Churning and Unsuitability Against Brokerage Firm Defendants
The legal principles governing churning claims are well-settled. Churning requires proof of three elements: (1) control over the account by the broker: (2) trading in the account that is excessive in light of the customer’s investment objectives: and (3) the broker’s intent to defraud or his willful or reckless disregard of the customer’s interests. Follansbee v. Davis, Skaggs & Co., Inc. (9th Cir. 1982) 681 F.2d 673, 676 (churning claim meritless where experienced customer directed frequent trades in accordance with his own expressed short-term trading objectives).
Whereas “churning” connotes trading which is excessive in light of a customer’s resources and objectives, a claim of “unsuitability” requires proof that a broker recommended securities which, in light of the customer’s disclosed objectives and background, the broker knows or reasonably believes to be inappropriate. To prevail on a claim of unsuitability, the following elements must all be proven:
- That the securities purchased were unsuited to the buyer’s needs;
- That the defendant knew or reasonably believed the securities were unsuited to the buyer’s needs;
- That the defendant recommended or purchased the unsuitable securities for the buyer anyway;
- That with scienter or fraudulent intent, the defendant made material misrepresentations (or owing a duty to the buyer, failed to disclose material information) relating to the suitability of the securities; and
- That the buyer justifiably relied to its detriment on the defendant’s fraudulent conduct.
Brown v. E.F. Hutton Group, Inc. (2d Cir. 1993) 991 F.2d 1020, 1031. Thus, whereas a “churning” theory requires proof of an excessive quantity of transactions in a customer’s account instigated by the broker, an “unsuitability” theory requires proof of a qualitative mismatch between the customer’s reasonable investment objectives and the broker-recommended investments - regardless of how many or how few investment transactions occurred.
