By Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold, NJ Estate Probate Litigation Attorney
In Part 1 of our series I told you about a case of “churning” by a stock broker. I explained a bit what churning meant as well as the legal questions presented in the case. Now I will review the elements of churning.
Discussion on the Three Elements of Churning:
Assume in the three cases referenced below, that each of the plaintiffs was an unsophisticated investor who sought to invest substantial portions of their assets in conservative annuities, low-risk investments, and other financial products.
Before a client begins building an investment portfolio, he usually engages in a dialogue with the broker about his investment interests, goals, and concerns. These investment objectives indicate to the broker what the court uses to judge the broker’s actions against. For example, if one were a gambler who indicated to the broker he wished to engage in highly speculative trading, then it would be very difficult to succeed on this element, much less even a churning claim.
In the case, the court believed that the first element – excessive trading – was satisfied. The plaintiff had an expert testify that in light of her conservative investment objectives, the transactions in the account were excessive in size and frequency. The judge instructed the jury to consider six factors: “(1) the nature and objectives of the account; (2) the turnover rate; (3) in-and-out trading; (4) the holding period of the respective securities; (5) the broker’s profit; and (6) observance of the Know-Your-Customer and Suitability rules.” In this case, high turnover rate and in-and-out trading completely contradicted the objectives of the plaintiff’s investment objectives.
In another case, the court noted, “While there is no clear line of demarcation, courts and commentators have suggested that an annual turnover rate of six reflects excessive trading.” Mahara v. Dean Witter & Co., 619 F.2d 814, 821 (9th Cir. 1980). The court cites other seminal cases where courts affirmed findings of churning: “an account that had been turned over 8 to 11.5 times during a six-year ten-month period; 45% of the securities were held for less than six months, 67% were held for less than nine months, and 82% were held for less than a year.” Id.
In the first case, the court found that the holding periods for securities in the plaintiffs account reflected a pattern of churning for the following reasons: there was significant run-over in the early stages, very short holding period for the securities purchased followed by longer holding periods in the later stages of the account. Id. This is done so that there are large commissions at the outset, which is usually followed by less trading and longer holding periods in the later stages, once significant commissions have been generated. Id. This pattern did not reflect an appropriate investment strategy for the conservative objectives of the plaintiff. Id.
In the case of Rolf the court did not find trading was excessive because the annual turnover rate never exceeded 1.85. Rolf v. Blyth Eastman Dillon & Co., 424 F. Supp. 1021, 1039 (S.D.N.Y. 1977). In this case, since it did not begin to approach an annual turnover rate of six, the court declined to find that trading was excessive. Id.
The court noted, “…[the plaintiff] was willing to take the risks involved in short-term trading, and he never instructed the broker not to engage in short-swing trades. Plaintiff’s twice-stated investment intent was to double his equity in approximately one year.” Id.
The requisite degree of control is met if the client routinely follows the broker’s recommendations.
In Rolf, the court noted that a broker must have “virtually exclusive control” over the trading in order to satisfy the “control” element. Id. at 1040. Here, the brokers did not have [virtually] exclusive control over the trading. They often engaged in letters, phone calls, and conferences discussing different investment routes. Even though the brokers utilized a quasi-legitimate investment technique called “free-riding stock manipulations,” it was”…clear that the trades were not without some investment purposes.” Id. These were the sort of strategies that would reach his investment goals.
But, in Miley, the court found that the broker did have nearly exclusive control over the account. 637 F.2d at 325. The broker “tended to err on the side of entering into, rather than of passing up, somewhat risky investment in order to earn a higher related commissions.” Id.
In Mihara, the court found that the broker did have control over the account. 619 F.2d at “The account need not be a discretionary account whereby the broker executes each trade without the consent of the client. The requisite degree of control is met when the client routinely follows the recommendations of the broker.” Id. Essentially, the broker recommended certain annuities and investments – Mihara, the plaintiff simply followed. Id.
When the client’s true and legitimate interests are not served, there is either intent to defraud or a reckless disregard for the client’s interests.
