Churning claims arise out of the inherent conflict of interest involved because a financial advisor is compensated by commissions earned in buying and selling securities on behalf of a client. As long as financial advisors are compensated by commissions, the unscrupulous ones will continue to attempt to enrich themselves by excessively trading accounts. When this happens, a FINRA arbitration claim against the financial advisor or the financial advisor’s employer is often the best way to recover the damages incurred as a result of the broker’s excessive trading.
The following is a brief overview of how to know if your broker is churning your account and if so, how to prove such a case.
Elements of a Churning Claim
There are three basic elements that must be proven in order to prevail in a churning case. Those elements are (1) control, (2) excessive trading, and (3) scienter (see, e.g. In re Al Rizek, Securities Exchange Act Release No. 41725, In re Joseph J. Barbato, Securities Exchange Act Release No. 41034), Craighead v. E.F. Hutton & Co., 899 F.2d 485, 489 (6th Cir. 1990).
In a FINRA arbitration case, if a financial advisor is to be found liable for churning or excessively trading an account, the arbitration panel must first find that the broker had either express or implied control over the account. For example, the excessive trading was at the direction of the advisor and not the client – a financial advisor is obviously not responsible if the client elects to excessively trade their own account for whatever reason.
The easiest way to prove control is when the client gives the stock broker discretionary authority to trade the account by signing a discretionary trading agreement.
More typically though, control is established by demonstrating that the broker had “de facto” control of the account through testimony evidence or course of conduct evidence. For example, if it can be demonstrated that the client followed the broker’s recommendations in most transactions, this is generally held to be sufficient evidence to establish that the broker had “control” over the account. See, e.g. District Business Conduct Committee v. Daniel Wright Sisson, NASD Decision, Complaint No. C01960020 (De facto control of an account may be established where the client habitually followed the advice of the broker).
Other factors in determining control are the client’s ability to understand and evaluate whether the financial advisor’s recommendations are appropriate. Factors that panels generally look at in determining whether the client had this ability include sophistication, formal education and occupation, prior or contemporaneous securities investment experience, the customer’s reading habits, the wealth of a customer relative to the size of the account and the client’s reliance/dependence on the broker’s advice. See, e.g., Carras v. Burns, 516 F.2d 251, 258 (4th Cir. 1975) (“[A] customer retains control of his account if he has sufficient financial acumen to determine his own best interests and he acquiesces in the broker’s management”).
If, however, it can be demonstrated that the investor lacked the sophistication to trade their own account and was therefore relying entirely on the advice of the financial advisor, this is generally sufficient to establish that the financial advisor had “de facto” control over the account.
(2) Excessive Trading
The second element of a churning claim is demonstrating that the account was actually excessively traded (or churned). Determining whether there is excessive trading in an account depends entirely on the type of account, the investor involved, and the investment objectives of the account. For example, the volume of trading necessary to prove that an aggressive day trader’s account was churned (versus a retired investor living on a monthly budget) is considerably higher. As such, case law generally establishes that excessive trading may only be gauged in light of the nature of the account, the dominant element of which is the investment objective of the client. For example, FINRA Rule 2111 regarding suitability states that churning may be evident if trading occurred that was not consistent with the client’s financial goals, risk tolerance, and knowledge of investment strategies.
Once a determination of the risk tolerance and general nature of the account is made, a quantitative analysis of the trading in the account is conducted to determine whether the account was excessively traded.
To determine whether the trading in a particular account rises to the level of churning, an analysis often used is the calculation of a “turnover ratio”. A turnover ratio is the total amount of purchases made in the account, divided by the average monthly equity in the account. That ratio is then annualized (by dividing the result by the number of months involved to get a per month ratio, and then multiplying that result by 12). Courts have often recognized that in a normal retail account a turnover ratio in excess of 6 can be considered excessive trading. See, e.g. Arceneaux, 767 F.2d at 1502 (“The courts which have addressed this issue have indicated that an annual turnover rate in excess of six reflects excessive trading.”).
Courts have also found that in retail securities accounts, for a conservative investor, an annualized turnover rate of two is suggestive, of four is presumptive, and, of six or more, is conclusive of excessive trading. See, e.g. 68 N.C.L. Rev. 327, 339-40 (1990), noting the “six” rule and the “2-4-6″ rule.
An alternative method is the C/E Ratio, or commission to equity ratio. The C/E Ratio is calculated by dividing the total commissions in the account by the average equity in the account and then annualizing the number.
Both methods are intended to establish the same basic principle – that the trading in the account was clearly intended to benefit the broker through the creation of commissions and the trading strategy implemented was not in the best interests of the client.
