It is obvious that broker-dealers and their registered representatives, and investment advisors, must be careful in making recommendations to clients. But the recent increase in regulatory interest relating to inaction in a client account should also give pause to members of the securities industry. Specifically, the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have begun to focus their attention on “reverse churning,” a claim alleging that a registered representative or investment advisor has breached the fiduciary duties owed to a client by moving an under-traded account from a commission to a fee-based compensation structure solely for the purpose of generating revenue from that account or by failing to make trades in an account that would have otherwise been made had the account been commission, instead of fee-based.
Traditionally, registered representatives and investment advisors have had to be careful in advising a client that a trade or transaction was suitable, an analysis dependent on the client’s investment objectives, age, other investments, time horizon, tax status, willingness to accept risk, and other factors. Under this advisory model, registered representatives and investment advisors were subject to criticism and liability for “churning,” a practice where the volume of trades in a client account or the speed of those trades, i.e. how long the purchased positions are held, suggest that the ulterior motive of the registered representative or investment advisor in recommending those transactions was to generate fees rather than improve the outlook of the client. The inherent conflict of interest at issue in instances of churning is self-evident: a registered representative or investment advisor paid by commission based on activity within an account has an interest contrary to, or at least inconsistent with, the client’s interest because the advisor will be paid regardless of whether or not the trade is successful.
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