Federal and state laws prohibit stockbrokersfrom making useless transactions for the sole purpose of generating commissions and fees. When a stockbroker knowingly and excessively buys and sells investments in your account, and the transactions are completely unsuitable for your objectives and needs, it is churning.
If your broker is making lots of trades that don't make sense, if your broker is charging you lots of money in transaction fees, or if you notice the same investment is being bought and sold over and over again, you may be the victim of churning and it warrants an investigation.
How Churning Happens
Churning may occur after an unscrupulous stockbroker persuades an investor to make a large number of pointless transactions. Churning may also occur after an investor signs paperwork that allows a dishonest broker to buy and sell investments without consulting him first.
Here are some common types of churning fraud:
High Turnover Ratio (a.k.a. Excessive Trading): When an investor's turnover ratio is extremely high, it can be an indicator of churning. To calculate your turnover ratio, add the value of all the purchases made during a year and divide it by the average monthly value of your account. A turnover rate of more than four or five definitely warrants an investigation, but sometimes churning may have occurred with a lower turnover ratio.
In-and-Out Trading (a.k.a. "Wash" Transactions): When a stockbroker buys and sells the same investment over and over again to generate commissions.
Mutual Fund Churning: When a stockbroker shifts money in and out of different mutual funds, buying and selling them to generate commissions.
Churning is an even bigger problem when you realize that some types of investments pay stockbrokers higher commissions than others. Mutual funds, annuities, ETFs, and transactions for many 'designer' investment products, pay much more than stock transactions.
The temptation for your stockbroker to recommend and sell one kind of investment over of another, simply because it puts more money in his pocket, is always present. So is the temptation to buy and sell any investment for the sole purpose of generating commissions.
Bringing Churning into Perspective
The problem of churning exists because of the way stockbrokers and investment advisors get paid. If your broker buys $10,000 of stock in your account, for example, you might pay a transaction fee of $100. Meanwhile, your stockbroker gets a percentage of this fee as his commission for making the sale.
Transaction fees caused by churning add up fast and they can dramatically affect your account balance. Not only that, but churning victims sometimes have extremely large tax liabilities from all the buying and selling. In the worst of cases, an investor might lose everything.
Consider that your stockbroker can make even more money by churning other clients' accounts in addition to yours, it's clear to see why churning is a threat to the trustworthiness of stockbrokers. The more worthless transactions a broker makes, the more he can fill his pockets with commissions and earnings. This conflict of interest exists in nearly all stockbroker/customer relationships.
Discovering Churning Fraud
Most victims of churning rarely discover the fraud until after they've lost a lot of money. However, reading monthly statements and having a keen eye for detail can help you spot churning before the damage gets worse.
Here's a checklist of things you should look for:
- Is there a high turnover rate (lots of buying and selling) that doesn't fit your needs?
- Has your stockbroker excessively bought and sold mutual funds or other specialty investments resulting in large fees?
- Is your stockbroker recommending or making transactions that don't make sense?
- Do you suspect your stockbroker is only interested in his own profit and gain?
- Are there unexplained losses in your account or declines in your account value?
- Did your stockbroker's pointless transactions increase your tax liability?
Know Your Rights
The Financial Industry Regulatory Authority (FINRA) governs and regulates the actions of its members. Your stockbroker and his employing firm are members of FINRA and must abide by its laws. If your stockbroker breaks those laws, the firm that supervises his actions should compensate you for his negligence and/or fraud – and you have the legal right to pursue such compensation.
When an investor files a FINRA claim for churning, the unsuitability of the transactions is a major issue, therefore FINRA Rule 2111 and FINRA Rule 2090 will apply to most churning claims. To learn more about unsuitability, you can read more about it here. Churning is also a violation of the Securities and Exchange Act (1934), SEC Rule 15c1-7 and other securities laws.
Generally, for churning to exist, these elements must be present:
- Your stockbroker "controlled" your account: The transactions made in your account were your stockbroker's idea. This can be shown by your history of always following your broker's advice. Or, you may have signed paperwork giving your broker the ability to buy and sell securities without consulting you first, in which case the 'control' is especially evident.
- Excessive trading: It is clear that the volume of trading was far too excessive in light of your objectives and needs.
- Your broker hurt you on purpose: Your stockbroker knowingly churned your account to generate commissions and fees for himself to your detriment.
Do you suspect churning in your accounts?
Financial damages can be economically crippling, but the realization you were lied to and played for a 'sucker' can be emotionally devastating. If you have fallen victim to this kind of fraud, it's important to remember this is not your fault!
Pursuing a stock fraud claim will teach Wall Street brokerage firms that it is unacceptable to prey upon innocent consumers. Your claim may even prevent others from suffering as you have by forcing Wall Street brokerage firms to conduct business with honesty and integrity.