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Churning (Excessive Trading)
- What is “CHURNING”?
- How is churning measured?
- What T/O ratio constitutes account churning?
- Can churning take place in fee based accounts?
- What is “reverse churning”?
Churning is defined as Excessive Trading in an account by a broker or financial advisor in order to earn commissions.
The most common metric to determine whether an account has been churned is the “turnover ratio” [“T/O”]. To measure the T/O, add all the purchases for the period, and divide by the average account balance. To get the annual T/O, divide the T/O ratio by the number of years of activity.
Historically, the following measures have been accepted:
- Annual T/O of 2: possible churning;
- Annual T/O of 4: presumption of churning;
- Annual T/O of 6+: conclusive presumption of churning
Generally, excessive trading to earn commissions takes place in commission-based accounts. However, see below for a discussion of “reverse churning”!
Reverse churning takes place when accounts are managed accounts with a flat fee when there is little or no activity taking place in the account which would be better served on a commission basis, as there is little or no account management taking place. Securities regulators have taken a very dim view of brokerage firm efforts to generate fees for no reason.
Churning (Excessive Trading)
Churning is a particularly vicious and invidious type of fraud. It differs little from outright theft; however, churning is sneakier because it is harder to detect. It is a direct violation of the duty owed by a broker or financial advisor to his customer to exercise good faith in his dealings with his client. It is also a failure of supervision whose duty it is to detect excessive activity.
Churning claims can be prosecuted under state or federal securities laws. Potential state law causes of action include constructive fraud, common-law fraud, breach of fiduciary duty, negligence, or equitable causes of action. Punitive damage awards and attorneys' fees may be available to the investor if the claim is brought under state law.
Churning occurs because the commission compensation system is still used in the securities industry. Many brokerage firms and registered representatives continue to earn their living by charging a commission on transactions that take place in a customer's account. Whether the transaction is a purchase or a sale, and regardless of profit or loss to the customer, the brokerage firm, and representative will be paid their commission. Therefore, the greater the number of transactions the registered representative can generate in the account, the greater the commissions he or she will earn.
Churning occurs when a broker engages in trading that is excessive in light of the customer's investment objectives. The broker clearly places his own interests ahead of those of his customer for the purpose of generating additional commissions and fees. When brokers buy and sell securities in an account to generate commissions, they often convince their clients of reasons the clients should take quick profits. While these reasons seem valid, these are often simply excuses for the broker to charge excess commissions. Although churning often occurs by trading in and out of stocks, churning can also occur by short-term trading in mutual funds, bonds or annuities. Churning may often result in substantial losses in the client's account, and even if profitable, the trading may generate an additional tax liability for the client.
There are three elements to establishing a charge of churning: scienter; control by the broker; and excessive trading. The customer must prove that the broker exercised actual control over the decision making in the account, the trading was excessive, and that the broker acted in reckless disregard of the customer’s interests.
What is ScienterWhere a broker trades his customers' account excessively for his own personal gain, disregarding the interests of his customer, the element of scienter is "implicit in the nature of the conduct" (Armstrong vs. McAlpin). It is not necessary to establish a specific intent to defraud as to each trade executed by the broker, since churning is, in itself, a scheme to defraud. The scienter requirement is satisfied where a broker conducts himself with reckless disregard for his clients' investment objectives.
Excessive TradingTo establish that your broker has churned your account, it must be demonstrated that the pattern of trading activity in your account was excessive. As set forth above, this can be done in a number of ways including calculations to determine the annualized rate of return that would be necessary to cover the commissions charged in your account; the number of times the equity in your account was turned over to purchase securities; the turnover ratio described above, and the purchase and sale trading activity that occurs in your account.
In order to determine whether trading in an account was excessive, it may be necessary to examine the investment objectives and risk tolerance of the customer. “The essential issue of fact is whether the volume of transactions, considered in light of the nature and objectives of the account, was so excessive as to indicate a purpose on the part of the broker to derive a profit for himself at the expense of his customer.” (Costello v. Oppenheimer & Co., Inc.)
In churning cases, the measure of damages is calculated by computing turnover and cost ratios.
If you belive you have suffered losses due to churning you may be able to recover your losses through securities fraud attorney Howard M. Rosenfield. Call us at 800-637-3243 for a FREE & CONFIDENTIAL claim evaluation to discuss your investment loss recovery options.
