Since I first started practicing law back in the 1980s, customer complaints against brokers have often involved allegations of “churning,” which is deemed to be fraud. Now, as it was 30+ years ago, to prove a churning claim, a customer needs to demonstrate that (1) the broker acted with scienter, which is defined to be either an intent to deceive or such recklessness that it essentially constitutes the equivalent of intent, (2) the broker “controlled” the account (either actually or in a “de facto” manner), and (3) the account was, quantitatively speaking, traded excessively. When an account is excessively traded, but there is no evidence of scienter, FINRA can still charge a violation, but it is simply deemed to be a suitability violation, specifically, a quantitative suitability violation. Because we are still routinely called upon to defend churning and excessive trading claims in both customer arbitrations and disciplinary actions, a look at a very recent FINRA Enforcement action involving these claims serves as a good refresher on what the expectations are in such matters.
Enforcement v. David M. Levy, et al., is a default decision against three individuals who were accused, and found guilty, of churning and excessively trading the accounts of several customers. Let’s first look at how the issue of “control” was addressed.
Control is easy to demonstrate when a broker has discretionary authority over the trading in a customer’s account. In that case, the broker controls the account as a matter of law. When an account is non-discretionary, on the other hand, control is generally shown by the fact that a customer routinely acquiesces to his broker’s recommendations. But, in fact, the analysis is somewhat more nuanced. It is not merely that a customer follows his broker’s recommendations; rather, it is that the customer lacks “sufficient understanding to make an independent evaluation of the broker’s recommendations,” and that is why the customer acquiesces. Thus, if the customer is an “inexperienced” and “naïve” investor, as was the case in Levy, a broker can wrest control over a non-discretionary account. But, if the customer is perfectly capable of understanding his broker’s recommendations, but nevertheless agrees with those recommendations, control over the account will still lie with the customer. The lesson is that the issue of control turns not on whether the customer routinely follows his broker’s recommendations, but why the customer does so.
As for the whether an account is excessively traded, it is important to bear in mind that this phrase does not connote some absolute standard (despite the 5% figure that appears in FINRA’s Mark-Up Policy); rather, the trading must be excessive relative to the customer’s stated investment objective. Thus, a customer with a speculative investment objective and an aggressive risk tolerance should expect to see more trading than a conservative customer. What is interesting about the Levy case is that while FINRA acknowledged this fact, it nevertheless concluded that the trading at issue was so frequent that it “would not be suitable for any customer, regardless of the customer’s financial circumstances and investment objectives.” The decision continued:
The Hearing Officer acknowledges that active trading leading to turnover rates well above six could conceivably be suitable for certain sophisticated customers who understand the risks associated with such trading. The Hearing Officer can conceive of no customers, however, for whom turnover rates coupled with cost-to-equity percentages at the levels found in this proceeding would be suitable…. No customers, regardless of their financial circumstances and investment objectives, would make a rational decision to invest on such a basis because they would know they would be highly unlikely to profit from the trading, and that the trading would primarily benefit the RR.
It astounds me that FINRA can substitute its judgment for investors in this fashion. Clearly, if an investor is so “sophisticated,” to use FINRA’s word, that he can “understand the risks associated with” frequent trading, then just as clearly that customer – and not the customer’s broker – controls the account. Since FINRA must prove that the broker controlled the account, however, to establish churning or excessive trading, I just don’t see how FINRA can ever prevail when the customer is truly sophisticated, no matter how excessive the trading.
FINRA attempted to address this in the decision. But, again, notice in the analysis below that the focus is not on “control” but, rather, the excessive nature of the trading and the costs associated with a frequent trading strategy:
Even if some customers invested only money that they were prepared to lose and understood that their accounts would be invested in speculative securities, the trading that actually occurred in their accounts was excessive. Those customers accepted market risk, that is, the possibility that the securities they invested in might decrease in value, costing them the funds they had invested. But in fact the customers’ losses were not primarily attributable to market risk, but rather to the RRs’ greed in trading the customers’ accounts for their own benefit. Indeed, in some of the customers’ accounts there was little or no net loss on the trades themselves; rather those customers lost significant amounts of money because of the extraordinary amounts, including commissions, markups and markdowns, and other costs, that they were charged for the trades. Even if the funds they invested were insignificant to their total financial circumstances, none of the customers intended that their investments serve primarily to benefit the RR through whom they invested.
FINRA cannot have it both ways. If a customer is sophisticated enough to be deemed to be in control of his account, then he cannot simultaneously be unsophisticated when it comes to appreciating that the frequent trading strategy he has elected is expensive. Regardless, it is odd to me how FINRA can so easily substitute its judgment for the investors’. Just because the Hearing Officer could not conceive of any customer willing to employ an aggressive, but expensive, trading strategy hardly means they do not exist.
Putting to one side the result in Levy, which, after all, was a default decision, it is clear that there are ways to successfully defend churning cases, at least those involving sophisticated customers.
 Under FINRA’s rules, even when a respondent fails to appear and defend himself, the Department of Enforcement is still required to produce evidence in support of its allegations. Not surprisingly, however, since no one is there to contest FINRA’s case, it is awfully difficult for FINRA to lose a default decision.