Investors are oftentimes curious about what "churning" is and how it relates to a brokerage account. Churning is a form of unsuitable recommendations and trading activity, and is also called excessive trading. Churning occurs when a securities broker engages in securities transactions and manages a customer's account for the purpose of generating commissions, at the expense of (instead of the benefit for) the client.
Churning typically has three elements:
1. Control. For churning cases, the broker must control the account. Control can be through explicit control such as a written discretionary agreement, or it can be de facto control, where the broker assumes control of the account through the client's acquiescence, trust, or reliance. For example, if a client always follows a broker's advice, the broker may be found to have de facto control over the account.
2. Excessive trading. The trading in the account must be considered excessive in view of the customer's investment objectives and other suitability information.
3. Scienter or Intent. There typically must be some type of required mental state of the broker (an intent element) to prove churning.
How is it determined that the trading in an account is excessive? A primary test for excessive trading is the relationship between the net amount of money invested and the transaction costs (commissions, margin interest, etc.) that are incurred. To that end, when evaluating whether an account was churned, an expert typically reviews the account activity and determines the cost to equity maintenance factor (or break-even factor). This demonstrates that percentage of return on the customer's average net equity needed to pay the commissions and other expenses, such as margin interest, associated with the trades. In many instances, a break-even rate of 8% may be presumed to be excessive trading, while a 12% rate is generally conclusive. But, this factor cannot be used alone, but must be considered along with the nature of the accounts, the stated investment objectives, the control exercised by the broker over the account, and that character of the trading. Another method used in analyzing excessive trading is the average annualized turnover rate, which measures the number of times an account turns over in a given year.
If you think your account may have been churned, contact a competent securities attorney for an evaluation.
