CHURNING
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A. SEC ADMINISTRATIVE ACTIONS:
1. In re Daniel L Zessinger, Initial Decision Release No. 94 (Aug. 2, 1996).
For conservative investors, a turnover rate of two [on an annual basis] suggests excessive trading; four is presumptively excessive trading; and six is conclusive of excessive trading.
2. In re Application of Rafael Pinchas, Review of Disciplinary Action Taken by the NASD, Securities and Exchange Act Release No. 41816 (Sept. 1, 1999).
i) Excessive trading occurs when a securities professional has control over trading in an account and the level of activity in that account is inconsistent with the customer�s objectives and financial situation. See Rafael Pinchas, Page 5
ii) In and out trading is a practice extremely difficult for a broker to justify and can, by itself, provide a basis for finding excessive trading. See Rafael Pinchas, Page 6.
3. In re J. Stephen Stout, Securities Exchange Act Release No. 43410 (Oct. 4, 2000).
Held: Broker found responsible for losses sustained in client's account as a result of overly-frequent trading in the account despite the broker's assertion that he was following the recommendations of Paine Webber. The Commission concluded, "He [broker] could not make a particular recommendation from a Paine Webber trading desk without assessing whether it was suitable for his client. Stout [broker] cannot excuse his failure to conduct this inquiry by claiming that he blindly relied on his firm�s recommendations." See Page 14.
4. In re Al Rizek, Securities Exchange Act Release No. 41725 (August 11, 1999).
Three elements are necessary to find churning: i) trading in the account that is excessive in light of the customer�s investment objectives; ii) explicit or de facto control over that trading by the salesperson; and iii) scienter on the part of the broker, which is established either by evidence of intent to defraud or by evidence of willful and reckless disregard of the customer�s interests. See Al Rizek Page 5.
Held: In finding that the broker in question had churned his customers' accounts, the Commission inferred that the broker had de facto control over those accounts. In so finding, the Commission stated:
Although Rizek's [broker] customers may have been successful businessmen and most of them had some degree of higher education, they were totally lacking in the degree of investor sophistication necessary to understand Rizek's strategy and unable to make any sort of independent evaluation of that strategy. Three of the customers testified that Rizek never explained the risks of his trading, and it is clear that none of the five had any real understanding of those risks, much less of the way the use of margin increased the risks. The information that Rizek supplied did not cure or alleviate his customers' lack of understanding. The customers placed their reliance on Rizek's supposed expertise, and almost invariably followed his recommendations. We conclude that Rizek exercised de facto control over the accounts of the five customers at issue. See Al Rizek, Page 7.
5. In re Donald A. Roche, Securities Exchange Act Release No. 38742 (June 17, 1997).
Churning, in essence, involves a conflict of interest in which a broker or dealer seeks to maximize his or her remuneration in disregard of the interests of the customer. This motivation creates the element of scienter necessary for a violation of the anti fraud provisions of the securities laws. Scienter, in turn, is what separates churning from excessive trading. See Donald A. Roche, Page 7.
6. In re Roger Fan, Securities Exchange Act Release No. 46359 (August 15, 2002).
The Customers were sisters in their late 50's who had no investment experience and possessed limited means. In only a nine-month period, Miller executed 121 options trades in one account and 108 options trades in the other account. This trading resulted in annualized turnover rates (i.e., how many times per year a customer's account equity is utilized to purchase securities) of 29.67 for the first account and 32.86 for the second account and a break-even cost factor (i.e., percentage of return-on-equity required for the account to break-even after paying for such costs as commissions and other fees) of 209.6% and 229.55% in the respective accounts. Miller entered into transactions and managed the Customers' accounts for the purpose of generating commissions rather than furthering his clients' interests. Miller had control of the Customers' accounts, and excessively traded in the accounts in light of the Customers' investment objectives.
7. In re Stanslav Kaminski, Securities Exchange Act Release No. 3-11023 (Jan. 29, 2003).
Respondent acted with scienter. Respondent knowingly or recklessly engaged in the fraudulent sales practices described above for the purpose of generating commissions. Respondent earned $20,509 in commissions from these fraudulent transactions, and the customers incurred realized and unrealized losses totaling $92,746. Respondent knowingly or recklessly disregarded the customers' financial situations, investment objectives, and interests for his own financial gain.
8. In re Wayne Miller, Securities Exchange Act Release No. 25520 (April 11, 2002).
A broker has de facto control over a customer's account if the customer is unable to evaluate the broker's recommendation and to exercise independent judgment.
