When an individual or a firm has been hired to invest on someone else’s behalf, they are expected to put that person’s best interests first. They’ve been hired because they are experts. They understand the market. They are supposed to use that expertise to get the best possible results for their client.
Churning is a practice that undermines this basic principle. It is focused on the best interests of the person who is doing the investing – or the firm – instead of the end client. This approach can often lead to disputes and potentially even to legal action. What is it, how does it work and why do people do it?
Churning involves buying excessive stocks or making an extravagant number of trades. The reason that this is done is because that an investor or firm is being paid a commission after each trade that they make. If they simply leave the money as is, there is no additional earning. But if they execute numerous trades – even if those trades are worthless or detrimental to the overall value of the portfolio – then they generate more commissions for themselves.
This is considered an unethical practice because it could cause the client to lose money. Plus, even if the client’s outcome is exactly the same, they would’ve lost money to commissions that they should not have had to pay.
What about flat fee accounts?
Of course, not everyone is paid on commission based on the number of trades executed. In some cases, there is a flat fee. This doesn’t lead to churning, but it can lead to something called “reverse churning.” When this happens, almost no trading is done because there’s no benefit to the investment firm. They get the same annual percentage, regardless of how an account performs. This can still be problematic for an investor, who (rightfully) believes that their own best interests should still come first.
As you can imagine, allegations of churning can lead to some complex disputes. Those involved need to make sure they are well aware of their legal options. If you have questions about civil or criminal exposure in financial matters, please contact the attorneys at Ford O’Brien.
Source: Investopedia, “Churning: Definition and Types in Finance,” 2022