Understand Churning and Protect Your Investments
Churning is the illegal and unethical practice by a broker of excessively trading assets in a client’s account to generate commissions. While there is no fixed qualitative measure for churning, frequent buying and selling of stocks or any assets that do little to meet the client’s investment objectives may signal suspicious activity.
Key Takeaways
- Churning is excessive trading of assets in a client’s brokerage account to generate commissions.
- It is illegal, unethical, and subject to severe fines and sanctions.
- Brokerages might charge commissions on trades or a flat percentage fee for managed accounts.
- Flat-fee accounts can be subjected to “reverse churning,” where little or no trading is done but fees are still collected annually.
- Investors can avoid both churning and reverse churning by maintaining an active role in decision-making regarding their portfolios.
Understanding Churning
Churning may cause substantial losses in the client’s account. Even when trades are profitable, they might generate greater-than-necessary tax liabilities for the client. Brokers overtrade by excessively buying and selling stocks on the investor’s behalf to increase the commissions earned on the transactions.
In specific scenarios, brokers at financial firms might have incentives for placing newly issued securities underwritten by the firm’s investment banking arm, sometimes accompanied by bonuses. Such actions may not always align with the investors’ best interests.
Churning can be difficult to identify. An investor might recognize overtrading when trade frequency becomes counterproductive to investment objectives, propelling commission costs without noticeable long-term benefits.
Identifying and Preventing Churning
If frequent commissions are outweighing portfolio gains, it’s worth evaluating if churning is happening. Excessive trading isn’t confined to stocks and can extend to mutual funds and annuities, especially A-shares that are pegged as long-term investments.
Here’s how you can stay vigilant:
- Monitor Trading Frequency: Watch for excessive frequent transactions that don’t align with your investment goals.
- Analyze Fees: Regularly assess the commissions and fees you’re being charged.
- Informed Decisions: Take control of your account decisions and ensure your broker is discussing proposed trades with you.
- Consider Alternatives: Use fee-based accounts instead of commission-based ones to mitigate the risk.
- Report Suspicion: Report suspected churning to regulatory authorities like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).
How to Prove Churning
Proving churning can be challenging but staying alert to your portfolio activity is critical:
- Ensure each trade aligns with your objectives, and demand to discuss every transaction in advance if necessary.
- Review every transaction notice and statement critically; frequent notifications could signal churning.
- Observe how much you are paying in commissions; higher-than-expected costs without matched benefits are red flags.
- For suspicions, approach SEC and FINRA to investigate potential misconduct.
The Penalties for Churning
The SEC defines churning as excessive account activity orchestrated by the broker to generate increased commissions. Violators of SEC Rule 15c1-7 may face severe repercussions including:
- Employment Termination: Brokers engaging in churning risk job loss and industry bar.
- Monetary Penalties: Fines ranging from $5,000 to $116,000; this may escalate depending on the severity of the instrument misuses.
- Suspension Enforcement: FINRA enforces suspensions that could range from a month to more than two years or permanent barring from the industry for more serious violations.
Frequently Asked Questions (FAQs)
What Is Credit Card Churning?
Credit card churning involves repeatedly opening new credit card accounts to utilize sign-up rewards and then closing or abandoning those accounts. Though not illegal, this practice is discouraged and often constrained by credit card companies to prevent repeated use.
What Is Reverse Churning?
When a broker paid a flat fee does minimal trading to justify their fee, that scenario is called reverse churning. This can be contrasted against clients charged per trade, creating a puzzling give-and-take deciding whether to pay-by-trade or a universal fee. Investigators must be critical, opting between a commissioned-based and holistic flat-fee depending on specific portfolio management engagement levels.
How Does Churning Occur in the Insurance Industry?
While insurance salespeople, commissioned per sale, could persuade customers to swap insurance products needlessly, churning in the insurance domain points to replacing existing policies undisclosedly extending customer contempt insurance switchout practices. Govern holdings rigid state standards drastically alleviate unauthorized changings.
Related Terms: reverse churning, broker misconduct, investment fraud.
References
- Stock Market Loss. “What Does Churning Stocks Mean?”
- U.S. Securities and Exchange Commission. “Investor Alert: Excessive Trading at Investor’s Expense”.
- U.S. Securities and Exchange Commission. “Investor Alert: Excessive Trading at Investors’ Expense”.
- U.S. Government Publishing Office. "§240.15c1-7 Discretionary Accounts".
- FINRA. “Suitability”.
- U.S. Securities and Exchange Commission. “NYSE Rulemaking”.
- FINRA. “Sanction Guidelines”, Page 78.
- Experian. “What Is Credit Card Churning?”
- Gen Re. “Avoiding Fraud: Life Insurance Sales Practices”.
