Churning - Definition
Churning is what happens when a stock
broker makes trades in an account more frequently than
necessary, with the sole intent of generating commissions.
Churning is considered an illegal and unethical practice
by a stock broker to earn profit from commissions disregarding
the interests of the client.
Churning Lawsuit Requirements
When an investor files a stock broker churning lawsuit
that results in an arbitration hearing, he or she must
meet three tests of law in order to prevail:
- The broker must be found to have had “control”
over the trading activity. Control is demonstrated
either by a written agreement between the broker and
the investor giving the broker “discretion”
to trade on behalf of the clients, or by showing a
pattern of the investor frequently trading based on
the broker’s advice.
- The broker must be found to have engaged in trading
that is “excessive” given the investor’s
risk tolerance and/or investment objectiives.
- The broker must be found to have acted either with
reckless disregard for the investor’s interest
or with “scienter.” Scienter is a legal
term that means intent. Scienter is an important concept
when making any claim of securities fraud.
Proving Broker Control for the Churning
Lawsuit
If the broker did not have discretion to trade, control
is a difficult concept to prove in the churning lawsuit.
In order to prove broker control for the churning lawsuit,
the investor must prove that he or she trusted the broker
to such an extent that he or she usually acted on the
broker’s recommendation when trading. Obviously,
an inexperienced or unsophisticated investor should
have an easier time than an experienced investor in
proving broker control, but this is not always the case.
Even with investors who have little or no investment
experience, a securities lawyer will often have difficulty
getting an arbitration tribunal to agree that the broker
had de facto control, despite the millions of dollars
that brokerage firms spend annually barraging investors
with the notion that a broker is a “trusted advisor”
who cares about “only you” and serves “one
client at a time.”
Proving “Excessive Trading”
was done for the Churning Lawsuit
It is possible to mathematically calculate whether
a brokerage account has been traded in an excessive
manner. This is done by performing two calculations.
One is to compare the "turnover ratio” to
the turnover ratio of mutual funds. The annualized turnover
ratio tells you what percentage of your portfolio’s
value has been turned over in a year. A turnover ratio
of 1.0 means that the entire value of the portfolio
has been turned over. This does not mean that every
item in the portfolio has been sold and new items bought,
only that the monetary value has been turned over.
Finance and securities law experts have shown that
most “conservative” mutual funds turn over
about 0.5 times annually, and the most aggressive mutual
funds turn over up to 1.18 times annually; the average
fund turns over about 0.8 times annually. If professional
money managers turn over a portfolio this frequently,
there is no reason a stockbroker should be turning over
a client portfolio any more frequently, other than his
or her desire to earn additional commissions.
The other necessary calculation is the portfolio’s
cost-equity ratio, sometimes called the “break
even” ratio. The cost-equity ratio shows how much
the portfolio would have to return in order to cover
costs of trading and any margin-loan interest.
Victim of Churning
If you suspect you are a victim of churning, you should:
- gather your monthly brokerage statements
- bring them to your accountant
- ask your accountant to perform a turnover
and cost-equity ratio analysis
- if the turnover ratio is greater than 3.0
or the cost-equity ratiio is greater than 5 percent,
consider filing a claim for arbitration against the
broker and brokerage firm.
Churning is only one way that stock brokers can commit
fraud against investors. Others include unauthorized
trading, forgery, and misrepresentation.
To avoid becoming a victim of churning or any other
stock broker fraud, I recommend using a registered investment
advisor (RIA) who invests in passively managed funds
through Dimensional Fund Advisors (DFA) or investing
directly in low transaction cost index funds through
a company such as Vanguard.
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