Churning
Churning is the illegal practice of excessive trading in a customer's account by a broker primarily to generate commissions, without regard to the customer's investment objectives.
🎬 Video Explanation
Exam Tip
Churning = excessive trading for commissions. Requires: control + excessive trading + intent. Turnover ratio > 6x = red flag.
What is Churning?
Churning occurs when a broker engages in excessive trading in a customer's account to generate commissions rather than to benefit the customer. It's a form of securities fraud that violates FINRA rules and fiduciary duties.
Elements of Churning
To prove churning, three elements must be present:
| Element | Description |
|---|---|
| Control | Broker had control over the account |
| Excessive Trading | Trading was excessive given account objectives |
| Intent | Broker acted for personal gain, not client benefit |
Measuring Excessive Trading
| Metric | Description | Potential Red Flag |
|---|---|---|
| Turnover Ratio | Annual trading volume / Account value | > 6x may indicate churning |
| Cost-to-Equity Ratio | Trading costs / Account value | > 20% annually |
| In-and-Out Trading | Quick purchase and sale of same security | Frequent occurrences |
Warning Signs of Churning
- Frequent trading without clear strategy
- High commission costs relative to account size
- Trades that don't match your objectives
- Broker discouraging long-term holdings
- Unauthorized trades
- Large positions held briefly
Regulatory Violations
| Rule | Violation |
|---|---|
| FINRA Rule 2111 | Suitability - recommendations must be suitable |
| FINRA Rule 2010 | Standards of Commercial Honor |
| Securities Exchange Act | Fraud and manipulation provisions |
| State Blue Sky Laws | Fraudulent practices |
Exam Alert
Churning requires: (1) control, (2) excessive trading, and (3) intent to generate commissions. Turnover ratio above 6x may indicate churning. Know this is a FINRA Rule 2111 suitability violation!
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Suitability Standard
The suitability standard is a broker-dealer regulatory requirement that investment recommendations must be "suitable" for a client based on their financial profile, but does not require acting in the client's best interest. This is a lower standard than the fiduciary duty required of investment advisers, though Regulation Best Interest (Reg BI) has enhanced broker-dealer obligations since 2020.
FINRA
FINRA (Financial Industry Regulatory Authority) is a self-regulatory organization that oversees broker-dealers and their registered representatives, administering qualification exams and enforcing securities rules.
Broker-Dealer
A broker-dealer is a financial firm that buys and sells securities for its customers (broker) and for its own account (dealer), regulated by FINRA and the SEC.
Fiduciary
A fiduciary is a person or organization legally obligated to act in the best interest of another party, putting the client's interests ahead of their own.
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