What Is churning?
Although most stockbrokers and investment professionals act with the utmost professionalism, unfortunately, there are always a few “bad apples” who are in it just for themselves. When a broker is trading your account simply to make commissions on the trading, this is called churning. As an investor, you need to be able to detect whether your brokerage account has been or is still being churned, and know what to do about it if you suspect you have been the victim of this activity.
According to the Securities and Exchange Commission (“SEC”) churning occurs when a broker engages in excessive buying and selling of securities in a customer’s account chiefly to generate commissions that benefit the broker. For churning to occur, the broker must exercise control over the investment decisions in the customer’s account, such as through a formal written discretionary agreement, although a broker can be deemed to have control without such an agreement-especially if the customer always accepts the broker’s investment recommendations. Frequent in-and-out purchases and sales of securities that don’t appear necessary to fulfill the customer’s investment goals may be evidence that your account is being churned.
Churning is both illegal and unethical. Churning violates both the Federal and state securities laws, as well as FINRA industry regulations and standards. Such conduct may also violate a myriad of other laws, such as those requiring that brokers act as fiduciaries and always put their client’s interests first. Churning also violates FINRA’s suitability rules.
What Does Churning Stocks Mean?
There are a number of types of churning investors should watch for. The most common is when a broker makes excessive trades in stocks. Excessive trading generates commissions for the broker but provides very little if any, the benefit to the investor.
One way churning is measured is by how many times the equity in the account is traded in a year. This is called the “turnover ratio” The turnover ratio can be calculated a number of 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 covered in the analysis. More simply put, if the average yearly value of your securities account is 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 called the cost-to-equity ratio. Cost-to-equity ratios are calculated by dividing the costs such as commissions, fees, margin charges, mark-ups, and mark-downs incurred in an account by the average yearly equity. In this measure, cost-to-equity ratios calculate the portion of the average equity in the account that is eaten up by the trading costs. A simple example would be if the average equity of the account was 100,000 but the costs of the trading in the account were 10,000. In this example, the cost-to-equity ratio would be 10%–meaning that the customer would have to earn at least 10% on the trading 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 limited to those types of securities alone. Brokers churn bonds, mutual funds, exchange-traded funds (“EFTs”), Exchange Traded Notes (“ETNs”), annuities, and life insurance policies (though churning activity is commonly called “twisting” when it happens in annuities and life insurance).
Churning bonds and other investments can occur with a much lower turnover ratio because these investments are supposed to be held long-term. For example, many bonds and EFTs have maturity dates in a particular year and are meant to be held until they mature. When a broker trades these types of investments before their maturity date, buying others which are similar and incurring additional charges, penalties and commissions, this can also be a form of churning.
Consequences of Churning: Sanctions, Fees and Penalties
Brokers who have been found liable for churning can be held liable to their clients not only for investment losses in the accounts but the commissions and costs of the trades themselves, as well as excess taxes paid. Additionally, investors are entitled to recover damages measured by how the account would have performed if handled appropriately (a “well-managed account” damage measure). Brokers may also be subject to enforcement action from regulators, who can fine or suspend the broker for a distinct period of time, or in particularly bad situations, forever. Regulatory penalties are typically more serious when brokers have previous regulatory problems or customer complaints on their records.
Red flags of excessive trading may include:
The SEC has identified the following warning signs of excessive trading:
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.
How Do I Protect Myself From Churning?
1. Your broker is required by federal regulations to send you a written confirmation of every transaction. Unless you are an active trader if you receive daily or weekly trading confirmations, your broker may be churning your account. This is particularly true if you did not sign a document giving the broker your explicit permission to trade in your account and your broker is not discussing each trade with you before the trade is made.
2. Bonds, Mutual funds, Exchange Traded Funds (“EFTs”), Exchange Traded Notes (“ETNs”) and annuities generally should not frequently be switched for other similar investments. Selling these types of investments shortly after they were purchased is something that is often done to maximize commissions at the expense of the customer. The broker may send what seems to be a routine form for you to sign agreeing to the switch. Be cautious about such trades as they may be a warning sign that your account is being churned.
3. If the price of your stocks and bonds are moving upward, but your account value is declining or staying level, it may be due to the commissions resulting from the excessive trading. If you detect this happening, this may be a sign that your account was churned.
4. Having a wrap account where you pay one annual fee for all of the trading done in the account is one way to protect yourself against churning. Generally, the fee is a percentage of the value of the account. Make sure you understand what this fee is before signing any document.
How to Prove You have a Churning Case
To prove you have been a victim of churning there are three legal elements:
1. The broker had control over your account. This means you gave the broker either express permission to trade without first clearing trades with you, or the broker simply took control over the account. Express control typically involves a signed agreement allowing the broker to trade within the account. Control can be implied if the evidence shows that you always followed the broker’s advice and relied upon the broker, or if the broker simply traded your account without first gaining your approval for each trade.
2. There was excessive trading on your account. This is done through looking at the turnover ratio or cost-to-equity ratio discussed above.
3. The broker’s intent in making excessive trading was to earn commissions. Even if the broker did not have the specific intent to defraud, you may still prevail if the broker acted with a “reckless disregard” or breached the fiduciary duty to you by putting their interest before your interest.
Churning is a Violation of the FINRA Suitability Rules
FINRA Rule 2111.05( c ) makes churning a customer’s account a violation of the quantitative suitability rule.
Quantitative suitability requires a broker who has actual control or control in fact over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile. No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer’s account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.
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 888-768-2499.