Mark J. Astarita is a nationally known securities attorney who represents investors and financial professionals in arbitration, compliance and regulatory matters. If you have a question, email him at email@example.com.
Churning claims dominated the securities arbitration landscape in the early part of this decade, but have declined over the years, as the trading mania waned. As the markets improved, we have begun to see a resurgence of churning claims again.
The common perception among the general public is that a customer who trades his or her account on a regular basis is a broker’s dream. While the commissions generated by such activity might very well enhance a broker’s payout, the activity could very easily turn into a broker’s nightmare if not carefully monitored.
Churning is excessive trading in a customer’s account by a broker taken in the context of the customer’s financial situation and investment objectives. While no one test is available to determine if an account has been churned, churning requires three elements, first, excessive trading, and second, control of the account by the Registered Representative, and three, intent to defraud the customer. The intent element is difficult to prove, but will typically be proven by establishment of the first two elements.
The problem with customers who trade heavily with a retail broker is that the broker may later be subjected to a claim for churning, if the trading does not turn out to be profitable. While it may sound like we are once again talking about rogue customers, the situation is not limited to those customers – the potential for a churning claim exists with even the most honest customers – if they do not fully appreciate the risks of frequent trading.
When an account is examined to determine if the trading in the account is excessive, the first determination is the type of account that is being analyzed. Churning is not a simple concept, and neither is excessive trading. A level of trading, in the context of a day trader’s account may be perfectly acceptable and proper, while the same level in a retiree’s account would be outrageous.
One would expect that an account which is engaged in speculative day trading will have a higher frequency of trades than an account which is designed for long term investing. The type of investments in the account must also be considered. Option and margin accounts typically require a different type of analysis than an account that invests in equities or bonds.
To determine whether the trading is excessive in light of the goals of the account, the most often used analysis is the calculation of a “turnover ratio”. A 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). An annualized turnover ratio of 6, which means that the equity in the account was invested 6 times in a year, can be indicative of excessive trading in the typical customer account. However, in a day trader’s account or in a heavily margined account, a ratio of 6 is meaningless.
The most difficult part of a churning analysis is a determination of whether the broker had control over the account. Typically brokers and customers in arbitration totally ignore this element of a churning case, to their detriment. The parties see a turnover ratio of 6 or 7 or 9, and automatically believe that the case is won or lost on that point alone. Customers who take this view are sometimes in for a surprise at the hearing, and brokers with this view often wind up settling a case that could be successfully defended. Brokers and firms have successfully defended cases with turnover ratios in excess of 20.
Excessive trading is measured not against a mythical yardstick, but rather against the investment objectives of the account. A broker, with discretion, handling a small account for a wealthy investor that is designed for heavy day trading, can have a turnover ratio of 20, and still not have churned the account, because the trading, was not excessive in light of the customer’s investment objectives. Alternatively, a turnover ratio of 4, or even 3, in an account that is designed for long term buy and hold can be excessive.
Control is a difficult concept to grasp, but it is a fundamental, and common sense element of a churning claim. Looking at the extremes, if the customer suggested every single trade in the account, using a discount broker, and the account wound up with a turnover ratio of 10, no one would suggest that the brokerage firm churned the account. The customer entered every trade without any suggestions by the broker, and therefore he controls the account.
At the other extreme is the situation where a broker has discretion over the account, with no intervention at all by the customer. In this situation, with a turnover ratio of 10, the trading was undoubtedly excessive – provided the customer’s investment objectives did not dictate such heavy trading. Since the broker clearly controls the account, churning would be a concern in such an account.
In the real world, the analysis is not always so black and white, and most cases fall into the grays. The goal of brokers and firms should be to clarify the gray areas before a problem arises, and an arbitrator is asked to do so. Although not frequently done, when an account that is going to be actively traded is opened, the customer can be asked to confirm, in writing, the trading strategy that is going to be used in the account, before the account is established. Periodic confirmations of that strategy during the life of the account can easily establish that the customer was directing the level of activity, and was therefore in control of the account.
Alternatively, many brokerage firms use activity letters in accounts with a high level of trading. Once the compliance department has identified an account as having a high level of trading, the branch manager or compliance officer will discuss the account with the registered representative, to determine the accounts goals and objectives. Assuming that the supervisor finds the level of trading to be suitable, or that the account is in the control of the customer, the firm then sends a letter to the customer, informing the customer that the trading in the account is more frequent than in a typical account, and seeking written confirmation from the customer that he is aware of the trading, and that the trading account is being handled to his satisfaction.
These letters, known as “activity letters” by some, and “suicide notes” by others, are sent to the customer and the written response is then kept in the customer’s file. The activity letters are called suicide notes since the letter often becomes important evidence against the customer when he attempts to claim that his account was churned, or that he was unaware of the high level of trading in the account. A customer who has signed an activity letter has a very difficult time establishing the control aspect of a churning claim.
At the same time, if an account that has been actively trading does not return an activity letter, the customer should be contacted by the branch or compliance department, and the trading ceased, until everyone concerned is convinced that the customer is aware of, or directing, the trading.
Often broker’s complain about activity letters, arguing that the letter will generate a complaint or will be sending the message to the customer that his broker is going something wrong in the account. While it is true that the wording of the letter may make a difference, the customer’s refusal to sign the letter may very well identify a customer who did not truly understand the activity in the account. If that is the case, it is in everyone’s interest to have the issue resolved sooner rather than later.
You may also be interested in:
- FINRA Discovery Guide
- SDNY Defines Customer under FINRA Rule 12200
- Overview of the Securities Arbitration Process
- How Long Does an SEC Investigation Take?
- Responding to an 8210 Request
Mark J. Astarita, Esq. is a partner in the law firm of Sallah Astarita & Cox, LLC, and represents investors and securities professionals in regulatory and litigation matters. He is also the sponsor of The Securities Law Home Page, (http://www.seclaw.com) and can be reached at 212-509-6544,