Churning

Definition

Churning is the unlawful practice wherein a registered representative engages in excessive trading within a client’s account to generate higher commissions. This behavior disregards the customer’s investment objectives and can lead to significant financial harm to the client. Such activity is deemed illegal, and if proven, clients can seek damages and recover losses.

Detailed Explanation

Churning involves a registered representative making frequent buy and sell actions that are unsuitable for the client, resulting in high commission fees. This practice is scrutinized by regulatory bodies such as the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). The key factor in identifying churning is determining whether the trading frequency benefits the broker more than the client. Indicators of churning include:

High turnover rate of securities in the client’s account.
Inconsistency between the trading activity and the client’s investment profile or goals.
Generation of substantial commissions from regular trades.

Examples

Frequent Trading: A registered representative executes 50 trades within a month in a retiree’s account, whose primary investment goal is to preserve capital.
High Turnover Ratio: An investor’s account reflects a turnover ratio significantly higher than the recommended norm, indicating excessive trading activity done to collect more commission fees.
Unsolicited Trading: Trades are made in the absence of client instructions, and they are detrimental to the client’s financial health but beneficial in terms of commission earnings for the broker.

Frequently Asked Questions (FAQs)

Q1: How can I know if my account is being churned? A1: You should regularly review your account statements for excessive trades, especially if they do not align with your investment objectives. High turnover ratios and sky-high commission charges are red flags.

Q2: What steps should I take if I suspect churning? A2: Immediately contact your broker in writing to question the trades. If you are not satisfied with the explanation, file a complaint with FINRA or the SEC. Consulting a securities attorney may also be beneficial.

Q3: Can I recover losses if churning is proven? A3: Yes, if churning is proven, you can reclaim damages, including the recovery of commission fees and any investment losses incurred due to the illegal practices.

Turnover Rate: The measure of the number of times securities are bought and sold in a particular period; a high rate may indicate churning.
Registered Representative: A professional who is licensed to trade securities for clients.
Excessive Trading: Trading activity that is significantly higher than what is suitable for the client’s investment goals and profile.
Brokerage Commission: A fee charged by a broker for executing a transaction.

Online References

Suggested Books for Further Studies

“Securities Regulation in a Nutshell” by David L. Ratner.
“Broker-Dealer Law and Regulation” by Norman S. Poser and James A. Fanto.
“The Law of Securities Regulation” by Thomas Lee Hazen.

Fundamentals of Churning: Securities Regulation Basics Quiz

### What is the primary motivating factor behind churning? - [x] Increasing commission fees - [ ] Meeting client investment goals - [ ] Diversification of portfolio - [ ] Reducing risk exposure > **Explanation:** The primary motivation behind churning is to increase commission fees at the expense of the client's financial wellbeing. ### Which regulatory body oversees practices like churning? - [x] FINRA - [ ] Federal Reserve - [ ] National Association of Insurance Commissioners - [ ] U.S. Department of the Treasury > **Explanation:** FINRA (Financial Industry Regulatory Authority) oversees the enforcement of rules and regulations regarding practices like churning. ### What should a client do if they suspect their account is being churned? - [ ] Ignore the activity - [x] File a complaint with FINRA or the SEC - [ ] Just request an account statement - [ ] Open another account > **Explanation:** If a client suspects churning, they should file a complaint with regulatory bodies like FINRA or the SEC. ### What type of trading frequency might indicate churning? - [ ] Annual trades - [ ] Monthly trades in alignment with the investment strategy - [x] Very high-frequency trades - [ ] No trades at all > **Explanation:** Very high-frequency trades that don't align with the client’s investment objectives may indicate churning. ### Which term describes the fee collected by brokers for executing transactions? - [ ] Spread - [x] Commission - [ ] Dividend - [ ] Margin > **Explanation:** Commission is the fee collected by brokers for executing transactions, which can become excessively high in cases of churning. ### Can a client recover losses caused by churning? - [x] Yes, through litigation and regulatory complaints - [ ] No, losses are not recoverable - [ ] Only partially - [ ] Only if a certain amount is lost > **Explanation:** Yes, clients can recover losses caused by churning through litigation and submitting regulatory complaints. ### What kind of turnover ratio might suggest churning? - [x] A very high ratio - [ ] A zero ratio - [ ] A ratio matching annual average returns - [ ] Any ratio > **Explanation:** A very high turnover ratio often suggests excessive trading indicative of churning. ### Which professional is involved in executing trades that might lead to churning? - [ ] Client Manager - [x] Registered Representative - [ ] Customer Service Agent - [ ] Financial Planner > **Explanation:** A registered representative executes trades in clients' accounts, which may lead to practices like churning if done excessively. ### Can churning be identified easily from a single month's account statement? - [ ] Yes, always - [x] Sometimes, but further examination is needed - [ ] No, never - [ ] Only in the first month > **Explanation:** Churning may sometimes be identified from a single month's statement; however, a comprehensive review over a longer period is more reliable. ### Whose interests are prioritized during the practice of churning? - [ ] Client's interests - [ ] Regulatory bodies' interests - [x] Broker's interests - [ ] Market stability interests > **Explanation:** During churning, the broker's interests are prioritized over the client's interests.

Thank you for deepening your understanding of securities regulations by exploring the complex issue of churning and tackling our challenging quiz questions. Stay diligent about protecting your investment assets!