Why Financial Advisors Must Avoid Reverse Churning

Reverse churning is the fraudulent practice of charging a flat fee for idle accounts. It can represent a breach in fiduciary duty to the client, who would be better served with a per-transaction fee structure. Engaging in reverse churning can cost your firm money, clients and potentially the ability to conduct business. It’s not enough to say you must avoid reverse churning. To reduce the risk of enforcement actions, you must also monitor your firm, its principals and associates to ensure that all files are compliant with churning rules. Here’s what you need to know.

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What Is Reverse Churning?

Reverse churning is the practice of charging an ongoing advisory or wrap fee for an account that receives few services and would likely be better suited to a different fee arrangement. Specifically, this refers to the practice of taking a client on a flat-fee basis and then intentionally or knowingly providing very little in the way of services. As the SEC defines it: “Reverse churning generally refers to the practice where a client is charged a wrap fee that covers all advisory services and trading costs even though the client trades infrequently.” Essentially, the client may pay more than is reasonable for the services they receive.

Churning, by comparison, is a practice in which a broker in a per-transaction fee arrangement abuses their customer’s trust by conducting unnecessary transactions in order to drive up costs. Instead of under-serving the client, the broker does too much for the sole purpose of collecting additional fees.

In both cases, the broker manages the client’s account in their own interest. With reverse churning, the broker collects a flat fee without taking any action, even if account activity and/or a transaction fee would be in the client’s best interest. With churning, the broker collects per-transaction fees regardless of whether any given transaction is in the client’s best interest.

Reverse churning and churning are both forms of fraud. Cornell’s Legal Information Institute notes that:

“As a matter of law, [this] is considered a violation of federal securities law proscribing fraud in connection with the purchase and sale of securities. Section 10(b) of the Securities Exchange Act of 1934 makes it unlawful to ‘use or employ, in connection with the purchase or sale of any security a ‘manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe.’” 

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Reverse Churning: Enforcement and Consequences

Reverse churning has generated increased scrutiny in recent years, as the SEC and plaintiffs’ attorneys have shifted their attention to include both traditional churning and its more passive form. While reverse churning is not explicitly listed in the SEC’s exam priorities for 2026, strict adherence to fiduciary standards among registered investment advisors is. Considering that reverse churning is considered to be a significant breach of fiduciary duty, it follows that the SEC is likely to scrutinize firms that engage in questionable transactions.

Keep in mind that reverse churning only constitutes fraud if it’s done to benefit a broker or advisor, rather than the client. It does not constitute reverse churning to hold a flat-fee portfolio as-is if you do so in good faith based on your judgment of a client’s best interests. This is true regardless of whether that choice is ultimately successful. The SEC generally evaluates whether the adviser acted consistently with its fiduciary obligations and whether the account type remained appropriate for the client.

That said, both the courts and the SEC have become increasingly suspicious of brokers that charge a flat fee for idle accounts. Advisors and firms are required to actively monitor their own book of business to prevent reverse churning in low-volume accounts. It’s one thing to leave an account alone for some time, but eventually, a broker has a fiduciary duty to advise their clients if a new fee structure would be in the client’s best interest.

In September 2022, for instance, the SEC announced settled charges against a firm for misconduct related to one of the firm’s wrap fee programs. The SEC alleged that the firm breached fiduciary duty when it failed to take reasonable steps to follow up on hundreds of wrap fee accounts that were flagged for potential reverse churning. The firm also failed to convert those accounts to brokerage accounts, as required by the company’s policies and procedures, according to the SEC. ¹

As part of the SEC’s settlement, the firm agreed to:

• Comply with a cease-and-desist order and a censure
• Pay disgorgement of $484,645, prejudgment interest of $90,944, and a civil money penalty of $200,000
• Distribute the funds to clients who were harmed by the firm’s misconduct

This monitoring obligation means that there are limits to a good-faith justification for a passive approach. Over the short term, a broker can hold a client’s position if they feel that’s the best financial decision. In the long term, if a client’s account is sufficiently passive, the broker has a duty to recognize that a transactional fee might be in the client’s best interest and act accordingly. 

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How to Avoid Reverse Churning

To maintain ethical standards and comply with regulatory requirements, financial advisors can implement some best practices designed to prevent reverse churning:

1. Conduct Thorough Assessments of Client Needs

Conducting an in-depth evaluation of each client’s objectives, requirements, and trading behaviors is essential. Advisors should document these evaluations and verify that the selected fee structure appropriately aligns with the client’s best interests.

2. Regularly Review Account Activity

Firms should regularly scrutinize account activity and the services rendered to clients. This examination can help uncover any discrepancies that exist between the client’s needs and the type of account they have. Additionally, it shows regulators that the advisor is diligently overseeing and managing client accounts.

3. Ensure Your Fee Structures Are Transparent

Clearly explaining fee structures in a transparent manner is also essential to avoiding reverse churning. Advisors must thoroughly explain to their clients how fees are determined and what services they encompass. This openness can build trust and help clients make well-informed decisions about their accounts.

4. Provide Regular Updates and Reports

Consistently providing clients with updates and detailed reports on account performance and the services delivered can help them recognize the value they receive in return for the fees they pay.

5. Complete Continuing Education and Training

Financial advisors should continuously pursue continuing education and training focused on ethical practices and regulatory requirements. Staying up-to-date on industry developments and best practices can help advisors uphold high standards and steer clear of issues like reverse churning.

Frequently Asked Questions

Bottom Line

Reverse churning occurs when brokers charge a flat fee for low-activity accounts. It is the corollary to churning, in which brokers conduct unnecessary trades for per-transaction fee accounts, and both are a form of fraud.

Tips for Managing Your Practice

• SmartAsset AMP (Advisor Marketing Platform) is a holistic marketing service financial advisors can use for client lead generation and automated marketing. Sign up for a free demo to explore how SmartAsset AMP can help you expand your practice’s marketing operation. Get started today.
• Managing your relationship with the SEC is critical if you are in the securities industry. They literally define what the industry is and how it operates, and it’s essential to stay on top of those rules. Working with an RIA compliance consultant can help you spot potential gaps in your firm’s policies and procedures so you can quickly and thoroughly address them.

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