UNITED STATES OF AMERICA
Before the
COMMODITY FUTURES TRADING COMMISSION
___________________________________
:
RICHARD HINCH and CAROL HINCH :
:
v. :CFTC Docket No. 95-R 66
:
COMMONWEALTH FINANCIAL GROUP, INC. :OPINION AND ORDER
and CARLTON ADOLPHUS BROWN :
___________________________________:
Richard and Carol Hinch brought this summary reparation proceeding against respondents Commonwealth Financial Group, Inc. ("Commonwealth"), a registered introducing broker ("IB"), and its associated person ("AP") Carlton A. Brown, alleging breach of fiduciary duty, churning and failure to supervise in connection with losses in the Hinches' commodity options account. The Judgment Officer issued an initial decision against respondents and awarded $13,651 in damages plus interest and costs. Respondents timely filed and perfected this appeal.
BACKGROUND
The Hinches filed their complaint on March 27, 1995. After the completion of prehearing proceedings, the Judgment Officer held a telephonic hearing on September 19, 1995, to take the oral testimony of Richard Hinch and Carlton Brown. On April 19, 1996, the Judgment Officer issued an initial decision finding that Brown had churned the Hinches' account in violation of Section 4c(b) of the Commodity Exchange Act ("Act"), 7 U.S.C. 6c(b) (1994), and Commission Rule 33.10, 17 C.F.R. 33.10 (1997); that Commonwealth was liable for Brown's misconduct pursuant to Section 2(a)(1)(A)(iii), 7 U.S.C. 2(a)(1)(A); and that Commonwealth violated Commission Rule 166.3, 17 C.F.R. 166.3 (1997)(duty to supervise).
The Hinches maintained their account at Commonwealth from May 1994 through August 1994. According to Richard Hinch, a machinist with a tenth-grade education, he saw a television infomercial in April 1994 that promoted an options trading strategy based upon seasonal trends in unleaded gasoline prices. This strategy called for the purchase of call options on unleaded gasoline futures contracts in anticipation of increasing prices resulting from rising demand for unleaded gasoline during the summer travel season.
Hinch spoke by telephone with Randi Levine, a Commonwealth associated person, after he responded to the television advertisement. Hinch was unclear about the sequence of events surrounding the initial contact with Levine, although he did recall that the commercial did not mention Commonwealth by name. (Tr. at 37-38) The Hinches were provided with a "Special Report on Unleaded Gasoline" ("Special Report") which was prepared by Commonwealth for its clients. The Special Report, like the commercial, promoted the seasonal strategy for trading unleaded gasoline contracts. The Special Report advised readers to buy and hold the options "now" and to ignore temporary dips in their value. The Hinches opened a nondiscretionary commodity options account and on May 5, 1994, purchased five September unleaded gasoline call options. They paid a total of $5,000 from which Commonwealth deducted $1,000 in commissions. No other trades were executed for the account while Levine handled it. At one point, Hinch rejected her recommendation to purchase corn options. (Tr. at 39)
Respondent Brown became the Hinches' AP after Levine was stricken by illness in mid-June 1994. According to Hinch, he was "a little bit shook" when Brown told him that he could not understand why Levine "got you into this gas." (Tr. at 47) Hinch testified that Brown recommended that the Hinches exit their unleaded gasoline position and establish a position in heating oil contracts because of "potential war in Korea or something in Africa, something about the oil or something." (Tr. at 49)
The Hinches followed Brown's recommendation. They sold the unleaded gasoline contracts for a profit and established a new position in heating oil options. Hinch said that, while he maintained his Commonwealth account, his reliance on Brown's recommendations was "total." (Tr. at 57)
Once Brown took over the their account, the Hinches made a series of trades in option contracts on heating oil, coffee, and Swiss franc futures from mid-June through late August 1994. Thus, on June 15, 1994, the Hinches' position in unleaded gasoline options was liquidated for a net profit of $1,185. On June 20, 1994, the Hinches purchased October heating oil options (ten calls and three puts for a partial hedge) for $11,830, from which they paid $2,600 in commissions. On June 30, July 1, and July 7, 1994, the Hinches purchased a total of six September coffee puts for a total purchase price of $6,337 and for which they paid $1,200 in commissions.
