What is Excessive Trading or Churning?
Excessive trading, or “churning,” is a practice of stockbrokers that constitutes fraudulent behavior that can be a cause of action in a Financial Industry Regulatory Authority (FINRA) arbitration claim for damages. Excessive trading can cause significant losses for investors, while benefiting the stockbrokers, as well as the brokerage firms they work for.
How Excessive Trading Works
Excessive trading occurs when a stockbroker engages in trading in excess of the investor’s goals in order to generate commissions. If the recommended investment strategy has, as its sole purpose, the enrichment of the brokerage firm and/or stockbroker by generating excessive commissions, fees, or costs, it may constitute a breach of fiduciary duty and a conflict of interest.
Ordinarily, a claim against a brokerage firm or stockbroker will be successful if the investor can prove the following:
- The stockbroker, not the investor, controlled the activity in the account; and
- The activity in the account rose to the level of excessive trading (or churning), based on the investor’s risk tolerance and investment objectives.
An investor who suspects that he or she has been harmed by excessive trading or churning can bring an arbitration claim against the brokerage firm or stockbroker. The arbitrator or securities arbitration panel will look to several factors in determining whether the stockbroker exercised the necessary control over the account, including, but are not limited to, the following:
- Level of client sophistication, which may include education and occupation;
- Client trust and reliance upon the stockbroker;
- Time the client devoted to his or her own, independent research;
- Previous securities investment experience of the client; and
- Extent to which the client understands the investment strategy.
Determining Excessive Trading
In determining whether the trading was excessive, the use of statistical formulas is common. Under FINRA rules, “factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer’s account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.” The turnover ratio measures the overall level of activity and is calculated by dividing the total annual purchases by the average balance of the account during a year.
The higher this number is, the higher the level of activity in the account. The turnover is the percentage of mutual funds or other holdings that have been replaced with different holdings, or “turned over,” during a year. A higher turnover will generate more brokerage transaction fees. When brokers artificially increase turnover in order to generate fees, an action for fraud may exist.
In addition to the turnover ratio, the cost-equity ratio is also used in evaluating a trading strategy. This ratio measures the total annual costs incurred from an investment strategy. It may also be called the breakeven rate of return. The cost-equity ratio is calculated by dividing the total annual costs (which include commissions and margins interests) by the average balance in the brokerage account.
Churning occurs at major Wall Street firms as well as many small or regional firms. We still see many cases including stockbrokers who cold call investors and then engage in excessive trading. In many cases we see churning combined with unsuitable investments in penny stocks or other speculative investments.
If you would like more information about the arbitration process through FINRA, speak with an experienced securities law attorney at the Silver Law Group today. Our firm proudly uses our expertise and knowledge in representing investors harmed by stockbroker and brokerage firm misconduct.
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