Though there are a number of cases on churning that try to address the definition
of churning in rather esoteric terms, I think the definition is rather simple.
It is the excessive trading by a broker- usually unauthorized- that is generated
primarily for the commissions. This meaning most often holds true even if
the account has gained in value since the use of many many trades would be
unsuitable for almost all investor accounts.
The courts view the unacceptability by analyzing whether the transactions
of purchase or sale were excessive in size or frequency in view of the financial
resources and character of a customer's account.
Most churning occurs where a broker has discretion to trade the account.
In such cases, it is not necessary that the broker receive prior approval
from the client for completing a transaction. (Note that while a supervisor
is NOT required to approve the trade when made, he/she still must approve
the trades on a daily basis. If the supervisor was negligent in such review,
he (and the firm) might also be held liable for the excessive activity- perhaps
even more so than the broker conducting such trades since the supervisor
is legally responsible through his principal's license for stopping such
activity and protecting the firm and clients from unsuitable trades/trading.)
Non- discretionary Accounts
As was identified in the section on fiduciary responsibility, the broker
with a non- discretionary account still has a quasi- fiduciary duty to act
in the best interest of the client. Therefore, excessive trading would obviously
violate that duty- whether it be done to generate a commission or whether
it is an attempt to try and time particular investments if, again, it can
be shown that the frequency of trades were excessive in regards to the financial
resources and character of a customers account.
It is also important to note that investors, due to their lack of sophistication,
experience, age, etc. may agree or acquiesce to such trading under various
assumptions that it was necessary to generate a gain, or even, in fact, that
previous trades had generated a gain. However, such agreement was invariably
given without an understanding of the risks involved nor, quite obviously,
the illegality of the actions. Therefore such acceptance cannot, in almost
all cases, be used as a mitigating factor for damage control- unless it can
be shown that the investor had the requisite skills to ascertain such impropriety
and was negligent in acting as a prudent man. As an added caution to such
use of prudent man or the sophisticated man rule however, remember that an
investor requiring information or assistance for his investment selection
an ongoing basis through a full service broker is NOT sophisticated.
Disagreement with prior court cases
Apparently the courts have held that a broker/dealer cannot normally be held
liable for overtrading of an account where the transactions are initiated
by the client.
But I submit that the same set of scrutiny need be applied to churning as
indicated above and as shown in the chapter on suitability. The point being
that if a client wants to engage in a transaction that is easily shown to
be unsuitable for that individual, then the broker is still liable in allowing
such transactions to occur- and so would the broker dealer firm. A client
CANNOT be allowed to trade in an unsuitable manner and on unsuitable investments
without a broker and/or firm incurring liability for such trading UNLESS
the firm specifically indicated to the investor, in writing PRIOR to such
trade, that such trading is unsuitable for their circumstances and is not
recommended. Even then, liability might be imputed if the commission was
It is my contention that solicited trades are NOT an offset to unsuitability.
Though most churning involves trades of individual securities, the SEC also
discourages the trading of mutual funds on a short term basis. While this
statement undoubtedly arose due to the loaded mutual funds that controlled
the market by shear numbers several years ago, mutual funds are, for the
most part, still considered longer term investments.
Short term trading of a loaded mutual fund can result in commissions as high
as 8 1/2% (rare)- far greater than commissions generated on single stocks.
Such trades/turnovers are generally only a factor when moving from one loaded
mutual fund FAMILY to another- such as a move from Putnam funds to Oppenheimer-
and where new commissions are generated. Moves within a SINGLE family, such
as Putnam alone, are almost always allowed without a new commission being
charged- though various funds within a particular family might have different
commission structures and must be addressed on an individual basis.
Though they are some formulas used to determine what may be excessive, I
would like to suggest one method which might also be useful. B/D firms feel
that if an account earns a broker more than 3% commission or total cost against
the total assets held for trading, it may be "guilty" of excessive trading.
This 3% rule is also an unwritten guide by the SEC. Within that guide however,
it must be noted that the 3% rule might not be exceeded for the total assets
held, but easily exceeded for one or two investments within the assets under
control. Therefore the arbitrators must analyze both the entire portfolio
as well as the individual investments therein. This is not to unilaterally
state that commissions above 3% are absolutely wrong- just that they bear
scrutiny in view of the investment, the investors needs and desires, economic
conditions and all the other factors regarding suitability, risk and return.
One formalized method to determine whether an account has been excessively
traded is through the use of the Looper formula- developed after a 1958
Commission proceeding. It is used for stock trading and is determined by
Total cost of purchases for a time period =
Average amount invested in account for that period
If an account had $1,000,000 and $10,000 was taken out an invested, then
you have 1 as an answer.
$10,000 investment = 1
$10,000 (average monthly investment)
There are no absolute figures that indicate an absolute number above which
number churning occurs. But it may help, when combined with a thorough review
of all other relevant matters, in determining whether churning has occurred.
Another method to determine whether churning has occurred is to analyze the
other accounts of the broker in question to determine if those clients, with
the same (or even similar) security, were traded with the same frequency.
Lastly, one might view the turnover rate as compared to a professional manager
in the same type securities. For example, the average turnover rate on an
aggressive mutual fund might be compared to the turnover rate for the portfolio
Though breakpoint sales might not be truly defined as churning per se, it
is an intent by the broker to generate commissions solely to the detriment
of the client and is therefore presented here.
Most mutual funds have breakpoints which are defined as the amount of an
investment to a fund above which a lower commission is charged. An example
more fully describes. (Note- the amount of the investment and the commission
charged varies by fund to fund. Breakpoints are not offered with all funds.
No load funds are not affected by this review since no fees are charged for
the purchase at all.
The Flexible Fund
Amount of Investment Commission Charged
$0 - $10,000 8.5%
$10,001- $25,000 6.0%
$25,001- $100,000 4.0%
$100,001 + 2.0
If an individual invests $8,000, the amount of commission charged is 8.5% or $680.00. But should the investor have initially invested $20,000, the ENTIRE investment is charged a commission of only 6% or $1,200. The point here is that it the first $10,000 is not charged at 8.5% and the remaining investment at 6%. If the investor put in $75,000, the entire amount is charged 4% or $3,000. The problem arises if the investor has $100,000 to invest. By putting it all in the Flexible Fund, the entire amount is charged only 4% ($4,000) on the entire sum. But should the broker have the investor put $10,000 into 10 separate fund families (assume same commission scale and breakpoints), he would be charged 8.5% on each investment or a total of $850 x 10 = $8,500.
This is illegal.
This probably occurs most frequently where a commissioned broker has changed firms and where a customer has followed. If the customer had held a- say- growth fund with broker A, the broker might like to switch the investor to growth fund B at the new firm. Using the same type fund in both cases is tantamount to selling solely for a commission and is illegal.