Another form of stockbroker misconduct or investment fraud includes excessive trading or churning. Securities brokers are typically compensated by each transaction effected in your securities account. Sometimes brokers effect these transactions in your account, not for the purpose of reasonably fulfilling your stated investment objectives, but instead in an effort to generate excessive commissions for themselves and their firm. Such conduct is called churning. See Mauriber v. Shearson/American Express, 567 F. Supp. 1231, 1237 (S.D. N.Y. 1983)(“No member shall affect in any accounts which such member or his agent or employee is vested with any discretionary power any transactions or purchase or sale which are excessive in size in frequency in view of the financial resources and character of such account.”) Mihara v. Dean Witter & Co., 619 F.2d 814 (9th Cir. 1980); Hecht v. Harris, Upham & Co., 283 F.Supp. 417 (9th Cir. 1980)(Where the customer routinely follows the broker’s advice, control will generally be found).
Churning is a type of fraudulent conduct in a broker-customer relationship where the broker over-trades a customer’s account to generate inflated sales commissions. According to FINRA Conduct Rule IM-2310-2, churning occurs when, to generate excessive commissions, a broker causes securities in a customer’s account to be bought and sold with a frequency too great in light of the customer’s financial needs, resources, and investment objectives.
Rule 2310(a) provides that “[i]n recommending to a customer the purchase, sale, or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.” Among the obligations under such suitability rules is “quantitative suitability,” which focuses on “whether the number of transactions within a given timeframe is suitable in light of the customer’s financial
circumstances and investment objectives.” Dep’t of Enforcement v. Medeck, Complaint No. E9B2003033701, 2009 FINRA Discip. LEXIS 7, at *32 (FINRA NAC July 30, 2009).
The necessary elements for a churning claim are:
- that the broker effectively exercised control over the account (either de facto discretionary authority or the customer always agreed to every purchase and sale recommended by the broker);
- the broker engaged in excessive trading in light of the character of the account; and that
- the broker acted with intent to defraud or with willful or reckless disregard for the interests of the client.
Churning or excessive activity is examined in light of the customer’s investment objective and the type of securities being traded. For example, it may be inappropriate to pay a sales charge by buying and selling a mutual fund in a period of, let us say, a year. The short term trading of fixed income securities over a period of year may also be inappropriate. However, during this same period, it may not be inappropriate for a person seeking to trade options turn over their account twenty times.
Churning is often measured by the account’s “turnover rate,” or the total purchases divided by the average value of the account. Most often churning is marked by short holding periods without any appreciable change in securities prices. Other indicia of churning or excessive activity are transactions costs. The “Goldberg rate” or how much would the account have to generate simply to break even after transaction costs. Once again, what is reasonable depends on the nature of the account. the securities being traded and the measure of anticipated returns.