9. In re Robert A. Papariella, Securities Exchange Act Release No. 47245 (January 24, 2003).
Furthermore, Papariella knew or was reckless in not knowing that he churned the securities in those customer accounts for the purpose of advancing his own interests by generating additional commissions for himself. Papariella controlled the activity in these four customer accounts either through oral discretionary authority given by the customer, or through de facto control exercised by Papariella by taking advantage of the customers' lack of investment experience and their trust in his investment recommendations, judgment and honesty.
10. In re Joseph J. Barbato, Securities Exchange Act Release No. 41034 (Feb. 10, 1999).
Churning occurs when a broker enters into transactions and manages a client's account for the purpose of generating commissions rather than furthering his client's interests. Churning requires a showing that: (i) trading occurred in an account that was excessive in light of the customer's investment objectives, (ii) the broker exercised control over the account, and (iii) the broker acted with the intent to defraud or with willful and reckless disregard for the interests of the
client. We find that each of these elements was satisfied with regard to Spangenberg's account.
Despite the fact that Spangenberg was retired, Barbato traded numerous speculative securities in and out of Spangenberg's account. Purchases in the Spangenberg account totaled $214,899 and generated $33,884 in commissions on an average account equity of $42,359. From March 1988 through July 1990, the account had turnover ratio of 2.1 and a break-even cost factor of 38 percent, and for the sub-period between July 1989 and July 1990, the turnover ratio was to 4.1 and the break-even cost ratio was 57.9 percent.�
11. In re application of David Wong, Securities Exchange Act Release No. 45426 (Feb. 8, 2002).
The scienter element of churning may be inferred from the amount of commissions charged by the registered representative.
12. In re Laurie Jones Canady, Initial Decision No. 76, Admin. Proc. File No. 3-8531 (Oct. 31, 1995).
i) For the period February 1, 1988 through November 24, 1989, the annualized turnover rate in Nagle's account was 3.99. Commissions as a percentage of average equity were 22.76 percent. The annualized break-even for his account was 28.88 percent. (Div.Ex.19c, p. 1). I find the Respondent churned this account.
ii) Control
The control issue has been a matter of substantial dispute. The Respondent argues, in substance, that the she had no control over the accounts in dispute and cites a plethora of reasons - none of which I find persuasive. She argues, among other things, that the accounts were not "discretionary" so as to give the broker authority to trade without asking for permission from the investor and further that the Davenport branch of Merrill Lynch did not have discretionary accounts. However, as noted in Carras v. Burns, 516 F.2d 251, 258, 259 (4th Cir. 1975):
In the absence of an express agreement, control may be inferred from the broker-customer relationship when the customer lacks the ability to manage the account and must take the broker's word for what is happening .... The issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker's suggestions. [The customers do] not have to prove both that they lacked the competence to manage the account and also that they gave control to [the broker]. Lack of competence itself may give rise to an inference of control.
I find that there is clear evidence supporting the view that the Respondent did have control over the accounts. First, theinvestor witnesses testified that, for the most part, they had atone time a great affection for the Respondent, had social relations with her, and trusted her implicitly. Second, I believe the investor testimony, over the Respondent's, that Respondent largely traded the accounts as if she had discretion. Further, the record clearly established that the investors were, for the most part, unsophisticated and deferred to the Respondent almost totally for investment decisions.
iii) Time Period for Churning Computations
The proper time frame for determining churning calculations is a matter in substantial dispute. Respondent argues that the period should extend during the entire length of the account (Respondent's Post Hearing Brief p. 1). The Division argues, more persuasively in my view, that the period should be based on the time that Respondent was actually engaged in misconduct. To follow Respondent's line of thought, one would have to credit a bank embezzler for those many years he was not caught stealing. Frederick C. Heller, 53 SEC Docket 791, 796
B. NASD REGULATORY MATERIAL:
13. NASD Department of Enforcement v. Frank Rocky Mazzei, NASD Disciplinary Proceeding No. C10970120 (June 24, 1998).
The Panel finds Respondent exercised de facto control over RB's accounts. [T]he requisite degree of control is met when the client routinely follows the recommendations of the broker. Mihara, 619 F.2d 814, at 821. Quoting Mihara, the S.E.C. found the requisite control in Michael David Sweeney, 50 S.E.C. 761, 765-766 (1991):
With few exceptions, the customers did not initiate the transactions in their accounts, nor did they fully understand the trading therein. When the customers decided to effect the transactions at issue, they were relying totally on the Sweeneys. Indeed, the Sweeneys' consultations with their customers on investment choices were merely a formality, since the customers invariably followed their recommendations.
