Churning and Unauthorized Trading

Churning and unauthorized trading are two serious violations that can result in significant penalties for securities professionals. Both practices harm customers and violate the trust relationship between financial professionals and their clients.

What Is Churning?

Churning (also called "excessive trading") occurs when a securities professional engages in frequent buying and selling in a customer's account primarily to generate commissions, rather than to benefit the customer.

Elements of Churning

For churning to exist, three elements must typically be present:

Control Over the Account

Control can be either:

• Explicit control: The agent has formal discretionary authority over the account
• Implicit control: The customer routinely follows the agent's recommendations without independent judgment

Exam Tip: Churning can occur even in non-discretionary accounts if the agent has de facto control because the customer always follows recommendations.

Measuring Excessive Trading

Several metrics are used to identify potentially excessive trading:

Turnover Ratio

The turnover ratio measures how many times the equity in an account has been turned over during a period.

Formula: Total Purchases ÷ Average Account Equity

Cost-to-Equity Ratio

The cost-to-equity ratio (also called "break-even analysis") calculates the annual return the account must earn just to cover transaction costs.

Formula: Total Annual Costs ÷ Average Account Equity

In-and-Out Trading

In-and-out trading involves buying and selling the same security within a short period. While not always improper, frequent in-and-out trading can indicate churning.

Customer's Investment Objectives

The customer's stated investment objectives are crucial in determining whether trading is excessive:

Key Point: High turnover in an account with conservative, long-term objectives is more likely to constitute churning than the same activity in a speculative account.

Unauthorized Trading

Unauthorized trading occurs when an agent executes transactions in a customer's account without proper authorization.

Types of Accounts

Requirements for Discretionary Authority

To exercise discretion over a customer account, an agent must have:

1. Written authorization from the customer (trading authorization or power of attorney)
2. Acceptance by the broker-dealer (firm must approve)
3. Proper documentation on file

What Constitutes "Discretion"?

Discretion means the authority to determine:

• Which security to buy or sell
• The number of shares or units
• Whether to buy or sell

Important Exception: If a customer specifies the security, action, and amount, but leaves only the timing and/or price to the agent, this is NOT considered discretion. For example: "Buy 100 shares of ABC whenever you think the price is right" does not require written discretionary authority.

Time and Price Exception

The time and price exception states that if a customer specifies:

• The security
• The action (buy or sell)
• The quantity

And only gives the agent discretion over timing and/or price, written discretionary authority is not required.

Consequences of Violations

Both churning and unauthorized trading can result in:

For the Agent/Adviser

• Suspension or revocation of registration
• Civil penalties and fines
• Criminal prosecution
• Requirement to pay restitution
• Permanent bar from the industry

For the Broker-Dealer/Firm

• Supervisory failures
• Fines and penalties
• Reputation damage
• Required enhanced supervision

Key Takeaways

• Churning is excessive trading primarily to generate commissions
• Three elements of churning: control, excessive trading, and intent
• Turnover ratios above 6 and cost-to-equity ratios above 10% are strong indicators of churning
• Unauthorized trading is executing transactions without proper authorization
• Discretionary authority requires written customer authorization and firm approval
• The time and price exception: if only timing/price is discretionary, no written authorization needed
• Both violations can result in civil, administrative, and criminal penalties