CHURNING

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.

Discretionary 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 substantial.

It is my contention that solicited trades are NOT an offset to unsuitability.

Mutual Funds

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.

Churning Statistics

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 dividing the

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 under question.

Breakpoint Sales

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.

Switching

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.