Churning is when a broker engages in excessive buying and selling securities in a customer’s account with one goal in mind – generating commissions for the benefit of the broker. It is illegal, as brokers have a fundamental duty to put the interests of their clients before themselves.
One of the ways brokers and firms try to mask churning is by making sure that the investment objective for the brokerage account has been marked “speculation” with a “high” or “aggressive” risk tolerance. Then, when the account is excessively traded, the broker and firm often argue that the customer was willing to take those risks and that active trading is what the customer asked for.
However, under the rules governing the securities industry, brokers and brokerage firms must be able to demonstrate that the recommended trading strategies are suitable for a particular customer. And in cases where an account has clearly been churned, the activity is not suitable for anyone, regardless of their investment objectives. And this makes sense, because even if you have an aggressive risk tolerance, no customer ever agrees or asks for their account to be manipulated solely for the purpose of deriving profits for the broker or brokerage firm.
So, how do you know if your investment account is being churned by your broker? The evidence that proves churning is hidden in your account statements.
It is considered fraud and is both illegal and unethical. In order to mask churning, unscrupulous brokers will hold on to the investments in your account that perform poorly, while selling off those that are profitable. In this way, your portfolio can appear to be performing well—thanks to the gains you see each time a profitable investment is sold. Unfortunately, your portfolio is actually losing money on frequent commissions and becoming filled with poorly performing investments.
How is Churning Proven?
Brokers have a duty to place their clients' interests ahead of their own. When a broker engages in excessive trading, typically for generating additional commissions, the broker violates that duty through an activity called "churning." This violation means the broker and brokerage firm may be held liable for any losses that arise out of the churning of the account.
Excessiveness is typically determined by evaluating your account's annual turnover rate and the "break even" or "cost-equity" ratio. Per both the SEC and the courts, a turnover rate of over 6% is excessive. However, with a vast majority of standard turnover rates being below 1%, churning may be proven at a significantly lower rate. Standards also exist that determine that most accounts requiring at least a 15% annual return to "break even" meet the definition of "excessively traded."
According to the U.S. Securities and Exchange Commission, churning is an illegal and unethical activity that violates numerous laws, including the SEC Rule 15c 1-7. The Financial Industry Regulatory Authority (FINRA) also has rules to prevent excessive trading for broker gain. These rules are found under the "suitability" section of FINRA rules. Specifically, churning violates the FINRA principle of "quantitative suitability" detailed in § 2111.05(c).
Quantitative suitability requires a member or associated person who has actual or de facto control 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, as delineated in Rule 2111(a).
Establishing Excessive Activity & Proof of Control
According to this rule, excessive activity as well as proof of control must be established. Even if it can be established that an account has been churned, for liability to exist, it must be proven that the broker had effective control of your account. Proof of control may be established through a written document granting the broker control of your account or by showing that you relied so completely on the advice and recommendations of your broker that the broker was effectively responsible for the number of transactions in your account and their frequency.
- Turnover rate
- Cost-equity ratio
- Use of in-and-out trading in a customer's account
Bringing a Churning Claim to Arbitration
When you bring a churning claim to arbitration, the following will be examined:
- Turnover: The dollar amount of opening buy transactions as compared to the average net worth or equity of the portfolio. The general rule of thumb is that if your portfolio has a turnover of 600 percent or six times the average net worth of the account, then churning most likely took place. This calculation is one of the most important factors in these claims.
- Control: Another key element is who was in control, meaning the person who decided what to buy and sell, how much and when to do it. To have a successful claim, you have to show that your broker or advisor controlled and directed the trading activity in your account.
You Need Meyer Wilson for Your Investor Claim
Meyer Wilson has decades of collective experience doing one thing: recovering client losses against the largest, strongest investment firms in the nation. Our practice, comprised of investment fraud attorneys and securities fraud lawyers, has devoted itself to serving the victims of stockbroker fraud, meaning that we have the skill, experience, and resources necessary to do so aggressively and excellently. We have helped hundreds of clients recover hundreds of millions of dollars in lost assets from the firms that handled them with negligent practices, such as churning.
We have helped clients recover over $350 million. Call us at (888) 390-6491 or complete our online form to request a free case consultation. Let us help you determine your next move.