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.
Under FINRA Rule 2110 brokers are required to “observe high standards of commercial honor and just and equitable principles of trade.” NASD Rule 2310(a) 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. Included in this rule is the obligation of “quantitative suitability,” which focuses on whether the number of transactions within a given timeframe is suitable in light of the customer’s financial circumstances and investment objectives.
In order to determine whether trading has been excessive, two commonly measured metrics are used: 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.
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.
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 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.
It is 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.