CHURNING:
DEFINITIONS AND CALCULATIONS

The Securities and Exchange Commission (SEC) and the federal courts have historically defined churning as occurring when a registered representative (RR) enters into transactions and manages a client’s account for the purpose of generating commissions and in disregard of his customer’s interests. Such conduct is deemed a violation of the antifraud Exchange Act Section 10(b) and Rule 10b-5.

When analyzing the appropriateness of transactions, industry compliance officers and regulators frequently employ a three-pronged churning test. The elements are as follows:

1. CONTROL of the account by the broker, either explicit (discretionary trading) or de facto (through acquiescence, trust, or reliance);
2. EXCESSIVE TRADING in the account in light of the customer’s investment objectives; and
3. SCIENTER on the part of the broker.

An RR may exercise control over a customer account in two fashions.

Explicit Control

At times, proof that an RR has exercised control over an account may be a simple burden for regulators. In cases where an RR trades pursuant to a written authorization to utilize discretion, regulators deem such a circumstance as evidence of explicit control. Explicit control could also occur under circumstances where the customer grants so-called oral discretion to an RR. Under most circumstances, "oral" discretion constitutes a sales practice violation (the notable exception being when a client limits the RR's discretion to the time and price of execution).

Many RRs mistakenly believe that by merely "discussing" trades with a client they have developed a defense against the allegation of exercising control over the account. When these CYA discussions occur before the trade, RRs are following proper sales practice procedure. Further, if there is a meaningful exchange of ideas and the customer actually possesses the competency to consider the risks and benefits of the contemplated transaction, then you may be demonstrating circumstances supporting your contention that you did not control the account. However, these discussions frequently occur after the trade, and in those cases, the RR has committed yet another violation by not obtaining prior authorization to enter an order. Clearly, customers cannot be exercising control over the investments in their accounts if they are approving transactions after the fact. Further, the regulators will examine the content of the discussions to determine whether the conversations were meaningful, as opposed to sales efforts designed to overcome client objections.

When an RR does not have express, written authorization to trade an account, the federal courts and regulators analyze the relevant facts to determine whether the RR is exercising de facto control. Some of the more common indications of de facto control are customers who

• habitually follow the advice of the broker, or
• are unable to evaluate the broker’s recommendations and to exercise independent judgment.

Now those two indications are very subjective and lead to many an argument. What does "habitually" mean? When is a customer blindly following an RR's advice as opposed to independently considering the RR's recommendations and then competently authorizing the suggested transactions? How does one determine whether a customer is "unable to evaluate" and "exercise independent judgment"?

All of the above objections and questions are valid. However, debating with the regulators once they begin to investigate your conduct will prove costly and time consuming. Before you incur legal fees, lost time from work, and the negative publicity from being named in a churning case, review your holding pages and new account forms from the regulators' perspective. Here's what they typically look for in determining a customer's ability to evaluate your recommendations and to exercise independent judgment in the transactions in the account:

• the investor’s sophistication;
• the investor’s prior securities experience;
• the trust and confidence the investor has in the broker;
• whether the broker initiates transactions or whether the investor relies on the recommendations of the broker;
• the amount of independent research conducted by the investor; and
• the truth and accuracy of information provided by the broker.

Admittedly, most of the above factors are subjective, but those are the same points that the federal courts and regulators frequently cite in assessing the customer's ability to exercise meaningful, independent judgment of your recommendations. Typically, in making a determination that an RR exercised de factocontrol, the SEC concludes that a given investor was "unsophisticated," had minimal investment experience, and was disposed to accept the RR's recommendations (and rarely initiated transactions on their own). 

Regulators use a number of analyses to gauge whether trading in an account is excessive. A popular misconception among RRs is that there is a "free bite" for activity up to but not exceeding one year. I've personally met with a number of RRs during my years of practicing law who were absolutely shocked to learn that new accounts with less than one year's trading could be reviewed for excessive trading.

Two of the most common methods used to determine whether excessive trading occurred are the turnover rate and the break even (the latter also know as the cost-to-equity ratio).

For the limited space permitted in this article, suffice it to say that the turnover rate generally calculates the total dollar amount of purchases during a time period divided by the average account equity and then annualized. There are a number of approaches used by regulators in computing turnover, but the most common technique is the Looper Formula, so named after an SEC case involving a brokerage firm of the same name. The rule of thumb concerning turnover is often referred to as the "2-4-6 Rule." Essentially, the guideline views annual turnover rates as follows:

• Twice a year turnover is "suggestive" of excessive trading;
• Four times a year turnover is "indicative" of excessive trading; and
• Six times a year turnover is "conclusive" of excessive trading.

Now let's finally get it clear, once and for all. The SEC has repeatedly stated that turnover rates of fewer than two may, nonetheless, still be proof of excessive trading. This extreme position is most likely to be advanced when a regulator is confronted with an investor whose needs are very conservative. Similarly, if the trading appears questionable, e.g., short-term mutual fund trading or short-term government securities trading, then the SEC is apt to lower the threshold. In a recent case, the SEC sustained findings of turnovers as low as 1.81, 1.52, and 1.38.

A number of factors will impact the turnover rate. First, the more conservative an investor's objectives and needs, the lower the trigger number. Second, certain account assets such as "delivered-in positions," options, and illiquid limited partnerships may be excluded or included in the calculations depending on a number of factors. Obviously the inclusion of additional assets in the turnover rate calculation will increase the value of the account equity and, consequently, decrease the resulting turnover rate. By way of example, if the average monthly equity in an account (excluding a $10,000 limited partnership) is $10,000 and you bought $20,000 that month, the monthly turnover rate would be two. However, if that same $10,000 limited partnership is factored in, then the average monthly equity would be $20,000 and the monthly turnover rate would be one.

A key battle often emerges over illiquid securities. Should they be factored into the turnover computation? If "yes" then at what price, and who determines that price: the RR or the regulator? If "no" then you may have a basis to appeal the computation. Remember, the more you increase the account's average monthly equity, the lower the resulting turnover rate. 

A further test of excessive trading examines the net amount of money invested and the transaction costs incurred. Referred to as the "break even" or "cost to equity ratio," this method calculates the cost of trading (including commissions, margin interest, and other expenses) and divides the result by the average equity and then annualizing it. Quite simply, the result is the percentage of return the account would have to earn before it returned any profit to the investor. The SEC has routinely determined that trading practices requiring an account to appreciate in excess of 16% just to break even constitute excessive trading. 

When analyzing the frequency of trading in customer accounts, self-regulatory organizations often present their evidence through the testimony of an examiner or supervisor. In a recent SEC case, the government presented its proof through an employee who was a Certified Public Accountant (CPA) and a non-employee expert witness (Expert). The CPA witness testified as to the factors used in computing turnover rates and break-even points, and pointedly explained the treatment used in including and/or excluding illiquid limited partnerships. The Expert testified about industry sales practices, including suitability, excessive trading and churning, and she also explained her turnover rate and break-even point calculations.

In determining whether an RR churned an account, the regulators will consider whether you acted with scienter. The United States Supreme Court defined scienter as "a mental state embracing intent to deceive, manipulate, or defraud." More plainly, if an RR knows what he intends to do is wrong and does it, he has acted with scienter. However, if your conduct was not intentional but highly unreasonable and represented an extreme departure from the standards of ordinary care, the SEC and federal courts deem it to be reckless and, consequently, sufficient to constitute scienter For more details about scienter, read our earlier article entitled Fraud and Scienter.