On July 18, the Hinches sold their heating oil put options for a net profit of $511. On the same day, they purchased four September Swiss franc options for a total purchase price of $2,500 from which they paid $800 in commissions. On August 1, 1994, they sold the heating oil call options for a net profit of $35. Also, on August 1, the Hinches again purchased heating oil options for a total purchase price of $6,720 from which they paid commissions in the amount of $2,000. These positions and the Swiss franc position remained open when the Hinches closed their account at Commonwealth in August 1994 and were transferred to their new account at First Pacific Group. The Swiss franc options expired worthless, and the heating oil options were sold at a loss. Overall, the Hinches invested $16,565 with Commonwealth and incurred losses of $13,651. Hinch said his new broker at First Pacific told him that his Commonwealth account had been churned.
Brown testified that, when he took over the account from Levine, Hinch explained that he never had traded commodity options before and that he was relying on Brown to advise him of "something that looked good, [that] he would take advantage of it if he could." (Tr. at 92) Brown testified that Hinch never articulated an explicit trading strategy nor stated an objective other than that he wanted to make money. Brown testified that Hinch:
specifically pointed out to me that, you know, he was there for one purpose, and that was to make money. I mean, he told me that, you know, if -- basically he was here, and he wanted to make money; that's why he was in this type of market. You know, [I] spoke to the gentleman every day.
(Tr. at 113)
Despite Hinch's limited trading experience, Brown testified that he was "a man of his own mind" (Tr. at 132) who was never afraid to ask questions. (Tr. at 132) Brown said that he did not control the trading in the Hinch account (Tr. at 132) and that he was surprised when he received a telephone call from Commonwealth's compliance department informing him that the Hinches were transferring their account to another firm. (Tr. at 108)
Brown denied that he ever recommended trades solely for the purpose of earning commissions. (Tr. at 127) He testified that he relied on an in-house commodity trading advisor employed by Commonwealth who each day recommended trades. Brown testified that he talked to Hinch "at least once a day, sometimes twice" (Tr. at 102) and that during these conversations Hinch agreed to the trades made for his and his wife's account.
The Judgment Officer issued an initial decision finding that the Hinch account had been churned. He found that the trades recommended by Brown generated a total of $6,600 in commissions and resulted in out-of-pocket losses of $13,651. Initial Decision at 12.
The Judgment Officer found that the Hinches had proven that Levine and Commonwealth induced them to open their account by urging them to follow a long-term strategy of holding unleaded gasoline contracts and that no further attempts were made to ascertain their trading objectives. He found that Brown, exercising de facto control over the trading, disregarded the unleaded gasoline strategy--the only objective articulated by complainants--in order to generate additional commissions. (Initial Decision at 13) He found that Brown's characterization of the Hinches' trading objective as a mere desire "to make money" was a demonstration of the respondents' indifference to any general trading objectives the Hinches may have had and to their specific interest in the unleaded gasoline market promoted by Commonwealth that had led them to open the account. (Initial Decision at 14-15) The Judgment Officer found respondents' indifference to the Hinches' trading objectives was underscored by Levine's failure to inform her supervisors or Brown about the Hinches' trading goals and by Brown's failure to ascertain what the Hinches' objectives were once he took over the account. (Initial Decision at 14) He found that Brown was unable to provide a sound basis for the trade recommendations he made to the Hinches and that the trading was therefore excessive. (Initial Decision at 8-10)
In ruling in the complainants' favor, the Judgment Officer determined that Hinch's testimony was more reliable and credible than Brown's. (Initial Decision at 1) He also drew adverse inferences regarding respondents' credibility based on Commonwealth's failure to produce a copy of the television advertisement (Initial Decision at 3-4) or recordings of the telephone conversations between Hinch and Brown. (Initial Decision at 7)
The Judgment Officer also found that Commonwealth had failed to supervise Levine and Brown in violation of Rule 166.3. He held on that claim:
Commonwealth's various record-keeping violations-- including the failure to require Levine and Brown to maintain routine records of conversations with Hinch and the failure to produce any tape recordings of these conversations--indicate a systemic breakdown in its supervision of Levine and Brown which facilitated Brown's fraud and which violated CFTC Rule 166.3.
