To understand churning you must first understand that one way a stockbroker may be compensated is on the volume of transactions conducted for a customer. When a stockbroker puts his or her own interests ahead of the interests of the customer by effecting trades that are “excessive in light of the objectives and resources of the customer’s account,” the broker is churning the account.
You can protect yourself from “churning” by limiting the stockbroker’s authority to engage in discretionary trading. Make it clear what you want and be very careful when signing any activity letters for your accounts. Unless you fully understand the nature of all the transactions executed in your account, do not sign anything without consulting an attorney first.
Tips to Determine if Your Account Has Been Churned:
The Turnover Ratio
Various methods are used to determine whether an account has been churned. The most common test of churning is to compute the turnover ratio. The turnover ratio can be calculated by dividing the average net equity into the aggregate amount of purchases over a given period of time. Although there is no fixed number which will establish churning, it has generally been found that an annual turnover ratio of six or more suggests excessive trading.
The Break-even Ratio
Another tool in evaluating churning is the commission-to-equity comparison or break-even ratio. This calculation will demonstrate how much the value of the account would need to appreciate just to compensate for the commission charged to it. This ratio can be derived by dividing the total commissions by the average equity over a specified period of time.
Losses in the account are not a necessary element of churning since churning serves to reduce profits which otherwise may have been earned. The intent on the part of the broker to defraud must also be demonstrated. Generally, once control has been established, intent will be inferred by the conduct (excessive trading) of the broker.
If you believe that your stockbroker may have churned your investment account or that you may have been a victim of any type of securities fraud, you have certain rights which you should be aware of, rights which may provide you an opportunity to recover your losses from your stockbroker or brokerage firm.