Churning is the practice of excessive trading in a customer's account by a broker primarily to generate commissions for the broker, rather than to further the customer's investment objectives. Churning is a violation of FINRA rules and securities law.
Legal basis: FINRA Rule 2010 (standards of commercial honor) and FINRA Rule 2111 (quantitative suitability). Also violates SEC Rule 10b-5 (fraud and manipulation).
Two elements required to prove churning: 1. Control: The broker controls the account (has discretion, or the customer relies entirely on the broker's recommendations with no independent judgment). 2. Excessive trading: The level of trading is inconsistent with the customer's investment objectives and financial profile.
Metrics used to identify churning: - Turnover rate: Annual portfolio turnover of 2× suggests possible churning; 4× or higher is presumptively excessive. - Cost-to-equity ratio: Annual commissions and fees as a percentage of the average account value. Above 20% is often considered excessive.
Defenses: The broker can argue that the trading was justified by market conditions or that the customer directed the trades.
Consequences: - FINRA arbitration — customer can recover lost profits + commissions paid. - FINRA disciplinary action — fines, suspension, or bar. - SEC enforcement — civil penalties, disgorgement. - Criminal prosecution in extreme cases.
Churning in discretionary accounts: Particularly problematic because the broker controls trades without seeking approval.
> Exam tip: Churning = excessive trading for commissions — not for the customer's benefit. Two required elements: control AND excessive trading. Turnover rate >4× and cost-to-equity >20% are red flags. Tested on SIE, Series 7, and Series 65/66.