In Mihara, the client multitudinously complained to the securities brokerage firm about the handling of his account. 619 F2d. at 817. On several occasions, he requested the account be closed, when the funds began to significantly dwindle. Id. at 818. However, his broker and the broker’s supervisors, continued to reassure him that the performance of the account would improve. Id. For the court, this alone was persuasive enough to satisfy the scienter element of the claim. Id. at 821.
The defendants unsuccessfully argued that it must be shown that each trade was done with the intent defraud or reckless disregard of the investor’s interests. Id. However, the court said that argument has no merit. Id. The Court stated, “The churning of a client’s accounts is, in itself, a scheme or artifice to defraud within the meaning of Rule 10b-5.” Id. It is the continuous pattern of activity that is the focus of the court’s scrutiny. Id.
If the salesman is bankrupt we could potentially go after the companies which approved him to sell their products. Respondeat superior is a well-known tort doctrine, but just for referential purposes, the primary elements of a successful claim are produced below. Conveniently, the Rolf case has a discussion on this vicarious liability applied to a churning matter, so a discussion on the court’s commentary will follow.
To prevail on respondeat superior claim, one must prove that (1) a master-servant relationship existed and (2) the tortious act occurred within the scope of employment.
To determine whether a master-servant relationship existed one must prove the following elements and consider the corresponding factors:
“(1) A servant is a person employed to perform services in the affairs of another and who with respect to the physical conduct in the performance of the services is subject to the other’s control or right to control.
(2) In determining whether one acting for another is a servant or an independent contractor, the following matters of facts, among others, are considered:
(a) the extend of control which, by the agreement, the master may exercise over the details of work;
(b) whether or not the one employed is engaged in a distinct occupation or business;
(c) the kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the employer or by a specialist without supervision;
(d) whether the employer or the workman supplies the instrumentalities, tools, and the place of work for the person doing the work;
(f) the length of time for which the person is employed;
(g) the method of payment, whether by the time or by the job;
(h) whether or not the work is a part of the regular business of the employer;
(i) whether or not the parties believe they are creating the relation of master and servant; and
(j) whether the principal is or is not in business.” Carter v. Reynolds, 175 N.J. 402, 409-410 (2003)
To determine whether the tortious act occurred within the scope of employment Carter court says the following, “[Scope of employment] refers to those acts which are so closely connected with what the servant is employed to do, and so fairly and reasonably incidental to it that they may be regarded as methods of carrying out objectives of employment.” Id. at 411.
“An employee’s conduct falls within the scope of employment if:
(a) it is of the kind he is employed to perform;
(b) it occurs substantially within the authorized time and space limits;
(c) it is actuated, at least in part, by a purpose to serve the master,
(2) Conduct of a servant is not within the scope of employment if it is different in kind from that authorized, far beyond the authorized time or space limits, or too little actuated by a purpose to serve the master.” Id.
Rolf on Churning and Respondeat Superior
In Rolf, the plaintiff asserted that the securities brokerage firm failed to supervise the broker and activity in the plaintiff’s account under (1) the doctrine of respondeat superior or (2) as a controlling person liable under Section 20 of the Exchange Act. 424 F. Supp. At 1043. The court notes that several other circuit courts affirmed that respondeat superior applies to brokerage firms in damages actions. Id. at 1044.
The court distinguishes between the two concepts above: “the key difference between respondeat superior and controlling person liability is “not entirely esoteric”. Sincere there us a good faith defense to the latter charge which is unavailable at common law.” Id.
The firm in Rolf failed to “satisfy good faith” because the controlling person did not maintain and enforce a reasonable and proper system of supervision and internal control over controlled persons so as to prevent, so far as possible violations of Section 10(b) and Rule 10b-5. Id.
The court lays out the reasons for finding the company liable; (1) The company completely failed to supervise any accounts being handled by individual brokers. (2) The company was exceedingly lax – they permitted a supervisor to recommend an investment adviser with no knowledge of the plaintiff’s account. (3) they allowed an unidentified person to trade in the plaintiff’s account for a short period of time. Id.
To discuss your NJ Estate Probate and Litigation matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at firstname.lastname@example.org. Please ask us about our video conferencing consultations if you are unable to come to our office. In Part 3 of this series I will discuss how to be successful on a respondeat superior claim.