This past week, regulators at the Financial Industry Regulatory Authority (“FINRA”) fined Aegis Capital Corp and sanctioned its supervisors for allowing its brokers to churn their clients’ accounts.
FINRA’s case resulted from its examination of Aegis after reviewing a customer’s FINRA arbitration complaint. FINRA found that during the period between July 2014 through December 2018, Aegis did not implement a proper supervisory system under FINRA’s suitability rule. Because of this, FINRA found, Aegis failed to identify its registered representatives’ potentially excessive and unsuitable trading in its customers’ accounts. Included in this fine was specific trading by eight Aegis brokers who were found to have excessively traded in 31 customer accounts. Further, FINRA found that the trading in those accounts generated average cost-to-equity ratios of 71.6 percent. (This means that the account value must increase by 71 percent just to cover commissions and other trading expenses). This excessive trading—called “churning” cost these Aegis customers more than $2.9 million in trading expenses and fees.
What is Churning?
The Securities and Exchange Commission (“SEC”) defines churning as a broker engaging in excessive buying and selling of securities in a customer’s account primarily to generate commissions for the broker’s benefit. For a churning violation to occur, the broker must exercise control over the investment decisions in the customer’s account, either by a formal written discretionary agreement, or by having control without such an agreement-especially where the customer always accepts the broker’s investment recommendations. The existence of frequent purchases and sales of securities that don’t appear necessary to meet the customer’s stated investment goals may serve as evidence that your account has been churned.
Churning is illegal as well as unethical. This conduct violates the securities laws as well as FINRA industry rules and standards of conduct. It also violates other laws, such as those requiring that brokers act as fiduciaries and always act in their customer’s best interest.
Churning also violates FINRA’s suitability rules. FINRA Rule 2111, which contains the suitability rules that brokers must follow, imposes a “quantitative suitability” obligation that focuses on whether the number of transactions within a certain time period are suitable in light of the customer’s stated financial circumstances and investment objectives. Churning occurs, and is unsuitable, when a broker, while exercising control over a customer account, recommends a level of trading activity that is inconsistent with that customer’s investment needs and objectives.
How Do I know If My Securities Account was Churned?
The two measures of excessive trading are the “turnover rate”and “cost-to-equity ratio”. The turnover rate is measured by looking at the number of times that a portfolio of securities is exchanged for another portfolio of securities. The cost-to-equity ratio measures the amount that a brokerage account must increase in value just to cover the commissions and other trading expenses charged—also referred to as the “breakeven point” where a customer can finally begin to make a profit. Turnover rated and cost-to-equity measures are different depending on the products being sold and type of customer account .
Excessive trading benefits the brokers. It generates commissions for the broker but provides very little if any, the benefit to the customer. Turnover ratio can be calculated a number of different ways. The simplest turnover measure divides total security purchases by the average month-end equity balance and then annualizes the turnover ratio by dividing it by the number of years the account was churned. More simply stated, if the average yearly value of your brokerage account was 100,000 and a broker executed 300,000 worth of trading in a year, the turnover ratio would be 3x.
The other measure of churning is the cost-to-equity ratio. This ratio is calculated by adding up the investment costs—things like commissions, fees, margin interest, mark-ups, and mark-downs—and dividing this by the average yearly account equity. This determines the portion of the average equity in the account that is eaten up by trading costs. A simple example is where the average equity is 100,000 but the costs of the trading in the account are 10,000. Here, the cost-to-equity ratio would be calculated as 10%–meaning that the customer’s account would have to earn at least 10% before breaking even.
Churning Bonds, Mutual Funds, Annuities, and Life Insurance
While most people think of churning in the context of over-trading stocks, it isn’t just limited to that. Brokers can also churn bonds, mutual funds, exchange-traded funds (“EFTs”), annuities, and life insurance policies (churning activity in annuities and life insurance policies is commonly referred to as “twisting”).
Because of the nature of these investments as long-term, churning can occur at a much lower turnover ratio. For example, many bonds have maturity dates in a particular year and are meant to be held until they mature. When a broker trades these types of investments frequently, or before their maturity date, and buying others that are similar and incurring fees, sales charges, penalties or commissions, this can also be a form of churning.
Penalties for Churning
Remedies available to a customer in a churning case can include not only investment losses in the accounts, but the commissions, fees and the costs of the trades themselves, and can even sometime include excess taxes paid. Additionally, under the “well managed account” theory investors are entitled to recover damages measured by how the account would have performed if handled properly. Brokerage firms, like in the Aegis action, may also be subject regulatory sanctions, and supervisors or brokers can be fined or suspend for a period of time.
What are Signs My Account Was Churned?
The SEC has identified the signs of excessive trading as follows:
1. Unauthorized Trading – Be alarmed if you become aware of trades in your account that you did not authorize your broker to make.
2. Frequent Trading– Be wary of frequent in-and-out purchases and sales of securities that don’t seem consistent with your investment goals and risk tolerance.
3. Excessive Fees– Be suspicious if the total amount of fees seems high or if one segment of your portfolio consistently generates high fees.
Call us for a Free Consultation
If you believe that your or your loved one has been the victim of excessive trading or stock churning or any other type of investment fraud, then you need an experienced, aggressive securities fraud attorney to zealously pursue your case against the perpetrators. We invite you to contact investor fraud lawyer Melanie Cherdack. Because she has been in the trenches as a former Wall Street attorney, investor fraud lawyer Melanie Cherdack and her team of experienced attorneys have seen just about every type of investment fraud or investment scam. While almost every investment carries a degree of uncertainty and risk, you may have been unnecessarily exposed to such risk due to the actions of others.
If you have lost money due to investment fraud or simple broker negligence, it is crucial to hire a lawyer who fully understands this area of law. Former Wall Street securities attorney Melanie S. Cherdack represents individual and institutional investors who are unwitting victims of investment fraud and broker negligence. She heads up a group of attorneys who represent investors across the United States. Contact us by filling out our online contact form, or calling 844-635-1609.