FINRA & NFA Rules Governing Churning
Although the industry has done a decent job of curbing the churning of investors’ accounts (relative to the number of churning claims that existed in the 80’s and 90’s), such claims are still prevalent. According to statistics published by FINRA, there were 212 churning claims filed in 2008, 306 churning claims filed in 2009, 270 churning claims filed in 2010, and 236 churning claims filed in 2011. Based on the total number of FINRA arbitration claims filed during these years, churning claims still represent approximately 5% of the total claims filed.
(1) FINRA Rules
FINRA Rule 2111 (generally modeled after former NASD Rule 2310) codifies a brokerage firms and associated persons’ obligations with respect to churning/excessive trading. Specifically, FINRA has enacted a suitability analysis for churning called “quantitative suitability.”
Quantitative suitability requires a broker who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile. Factors such as turnover rate, cost-equity ratio and use of in-andout trading in a customer’s account may provide a basis for finding that the activity at issue was excessive.
(2) NFA Rules
Churning claims are also prevalent in the commodities and futures trading worlds. When a churning claim arises in the commodities and futures context, such claim is generally arbitration through the National Futures Association (or NFA).
The following is the verbatim language provided to NFA Arbitrators regarding churning:
Churning is a violation of the anti-fraud provisions of Section 4b of the Commodity Exchange Act (7 U.S.C. § 6b). At its simplest, churning is excessive trading of a customer’s account for the purpose of generating commissions. Case law has generally defined churning as a volume or frequency of trading that, in light of the nature of the account and the situation as well as the needs and objectives of the customer, indicates a purpose of the broker to generate commissions rather than to protect the customer’s interests.
To establish a churning claim, a customer must prove that:
1) the person who allegedly churned the account controlled the level and frequency of trading in the account (including defacto control);
2) the overall volume of trading was excessive in light of the customer’s trading objectives; and
3) the person who allegedly churned the account acted with intent to defraud or in reckless disregard of the customer’s interests.
Whether an account has been traded excessively is a question of fact that cannot be determined by a specific rule or formula. No precise mathematical test exists. Rather, a number of factors should be considered in light of the needs and objectives of the customer.
Among the factors which have been considered by the courts and the Commodity Futures Trading Commission (CFTC) are:
1) the commission-to-equity ratio;
2) the percentage of day trades;
3) departure from a previously agreed upon strategy;
4) whether the account was traded while it was undermargined; and
5) re-establishment of previously liquidated positions in the same or related contracts.
In considering a churning claim, arbitrators should keep in mind that the turnover of futures contracts, by nature, far exceeds the frequency with which most securities investors alter their portfolios. Day trading, for instance, is commonplace in futures, especially among the professionals. Therefore, the level of trading that can occur without being excessive is much higher for futures than for securities.
As you can see, the basic analysis then for both FINRA and the NFA is that churning is any type of trading that is clearly done to increase commissions and which couldn’t possibly be in the best interests of the client.
If you believe that you have been the victim of churning or excessive trading, please call the securities attorneys of The White Law Group at 888-637-5510 for a free consultation.
The White Law Group is a national securities fraud, securities arbitration, and investor protection law firm with offices in Chicago, Illinois and Vero Beach, Florida.
For more information on The White Law Group, visit http://www.whitesecuritieslaw.com.