“Churning” is essentially investment trading activity that serves little useful purpose or is inconsistent with the investor’s objectives and is conducted solely to generate commissions for the broker. Churning is also a type of securities fraud.
Recently, the National Adjudicatory Council (“NAC”) provided a detailed description of the elements and factors evaluated in determining a claim of churning. The NAC affirmed a Financial Industry Regulatory Authority (FINRA) finding that Alan Jay Davidofsky (Davidofsky) engaged in unauthorized trading, excessive trading, and churning in a customer’s account. The panel barred Davidofsky from the financial industry for the unauthorized trading, imposed a separate bar for the excessive trading and churning, and ordered Davidofsky to pay a fine of $11,741 as disgorgement of the financial benefit earned through the misconduct.
As the NAC ruling explained, NASD Rule 2110 requires brokers to “observe high standards of commercial honor and just and equitable principles of trade.” NASD Rule 2310(a) provides that in recommending securities, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer based upon the customer’s financial situation and needs. Included in this rule is the obligation of “quantitative suitability,” which focuses on whether the number of transactions within a given timeframe is suitable in light of the customer’s financial circumstances and investment objectives.
To demonstrate excessive trading the broker must have control over the account and second excessive trading activity inconsistent with the customer’s financial circumstances and investment objectives. The NAC held that excessive trading is closely related to, but distinct from, churning. Churning exists where excessive trading involves fraud. Both excessive trading and churning are independent violations of the FINRA rules. But to prove that excessive trading amounts to churning, a third element, scienter or the mental state of intent, must be shown.
As to the first element of control, a broker exercises control over an account if the broker has either discretionary authority or de facto control over the account. The NAC affirmed that, de facto control has been found where trade discretion is found. Brokers may exercise trading discretion where the securities selected for purchase or sale and the amounts purchased and sold are made without the customer’s knowledge or approval. Broker control over the trading in the account can also constitute unauthorized trading.
As for evidence of excessive trading, the NAC found that factors such as turnover rate, cost-to-equity ratio, and use of “in-and-out” trading in an account may provide a basis for a finding of excessive trading. “In-and-out trading” is where securities in an account are sold and there is a reinvestment of the sales proceeds in other securities followed by the sale of the newly acquired securities. While there is no clear line indicating what trading is excessive, courts have found that turnover rates between three and five have triggered liability for excessive trading.
Finally, to find that the excessive trading also amounted to churning a finding of scienter is required. The NAC found that scienter requires proof that a respondent intended to deceive, manipulate, or defraud, or acted with severe recklessness involving an extreme departure from the standards of ordinary care.
The NAC affirmed FINRA’s finding that Davidofsky’s conduct constitute both excessive trading and churning. The attorneys at Gana Weinstein LLP are experienced in investigating claims of excessive trading and churning. Our attorneys can help you detect and uncover suspicious activity in your accounts. Our consultations are free of charge and the firm is only compensated if you recover.