What is Churning
Churning is a term applied to the practice of a broker conducting excessive trading in a client's account mainly to generate commissions. Churning is an unethical and illegal practice that violates SEC rules (15c1-7) 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 evidence of churning.
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BREAKING DOWN Churning
Churning may often result in substantial losses in the client's account, or if profitable, may generate a tax liability. Since churning can only occur when the broker has discretionary authority over the client's account, a client may avoid this risk by maintaining full control. Another way to prevent the chances of churning or of paying excessive commission fees is to use a fee-based account. However, placing a customer in a fee-based account when there is little to no activity to justify the fee is indicative of another form of churning called reverse churning.
Types of Churning
The most basic churning comes from excessive trading by a broker to generate commissions. Brokers must justify commissionable trades and how they benefit the client. When there are excessive commissions with no noticeable portfolio gains, churning might have occurred.
Churning also applies in the excessive or unnecessary trading of mutual funds and annuities. Mutual funds with an upfront load (A shares) are long-term investments. Selling an A-share fund within five years and purchasing another A-share fund must be substantiated with a prudent investment decision. Most mutual fund companies allow investors to switch into any fund within a fund family without incurring an upfront fee. A broker recommending an investment change should first consider funds within the fund family.
Deferred annuities are retirement savings accounts that usually do not have an upfront fee like mutual funds. Instead, annuities typically have contingent deferred surrender charges. Surrender charge schedules vary and can range from 1 to 10 years. To prevent churning, many states have implemented exchange and replacement rules. These rules allow an investor to compare the new contract and highlight surrender penalties or fees.
Sanctions for Churning
Churning is a severe offense and, if proven, can lead to employment termination, barring from the industry, and legal ramifications. Also, the Financial Industry Regulatory Authority (FINRA) may impose fines ranging from $5,000 to $110,000 per instance. FINRA also has the right to suspend the broker for anywhere from ten business days up to one year. In more egregious cases, FINRA can suspend the violator for up to two years or even bar the broker indefinitely.