Unsuitable Investments and Churning: Claims Against Brokers

The rules a broker must follow

Three rules do the work. Since June 30, 2020, Regulation Best Interest (17 C.F.R. § 240.15l-1) governs any recommendation of a securities transaction or investment strategy to a retail customer, meaning a natural person who uses the recommendation for personal, family or household purposes. Its care obligation requires the broker to use reasonable diligence, care and skill to understand the risks, rewards and costs of the recommendation; to have a reasonable basis to believe the recommendation is in the particular customer's best interest in light of that customer's investment profile; and, for a series of recommended transactions, to have a reasonable basis to believe the series is not excessive and is in the customer's best interest when taken together.

FINRA Rule 2111, the suitability rule, still applies to recommendations made before that date and to customers who are not retail customers under Regulation Best Interest, such as a business entity or an institutional account. Its three parts mirror the care obligation: reasonable-basis suitability (the product is suitable for at least some investors), customer-specific suitability (suitable for this customer's profile), and quantitative suitability (a series of trades is not excessive). The rule's supplementary material names turnover rate, cost-to-equity ratio and in-and-out trading as indicators of excessive activity.

FINRA Rule 2090, know your customer, requires the firm to use reasonable diligence when opening and maintaining every account to know the essential facts about the customer. A broker cannot defend a recommendation by saying he never asked.

What makes an investment unsuitable

Unsuitability is a mismatch between the product and the person, judged at the time of the recommendation. The common patterns:

• Illiquid or long-lock-up products (non-traded REITs, private placements, structured notes, variable annuities with long surrender periods) sold to a retiree who needs income or access to principal.
• Concentration: a large share of net worth in one issuer, one sector or one sponsor's programs.
• Leveraged and inverse exchange-traded products, options strategies or margin for a customer with a conservative profile or no experience.
• High-cost share classes or products when the same exposure was available for less, which Regulation Best Interest treats as a cost question the broker must answer.
• A new-account form that was filled in to fit the product rather than the customer: inflated net worth, "speculation" checked for a widow's only account.

The investor's actual profile, not the form, controls when the form was wrong and the broker knew it. Emails, notes and the customer's other accounts show what the broker knew.

What churning is and how it is proved

Churning is excessive trading of an account by a broker who controls it, done to generate commissions rather than to serve the customer. The three elements an arbitration panel or court looks for:

1. Control. Either formal discretionary authority, or de facto control shown by a customer who approved every trade the broker suggested without independent judgment.
2. Excessive trading in light of the customer's objectives, measured by the indicators below.
3. Intent to defraud or reckless disregard of the customer's interests, which is usually inferred from the first two elements and the commissions earned.

The numbers come from the account records:

No single number decides it; FINRA's own guidance says no single test defines excessive activity. The ratios are read against the customer's stated objectives. An active trader who asked for frequent trading is not churned; a retiree with an income objective and a cost-to-equity ratio in double digits is a strong case. Under Regulation Best Interest the control element is not part of the care obligation for retail customers, so a series of recommended trades can violate the rule even where the customer technically approved each one.

Example

Suppose a retired Fort Worth schoolteacher opens a $400,000 account with an objective of "income and preservation of capital." Over two years the broker recommends 140 trades, each approved by phone, in closed-end funds and preferred stocks that are sold within weeks and replaced with similar positions. Purchases total $2.4 million, commissions and fees total $58,000, and the account ends down 20 percent in a flat market. Turnover is about three times a year and the cost-to-equity ratio is over seven percent, against an income objective. Each trade may have been defensible alone. The series was not, and the firm's exception reports should have flagged the account long before the customer did.

Who is liable

The broker, for the recommendations. The brokerage firm, on three theories: it is responsible for its registered representative's conduct within the scope of employment; it has its own duty under FINRA Rule 3110 to maintain a supervisory system reasonably designed to achieve compliance, including review of transactions and exception reports that are designed to catch exactly this activity; and Regulation Best Interest places the compliance and conflict-of-interest obligations on the firm itself. In practice the firm is the defendant that pays, so the supervision evidence (what the branch manager saw, when the exception report fired, what was done) is as important as the trading evidence.

Damages

Three measures are argued. Net out-of-pocket loss: deposits minus withdrawals minus ending value. Well-managed portfolio: the difference between the account's actual result and what a portfolio matching the customer's stated objectives would have earned over the same period, which captures the opportunity cost of being in the wrong investments. Commission disgorgement: in a churning case, the commissions and fees generated by the excessive trading are recoverable on their own, even if the account did not lose money, because they are the fruit of the wrong. Texas Securities Act rescission is available when a specific security was sold by a misstatement. Attorney's fees and costs depend on the claims pleaded and the panel's discretion.

What the firm will argue

• Ratification. The customer received confirmations and monthly statements and never objected. Panels weigh this against what the customer could realistically understand from the documents and whether the broker explained away the activity.
• Sophistication. The customer was experienced or wealthy and knew the risks. Relevant to customer-specific suitability, not a complete defense, and not a defense at all to a cost-to-equity ratio the customer could not earn back.
• The customer directed the trades. Unsolicited trades are not recommendations. The firm's own order tickets mark trades solicited or unsolicited, and a pattern of "unsolicited" marks on trades the customer could not have originated is itself evidence.
• Market loss. The firm will attribute the decline to the market. The well-managed portfolio measure answers it.
• Time. FINRA's six-year eligibility rule and the state and federal statutes of limitations, covered in the guide on securities deadlines.

Forum and process

Nearly every brokerage account agreement requires FINRA arbitration, and a customer can demand it even without a clause. The case begins with a statement of claim, followed by document exchange under FINRA's discovery guide (the firm's commission runs, exception reports, supervisory notes and the broker's compliance file are standard requests), then a hearing before one or three arbitrators with no appeal on the merits. Claims against a stand-alone investment adviser, who owes a different duty, go to court or private arbitration; the guide on FINRA arbitration versus court explains the choice, and the one on adviser versus broker duties explains why the label matters.

When to involve a litigator

As soon as the statements stop making sense. A litigator with the account statements and the new-account form can compute turnover and cost-to-equity in an afternoon and tell you whether the pattern is a claim. Waiting costs evidence: brokers move firms, exception reports are purged on retention schedules, and the six-year eligibility clock runs from each trade. Tina Wysk represents investors and firms in securities and investment disputes in FINRA arbitration and in Dallas state and federal courts.