(Initial Decision at 15)
In awarding damages in the amount of complainants' out-of- pocket losses rather than the amount of their commissions, the usual measure of churning damages, the Judgment Officer found that the Hinches had proven "fraudulent promises, [and] fraudulent profit guarantees . . . . " (Initial Decision at 16) He held that these factors warranted the higher award on the churning claim.
DISCUSSION
The respondents assign three errors on appeal. First, they argue that the evidence is insufficient to support the Judgment Officer's findings that Brown rather than the Hinches controlled the trading in the Hinches' account and that the trading was excessive. Second, the respondents argue that, even if control and excessive trading were proven, the Hinches are entitled to recover only their commissions as damages and the Judgment Officer erred in awarding them their trading losses. Third, the respondents argue that the Judgment Officer violated their due process rights by becoming a "de facto attorney" for the Hinches when he sua sponte issued a discovery order under Commission Rule 12.34, 17 C.F.R. 12.34 (1997).
Churning is a violation of Section 4c(b) of the Act and Commission Rule 33.10. See Johnson v. Don Charles & Company, [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) 24,986 (CFTC Jan. 16, 1991). To prove churning, a complainant must show that (1) the AP controlled the level and frequency of trading in the account, (2) the overall volume of the AP's trading was excessive in light of the complainant's trading objectives, and (3) the AP acted with intent to defraud or in a reckless disregard of the customer's interests. Id.
Control. Respondents first argue that the record is "completely devoid" of evidence that Brown controlled the trading in the Hinches' account. (App. Br. at 2-3) They argue that the Hinches had "previous speculative investment experience" in trading precious metals and stocks; that they understood futures and options trading; that they were aware of the risks of trading; and that they were in regular contact with Levine and respondent Brown regarding the course of trading in the Commonwealth account. (App. Br. at 3-5) They also point out that the Hinches were required by Commonwealth directly to place their trades through the firm's trading department and that this further supports their contention that the Hinches, not Commonwealth's APs, controlled the trading. (App. Br. at 4)
The Hinches defend the Initial Decision by arguing that the evidence shows that they knew little about commodities trading and relied on the trading advice of the Commonwealth APs.
The Commission has identified six factors tending to show the existence of a broker's de facto control over a customer's nondiscretionary account. See Lehman v. Madda Trading Company, [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) 22,417 (CFTC Nov. 13, 1984). These factors are:
(1) lack of customer sophistication, (2) lack of prior commodity trading experience by the customer and a minimum of time devoted by the customer to the trading in the account, (3) a high degree of trust and confidence reposed in the AP by the customer, (4) a large percentage of transactions entered into by the customer based upon recommendations of the AP, (5) the absence of prior customer approval for transactions entered into on his behalf, and (6) customer approval of recommended transactions where approval is not based upon full, truthful and accurate information supplied by the AP.
It is not mandatory that each of these factors be present in order to establish control in every case, and the relative weight to be accorded to each factor will depend upon the facts of each particular case. Id.
Turning to the facts of record, there is no dispute that the Hinches were first time options traders with limited education and that Richard Hinch reposed a high degree of trust in Brown. Brown admitted at the hearing that he knew the Hinches were relying upon him for trading recommendations. While Brown contended that one trade originated with Hinch, there is little real basis to dispute that all of the other trades were recommended by Commonwealth. Under these circumstances, we conclude that the respondents have failed to show error in the Judgment Officer's determination that Brown controlled the trading in the Hinches' account.
