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Churning is a slang term that is defined as excessive trading on a client account by a broker. The purpose of the activity is not to benefit the investor, but to generate additional commissions for the broker. Also referred to as twisting, the practice of churning is considered to be highly unethical and is illegal in many markets.
Abuse of a client’s account is a practice that is expressly considered illegal in the United States. The Securities and Exchange Commission understands churning to be a form of unauthorized trading in a discretionary account. For this reason, the practice is subject to fines, up to and including imprisonment. However, churning is not always easy to prove, since the activity could simply be a series of poor decisions on the part of the broker, with no intent to defraud the investor.
Along with the SEC, churning is also a breach of the NASD rules as they relate to the trading process. Brokers who appear to be violating the rules may find themselves temporarily barred from trading activity. During this period, an investigation will be launched to determine if recent transactions on a customer account were in fact conducted with no regard for the financial welfare of the client. In the event that the broker is found to have executed the orders in good faith, then his or her trading privileges are restored.
There are circumstances that lend themselves more readily to the potential for churning. When the broker is granted broad powers to act on behalf of a client, such as with authorized access to a discretionary account, it is possible for the broker to rapidly conduct transactions involving similar securities. This flurry of buying and selling with no apparent gains for the investor could indicate overtrading activity.
However, it is also possible that a rapid succession of trades is in fact not churning activity. In the event that an investor notices this type of activity on his or her brokerage account, it is certainly a good idea to contact the broker and ask for an explanation for the series of trades. Should the broker be unable to articulate the reasoning behind the trades to the satisfaction of the investor, then it is definitely time to move the account to another brokerage firm.