Statutes regulations and rules, as well as common law, apply to customers' claims, making defense counsel's job complex
LIABILITY of financial advisors is a broad and complex area of the law. The category of financial advisors includes, among others, registered investment advisors, broker-dealers, future commission merchants, and banks that engage in investment counseling. Their liability arises from various statutes, regulations and common law theories, including, again among others, the Securities Exchange Act of 1934, the Securities Act of 1933, the Racketeer Influenced and Corrupt Organizations Act (RICO), the New York Stock Exchange Rules, and the common law of tort, fraud and contract.
Various causes of action may be asserted under these statutes, regulations and common law theories. This article concentrates on two common forms of liability--"churning" and "unsuitability"--both of which are and will be asserted routinely.
A. What Is It?
In general terms, churning refers to over-trading or the excessive rate of turnover caused by a broker in a controlled account for the purpose of increasing the commissions gained by a broker.(1) Claims for churning can be set forth under various statutes, including Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. [sections] 78j(b), Rule 10b-5, which derives from Section 17(a) of the Securities Act of 1933, 15 U.S.C. [sections] 77(q)(a), and common law state causes of action for breach of fiduciary duty and fraud.
Additionally, some states' securities laws may provide a basis for a churning claim. Some states' consumer protection laws also may provide an avenue for filing a churning claim,(2) while other states do not .(3)
A provision in the Private Securities Litigation Reform Act of 1995 amended 18 U.S.C. [sections] 1964(c) to abolish the assertion of claims for churning under RICO, unless the conduct results in a criminal conviction of the person charged. It is not expected that RICO will provide a basis for churning claims in the future.
B. Plaintiffs' Burden of Proof
A churning cause of action requires proof of three elements: (1) control over the account by the broker: (2) trading in an account that is excessive in light of the customer's investment objectives; and (3) the broker's intent to defraud or willful or reckless disregard of the customer's interest.(4)
1. Control over Account
The first element requires that the broker or account representative exercise a certain amount of control over the account. Control in the context of churning can be either express or implied.
Express control, which also is referred to as discretionary power or formal control, requires that control or power be given to a broker in writing.(5) Such power generally derives from an account in which the customer gives the broker discretion as to the purchase and sale of securities, including selection, timing and price to be paid or received.(6) Under express or formal control, a broker owes his client the highest obligation of good faith and fair dealing.(7)
When there is no writing, implied control or de facto discretionary power may be found. The actual extent of the broker's control is analyzed by answering this question: "Did the customer have the financial acumen to adequately determine his own best interests and to independently evaluate his broker's suggestions."(8) A negative answer leads to a finding of implied control. Such control is based on the totality of the circumstances and is measured subjectively.
As set forth by the federal district court in M & B Contracting Corp. v. Dale, factors to be addressed include:
(1) the identity, age, education, intelligence,
and investment and business experience of
the customer: (2) the relationship between
the customer and the account executive, that
is, whether it is an arms-length one or a particularly
close relationship; (3) knowledge of
the market and the account; (4) the regularity
of discussions between the account executive
and the customer; (5) whether the customer
actually authorized each trade, and (6) who
made the recommendations for trades. …