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Why Financial Advisors Must Avoid Reverse Churning


Reverse churning is the fraudulent practice of charging a flat fee for idle accounts. It represents a breach in fiduciary duty to the client, who would be better served with a per-transaction fee structure. It can cost your firm its money, its clients and potentially even its ability to conduct business. It’s not enough to say you must avoid reverse churning. To prevent 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 collecting a brokerage or advisory fee for doing little or nothing. 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.” The client ends up paying for nothing. 

This is the corollary to churning, 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. 

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. As Cornell’s Legal Information Institute writes: “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.’” 

Beware of Reverse Churning

SmartAsset: Why Financial Advisors Must Avoid Reverse Churning

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. As the law firm, Burr & Forman wrote on the issue in 2014 as enforcement began to step up: 

“[T]he rise of claims related to inaction in a client account should … give members of the securities industry cause for concern. In particular, the U.S. Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and other critics have begun to focus their attention on ‘reverse churning,’ a claim arising from an allegation that a registered representative or investment advisor breaches a duty to his or her client by moving an under-traded account from a commission to a fee-based compensation structure solely for the purpose of generating revenue.”

Reverse churning only constitutes fraud if the broker does it in their own favor. That is to say if the broker makes trading or transactional decisions based on their own financial self-interest rather than that of the client. It does not constitute reverse churning to hold a flat-fee portfolio as-is if the broker is doing so in good faith based on their judgment of the client’s best interests. This is true regardless of whether that choice is ultimately successful. It is the intent that matters.

That said, both the courts and the SEC have become increasingly suspicious of brokers that charge a flat fee for idle accounts. Brokers 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 one 2016 enforcement action, the SEC fined a group of advisors more than $10 million for, among other related matters, allegedly failing to adequately monitor their own accounts for clients that no longer needed a flat-fee structure. 

The result of this monitoring duty means that there are limits to a passive good-faith argument. Over the short term, a broker can hold a client’s position if they feel that’s the best financial decision. However over 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. 

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 fees 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. Offers Continuing Education and Training

Financial advisors should continuously pursue 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.

Bottom Line

SmartAsset: Why Financial Advisors Must Avoid Reverse Churning

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.

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