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STOCK ISSUES

Churning in Stock Accounts ...

Churning or trading by a broker in a customer account that is excessive in size or frequency has long been recognized as a fraud on the customer in the United States. As such, it is prohibited under both Section 10(b) of the Securities Exchange Act of 1934 and Regulation 10(b)(5) of the Securities Exchange Commission. In addition, various state laws including those adopted under the Uniform Securities Act also prohibit the practice, as do various consumer protection statutes.

The defining characteristic of churning is that it is entered into primarily or exclusively for the benefit of the broker initiating the trades, who derives commission income and possibly other income from it, and not for the benefit of the customer. More particularly the elements of the fraud are that

1. The broker have control of the account either by virtue of a formal grant of discretion (a so-called “discretionary account”), or that he have control in a de facto sense in that he is recommending most if not all of the trades, with a passive or unsophisticated customer who is responsible for few or none of the trades.
2. That the trading is excessive in size or frequency and
3. That the broker is acting willfully, or with disregard for the interests of the customer (the so-called “scienter” requirement).

In practice scienter is often inferred from the presence of the first two elements, but it is always wise to plead it and present evidence if it is present. Cases have been known to fail for lack of independent proof of willful or reckless disregard.

Important Ratios

Churning is an offense that is to be determined based on all the facts of a situation. Nonetheless, measurement of trading activity relative to account equity is an important part of any determination that churning has occurred. This may be done by first determining the annualized “turnover ratio” from

Annualized Turnover Ratio =
(Total Purchases / Average Equity) x (Number of Months Traded / 12)

Thus, if total purchases over 3 months equaled the total average equity in the account the raw turnover ratio is 100%. This ratio is 400% when annualized. Notice also that the ratio is assessed based on purchases that have been initiated by the broker, not sales.

To understand this ratio in a client’s investment account consider a situation where a broker has taken over an account from another broker and concludes that all of the securities positions in it are inappropriate, and proceeds to replace them with entirely new positions. If he sells all of the old positions and uses the proceeds to purchase an entirely new portfolio with all of the account assets, then the turnover ratio will be 100%, or 1 in absolute terms. Of these new purchases, what percent are likely to mature, or reach their investment goal within the next year? Alternately, what percent are likely to fail to perform to the level that led to them being purchased in the first place? 25-50% may be a reasonable estimate of those that either reach their investment objective or perform so badly they must be sold within the year. Therefore, under these circumstances a 1.25 to 1.5 annualized turnover ratio may be expected in the first year of an investment account that has just been established, or transferred from one brokerage house to another.

In subsequent years, barring major market turmoil, by the same thinking, a turnover ratio of .25 to .5 is to be expected. Should major market disruption occur, repositioning of the entire portfolio may again be necessary with turnover ratios perhaps approaching 1.25-1.50 in such a second time period.

In a trading account there is room for turnover ratios of 4, 5 or 6 in appropriate circumstances. Such ratios are permissible where there is a trading plan that is suitable for the client, and to which he has knowledgeably agreed.

In addition to the turnover ratio, two other ratios are of interest:

• Commission / Equity Ratio: This consists of the total commissions relative to the average equity over a period.
• Total Cost / Equity Ratio: Here margin interest income, if present, is added to total commissions in the above ratio in order to see the total income to the brokerage house from the account over the period. Interest income from margin borrowing is potentially huge. In a recent year, Merrill Lynch earned approximately $3 Billion from interest income through margin borrowing in customer accounts. In a particular account if heavy margin borrowing is present, the Total Cost / Equity Ratio is likely to considerably exceed the Commission / Equity Ratio.

To these important ratios can be added such factors as the ratio of the commissions of the particular account to the total commissions of the broker, the total of such commissions to the total income of the branch, and other factors to assist in evaluating whether churning has occurred. Other motivational factors if present such as broker debts and flamboyant lifestyle may assist in reaching a conclusion that churning has occurred.

A final point …

Churning is a unitary offense. It is usually based on the total trading in the account and can only be pronounced with certainty by a professional after considerable trading has occurred. Thus alleged ratification by the customer is often a poor defense. In contrast, where the customer was sophisticated and had knowledgeably agreed to the trading after, say, having been presented with a high-velocity trading program that made money in the past he may then be said to have meaningfully ratified such a trading program.

Based on the above, annualized turnover ratios exceeding 50-100% per year are inherently suspect in securities investment accounts, although ratios of 600% per year have been found to be acceptable for trading accounts.

CHURNING IN MUTUAL FUNDS

Often a customer will have an account that is exclusively invested in mutual funds or a combination of mutual funds and stocks. What does churning mean in this context? The nature of the offense is the same: the account is being traded for the benefit of the broker, and not the customer. Here the goal for the broker in short term trading of load-type mutual funds may be to realize repeatedly the sales commissions, which can range to as high as 8% or more for individual funds.

If this happens in the context of an investment account that also contains stocks, it may be possible to analyze for churning using the activity ratios from the previous section without alteration. If the SEC and various brokerage firms use, say, a 3% commission/equity ratio to flag potential abuse in a stock-only account, should not this ratio apply as a starting point where some load-type mutual fund trading has occurred in the account? After all, the result to the customer's account is the same: the earning of a like amount of wrongful income by the broker. In the case of mutual funds the review of the factors that should accompany any churning analysis should also focus on such factors as the similarity (or lack thereof) of the fund being exchanged, the strength of the reasoning in abandoning the earlier fund(s) after a load fee has been paid, and other similar factors. But notice that when applied to a portfolio containing mutual funds only, in all probability the exchange of one or more funds with a second load fee charged may exceed any preset limit such as the 3% above. This results as mutual fund portfolios are typically limited to only a few funds.

Finally, it is interesting to inquire if churning can occur within a mutual fund. Certainly, if the trading is excessive relative to the goals of the fund as indicated in its prospectus, and if the advisor receives some benefit from the commissions generated, the possibility can be contemplated. To the author’s knowledge this has happened at least once, albeit in a commodity fund and not a mutual fund. Here the fund’s adviser traded through a broker who shared the excessive brokerage commissions with the adviser.

A Note of Caution in Churning Cases

Churning cases are among the most time-consuming for an expert to prepare because of the excessive amount of trading involved. Therefore an attorney with a case where he suspects churning has occurred should be careful to get an early start in selecting a stock churning expert witness and in initiating what forensic analysis it is agreed that the expert will perform.