See also Erdos v. S.E.C., 742 F.2d 507, 508 (9th Cir. 1984)(Mrs. Cole lacked a sufficient understanding of the trading to evaluate Erdosi recommendations independently.[S]he completely relied upon his advice and always followed his recommendations); Gerald E. Donnelly, 61 S.E.C. Docket 31, 34, fn. 17 (1996) (customer relied heavily on Donnelly's advice...and, with respect to most of the trades, approved individual transactions simply on the basis of Donnelly's recommendations and could not remember ever rejecting his advice).
14. District Business Conduct Committee v. Daniel Wright Sisson, NASD Decision, Complaint No. C01960020 (Nov. 18, 1998).
De facto control of an account may be established where the client habitually followed the advice of the broker.
15. NASD Department of Enforcement v. Daniel Richard Howard, NASD Decision, Complaint No. C11970032 (Nov. 16, 2000).
Even where a customer affirmatively seeks to engage in highly speculative or otherwise aggressive trading, a representative is under a duty to refrain from making recommendations that are incompatible with the customer's financial profile. See In re John M. Reynolds, 50 S.E.C. 805, 808-09 (1992) (regardless of whether the customers wanted to engage in aggressive and speculative trading, the representative was obligated to abstain from making recommendations that were inconsistent with their financial situation); In re Gordon Scott Venters, 51 S.E.C. 292, 294-95 (1993) (same). With these general principles in mind, we turn to the pertinent facts in this case.
16. NASD Dept of Enforcement v. Castle Securities Corp., & Michael Studer
Disciplinary Proc. No. C3A010036 (March 28, 2003).
There is no magic formula for determining whether a particular level of trading is excessive. Historically, NASD, the SEC and the courts have looked at turnover ratio, the use of "in and out" trading, and the overall pattern of trading activity in the account in determining whether it was excessive. See, e.g., District Bus. Cond. Comm. for Dist. No. 2 v. Gliksman, 1999 NASD Discip. LEXIS 12, at *25-26 (NAC Mar. 31, 1999), aff'd, 1999 SEC LEXIS 2685 (Dec. 20, 1999). Ultimately, however, "[t]he 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." Costello v. Oppenheimer & Co., 711 F.2d 1361, 1368 (7th Cir. 1983).
17. NASD District Business Conduct Committee For District No. 2 v. Harry Gliksman & William Gallagher, Complaint No. C02960039 (March 31, 1999).
i) Turnover rates between three and four, for instance, have triggered liability for excessive trading,20 and the courts and the Commission have held that there is little question about the excessiveness of trading when an annual turnover rate in an account is greater than six.21 Excessive trading has also been found in cases in which the cost-equity ratio was between 15 and 30 percent, or more.22 With regard to evidence of "in and out" trading, the Seventh Circuit Court of Appeals has remarked that, "it is a practice extremely difficult for a broker to justify." Costello, 711 F.2d at 1369 n.9; see also Peter C. Bucchieri, supra, at 7.
ii) In this case, Respondent Gliksman had a duty to recommend and effect a course of trading that offered a degree of risk commensurate with Wilshire-Dayton's overriding need for retention of principal. This Respondent Gliksman obviously did not do. Respondent Gliksman's trading strategy was likely to and in fact did put Wilshire-Dayton's principal at risk. Indeed, he effected a course of frequent short-term trading that benefited him in the form of large commissions at the expense of his customer, Wilshire-Dayton. We therefore affirm the DBCC's finding that Respondent Gliksman engaged in unsuitable trading in violation of Rules 2110 and 2310.
18. NASD District Business Conduct Committee For District No. 3 v. Investment Management & Research, Inc., Milton Anthony Greene, Kenneth Craig Krull, & Michael John DiGirolamo Complaint No. C3B940028 (July 25, 1997).
The Securities and Exchange Commission ("SEC") and NASD have long held that excessive turnover rates of mutual funds are not consistent with the mutual fund concept of investment. In 1963, the SEC stated that, "[e]xcept in unusual cases, a switching transaction is analogous to 'churning' or overtrading an account in listed or over-the-counter securities, and violates the NASD suitability rule."
C. SEC STAFF COMMUNICATIONS:
19. SEC Description of Churning,
http://www.sec.gov/answers/churning.htm.
