Financial advisors are like any profession – there are good ones and there are bad ones. As long as financial advisors are compensated by commissions, some of the unscrupulous ones will continue to attempt to enrich themselves by excessively trading accounts.
Churning is excessive trading by a broker in a client’s account largely to generate commissions. Churning claims arise out of the inherent conflict of interest involved when a financial advisor is compensated by commissions earned in buying and selling securities on behalf of a client.
So what are the warning signs that your broker may be churning your account? The best clues are usually the documents that you receive from your brokerage firm.
Brokerage firms are required to send you confirmations after every transaction. Unless you are an active, sophisticated trader, there should not be that much trading in your account. For conservative, long-term investors, it is considered general wisdom that buy and hold strategies are the best way to go. So, if you are receiving confirmations once or twice a week, or 10 or more times per month, this may be a warning sign that your broker is excessively trading your account.
Another document that most brokerage firms require that may be a clue is one that is generated any time a mutual fund or annuity is switched for another mutual fund or annuity. Because mutual funds and annuities generally have an upfront load, if a client sells this type of investment shortly after purchasing it, the brokerage firm will often send the client a letter confirming that this is what they want to do or they may have the client sign a form acknowledging that this is what they want to do. Brokerage firms do this because such transactions are often done by brokers looking to maximize commissions and brokerage firms want to be sure that the client is aware of the impact of the switches. So if you have received a number of such forms this too may be a warning sign.
Another clue is an account value that is declining despite an upward moving market, or one that is declining faster than a downward moving market. Unnecessary commissions will work to erode an account and cause the account to underperform relative to the market. As such, large losses can be the best clue that the account is being excessively traded.
If you are the victim of churning, a FINRA arbitration claim against the financial advisor or the financial advisor’s employer is often the best way to recover the damages incurred as a result of the broker’s excessive trading.
To determine whether you may have a viable claim to recover your churning losses, consider that there are three basic elements that must be proven in order to demonstrate that an account has been excessively traded. Those elements are (1) control, (2) excessive trading, and (3) scienter.
Control refers to whether the broker was responsible for the trading (i.e. the trading was not actually done at the request of the investor). This usually involves demonstrating that the broker had either express or implied control over the account. The easiest way to prove control is when the client gives the stockbroker discretionary authority to trade the account by signing a discretionary trading agreement. More typically, though, control is established by demonstrating that the broker had “de facto” control of the account, like when a client always follows the broker’s recommendations.
The second element of a churning claim is demonstrating that the account was actually excessively traded (or churned). Determining whether there is excessive trading in an account depends entirely on the type of account, the investor involved, and the investment objectives of the account. FINRA Rule 2111 regarding suitability states that churning may be evident if trading occurred that was not consistent with the client’s financial goals, risk tolerance, and knowledge of investment strategies.
Churning though is generally determined by looking at the turnover ratio. 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). Courts have found that in retail securities accounts, for a conservative investor, an annualized turnover rate of two is suggestive of churning, of four is presumptive, and, of six or more, is conclusive of excessive trading.
Finally, to demonstrate that an account has been churned, you must establish scienter, or intent. As such, you must also demonstrate that the financial advisor excessively traded the account with the specific intent to defraud, or at least with reckless disregard of the interests of the client. Churning, in essence, involves a conflict of interest in which a broker or dealer seeks to maximize his or her compensation in disregard of the interests of the customer. If the level of trading is high enough, the motivation to create such high commissions, by its very nature, often is all that is necessary to satisfy the element of scienter.
Typically the damages in an excessive trading case are any excessive commissions or expenses the client paid and any actual losses to the client’s portfolio caused by the churning. Even in an upward moving market an investor may be entitled to compensation if it is demonstrated that the account was churned. For example, the damages may be the market gain that should have been experienced had the account been appropriately invested.
Churning claims can be complex and sometimes difficult to prove. Brokerage firms almost always hire experienced securities defense firms to defend them in these claims. If you believe that you are the victim of churning by your brokerage firm or financial advisor, it is recommended that you consult with an experienced securities attorney.
D. Daxton White is the managing partner of The White Law Group, LLC, a national securities fraud, securities arbitration, and investor protection law firm. He has represented investors in virtually every U.S state and litigated over 500 FINRA arbitration claims. Find out more about White at www.WhiteSecuritiesLaw.com. He tweets at @SecuritiesAtty and can be found on Facebook here.