Finally, to win a churning claim, you must establish scienter, or intent. As such, you must also demonstrate that the financial advisor excessively traded the account with the specific intent to defraud, or at least with reckless disregard of the interests of the client. Churning, in essence, involves a conflict of interest in which a broker or dealer seeks to maximize his or her remuneration in disregard of the interests of the customer. If the level of trading is egregious enough, the motivation to create such high commissions, by its very nature, often is all that is necessary to satisfy the element of scienter. Scienter, in turn, is what separates churning from excessive trading. See, e.g. In re Donald A. Roche, Securities Exchange Act Release No. 38742. See, also, Franks v. Cavanaugh, 711 F. Supp. 1186 (S.D.N.Y. 1989) (the mere fact that the account was churned is typically sufficient to a scheme or artifice to defraud within the meaning of 10b-5).
It can be more difficult to establish scienter with excessive trading rather than churning, however, arbitration panels can often recognize when an unscrupulous financial advisor is trading for the express purpose of maximizing commissions. This is usually established by discussing the financial advisor’s industry track record (FINRA BrokerReport, or CRD). For example, if a financial advisor has previously been sued for churning or excessive trading, it is not difficult for an arbitration panel to determine that the broker was again acting with scienter in excessively trading the account now at issue.
Applicable FINRA Rules
The primary FINRA Rule used at arbitration hearings when discussing churning is FINRA Rule 2111 regarding suitability.
Essentially, though, FINRA Rule 2111 requires that a broker-dealer or associated person “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer’s investment profile.” In general, a customer’s investment profile would include the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance.
For excessive trading cases, FINRA Rule 2111 also has a quantitative suitability standard that applies. Quantitative suitability requires a broker who has actual or de facto control over a customer account to have a reasonable basis for believing that, in light of the customer’s investment profile, a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer. Factors such as turnover rate, cost-to-equity ratio, and use of in-and-out trading in a customer’s account may provide a basis for finding that the activity at issue was excessive.
Churning, then, is a fairly obvious violation of Rule 2111 because the churning of an account, if proven, can never be suitable.
FINRA keeps statistics on FINRA arbitration awards, broken down by the type of claim involved. According to FINRA’s published statistics, the following securities arbitration claims involving churning or excessive trading were filed over the last few years:
|Year||Number of FINRA Claims Filed||Number of Claims Involving Churning|
As you can see, although the churning claims have decreased slightly since 2009, the number of total claims filed has decreased significantly. The number of churning claims has not decreased proportionately with the overall decline in arbitration filings. Churning cases are relatively constant and actually easier for financial advisors to get away with when the market is moving up (because the client is less likely to notice as long as their account is increasing in value). Unfortunately, as long as financial advisors are compensated by commissions, the unscrupulous ones will take advantage to maximize their own commissions.
Typically the damages in an excessive trading case are any excessive commissions or expenses the client paid and any actual losses to the client’s portfolio caused by the churning. See, e.g. Securities Regulation & Law Report, Volume 35, Number 10, ISSN 1522-8797. In an upward moving market, an investor may also be entitled to the market gain that should have been experienced had the account been appropriately invested.
Because of the number of trades involved in a typical churning case, damages are usually best proven through expert reports that analyze the gains, losses, and commissions of every trade and breakdown the results in a format that is easy for the FINRA arbitration panel to understand. These reports vary in cost depending on the expert and the number of trades involved but churning cases are virtually impossible to prove without them.
Although the parties are likely to agree on the approximate amount of damages and the respective turnover ratio or P/E ratio, brokerage firm usually defend these cases by fighting the “control” element of the claim.
For example, brokerage firms often attempt to argue that the investor was directing the account and the firm was simply following the client’s instructions. Once again, this is where the client’s background is important because obviously it is more difficult for a FINRA arbitrator to believe that an 80 year old retiree was day trading their own account as opposed to a 40 year old high income executive.
Brokerage firms will often attempt to paint the client as extremely sophisticated and clearly capable of both understanding the trading involved and exercising control over the account. See, e.g. Follansbee v. Davis, Skaggs & Co., 681 F.2d 673, 677-78 (9th Cir. 1982) (no control by broker where customer had degree in economics, read and understood corporate financial reports, and regularly read investment literature), and Newburger, Loeb & Co., Inc. v. Gross, 563 F.2d 1057, 1070 (2d Cir. 1977), cert. denied, 434 U.S. 1035 (1978) (no control by broker where customer had post-graduate degree, years of experience in the market, and subscribed to investment services).
If a brokerage firm is unable to establish that the client had control of the account, the second typical defense seen in these cases is the affirmative defenses of ratification, waiver, and estoppel. These legal theories basically state that a customer cannot wait to see whether an investment proves to be profitable or unprofitable before he complains that the transaction was unauthorized, or that the trading was excessive. A customer who receives trade confirmation slips, monthly account statements, or other information reflecting that transactions have occurred and the nature and frequency of those transactions, and who fails to complain in a timely fashion, may have his claims barred under the doctrines of ratification, waiver, and estoppels. See, e.g., Brophy v. Redivo, 725 F.2d 1218 (9th Cir. 1984) (If the customer receives confirming documents and does not object, by his silence he has ratified the trades, or waived his claim).
