Liability of stockbrokers: claims for churning and unsuitability.

• Author: Gallagher, Michael D.

Statutes regulations and rules, as well as common law, apply to customers' claims, making defense counsel's job complex

LIABILITY of financial advisors is a broad and complex area of the law. The category of financial advisors includes, among others, registered investment advisors, broker-dealers, future commission merchants, and banks that engage in investment counseling. Their liability arises from various statutes, regulations and common law theories, including, again among others, the Securities Exchange Act of 1934, the Securities Act of 1933, the Racketeer Influenced and Corrupt Organizations Act (RICO), the New York Stock Exchange Rules, and the common law of tort, fraud and contract.

Various causes of action may be asserted under these statutes, regulations and common law theories. This article concentrates on two common forms of liability--"churning" and "unsuitability"--both of which are and will be asserted routinely.

CHURNING

1. What Is It?

   In general terms, churning refers to over-trading or the excessive rate of turnover caused by a broker in a controlled account for the purpose of increasing the commissions gained by a broker.(1) Claims for churning can be set forth under various statutes, including Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. [sections] 78j(b), Rule 10b-5, which derives from Section 17(a) of the Securities Act of 1933, 15 U.S.C. [sections] 77(q)(a), and common law state causes of action for breach of fiduciary duty and fraud.

   Additionally, some states' securities laws may provide a basis for a churning claim. Some states' consumer protection laws also may provide an avenue for filing a churning claim,(2) while other states do not .(3)

   A provision in the Private Securities Litigation Reform Act of 1995 amended 18 U.S.C. [sections] 1964(c) to abolish the assertion of claims for churning under RICO, unless the conduct results in a criminal conviction of the person charged. It is not expected that RICO will provide a basis for churning claims in the future.

2. Plaintiffs' Burden of Proof

   A churning cause of action requires proof of three elements: (1) control over the account by the broker: (2) trading in an account that is excessive in light of the customer's investment objectives; and (3) the broker's intent to defraud or willful or reckless disregard of the customer's interest.(4)

   1. Control over Account

      The first element requires that the broker or account representative exercise a certain amount of control over the account. Control in the context of churning can be either express or implied.

      Express control, which also is referred to as discretionary power or formal control, requires that control or power be given to a broker in writing.(5) Such power generally derives from an account in which the customer gives the broker discretion as to the purchase and sale of securities, including selection, timing and price to be paid or received.(6) Under express or formal control, a broker owes his client the highest obligation of good faith and fair dealing.(7)

      When there is no writing, implied control or de facto discretionary power may be found. The actual extent of the broker's control is analyzed by answering this question: "Did the customer have the financial acumen to adequately determine his own best interests and to independently evaluate his broker's suggestions."(8) A negative answer leads to a finding of implied control. Such control is based on the totality of the circumstances and is measured subjectively.

      As set forth by the federal district court in M & B Contracting Corp. v. Dale, factors to be addressed include:

      (1) the identity, age, education, intelligence,

      and investment and business experience of

      the customer: (2) the relationship between

      the customer and the account executive, that

      is, whether it is an arms-length one or a particularly

      close relationship; (3) knowledge of

      the market and the account; (4) the regularity

      of discussions between the account executive

      and the customer; (5) whether the customer

      actually authorized each trade, and (6) who

      made the recommendations for trades.(9)

      Other factors include the customer's reliance on other investment advisors for advice, the customer's periodic rejection of the broker's recommendation, and the customer's initiation of trades.(10)

      Analyzing the various factors, the following cases have found that the broker exercised implied control:

      * In McQuesten v. Advest Inc.,(11) the customer was a sales employee, did not read financial literature, was inexperienced in trading securities, never rejected recommendations and only "feebly" initiated a few transactions.

      * In Hatrock v. Edward D. Jones & Co.,(12) the plaintiffs were a young, unsophisticated and inexperienced couple who invariably followed the broker's advice.

      * In Stevens v. Abbott, Proctor & Paine,(13) the broker had complete control over the plaintiff's account because of the plaintiff's lack of any sophistication or understanding of financial matters.

      * In Kravitz v. Pressman, Frohlich & Frost,(14) the customer put complete trust in the registered representative, relied on him for advice in many different matters, and gave him signed blank checks for deposits to the account.

      But these cases found no control when analyzing the various factors:

      * In Nunes v. Merrill Lynch, Pierce, Fenner & Smith,(15) the plaintiff was experienced in the stock market, had prior accounts, had previously sued his former broker, and had spoken daily to the broker.

      * In Hotmar v. Lowell H. Listrom & Co.,(16) the plaintiff owned several businesses and rental property, had previously engaged in high-risk trading, had maintained intense interest in account, spoke with the broker daily, knew how to use the broker's computer to get updates, and had rejected the broker's recommendation.

      * In M & B Contracting,(17) the customer and the account executive had a strictly business relationship and dealt at arms-length.

      * In Sheldon Co. Profit Sharing Plan and Trust v. Smith,(18) an investment manager followed the broker's recommendations 75 percent of the time but still retained the final decision as to what to buy or sell.

      * In Tiernan v. Blyth, Eastman, Dillon & Co.,(19) the plaintiff played an active role in handling his account, including rejecting advice of the broker and seeking advice from other brokers.

      * In Cummings v. A.G. Edwards & Sons,(20) the customer was actively involved in the investment decisions for his account, refused to follow the broker's recommendations and regularly reviewed his statements.

      To determine whether or not there is control, courts will look to expert testimony.(21)

   2. Excessive Trading

      There has not been a specific test enunciated to determine whether account activity is excessive. However, it appears that the "essential issue of fact is whether the volume of transactions, considered in light of the nature and objectives of the account, was so excessive as to indicate a purpose on the part of the broker to derive a profit for himself at the expense of his customer."(22) To evaluate excessive trading, various factors usually are addressed by courts, including the turnover rate, the investment objectives of the customer, "in-and-out" trading(23) and the proportion of size of the account to commissions generated.

      One of the most important factors is the turnover rate. It is the measure of the volume of trading that changes the holdings of a portfolio without changing its size.(24) Stated differently, the turnover ratio "is the ratio of the total cost of purchases made for [an] account during a given period of time to the amount invested."(25) The turnover rate then must be evaluated in relation to the investment objectives of the customer.

      In general, an annual turnover rate of less than two, absent special circumstances, is, as a matter of law, not excessive. Additionally, some courts have held that an annual turnover rate of over six is per se excessive.(26)

      Proof of excessiveness of trading usually requires expert testimony and statistical data.(27)

   3. Broker's Intent

      In order to establish churning under either Section 10(b) of the Securities Exchange Act of 1934 or common law...