FINRA Unscripted

Excessive Trading: When A Lot Becomes Too Much

Episode Summary

For some investors a high-volume trading strategy could be something that they seek. For others it might be a sign of excessive trading. But when does a lot become too much? What does a firm's responsibility when it comes to supervising for this behavior? On this episode, FINRA Enforcement's Chris Kelly joins us to tell us more.

Episode Notes

For some investors, a high-volume trading strategy could be something they seek. For others, it might be a sign of "excessive trading.” But when does a lot become too much? What is a firm’s responsibility when it comes to supervising for this behavior? 

On this episode, Chris Kelly, deputy head of FINRA Enforcement and head of Main Enforcement and Sales Practice Enforcement joins us to talk about excessive trading or churning. He shares why this practice remains in focus for FINRA Enforcement and some recent trends. 

Resources mentioned in this episode:

Monthly Disciplinary Actions

Blog: Red Flags to Detect Excessive Trading

Investor Insights: 3 Ways to Guard Against Excessive Trading

Episode Transcription

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FULL TRANSCRIPT 

00:00 - 00:22

Kaitlyn Kiernan: For some investors a high-volume trading strategy could be something that they seek. For others it might be a sign of excessive trading. But when does a lot become too much? What does a firm's responsibility when it comes to supervising for this behavior? And what are the latest trends? On this episode, FINRA Enforcement's Chris Kelly joins us to tell us more. 

00:22 – 00:31

Intro Music

00:31 - 00:45

Kaitlyn Kiernan: Welcome to FINRA Unscripted. I'm your host Kaitlyn Kiernan. Today, I'm pleased to welcome back to the show Chris Kelly, the deputy head of Enforcement and head of both Main Enforcement and Sales Practice Enforcement. Chris, welcome back. 

00:45 - 00:47

Chris Kelly: Thanks. Happy to be here. 

00:47 - 01:07

Kaitlyn Kiernan: So, Chris, last time we spoke we talked about Enforcement's focus on protecting senior investors. Today we wanted to talk about another Enforcement priority, which is excessive trading. So quantitative suitability, excessive trading, churning. What are all of these things? Do they all mean the same thing? What are we talking about here? 

01:08 - 01:39

Chris Kelly: Yeah, that's a great question. The short answer is that we use the terms quantitative suitability and excessive trading interchangeably. Both refer to the situation where a broker makes a large number of trades in a customer's account not to benefit the customer but to generate commissions for the broker. Churning is really a more egregious variation of excessive trading. So when we use the term churning we're referring to the situation where not only did the broker execute an excessive amount of trades in the customer's accounts, but he or she did so with either an intent to defraud or with reckless disregard for the customer's interests.

01:40 - 01:45

Kaitlyn Kiernan: All of them would be a violation of securities rules and regulations? 

01:45 - 01:46

Chris Kelly: That's right.

01:47 - 01:58

Kaitlyn Kiernan: So, if you look at FINRA as Monthly Disciplinary Actions report, you see it come up time and again. Why does excessive trading remain an issue in the securities industry? 

01:59 - 02:39

Chris Kelly: Well first I should note that while you're absolutely correct that excessive trading is common in terms of the types of violations that we bring in FINRA Enforcement, it's not common across the industry. The overwhelming majority of brokers have never engaged in excessive trading. What we're really talking about is a relatively small population of bad apples. But to answer your question, for those bad apples I think the answer is probably that it's just a very tempting violation. Most of these brokers are compensated on a commission basis. So, in the simplest terms the more trades they make the more they get paid. And so, I think it can be tempting to engage in excessive trading to generate excessive commissions, particularly when it may not be affected by the customer or the firm. 

02:40 - 02:46

Kaitlyn Kiernan: Well why is this such a priority for you and FINRA Enforcement? 

02:46 - 03:34

Chris Kelly: A couple of reasons first. As you mentioned, it remains one of the most common violations we see year after year. Second, excessive trading and cause enormous harm to customers. We brought a case just a few years ago where a broker churned the account of a 93-year-old Holocaust survivor causing the customer to lose over $700,000 while the broker made almost that exact amount in commissions. And third, it can be very difficult for customers to detect excessive trading. The commissions on an individual basis may not be high, but gradually over time they build up to become excessive. So, unless customers are really paying attention to their account statements in their confirmations it can be hard to detect. And frankly even for the most vigilant customers who are reading their accounts statements, it's hard for them to pass out the exact fees and commissions they're being charged and see how they accumulate over time. 

03:35 - 03:44

Kaitlyn Kiernan: That's really heartbreaking to hear that someone would do that to a Holocaust survivor. And so, are you seeing any trends when it comes to excessive trading? 

03:44 - 04:38

Chris Kelly: Yes. One trend we are seeing is sort of a variation of excessive trading and that is short term trading in long term products. So typically, when we talk about excessive trading, we are talking about frequent buys and sells of equities. But what we've seen more frequently are brokers who are rapidly buying and selling more expensive products like mutual funds, variable annuities, unit investment trusts and closed-end funds. Because these products generally have higher commissions than equities the broker can execute fewer trades but still generate very high commissions. And the variation on the variation of that pattern we've seen most recently are brokers who switch not from mutual fund to mutual fund, but among different long-term products. So, for example buying a mutual fund, selling that mutual fund shortly thereafter to buy a UIT, waiting a short period time and selling the UIT to buy a closed-end fund, selling the close-end fund to buy a UIT and so on and so forth. 

