Churning is a regulatory term that describes excessive trading by a broker for a client account that is unnecessary for meeting the client’s investment goals. Brokers accused of churning are assumed to be conducting excessive trading with a client’s account to produce unnecessary commissions.
Churning is illegal and the SEC will prosecute suspected cases of churning. There is no objective or quantifiable measure of churning, and each case is investigated based on its own individual standard.
Prosecuting Churning
There is no set rule for what precisely constitutes churning, so prosecutors rely on the justification for the trades made by the broker. If the broker cannot adequately explain why the commission expended to make the trade was justified by the effort to meet the client’s investment goals, then this is often considered sufficient evidence of churning.
Most cases tend to be egregious before they are even prosecuted. A small number of unnecessary trades is unlikely to be noticed by clients. It is usually only clients who notice high reported commission costs relative to returns who go on to report brokers for possible churning. As such, most prosecuted cases are considered to be clear cases one way or the other.
Protection from Churning
The best way for traders to protect themselves is to ensure that their account is strictly self-managed. Many investors take advantage of offers from brokers to trade on their behalf, which is where the potential for churning most often arises.
By only actively trading for themselves, traders ensure that there is no opportunity for the broker to create excess trades for the purposes of churning and accumulating unnecessary commissions.
An alternative protection is to only use managed accounts that are strictly fee-based on performance or some other measure with no association to the number or volume of trades performed. This arrangement eliminates the possibility of churning, though this may be a rare arrangement for a broker to offer.
Sanctions for Churning
Churning is considered to be a very serious offense in the investing world. Brokers convicted of it can be fined anywhere from $5,000 to $110,000 and face suspensions from 10 days to 10 years, as well as permanent bans.
Final Thoughts
Churning is not an issue that most day traders will face, as they will be actively trading instead of using a broker’s services to manage their account.
However, it can still occur in similar scenarios, such as when a day trader makes a block trade or a complex trade that requires broker assistance, input or approval.
Brokers make their profit from commissions, and it is in their interest for their clients to make as many trades as possible. Therefore, day traders should be wary of brokers who encourage a high volume of trading or who offer trade assistance services that might encourage unnecessary trading.
Ultimately it is up to each trader to protect themselves by being prudent in the advice and assistance that they take from their brokers, who do not always have the best interest of their clients as their primary goal.