Churning refers to excessive buying and selling in your account by your broker. 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, and must engage in excessive trading in light of the financial resources and character of the account for the purpose of generating commissions.
D. SECURITIES REGULATION & LAW REPORT MATERIAL:
20. Securities Regulation & Law Report, Volume 35, Number 10, ISSN 1522-8797 (March 10, 2003).
Addressing as yet undecided issues under Florida Law, the U.S. District Court for the Middle District of Florida Jan. 31 said that plaintiffs charging their broker with churning annuity investments may recover as out-of-pocket damages any excessive commissions or expenses they paid and any actual losses to their portfolio caused by churning.
21. Securities Regulation & Law Report, Volume 33, Number 6, ISSN 1522-8797 (February 12, 2001).
An arbitration panel did not exceed its authority in awarding $250,000 in punitive damages and $1 in compensatory damages to an investor who brought churning and other claims against her brokerage firm, the U.S. District Court for the Eastern District of Louisiana ruled Jan. 16. (Morgan Keegan & Co. v. Lalonde, E.D. La., Civil Action No. 00-2520, 1/16/01).
22. Securities Regulation & Law Report, Volume 34, Number 22, ISSN 1522-8797 (June 3, 2002).
i) The Securities and Exchange Commission's director of compliance inspections and examinations told a congressional subcommittee May 23 that an agency staffer made a judgment call nine years ago when it failed to contact an investor whose account allegedly was churned by rogue broker Frank Gruttadauria to determine the legitimacy of the trading activity--allowing the broker to continue his scam for nine more years.
ii) Lori Richards, testifying before the House Financial Services Subcommittee on Oversight and Investigations, said the commission was alerted in 1993 to possible churning --or excessive, inappropriate trading done to boost commissions--in the client's account through an anonymous tip.
iii) Rep. Steven LaTourette (R-Ohio), a member of the subcommittee, responded, "It's ludicrous to me. As a former prosecutor, I know you go after the witnesses. The best witness [in a churning case] is the customer." LaTourette also said he had information that Gruttadauria churned another account 32 times in one year; Richardson said a turnover ratio of two or three is enough to cause the SEC to focus hard on a particular account.
23. Securities Regulation & Law Report, Volume 30, Number 36, ISSN 1522-8797 (September 4, 1998).
In a press release issued by the North American Securities Administrators Association, NASAA President Denise Voigt Crawford urged both boom and bad times are good times for con artists. Crawford is also the Texas Securities Commissioner.
Aside from concerns stemming from the current volatility of the market, NASAA advised, "the bull market could be masking sales practice problems such as churning (high volume trading encouraged by a broker), unsuitable investments, high fees, and excessive commissions. "
24. Securities Regulation & Law Report, Volume 32, Number 26, ISSN 1522-8797 (July 3, 2000).
A Paine Webber Inc. vice president failed June 16 to persuade the U.S. Court of Appeals for the First Circuit that the Securities and Exchange Commission should not have barred him permanently from the securities industry for churning the accounts of five customers (SEC v. Rizek, 1st Cir., No. 99-2114, 6/16/00).
Affirming the SEC sanctions, the court disagreed that in imposing the most drastic solution available, the commission was required to show that a lesser sanction would be insufficient to protect the public interest.
Risky Strategy
Judge Sandra Lynch recounted that over a 10-month period in 1993, Al Rizek allegedly churned the accounts of five customers, causing approximately $195,000 in losses on accounts with average balances of about $700,000. Moreover, the court related, while Rizek's customers indicated that they had conservative investment objectives, Rizek pursued the extremely risk strategy of trading U.S. Treasury bonds in an attempt to take advantage of short-term fluctuations in the market. He magnified the risk by trading the accounts on margin, the appeals court added.
In the enforcement proceedings that followed, the SEC permanently barred Rizek from the industry. It also ordered him to cease and desist from future violations, to disgorge more than $120,000, and to pay a $100,000 civil penalty. In so deciding, the court noted, the commission departed from the recommendations of an administrative law judge, who would have ordered disgorgement of more than $275,000, but imposed only a two-year suspension.
In seeking review of the SEC order, Rizek did not challenge the findings that he excessively traded his customers' accounts, but objected to the civil penalty and the permanent bar order. Essentially, the appeals court said, Rizek argued that, having a "good faith belief'' in his investment strategy, he did not have the degree of scienter required for such a sanction. He also urged the court to adopt a rule that when the SEC imposes a permanent bar, "it must show that a less drastic remedy would not suffice to protect the public.''
