Churning (Excessive Trading)

Both state securities rules for broker-dealers (BDs) and investment advisers (IAs) prohibit churning, but establishing a churning claim requires more than just a busy account. Three specific elements must be present.

Definition

• Churning means inducing transactions in a customer or client account that are excessive in size or frequency in view of the customer's financial resources, investment objectives, and the character of the account
• Applies to both broker-dealers and investment advisers
• For IAs, state rules specifically note that advisers can directly benefit from the number of transactions, making the conflict acute for fee-per-trade advisers

Three Elements of Churning

All three must be present to establish a churning claim:

1. Control Over the Account

• The broker-dealer or agent must have controlled the trading activity
• Control can be actual (formal discretionary authority) or de facto (customer routinely follows every recommendation without independent judgment)
• If the customer independently initiates all trades, churning is very difficult to establish even with high turnover

Exam Tip: Gotchas

• De facto control is enough. The agent does not need formal discretionary authority. If the customer simply goes along with every recommendation without exercising independent judgment, a regulator can treat that as control.

2. Excessive Trading

• Trading must be excessive relative to the customer's investment objectives, financial situation, and needs
• Common indicators:
  • High turnover ratio - a ratio of 2 is suggestive, 4 is presumptive, and 6 is conclusive of churning for a conservative retail account
  • High cost-to-equity ratio - the cost of trading relative to the account's equity
  • Frequent in-and-out trading - buying and selling the same or similar securities in rapid succession
  • A pattern of trading that primarily generates commissions rather than profits for the customer

3. Intent to Defraud (Scienter)

• The broker-dealer or agent must have acted with intent to defraud or reckless disregard for the customer's interests
• It is not necessary to prove specific intent for each trade; churning is itself a scheme to defraud
• Reckless disregard for client objectives satisfies the scienter requirement

Churning vs. Suitability

These are related but distinct concepts:

Exam Tip: Gotchas

• A suitable trade can still be part of churning. Suitability evaluates each recommendation individually; churning evaluates the account as a whole. An agent can recommend individually reasonable trades while still generating an overall pattern that is excessive.