What is your financial advisor really up to?
Like most professions, financial advisors come in all varieties from great to self-serving and greedy. Before you trust your financial future to someone, make sure you’ve got a good one. White-collar prisons are full of people, male and female, each of whom appeared respectable and trustworthy, while bilking clients out of their savings. Many worked far harder to create a façade of success than they ever did to actually succeed at investing client money. That’s why it can be difficult even for sophisticated investors to detect the fraud at times.
Here’s one aspect of financial fraud that experts in the investment field warn of. It’s called churning. CNBC defines churning this way: It involves “trading in and out of securities — often over a short period of time — in a way that serves no purpose for the investor but generates commissions for the broker.”
Churning represents a huge conflict on the part of the advisor, because he or she does not get paid unless transactions are made. So if your advisor has your permission, you might wake up to find your money has been moved around, ostensibly to get you the best possible investment. But in reality, your advisor is in it for the commissions. What could happen? First, your money could be taken out of a well-performing investment and put in a riskier one. But it gets worse. You could lose large chunks of money to commissions, taxes and surrender fees. By the time you know about the transactions, the money is lost.
What are the warning signs to watch for?
Start with the documents sent to you by the broker. After every transaction, your broker must send you a confirmation of the action taken. Generally there isn’t much activity in an account, unless you are a sophisticated trader. If you’re a conservative investor, in it for the long-term, it’s generally considered wise to buy and hold. So if you end up receiving confirmations of activity several times a month, contact your broker to ask what’s going on.
You must also receive a document if your mutual fund is switched for another mutual fund, or your annuity for another annuity. These accounts come with upfront loads, so if they are sold soon after purchase, a brokerage firm generally will send you a confirmation that this is what you want to do and ask you sign an acknowledgment. This is done to prevent excessive transactions that would generate commissions. If you find you are receiving many such confirmations, this could be a red flag that your account is being churned.
Another red flag: Do you have accounts that are declining even when the market is moving upward? Or if the market is moving downward, is your account declining even faster than the general market? The decline could be excessive commissions that erode an account and cause an underperformance compared to the general market.
If you believe your account has been churned, you may have a claim to recover churning losses, if these elements are present: control, excessive trading and scienter.
Control. Who had the control? Did the broker have your express or implied permission to make a trade? You may have been asked to sign a discretionary trading agreement. Or, if you have always followed your broker’s advice, or you may have given him or her “de facto” control.
Excessive trading. What is the turnover ratio of your account? Here’s how to determine this figure:
1. It’s the total amount of purchases in the account divided by the average monthly equity in the account.
2. To annualize this amount, divide the result by the number of months involved to get the per-month ratio, then multiply that by 12. So if you purchased the investment in early January and sold it in late July, divide the amount in step 1 by 7 (months) and multiply by 12 (months).
Courts have said that generally for a conservative investor, the annualized turnover rate of two suggests there may be churning. A turnover rate of four presumes churning, and six or more is conclusive of excessive trading.
Scienter, or intent. To prove churning the final element is that the broker had the specific intent to defraud your account, or at least had reckless disregard for your interests.
Suppose you take this to court. What can you recover? Typically the damages in an excessive trading case are the excessive commission or expenses, and the actual losses to the client’s portfolio from churning.
If you suspect your accounts have been churned
Stockbrokers are members of the Financial Industry Regulatory Authority (FINRA), and they and their employers must abide by its laws. If your stockbroker breaks those laws, contact the firm that employs him or her. The firm must supervise the broker’s actions and should compensate you for any negligence and/or fraud – and you have the legal right to pursue such compensation. If you don’t get satisfaction you should contact your attorney, or a securities defense attorney.