We decline that invitation and affirm the Commission order, the court responded.
E. FINANCIAL EDUCATION NETWORK DEVELOPMENT:
25. Mason A. Dinehart - Financial Education Network Development, See http://www.fend.com/ca.html October 4, 1997, updated 1-20-03. (Caution: The following was pulled from Mason A. Dinehart�'s web site. All text below that is not in quotations must be paraphrased or attributed to Mason A. Dinehart.)
(Pages 3-9).
A. What is churning? Churning occurs when an account executive recommends or effects transactions which are excessive in cost, size or frequency, without regard to the customer�s stated investment objectives and previous investment history. Often it includes the excessive trading of low quality speculative stocks, traded frequently, with low spreads between buys and sells. This is especially seen when the stocks are ones in which the broker makes a market or specializes. It is settled that when a broker, unfaithful to the trust of his customer, churns an account in the broker's control for the purpose of enhancing the broker's commission income in disregard of the client's interest, there is a violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.A. s 78a et seq., and Securities and Exchange Commission Rule 10b-5.
B. Incentives to churn - Competition forces a demand for higher production. Further, broker dealers offer higher incentives and promotions to big producers. There is also greed and fear.
C. There are 3 factors involved in a churning case. These are control, scienter and excessive trading.
1. Control - It is important to determine whether the broker controls the investment decisions in the account. The account does not have to be discretionary for control to exist. Thus, a broker dealer can still be liable for churning, even though the account was not formally a discretionary account.
Standard of practice - If it is found that the client followed the broker's recommendations in most transactions, it is generally held to be sufficient.
De facto control - This is indirect demonstration of control. In the Mihara case and Hecht v. Harris Upham & Co. N.D. Cal. 1968 - "The requisite degree of control is met when the client routinely follows the recommendations of the broker." This is de facto control by the broker. Therefore, control can be implied when a stockbroker possesses overwhelming influence over an unsophisticated customer. The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker's recommendations and to reject one when he thinks it unsuitable. An interesting method of determining control through trading patterns can be observed by examining confirmation slips and monthly statements for disclosure as to whether a number of transactions were "unsolicited" by the stockbroker, meaning, that the customer ordered many of the transactions without ever having had the securities called to his or her attention by the stockbroker. There are ten principal characteristics of a customer on which the courts have traditionally relied in reaching a decision as to whether or not control can be inferred. The important characteristics are: Sophistication, formal education and occupation, prior or contemporaneous securities investment experience, the customer's reading habits, the wealth of a customer or the size of the account and most importantly, the element of the psychological dominance of the broker over the customer, which is really a conclusion based on the above factors. The SEC has thus noted the customer's inability to understand the difference between how a margin account or options work, or the effect of the ex-dividend date on the price of a security. A finding that the customer had difficulty in understanding the investment advice given to him, even when the broker tried to explain it, is particularly relevant. These inadequacies tend to make the customer dependent on his broker. The mere fact that the customer approves the trades and receives confirmations does not prove ratification of churning activity. In Hecht v. Harris Upham, it states, "The Court concluded that while confirmation slips were sufficient to inform plaintiff of the specific transactions made, they were not sufficient to put her on notice that the trading of her account was excessive." The fact that a customer received confirmations and monthly statements will not defeat establishment of control over the account where such documents are beyond the comprehension of the customer or the broker reassures the customer after receiving complaints.
2. Scienter - The intent to defraud or reckless disregard of the customer�s best interest by the broker. M&B Contracting Corp. v. Dale - 6th circ. 1986 - Also, Mihara v. Dean Witter (Landmark case). "The churning of a clients account is, in itself, a scheme or artifice to defraud within the meaning of 10b-5. The evidence in Mihara reflects, at the very minimum, a reckless disregard for the clients stated interests." See Franks v. Cavanaugh, 711 F. Supp. 1186 (S.D.N.Y. 1989) ("scienter element of churning may be inferred from an annual turnover rate in excess of six."). The element can be met by a showing that the broker in control of a customer's account traded the account excessively for the purpose of generating commissions and acted with intent to defraud or at least with willful and reckless disregard of the customers best interests. When there is a fiduciary duty to the defrauded party, recklessness can suffice for the necessary scienter. Armstrong v. McAlpin, 669 F.2d 79 (2nd Cir. 1983); In re Inserra, SEC Admin. Proc. File No. 3-6691, [1988] Fed. Sec. L. Rep. (CC) #84,334, at 89,499 (Sept. 30, 1988) opinion of administrative law judge).