04:38 - 04:44

Kaitlyn Kiernan: So excessive isn't just volume of trades. It can be more than that? 

04:44 - 04:50

Chris Kelly: Yeah, it's really any trading that is intended not to benefit the customer but to generate commissions for the broker.

04:51 - 04:57

Kaitlyn Kiernan: Are there any general guidelines that FINRA Enforcement uses when talking about what excessive is?

04:58 - 05:43

Chris Kelly: Absolutely. We generally look to two primary indicators of excessive trading and those are first, turnover rate, and second, cost-equity ratio. When I say turnover rate, I'm referring to the number of times that the equity in the account turns over. So, in other words the turnover rate is the number of times during a given period that the securities and account are replaced by new securities. The cost-equity ratio is the amount the account would need to appreciate in order for the customer to break even. So, for example, if the cost equity ratio in the account is 30 percent, the account would have to appreciate 30 percent just for the customer to cover the costs and expenses in the account. And as a general rule of thumb, FINRA and other regulators view turnover rates of 6 or more in cost equity ratios of 20 percent or more suggestive of excessive trading.

05:44 - 05:54

Kaitlyn Kiernan: So, if a registered rep is frequently butting right up against those numbers, say with a turnover rate of 5.9. Would that be a concern?

05:55 - 06:15

Chris Kelly: Yes, absolutely. The case law is clear that while a turnover rate of 6 in a cost equity ratio of 20 percent are suggestive of excessive trading, they're not strict guidelines. So, courts have found respondents liable for excessive trading at turnover rates less than 6 and cost-equity ratios of less than 20 percent. There are indicators of excessive trading, but they're not strict thresholds.

06:16 - 06:23

Kaitlyn Kiernan: And how does an investor's risk tolerance and investment objective come into play when you're talking about excessive trading?

06:25 - 06:50

Chris Kelly: An investor's risk tolerance and investing objective are absolutely critical considerations. Excessive trading is only a violation if the pattern of trading is excessive and unsuitable as compared to the customer specific investment profile. So, in simple terms, an active trading strategy is much more likely to be appropriate for a customer with a speculative investment objective and a high-risk tolerance than for a customer with a conservative investment objective and a low risk tolerance. 

06:50 - 06:56

Kaitlyn Kiernan: What is a broker dealer’s role when it comes to supervising against excessive trading? 

06:58 - 07:16

Chris Kelly: As is often the case, broker dealers are really the first line of defense. Broker dealers are much more likely to discover excessive trading at an early stage and have the ability to stop it then, for example, FINRA. We would usually come in much later in the process. So again, broker dealers are the first line of defense against excessive trading.

07:17 - 07:27

Kaitlyn Kiernan: And is it enough to just have internal systems flagging say when an account hits a turnover ratio of 6 percent or a cost equity of 20, is that enough? 

07:28 - 08:35

Chris Kelly: It's a complicated question because every firm is different and what might be a reasonably designed system to detect excessive trading at one firm might be inadequate for another firm depending on the volume of their business or the business model, for example. But with that caveat I would say that for most firms who conduct a substantial retail business, if their sole defense against excessive trading was an alert that triggered at a turnover rate of six and a cost equity ratio of 20, that likely would not be sufficient for a couple of reasons. 

First, as we just discussed you can't have excessive trading at less than a turnover 6, at less than a cost equity ratio of 20, so I wouldn't want those thresholds to be the firm's sole trigger. Second, detecting the potential excessive trading is only half of the issue. An important consideration is what does the firm do once excessive trading is detected. For example, does the firm provide trading and guidance to supervisors and principals on what they should do once they see red flags of excessive trading? And what then do those supervisors do in response those red flags? So, these are all important considerations in all of those things would be part of a reasonably designed supervisory system at a firm. 

08:35 - 08:39

Kaitlyn Kiernan: What have you seen as far as ad brokers trying to skirt those alerts? 

08:40 - 09:30

Chris Kelly: A couple of things. One, engaging in a high volume of trading that comes close to triggering the firm's alert but doesn't quite trigger those alerts. Two, engaging in excessive trading not across the broker's book business but only in one or two customer accounts. Perhaps the customer that the broker thinks is going to be least likely to notice or to complain. Then switching those one or two accounts over time so it's not the same customers and the same accounts year after year that would likely be noticed by the firm. And third way in which I've seen brokers trying to skirt those alerts and avoid detection is the pattern I mentioned earlier which is not necessarily excessively trading equities but actually trading more long term products like mutual funds, UITs and closed-end funds, which can generate really high commissions but not necessarily with a very high turnover rate. 

09:30 - 09:37

Kaitlyn Kiernan: What should investors be looking for and when should they be concerned that maybe the trading in their account is too much? 

