Churning

Churning occurs when a broker engages in excessive buying and selling of securities in a customer’s account for the primary purpose of generating commissions for the broker’s benefit. This type of trading by a broker that is excessive in size or frequency is recognized as a fraud on the customer. As such, it is prohibited under both Section 10(b) of the Securities Exchange Act of 1934 and SEC Regulation 10(b)(5). In addition, various state laws including those adopted under the Uniform Securities Act also prohibit the practice, as do various consumer protection statutes and other rules governing brokers.

Ratios used to Determine Whether Churning has Occurred

Churning is often analyzed by looking at the turnover ratio of the account. This is the total sales in the account divided by the average value of the account in a given year. The higher the ratio, the more likely a churning charge can be sustained. There is no set turnover ratio that establishes the violation nor is that the only factor to take into account. Another measuring stick is the commission to equity ratio which looks at the total commissions from trading compared to the average amount of the customer’s investments over a period. Finally, the total cost to equity ratio adds in the margin interest income and any other expenses are added and then compared to the average value of the customer’s investments over a period.

Other factors in churning cases involve patterns of sales of securities. For instance, the sale of securities shortly after they are purchased may be evidence of churning.

Customer Sophistication

Determining whether churning has occurred is based on the totality of trading in the account and will typically need to be analyzed by a professional. Therefore, a defense that the customer acquiesced to the trading is difficult to establish because an average investor may not be able to identify churning. However, where the customer was highly sophisticated and agreed to the trading after reviewing a high-velocity trading program, it may be successful to argue that the investor knowledgeably agreed to the excessive trading program.