1989 NASD Manual - Art. III, Sec. 2 #2152.10 - "It is not necessary to show scienter in order to establish excessive trading under the NASD Rules of Fair Practice." SEC Release No. 34-20376 (1983). Art. III, Sec. 3 #2152.49 - "No finding of scienter is necessary is necessary to show violations of NASD rules". Eugene J. Erdos v. SEC, No. 84-7033 (9th circuit, 1984).
3. Excessive trading - As the Securities and Exchange Commission ("SEC") has recognized, "excessive trading represents an unsuitable frequency of trading and violates NASD suitability standards". Paul C. Kettler, 51 S.E.C. 30,32 (1992); see also Harry Gliksman, Exchange Act Rel. No. 42255, at 4 (Dec. 20, 1999); Michael H. Jume, Exchange Act Rel. No. 35608. at 4 n.5 (April 17,1995): Rafael Pinchas, Exchange Act rel. No. 41816, at 10 (Sept. 1, 1999). Even in cases in which a customer affirmatively seeks to engage in highly speculative or otherwise aggressive trading, a representative is under a duty to refrain from making recommendations that are incompatible with the customers financial profile. (emphasis added) See Pinchas, supra, at 11 (customer's desire to "double her money" does not relieve registered representative of duty to recommend only suitable investments); Jphn M. Reynolds, 50 S.E.C. 805,809 (1992) (regardless of whether the customers wanted to engage in aggressive and speculative trading, the representative was obligated to abstain from making recommendations that were inconsistent with their financial situation). In re. Frederick c,. Heller, Rel. No. 34-31696, January 7, 1993: A customer's wealth certainly "does not provide a basis for engaging in excessive trading in his account citing In re Arthur Joseph Lewis. In re. Eugene J. Erdos, Rel. No. 34-20376, November 16, 1983: Even though Mrs. C. may have desired 'quick profits' that did not entitle Erdos to ignore her individual situation and place her limited assets in risky investments. Whether or not Mrs. C considered the transactions in her account suitable is not the test for determining the propriety of Erdos' conduct. Citing Phillips & company...Even assuming that Mrs. C's objective was to make quick profits, the activity in her account was clearly excessive in the light of her financial situation. And the fact that Mrs. C. may have authorized the transactions in her account does not alter that conclusion.
a. Qualitative factors
Investor objectives
Investment strategy - clients understanding and evaluation of strategy
Aversion to risk
b. Quantitative factors
Cost/Equity Maintenance Factor - Annualized
Turnover Ratio - Annualized
Cost to Equity - Simply a determination of the percentage of return on the customers average net equity in order to pay broker-related commissions and costs. These costs include commissions, fees, mark-ups, mark-downs, selling concessions and margin interest. In other words, any compensation that drives the trade. The question to ask is whether the broker would have sold the security if not for the compensation! Michael David Sweeney, SEC Release No. 34-29884 (October 30, 1991). See also Shearson Lehman Hutton, SEC Release No. 34-26766 (April 29, 1989). "A primary test for excessive trading is the relationship between the net amount of money invested and the transaction costs that are incurred." See McCann, Craig, and Richard G. Himelrick, "Spreads, Markups, Sales Credits and Trading Costs, "PIABA Bar Journal, Summer 2002, for an explanation of calculating trading costs. For the purpose of calculating break-even analysis (BER) however, the only relevant "commission" is the cost to the customer, which equals any agency commission plus the spread and/or slippage on the trade. Because of the difficulties in determining historical spreads, the commission credit paid to the broker is commonly used as a reasonable approximation of the cost to the customer.
As a general rule, in a conservative investment account, an inference of excessiveness will come about with a cost/equity maintenance factor of four percent and a turnover rate of two times; a presumption would be raised when the respective formulas result in findings of C/E of eight percent and a ATR of four times; and a conclusion might be reached at levels wherein the cost/equity maintenance factor is twelve percent and the annualized turnover rate (ATR) is six times.
Turnover ratio - Total cost of purchases divided by the average net equity. This shows the number of times that the total purchases in the account exceed the average net equity.
