An unethical practice used by brokers in the world of finance.

Author: David Bickerton
David Bickerton
David Bickerton
Asset Management | Financial Analysis

Previously a Portfolio Manager for MDH Investment Management, David has been with the firm for nearly a decade, serving as President since 2015. He has extensive experience in wealth management, investments and portfolio management.

David holds a BS from Miami University in Finance.

Reviewed By: Hassan Saab
Hassan Saab
Hassan Saab
Investment Banking | Corporate Finance

Prior to becoming a Founder for Curiocity, Hassan worked for Houlihan Lokey as an Investment Banking Analyst focusing on sellside and buyside M&A, restructurings, financings and strategic advisory engagements across industry groups.

Hassan holds a BS from the University of Pennsylvania in Economics.

Last Updated:October 24, 2023

What Is Churning?

Churning is an unethical practice used by brokers in the world of finance.

It can be defined as a practice of the broker making excessive trades like buying and selling securities, assets, and other financial assets on behalf of their client directly for the client's investment account. 

It is unethical because brokers practice it only for their gains in the form of excess commissions.

While completing such transactions, brokers do not consider their client's interests. It is a practice that reflects the broker's misconduct. Brokerage firms or brokers are supposed to work only to protect the interests of their clients and assist them in achieving their financial targets.

In finance, churning by any financial advisor violates Security and Exchange Commission rules. A financial advisor guilty of doing this can be fired from his firm and banned from the industry. Brokers are also ordered to pay regulatory fees.

Clients suffering these repercussions are well within their rights to file an arbitrary claim in front of the Financial Industry Regulatory Authority (FINRA).

Finra is a regulatory authority that has the responsibility of upholding market integrity. It exists to protect the interest of every investor in the market. 

If they win their case, the broker will have to compensate for all the monetary damages (in the form of excess commission paid and loss incurred due to ignorant trades made by the broker) the client's faces.

It is a serious and punishable crime as it violates several Federal laws, industry regulations, and rules of FINRA. For instance, brokers are bound only to suggest or make trades that get the investors closer to their investing goals.

Key Takeaways

  • Churning is an unethical practice in the finance industry where brokers make excessive trades on behalf of their clients to generate higher commissions for themselves.
  • Brokers engage in churning without considering their clients' best interests, violating SEC rules and regulations.
  • Churning can result in financial losses for clients and damage to their investment portfolios.
  • Investors can take legal action against brokers engaged in churning by filing claims with regulatory authorities like FINRA.
  • To prevent churning, investors should maintain active involvement in their investment accounts, regularly review transaction notifications, assess the cost-to-equity and commission-to-equity ratios, and question brokers about the rationale behind investment decisions.

A deeper look at churning

There is mass unawareness when it comes to knowledge about investing in stocks and other financial assets. Unfortunately, professional financial advisors use this unawareness among their customers for their gains. 

An honest and fiduciary relationship between a broker and his client is significant for the broker to work to protect his client's investing interests. Unfortunately, it is easy for professionally trained brokers to wear garb and pretend to work in the client's best interest. 

Usually, clients do not pay much attention to their investing accounts till the time something goes very catastrophically wrong, as earning through stocks is either perceived as a passive income or savings by most of them.

Brokers are supposed to take permission from their clients before making any trade unless and until full autonomy is provided to them to make trades on behalf of their clients by their clients. 

Clients should always keep themselves involved in the decision-making procedure to ensure transparency in brokers' actions and to stay alarmed regarding their financial position.

Understanding Conflicts of Interests

The relationship between a broker and his client is very complicated. The lines between ethics and morality are skinny due to the clients' unawareness of the financial world. 

All the brokering firms endorse themselves to be the ones making the most prudent and accurate decisions all the time. 

However, sometimes they may not have the expertise to claim so or might not make the decisions keeping clients' best interests as their first and foremost priority purely out of avarice.

The relationship is symbiotic too. For example, a Commission-based advisor only earns his commission on making or recommending transactions for his clients. But on the other hand, the client only receives returns on his investment based on the prudent decisions made by the advisor/broker.

A broker does not make a single penny unless and until the client buys or sells any security. After that, however, clients' decisions are heavily based on the broker's judgment. 

Therefore, it becomes very convenient for a broker to give his interests priority. He has to recommend any transaction to the gullible client to make money while providing little or no benefit to the customer.

Forms of Churning

A deceitful broker may churn an account by recommending transactions that might reward him exorbitant amounts in terms of the commission but are not necessary or required for achieving investing goals of the clients.

A broker can also get the client's signature on the paperwork that states full autonomy is being given to the broker concerning making transactions for the client on his behalf.

Some types are as follows: 

1. High Turnover Ratio (Excessive Trading/Overtrading)

It occurs when an unscrupulous broker makes or recommends various pointless transactions in an accounting year only to generate his commission. 

A high turnover indicates that one's assets or securities were replaced multiple times. For instance, if someone buys 100% of shares and returns half of them within a year, the turnover ratio will be 50%. 

Whenever the turnover ratio reaches 4 or 5 for any portfolio, it is mandatorily under investigation because of suspicious activities. However, this can be committed while maintaining a lower turnover ratio.

2. In-and-Out Trading (Wash Transactions)

A broker gets paid only when transactions are made. 

So, sometimes to earn more from the commissions, the broker buys and sells the same investment time and again, resulting in no benefit to the client but jacking up the broker's fees in terms of commission per transaction.

3. Mutual Fund Churning

Mutual funds (a.k.a A shares) are for long-term investments and do not have high volatility. Therefore, investments like these do not require proactive buying and selling. 

However, brokers may still switch between mutual funds time and again only to increase the number of transactions, which will result in less return on investment for the client but a higher commission for the broker. 

