Churning

Churning is excessive trading in a client's account by a broker, who has control over the account, with the intent to generate fees or commissions rather than benefit the client. Brokers—who are typically employees of a brokerage or investment banking firm with responsibility for handling the investment portfolios of clients—often occupy a dual role as sellers of securities and trusted advisers. In the former role, brokers have [Page 314]only the obligations of sellers in a market, but in the latter capacity, they have both moral and legal obligations, a fiduciary duty, to act in the interests of a client. Because brokers are compensated by fees and commissions from the sale of securities, they have a conflict of interest when they also serve as an adviser or have control of an account due to the opportunity to enrich themselves at a client's expense. To engage in churning, then, is to violate a fiduciary duty to act in a client's interest as the result of a conflict of interest.

Churning can be legally prosecuted either under the common law doctrines of fiduciary duty and fraud or under various federal and state securities laws. A fiduciary duty may be created by an explicit pledge by a broker to serve as a trusted adviser. Absent such a pledge, a fiduciary duty may be inferred by the “shingle theory,” which holds that by offering a professional service (“hanging out a shingle”) a broker implies the he or she will deal with clients fairly and honestly. The common law elements of fraud are the willful misrepresentation of a material fact that causes harm to a person who reasonably relies on the misrepresentation. Thus, a broker who willfully misrepresents either his or her trustworthiness as an adviser or the reasons for recommending or executing a trade commits fraud.

Most actions for churning are brought under Rule 10b–5 of the 1934 Securities Exchange Act, which prohibits any manipulative, deceptive, or other fraudulent device or contrivance in connection with the purchase or sale of a security. In addition, the National Association of Securities Dealers (NASD), an industry organization, holds that churning is a violation of its suitability rule, which requires members to recommend only transactions that are suitable for a client. Although an action can be brought by the Securities and Exchange Commission (SEC), state regulators, or the NASD with the aim of imposing penalties, most cases of churning are private suits or arbitration claims brought by individuals seeking restitution.

Individuals who charge a broker with churning are required by the courts to prove three elements: (1) that the broker had control over the account, (2) that the broker engaged in excessive trading given the investment objectives of the client, and (3) that the broker acted with an intent to defraud or acted with a reckless disregard of the client's interests. Although each of these elements raises certain difficulties, the first two are especially problematic.

A broker who is authorized in writing by a client to make transactions without further approval has explicit or formal control. Ordinarily, a broker who is merely executing a trade for a client has no fiduciary duty to serve the client's interest. However, implicit or informal control and an attendant fiduciary duty may be established when an unsophisticated client always or usually follows a broker's advice. Both elements are necessary—a pattern of reliance and a lack of knowledge or experience. The reason for imputing control in the case of an unsophisticated, easily influenced client is that a broker may have the de facto power to control this person's account without being explicitly authorized.

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