Churning is excessive trading that is frequently accompanied by excessive use of margin. A typical scenario involves a broker, who effectively controls the account, engaging in excessive trading on margin for the purpose of generating commissions. Churning is a breach of a broker’s duty to recommend suitable investments and investment strategies.
A written discretionary trading authorization clearly establishes a broker’s control of an account. A broker can control an account, however, without a formal grant of discretion. Control may be established where an investor, although not granting the broker a formal power of attorney, so relies upon the broker that the latter is in a position to control the volume and frequency of transactions in the account.
In order to determine whether a given account has been excessively traded, courts, arbitration panels, and the SEC have looked primarily at two factors: 1) the annual turnover rate of the account, and 2) the “break even” or “cost-equity maintenance” ratio. The most frequently used measure of excessiveness used in churning cases is the turnover rate. It has been described as a measure of the volume of trading that changes the holdings of a portfolio without changing the size. The turnover rate is computed by dividing the total dollar amount of purchases during a particular time period by the average net equity. The SEC and courts have regarded a turnover rate of 6 or more as excessive per se. Excessiveness may be established by much lower turnover ratios. For example, according to a Morningstar survey, approximately 75% of the mutual funds surveyed had turnovers of less than 1.
A second test employed to detect churning is the “cost-equity maintenance” or “break even” ratio. This ratio compares the commissions, margin interest and fees paid by an account with the average net equity in the account, thus determining what the account would have to earn merely to “break even.” Any account that needs to earn 5% or more annually to “break even” may have been excessively traded.