A. New York Bankruptcy court, re: Thomson Mckinnon Sec. Inc. 1996 WL 60480 "In determining that a 2.22 turnover ratio presented evidence of churning, the court cited a 1990 study which found that the turnover ratio of even the most aggressive mutual funds is 1.18, while more conservative funds� turnover is .58." (Winslow & Anderson, A Model for Determining the Excessive Trading Element in Churning Claims), 68 N. Ca. L. Rev. 327 [1990]). Walter S. Grubbs, Release No. 34-4138, July 30, 1948 (a turnover of 2.5X in 3+ years was found to be excessive.) In re. R.H. Johnson & Co., Release No. 34-4694, April 2, 1952 (Chart showing turnover rate over five (5) years: 1944 - 2.35X, 1945 - 3.29X, 1946 - 1.99X, 1947 - .83X, 1948 - .82X held excessive). Gerald E. Donnelly, Exchange Act Rel. No. 36690, 61 S.E.C. Docket 31 (January 5, 1996) (turnover rate ranging between 3.7 and 4.4 was excessive).
B. Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Burke, 741 F. supp. 191, 192-194 (N.D. Cal. 1990) The court affirmed an arbitration award based on a 4.4 to 1 turnover ratio. Gerald E. Donnelly, Exchange Act Rel. No. 36690, 61 S.E.C. Docket 31 (January 5, 1996) (turnover rate ranging between 3.7 and 4.4 was excessive).
2. Churning by Securities Dealers - Harvard Law Review - 869 (1967) "The turnover ratio (ATR) is the "litmus test". An annualized turnover ratio of greater than 6 is likely to be excessive. The objective measure of ATR is to be evaluated with the subjective measure of the investor�s investment objectives". Some courts have held that an annual turnover rate of over six is per se excessive. Craighead v. E.F. Hutton & Co., Inc., 899 F.2d 485, 490 (6th Cir. 1990). Berg, Howard G. and J. Julie Jason, "Does the Literature of Churning Reflect the Current State of the Brokerage Industry?" Securities Arbitration 1996, Volume Two, Practicing Law Institute, 1996. "Analyzing ATR in terms of industry norms from 1947 through 1996, as well as how it has been interpreted through the decades, the shrine that has been erected around the magic number of 6 should be dismantled and the benchmark lowered to a suggested level of 3".
3. Mihara v. Dean Witter: While there is no clear line of demarcation, courts and commentators have suggested that an annual turnover rate of 6 reflects excessive trading. Kaufman v Magid (1982, DC Mass) F Supp 1088, CCH Fed Secur L Rep P 98713: 6 times. Arceneaux v Merrill Lynch, Pierce Fenner & Smith, Inc. (1985, CA11 Fla) 767 F2d 1498, CCH Fed Secur L Rep #92247: 8 times. Shearson, Lehman, Hutton, Inc. 49 S.E.C. 1119,1122 (1998) (turnover rate of 7.4 was excessive).
4. See Rolf v. Blythe Eastman Dillon, Churning by Securities Dealers, Harvard Law Review (1967) and Hecht v. Harris Upham N.D. Cal (1968, DC Cal) 283 F Supp 417, affd. 9th dist. �70: "This court affirmed a finding of churning where an account had been turned over 8 -11.5 times, during a six-year, ten-month period."
Frequency or number of trades -
- Mihara v. Dean Witter: 15+ trades per month raises the specter for supervision and compliance to determine churning.
- Industry custom and practice: 10 trades per month is generally acceptable. 15 trades per month will typically trigger management to send an activity account letter to the client. This analysis was initiated by the Dean Witter computer whenever an account showed 15 or more trades in one month or commissions of $1,000 or more. Mihara v. Dean Witter Nos. 78-2022, 78-2729 U.S. Court of Appeals, Ninth Circuit. May 23, 1980
Cost to Equity -
- Costs in excess of 5% of account equity should be seriously questioned by any customer. This is because a low load mutual fund can be purchased for 3%-5%. Further, any managed or wrap account typically carries with it an overall cost of 3.5% - 4.5% annually, when all transaction costs are considered. These industry benchmarks should be compared to the clients annualized cost to equity maintenance factor. According to one court, "Turnover rate is but one indicia of churning. One authority has suggested a more meaningful computation and one more readily comprehensible to investors as well; the percentage of return on the investor's average net equity needed in order to pay broker-dealer commissions and other expenses*. This figure, termed "The Goldberg Cost Equity Maintenance Factor," amounts in essence to a sales load. Jenny v. Shearson, Hammill & Co. 1978 Fed. Sec. L. Rep. (CC) #96,568 (D.C.N.Y. Oct. 6, 1978)(citing S. Goldberg, Fraudulent Broker-Dealer Practices, #2.9(b){5}(Am Inst. for Sec. Reg. 1978). *S. Goldberg, Customer Recovery, supra bite 32 at 15. Mr. Goldberg uses the following example: For example, suppose a customer has a securities account valued at $50,000 and the stockbroker's commissions for one year are $20,000. What this means is that the customer's account must earn a rate of return of 40% per year just to meet expenses. Thus, in this example, the Goldberg : Cost/Equity Maintenance Factor is 40% (emphases in original.) Michael David Sweeney, 50 S.E.C. 761 (1991) (excessive trading where customers would have had to earn returns of 22% to 44% to break even); and Shearson, S.E.C. 1119, at 1121 (excessive trading where customer would have had to earn return of 50% to break even). Berg, Howard G. and J. Julie Jason, "Does the Literature of churning Reflect the Current State of the Brokerage Industry?" Securities Arbitration 1996, Volume Two, Practicing law Institute, 1996 - "In view of expected performance over time...commissions of about 5% to 6% annually in a brokerage account with a growth and income or conservative investment objective over which a broker exercises control is probably about the limit the account can bear."
