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Churning (Excessive Trading)

“Churning” is essentially investment trading activity that is excessive and serves little useful purpose and is conducted solely to generate commissions for the broker. The elements to establish a churning claim are:

  • Excessive purchases and sales of securities for the purpose of generating commissions; and
  • Broker control.
Excessive Trading

According to FINRA, there is not one single test that ultimately determines whether trading has been excessive. In order to determine whether trading has been excessive, there are two commonly measured metrics: the account's ‘annualized turnover ratio’ and its ‘cost to equity ratio,’ which is also known as its ‘break even percentage.’

The turnover ratio of the account is widely regarded as the litmus test for determining whether an account has been churned. Depending upon the objectives of the account, a turnover ratio as much as 1 to 1 can support a finding of churning. However, churned accounts typically will experience turnover ratios in the 3 to 6 range. However, some courts have found that an annualized turnover rate of between two and four is sufficient to gain a presumption that an account has been churned by a broker and requires the broker or brokerage firm to then prove it did not churn the account. The burden shifts.

The cost to net equity ratio measures how expensive the trading strategy was in the account. For example, an annual cost to net equity ratio that is 5% would require the account to earn a 5% profit to breakeven. The more expensive the trading strategy is to employ in the account the more likely excessive trading will be found. However, as the total value of the assets under management increases, the client ought to be able to achieve economies of scale and discounts sufficient to lower the cost of trading.

When reviewing churning cases, it is important to determine the broker’s commission rate and total commissions in the account as well as the excessive trading in the account. When the commissions are high, it serves as additional evidence for a claim of churning.

Broker Control

Broker control is established by the broker’s solicitation of the transactions or discretion over account activity. If the customer accepts the recommendations of the broker to trade in the account control may be found. Control of the customer account can either be expressed or implied. Express control exists where the customer has a discretionary account established pursuant to a written agreement giving the broker discretionary trading authority without first consulting with the investor. Implied authority, or de facto control, is determined by the investors: 1) age; 2) education; 3) business acumen; 4) investment experience; 5) knowledge of investments; 6) frequency of trades; and 7) initiation of trades versus the broker’s initiation of trades.

Generally speaking, under FINRA Rule 2110 brokers are required to “observe high standards of commercial honor and just and equitable principles of trade.” FINRA Rule 2111 provides that in recommending securities, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer based upon the customer’s financial situation and needs. This rule requires a broker to conduct “quantitative suitability” analysis. Quantitative suitability focuses on whether the number of transactions within a given timeframe is suitable in light of the customer’s financial circumstances and investment objectives and is similar to a claim of churning, but generally is easier to prove at an evidentiary hearing.

It is also important to note that pursuant to FINRA Rule 12206, no claim is eligible for arbitration where six years have elapsed from the event or occurrence giving rise to the claim. These issues are generally resolved by the FINRA panel but if you believe you have a viable churning claim, you should contact an attorney immediately.

The lawyers at Gana Weinstein LLP have had extensive experience successfully suing brokerage firms for churning. If you believe you have been a victim of churning, contact us. Our attorneys have handled churning cases for nearly two decades. Our team analyzes accounts to determine whether the necessary elements have churning have been met.

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