Other investments which can be used are Exchange-traded funds (ETFs), annuities, bonds, and life insurance policies. 

One needs to be extra cautious while investing in long-term investments, as stockbrokers charge higher commissions for such investments than regular stock transactions. 

Moreover, a penalty is attached for withdrawing funds from such investments before a certain period. 

So, if the broker is switching before the exhaustion of the period, clients should ask for a proper explanation from the broker.

4. Reverse Churning

When a broker charges fees from the client and does not do anything in return, that is when the broker can be served with a reverse churning lawsuit. Fee-based brokers usually commit it.

Customers don't see any practical improvements in their accounts, yet brokers continuously charge them different alleged fees. It can lead to investors losing lots of money during sharp market corrections.

Excessive trading is not costly only because of the bloated commissions. It gets more expensive because of the additional cost every transaction requires. In addition, various kinds of tax liabilities get attached to every transaction.

For a client with a commission-based broker, earning returns on their investments becomes even more difficult. This is because their investments need to have very high margins of returns to even reach a break-even point after paying off the commission and other additional costs. 

It traps them in a loop of investing in high-volatility shares in the hopes of earning adequate returns.

How to Detect Churning

It is difficult for a layman to identify churned accounts at first. However, due to their expertise, brokers can hide their crime to a great extent in front of someone who has left his account in the hands of a dishonest broker. 

However, to protect the interests of such investors, authorities like FINRA have made some regulations: 

1. Investors should stay in contact with brokers constantly to discuss the buying or selling of any security. They should never give full autonomy to their brokers to make financial decisions without informing them and taking their approval in advance.

Even if investors have enabled their brokers to make transactions on their behalf, they will receive notifications when transactions are made due to a federal notice. 

If the frequency of such notices increases weekly or monthly without any substantial returns, then the broken is probably practicing churning.

2. Notices regarding transactions should be reviewed even more seriously if the transactions are regarding long-term investments like mutual funds, annuities, or insurance policies. This is because these investments do not need as much switching as stock transactions. 

Moreover, switching such assets result in additional cost and penalties.

3. Investments can sometimes be held for as long as five years. Customers should immediately discuss it with their brokers if transactions are made in this department before a certain period depending upon the asset. 

They should demand a proper explanation behind such moves made by the broker.

4. Expenditure on commission should be compared with the monthly return on investments thoroughly and frequently. A higher commission total means less return on investment.

Moreover, commissions should be charged only for prudent investment decisions, so the transaction beneficial for you should also be observed. 

On top of that, the number of times the commission is being charged should also be checked to prevent excessive trading on your account.

Mathematical metrics 

Investors, with a little help, can also assess the decisions made by their financial advisor by calculating the following metrics: 

1. Turnover Ratio

This ratio helps to calculate the number of times assets have been "turned over" or replaced/switched with new assets. A large turnover ratio reflects the frequent replacement of financial assets. 

Any account with a ratio of more than four is investigated as a federal procedure. Still, churning can occur at a ratio of less than 4. Therefore, if one's assets are being replaced constantly, one should discuss the reasons behind this with their brokers.

2. Cost to Equity Ratio

This ratio compares the return on investment with the cost incurred to receive those returns. If the cost (including commission, tax liabilities, and other charges) is too high compared to the returns received, it is difficult for the customer's account to be profitable.

Accounts can be churned in the form of pointless transactions, which can be one of the reasons behind the increased cost of investment.

3. Commission to Equity Ratio

This ratio can be calculated to compare the commission charged by the broker with the average equity. This is to ensure that the broker is charging the commission he deserves.

Legal Consequences of Churning

Churning is an unethical and, more importantly, an unlawful practice. It endangers the customers' financial resources. This can create skepticism in the customers regarding consulting any investment firm, which can further hinder the country's financial literacy. 

Therefore, regulatory authorities take strict steps against a broker guilty of churning. The Securities and Exchange Commission (SEC) has laid down three rules against it.

  • SEC Rule 15c1-7 says any broker's actions are punishable if it is proved that he has misused his freedom over the customer's account by making irrelevant transactions concerning any financial resources only to inflate his commissions. 
  • FINRA Rule 211 prescribes a broker's responsibility and obligation to work while keeping his customer's best interests in mind. Accordingly, brokers should always be objective while making any transaction. 

The broker's reasoning behind making any transaction should align with the customer's investing goals and other factors like risk tolerance.

  • NYSE Rule 408(c) prevents investment firms from allowing their brokers to churn accounts or to hide any churned account by one of their brokers. If any broker associated with any investment firm is caught, investor firms must report him to the concerned authorities. 

How to prevent Churning

It can always be prevented by having greater control over one's investment portfolio. Investors need to keep a close eye on their broker's actions. Investors should not turn a blind eye to their portfolio and transactions made by the broker.

Investors should indulge in decision-making procedures before buying or selling any financial resource. Due to the conflict of interest, investors should never completely trust the broker's thinking. 

Investors should ask for the rationale behind any decision or recommendation the broker makes.

It is easier for commission-based brokers. Brokers only need to increase the number of transactions to ask for inflated commissions. But, of course, investors can always opt for a wrap account instead. 

Suppose investing firms ask for a flat fee upfront (including management, commission, and administrative expenses). In that case, the number of transactions will not significantly affect the inflated investment cost.

However, wrapped accounts can also be churned through reverse churning. As a result, brokers might not unnecessarily make transactions in a wrap account; they can still ask for the fees upfront and then not put adequate effort into the customer's account.

Therefore, even if investors have opted for a wrap account, they need to be cautious and involved in buying or selling financial resources.

Researched and Authored by Priyansh Singal | LinkedIn

Edited by Colt DiGiovanni | LinkedIn

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