Understanding Churning and Excessive Commissions:

How CIRO-Regulated Firms Can Detect and Prevent Misconduct Through Turnover and Cost-to-Equity Analysis

Practical Solution

Introduction

In Canada’s investment industry, client protection and ethical trading practices lie at the heart of regulatory oversight. The Canadian Investment Regulatory Organization (CIRO, formerly IIROC) requires firms to ensure that all account activity is consistent with the client’s best interest, suitability, and fair-dealing standards.

Two of the most common red flags uncovered during compliance reviews are churning and excessive commissions.

While both involve inappropriate trading behavior, they differ in nature — and both can be detected using simple but powerful quantitative tools: the Turnover Ratio and the Cost-to-Equity Ratio.

This article explains how these ratios work, why they matter, and how compliance teams can apply them effectively using CIRO-aligned best practices.

1. What Is Churning?

Churning refers to excessive trading activity in a client’s account primarily to generate commissions for the dealing representative or dealer — without regard for the client’s investment objectives, risk tolerance, or best interest.

Under CIRO Rules 1400 and 3110, churning is considered a serious breach of conduct because it violates:

• The client’s best interest standard;

• The fair and good faith trading obligation; and

• Often indicates unsuitable recommendations or conflicts of interest.

  
  

In essence, churning benefits the advisor or dealer — not the investor.

2. What Are Excessive Commissions?

Excessive commissions occur when:

• The frequency or size of trades generates disproportionate fees relative to the account’s value or returns;

• The same or similar transactions are repeated unnecessarily (e.g., switching between funds); or

• Multiple fee structures are combined (such as fee-based plus embedded commissions), resulting in double charging — known as fee layering.

  
  

Like churning, this practice erodes investor returns and undermines confidence in fair dealing.

3. How Compliance Officers Detect These Issues

The most reliable way to spot churning or excessive commissions is by analyzing two key quantitative indicators:

A. Turnover Ratio

This ratio measures how many times an account’s holdings have been replaced (or “turned over”) in a year.

• A ratio under 2× suggests normal activity.

• A ratio between 2× and 3× warrants monitoring.

• A ratio above 3× should trigger a review for potential churning.

  
  

B. Cost-to-Equity Ratio

This ratio reveals what percentage of an account’s value is consumed by trading costs each year.

• Below 4 % is typically acceptable.

• 4–6 % is elevated but may be explainable.

• Above 6 % signals potential over-trading or excessive cost to the client.

  
  

4. Calculating Average Account Equity

To ensure accuracy — especially when deposits or withdrawals occur — firms may use the Monthly Average. It is not the most accurate method , but more simple and yet still efficent enough.

Balance Method:

1. Record each month’s ending balance (cash + investments).

2. Add all twelve month-end balances.

3. Divide by 12 to determine the average account equity.

   
   

Only accounts that have been open for at least 12 months should be included in this analysis. Newer accounts may show distorted ratios due to initial funding or liquidation events.

5. Interpreting Results in Practice

Ratio Type	Typical Range	Supervisory Action
Turnover ≤ 2×	Normal trading	No concern
Turnover 2–3×	Active but explainable	Monitor
Turnover ≥ 3×	Potential churning	Investigate
Cost-to-Equity ≤ 4 %	Normal cost level	No concern
Cost-to-Equity 4–6 %	Elevated but explainable	Monitor
Cost-to-Equity ≥ 6 %	Potential excessive costs	Investigate / escalate

Compliance officers should document the rationale for each flagged account, review trading notes, and confirm consistency with the client’s KYC and stated objectives.

6. Why These Metrics Matter

Regularly monitoring turnover and cost-to-equity ratios helps firms:

• Detect and deter churning before it becomes a disciplinary issue.

• Ensure fees remain proportionate to the client’s portfolio size and strategy.

• Demonstrate a robust supervisory system, as required under CIRO Rule 3110.

• Strengthen investor confidence through transparent, ethical business conduct.

  
  

7. Recordkeeping and Audit Readiness

All calculations, supporting data, and supervisory notes should be retained for at least seven years under CIRO Rule 3800.Firms should apply a consistent methodology across all advisors and re-evaluate thresholds annually to ensure continued relevance.

Conclusion

By integrating turnover and cost-to-equity monitoring into monthly compliance reviews, CIRO-regulated firms can proactively safeguard investors, identify potential misconduct early, and uphold the highest standards of fair dealing.

Churning and excessive commissions may seem like numbers on a spreadsheet — but behind every ratio is a client who deserves integrity, transparency, and trust.