Churning is illegal conduct whereby a broker trades your account in excess of goals and norms, typically with the intent of generating commissions, and at the expense of the customer’s interest. Churning constitutes fraud under the federal securities laws and certainly violates the conduct rules of securities regulators. Courts have examined a variety of factors in determining churning, including patterns of frequent in and out trading, a high turnover ratio, a high cost-equity ratio, or a high commission-to-equity ratio.

“Turnover ratio” refers to the ratio between the total cost of purchases for an account divided by the account’s average net asset value during a specified period of time. No annual turnover rate is universally recognized as determinative of churning, though historically a turnover ratio in excess of 6 generally has been presumed by the SEC to reflect excessive trading. However, the SEC has found that much lower turnover levels can indicate excessive trading. A customer’s investment objectives are also key factors in determining whether a particular turnover ratio supports a claim for churning or excessive trading.

Other useful ratios examined in churning cases are the commission-to-equity and the cost-equity ratios. The commission-to-equity ratio is obtained by dividing the total commission charges by the average equity in the customer’s account.

The cost-equity ratio can be the most useful of these ratios. It reflects the rate of return an account would have to earn on an annual basis to “break even” after all costs and charges, not just the costs of commissions, are factored into the calculation. In re Barbato, 53 S.E.C. 1259, 1273 (1999). The SEC has taken the position that a break-even cost ratio in excess of 20% is indicative of excessive trading.

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