Over the past decade, the securities industry has moved from commission based stock brokerage accounts to "fee-based" accounts to curtail "churning" by stockbrokers of their customers' accounts.
Regulators were concerned that brokers who were charging commissions for each trade had an incentive to churn the accounts. The hope was that fee-based accounts (typically one percent) would put an end to churning. Churning occurs when brokers turn over their clients' stocks and bonds continuously in order to generate commission dollars.
Another form of churning is when a broker switches clients from one mutual fund or annuity to another, generating further upfront or back-end commissions for himself without necessarily benefiting the client.
Despite these regulatory concerns, it seems that churning is still alive and well, and investors need to beware of brokers who are turning over their accounts primarily to generate large commissions for themselves and their firms.
The lesson for investors is to keep a close watch on the activity of trades in their brokerage accounts. Too many, or even too few, trades of stock, bonds, mutual funds and ETFs -- exchange-traded funds -- could be eroding the value of a client's account during a record-breaking bull market.
As the stock market continues to rise to record heights, most investors who simply held a stock index would have reaped large returns.
But some commission-based stockbrokers, instead, assumed discretion over customers' accounts, meaning they had the ability to trade in a client's account without first asking the client, and churned their accounts to generate large commission revenues. The losses in those accounts were often disguised by the rising stock prices, but the large commission amounts dramatically reduced investors' returns.
Investors can see if their account is being churned when their account value is declining despite an upward moving market, or one that is declining faster than a downward moving market. That's because unnecessary commissions will erode an account and cause the account to underperform relative to the market.
According to statistics kept by FINRA, the self-regulatory agency, securities arbitrations that involved "churning" and "unauthorized trading" constituted over 13% of all securities arbitration cases filed from 2012 to 2014.
This level of investor complaints involving damaging trading activity by brokers is a clear concern. A recent report by Jean Eaglesham of The Wall Street Journal did an extensive survey of stockbrokers who failed their Series 7 exams. The study found that stockbrokers who failed their exams at least three or more times were more likely to have engaged in "unauthorized trading, churning or excessive trading in customer accounts to generate commissions."
FINRA does not require its brokers to show that information on its database of industry personnel, called BrokerCheck. Would you want to go to a doctor who had failed his medical boards several times?
Conversely, The Wall Street Journal recently reported that the Securities and Exchange Commission says the practice of so-called "reverse churning" -- putting investors in accounts that pay a fixed fee but generate little or no activity to justify that fee -- is on its radar. Regulators will be watching for signs of double-dipping by advisers who generate significant commissions within a client's brokerage account, and then move that client into an advisory account and collect additional fees.
"Broker-dealers, experts say, should consider offering detailed training to representatives on how to approach such transfers with customers; documenting discussions with customers that include clear disclosure of the available options, their benefits and detriments; and surveillance reports that monitor for low-volume activity in fee-based accounts and high volume activity in commission-based accounts as well as similar reports that evaluate the purchase of high up-front load products followed by switches to fee-based accounts," according to the Journal's Daisy Maxey.
As investors review their monthly account statements, they need to be aware of the amount of commissions being charged and whether their accounts are being "churned" or "reverse churned" by their brokers. Keep a close eye on the trading activity and the dollar amount in fees and commissions that you are being charged. A careful eye on the expenses charged in your account is a simple step to take to ensure your hard-earned savings continue to work for you rather than your broker or his company.
Zamansky LLC are investment and stock fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.