Excessive Trading. The next issue is whether Brown traded the Hinches' account excessively "for the purpose of generating commissions, without regard for the investment or trading objectives of the customer." In the Matter of Lincolnwood Commodities, Inc. of California, [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) 21,986 at 28,246 (CFTC Jan. 31, 1984). As is true with the issue of control, excessive trading is a question of fact that cannot be determined by any precise formula or rule. Rather it must be determined on a case-by-case basis. In re Paragon Futures Association, [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) 25,266 at 38,847 (CFTC April 1, 1992); Fields v. Cayman Island Associates, Ltd., [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) 22,688 (CFTC Jan. 2, 1985). We have identified the following as relevant, but non-exclusive, factors:
(1) a high commission-to-equity ratio, (2) a high percentage of day trades, (3) the broker's departure from a previously agreed upon strategy, (4) trading in the account while it was undermargined, and (5) in and out trading.
Paragon Futures, 25,266 at 38,847; Lincolnwood Commodities, 21,986 at 28,250. We note that these cases involve futures.
Respondents argue that the Judgment Officer's analysis of the excessive trading element of churning was flawed because he focused on only one factor of excessive trading--departure from a previously agreed upon strategy--to the exclusion of all other factors. (App. Br. at 5) Moreover, they contend that the record fails to establish even that factor. Respondents challenge the Judgment Officer's conclusion that the complainants' strategy consisted of buying and holding unleaded gasoline contracts to exploit seasonal price shifts in that commodity, contending that the Hinches' trading objectives were far more open-ended. They suggest that the Hinches were "fundamental" traders, open to trading in a wide range of contracts, and were simply interested in "mak[ing] money." (App. Br. at 7-8; Initial Decision at 14)
The Hinches defend by arguing that, as found by the Judgment Officer, there was no convincing justification for any of Brown's trading recommendations. Trading strategy apart, they contend that the $6,600 they paid in commissions on trades recommended by Brown indicates excessive trading in light of the amount they invested. (Ans. Br. at 2-3)
Owing to differences in the mechanics and trading principles underlying futures and options contracts, precedent analyzing excessive trading in the context of futures may be of limited relevance in determining whether excessive trading has occurred in the context of an options account. For instance, undermargined trading, while relevant to futures accounts, ordinarily would not be relevant in the options context where the options purchaser pays the full option premium or purchase price upon acquiring the position. Similarly, the commission-to-equity ratio is not particularly meaningful in determining whether an options account has been traded excessively. Departure from agreed on strategies and objectives, however, is equally applicable in the futures and options contexts as a measure of excessive trading.
When a customer has been solicited on the basis of one specific trading strategy and soon after the account opening the AP urges a switch to another trading strategy, an AP who controls the account bears the burden of providing a credible explanation justifying the change. We place considerable weight upon the fact that the Hinches were steered away from their original trading objective as soon as Brown gained control of this account.
While Brown argues that he was trading the account on the basis of fundamentals, we agree with the Judgment Officer that he failed to support this contention or to articulate a reasonable basis to justify any of the individual trading suggestions he made to complainants. It was not enough for Brown to say that he simply relayed to his clients the generalized recommendations of Commonwealth's in-house commodity trading advisor. Brown had to show a reasoned application of those recommendations to the particular needs and desires of his clients, something he was unable to do.
The initial switch from a position in unleaded gasoline options to heating oil appears to be based on nothing more than Brown's determination to earn his own commission from an account he had inherited from Randi Levine. In addition, we find the partial hedge of the ten heating oil calls with three puts to be particularly inexplicable. Without any showing of how the dynamics of spread trading were expected to operate on this position, we can conclude only that respondent encouraged complainants to bet against themselves.
