Churning--rapid buying and selling of an investor's stocks--is an illegal broker/dealers practice. The reason for the illegality of churning is simple--broker/dealers typically get commissions on each trade they make for an investor, so they have a financial incentive to buy and sell as many stocks as possible. Obviously it is not in the best interest of the investor for he or she to pay commissions for tons of pointless trades. Churning can be illegal (though not typically) even for non-discretionary accounts, in which the broker/dealer must get client approval for all trades, if it can be shown that the trades were not in the client's best interest.

There is, of course, a lot of grey area as to what is a "pointless trade." The SEC has to look at the market at the time of trades and the investor's financial situation to determine whether trades were reasonable or churning occurred. A rule of thumb is that if broker/dealer commissions on an account exceed three percent of the total investment assets of a client, that is evidence (though not nearly conclusive) of churning. I have seen a case of a broker/dealer/felon who regularly earned ten percent commissions.

The bottom line is broker/dealers have a fiduciary responsibility for investments. This means legally and ethically that the investments must be treated with the utmost care and good faith. Obviously churning to generate commissions is fiduciary irresponsibility. But the financial incentive is always there, so investor beware.

Churn"ing, n.

1.

The act of one who churns.

2.

The quantity of butter made at one operation.

 

© Webster 1913.

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