Churning And Unauthorized Trading
Churning occurs when a financial adviser engages in excessive trading for the purpose of generating commissions. The act of churning is a breach of the adviser’s duty to recommend suitable investments and investment strategies and is considered to be negligent and/or fraudulent conduct.
Over the past decade, the compliance systems that brokerage firms use to uncover sales practice violations by brokers have become more sophisticated and better equipped to uncover churning in an account. When excessive trading or churning is detected, an exception report typically is generated. An exception report is a report that generally is provided to the supervisors, indicating that the compliance software has detected a “red flag.” In general, it is the branch office manager’s responsibility to question the individual broker about the rationale for his or her conduct and determine whether further action is required.
In the typical churning case, the aggrieved customer does not know that churning has occurred in an account unless the value of that account drops, raising concerns. Clients typically do not come into an attorney’s office claiming that their account has been churned. They complain that they do not understand how their account could have dropped in value so much. It is not until the attorney reviews the monthly account documents that he or she notices that large volumes of trades occurred in the accounts without any legitimate explanation. When an attorney suspects churning has occurred in an account, he or she should send the account statements to an expert to confirm the suspicions. This is because, as explained below, churning ultimately is proven through a complicated mathematical equation that determines the annual turnover ratio in the account.
Proving A Churning Case
A plaintiff must prove three elements in order to establish a cause of action for churning:
- Trading in his account was excessive in light of his investment objectives;
- The broker exercised control over trading in the account; and
- The broker acted with the intent to defraud or with willful and reckless disregard for the investor’s interest. See Arceneaux v. Merrill Lynch, Pierce, Fenner and Smith, Inc., 767 F.2d 1498 (11th Cir. 1985).
How To Prove Excessive Trading
Excessive trading is typically established through an expert who reviews account statements to determine turnover ratio and the cost to equity analysis. Turnover ratio is the measurement of the number of times investments are replaced in an account during a given time period.
Turnover ratio is calculated by dividing the total purchases in the account by the average account equity. However, as stated above, it is important to hire an expert witness to make this determination, because a high turnover ratio and/or high cost to equity result does not necessarily mean that an account has been churned.
The cost to equity or “break even” analysis is the annualized cost of trading (including commissions, margin interest, and other expenses) divided by the average equity. The result is the percentage of return the account would have to earn before it returned any profit to the investor.
How To Prove Control Over An Account
If a broker exercises control over the trading in an account, he or she typically has discretionary authority. Discretion means that the broker has authority to make trades in an account without first obtaining client approval. Most accounts, however, are marked as nondiscretionary, which means that the broker must fi rst call the client and obtain his or her permission to purchase or sell a security in the account. Sometimes a broker will disregard the fact that the account is nondiscretionary and will exercise control over the investments in the account simply because the broker has superior knowledge and expertise about investing. When a broker exercises control in a nondiscretionary account, the broker has de facto control. In that case, the important documents to review when analyzing this element of a churning claim are the trade confirmations that are sent to the customer after each trade. They will be marked either as solicited or unsolicited. A trade confirmation that is marked “solicited” means that the broker called the client and recommended that the investment be purchased or sold. If the trade confirmation is marked “unsolicited,” unless the facts surrounding the transaction differ, the client is the one who called the broker and asked for a particular trade. For example, if a client called the broker and asked the broker to purchase 100 shares of General Electric stock, and the broker fulfilled that request, the trade confirmation that is sent to the client should read “unsolicited.” However, if the broker called the client and recommended that he or she purchase 100 shares of General Electric stock and the client accepted, the trade confi rmation should be marked “solicited.” If a confirmation is not marked “unsolicited,” often it is presumed to be a “solicited transaction.”
How To Prove Intent To Defraud
Since churning claims are typically based on federal and/or state securities act violations, the intent-to-defraud element may differ between claims. For example, a churning claim based upon section 10(b) of the Securities Exchange of Act of 1934 requires that the plaintiff prove scienter (or intent to defraud) by showing that the broker acted recklessly. Some states’ securities acts, however, are based on section 12(2) of the Securities Act of 1933. State securities acts that adopted the Uniform Securities Act are based on section 12(2). In those instances, state case law would control, but most courts hold that the scienter element of a state securities act claim based on the Uniform Securities Act only requires that the broker acted negligently, which is obviously a lower standard than recklessness.
DEFENSES TO CHURNING CLAIMS To defend a churning claim, respondents may first argue that the broker did not control the account. A customer in a churning case may not be able to prevail on this claim if the customer retained control over the account at issue. The broker must have maintained control over the account. A broker may have express control or implied control over an account. Express control exists where the customer specifically authorized the broker to act on the customer’s behalf.
This is sometimes called a discretionary account. In a discretionary account, the broker is a fiduciary and must act in the best interest of the customer. Unless the customer has signed a document giving the broker discretion in the account, it is unlikely that a client will be able to prove express control by the broker.
If a customer has not opened a discretionary account, the broker may still maintain implied control over the account. To show that a broker had implied or de facto control over an account, the claimant must provide evidence that he or she was so unsophisticated that he or she could not understand or evaluate the broker’s recommendations. Factors that indicate a client’s ability to understand a broker’s recommendations may include the customer’s education, work experience, age, prior investment experience, knowledge of finance, communications with the broker, and net worth. The less sophisticated, experienced, and educated a client is, the more likely it is that the broker had de facto control over the customer’s account.
Since trade confirmations are sent to customers, a common defense to churning claims is ratification. In other words, the clients ratified the conduct by not objecting to the excessive trades made in the account. The equitable defense of ratification, however, often is a factual question that is based, in part, on the sophistication of the client and the client’s ability to identify when excessive trades were being made in the account. Furthermore, equitable defenses such as ratification are not available if the respondent had “unclear heads” by engaging in unlawful activity.
Respondents may also argue that any trading in an account was not necessarily excessive. As stated above, two common methods for deter- mining the excessive trading element are turnover rate and cost to equity analysis. With regard to turnover rate, the rule of thumb is that turnover four times in a year is indicative of excessive trading and six times in a year is conclusive of churning.
As stated above, the cost to equity or “break-even” analysis is the annualized cost of trading (including commissions, margin interest, and other expenses) divided by the average equity. The result is the percentage of return the account would have to earn before it returned any profit to the investor. Whether a particular turnover rate or cost- to-equity ratio will constitute churning depends upon the customer’s investment objectives and experience and the level of control exercised by the broker.
Finally, respondents may argue that the broker did not intend to de- fraud the customer or that the broker did not act willfully or recklessly. This argument, of course, is usually based on the broker stating that he or she never intended to harm the client. If the turnover ratio or breakeven point is high enough, however, a panel may find that the broker acted recklessly.
Unauthorized Trading/Failure To Execute
In short, if a broker purchases or sells a security in an investor’s account without that investor’s approval, the broker has engaged in unauthorized trading. A nondiscretionary account requires customer contact and consent prior to the execution of each and every trade. A failure-to-execute claim is based on an order being placed by the client and the broker’s failing to timely execute the order. The failure may be an order to either sell or purchase. These claims are often difficult to prove without written or recorded orders from the customer.