When Michael called me to tell me about the subject of this post, I frankly thought he was making it up. The notion that FINRA was seriously suggesting deleting one of the historically recognized essential elements of a churning claim — principally because otherwise it was too difficult for FINRA to prove churning — seemed ridiculous. Then I read the Reg Notice. Cleverly, FINRA tries to make it seem like the amendment isn’t necessary, arguing — incorrectly, in my view — that “[b]ecause FINRA must how that the broker recommended the transactions in order to prove a Rule 2111 violation, culpability for excessive trading will still rest with the appropriate party even absent the control element.” But, that is wrong, unless, as FINRA seems to be suggesting, you want to split hairs and call one thing “churning” and the other “excessive trading.” Please, even if you have never before commented on a rule proposal, now is the time to speak up. FINRA cannot be permitted to get away with something like this, that is, simply ignoring legal precedent, because that precedent makes FINRA’s Enforcement efforts harder.
Also, I just wanted to put in a plug for Ulmer & Berne’s Financial Services Seminar in Chicago on May 23. If interested in attending, click here to reserve your spot. – Alan
FINRA has been busy lately issuing Reg Notices on proposed changes to its Rules. Several of the proposed changes seek to give FINRA more discretion and authority over its members and associated persons. I get that. Who wouldn’t like more control and power? But FINRA’s Reg Notice 18-13, issued on 4-20-18 of all days, makes me wonder what FINRA was smoking on this one. In that Notice, FINRA seeks to change decades-old federal securities law on churning in order for it to more easily prove that a customer’s account has been churned. That is bold.
Under well-established federal law, an investor must prove the following three elements to prevail on a churning claim: (1) the trading in the account was excessive in light of her investment objectives; (2) the FA exercised control over her account; and (3) the FA acted with scienter – intent to defraud or reckless disregard for the investor’s rights. One of the most frequently cited cases on the elements of churning is Rolf v. Blyth, Eastman, Dillon & Company, Inc., a decision issued by the Southern District of New York in the 1970s. Churning constitutes a violation of federal securities laws, specifically, Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 thereunder.
Consistent with federal securities laws on churning, FINRA Rule 2111.05(c) currently provides that a quantitative suitability violation (i.e., churning) occurs when FINRA can establish the same three elements, namely, excessive activity, control, and scienter: “Quantitative suitability requires a member or associated person who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile, as delineated in Rule 2111(a).”
In Reg Notice 18-13, FINRA even acknowledged that Rule 2111.05(c) “codified the line of cases on excessive trading (sometimes referred to as ‘churning’).” The proposed change to Rule 2111, however, seeks to break from that line of cases by eliminating one of the elements of a churning claim: control. In other words, FINRA seeks to change well-established federal securities law by changing the definition of what does and does not constitute churning.
Remarkably, one of the reasons that FINRA cites for the proposed change is “its experience with the rule.” This negative experience for FINRA is presumably based on a series of unsuccessful attempts to pursue churning charges in settlements and hearings (e.g., 2009 Medeck NAC Decision). In other words, the proposed change is borne out of FINRA’s attempts to fit a square peg in a round hole by pursuing churning charges where it cannot satisfy the control element of the claim.
In the Notice, FINRA goes on to say that the control element “places[s] a heavy and unnecessary burden on customers [and FINRA] by, in effect, asking them to admit that they lack sophistication or the ability to evaluate a broker’s recommendation.” (Apparently, those at FINRA responsible for the proposed Rule have never seen a customer testify at an arbitration hearing as if he just had a frontal lobotomy.) The real “control” problem here lies with FINRA, and its lack of control over customers. FINRA does not possess jurisdiction over customers. Therefore, FINRA cannot force customers to testify or even cooperate, hindering its ability to prove that a customer lacks the ability to evaluate an FA’s recommendation, or, in many instances, to rebut a letter signed by the customer acknowledging that he possess that ability.
There are several other issues with FINRA’s position. First, the control element is not an unnecessary burden. It is a burden imposed by federal securities laws and the federal courts that have interpreted those laws. If a customer has an issue with how his account is being invested, then he should say or do something about it, and not sit idly by; investing is not a heads I win (trading strategy is profitable), tails you lose (firms reimburse trading losses) endeavor. An experienced, sophisticated, or even moderately intelligent person should not be able to prevail on a churning claim if he could and should have put an end to activity that he doesn’t like; the failure to do so reflects that the investor had no issues with how his account was being handled.
Second, the burden to establish churning is heavy because the consequences for violating federal securities laws are stiff. The FINRA Sanction Guidelines on churning recommend that adjudicators “[s]trongly consider barring an individual for reckless or intentional misconduct (e.g., churning).” This, of course, makes sense. An FA should be sanctioned severely for taking advantage of a customer who lacks the sophistication or ability to evaluate his recommendations. There is no mention in the Notice of reducing the specific guideline for churning if the term is redefined, which leads me to believe that no such commensurate change will be forthcoming.
Third, the proposed change to the definition of churning presents interesting charging and legal questions. Willful violations of certain federal securities laws, including Rule 10b-5, result in an FA being subject to statutory disqualification, which is quite consequential. If the Rule change passes, it will be interesting to see if FINRA charges churning claims as violations of Rule 10b-5 under its new definition or under the actual legal definition. If it is the former, then the FA should not be subject to statutory disqualification based on existing federal case law interpreting Rule 10b-5. Notably, there is no mention of Rule 10b-5 in the Notice.
Fourth, the proposed Rule change would be a real gift to PIABA and attorneys who represent investors in FINRA arbitrations. Despite existing federal case law, these attorneys will undoubtedly argue that their clients need not prove one of the most challenging elements of a churning in order to get a payday.