Stock churning is an illegal practice whereby a broker repeatedly trades a security in order to generate commissions. This practice is most common in situations where a broker has full access to an account and may execute trades without informing the account holder of the situation. Each time the broker executes a trade on the investor’s behalf, he is paid a predetermined commission. If the broker trades a security several times a month, this will eat up the investor’s profits and ruin the investment.
In order for stock churning to occur, the broker needs full access to the account. In most cases, this means the broker is managing something like a mutual fund, investment account or retirement package. In cases such as these, the broker receives an amount of money and invests it as he sees fit. The broker makes the decisions as to when securities should be bought or sold and, as a result, determines when he receives a commission.
In most cases, these investments are designed to provide a low, but continuous, yield over a long period of time. This means that very few trades are required to keep the investment profitable. A common investment of this style will have about one trade per month on average. This is a testament to the investment's stability and a way of increasing yield through low brokerage fees.
If a broker is involved in stock churning, the number of transactions is much higher. In most stock-churning cases, the broker attempts to perform as many trades as possible in order to keep the overall profitability around even; essentially, the investment neither gains nor loses money. This way, the investor doesn’t immediately notice something is wrong, as she doesn’t appear to be losing any money.
Assessing the number of transactions on the account is the primary method of proving stock churning. When an outside expert examines the account, he generally looks at two things—the number of trades and the profitability of the securities. A high number of trades is often the first major red flag—any number over five per month is generally worthy of a look. Afterward, the examiner looks at the profitability of securities traded away and sees whether any securities were sold and repurchased within a small amount of time.
Should the broker be found guilty of stock churning, he is liable for two main monetary amounts and will likely face some jail time. He needs to repay any brokerage fees that are considered over the number required to maintain the account. In addition, he needs to repay the approximate amount the account would have made if he hadn’t tampered with it. Most settlements also include a large sum for damages to the investor.