Ethical and Legal Issues Surrounding Churning

What is Churning:

Churning takes place when a broker undertakes excessive trading, i.e. buying and selling of securities in the investor’s account for generating commissions that may benefit the broker or the securities agent. The broker has to exercise unwarranted control over the critical decisions about the investor’s account. Evidence of churning is where there are frequent in-out buying and selling of securities which do not fulfil the investor's investment goals.

When the agents trade securities, they make a potential commission from the transactions, churning takes place when an agent or a broker undertakes to buy and to sell off securities to increase the commission instead of working in the best and compelling interests of the investor. In the process, the agent gains considerable control over the critical investment decisions of the investors.

Legality and Ethicality of Churning:

Churning is unethical as well as illegal. It constitutes violation and infringement of Securities Exchange Commission (“SEC”) Rule 15c1-7 and other aspects of securities laws.

SEC Rule 15c1-7 – Discretionary accounts

• Section 15c defines the terms manipulative, or fraudulent device, deceptive or contrivance for including acts of the agent or the dealer, which substantially affects the investor’s account. In the process, the agent gets the discretionary power for trading in excessive quantity or frequency according to the financial status of the account.
• Secondly, it consists of any acts of the broker where the discretionary power vested allows the agent to record the names of the investor, the price and amount of the security in place and the time as well as the date as to when the deal took place.

It basically states that an agent acts in a deceptive and manipulative manner constituting fraudulent ways where the agent has a discretionary control and authority over the client’s accounts and makes the excessive transactions of the account.

Financial Industry Regulatory Authority (“FINRA”) Rule 2111:

The FINRA Rule 2111 requires the agent to substantiate a "have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer's investment profile."

New York Stock Exchange (“NYSE”) Rule 408(c): Discretionary Power in Customers' Accounts

• The underlying principle behind the NYSE rules is to restrict a member of an organization who if he exercises control over the account, should first obtain written consent from the investor.
• The member must notify and obtain approval from a person delegated by Rule 342(b)(1)  for handling the accounts. Every order entered by the member must be considered as a discretionary at the time of entering into the records. These accounts are to be overlooked and reviewed by the person who is delegated with such responsibility under Rule 342(b)(1) who shall provide a written statement for the supervisory procedures.
• No member exercising the control over the investor’s account shall trade in and out of securities which are larger considering the financial resources of the investor.

It basically prohibits the NYSE members from exercising unrestricted power in order to effect the transactions which in fact are excessive in quantity of the investor's resources.

All and all, churning results in violation and infringements of the agent’s basic duty to act in the best interests of the investor, which results in securities fraud.

Ways to perceive Churning:

Following are the steps to analyse and detect churning:

1. Constant check on the resources and the investment aims of the investor’s account
2. Establishing excessive trading activity
   1. Turnover rate
   2. Use of in-and-out trading in the investor’s account
   3. The ratio of Cost to equity

The Cost to Equity ratio determines the annual costs, which may be incurred on the investment policy. Sometimes, called the ‘breakeven rate of return’. The ratio is calculated as under:

Cost-Equity Ratio=Total annual cost                                       

     The average balance in the account

3. Proof of the agent’s control
   1. Establishing control is another aspect. That means, we have to establish as to who decided the was of the transaction and the terms of it.
4. Once churning is detected, filing a complaint with the SEC at https://www.sec.gov/complaint/select.shtml or FINRA’s Complaint Center at http://www.finra.org/investors/investor-complaint-center

Claiming against Churning:

The victim of unethical churning will be able to claim compensation and damages for the loss and the commissions that the agent received in the due course of frequent trading in and out of the investor’s account.

The claim will be successful if the investor is able to prove the following:

1. The agent and not the investor exercised excessive control over the investor’s account
2. The churning took place on the basis of the rise in the account activity and the client’s risk tolerance and investment aims

Arbitration:

In the event that the investor is suspecting illegal activities in his account and that Churning is established, the aggrieved party can institute an arbitration claim against the agent and his firm. The Arbitration tribunal will look into some of the following aspects in order to determine control:

1. Client sophistication
2. Trust and reliance on the agent
3. The time given by the client on his investment portfolio
4. Client’s past investment experience
5. Level of understanding concerning the investment strategy

Arbitrary Action against ‘Churning’ Firms:

In this case, the Arbitration Center at the FINRA made an award for more than USD 1 Million to a customer who contested churning. The investor had invested USD 10,000 but lost around USD 375,000. These damages were awarded in line with the enormous amounts being traded and due to excessive turnover in the investor’s account. The brokerage firm involved in the matter was expelled from its authority.

Case Laws for Churning:

The SEC has successfully brought arbitrary actions against the agents who have committed fraud with innocent investors by the way of churning.

• SEC vs Dean and Fowler:

Two were charged for ‘churning’ the brokerage accounts for three investors and making a recommendation of an investment strategy on an unreasonable standing to make it as a belief that the strategy is suitable for the investors. The SEC held that the strategy employed by the agents were not suitable and incurred heavy losses to the investors.

• SEC vs Paul T. Lebel:

SEC held liable the agents and the firms for churning brokerage accounts where no explanation or justification was provided to the investors for laundering in and out of their portfolio accounts.

Financial Fraud measures in UAE

UAE allows the victims of Financial Fraud to initiate criminal proceedings and claim compensation for the losses and damages suffered by them. The UAE Federal Law Number 35 of 1992, under Article 22 states that the individuals who have suffered a direct loss in consequence of the crime are eligible to file a civil claim, during procuring evidence, the investigation stages, or at any stage before the criminal court before the completion of closing submissions…”

Conclusion

Churning is illegal in most parts of the world. With the growth and development in the economy, there are several instances of money laundering. Majority of the jurisdictions have laws in place to curb the unnecessary and unwarranted occurrences of churning. As for the UAE, the Federal Laws make solid provisions for curbing the menace of securities fraud.