What is Reverse Churning
Reverse churning is the practice of a financial advisor placing an investor's funds in a fee-based account for no reason other than to collect the fee. These accounts require the investor to pay a regular, fixed fee to the advisor, but it is often in exchange for very little actual advice, trading, or account activity. Therefore, the advisory firm generates more revenue while the customer does not receive any recognizable benefit.
In contrast, churning is the practice of excessive trading in an investor's account in order to generate a commission. Both practices use illegal and unethical methods in order to generate profit for the broker, and the Securities and Exchange Commission (SEC) is actively cracking down on this abuse of power.
BREAKING DOWN Reverse Churning
Due to a new rule established in 2007, advisors cannot charge fees for brokerage accounts. These advisors have the influence to convince their existing clients to switch to fee-based accounts, and it is beneficial to them to make this switch.
However, just because reverse churning exists does not mean that fee-based accounts are always bad. There are many cases in which the fee is justified and the investor experiences added benefits by choosing this type of account, but it is important to be able to recognize if you're a victim of reverse churning. If your financial advisor suggests moving to a fee-based account, ask questions in order to determine the benefit you'll receive from this change. What is the fee? What specific services and benefits will accompany this account? What types of investments are involved? Does the financial advisor or the company you're working with have a solid reputation?
Regulation by the Securities and Exchange Commission
As the practice of reverse churning becomes a more widespread problem, the SEC is cracking down on the misuse of fee-based accounts. One tell-tale sign of reverse churning is double dipping, which occurs when a financial advisor receives significant commissions from a client's brokerage account, then switches the client to an advisory account in order to keep making money. Often, the advisor had been making a significant profit from the brokerage account at one point, but the commission has since leveled off. In order to continue to benefit from the funds, the advisor might suggest that the investor move to a fee-based account, also called a wrap account, even though there is essentially no benefit to the investor.