Typically, stockbrokers earn commissions each time an investor enters a securities order to buy stock or sell stock. Full-service stockbrokers earn higher commissions than online stockbrokers because, unlike online stockbrokers, full-service stockbrokers provide investors with the added service of advising you when to buy, sell or hold particular investments.
Because stockbrokers are paid on commission, there is an inherent conflict of interest, a financial incentive for the stockbroker to persuade investors to trade frequently. Unless the quality of the investment advice justifies the commission received, the stockbroker is getting the better end of the bargain at the investor’s expense. And this is a problem because stockbrokers devote significant time and resources to cultivating a perception of trust with the public. If the stockbroker lets commissions get in the way of a customer’s best interest, the stockbroker has betrayed the trust that the investor has given to them. It can even amount to investor fraud.
This betrayal can manifest itself in two ways: unauthorized trading and excessive trading, a.k.a. churning. The rules governing stockbrokers require the stockbroker to have investor permission before entering any order on their behalf. A stockbroker who cannot persuade investors to trade frequently may be tempted to act without the investor’s knowledge or permission and trade the account anyway hoping the investor is none the wiser. Unauthorized trading goes to the heart of the trustworthiness of a securities professional, and is a fundamental betrayal of the duty owed by a broker to their customers.
Some unauthorized trading can result from a harmless error. But more often unauthorized trading is a pretext to stockbroker fraud, known as excessive trading or churning, perpetrated for the primary purpose of generating commissions for the stockbroker without regard for what is in the investor’s interest.
In churning, the stockbroker will enter many trades over a short period of time. The investment fraud lawyers in our San Diego office handled a case in which a stockbroker entered over 120 trades in a nine-month period and turned the investor’s portfolio over several times. The excessiveness of the trading activity came into question when compared to the annual turnover rates of most actively managed mutual funds, which can be one time or less each year. The fact that the investor was sustaining large losses while the stockbroker was generating substantial commission income for themselves demonstrated the stockbroker acted in reckless disregard of the investor’s interests and account objectives, and in favor of their own interests.
Another hallmark example of churning is “in and out trading”, or multiple and overlapping trades in the same or similar securities within weeks, or even days, of one another. Recommending that an investor trade in-and-out of the same stock 15-20 times in a short period of time is extremely difficult for a stockbroker to justify, especially if the account is losing money. Typically, commissions, not the investor’s well-being, are the motivating factor.
There is no bright-line test for identifying churning. What may be excessive for one investor may be perfectly normal for another. An investor with little knowledge or experience in stock market matters should not be slinging stock in and out of their account. At the same time, a seasoned stock trader who is continuously trading their account understands and is willing to bear the investment risks of an active trading strategy. Primarily, the test is based on an investor’s level of understanding of investment risks, the investor’s investment strategy, and the trust and confidence the investor has placed with the stockbroker.
Any account that has lost value during this period of advancing stock prices may be an indication of stockbroker misconduct. If you feel you have been the victim of securities fraud, please contact one of the investment fraud lawyers in the San Diego or New York offices of Sanford Heisler Sharp.