Illegal and unethical investment practices dominated the financial news media in 2008. The crash brought to light several questionable practices at various prestigious Wall Street firms. The securities profession is rife with unscrupulous stock brokers who persuade their clients to make investments designed only to give the broker commissions. The Securities and Exchange Commission cannot catch everyone, but it does have jurisdiction over crimes that violate securities law.
Stock churning is a crime that violates securities law. Stock churning is buying and selling excessively to generate commissions. Churning hurts investors because it generates fees and taxes well above what is ordinarily necessary. Unlike other unethical practices, this crime is very clear. There are well-defined rules about stock churning and under what circumstances it occurs. This article is an examination of stock churning and what investors can do if they discover their brokers have engaged in it with their accounts.
Brokers usually have discretionary control over the investments in their clients’ accounts. This is the entire point of hiring a broker. Most customers do not have the expertise to trade in securities themselves, so they hire brokers to do the job for them. They give brokers their money and trust them to only make trades that are in their best interest. This discretion is the first circumstance necessary for stock churning.
Stock churning occurs when a broker engages in excessive trading far beyond what is necessary for the fulfillment of portfolio objectives. Excessive trading inconsistent with the character and financial resources of the account is a major red flag. The only reason a broker would engage in this kind of behavior is to generate commissions. Stock churning is not only unethical, it is illegal. It violates the National Association of Securities Dealers’ Fair Practice Rules. It is also a violation of SEC Rule 15c1-7 as well as other securities laws.
Investors should check in on their portfolio regularly. Once every few months is an acceptable time frame, but each investor must determine how frequently they need to check on their broker. Another option is to hire an investigative firm to perform a background check on a particular broker. Once an investor has discovered clear evidence of churning, they can file a complaint with the SEC. The SEC’S Division of Enforcement will look into the matter. To prevent brokers from having an incentive to churn, try a wrap account that pays a flat fee.
