IT''S OUR CHURN
December 4, 2000
It should come as no surprise to learn that many investors do not trade over the Internet, do research, or decide on their own when to buy or sell securities. That’s right, some people (perhaps even a majority) continue to rely upon established brokerage firms and traditional broker-customer relationships. And that leads to common broker-customer disputes, involving issues like unauthorized trading, suitability and churning. Here, we offer a few thoughts on churning.
Just what is churning? Churning occurs when a broker makes an excessive number of trades for a customer’s account for the sole purpose of generating commissions. In order to do this the broker must control the account. That control certainly exists when the customer has surrendered discretion to the broker. In such instances churning may occur when the broker makes trades that are inconsistent with the financial goals and risk tolerance level of the customer.
But control is also present when an inexperienced or unsophisticated customer relies upon the broker for recommendations and investment decisions. In that case the broker has de facto control over the account.
Generally, churning involves a large number of trades and a high “turnover ratio.” The “turnover ratio” refers to the frequency with which the equity in a client’s account is used for investments. For example, in many churning cases the broker engages in repeated “in and out” trading, constantly buying and selling securities for the account. Sometimes the broker repeatedly buys and sells the same security. The customer may experience only small profits and losses on each of those trades, but the value of his or her account is rapidly diminished by commissions paid to the broker.
Churning can become intertwined with other instances of brokerage misconduct. Where a broker engages in unauthorized trading, for example, he or she may also be churning the account. And while excessive volume is a red flag, even one trade can signify churning if the broker, without a legitimate purpose, entered that transaction to get a commission.
So how can investors guard against their accounts being “churned” by a broker?
1. Read every trade confirmation as soon as it arrives in the mail. Some investors wait until the end of the month to review brokerage transactions or, worse yet, do not even open the envelopes until tax time.
2. Review your monthly account statement with care. That way you will immediately notice any flurry of activity.
3. Keep track of the value of your account and the commissions you have been paying. You can do this by comparing each monthly statement with the one for the previous month. Look for the common signs of churning. Are there frequent trades? Does the broker continue to buy and sell the same stocks? Has the value of your account been decreasing because you have been paying a steady stream of commissions?
4. Don’t open a “discretionary account.” Always avoid giving a broker the right to make trades without first consulting you.
5. Ask the broker to provide you with research materials on any stock that is being recommended. That way you will have an opportunity to review the potential investment and dictate the timing of any trade.
6. If you suspect that your account has been churned, contact the brokerage firm’s compliance department immediately. If that doesn’t resolve the problem, contact the NASD and consider filing an arbitration claim against the broker and the firm.
Sort of makes you long for the days when churning was nothing more than a method of making butter.
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