Stock Churning

STOCK CHURNING IS THE excessive trading of securities in a brokerage account. Also called burning and churning and over-trading, churning is done in order to increase the broker's commissions, which are directly related to the volume of trading rather than customer profits. Part, or sometimes all, of the client's potential profit may be absorbed by the broker's commission on some trades even though there would otherwise seem to be a profit. Sometimes, the commission will result in the client actually taking a loss on what would have been a profitable trade. In these cases, the broker makes a profit but the client would have been better off with an unchanged portfolio. Although some changes are necessary or good business for the client, excessive trading or churning is good business only for the financial adviser and her firm.

According to PR Newswire, churning is involved if these conditions are met: “The trading in the customer's account was excessive in the light of the customer's investment objectives; the broker exercised control over the trading in the account; the broker intended to defraud or demonstrated willful and reckless disregard for the customer's interest.”

Over-trading is not solely within the realm of stockbrokers. Because the charge, or load, to a client on a mutual fund is typically higher than it is on stock sales, fund advisers can make larger commissions by moving an investor's holdings less often than with stocks. There are several forms this deceit can take.

Mutual fund managers sometimes churn the portfolio of stock holdings within their funds, sometimes on a daily basis. If the fund manager simply exchanges one of a client's funds with a similar one, he reaps the commission but the portfolio's performance does not change significantly. Because the performance is unchanged, the owner might not notice the change, but her value or interest has been lessened or depleted by the manager's commission on the trade.

Another kind of mutual fund churning occurs when a fund manager switches from one kind of fund to another, such as a mutual fund to a unit investment trust then to another mutual fund. Sponsors or families of investment vehicles will usually allow investors to shift money between funds within their group with no commission charge, so if a change is desired or necessary, staying within the same sponsor or family can be beneficial to the fund holder without costing him a commission on the change. Unscrupulous brokers will exchange sponsors simply to get a commission.

A side effect of churning is that it can be problematic for companies whose shares are traded often. Long-term stock holders may provide a company[Page 768] with more stability and options for long-term planning and profits than having a majority of short-term investors.

Although high trading volume is typical of churning or overtrading, all relatively high turnover is not necessarily a concerted effort by a broker or manager to increase commissions. An investment house basing buy and sell decisions on short-term technical and liquidity indicators will have higher turnover than a house with the “buy and hold” approach. Some decisions are also based on an exceptional offer to buy or to sell or other valid investment reasons.

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