Account Churning Prohibited by Securities Laws
Account churning is an illegal practice used by securities brokers to enrich themselves at the expense of their clients. Churning occurs when a broker completes an excessive number of trades on a customer’s account for the purpose of generating commissions. Churning is prohibited by federal laws, industry rules, and an investment adviser’s fiduciary duty to his or her clients.
What Laws or Rules Prohibit Account Churning?
Several laws and regulations attempt to prevent account churning. The Securities Exchange Act of 1934 (the “Act”) prohibits a person from using a “manipulative, deceptive, or other fraudulent device or contrivance” to complete a securities transaction. Although on its face this statute may not appear to address churning, SEC Rule 15c1-7 further defines the Act’s operative phrase. The rule, codified at 17 C.F.R. § 240.15c1-7, clarifies the definition of “manipulative, deceptive, or other fraudulent device or contrivance” to include excessive transactions made by a broker with the authority to complete trades on behalf of his or her client. The effect of these two federal statutes is to ban churning.
Industry regulations also prohibit account churning. The Financial Industry Regulatory Authority (FINRA) is a private organization that self-regulates the investment industry by promulgating rules its members must follow, investigating and enforcing violations of its rules, and referring cases to the Securities and Exchange Commission (SEC). FINRA Rule 2111 requires that brokers have a reasonable basis to believe that a particular transaction is suitable for the intended client. Rule 2111 has been interpreted to prohibit account churning, since the primary purpose of account churning is to enrich the broker at the expense of the investor.
What Is Required to Prove a Churning Case?
Investors who suffered losses due to account churning may bring a lawsuit or arbitration case against their broker. To prove the case, a plaintiff must establish three elements. The first is that the broker had control over the client’s account. This can either be express control, as evidenced by a signed agreement between the client and the broker, or it could be implied or de facto control. The broker may have de facto control over the account if the client, for example, always follows his or her broker’s advice.
The second element is the excessive trading itself. Whether trading is excessive depends on the client, the size of the account, the client’s financial goals, and other factors. Courts and arbitrators will also consider the turnover ratio, the commission-to-equity ratio, and other calculations. Often, an expert witness with special knowledge of investing can help prove whether the trading constituted churning.
The last element is scienter, which is a legal term that means intent. The broker must have either specifically intended to defraud the client or acted with a reckless disregard for the client’s interest.
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