What Is Churning in an Investment Account?

Churning is a deceptive and illegal practice where a broker engages in excessive trading within a client’s account. This is done not to benefit the client, but to generate higher commissions for the broker. This practice can lead to substantial losses for investors by accumulating transaction costs and potentially incurring unfavorable tax consequences.

Defining Churning

Churning is an investment fraud characterized by three elements. First, the broker must have control over the client’s account. This control can be explicit, such as through a written discretionary agreement that allows the broker to make trades without prior client approval. Control can also be implied or “de facto,” occurring when a client consistently follows a broker’s recommendations due to a lack of financial sophistication or reliance on the broker’s expertise.

The second element is excessive trading within the account. This means the volume and frequency of trades are inconsistent with the client’s investment objectives, risk tolerance, and financial situation. Even if individual trades seem suitable, their cumulative effect can be considered excessive. Finally, the third element requires the broker to have intent to defraud or a reckless disregard for the client’s best interests, primarily to generate commissions.

Identifying Excessive Trading

Recognizing excessive trading involves examining several indicators. One metric is the “turnover ratio,” which measures how many times the value of securities in an account has been replaced over a year. It is calculated by dividing the total value of purchases or sales (whichever is less) by the average account equity over a specific period.

While no single number definitively proves churning, a turnover ratio above six is often presumed by regulators to reflect excessive trading, though lower ratios can also be indicative depending on the investor’s objectives. For example, a conservative investor seeking long-term growth would typically have a much lower turnover than an aggressive day trader.

Another indicator is the “commission-to-equity ratio” or “cost-to-equity ratio.” This ratio calculates the total commissions and fees charged in an account relative to its average equity. A high percentage suggests that a significant portion of the account’s value is being consumed by trading costs, making it difficult for the investor to realize a profit. For instance, a cost-to-equity ratio above 12% is considered strong evidence of excessive trading. The SEC has indicated that a break-even cost ratio exceeding 20% can suggest excessive trading, meaning the account would need to appreciate by that percentage just to cover costs.

“In-and-out trading” is a specific pattern where securities are bought and then quickly sold, often within a short timeframe, only to be replaced by other securities that are also rapidly traded. This pattern generates frequent commissions without a coherent investment strategy, highlighting trades made for the broker’s benefit rather than the client’s. Churning often involves trades that are unsuitable for the client’s stated investment objectives, risk tolerance, or financial situation, simply to facilitate more transactions and generate fees.

Regulatory Framework and Investor Recourse

Churning is a violation of securities laws and regulations. Regulatory bodies like the Financial Industry Regulatory Authority (FINRA) and the U.S. Securities and Exchange Commission (SEC) prohibit such practices, recognizing that brokers have a duty to act in their clients’ best interests. These organizations oversee brokerage firms and their representatives, enforcing rules designed to protect investors from misconduct.

If an investor suspects churning, several initial steps can be taken. Document all communications with the broker and the firm, and retain all account statements and trade confirmations. These documents provide evidence of trading activity and associated costs. The investor should then contact their brokerage firm directly, expressing their concerns to the broker’s branch manager or the firm’s compliance department. Many firms have internal processes to address client complaints, and this initial contact can sometimes resolve the issue.

If a resolution is not reached with the firm, the investor can consider filing a formal complaint with FINRA. FINRA provides an online Investor Complaint Center where information about the alleged misconduct can be submitted, including specific dates, transactions, and involved parties.

While the SEC also accepts complaints, its primary role is enforcement and it typically does not recover money for individual investors. For potential recovery of financial losses, FINRA’s arbitration process is often the avenue pursued. Consulting with legal counsel specializing in securities law can provide further guidance and help investors navigate these complex processes.