Graveling; regraveling

What Is Churning?

Churning is an unethical and illegal practice in the financial industry classified under Financial Misconduct where a broker excessively trades in a client's account to generate additional commissions for themselves, without regard for the client's investment objectives or best interests. This practice often leads to substantial transaction costs that can significantly erode a client's portfolio value, even if the underlying investments perform well. Regulators such as the SEC and FINRA actively prohibit churning due to its detrimental impact on investors.

History and Origin

The concept of churning emerged as brokerage activities became more prevalent and commission-based models dominated the industry. As brokers earned a portion of each transaction, a perverse incentive sometimes arose to execute trades more frequently than necessary. Early regulatory efforts and legal precedents began to define and prohibit this practice, recognizing it as a breach of a broker's duty to their client. The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have long viewed excessive trading as a serious violation. In fact, the SEC's Office of Investor Education and Advocacy has issued investor alerts specifically to help individuals identify and report instances of excessive trading in their brokerage accounts.⁴

Key Takeaways

• Churning is the excessive buying and selling of securities in a client's account solely to generate commissions for the broker.
• It is an illegal and unethical practice, violating a broker's suitability obligations and, in some cases, their fiduciary duty.
• The primary victim of churning is the client, who incurs inflated transaction costs and potentially missed opportunities for genuine portfolio growth.
• Signs of churning can include unusually high portfolio turnover rates or frequent, unsolicited trades that do not align with an investor's stated goals.
• Regulatory bodies actively enforce rules against churning, and investors have avenues for recourse if they suspect such activity.

Interpreting Churning

Identifying churning requires a careful examination of the trading activity within an account relative to the client's stated investment strategy, financial situation, and risk tolerance. There isn't a single formula to definitively prove churning, as what constitutes "excessive" depends heavily on individual circumstances. However, key factors often considered include the frequency of trades, the amount of commissions generated as a percentage of account value, and whether the trades served any legitimate investment purpose. For instance, a highly active day trading account might naturally have high turnover, but a conservative retirement portfolio would not. The focus is on the broker's intent—whether the primary motive for the trades was to benefit the broker through commissions rather than the client.

Hypothetical Example

Consider an investor, Ms. Chen, who informs her broker-dealer that her primary goal is long-term capital appreciation with a moderate risk tolerance. Her account has a value of $200,000. Over a six-month period, her broker executes 50 buy and 50 sell orders, resulting in $15,000 in commissions. This level of activity and cost seems high for a moderate, long-term investor.

Let's break down the potential impact:

1. Initial Account Value: $200,000
2. Commissions Incurred: $15,000
3. Net Account Value (pre-market movement): $185,000 ($200,000 - $15,000)

Even if the underlying securities in Ms. Chen's portfolio saw some gains, the substantial commission drain would severely hinder her net returns. If the broker’s actions consistently involved buying and selling different stocks or sectors without a clear, documented change in Ms. Chen's financial objectives, it could suggest that churning was occurring, as the activity does not align with her stated intent of long-term appreciation.

Practical Applications

Churning typically manifests in accounts where the broker-dealer has discretion or significant influence over trading decisions, often in a discretionary account. It is less common in accounts where clients make all trading decisions independently, though even then, a broker can be held accountable for recommending excessive trades.

Regulatory bodies like FINRA and the SEC play a crucial role in preventing and prosecuting churning. They define rules around suitability, requiring brokers to recommend investments and strategies that are appropriate for their clients. The FINRA Trading Activity Fee (TAF) is one of the regulatory fees FINRA assesses to help recover the costs of supervising and regulating firms, which includes activities aimed at preventing excessive trading.

Ac³ademic research has also explored the phenomenon of excessive trading. A notable study by Terrance Odean, "Do Investors Trade Too Much?", published in the American Economic Review, found that individual investors who trade more frequently often earn lower returns, particularly due to the impact of trading costs. Whi²le Odean's study primarily focused on investor overconfidence as a driver for excessive trading, its findings underscore the real economic impact of high trading volume, whether initiated by the investor or a broker.

Limitations and Criticisms

The primary limitation in proving churning lies in distinguishing it from legitimate, albeit active, trading strategies. Some investors, particularly those engaged in speculative or short-term trading, may genuinely desire high-frequency transactions. In such cases, high portfolio turnover and associated transaction costs would be expected and, if adequately disclosed and understood by the client, might not constitute churning. The challenge for regulatory bodies is to determine whether the trading was "excessive" given the client's stated goals and whether the broker's intent was to generate commissions rather than serve the client's best interests.

Another criticism points to the difficulty investors face in fully grasping all the "hidden costs" associated with their investments, which can be exacerbated by excessive trading. Even seemingly "free" services might have indirect costs that erode returns over time. Inv¹estors may not always be aware of the full impact of brokerage fees and transaction costs on their accounts.

Churning vs. Excessive Trading

While the terms "churning" and "excessive trading" are often used interchangeably, particularly in common discourse, churning is a specific subset of excessive trading with a clear legal and ethical implication.

The key distinction lies in the broker's malicious intent to enrich themselves through unnecessary trades. Excessive trading might describe a high volume of transactions, but churning implies a fraudulent purpose behind that volume.

FAQs

How can I identify if my account is being churned?

Look for unusually frequent buying and selling of securities that don't seem to align with your stated investment objectives or risk tolerance. Review your account statements for high commissions relative to your portfolio size and the overall returns. If you have a conservative long-term strategy but see many short-term trades, it could be a red flag.

What should I do if I suspect churning?

If you believe your account is being churned, first contact your broker-dealer's compliance department in writing to express your concerns and request an explanation for the trading activity. If unsatisfied, you can file a complaint with FINRA or the SEC. These regulatory bodies have processes in place for investigating such complaints, which may include arbitration.

Does churning only apply to commission-based accounts?

While churning is most commonly associated with commission-based accounts, the principle of excessive, inappropriate activity can also apply to fee-based advisory accounts. In fee-based accounts, a broker earns a percentage of assets under management, so the direct incentive for trade-by-trade commissions is removed. However, a broker could still recommend unnecessary trades to appear active or to justify their fees, though this might be harder to prove as churning in the traditional sense, and would likely fall under broader suitability or ethical breaches.