Churning

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What does 'Churning' mean

Churning means excessive trading by a broker in a client's account largely to generate commissions. Churning is an illegal and unethical practice that violates SEC rules and securities laws. While there is no quantitative measure for churning, frequent buying and selling of securities that does little to meet the client's investment objectives may be construed as evidence of churning.

BREAKING DOWN 'Churning'

Churning may often result in substantial losses in the client's account, and even if profitable, may generate a tax liability for the client. Since churning can only occur if the broker has discretionary authority over the client's account, the way to avoid this risk is for the client to always maintain full control over the account. Another alternative is to use a fee-based account rather than a commission account, since this ensures the broker's objectives are aligned with those of the client.

Types of Churning

Churning is a very serious offense in the financial services industry, and FINRA and the SEC have been working to minimize this occurrence. The most basic churning comes from excessive trading by a broker to generate commissions. Many investors rely on the trust of their broker to do what is in their best interest, so some unethical brokers have taken advantage. Brokers need to justify the reason for making a commissionable trade and how it benefits the client. If a client has excessive commissions with no noticeable gains in the portfolio, churning might have occurred.

Churning also applies in the excessive or unnecessary trading of mutual funds and annuities. Mutual funds with an upfront load, called A shares, are considered to be long-term investments. Selling an A share fund within five years and purchasing another A share fund needs to be substantiated with a prudent investment decision. Mutual fund companies allow investors to switch into any fund within the fund family without having to pay another upfront fee. If a broker recommends changing the investment strategy, looking at other funds in the fund family should be the first option.

Annuities don’t usually have an upfront fee like mutual funds but instead have a contingent deferred surrender charge. Annuities are also meant to be long-term investments and could have surrender charges that last upwards of seven to 10 years. In order to prevent churning, many states have implemented exchange and replacement rules. This allows an investor to compare the new contract and highlight all surrender penalties or fees to be incurred.

Sanctions for Churning

Churning is a very serious offense and if proven, can lead to an immediate termination of the broker and potential barring from the industry. In the event a broker is caught churning, FINRA may place a monetary fine of $5,000 to $110,000 per instance. FINRA also has the right to suspend the broker from 10 business days to one year. In more egregious cases, FINRA can suspend for up to two years or even bar the broker indefinitely.