KEY TAKEAWAYS 

  • A proposed amendment to FINRA Rule 2111 eliminates the requirement for FINRA to prove the broker exercised “control” over the customer's account to establish excessive trading.
  • FINRA acknowledges that the amendment may increase the probability of establishing an excessive trading violation, but believes the Rule’s existing requirement that the broker “recommend” the transaction ensures that culpability rests with the appropriate party.
  • The proposed amendment further diverges the elements of what FINRA must prove to establish a disciplinary violation for excessive trading from what a customer must prove to recover under a churning claim.
  • The comment period expires June 19, 2018.

LOSS OF CONTROL 

Following FINRA's 2010 amendment to the suitability rule that incorporated case law on excessive trading, one of the threshold requirements to prove an excessive trading violation under FINRA Rule 2111 is “actual or de facto control of a customer account.”

In Regulatory Notice 18-13 ("Notice"), FINRA proposes to amend Supplementary Material .05(c) of Rule 2111 by eliminating the phrase “who has actual or de facto control over a customer account” in describing the member or associated person subject to the rule. Without citing any empirical evidence, FINRA asserts as justification for the rule change that currently “brokers may be able to recommend excessive levels of trading to their customers but avoid disciplinary actions for violating the quantitative suitability obligation because of the difficulty in assessing and proving de facto control over their customers’ accounts.” As a further rationale for proposing the amendment, FINRA notes that the SEC’s proposed Regulation Best Interest (comment period open until August 7, 2018) would likewise eliminate "control" from its proposed suitability requirement for broker-dealers.

If adopted, this amendment will further deviate what FINRA must prove to establish a disciplinary violation for excessive trading from what a customer must prove to recover under a churning claim. Although “excessive trading” and “churning” are often used interchangeably, FINRA's comments in the Notice note that churning requires scienter (intent) to prove a fraud. Generally, a civil action for churning under Rule 10b-5 requires the following elements: (1) the trading in the account was excessive in light of investment objectives, (2) the broker exercised control over the trading in the account, and (3) the broker acted with intent to defraud or with willful and reckless disregard of the client's interests. See, e.g., Mihara v. Dean Witter & Co. 619 F.2d 814, 820-21 (9th Cir. 1980). Under the proposed amendment, FINRA would only need to prove one of the equivalent churning elements (excessive trading in light of customer's investment profile) to establish a disciplinary violation.

For brokers, the absence of the control requirement is concerning because that element has traditionally been an important check on excessive trading allegations. The element of "control" focuses the inquiry as to who is actually controlling the trades at issue―the customer or the broker. As an example of how the control element has worked in practice, a Ninth Circuit decision examined the dynamic between the broker and customer with respect to control of the trades and stated: “It simply cannot be construed to mean that the most sophisticated investor is not in control of his account simply because he usually follows the recommendations of his broker. As long as the customer has capacity to exercise the final right to say ‘yes’ or ‘no,’ the customer controls the account.” Follansbee v. Davis, Skaggs & Co., 681 F.2d 673 (9th Cir. 1982). Under the proposed amendment, the threshold inquiry would only be whether the brokers recommended the trade, which removes the customer's actions from the equation and consequently eliminates a layer of protection for brokers.

Because FINRA Rules do not establish a private right of action, the elimination of the control element for proving excessive trading for disciplinary actions in theory should not impact churning claims. However, the amendment would result in a further divergence between the standards for disciplinary actions and the standards for churning claims. Counsel representing brokers will have to redouble efforts to ensure that arbitration panels understand the more rigorous standard for churning claims.