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Churning
Churning occurs in accounts holding traditional securities.
Churning of an account by a broker is a species of fraud.
Churning occurs when a broker directing the volume and frequency
of trades abuses the customer’s confidence for the broker’s
own personal gain by initiating transactions that are excessive
in view of the account’s character and its investment
objectives as expressed to the broker. While an essential element
of churning is the broker’s control of the customer’s
account, the control need not be written discretionary control.
It can be “de-facto” control of the account by
the broker, in which the customer generally follows the recommendations
of the broker or allows the broker to habitually make unauthorized
transactions in the customer’s account, informing the
customer later.
Churning more often occurs in margin accounts than in non-margin
accounts because the calculation of the turn over rate, under
most theories, is based upon the net assets in the account.
As a rule of thumb, a net equity turn over rate of 6 times
or more per year indicates churning. The required rate may
be lower or higher depending on the character of the account
and the investment objectives of the customer. Some customer
margin accounts are funded by the deposit of large positions
of investment stock or mutual funds, which are used as collateral
to borrow money for the trading activity. In certain of these
cases, the rate of turn over may be calculated using the trading
portion of the account.
Churning is also characterized by in-and-out trading in the
account, short holding periods, high turnover, high commissions,
and high margin interest. A customer need not lose money in
the account for the account to be churned.
An account that does not meet all of the criteria of churning,
(i.e., the salesman did not control the account) may still
need to be analyzed for suitable use of margin, suitable investment
strategies and/or suitable recommendations.
Next topic: Fraud
by Conduct: Switching
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