Churning
Churning
Excessive trading in a client's account to generate commissions without regard to the client's investment objectives. Requires three elements: control over the account, excessive trading activity, and intent to generate commissions. A prohibited practice that violates fiduciary duty and suitability standards.
An adviser with discretionary authority buys and sells the same securities multiple times per month in a conservative client's account, generating 15% in annual commissions while the account returns only 2%.
Churning requires all three elements: control over the account (discretionary authority or de facto control), excessive trading inconsistent with client objectives, and intent to generate excess commissions. High turnover alone is not churning without the commission-generation motive.
How This Is Tested
- Identifying all three required elements of churning: control, excessive trading, and intent
- Distinguishing between churning in commission-based vs. fee-based advisory accounts
- Recognizing indicators of excessive trading such as high turnover ratios and cost-to-equity ratios
- Understanding that discretionary authority or de facto control must exist for churning to occur
- Determining when high trading activity violates suitability standards vs. constitutes churning
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Turnover ratio indicating potential churning | 6x annually or higher | Complete account turnover 6+ times per year is a red flag, though no absolute threshold exists |
| Cost-to-equity ratio indicator | 20% or higher | When annual costs exceed 20% of account equity, scrutiny for churning increases |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Robert, a 68-year-old retiree with conservative investment objectives, has a discretionary account managed by his broker. Over the past year, the account had a turnover ratio of 8.5 (the entire portfolio was replaced 8.5 times) and generated $18,000 in commissions on an average equity of $200,000. The account gained 4% while the S&P 500 gained 12%. Which statement best describes this situation?
B is correct. This scenario exhibits all three elements of churning: (1) control via discretionary authority, (2) excessive trading with 8.5x turnover far beyond what's suitable for a conservative retiree, and (3) intent to generate commissions evidenced by $18,000 in fees (9% cost-to-equity ratio) while significantly underperforming the market.
A is incorrect because positive returns don't justify excessive trading that violates suitability and generates excessive commissions. C is incorrect because discretionary authority enables churning; client authorization doesn't eliminate the prohibition. D is incorrect because there is no "safe harbor" turnover ratio; 8.5x is excessive for conservative objectives regardless of any threshold.
The Series 65 exam tests your ability to identify churning by analyzing the three required elements together. You must recognize that all three factors. control, excessive activity, and commission intent. must be present, and understand how turnover ratios and cost-to-equity percentages serve as red flags even when no absolute threshold exists.
Which three elements are required to establish that churning has occurred in a client account?
B is correct. Churning requires three specific elements: (1) control over trading decisions (through discretionary authority or de facto control), (2) excessive trading activity inconsistent with the client's investment objectives, and (3) intent (scienter) to generate commissions or fees rather than serve client interests.
A is incorrect because written complaints and losses, while often present, are not required elements of churning. C is incorrect because margin and unsuitable investments may accompany churning but are not defining elements. D is incorrect because client dissatisfaction is a consequence, not a required element, and commission-based compensation alone doesn't prove churning without the other elements.
The Series 65 exam frequently tests knowledge of the precise legal elements that constitute churning. Understanding these three specific requirements helps distinguish churning from other prohibited practices and from legitimate active trading strategies.
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A is correct. Calculate turnover ratio: Total purchases ÷ Average equity = $900,000 ÷ $150,000 = 6x. Calculate cost-to-equity ratio: Total costs ÷ Average equity = $12,000 ÷ $150,000 = 8% (or 0.08).
B incorrectly calculates cost-to-equity as $12,000 ÷ $90,000 = 13.3%, confusing the denominator. C incorrectly calculates turnover using a different formula. D makes errors in both calculations. Both 6x turnover and 8% cost-to-equity are potential red flags for churning, though no absolute threshold exists.
Turnover ratio and cost-to-equity ratio calculations appear on the Series 65 exam as quantitative indicators of potential churning. While regulators don't set absolute thresholds, turnover above 6x annually and costs exceeding 20% of equity raise significant scrutiny. You must be able to calculate both metrics accurately.
All of the following statements about churning are accurate EXCEPT
C is correct (the EXCEPT answer). Churning CAN occur in fee-based accounts, though it's less common. While the commission-generation motive is different, an adviser could still engage in excessive trading in a fee-based account to justify or increase their fee percentage, or simply through negligence that amounts to breach of fiduciary duty. The three elements can still be present.
A is accurate: De facto control (where the client routinely follows all recommendations without question) can establish the control element even without formal discretionary authority. B is accurate: The trading must be excessive relative to the client's stated objectives and risk tolerance to constitute churning. D is accurate: These ratios are red flags that prompt investigation, but churning determinations also consider the client's objectives, the nature of securities traded, and other qualitative factors.
The Series 65 exam tests nuanced understanding of when churning can and cannot occur. Many candidates incorrectly believe fee-based accounts eliminate churning risk entirely, but the exam requires you to understand that excessive trading inconsistent with client objectives violates fiduciary duty regardless of fee structure.
An investment adviser representative reviews a client account and observes the following over the past year: turnover ratio of 7.2x, cost-to-equity ratio of 11%, account underperformed benchmark by 8%, and the client has moderate-conservative objectives. The account is non-discretionary, but the client has historically accepted every recommendation. Which factors suggest potential churning?
1. The turnover ratio of 7.2x
2. The cost-to-equity ratio of 11%
3. De facto control through client acceptance of all recommendations
4. The account's underperformance relative to the benchmark
B is correct. Statements 1, 2, and 3 are all indicators of potential churning.
Statement 1 is TRUE: A 7.2x turnover ratio (entire portfolio replaced 7.2 times in one year) is extremely high and suggests excessive trading, especially for moderate-conservative objectives.
Statement 2 is TRUE: An 11% cost-to-equity ratio means the client paid 11% of their account value in costs, which is very high and suggests commission-generation motive.
Statement 3 is TRUE: De facto control exists when a client routinely accepts all recommendations without independent judgment, satisfying the "control" element even in non-discretionary accounts.
Statement 4 is FALSE: While underperformance often accompanies churning, it is not a required element. Churning focuses on excessive trading and commission generation, not investment performance. An account could outperform and still be churned.
The Series 65 exam tests your ability to identify multiple indicators of churning simultaneously and understand which factors are core elements versus common consequences. You must recognize that de facto control satisfies the control requirement, that quantitative metrics like turnover and cost ratios serve as red flags, and that performance is not a defining element of churning.
💡 Memory Aid
Remember "C-E-I" for churning: the adviser has CONTROL over your account, makes EXCESSIVE trades you didn't need, all with INTENT to generate commissions from YOUR money. Picture your account as a butter churn: the adviser keeps churning and churning (trading), extracting cream (commissions) while your principal gets beaten down. All three elements must be present.
Related Concepts
This term is part of this cluster:
More in Prohibited Practices
Where This Appears on the Exam
This term is tested in the following Series 65 exam topics: