Beware, Unwary : Churning: Trading in Stock Abuse

The case of fine wine arrived one October day at Helen Aldrich’s apartment with a rather sweet handwritten note. “Dear Helen, enjoy, enjoy,” it read, followed by the valediction: “Your stockbroker, financial adviser, confidant and friend, George.”

Aldrich was pleased if a little mystified at the attention from George Serhal, her stockbroker at Thomson McKinnon Securities. In recent days he had also invited her out for an afternoon cocktail, carefully steering the conversation away from the condition of her brokerage account and toward her social life and the health of her ailing mother.

That Serhal did not mention her only substantial asset--$400,000 of corporate bonds in her Thomson account--was not surprising. The 50-year-old divorcee later learned, according to court records, that in the month before the wine arrived, Serhal’s management of the money had cost her losses of $70,000 while he charged her commissions of another $70,000.

Tip of the Iceberg

That was the tip of the iceberg. In the 10 months he served as her broker, Serhal lost Aldrich’s entire account by trading against her instructions, leaving her with a $60,000-deficit in her brokerage firm account. The $30,000 in annual investment income she relied on to support herself and her mother evaporated. She was forced to mortgage her family farm; in the aftermath of her losses, she sold off jewelry and family heirlooms. “It was so horrible,” she said later.

As Helen Aldrich’s fortunes fell, Serhal’s soared. In the five months before he met Aldrich, he earned commissions for his firm totaling only $4,782, and he was forced to file for personal bankruptcy. In the 10 months that followed, he charged commissions of $143,754 to her account alone. In that period, Aldrich’s account was the source of 80% of Serhal’s income.

Aim Was Commissions

A federal court jury, presented with this evidence, and more, concluded recently that Serhal took his conservative client on a wild ride through some of the riskiest shoals of Wall Street for a single reason: to generate commissions for himself. This is a practice known as “churning.”

As the name implies, churning is the furious trading of securities in a customer’s account by a broker intent on earning commissions. Churning is the single most severe form of abuse of brokerage customers. Moreover, by the estimation of experts throughout the securities industry, it is on the rise as brokerage firms put increasing pressure on their salesmen to generate more income.

While stock market schemes such as insider trading and takeover manipulations have drawn intense government scrutiny and wide public attention in recent years, the average investor generally is affected in only the most indirect way. But churning “is a violation that really touches the public,” says Ira L. Sorkin, New York enforcement chief for the Securities and Exchange Commission. “It’s the little old ladies who get taken.”

In contrast to the “boiler room” investment frauds perpetrated by peripheral characters in the investment markets, churning is one that often involves the largest and most well-respected names in the brokerage business. Virtually every major brokerage has been accused by customers at one time or another of employing a broker who churned their accounts.

Churning cases, however, are rarely pursued by the SEC. The agency’s New York office alone must oversee the operations of an estimated 2,000 brokerage branches with only 28 examiners.

Following up on every churning complaint from investors would leave the staff scarce time for any other enterprise, Sorkin says. Because victims are generally vocal about their losses, the SEC reasons that courts and Wall Street’s “self-regulatory” organizations such as the stock exchanges are better equipped to enforce the law. Most such complaints are settled out of court or referred to arbitration, lawyers say.

Impact of Case Assessed

Helen Aldrich’s case, however, may lead aggrieved investors to challenge their stockbrokers more aggressively. Even though the jury awarded Aldrich compensatory damages of only $175,000--scarcely half her real losses--it found Thomson McKinnon’s supervision of her broker so egregiously lax that it added punitive damages of $3 million (later reduced by a higher court to $1.5 million).

Serhal, who no longer works for Thomson McKinnon, was held personally liable for a portion of the damages.

Evidence of broker Serhal’s long leash at Thomson McKinnon abounded during the trial of Aldrich’s claim. Among other things, although Serhal’s supervisors asked him several times to justify his heavy speculative trading in her account, they never followed up when he failed to respond. Serhal himself filled out most of Aldrich’s account forms, generally with falsified information about her income and net worth. The information was never checked by managers.

At one point, Serhal had Aldrich holding three times the number of speculative stock options in a single stock--a particularly risky investment--that Thomson McKinnon permitted any customer to own. When supervisors asked why a client who had opened her account with a conservative strategy was playing the market like a Wall Street scalper, Serhal dictated the wording of a handwritten note to the firm in which Aldrich acknowledged that she was “aware” of the trading. The firm’s inquiry went no further.

The brokerage industry, which considers itself already heavily regulated, has been howling about the punitive award. “When you apply punitive damages to a heavily regulated business, it’s a disaster,” says Saul Cohen, a lawyer for the Securities Industry Assn. “It’s a terrorist approach by the plaintiff.”

Thousands Threatened

But the appellate judges who reviewed the award disagreed. Ruling that Thomson McKinnon’s lax supervision of Serhal exposed a system that “threatened . . . thousands of customers from the investing public,” they concluded: “If ever there was a case for the imposition of punitive damages against a brokerage firm and its employee, this is that case.”

Helen Aldrich’s experience is not unique in scope or nature.

Evelyn Juster, a 70-year-old retired radio actress, complained that over a five-year period ending in mid-1982, her broker charged her commissions of $310,000 for thousands of pointless trades in her account while its value dwindled from almost $550,000 to $66,771. Roughly 80% of the securities purchased for Juster’s account were sold within 60 days, an extraordinarily rapid turnover for an ostensibly conservative investor.

When she questioned the large number of trade confirmation slips she was receiving at one point, Juster says, the broker told her to “throw them away.” Three of the four brokerages that employed the salesman during the period in question have settled her claims out of court. A trial against the fourth is pending.

In another case, R. Stockton Rush III turned his trust account of 20,000 shares of Natomas Corp. over to an Oppenheimer & Co. broker in 1981 when he was a freshman at Princeton University. In the next two years, Rush contends, the broker executed scores of unauthorized transactions in stock options, which represent the right to buy or sell a stock within a specified period and at a specified price.

Losses Put at $300,000

The result for Rush: investment losses of $300,000 during a period in which the Dow Jones Industrial Average rose 40% and Natomas stock rose 60%. Rush’s broker, he contends in a federal lawsuit filed here, charged commissions totaling $92,000. An attorney for Oppenheimer & Co. declined to comment on the case.

Many other examples inspire nothing so much as pathos. In one New Jersey case, a man who had lost a leg in a car crash lost most of the proceeds of his legal settlement to churning. In a Baltimore case settled two years ago, the victim was a 73-year-old blind woman.

Customer abuses by brokers are impossible to prevent entirely, say brokerage experts, because a sizable securities house can have thousands of brokers working out of hundreds of branch offices where even the most stringent standards for supervising brokers may be routinely disregarded.

Brokerages can be particularly lax when managerial suspicion or customer complaints involve a top-earning broker, they say.

SEC officials say that it is hard to make a comprehensive case against any major brokerage for the malfeasance of isolated brokers in remote branches. “To impute supervising responsibility to the entire firm is very difficult unless a lot of evidence indicates the home office was aware of what’s going on,” Sorkin says.

Brokerage ‘Censured’

Still, the agency will act if it finds indications of consistently loose supervision. In March, the SEC “censured” Smith Barney, Harris Upham, the nation’s 10th largest brokerage firm in branch offices, for allowing a broker in its Rhinelander, Wis., branch to repeatedly mishandle options trades, in some cases fraudulently, for 10 customers.

The censure carries no practical sanctions against the firm; the branch manager was barred from supervisory duties for four months and the broker suspended from the securities business for six months.

At Thomson McKinnon, where Helen Aldrich kept her account, supervision of brokers was so lax between November, 1979, and August, 1982, that customers lost $2 million to fraud, the SEC charged last year in a proceeding that led to the firm being suspended from opening new branch offices for six months. Thomson, the ninth largest brokerage in terms of offices, had 20 branches and 1,800 salesmen at the end of last year.

Even securities professionals who believe Serhal’s excesses should never have been overlooked say that catching all such cases takes more vigilance than anyone can really muster. “There’s no firm on Wall Street where you can’t find a Thomson case,” says the general counsel for one major firm that, like Thomson, was recently censured for supervisory failures, “because human greed is always there.”

No Surprise to Experts

That the defenseless are victimized comes as no surprise to market professionals, for two almost indispensable characteristics of a churning victim are a lack of investment sophistication and a personal, trusting reliance on the broker.

“The classic example,” remarked Norman S. Poser, a Brooklyn Law School professor who has testified as an expert witness in several churning cases, in a recent study, “is the lonely widow inexperienced in financial matters, who comes to place her trust in an aggressive young securities salesman.”

Helen Aldrich’s jury apparently felt that she might have saved herself some grief had she read the frequent invoices and account statements she was receiving from Thomson, rather than storing them unread in a desk drawer. (She explained that a family friend had handled all her previous investments before his abrupt death in 1978.)

The jury’s compensatory award of less than her real losses, the appellate judges observed, demonstrated that her “inattention to her own affairs, as well as her incredible gullibility, contributed to her losses.”

Churning often occurs when a customer allows a broker to make investments he or she has trouble understanding, so the customer must rely on the salesman’s explanations. But even sophisticated investors often relinquish control of their accounts to brokers by not taking an active role in selecting securities.

Added Pressures Cited

Many regulators and securities professionals believe that broker fraud of all kinds is rising, largely because brokerage houses with exploding overhead expenses have placed increasing pressure on salesmen to generate income. Says Perrin Long, a brokerage analyst for Lipper Analytical Services in New York: “A new salesman today is told that the firm hopes for average gross commissions of at least $150,000 three years out. Five years ago, the firm wouldn’t have set any limit.”

Simultaneously, major brokerages have slashed their “pay-out”--the percentage of total commissions that a broker, known in the business as a producer, gets to keep. That means most salesmen must sell more for equivalent income.

The most severe cuts were made at Merrill Lynch, the nation’s largest brokerage, where the pay of a broker generating $100,000 in gross commissions would drop this year to $45,000 from $54,000 last year, and those who fail to generate at least $250,000 a year after three years on the job would be asked to leave.

Such pressure “mostly has an impact on people who are marginal producers struggling to keep their heads above water,” says Donald S. Malawsky, senior vice president for enforcement and regulatory standards at the New York Stock Exchange. “The evil is there always; any time you have pressures put on salesmen to produce, there will be those who will churn their clients’ accounts.”

Conflict of Interest

The very commission system, some argue, produces a conflict of interest for brokers between their inclination to sell clients high-commission investments and their responsibility to sell them only suitable ones. Securities firms have wrestled with this conflict for years without success, occasionally considering placing salesmen on salary rather than commission. Even experts who believe this would be a laudable change think that the major firms would never be able to implement it on their own.

“It would be virtually impossible to put brokers on salary without a regulatory mandate because of the competitive nature of the industry,” says the general counsel for one major brokerage.

The apparent bull market in broker fraud concerns securities regulators because such abuses promote a public view of the stock market as a shark’s game with the defenseless small investor as bait.

“Once churning turns off customers in any large degree it affects the market,” says Malawsky, whose office is currently investigating 550 customer complaints against brokerages, including 40 for churning, 76 for unauthorized trading and 17 for luring customers into unsuitable investments. The number of complaints, he says, is down about 20% from last year--possibly because the market’s steady rise has reduced the scale of investment losses--but the caseload of active investigations is about the same.

Complaints Up Sharply

At the SEC, customer complaints of all kinds have risen to 15,196 in fiscal 1984 from 7,648 in fiscal 1982. Of these totals, complaints about unauthorized purchases and sales in customers’ accounts--activities that generally go hand-in-hand with churning--rose to 552 from 232 in that period.

“I don’t have a problem with people increasing their productivity,” says Aulana L. Peters, an SEC commissioner. “But I’m concerned that firms might ignore the need to supervise their registered representatives (salesmen) when they’re putting pressure on them.” The problem is less one of forcing firms to establish rules than ensuring they follow the ones they have, she says.

Brokers with an inclination to defraud customers, furthermore, have a larger number of useful instruments at hand. Many churning cases and other abuses, judging from interviews with securities professionals and a review of court documents, involve trading in stock options, which, from an unscrupulous broker’s point of view, have the dual appeal of a particularly high commission rate and virtual incomprehensibility for the average customer.

Stock options were approved by the SEC for listing on public exchanges in 1974. The first major case of options-based churning appeared almost instantaneously when Richard A. Graham, a broker in the San Francisco office of Bear, Stearns & Co. allegedly churned the accounts of nine customers, who had wanted their money conservatively managed.

$478,173 in Commissions

Altogether Graham controlled customer accounts worth $737,685 at the outset. Within three years, his customers lost more than $300,000, and Graham reaped commissions of $478,173. The SEC later charged Graham with securities fraud and allowed him to settle the case without admitting or denying the charges.

SEC figures show a recent rise in two complaint categories--improper option recommendations and unauthorized option transactions--to a combined 110 in 1984 from 69 in 1982.

Rush and Juster both contend that they were similarly victimized by their brokers’ representations that they could trade options conservatively to make money virtually risk-free. Rush contended in court documents that his broker at Oppenheimer claimed to have developed a system of selling options on the Princeton student’s trust-fund stock that would produce income “as regularly as dividends on blue-chip stock.”

The actual system was so complex that it afforded no understanding, court testimony suggests. Rush says his suspicions were naturally aroused, however, because the account was steadily losing money.

The best defense against churning is to check your monthly statement. Details in Business.