“Churning” is excessive investment trading activity by a broker in a client’s account done to generate commissions for the broker.
Account churning is unethical and illegal. A victim of churning can pursue a claim for recovery of any lost money.
The Problem with Churning
Financial advisers’ duties include making suitable investments and placing the interests of their clients above their own.
However, because advisers are sometimes paid commissions when they make trades, some advisers engage in unnecessary and excessive buying and selling. They “churn” a client’s account to generate additional profits for themselves.
The transaction fees, potential tax liabilities, and poorly performing investments that commonly result from churning are not in the client’s interest.
Account churning, whether done in isolation or in combination with unsuitable investments or other unethical practices, violates Financial Industry Regulatory Authority (FINRA) principles, such as the principle of “quantitative suitability,” as well as various state laws.
Elements of a Churning Claim
An investor wishing to bring a churning claim against a financial adviser/brokerage firm must establish excessive activity and proof of control.
Proof of control means the broker/firm had effective control of the investment account. No single test defines excessive activity, but the following factors may provide evidence:
- Turnover ratio: Turnover ratio is the total value of annual purchases made in the account divided by the account’s average monthly balance. An annualized turnover rate of 4 to 6 or higher typically indicates churning, but churning does occur at lower rates.
- Cost-equity ratio: The cost-equity ratio (or “break even percentage”) measures how expensive the account’s trading strategy was. To calculate the cost-equity ratio, divide the total annual costs (including commissions and margin interests) by the account’s average balance. Trading that requires an account to earn annual returns of 15-20% or more indicates possible churning.
- In-and-out trading: Buying and selling the same investment repeatedly is known as in-and-out trading, or “wash” transactions.
Clients who successfully demonstrate that their account was churned can typically recover damages for excessive commissions or expenses and any portfolio losses caused by the churning (including market gains that should have been realized had the account been properly managed).
Churning claims can be difficult to prove and should be discussed with an attorney.
