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Know The Tricks Of The Churning Analysis
ery few claims are as misunderstood and as manipulated as the churning or excessive trading claim.
Most folks accurately can state the three basis components of a churning claim. They are, first, that the trading was excessive in light of the customer's objectives. To determine whether trading was excessive, one calculates the turnover ratio. Second, that the broker controlled the account. Importantly, control is not limited to discretionary accounts. Arbitrators consider such factors as the relative sophistication of the parties, and the number of times that the customer rejected a broker's trade recommendation. Third, that the broker acted with scienter - meaning he intentionally or recklessly placed his interests ahead of the interests of his customers, typically to generate commissions.
However, when it comes to determining what kind of turnover ratio is sufficient to find excessive trading, there is great confusion. Unfortunately, many courts, commentators and attorneys cling to a remarkably unsophisticated general rule that was announced years ago by a particular court and blindly followed since. That court announced the so-called "2-4-6 Rule". This was little more that its own belief that a turnover ratio of 2 gives rise to an inference of churning, a ratio of 4 creates a presumption of churning, and a ratio of 6 constitutes conclusive proof of churning.
Brokers beware that there is no such tenet! In fact, know that industry-savvy courts have rejected the "2-4-6 Rule". For example, the court in Newburger v. Loeb & Co. v. Gross, 563 F.2d 1057 (2d Cir. 1977), announced the very sensible position that an annual turnover ratio of 7 is not excessive given that the investor had wanted speculation and trading. Likewise, some commentators wisely have advised that the entire turnover analysis has no application whatsoever when examining options trading. For example, see Packard, A Test for Churning in Stock Options, 4 Corp. Law Rev. 222 (1981).
The second trick relates to how the turnover ratio is calculated. Understand that different calculations can influence the outcome dramatically.
For example, consider the scenario in which the customer has a margin account. In a churning case that I defended, the customer's expert calculated the turnover ratio by taking the Total Cost of Purchases, dividing it by the Average Month End Equity, times the Number of Months that the account was open, and then annualized the figure. He opined that the turnover ratio was a strikingly high 13!
But the expert's calculation was misleading. In using average equity, the expert actually gave the claimant a windfall. Why? Average equity does not reflect the customer's margin balance. Who cares? We argued that, without margin, the amount of purchases would have been much smaller. After all, the use of margin allowed the customer to make the purchases. We convinced the arbitrators to request that the expert recalculate, so as to include the hefty debit balance in the account. This gave us an "apples to apples" comparison.
What happened when the expert recalculated? His turnover ratio was reduced from 13 to 5!
There are several other tricks to know, which I mention just briefly. First, one may consider using a different turnover calculation called the "Mutual Fund Turnover Ratio". The reason is that this method requires one to choose the lesser of purchases or sales in the numerator (then divided by the average monthly account value). Obviously, in defending churning claims, one wants as small a numerator as possible so that the turnover ratio is less.
Another trick is the number of months that is used in the denominator. Do not assume that the life of the account must be used. The fairest measure is to use the period of the allegedly excess activity. In a churning case that I defended, claimant's expert attempted to use several months of inactive status, where the account balance was low, and much lower than in the earlier months of the account. The expert sought to include these low account value months because they had the effect of decreasing the denominator, which made the turnover ratio higher. We convinced the arbitrators that the expert should revise his calculation. He did so and, as we had predicted, the turnover ratio was less than it had been.
The devil is in the details when it comes to churning analyses!
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
investors nationwide in arbitration, litigation and regulatory matters, and a shareholder with the law firm
Shaheen, Novoselsky, Staat, Filipowski & Eccleston
P.C.(www.snsfe-law.com). This Web site contains material
of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment advisor when building and protecting your wealth.
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