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.

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:

1. The stockbroker, not the investor, controlled the activity in the account; and
2. 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:

1. Level of client sophistication, which may include education and occupation;
2. Client trust and reliance upon the stockbroker;
3. Time the client devoted to his or her own, independent research;
4. Previous securities investment experience of the client; and
5. Extent to which the client understands the investment strategy.

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.

Whatever you decide to invest in, there will always be fees, costs, and other related expenses. Many investors may just consider them “the cost of doing business,” but may not consider what it means for their portfolio and individual investments.

Charges and fees may seem small but add up quickly. Over time, they can erode the amount of your investment and your portfolio. Money spent on fees and costs is money not invested and lowers your returns over time.

You should regularly examine your statements from your brokerage to see what your account is costing every month, such as:

• Transaction fees are those charged whenever you buy, sell, or exchange an investment, and can lower your total portfolio amount. If you go with a broker, chances are their commission is bundled into the charges.
• Front-end and back-end loads are charges associated with mutual funds. The front-end is charged when an investor makes the investment, and the back-end is charged when the investor sells during a specified period.
• Surrender charges are charged for the early withdrawal from a variable annuity investment, which are normally from 6 to 8 years, but could be as long as 10. The charge is a percentage of the amount withdrawn, with the percentage gradually declining over the term of the annuity.
• Commissions, when trading, buying or selling
• Ongoing fees are those that are part of the monthly or yearly continuance of your account and can also lower the value of your portfolio, including:
  • 401(k) fees, for administering and operating the account, in addition to any fees for mutual funds that may be included in the plan.
  • Annual operating expenses. Mutual funds and exchange-traded funds (ETFs) are investment vehicles created and overseen by seasoned investment experts. As part of their management and promotion, these investment products entail various expenses and charges, which are typically passed on to the investor in the form of fees deducted from the fund's assets. These ongoing fees, paid annually, encompass management fees, distribution (and/or service) fees known as 12b-1 fees, and other incidental costs. These fees are identified as a percentage of the fund's assets. They are outlined in the fund's prospectus as the total annual operating expenses, also referred to as the fund's expense ratio.
• Miscellaneous fees, such as account maintenance, advisory fees, fees for not having a minimum balance, account inactivity, account transfer, wire transfer, or others.
  • Annual variable annuity fees. If you decide to invest in an annual annuity, you may be charged fees for its administration. There may also be fees called riders, which are for insurance as well as other optional features. Additionally, you may be charged any fees for mutual funds and other investments held in the annuity.

These are just some of the many fees and charges that you may encounter in an investment or brokerage account.

The fees and costs charged to you may not always be explicitly indicated on your account statement or confirmation statement. You should proactively seek information about all fees levied and understand the reasons behind them. If any of the fees are confusing or unclear, you should reach out to your broker-dealer and request a thorough explanation of everything.

As a portfolio grows, so does the amount of fees. In an example from Investor.gov, three investment strategies with different fee and cost amounts have markedly different returns on three investments of $100,000 each over a 20-year period with a 4% annual return:

• The first investment has annual fees of .25%, with an end balance of $220,000.
• The second investment has annual fees of .50%, reducing the investment by $10,000, and an end balance of just under $200,000
• The third investment includes annual fees of 1.0%, reducing the investment by nearly $30,000, and an end balance of just under $180,000.

The difference is considerable and could be reinvested. That’s why understanding the impact of fees and costs requires long-term thinking.

Investors must carefully consider any recommendations made by their broker, and always do their own due diligence before investing any money. Customers who do not at least review any recommendations risk signing up for something that could cost more than they anticipate.

Two customers, both elderly males, were customers of a broker named Mirsad A. Muharemovic (CRD# 312259) who made recommendations. Because they trusted him, both accepted Muharemovic’s recommendations without question, even when it required the risky step of buying on margin. Additionally, Muharemovic engaged in excessive trading, buying and selling more often than necessary, which charged these customers excessive fees and commissions. One customer recognized losses of $185,966 in his account, while the second customer lost $74,338 in two accounts.

It’s possible. One big difference is actively managed fees vs. passively managed fees. A report from Morningstar shows that actively managed fees average 1.2%, while fees for electronic traded fund (ETF) average 0.44%. In that same report, Morningstar found that lower fees led to better investor returns.

Moving money around can make things more expensive, so it’s important to know when to move money and when to wait. Each trade includes costs. An investment that’s traded more often than it should be will also cost more and can negatively impact your principal. That’s why buying and holding tends to have better returns than trading frequently.

Before you open an account, make sure you understand the fees and costs associated with the account. If you believe they are too high, ask your broker or broker dealer for ways to lower your investment costs. But if you discover that you are being over-charged for costs associated with your account, and your broker doesn’t help, Silver Law Group can give a full review of your accounts.

Silver Law Group represents investors in securities and investment fraud cases. Our lawyers are admitted to practice in New York and Florida and represent investors nationwide to help recover investment losses due to stockbroker misconduct. If you have any questions about how your account has been handled, call to speak with an experienced securities attorney. Most cases are handled on a contingent fee basis, meaning that you won’t owe us until we recover your money for you. Contact us today at (800) 975-4345 and let us know how we can help.