Did your broker or financial advisor excessively buy and sell securities in your account? Generally, churning is the practice of executing trades in order to generate commission for the broker or financial advisor. For churning to occur, your broker or financial advisor must exercise control over the investment decisions in your account. Churning can be a violation of SEC Rule 15c1-7 and other securities laws.
The Financial Industry Regulatory Authority (FINRA) has rules prohibiting churning and excessive trading. Excessive trading is the same as churning, but without the requirement that the person engaging in the trading does so for the purpose of generating commissions. Churning and excessive trading can violate FINRA Rule 2310, and FINRA Rule 2310-2(b)(2).
It is also against state securities laws and federal securities laws to churn an account. If you are a victim of churning you may have legal rights against your broker and the brokerage firm.
Did you lose money due to a stock broker or financial advisor churning your account?
Broker-client disputes typically involve allegations that a brokerage firm and its registered representative churned or excessively traded a client’s portfolio in order to generate income for the broker and the firm and/or that the client was sold investments which were not suitable given the client’s investment objectives. At the root of churning cases is the question, “Was there a reasonable probability that the securities trading would be sufficiently profitable to cover its cost?”
Economists and securities industry professionals are often called as expert witnesses to assist arbitration panels in determining whether an account has been churned and, if so, what damages have been suffered by the client. Simple ratios and rules of thumb have long served as traditional economic analyses of liability and damages issues in churning cases. However, advances in computer technology and in our understanding of financial economics now allow for more thorough analyses.
The two common indicators of alleged excessive trading in churning cases: 1) turnover ratios and 2) cost-to-equity ratios. Turnover ratios measure how often, on average, the securities in a client’s portfolio are traded in a year. Cost-to-equity ratios measure the annual cost of the trading as a percentage of the client’s investments.
There are three common measures of damages in churning and suitability cases: 1) out-of pocket loss, 2) benchmark portfolio, or well-managed account, damages, and 3) trading costs. Out-of-pocket loss is the change in a client’s equity less any net deposits made during the period. Out-of-pocket loss is an inappropriate measure of damages because it ignores the opportunity cost of invested funds. Also, general market movements that are unrelated to the alleged fraud significantly affect the out-of-pocket measure.
The benchmark portfolio measure of damages corrects the deficiencies in the out-of-pocket loss measure. The benchmark portfolio measure of damages is the difference between what the client’s equity would have been had the portfolio been appropriately managed and the client’s actual equity at the end of the disputed period. The benchmark portfolio measure of damages is most widely used in cases where the primary allegation is that unsuitable securities were purchased for the client.
Trading costs (commissions, bid-ask spreads, mark-ups and markdowns, margin interest, and fees incurred by the client) are a widely used measure of damages in churning cases. Although not generally understood, the simple trading cost measure suffers the same flaws as the out-of-pocket loss because, like out-of pocket losses, it ignores the opportunity cost of invested funds. Fortunately, the adjustment necessary to correct the simple trading cost measure is straightforward and closely related to the benchmark portfolio measure of damages.