Churning is excessive trading in an investor’s portfolio to generate commissions for the stockbroker. Sometimes brokers or INVESTMENT advisors are given discretionary authority over an investor’s account. Many investors do not want to or do not have the knowledge necessary to actively manage their investments. These investors will often entrust their investment CAPITAL to a broker, giving him or her general instructions about their investment objectives. With discretionary authority a broker can move a client’s funds into different investments in order to take advantage of market opportunities. During the DOT-COM era of the 1990s, many brokerage houses allocated shares of INITIAL PUBLIC OFFERINGs (IPOs) to only their best customers. Some investors gave discretionary authority in order to get their broker to include them in these hot-issue stocks. Churning is illegal; SECURITIES AND EXCHANGE COMMISSION Rule 10b-5 can be the basis for claims for state and federal securities FRAUD, COMMON LAW fraud, NEGLIGENCE, breach of CONTRACT, and breach of fiduciary duty. Churning usually involves a large number of trades, but large is a debatable term. Courts often use turnover ratios, the number of times the value of the account is traded in a given time period, as a basis for determining that churning has occurred. Because churning is defined as trading that is done to benefit the broker rather than the investor, even one trade can be considered churning if it has no legitimate purpose. For example, if a broker moves a client’s money from one family of MUTUAL FUNDS to another, he or she must have a good reason for doing so. This is why most brokers use written confirmation that the customer wants to switch funds in spite of the fees that will be incurred. Brokers who churn accounts often use frequent in-andout trades of the same stock and “wash” transactions (simultaneous or roughly simultaneous buy-and-sell transactions that nullify each other). When adjudicating a churning claim, the courts evaluate whether the broker or advisor had control over the account in the form of either discretionary authority or practical (“de facto”) control. The broker or advisor has de facto control when, as a practical matter, the investor lacks the knowledge and sophistication to make his or her own independent investment decisions and instead always follows the broker’s recommendations. Bruce D. Fisher and Michael J. Phillips describe a case where the broker engaged in 147 separate purchases and sales for a customer’s account, resulting in over $24,000 in commissions, fees, taxes, and margin interest against an account that started with only $25,000. In addition to churning, the other major investor complaint against stockbrokers is inappropriate recommendations. Unethical brokers often convince unsophisticated investors to purchase high-risk (and high-commission) investments ranging from real estate scams to shares in obscure foreign companies.
See also STOCK MARKET, BOND MARKET.