earning commissions from these trades, a broker may then persuade the client to move to a fee-based platform—usually 1-2% annually—where the broker will continue to earn despite not needing to do any significant work.   

Reverse churning problems may have become more prevalent in the last decade, following the SEC’s decision not to contest a 2-1 decision by the U.S. Court of Appeals for the District of Columbia to vacate Rule 202, or what was commonly referred to as the “Merrill Lynch Rule.”  The rule originally allowed brokers dealers to receive the benefits of fee-based accounts without registering as investment advisers and thereby being free from regulation under the Investment Advisers Act of 1940. In over-turning the rule, advisors found themselves forced to register as investment advisers resulting in the blurred distinction between investment advisory activity and that of broker-dealers. 

To protect yourself against reverse churning, make sure you know how much you pay your financial advisor each year.  For example, if you pay 1.5% on $500,000 in assets, you’re effectively paying about $7,500 each year.  You should consider whether the services, advice, and counseling you receive are really worth that much money.

           

 

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