Most investors have heard the term Churning. This article discusses the definition of churning, why brokers may engage in churning, how to spot churning and what to do if you think you are a victim of churning.
Churning occurs when a broker trades an account excessively, with his primary purpose being the generation of commissions for the broker and his company. In other words, the broker uses your life savings as his personal piggy bank, subject it to great risk in order to generate revenue.
Churning is both illegal and unethical. Brokers that engage in churning risk being fired, being named in a regulatory action, and being named in a FINRA arbitration by the customer he took advantage of.
The Basics of Churning
Churning generally implies high trading volume. There are several methods utilized to measure whether the activity in the account rises to a level that it constitutes churning. The methodologies typically used when making the presentation of a churning case to an arbitration panel include:
- Cost-Equity Ratio: this measures the cost to the investor, generally measured as the annual percentage. It is calculated by dividing total costs (commissions, interest, fees) by the average balance in the account. The resulting percentage is the break even point, ie; how much does the account have to make just to pay the firm, and before the account holder makes anything. We have seen cases where the cost-equity ratio is 15% and greater. This means that for the account holder to realize a 5% gain, the account has to make 20%
- Turnover Ratio: this is calculated by dividing the amount of annual purchases in the account by the average balance of the account. For the typical retiree, seeking conservation of principal and low risk tolerance, this ratio should be 50% or less. We have seen cases where the turnover is 2-300% annually.
Churning (sometimes referred to as ‘twisting’) can also occur with products like annuities, insurance, and mutual funds. These products typically generate high commissions for the broker and his firm. Brokers choosing to do the wrong thing for the customer will have the customer liquidate a mutual fund, insurance policy or an annuity and immediately purchase a replacement product, giving the customer some inaccurate and misleading reason for the change. In abuse cases the replacement product is not substantially different that the product it replaced. All that has been accomplished is the generation of additional commissions for the broker and his firm.
Churning is Bad for the Customer
Churning does nothing beneficial for the customer and only serves to generate commissions for the broker and his firm. The problem is further exacerbated by the fact that the broker has to take greater risk with your money in order to cover his high commission rate plus some kind of return for you.
Regulatory Provisions Dealing with Churning
The Securities Exchange Act and SEC Rule 15c1-7: clarifies the definition of manipulative, deceptive, or other fraudulent device or contrivance to include excessive trading by a broker.
SEC Enforcement Action-Example of Excessive Trading
In the Matter of Paul T. Lebel
The SEC charged a broker for churning the accounts of 4 customers and found that the broker engaged in excessive trading of mutual fund A shares, which are designed for long term investing, to the detriment of the customers and with no justification other than to generate commissions.
FINRA Rule 2111: requires, in part, that a broker must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security is suitable for the customer, based on the information obtained through reasonable diligence of the firm…
Identifying and Avoiding Churning
Signs of Churning
- Excessive amounts of trading. Are you receiving an unusual number of trade confirmations?
- Unauthorized trading. If you have a non-discretionary account is the broker making trades that he has not discussed with you? Did you grant authority for these trades?
- Unexplained losses. Check your statements regularly.
Seeking Recourse
If you think you are a victim of churning, call Rex Securities Law to discuss your situation with an experienced securities lawyer.
We have been helping investors deal with these kinds of issues for 30+ years. We do not charge to evaluate a case and welcome your call. If you think your account has been mishandled in any manner, call to speak with experienced investment fraud lawyer Bob Rex at (877) 224-3199 for a free consultation.