09:37 - 10:41

Chris Kelly: Well, first, to take a step back, I think investors should look at their account documents and make sure that the investment objective and the risk tolerance listed there are actually reflective of their true investment objective and risk tolerance. And so, if it says speculation and high risk, make sure that that's what the investor really wants and meant to indicate as their risk tolerance and investment actives. Second, customers should always read their account statements and make sure they're comfortable with the volume of trading in their accounts. A couple of other things to look for in terms of red flags of potentially excessive trading, I would say look for any trades that the customer did not authorize. 

I would say also look for in-and-out trading, and by in-and-out trading I mean purchasing a security only to sell that security a short time later than to buy back into that security a short time after that. So, buying in and out of security and in a shorter period of time. And I should mention and give a plug to an article that was recently published by FINRA's Investor Education Department that outlines a lot of these same tips and provides guidance to investors who may be worried that their accounts are being excessively traded. 

10:41 - 10:49

Kaitlyn Kiernan: We'll link to that in our show notes. And where should investors turn if they think there is a problem? 

10:49 - 11:07

Chris Kelly: If investors think there is a problem, they should start with their broker and ask questions like, "What is the rationale for this high volume of trading? What are the fees and commissions I am paying? What is the cost-equity ratio on my account?" And if an investor is not comfortable with those answers, they should escalate their concerns and go straight to the broker dealer.

11:07 - 11:22

Kaitlyn Kiernan: So, switching back to the actual rules and regulations here, has FINRA Enforcement's expectations around excessive trading changed at all since the implementation of Reg BI in June of this year?

11:22 - 12:09

Chris Kelly: The short answer is no. I don't think you'll see much of a difference in the excessive trading cases we traditionally brought under FINRA suitability rules and the cases that we are likely to bring under Reg BI with one important difference. Reg BI eliminated one of the key legal elements of an excessive trading case that we are required to prove and that is the element of control. So traditionally, in order to bring excessive trading case against the broker the enforcement action would have to establish that the broker controlled either in fact or had de facto control over the trading in the customer's account. Reg BI explicitly eliminates that requirement of control and so we no longer need to prove that to bring an excessive trading case under Reg BI. Other than that, I think the cases are very much going to look the same. 

12:10 - 12:16

Kaitlyn Kiernan: And are there any key takeaways you can share from some recent enforcement actions? 

12:16 - 13:06

Chris Kelly: You know it's interesting, I took a look back at some of the excessive trading and churning cases that we have brought in FINRA Enforcement the last couple of years and the pattern I saw was that there really was no pattern, that the excessive trading cases come in different shapes and sizes. We've seen excessive trading cases against brokers at the largest firms and we've seen them against brokers at very small firms. We've seen excess trading involving equities, excessive trading involving fixed income products. And we've seen excessive trading cases that result in enormous losses to individuals like the $700,000 loss I mentioned earlier. But we've also seen excessive trading that results in more modest losses $10-, $15,000 to a customer, which by the way, if that's the customer's entire life savings can be just as devastating. So, I think, again, excessive trading cases, there is no one pattern. They come in all different variations.

13:06 - 13:12

Kaitlyn Kiernan: What kind of sanctions does enforcement typically consider when it comes to excessive trading cases? 

13:13 -13:52

Chris Kelly: The sanctions for excessive trading and turning violations can be quite severe. The sanction guidelines with respect excessive trading recommend a suspension of up to two years and where there are aggravating factors a bar from the industry. For churning the standard sanction recommended is a bar from the industry. And for firms who are found to have failed to supervise brokers who engage in excessive trading, the sanctions include suspensions, fines and restitution. And I should mention that whether the case we bring is against an individual broker or against the firm our first priority is always going to be to get restitution for the customer, so have the broker, the firm or both make the customer whole for their losses.

13:53 - 14:07

Kaitlyn Kiernan: So just to wrap up what is FINRA's overall goal in shining such a spotlight on this issue right now. We've got the Investor Insight and a blog post, now this podcast on the topic. Why now?

14:08 - 14:56

Chris Kelly: So just to take a step back, our mission is investor protection and one of the best ways that we at FINRA can protect investors is to highlight for broker dealers issues that we are seeing in the industry so they can take steps to respond. And sometimes that means highlighting a new or novel product or trading practice that maybe we haven't seen before. But it's just as important to remind firms of some of the risks that, while not new or novel, continue to be prevalent and should not fall off the radar. So excessive trading isn't new, but it's still very prevalent and we want to let the industry know that we are still seeing many many excessive trading cases every year. There has not been a decline and so they know that they should remain vigilant and make sure that their supervisory system and procedures are up to date and ready and effective to detect and prevent excessive trading. 

14:57 - 15:15

Kaitlyn Kiernan: Chris, thanks so much for joining us to talk about this important topic. Listeners if you don't already make sure to subscribe to FINRA Unscripted on Apple Podcast, Spotify or wherever you listen to podcasts. If you have any ideas for future episodes you can send us an email at FINRAunscripted@finra.org. Until next time. 

15:15 – 15:21

Outro Music 

15:21 - 15:48

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15:48 – 15:54

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