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How to Prove a Churning Claim in FINRA Arbitration
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 prove a churning claim and some of the information that you would need to know in order to present such a case.
A. 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).
(1) Control
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 (i.e. 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 in establishing churning is called the commission to equity ratio (the C/E 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.
(3) Scienter
Finally, to prevail in 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 high enough (i.e. 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).
When the trading only constitutes excessive trading (as opposed to outright churning), it is more difficult to establish scienter, 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 Broker Report, 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.
B. 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.
C. FINRA Statistics
FINRA keeps statistics on FINRA arbitration awards, broken down by the type of claim involved. According to FINRA’s published statistics, the following number of securities arbitration claims involving churning or excessive trading were filed over the last few years:
2009 – 306
2010 – 270
2011 – 236
2012 – 245
These numbers would seem to indicate that churning is becoming less of a problem in the securities industry. However, a closer look at the numbers reveals the opposite because the number of churning claims is not decreasing proportionately with the overall decline in arbitration filings. Here are the numbers of overall FINRA arbitration claims filed during this same time period.
2009 – 7,137
2010 – 5,680
2011 – 4,729
2012 – 4,299
As such, even though the overall numbers are down, proportionately speaking, churning cases are up. Whereas in 2009 churning cases represented only 4.28% of the total number of cases filed, in 2012 churning cases represented 5.7% of the total number of cases filed. Whereas in 2009, when overall filings were up because of the market decline in 2008 and then cases declined slowly as we got further away from the market decline, churning cases did not experience the same percentage decrease in filings.
This is likely because 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.
D. Damages
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.
E. Typical Defenses
Since the numbers are, in theory, “what they are” (i.e. 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 comes in 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.
To this end, 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).
Practically speaking, at hearing brokerage firms will examine the investor by going through with the investor the confirmation slips 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 properly marked as “unsolicited” (i.e. 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.
F. 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.
G. Additional Caselaw / Authority for Churning Claims
i. In re Daniel 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.
ii. 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.
iv. 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.
v. 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.
vi. 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).
H. Conclusion
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 312/238-9650.
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.
Securities Attorney’s view of the basics of churning fraud
Churning is defined as an unethical practice employed by some financial advisors to increase their commissions by excessively trading in a client’s account. This practice violates various FINRA Rules and is often referred to as “churn and burn”, “excessive trading”, “twisting” and “overtrading.”
FINRA Rule 2111 codifies a brokerage firms and associated persons’ obligations with respect to churning/excessive trading. Specifically, FINRA has enacted a suitability analysis for churning called “quantitative suitability.”
Quantitative suitability requires a broker who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile. Factors such as turnover rate and cost-equity ratio may provide a basis for finding that the activity at issue was excessive.
Although there is no one turnover rate that is universally recognized as being determinative of churning, an annual turnover rate in excess of six is generally presumed to reflect excessive trading. 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”).
Essentially, churning is anytime that the trading strategy implemented by a financial advisor is clearly intended to maximize commissions at the expense of the client and the client’s investment objectives.
If you believe that you have been the victim of churning, please call the securities attorneys of The White Law Group at 312/238-9650 for a free consultation.
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.
For more information on The White Law Group, visit http://www.whitesecuritieslaw.com.
SEC accuses 3 former JP Turner Brokers of Churning
According to reports, three former JP Turner & Company brokers have been accused by the Securities and Exchange Commission of defrauding clients out of $2.7 million by “churning” their accounts.
The reports indicate that brokers Ralph Calabro of Matawan, N.J., and Jason Konner and Dimitrios Koutsoubos, both of Brooklyn, N.Y., allegedly disregarded their clients’ conservative investment goals and engaged in excessive trading to generate commissions and other revenue—a practice referred to in the industry as “churning.”
JP Turner has consented to a settlement in which they neither denied nor admitted to the SEC’s findings. In the settlement, JP Turner agreed to pay $200,000 in disgorgement, a $200,000 penalty and $16,051 in prejudgment interest. These sanctions were as a result of the SEC’s claim that JP Turner failed to adequately supervise the three brokers accused of churning.
The brokers are accused of churning the accounts of seven clients between December 2008 and December 2009. According to the SEC, the churning allegedly undertaken by these three JP Turner advisers generated commissions, fees and margin interest totaling about $845,000 and resulted in total losses of about $2.7 million for the clients.
According to their FINRA Broker Reports, Ralph Calabro, Jason Konner, and Dimitrios Kousoubos are no longer affiliated with JP Turner, having moved to National Securities Corporation, DPEC Capital, Inc., and Caldwell International Securities, respectively.
The foregoing information, which is publicly available, is being provided by The White Law Group. 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 represented numerous clients in churning claims similar to those discussed above.
If you believe that you are the victim of excessive trading or churning, please call the securities attorneys of The White Law Group at 312/238-9650 for a free consultation.
For more information on The White Law Group, visit http://www.whitesecuritieslaw.com.
