Churning occurs when you can wallpaper a room in your house with the confirmations you’ve received for the buys and sells that have taken place in your brokerage account. Seriously, it means that the broker has engaged in the excessive buying and selling of securities in a customer’s account. And it can be shown that the reason for that activity was not for the client’s benefit, but rather to generate commissions that benefit the broker. Many investors don’t realize that stockbrokers make money by buying and selling securities, which is a conflict of interest, because it makes it harder for the broker to do what’s in your best interest.
For churning to occur, the broker must exercise control over the investment decisions in the customer’s account. The easiest way to prove this is if the customer granted the broker discretion through a formal written discretionary agreement. However, that is not the only way to satisfy the “control” requirement. I’ve had many a case where we were able to establish control because either the stockbroker acted with discretion (even though he did not technically have discretion) or simply because the customer agreed with every recommendation of the stockbroker and never suggested her own investment ideas. Frequent in-and-out purchases and sales of securities that don’t appear necessary to fulfill the customer’s investment goals may be evidence of churning.
Cross examination of stockbrokers in churning cases is always fun, because first you get the broker to explain the reasons he bought the stock. Brokers love to expound on the positives of investments. Then ask the broker, “If all of those positives are true, why did you sell the stock five days later?” The answer is usually disingenuous, because the broker is attempting to hide the fact that he succumbed to the conflict of interest of lining his own pockets, as opposed to doing what is in the best interest of the investor. This can be done on the many investments that were bought and then sold.
An expert is almost always needed to prove a churning case, because the expert will rely upon accepted standards to calculate churning. FINRA Rule 2111, referred to as the Suitability Rule, states “No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer's account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.” Although FINRA did not use the word “churning”, these are the factors that determine if there was churning. If a brokerage firm/broker has churned an account, that is de facto a violation of FINRA’s Suitability Rule 2111.
The brokerage firms always try to argue that investors have to prove scienter – that the broker knew that what he was doing was wrong. As you can imagine, this is a difficult standard to meet. However, although there may be some court cases that uphold the scienter standard, FINRA does not. This is an example of something only an experienced FINRA securities arbitration lawyer would know.
Churning is illegal and unethical. It can violate SEC Rule 15c1-7 and other securities laws.
Contact Ms. Stoneman if you think you've been a victim of churning.
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