We also have considered the amount of the complainants' out- of-pocket investment and compared that amount to the level of commissions charged. During the course of this short-lived account, the Hinches deposited $16,565 and were charged $6,600 in commissions. Thus, the level of commissions charged amounted to approximately 40% of the level of the Hinches' total investment. Given the high commissions charged, the purchase of deep-out-of-the-money coffee options for this account, which were nearing expiration, strikes us as facially excessive trading undertaken to earn commissions for Brown.
Because the Hinches made a prima facie showing of excessive trading, the Judgment Officer did not err in taking into consideration Brown's failure to provide a credible explanation for the trades he made in the Hinch account. Gilbert v. Refco, Inc., [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) 25,081 at 38,057-058 (June 27, 1991); Don Charles, 24,986 at 37,624-625. Under the circumstances, we believe that the record is sufficient to sustain the finding of excessive trading.
Damages. The second error assigned by respondents pertains to the amount of damages awarded. The usual measure of damages for churning violations is the amount of commissions and fees charged. Trading losses are not awarded absent proof that the losses would not otherwise have occurred had the account not been churned. At a minimum, a complainant must demonstrate that churning exposed the account to risks of market loss greater than those which the customer agreed to undertake. DeAngelis v. Shearson/American Express, Inc., [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) 22,753 at 31,139 (CFTC Sept. 30, 1985). Accordingly, respondents assert that the Judgment Officer erred in awarding trading losses rather than commissions as damages to the Hinches. They claim that direct evidence is required to show fraud.
Trading losses may be awarded on a churning claim when there exists evidence of fraudulent promises, fraudulent profit guarantees, and exposure to a greater market risk than was necessary. Here, the Hinches' losses clearly resulted from trading in contracts other than the unleaded gasoline contracts they originally intended to trade, contracts which we have found they were persuaded to trade solely for the purpose of earning commissions for Carlton Brown. Accordingly, we conclude that the Judgment Officer did not err in awarding damages in the amount of complainants' trading losses and that the Initial Decision is entirely consistent with our case law. See Davis v. Murlas Commodities, Inc., [1986-1987 Transfer Binder] Comm. Fut. L. Rep. (CCH) 23,376 at 33,033 n.1 (CFTC Nov. 12, 1986).
Propriety of the Judgment Officer's Conduct. The respondents' third and final assignment of error goes to the manner in which the Judgment Officer conducted this proceeding. Specifically, the respondents argue that the Judgment Officer became a "de facto attorney" for the Hinches during the discovery phase of the proceeding when he entered his May 24, 1995 discovery order. This order directed each side to produce various documents, tape and audio cassettes, and other items, as well as establishing deadlines and setting a tentative telephonic hearing date. See Order dated May 24, 1995. The Hinches argue that respondents failed timely to object to the Judgment Officer's conduct and in any event that the conduct they complain of does not constitute disqualifying bias.
While the respondents acknowledge that the Commission's rules specifically allow decision-making officials to enter discovery orders sua sponte pursuant to Rule 12.34, their argument misapprehends the nature of summary decisional proceedings. In a summary decisional proceeding under Subpart D of the Commission's Part 12 Rules, the Judgment Officer exercises a considerable role in the development of the record. See, e.g., Commission Rules 12.201 and 12.209, 17 C.F.R. 12.201 and 12.209 (1997). The Judgment Officer in this matter did not exceed or abuse the considerable discretion he enjoys in such a proceeding. Wichman v. Hewitt, [1987-1990 Transfer Binder] Comm. Fut. L. Rep. (CCH) 24,613 (CFTC Mar. 7, 1990).
CONCLUSION
In light of the foregoing, the Judgment Officer's initial decision is affirmed.
IT IS SO ORDERED.
By the Commission (Chairperson BORN and Commissioners DIAL, TULL, HOLUM and SPEARS).
_______________________________
Jean A. Webb
Secretary of the Commission
Commodity Futures Trading Commission
Dated: May 13, 1997