Excessive Trading, Churning, and Twisting

Brokers typically get paid in one of two ways: They can earn a commission on each investment that they buy or sell for a customer, or they can earn an annual fee (usually charged on a quarterly basis) based on the total amount of assets under their management (this is sometime referred to as a “wrap fee”).

Unfortunately, it is human nature that if a broker is paid commissions on a transaction-by-transaction basis, he (or she) has a built-in incentive to buy and sell lots of investments in order to maximize the commissions he (or she) will earn (as opposed to because he or she thinks the investments are in his customer’s best interests). When a broker excessively trades securities for the purpose of earning commissions, it is called “churning.” When a broker excessively trades life insurance policies, it is called “twisting.” In either case, it is a violation of the broker’s duties and can give rise to a legal claim.

There are several objective measures of investment activity that can be helpful for purposes of determining whether an account has been churned, including:

• Turnover Ratio — This is determined by dividing the total amount of purchases made in an account by the average monthly equity in the account and then annualizing the result (by dividing the result by the number of months involved to get a per month ratio, and then multiplying that result by 12).
• Commission-to-Equity Ratio — This is determined by dividing the total amount of commissions charged in an account by the average account equity over a specific period of time.
• Cost-to-Equity Ratio — This is determined by adding up all of the costs charged in an account (e.g., commissions, margin interest, management fees, etc.) and dividing the total by the average account equity over a specific period of time.

Importantly, however, while such objective measures can be a useful starting point for evaluating a churning claim, they are not definitive of whether an account has in fact been excessively traded. That is because the excessiveness of the activity in a brokerage account must be evaluated in the context of the customer’s investment objectives. For example, if a customer wants to day-trade or invest in short-term investments such as options, one would expect his or her account to exhibit a higher level of activity than an investor who was interested in pursuing a buy-and-hold strategy of investing bonds or mutual funds.

If your accounts or investments were churned, contact Jacobson Law P.A. to discuss the specific facts of your case. You may have a claim and could be entitled to recover damages.