Despite regulators' efforts, a recent Wells Fargo settlement shows the abuse known as "churning" is still rearing its ugly head in the brokerage industry.
Wells Fargo's brokerage arm, Wells Fargo Clearing Services, agreed this week to pay just over $3 million to resolve allegations that it failed to detect that advisors were racking up sales fees and commissions by recommending quick sales of securities meant to be held for the long term. The allegations paint a classic picture of a type of malpractice known as "churning," which refers to making frequent trades in clients' accounts for the sole purpose of amassing per-transaction payouts.
The Financial Industry Regulatory Authority's accusations center mainly on the actions of a broker accused of recommending unsuitable short-term trades from January 2017 to December 2018. The trader, who's not identified in the settlement, is no longer employed by Wells, according to FINRA, the broker-dealer industry's self-regulator.
FINRA alleges that the broker went undetected while on a spree of recommending a series of sales and then repurchases of securities known as syndicate preferred stocks, closed-end funds and medium term notes. Syndicate preferred stocks are stock-bond hybrids whose owners receive dividends before holders of "common" stock; closed-end funds are mutual funds that sell shares only once, during an initial public offering; and medium-term notes are a type of fixed-income instrument often maturing in five to 10 years.
READ MORE:
SEC's latest reverse churning case signals shift in industry crackdown
Judge: Edward Jones didn't breach fiduciary duty by moving client assets
FINRA bars Ami Forte for allegedly churning accounts of HSN's co-founder
Class action: Wells breached fiduciary duty, failed to catch Ponzi scheme
FINRA's settlement says all of these instruments "are generally purchased for their income features and held long-term." The products also paid Wells Fargo sales concessions when they were initially purchased and then commissions when they were sold again. Part of the proceeds were shared with the advisor.
"Trading in syndicate preferred stock, [closed-end funds] and [medium-term notes] is subject to potential abuse where representatives make recommendations to customers to purchase the security, collect the sales concession, and then recommend a short-term sale of the security," according to FINRA.
A Wells Fargo spokesperson said, "We take our supervisory responsibilities seriously, and we have enhanced our supervisory system to better serve our clients. We're pleased to resolve this matter."
FINRA alleges the trader at the heart of the settlement managed to rack up $578,023 in sales concessions from these investments and roughly $282,564 in commissions. That came from 131 purchases of syndicate preferred stock, closed-end funds and medium-term notes in 2017 and 2018.
Wells Fargo, according to FINRA, did have a supervision system set up to sound an alarm when a security was resold within 90 days of its initial purchase. But the securities involved in these allegations were generally designed to be held for at least 180 days. And 111 of the sales undertaken by the advisor — usually at a loss — occurred within 91 and 180 days of the initial purchase.
FINRA said Wells Fargo did flag the advisor's behavior as questionable on several occasions. At one point, the firm sent the broker an email about his trading in medium-term notes, warning that customers were "incurring losses on the transactions and are being charged commissions on the opening buys and maximum commissions on the closing sells."
"After receiving this email, the representative ceased recommending short-term trading in [medium-term notes] but continued to recommend that his customers trade preferred stocks and [closed-end funds] on a short term basis, even though his customers experienced losses," according to FINRA.
Separately, FINRA alleged that Wells had failed to supervise 40 other advisors accused of committing the same violations with 1,504 purchases of syndicated preferred stock and closed-end funds in 2017 and 2018. Those transactions, according to FINRA, generated $1,453,948 in sales concessions and roughly $316,460 in commissions for the firm.
Wells' penalty consists of a $400,000 fine; $599,025 in restitution, plus interest; and $2,031,972 of disgorgement.
This isn't the first time FINRA has hit Wells Fargo with penalties for failing to supervise its brokers' activities. In 2021, for instance, the firm was ordered to pay $3,367,929 in restitution to settle allegations that it had failed to set up a system to reasonably supervise advisors' recommendations related to college savings plans. The year before, it had to pay a whopping $35 million civil penalty to settle Securities and Exchange Commission allegations that it failed to reasonably supervise recommendations for buying and holding investment products known as single-inverse exchange traded funds.
