The SEC defines “churning” as “the excessive buying and selling of securities in your account by your broker, for the purpose of generating commissions and without regard to your investment objectives.” If your broker has been aggressively trading your account (or urging you to trade your account) directing a high volume of trades that make money for him but not for you, there is a good chance that he is guilty of churning the account.
FINRA, the self-regulatory agency of the financial industry, has strict rules against churning, which is a violation of the broker’s duty to only make investment recommendations that are suitable for the client’s investment objectives. Churning often occurs at the end of a quarter, year, or sales promotion period, when brokers may have an incentive to run up commissions in order to reach a sales goal, to win a sales contest, or qualify for a higher percentage or bonus. Brokers who are contemplating a move to another firm also have a particular incentive to churn accounts, because their compensation at the new firm is typically based upon their previous production.
Many churning cases also involve unauthorized trading, because a broker is not legally permitted to make a trade on behalf of a client without prior approval as to the name of the security and the amount to be purchased?unless the broker has a power of attorney, which is rare. Often unscrupulous brokers will gain the confidence and trust of a client and then assume de facto control over the account without proper legal authorization, which is fraught with the possibility for excessive trading and other abuses.
According to investor’s rights attorney Craig T. Jones, “if the equity in an account is completely turned over more than once or twice a year, there is a good chance that the account is being excessively traded to generate commissions.” Jones, is a partner in the Atlanta law firm of Page Perry, which represents investors in securities industry arbitrations all over the country ? many of which involve allegations of churning and other unsuitable trading. “There are court decisions,” says Jones, “that have held that there is a rebuttable presumption of churning if the annualized turnover rate in an account is greater than 6?for example, if the account was being traded so aggressively that it would turn over more than 6 times if that level or trading were maintained for a full year.” Many experts have concluded that a much lower turnover rate qualifies as churning.
Another metric that is often used to determine if an account is being excessively traded is the cost-to-equity ratio, which is a measure of the trading costs, or commissions, over the value of the account, expressed in terms of an annualized percentage that demonstrates the impact of excessive trading on return. For example, a cost-to-equity ratio of .10, or 10%, means that that the account must earn a return of greater than 10% before the account breaks even after recouping trading costs. “If your account is generating a 10% gross return but it is being traded so heavily that you need a 20% return to cover the commissions, then you are losing money and all of that trading is benefiting no one but your broker,” says Jones.
Jones also points out that every case is different, and numbers alone do not tell the story. “For example, investments like mutual funds and annuities are not trading vehicles. The purchase and sale of those investments within a short period of time is almost always indicative of excessive trading. If you believe that your investment account is being mishandled by your broker or financial advisor,” says Jones, “we are always happy to take a look and let you know your legal options.”