By Martin Mushkin
Unfortunately, churning is one of the most common frauds committed by errant securities firms and the occasional wayward broker they may employ. It consists of a broker exercising control over a customer’s account, and excessively trading in the account without regard to the customer’s needs and investment objectives. Over time, this activity results in the generation of substantial commissions. The joke in the business is that it “turns capital into commissions.” Churning is difficult to spot because most monthly brokerage account statements do not show commissions. The confirmation slips sent to customers do show commissions but they look small in comparison to the gross amount of the trade. The first time a customer is likely to realize there is something really wrong is at the end of the year when his accountant looks at the year-end summary that the customer receives from the brokerage house and adds up the commissions. It is also at that time that the overall gain or loss on combined purchases and sales will first be known. Even if there is a profit, most or all of it may be eaten up in commissions.
The broker who is churning will not suggest the sale of a losing security. He will sell a security, which is up only a few points, and take his commission rather than sell a security that is down. He can then tell the customer, “I made you $200 today” or “I made you $1,000 today” and omit that his commission ate up 25% to 50% of the profit – and sometimes even more. His game with securities in the loss column is to hold them until they become profitable – which may never occur. He will not recommend a sale even at year-end because that will show just how badly the account has done. This game is played when the market is going up and also when it is going down. In a down or flat market, the churning broker may increase his commissions by purchasing options which expire unexercised.
Brokerage houses have computer programs that spot this kind of activity. Branch managers are supposed to make sure that churning does not occur. Some do not spot it, and the few who permit it are sometimes blinded by the fact that their compensation is based on their branch’s overall revenues.
The elderly and immigrants are the most vulnerable. The elderly are a trusting group whose accounts are among those most often churned. And immigrants seem particularly vulnerable to this ploy, particularly entrepreneurs and professionals such as doctors, dentists, and engineers. For the first time in their lives, these vulnerable immigrants find themselves with money in excess of their consumer needs. All too often, exhilarated by their unaccustomed affluence and dazzled by the stock market, they place their trust in securities brokers who are fellow countrymen, co-religionists, or clan members, and who appear to have succeeded in that most American phenomenon, the stock market. After some time, maybe months or years later, the broker calls to apologize for losing all the customer’s money “in the market.” An analysis will show that most of the “loss” was really commissions paid.
Churning is not a simple market loss; it is a fraud and actionable. Accountants should look back at the tax returns they prepared to see whether there is a pattern of suspiciously excessive trading and inform their clients. Attorneys and particularly elder law and immigration law attorneys should heed this admonition when they examine the financial activities of their clients. Suspicious activity is a ground to consult counsel experienced in dealing with securities fraud.