Cost to Equity in Options Accounts -
Report of Special Study of the Options Markets to the SEC (December 22, 1978 - The Options Study of 1978 was critical of the use of ATR in an options account, reasoning that short options that expired would be reflected in the calculation. However, any such effect would almost always be very small; moreover, it would only serve to understate the customer's turnover calculation, thereby making it conservative. The Study came down squarely in favor of the use of a commission-to-equity ratio of which BER, which includes margin interest, is a logical extension, as a means of evaluating accounts for excessive trading. Usually, however, the options debate is more qualitative than quantitative, arguing that options are by design short-term instruments and that a higher turnover rate is expected. Here again, the use of BER will create the rebuttal for the argument: the harm in frequent is the cost. BER allows us to to look at the cost of trading in an options account and evaluate whether it was suitable for the customer in question. A number of SEC releases support the premise that the cost-to equity ratio is the appropriate measure for analyzing an options account for churning.
D. How have damages been calculated?
Stockbroker "Churning" Liability by Ferdinand S. Tinio, LL.B., LL.M. 32 ALR3d 635 "The liability of a broker or dealer for damages is another troublesome aspect of an action for churning. One view is that the broker is liable for the commissions or other profits which he earned from the excessive trading, while another view is that the broker or dealer must pay to the victimized customer the difference between the probable value of the account if it had not been improperly handled and its actual value after it had been churned. As to whether the aggrieved customer may, in addition to his actual damages, recover punitive damages for what is in effect an intentional tort by his broker or dealer, it has been suggested that such recovery may be possible only in a common-law action, but not in a suit brought under the antifraud provisions of the SEC act of 1934, since this statute in effect prohibits double recovery".
Mihara v. Dean Witter & Co., Inc. 619 F.2d 814 (9th cir. 1980), Miley v. Oppenheimer & Co. 637 F.2d 318, 326-27 (5th cir. 1981)
E. Who is responsible for liability in a churning case?
Stockbroker "Churning" Liability by Ferdinand S. Tinio, LL.B., LL.M. 32 ALR3d 635 "The liability for churning a customer's account is not limited to the acts of the broker or dealer alone. Thus, in large securities-brokerage firms with many salesmen or with branch offices in several cities, the managing partners or other top officers cannot escape liability for the acts of their individual salesmen, in the absence of a showing that those salesmen were closely supervised in their activities". Further, that supervision must be in place to "prevent violations".
In many instances, the monthly statement that is produced by the brokerage firm contains, in the extreme right-hand corner, cumulative information regarding all of the commissions, selling concessions, and mark-ups/downs in the account both for the month and year to date. Regrettably, this portion of the monthly statement is ripped off before the statement is transmitted to the customer i.e. the great brokerage statement rip-off! The brokerage firm is clearly part of the mechanism that prevents the customer from ever learning of the compensation charged to his or her account. This lack of disclosure clearly places responsibility of churning squarely on the brokerage firm. Customers are simply not informed that they can insist that their brokerage firm supply an unaltered monthly statement or separate commission payout run. Further evidence of supervision liability can be shown in a great number of arbitration decisions where the award is joint and several against the broker and the firm.
NOTE: Margin interest and option trading, two factors that complicate the churning process, are only briefly considered here. SEC rulings have clearly shown that the Cost to Equity Maintenance Factor should be the controlling churning ratio as opposed to the Turnover Rate. This is because options and margin trading necessitate much greater activity than normal, as a general rule.
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