What Is Churning?

Churning is the illegal and unethical practice by a broker of excessively trading assets in a client’s account in order to generate commissions.

While there is no quantitative measure for churning, frequent buying and selling of stocks or any assets that do little to meet the client’s investment objectives may be evidence of churning.

KEY TAKEAWAYS

• Churning is excessive trading of assets in a client’s brokerage account in order to generate commissions.
• Churning is illegal and unethical and is subject to severe fines and sanctions.
• Brokerages may charge a commission on trades or a flat percentage fee for managed accounts.
• Flat-fee accounts can be subjected to “reverse churning,” in which little or no trading is done in return for an annual slice of the assets.
• Investors can avoid churning and reverse churning by maintaining an active role in decision-making regarding their portfolios.

Understanding Churning

Churning may result in substantial losses in the client’s account. Even if the trades are profitable, they may generate a greater than necessary tax liability for the client.

A broker overtrades by excessively buying and selling stocks on the investor’s behalf in order to increase the commissions earned on the transactions.

In some cases, a broker for a financial firm may be incentivized to place newly issued securities that were underwritten by the firm’s investment banking arm. For example, brokers may receive a 10% bonus if they buy a certain number of shares on behalf of their clients. Such incentives may not be offered with the investors’ best interests in mind.

Churning is hard to spot. An investor may conclude that a broker has been overtrading when the frequency of trades becomes counterproductive to the client’s investment objectives, driving commission costs higher without observable results over time.

Types of Churning

At its most basic level, churning is defined by excessive trading by a broker to generate commissions. If a client is being charged frequent commissions with no noticeable portfolio gains, churning might be the problem.

Churning also applies to excessive or unnecessary trading of mutual funds and annuities. Mutual funds with an upfront load, the so-called A-shares, are intended to be long-term investments. Selling an A-share fund within five years and purchasing another A-share fund needs to be justified as a prudent investment decision.

Most mutual fund companies allow investors to switch into any fund within a fund family without incurring an upfront fee. A broker recommending an investment change should first consider funds within the fund family.

Deferred annuities are retirement savings accounts that usually do not have upfront fees like mutual funds. Instead, annuities typically have surrender charges, a type of penalty for early withdrawal of funds. Surrender charges vary from one to 10 years.

To prevent churning, many states have implemented exchange and replacement rules. These rules allow an investor to compare the new contract and highlight surrender penalties or fees.

Tip:

To prevent churning, keep an eye on your account. Read every transaction notice, and review every monthly statement. Know how much commission you’re paying.

How to Prevent Churning

Churning can only occur if a broker has discretionary authority over the client’s account. A client can avoid this risk by maintaining full control, requiring the client’s permission to make changes in the account.

Another way to eliminate churning is to use a fee-based account rather than a commission-based account. Known as a wrap account, this type of account eliminates the incentive for churning. The fee is charged quarterly or annually and is generally 1% to 3% of the assets under management.

The wrap account does not work for all investors. The flat fee can turn out to be excessive if there is little or no trading of the assets in the account. In fact, that situation is indicative of another form of churning called reverse churning.

How to Prove Churning

Churning is serious financial misconduct, but it’s not easy to prove. Your best defense is to pay careful attention to your portfolio.

• You can request that your broker discuss any buy or sell transactions with you in advance. You can explicitly sign that right away when opening the account but you can opt not to do that.
• Whether or not you discuss transactions with your broker in advance, you will receive a written notice from everyone. That’s a federal requirement. If you’re receiving notifications every day or every week, you might be a victim of churning.
• The above is particularly true if the transactions are in mutual funds, annuities, or insurance products. These are not the kinds of investments that should be traded frequently.
• When you review your monthly statements, check how much you’re paying in commissions. High total commissions mean less profit for you.

If you think your broker is churning, you can report it to the Securities and Exchange Commission (SEC) or the Financial Industry Regulatory Authority (FINRA).

Sanctions for Churning

The SEC defines churning as excessive buying and selling in a customer’s account that the broker controls in order to generate increased commissions. Brokers who overtrade may be in breach of SEC Rule 15c1-7, which governs manipulative and deceptive conduct.

The Securities and Exchange Commission (SEC) looks into complaints about brokers who appear to be putting their own interests over that of their clients.

The Financial Industry Regulatory Authority (FINRA) governs overtrading under rule 2111 and the New York Stock Exchange (NYSE) prohibits the practice under Rule 408(c).

Investors who believe they have been a victim of churning can file a complaint with either the SEC or FINRA.

Churning is a serious offense and, if proven, can lead to employment termination, barring from the industry, and legal ramifications. In addition, FINRA may impose a fine ranging from $5,000 to $116,000.

FINRA also has the right to suspend the broker for anywhere from one month to two years. In more egregious cases, FINRA can suspend the violator for a longer period or even bar the broker indefinitely.

Churning FAQs

Here are the answers to some commonly asked questions about churning.

What Is Credit Card Churning?

Credit card churning involves opening a series of new credit card accounts in order to take advantage of the introductory rewards offered by each, and then closing the accounts or leaving them unused. Credit card churners used to be able to rack up a lot of rewards points by doing this.

This practice is not illegal but credit card companies don’t like it. They have now put in place safeguards to prevent customers from repeatedly opening and closing accounts.

What Is Reverse Churning?

Churning occurs when a broker who is paid a commission for every trade makes many trades just to boost the commission pot. Reverse churning occurs when a broker who is paid a flat fee does little or no trading to earn that fee, which is a percentage of the assets under management.

To back up a step, investors have a choice to make when opening an account with a broker:

• An account that pays the broker a commission for each buy and sell order made for the account, or,
• An account that pays the broker a flat-rate commission, usually ranging from 1% to 3% per year of the total assets under management.

Online or discount brokers charge a flat fee for every transaction, with zero fees common for certain transactions up to a limit. This is the do-it-yourself option with no professional advice or management, although online brokers are adding premium tiered services for those who want that.

In the worst-case scenario, an investor could flee a commission-based broker to avoid excessing transaction fees, only to open an account with a flat-rate broker who does nothing but take a slice off the top of the account every year.

A better option for the investor might be to maintain control over the account, approving or disapproving any buy and sell decisions. And, make it clear at the outset how active you expect the management of your portfolio to be.

What Is Churning in the Insurance Industry?

Insurance salespeople work on a commission basis. If they attempt to boost their own commissions by persuading their customers to switch insurance products instead of automatically renewing their existing policies, then they are churning.

The practice is illegal in most states.

Article Source: investopedia.com