One of the most common allegations in a FINRA arbitration claim or complaint is that of churning, also known as excessive trading. If a client has received numerous trading confirmations and multi-page monthly account statements for a period of time, and has trouble following or even understanding the trading that is occurring in her account, it may be wise for that customer to consult an experienced securities arbitration attorney to review the account activity.
The SEC describes churning as “when a broker engages in excessive buying and selling of securities in a customer’s account, chiefly to generate commissions that benefit the broker” and as being illegal and unethical.
FINRA’s suitability rule, Rule 2111, discusses “quantitative suitability” and states that a broker who has actual or de facto control over a customer account has “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….”
A customer or regulator alleging churning must prove that the broker had control over the account in question, that the trading in the account was excessive in light of the account’s objectives, and that the broker acted in the broker’s best interest, rather than the client’s; in other words, the broker acted with scienter (a legal term that means “evil intent”).
If the client has given written authority for the account to be traded on a discretionary basis, the first element might easily be met. However, most churning cases involve non-discretionary accounts of retail customers. In those cases, in order for an arbitration or enforcement panel to find churning, there would have to be evidence that the broker exercised de facto control over the subject account. For instance, if a client agreed with virtually all of the recommendations of the broker and never made her own investment decisions, one could argue that the broker had effective control over the account. Therefore, even if the broker regularly consults the client before entering any trades in the account, that doesn’t mean that the trading activity in the account is proper. If the client, because of the lack of prior investment experience, unfamiliarity with financial matters, etc., doesn’t appreciate the risk and increased cost involved with an actively traded account, that client may have a valid complaint of churning.
Alternatively, if the client is a businesswoman, medical doctor, or other professional with years of investment experience behind her, and she simply decided she is too busy and ceded investment decisions to the broker, the issue of control in the context of churning is not so clear. Yes, in the second scenario, the client habitually follows the recommendations of the broker. However, she is certainly capable of understanding the activity ongoing in the account and could assert control over her account at any time.
The issue of control, therefore, is a fact intensive analysis and requires the judgment of an experienced securities attorney.
The second element in a churning claim also requires in depth examination. The number of trades in an account with “trading” and “speculation” as the investment objectives might be entirely appropriate; the same number of trades in an account with “long term growth” and “conservative” as the objectives could be indicative of excessive trading. There are two account analyses typically performed in examining an account for churning. One is the calculation of the “turnover” ratio. That ratio is determined by dividing the total dollar amount of purchases by the average monthly equity and annualizing the result. It is the generally held view that for a conservative retail account, a turnover ratio of two is suggestive of churning, a turnover ratio of four is presumptive of churning, and a ratio of six is conclusive of churning.
The other metric used is the commission to equity ratio. Again, it is a mathematical calculation (total commissions divided by the average equity) that measures the return necessary for the account to “break even,” factoring in the cost of trading.
In either case, the sophistication of the client and the account objectives must be examined in conjunction with the level of account activity to determine if churning has occurred. A client’s lack of sophistication and inexperience with the financial markets can be a key component of a churning claim.
The last element, the broker’s intent to defraud the client, is closely related to the existence of the excessive trading. Indeed, some commentators simply infer evil intent from the mere existence of the excessive trading. An experienced securities attorney knows that this element may be proved by various means. An examination of the broker’s commission reports for all his accounts might reveal that this particular account is by far his largest commission-generating account. The reports might show this one particular account makes up a significant percentage of the broker’s total production.
Another factor to be examined is the employing firm’s active account review process. Accounts that exceed certain criteria, such as number of trades per month, amount of commissions generated per month, etc., appear on reports that are typically sent to branch managers and compliance personnel. If the account in question frequently appeared on an active account report, the broker’s and branch manager’s response could be very material. If the broker in question routinely had several accounts appearing on the active account report, he and his manager will have some significant questions to answer regarding the conduct of his business.
For instance, a branch manager may call a customer whose account appears on an active account report. After introducing himself, he thanks the customer for his business and asks the customer if he is happy with his broker. The manager does not tell the customer his account appeared on an exception report, discuss the level of trading activity or the amount of commissions charged in the last three months. If the customer is unsophisticated, he may not appreciate the implications of an actively traded account. The failure of the manager to fully explore that with the client in the situation above points to a failure to supervise on the part of the manager.
One last factor to also consider is the broker’s complaint history. Does he have past instances of customer complaints/arbitration claims alleging excessive trading? The answer to that question has a significant impact on the issue of the broker’s intent. Any public customer can obtain a broker’s complaint history through FINRA’s BrokerCheck website.
As far as calculating damages, often, the return of some or all of the commissions charged in an excessively traded account is a common measure of damages. Please note, this means that even if an account is profitable, there still may be a valid claim for churning.
As can be seen from the above, a churning analysis in the context of a securities arbitration or a regulatory investigation requires an experienced securities attorney to provide a thorough review. Contact the securities lawyers at Lubiner, Schmidt & Palumbo to assist you in your churning case.