Churning: What it is and how it should be monitored

Traditionally, the Securities and Exchange Commission (SEC) describes Churning as

In determining whether an account has been churned, two calculations are usually undertaken:

The Pigeon

Quite often, a customer whose account was victimized by churning was aggressively cold-called by the servicing stockbroker, who pressed for permission to exercise "discretion" in trading the account.  Victims of churning are frequently unsophisticated investors who rely upon their brokers to make investment decisions for them. In some cases, there is an executed power of attorney (which the customer may not always understand ) that grants the broker permission to trade the customer's account; however, just as often, the grant of permission to trade is only an oral agreement that is generally contrary to regulatory requirements.

Upon reviewing the allegations of a complaining customer whose account has been churned, regulators and claimants' counsel typically discover that the customer had no idea of the extent or nature of the active trading, and, in many cases, the customer's  financial situation did not warrant such risk.  Such customers are generally dismayed when shown how much money their broker made from commissions derived from churning versus how much the client sustained in net losses.

Active Account Letters

All U.S. broker dealers are required to prepare and maintain Written Supervisory Procedures ("WSP"), which normally include descriptions of policies and practices that are supposed to alert the firm to red flags involving inappropriate trading in customer accounts. Among other things, WSP should require that when a turnover ratio exceeds six that a designated supervisor must immediately review the account and take steps to determine if the trading was authorized by the customer and conformed to the customer's objectives. In industry parlance, such notices to customers are known as Active Account Letters.

Of course, there are Active Account Letters and then there are, well, you know how such things go. A well-intentioned Active Account Letter should explain to the subject customer what triggered its transmission. However, many firms don't want to raise what they see as unwarranted concerns and will simply send out an innocuous letter, which may not identify the respective accounts, the body of reviewed trades, or even the relevant statistical data - these dubious communications are couched in language that suggests it's all just a routine query to make sure that the client is a happy camper.

Best practices require that

• logs be kept of the sending of Active Account Letters,
• records be maintained of the receipt of all customer responses,
• non-responses by customers are diligently followed up,
• any customer complaints elicited by the Active Account Letter are fully investigated and appropriate action is promptly taken,  and
• a designated supervisor investigate a given stockbroker's other accounts to determine if there is an emerging pattern. 

Going Through the Motions

Some brokerage firms take their compliance duties seriously and then there are those who discharge their obligations in a merely perfunctory fashion. Sure, many firms prepare account activity reports that present comprehensive analyses of annualized turnover ratios, break even ratios, and other account metrics. Such reports are further cross-indexed by top producing brokers, top commission generating accounts, etc. Notwithstanding how impressive such supervisory reports appear, the ultimate effectiveness of these statistics depends upon the diligence of a given supervisor and the reputation of a given firm. It's the difference between a perfunctory eyeballing and a serious review.  As such, oversight on Wall Street is often sleepwalking or benign neglect.

If a federal, state, or self regulator were to receive a customer complaint or get wind of questionable sales practices, in addition to some of the points noted above, the regulator would ask the brokerage firm to produce a log showing how trading was monitored, and to provide proof of transmission of Active Account Letters to customers. Brokerage firms that simply send out Active Account Letters but fail to follow-up when there is no response are not going to find much sympathy from the regulators. Although some firms treat activity letters as "Negative Response Letters" - that is, you only worry about responses to the letters and assume that no response is a sign that all is fine - such a practice will only draw the regulators' ire. Finally, if the churning stockbroker has a prior history of engaging in the same or similar conduct - that could be in the form of prior customer complaints or even settlements with regulators -- and the firm was lackadaisical in supervising that individual, there could be hell to pay in terms of fines or awards to customers.

• Churning
• turnover
• SEC
• FINRA
• Bill Singer
• BrokeAndBroker.com