Answer: First, and this has become a near mantra for me, you need to document your conversations, and activities in the account. While this may not help with this particular account, keeping notes about your customers will help to prevent this type of claim, and will help in the defense of the claim should it arise. The first column that I wrote for Research Magazine was on keeping records, and is a must read for every registered representative - For the Record.
My article, Churned or Traded, provides an analysis of the claim, and the defense to the claim, and I recommend a review of the article, which is posted at SECLaw.com. For the moment, the definition is important.Churning is excessive trading in a customer's account by a broker taken in the context of the customer's financial situation and investment objectives. Churning requires three elements, first, excessive trading, and second, control of the account by the Registered Representative, and three intent to defraud the customer.
The most difficult part of a churning analysis is a determination of whether the broker had control over the account, and notes and written communication between the broker (or firm) and the customer is important. The fact that the customer was picking the stocks is important, and documentation of that fact will be a great benefit in defending the claim. The customer's new account form is important, as it documents the investment objectives of the customer, as well as his investment experience and financial condition.
Although not frequently done, when an account that is going to be actively traded is opened, the customer can be asked to confirm, in writing, the trading strategy that is going to be used in the account, before the account is established. Periodic confirmations of that strategy during the life of the account can easily establish that the customer was directing the level of activity, and was therefore in control of the account.
Alternatively, many brokerage firms use activity letters in accounts with a high level of trading. Once the compliance department has identified an account as having a high level of trading, the branch manager or compliance officer will discuss the account with the registered representative, to determine the accounts goals and objectives. Assuming that the supervisor finds the level of trading to be suitable, or that the account is in the control of the customer, the firm then sends a letter to the customer, informing the customer that the trading in the account is more frequent than in a typical account, and seeking written confirmation from the customer that he is aware of the trading, and that the trading account is being handled to his satisfaction.
These letters, known as "activity letters" by some, and "suicide notes" by others, are sent to the customer and the written response is then kept in the customer's file. The activity letters are called suicide notes since the letter often becomes important evidence against the customer when he attempts to claim that his account was churned, or that he was unaware of the high level of trading in the account. A customer who has signed an activity letter has a very difficult time establishing the control aspect of a churning claim.
At the same time, if an account that has been actively trading does not return an activity letter, the customer should be contacted by the branch or compliance department, and the trading ceased, until everyone concerned is convinced that the customer is aware of, or directing, the trading.
Often broker's complain about activity letters, arguing that the letter will generate a complaint or will be sending the message to the customer that his broker is going something wrong in the account. While it is true that the wording of the letter may make a difference, the customer's refusal to sign the letter may very well identify a customer who did not truly understand the activity in the account. If that is the case, it is in everyone's interest to have the issue resolved sooner rather than later.
