Recognizing Excessive Trading (Churning) in Investment Accounts: Key Legal Standards and Investor Remedies

Excessive trading, often referred to as "churning," is an unethical and illegal practice where a stockbroker excessively buys and sells securities in a client’s account to generate commissions rather than serve the client’s best interests. This practice harms investors and is prohibited under federal securities laws, rules, and regulations.

This blog will explore how to recognize excessive trading, the legal consequences of engaging in or falling victim to such practices, and the remedies available. Given the complexity of these issues, I aim to keep the discussion clear and practical by avoiding unnecessary legal jargon and technical language, making the content accessible to readers without a legal background.

Understanding Excessive Trading & Churning 

Churning is a fraudulent practice that violates federal securities laws and industry regulations. It violates Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, which prohibit manipulative and deceptive practices in connection with the purchase or sale of securities. Additionally, it breaches Regulation Best Interest (Reg BI), which mandates broker-dealers to act in the best interest of retail customers when making investment recommendations. Beyond federal law claims, investors may pursue claims under state securities laws and common law fraud for recovery in excessive trading arbitrations and disputes.

To establish a claim of churning under federal law, the plaintiff or claimant must prove three elements:

• The trading in the account was excessive in light of the customer's investment objectives

• The broker exercised control over the account  

• The broker acted with intent to defraud or with willful and reckless disregard for the customer's interests

I. Establishing Churning/Excessive Trading

Churning occurs when a broker executes an excessive number of trades that are inconsistent with the investor’s financial goals and risk tolerance. It takes place when a broker trades in a customer’s account to generate commissions, disregarding the customer’s interests. In doing so, the broker abuses the customer’s confidence and trust for personal financial gain. Put simply, brokers who engage in churning prioritize their commission earnings over their clients' financial well-being, causing unnecessary transaction costs and potential financial losses.

There are several quantitative and qualitative methods used to detect excessive trading in an investment account.

Turnover Rate

One such indicator of excessive trading is the turnover rate, which reflects the number of times during a given period that the securities in an account are replaced by new securities. For example, if an investor has an average account balance of $100,000 and the total dollar amount of securities purchased in a year is $600,000, the turnover rate would be 6, indicating excessive trading. A high turnover ratio suggests frequent trading that may be inconsistent with the investor’s objectives.

While no turnover rate conclusively establishes excessive trading, turnover rates as low as between three and five have triggered liability for excessive trading. Moreover, courts and regulators have found that a turnover rate greater than six creates a presumption that the trading was excessive.

Cost-to-Equity Ratio

Another indicator of excessive trading is the cost-to-equity ratio, which is the percentage of return on the customer's average net equity needed to pay broker-dealer commissions and other expenses. In other words, the cost-to-equity ratio measures the amount an investment would have to appreciate to break even. For instance, if an investor's account balance is $100,000 and they are charged $20,000 in commissions and fees annually, the cost-to-equity ratio is 20%, which may indicate churning.

Cost-to-equity ratios as low as 8.7 have been considered indicative of excessive trading, and ratios above 12 generally are viewed as very strong evidence of excessive trading. In today’s low-commission environment, such high cost-to-equity ratios are even more concerning, as they suggest a significant volume of trading despite the reduced costs of executing transactions. This makes it even more likely that such trading is excessive and primarily benefiting the broker rather than the investor.

In-and-Out Trading

Furthermore, the holding period of investments can indicate potential churning, as excessive trading usually leads to abnormally short holding periods for securities that are intended to be long-term investments. The in-and-out trading refers to a pattern of trading in which a broker rapidly buys and sells securities within a short period in a customer's investment account without regard to the client’s investment objectives.

If an investor's account consistently shows stocks being bought and sold within days or weeks despite a long-term investment strategy, it could indicate excessive trading. A broker's use of in-and-out trading coupled with high trading costs relative to the investor’s account balance is ordinarily a strong indicator of excessive trading.

Inconsistent Trading Patterns

Another red flag is inconsistent trading patterns, where transactions appear to lack a coherent investment strategy and instead appear to focus on generating commissions. Investors should also be wary of frequent transactions that are not in alignment with their stated financial goals, as well as brokers who recommend frequent trades without clear justification.

II. Proving Intent to Defraud

Churning, as the SEC recently stated, “is excessive trading committed with scienter.” To establish a churning claim, it must be shown that the broker acted with intent to defraud or with willful and reckless disregard for the client’s best interests. Scienter can be demonstrated by evidence of reckless behavior.

Courts and regulators may infer scienter from the commissions charged by the broker. It has been established in cases where excessive commissions lead to high turnover rates and cost-to-equity ratios, indicating that the broker’s primary objective was generating commissions rather than serving the client’s best interests, thereby demonstrating reckless disregard for the customer’s financial well-being.

II. Establishing Broker Control Over the Account

To prove churning, it must be shown that the broker exercised control over the trading in the account. This control can be de jure (formal discretionary authority) or de facto (where the customer relies on the broker's expertise and recommendations).

A broker's control over a customer's account is most clearly established when the account is discretionary, meaning the broker has the authority to make trades without prior approval from the customer. In such cases, the broker assumes a fiduciary duty to act in the best interests of the customer.

In non-discretionary accounts, the client typically retains legal control over trading decisions. However, courts have recognized that brokers may exercise de facto control if the client heavily relies on the broker's advice and lacks the expertise to make independent decisions. For example, in cases where the broker's recommendations are routinely followed, the control element of a churning claim may be satisfied. This principle underscores the importance of evaluating the broker's influence over the account, even without formal discretionary authority.

Legal Recourse for Investors

The consequences of churning for investors can be severe. Excessive fees and commissions erode overall returns, as frequent transactions generate high costs that diminish the investor’s capital.

Victims of churning may bring legal claims under federal securities laws, state securities laws, and common law fraud. Affected investors may also pursue claims for breach of fiduciary duty, negligence, and unjust enrichment against brokers, as well as brokerage firms that fail to properly supervise and prevent excessive trading in their accounts.

One primary avenue for recourse is to file a FINRA arbitration claim, as many brokerage agreements require disputes to be resolved through arbitration. Investors can also report misconduct to the SEC and FINRA, regulatory authorities that have the power to initiate investigations and take enforcement actions against brokers involved in excessive trading.

Churning is a serious financial malpractice that can inflict significant financial harm on investors. By understanding the warning signs of churning and pursuing available legal remedies, investors can protect their assets and interests and ensure that their financial goals are met.