Regulatory Rules Governing Churning
Although the industry has done a decent job of curbing the churning of investors’ accounts (relative to the number of churning claims that existed in the 80’s and 90’s), such claims are still prevalent. According to statistics published by FINRA, there were 212 churning claims filed in 2008, 306 churning claims filed in 2009, 270 churning claims filed in 2010, and 236 churning claims filed in 2011. Based on the total number of FINRA arbitration claims filed during these years, churning claims still represent approximately 5% of the total claims filed.
(1) FINRA
FINRA Rule 2111 (generally modeled after former NASD Rule 2310) codifies a brokerage firms and associated persons’ obligations with respect to churning/excessive trading. Specifically, FINRA has enacted a suitability analysis for churning called “quantitative suitability.”
Quantitative suitability requires a broker who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile. Factors such as turnover rate, cost-equity ratio and use of in-andout trading in a customer’s account may provide a basis for finding that the activity at issue was excessive.
(2) NFA
Churning claims are not only prevalent in FINRA arbitration. Such claims are also seen quite frequently in the commodities and futures trading worlds. When a churning claim arises in the commodities and futures context, such claim is generally arbitration through the National Futures Association (or NFA).
The following is the verbatim language provided to NFA Arbitrators regarding churning:
Churning is a violation of the anti-fraud provisions of Section 4b of the Commodity Exchange Act (7 U.S.C. § 6b). At its simplest, churning is excessive trading of a customer’s account for the purpose of generating commissions. Case law has generally defined churning as a volume or frequency of trading that, in light of the nature of the account and the situation as well as the needs and objectives of the customer, indicates a purpose of the broker to generate commissions rather than to protect the customer’s interests. To establish a churning claim, a customer must prove that:
1) the person who allegedly churned the account controlled the level and frequency of trading in the account (including defacto control);
2) the overall volume of trading was excessive in light of the customer’s trading objectives; and
3) the person who allegedly churned the account acted with intent to defraud or in reckless disregard of the customer’s interests.
Whether an account has been traded excessively is a question of fact that cannot be determined by a specific rule or formula. No precise mathematical test exists. Rather, a number of factors should be considered in light of the needs and objectives of the customer. Among the factors which have been considered by the courts and the Commodity Futures Trading Commission (CFTC) are:
1) the commission-to-equity ratio;
2) the percentage of day trades;
3) departure from a previously agreed upon strategy;
4) whether the account was traded while it was undermargined; and
5) re-establishment of previously liquidated positions in the same or related contracts.
In considering a churning claim, arbitrators should keep in mind that the turnover of futures contracts, by nature, far exceeds the frequency with which most securities investors alter their portfolios. Day trading, for instance, is commonplace in futures, especially among the professionals. Therefore, the level of trading that can occur without being excessive is much higher for futures than for securities.
As you can see, the basic analysis then for both FINRA and the NFA is that churning is any type of trading that is clearly done to increase commissions and which couldn’t possibly be in the best interests of the client.
If you believe that you have been the victim of churning or excessive trading, please call the securities attorneys of The White Law Group at 312/238-9650 for a free consultation.
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.
For more information on The White Law Group, visit http://www.whitesecuritieslaw.com.
Victim of Excessive Trading?
Has your account been excessively traded or churned by your financial advisor? If so, you may have a securities fraud claim to recover the damages resulting from this improper trading.
FINRA Rule 2111 requires that broker-dealers must have a reasonable basis to believe the number of recommended transactions within a certain period is not excessive (i.e., that the investor’s account is not being churned). This is commonly called “quantitative suitability.” Essentially, it means that if an account is excessively traded it could not have been suitable for the client because the strategy could only benefit the advisor (through the generation of commissions) and not the investor.
To determine whether the level of trading in an account rises to the level of excessive trading or churning, the customer’s financial situation and investment objectives must be considered. While no one test is determinative in evaluating whether a specific amount of trading is per se churning, to prove such a claim you must demonstrate the following basic elements:
i. excessive trading,
ii. control of the account by the financial advisor (you cannot hold a broker-dealer liable for your own excessive trading), and
iii. intent by the advisor to defraud the customer.
When an account is examined to determine if the trading in the account is excessive, the type of account that is being analyzed is significant. For example, a high turnover ratio in a day trader’s account is meaningless, whereas the same turnover ratio in a retiree’s account may be considered churning.
To determine whether the trading is excessive in light of the goals of the account, the most often used analysis 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). An annualized turnover ratio of 6, which means that the equity in the account was invested 6 times in a year, is often considered excessive trading in the typical customer account.
Control of the account refers to who is actually directing the trading. To prove a claim for churning, you must establish that the registered representative had actual or de facto control over your account.
Intent is often the easiest element to prove. Generally if you can demonstrate the first two elements, the intent to maximize commissions at the expense of the client is obvious.
If you believe that your account has been excessively traded to maximize commissions, the securities attorneys of The White Law Group may be able to help. For a free consultation, please contact the firm’s Chicago office at 312-238-9650.
The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida.
For more information on The White Law Group, please visit the firm’s website at http://www.whitesecuritieslaw.com.