Churning a Client’s Investment Into a Broker’s Bread and Butter

By Nataliya Nemtseva, Spring 2014 Student Intern

churningIt is safe to say that most of us have never made our own butter. We find it nicely packed in a bright container in the dairy aisle of a grocery store. Many, however, may know that butter is made by a process called “churning.” This process involves vigorously stirring or beating the milk to separate out the fat and turn it into butter. But why are we talking about churning?” you ask. In the financial context, the term “churning” is used to describe an excessive trading activity undertaken by a broker in an investor’s account solely for the purpose of, by analogy, producing more “butter,” which is the broker’s commission. This blog post will introduce you to how churning may give rise to a claim against a broker, the measurements that are used to determine if excessive trading has occurred and what you can do to spot or prevent churning.

Unethical and Illegal Conduct

While buying and selling securities is a necessary part of managing investments, doing so excessively may not be in line with the client’s best interests, investment goals and risk tolerance. If a broker is buying and selling securities just to make a profit on the commissions and not for the best interest of the investor, the broker is breaking the law. Besides breaking the law, excessive commissions erode the value of the client’s investment. Such activity may give rise to a claim against a broker.

Control Factor

To bring a claim of churning, one of the things you must be able to show is that your broker had control over your account. Having control over the account is what enables a broker to effectuate the frequent trades. A broker officially obtains control when an investor establishes a discretionary account, which essentially authorizes the broker to trade on the investor’s behalf without seeking the investor’s approval for each trade.   In the absence of a formal authorization, a broker may gain control by default when the client lacks sufficient expertise to make investment decisions and relies on the opinions and recommendations of the broker. On the other hand, an investor who maintains control over the account is not likely to succeed in proving that churning has occurred.

Is a Certain Trading Activity Excessive? 

Several measurements are used to determine whether the frequency of trades was excessive. These measurements involve looking at the number of trades executed in a client’s account over a period of time; the cost of the trades relative to the client’s total investment; and the dollar amount of purchases made by the broker relative to the average dollar amount of the investment. However, what is and is not excessive depends on the type of client account, the client’s investment objectives and other circumstances.

What You Can Do to Spot or Prevent Churning

Although it may in some circumstances take an expert to accurately determine whether churning has actually occurred, you should always be on the lookout for warning signs. To protect your investments from churning, make sure to frequently and thoroughly review the statements you receive from your broker. Do not be afraid to question your broker about any irregular activity you notice in your account. Also, remember to check your statements for excessive trading fees.