Applicable law/agency: Securities and Exchange Commission (SEC), National Association of Securities Dealers (NASD)
Related topics: Securities, Breach of Fiduciary Duty, Failure to Supervise, Stock Market Losses, Unauthorized Trading, Broker Fraud
Churning is a breach of the National Association of Securities Dealers (NASD) Fair Practice Rules in which brokers trade client assets in order to increase their own commission. Churning is also a breach of rules set out by the Securities and Exchange Commission (SEC) and the New York Stock Exchange (NYSE). Brokers or advisors who participate in churning must be bound by fiduciary duty, or have enough control over a client’s account to trade without specific authorization. A turnover ratio may be calculated to determine if trading is excessive. A turnover ratio is a comparison between the number of purchases made in an account and the equity in the account.
Securities Laws Prohibit Excessive Trading Solely For Broker Gain
Churning is an unethical practice employed by some financial advisors/brokers to increase their commissions by excessively trading in a client’s account. This practice violates the National Association of Securities Dealers (NASD) Fair Practice Rules, well the New York Stock Exchange (NYSE) and Securities Exchange Commission (SEC) rules. The specific rules that prohibit churning are the NASD’s churning rule, Rule 2310-2(b)(2) and the NYSE’s churning rule, Rule 408(c).
For churning to occur, the broker must exercise control over the investment decisions in the client’s account, having “fiduciary duties”. This duty occurs either through a formal written discretionary agreement or through “de facto control” of the trading in the account. In addition, the advisor/broker must engage in excessive trading in light of the financial resources and character of the account, risk profile and investment goals, for the purpose of generating higher commissions.
An account that is churned will frequently exhibit some of the following characteristics:
• Excessive and/or frequent trades, frequently without prior authorization of the client.
• High commissions generated by the trading activity.
• Short-term trading, frequently without any significant gain or loss on the transactions.
• Control of account by broker, either through a written discretionary agreement or through the broker’s undue influence over the client.
When an account is reviewed to determine if the trading in the account is excessive, the first determination is the type of account being analyzed. Churning is not a simple concept, and neither is excessive or frequent trading. The type of investments in the account must also be considered. Option and margin accounts typically require a different type of analysis than an account that invests in equities or bonds.
To determine whether the trading is excessive for the goals of the account, the most often used analysis is the calculation of a “turnover ratio”. A turnover ratio is the total amount of purchases made in the account, divided by the average monthly equity in the account. That ratio is then annualized (by dividing the result by the number of months involved to get a per month ratio, and then multiplying that result by 12) to determine the turnover ratio. Turnover ratios may be an indication of excessive trading relative to the investment objectives established.
To establish if excessive commissions have been generated a review of the investor’s complete investment portfolio and the fees associated with the trades, including short term trading without any significant gains or losses, is necessary.
The most difficult part of a churning analysis is a determination of whether the broker had control over the account, unless there is written documentation. Control is a key fundamental element of a churning claim. If the customer entered every trade without any suggestions by the broker, and therefore controls the account, churning is not an issue. If not, there may be a control component that requires additional investigation. Brokers who engage in the practice of churning may be liable to a client for the extra fees and/or commissions earned in that account.