Abusive Sales – Churning

Churning — South Florida Elder, Senior and Retirement Abuse FINRA Arbitration, Litigation and Probate Estate Attorney

Churning

An abusive sales practice in which unethical securities professionals make unnecessary and/or excessive trades in order to generate commissions. Most churning occurs where a broker has discretion to trade the account. In such cases, it is not necessary that the broker receive prior approval from the client to complete a transaction. Investors should be careful to review their monthly account statement and cognizant of any abnormally high trading activity.

Specifically, churning refers to the excessive buying and selling of securities in your account by your broker, for the purpose of generating commissions and without regard to your investment objectives. For churning to occur, your broker must exercise control over the investment decisions in your account, either through a formal written discretionary agreement or otherwise. For example, if you relied on your broker’s advice because you were unable to evaluate the broker’s recommendations and exercise your own judgment, your broker may have exercised control over your account. Churning can be a violation of SEC Rule 15c1-7 and other securities laws.

The major securities industry self-regulatory organizations have rules prohibiting churning and excessive trading. Excessive trading is the same as churning, but without the requirement that the person engaging in the trading does so for the purpose of generating commissions.

There are numerous state and federal court cases that set forth the legal requirements that must be proven to establish a claim for churning. The case that I have enjoyed reading and re-reading on this issue is styled Miley v. Oppenheimer & Company, Inc., cited at 637 F.2d 318 (5th Cir. 1981), which was a case decided by the United States Court of Appeals for the Fifth Circuit in 1981. The reason that I have always enjoyed reading this case is because it is in prose. It equates a discussion of the securities laws with the “churning” of milk.

First, it discusses the ingredients of a “churning case” as “skimmed versus evaporated milk.” As the court noted, “churning occurs when a securities broker enters into transactions and manages a client’s account for the purpose of generating commissions and in disregard of his client’s interests. Once an investor proves that: (1) the trading in his account was excessive in light of his investment objectives; (2) the broker in question exercised control over the trading in the account (which can be established in various ways — for example a hybrid-type account); and (3) the broker acted with intent to defraud or with willful and reckless disregarded for the investor’s interests, the broker may be held liable for a violation of section 10(b) of the Securities Exchange Act of 1934 and S.E.C. Rule 10b-5.” Additionally, upon proving the three elements of a federal securities law churning violation, the investor will, in most or perhaps all cases, be entitled to hold the broker liable for breach of fiduciary duty.

Second, compensatory damages, “crying over the spilt milk.” In the Miley case, the judge allowed the plaintiff to recover for both the commission and interest paid as a result of the excessive trading and for the decline in the value of the portfolio in excess of the average decline in the stock market during the time in which the defendant handled the account.

In discussing this method of damage calculation, the court held that “First, and perhaps foremost, the investor is harmed by having had to pay the excessive commissions to the broker the “skimmed milk” of the churning violation. Second, the investor is harmed by the decline in the value of his portfolio the “split milk” of the churning violation as a result of the broker’s having intentionally and deceptively concluded transaction, aimed at generating fees, which were unsuitable for the investor.”

Where there is churning, the customer can be damaged in many ways. He must pay the brokerage commissions on both purchases and sales, he may miss dividends, incur unnecessary capital gain or ordinary income taxes depending on the holding period and, most difficult to measure, he may lose the benefits that a well-managed portfolio in long-term holdings might have brought him.

If you believe that you or a member of your family has been exposed to this unethical conduct, please contact us for your initial free consultation.