At the hearing, brokerage firms will typically examine the investor by going through the investor confirmation slips with the investor that were provided and asking why the investor did not immediately complain if they knew that the trading strategy implemented was not what they wanted. The counter to this argument is the ruling of the Court in Hecht v. Harris Upham, which stated, “that while confirmation slips were sufficient to inform plaintiff of the specific transactions made, they were not sufficient to put her on notice that the trading of her account was excessive.” Hecht v. Harris Upham & Co., N.D. Cal. 1968. As such, the mere fact that confirmation slips were provided to the client is not determinative. A ratification or waiver defense can fail if the customer proves that he did not have all the material facts relating to the trade at issue. See, e.g., Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 906 F.2d 1206, 1213 (8th Cir. 1990). However, the longer that the churning of an account is allowed to go on by the investor the more difficult it is to counter the ratification argument or to demonstrate that the broker hid the true nature of the trading strategy.
Brokerage firms will also attempt to argue against the control of the account if the confirmation slips are marked as “unsolicited” –meaning that the customer allegedly ordered many of the transactions without ever having had the securities called to his or her attention by the stockbroker. Whether the confirmation slips were the customer’s idea is often a credibility battle as the client will likely testify that the trades were the broker’s idea and the broker will claim that the trades were the client’s idea.
Documents Needed to Prove Churning Cases
In addition to the typical documents needed in every FINRA arbitration claim, for churning claims the following documents are also needed:
1) All commission runs relating to the customer’s account(s) at issue or, in the alternative, a consolidated commission report relating to the customer’s account(s) at issue.
2) All documents reﬂecting compensation of any kind, including commissions, from all sources generated by the Associated Person(s) assigned to the customer’s account(s) for the two months preceding through the two months following the transaction(s) at issue, or up to 12 months, whichever is longer. The ﬁrm may redact all information identifying customers who are not parties to the action, except that the ﬁrm/Associated Person(s) shall provide at least the last four digits of the non-party customer account number for each transaction.
3) Documents sufﬁcient to describe or set forth the basis upon which the Associated Person(s) was compensated during the years in which the transaction(s) or occurrence(s) in question occurred, including: a) any bonus or incentive program; and b) all compensation and commission schedules showing compensation received or to be received based uponvolume, type of product sold, nature of trade (e.g.,agency v. principal), etc.
4) All conﬁrmations for the customer’s transaction(s) at issue.
5) All agreements with the customer, including, but not limited to, account opening documents, cash, margin, and option agreements, trading authorizations, powers of attorney, or discretionary authorization agreements, and new account forms.
6) All account statements for the customer’s account(s) during the time period and/or relating to the transaction(s) at issue.
- Additional Case law / Authority for Churning Claims
- In reDaniel L Zessinger, Initial Decision Release No. 94 (Aug. 2, 1996) – For conservative investors, a turnover rate of two [on an annual basis] suggests excessive trading; four is presumptively excessive trading; and six is conclusive of excessive trading.
- In re Application of Rafael Pinchas, Review of Disciplinary Action Taken by the NASD, Securities and Exchange Act Release No. 41816 (Sept. 1, 1999) – In and out trading is a practice extremely difficult for a broker to justify and can, by itself, provide a basis for finding excessive trading.
iii. In re Wayne Miller, Securities Exchange Act Release No. 25520 – A broker has de facto control over a customer’s account if the customer is unable to evaluate the broker’s recommendation and to exercise independent judgment.
- In re Joseph J. Barbato, Securities Exchange Act Release No. 41034 – Churning occurs when a broker enters into transactions and manages a client’s account for the purpose of generating commissions rather than furthering his client’s interests.
- In re application of David Wong, Securities Exchange Act Release No. 45426 – The scienter element of churning may be inferred from the amount of commissions charged by the registered representative.
- Carras v. Burns, 516 F.2d 251, 258, 259 (4th Cir. 1975) – In the absence of an express agreement, control may be inferred from the broker-customer relationship when the customer lacks the ability to manage the account and must take the broker’s word for what is happening
vii. Hecht v. Harris Upham & Co., N.D. Cal. 1968 – The requisite degree of control is met when the client routinely follows the recommendations of the broker.
viii. Hotmar v. Lowell H. Listrom & Co., 808 F.2d 1384 (10th Cir. 1987) (no control by the broker where evidence showed customer owned several businesses and rental property, spoke with broker almost daily, knew how to use broker’s computer, and occasionally rejected broker’s recommendations).
As you can see, churning claims can be complex and sometimes difficult to prove. Brokerage firm almost always hire experience securities defense firms to defend them in these claims. If you believe that you are the victim of churning by your brokerage firm or financial advisor, it is recommended that you consult with an experienced securities attorney. For a free consultation with a securities attorney, please call The White Law Group at 888-637-5510.
The White Law Group is a national securities fraud, securities arbitration, and investor protection law firm with offices in Chicago, Illinois and Boca Raton, Florida. The firm has extensive experience representing investors in churning/excessive trading claims against brokerage firms and financial advisors.
For more information on The White Law Group, visit http://www.whitesecuritieslaw.com.