Excessive trading of an account, considering the investment objectives of the customer, by a broker with discretion to trade the account is called churning. It is a violation of Section 10 of the Securities Exchange Act of 1934 and SEC Rule 10b5 thereunder and Section 12 of the Illinois Securities Act. The broker does not need to have actual discretion over the account. It is sufficient if the broker has actual control over the account.

The elements of a churning claim are: 1) excessive trading; 2) stocks purchased or sold to generate commissions and not with the customer's best interests in mind; 3) reliance by the customer on the broker to make sound investment decisions for the customer. Churning is often analyzed by means of the turn over ratio in the account. This is the total of sales in the account divided by the average value of the account in a given year. The higher the ratio, the more likely a churning charge can be sustained. There is no set number that establishes the violation. Other matters must be reviewed as well. A pattern of sales of securities soon after they are purchased (or vice versa) is one consideration. Another consideration is a pattern of sales or purchases between accounts over which the broker has control.

Churning is prohibited by SEC Rule 15cl-7.

(a) The term 'manipulative, deceptive, or other fraudulent device or contrivance,' as used in Section 15(c) of the Act, is hereby defined to include any act of any broker...designed to affect...for any customer's account in respect to which such broker...or his...employee is vested with any discretionary power any transactions of purchase and sale which are excessive in size or frequency in view of the financial resources and character of such account.

Rule 408 (c) of the New York Stock Exchange states:

No member...or employee of a member organization exercising discretionary power in any customer's account shall...effect purchases and sales of securities which are excessive in size or frequency in view of the financial resources of such customer.

NASD Conduct Rule 1M-2310-2 states:

(a) (1) Implicit in all member and registered representative relationships with customers...is the fundamental responsibility for fair dealings. ... (b)...Some practices that have resulted in disciplinary action and that clearly violate this responsibility for fair dealing are...: ... (2) Excessive activity in a customer's account, often referred to as 'churning' or 'overtrading'. There are no specific standards to measure excessiveness of activity in customer accounts because this must be related to the objectives and financial situation of the customer involved.

A broker exercising discretionary authority on a customer account is a fiduciary with respect to the customer. Churning is a breach of that duty. Breach of fiduciary duty is actionable in Illinois.

The fact that the account is not discretionary and the customer approves all trades does not necessarily constitute a defense to churning. Control over the account must be determined from all the facts and circumstances. The factors to be considered are the sophistication, age, education, and investment experience of the customer, whether all or most transactions in the account were made pursuant to the broker's recommendations and, whether the broker customer relationship is arm's length or close.

Ordinarily when a customer knows of transactions in his or her account he or she is held to have ratified and approved them unless action is taken to reverse the transactions. However, even actual consent of the customer induced by the undue influence of the fiduciary does not constitute a defense to churning.

Mere failure of a customer to read statements and confirmations from a broker or to object to the actions of a salesman does not necessarily constitute a defense to a violation of Rule 10b5 in a churning case. Where the customer is dependent on the broker, disclosure by means of confirmation slips is not automatically sufficient since the broker may have a duty to explain the significance and meaning of what the confirmation slips show.

Donald M. Thompson * 55 W. Monroe #3950; Chicago, IL 60603
Ph: 312-782-0844 * Fax: 312-201-1436 * Email: donthompsonlaw@sbcglobal.net