According to the complaint, sometime before July 1980 defendants Thomas and Katherine Clark agreed to act as stockbrokers for the plaintiffs. The Clarks, employees of defendant E.F. Hutton, allegedly knew of the plaintiffs' desires to invest only in stable, income-producing stocks and other securities geared toward the protection and conservation of the principal invested. Nevertheless, the Clarks subsequently persuaded the plaintiffs to open accounts with Hutton for the purpose of trading in the commodities futures market, a highly speculative area of investment.
Defendant Thomas Clark allegedly advised the plaintiffs that defendant Tony Watson, also a Hutton employee, was "an expert" in the field of commodities, had been extremely successful in trading futures and had, in fact, realized substantial gains for the benefit of other investors as well. The plaintiffs assert that Clark told them that if they entrusted their money to Watson, they would experience no losses. Indeed, Clark represented, Watson would personally guarantee success by depositing his own funds in any account that suffered a loss. Purportedly as a result of these assurances, the plaintiffs each deposited substantial sums into commodities accounts with Hutton and agreed that the defendants would have total discretion in making the trading decisions. It is alleged that during the remainder of 1980 and into 1981, the defendants "churned" the plaintiffs' commodities accounts by effecting an excessive number of trades without regard to the investors' needs and for the sole purpose of generating commissions for Watson, the Clarks and Hutton.
The Clarks reported to the plaintiffs that large profits were being made on their accounts. The plaintiffs' monthly statements, however, began to show losses. The plaintiffs allege that when questioned about this, the Clarks falsely represented to them that the monthly written statements for the accounts were inaccurate because of bookkeeping delays. In addition, the plaintiffs assert, they were told that Watson was experiencing some personal problems which affected his ability to trade effectively, but that, if the accounts remained open, sufficient amounts would soon be deposited to cover the losses. Eventually, the plaintiffs lost nearly all of the sums invested in their accounts and defendant Watson never deposited any funds to cover their losses.
In Count I of the complaint, the plaintiffs attempt to state a claim under the Commodity Exchange Act to redress the defendants' alleged churning of their accounts. The defendants move to dismiss this count on the ground that churning does not violate the antifraud provisions of the Act.
Relying upon cases decided under Rule 10b-5,
the defendants assert that the plaintiffs' churning claim must be dismissed on the ground that "mere allegations of 'churning' do not properly state claims of fraud under the Commodity Exchange Act where plaintiffs concede that they expressly authorized defendants to engage in commodities transactions in their discretion, thereby entrusting the decision making to defendants." Memorandum of Law in Support of Defendants' Motion to Dismiss at 10, Document 12 of the Record. The defendants argue that the traditional element of "deception" which must be present in 10b-5 actions is absent here. In addition, the defendants contend that the requisite element of "reliance" is absent in that "it is clear that [the plaintiffs] did not rely on any misstatements or omissions in connection with any commodity futures transaction made or proposed to be made in their accounts." Id. at 10-11.
For nearly 15 years it has been settled law that allegations of "churning" state a valid cause of action for fraud under Rule 10b-5 and § 10(b) of the '34 Act. See, e.g., Booth v. Peavey Company Commodity Services, 430 F.2d 132, 133 (8th Cir.1970); Johnson v. Arthur Espey, Shearson, Hammill & Co., 341 F. Supp. 764, 766 (S.D.N.Y.1972); Hecht v. Harris, Upham & Co., 283 F. Supp. 417, 437 (N.D. Cal.1968), aff'd, 430 F.2d 1202 (9th Cir.1970). The defendants assert, however, that "many of the decisions cited by plaintiffs which appear to uphold a claim of 'churning' . . . predate the decision of the Supreme Court in Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 97 S. Ct. 1292, 51 L. Ed. 2d 480 (1977), and therefore are inapposite." Reply Memorandum in Support of Defendants' Motion to Dismiss the Complaint at 8, Document 19 of the Record. In Santa Fe, the Supreme Court observed that "the language of § 10(b) gives no indication that Congress meant to prohibit any conduct not involving manipulation or deception." 430 U.S. at 473, 97 S. Ct. at 1301. Accordingly, the Court held that a simple breach of fiduciary duty, without more, does not rise to the level of a 10b-5 violation merely because it occurs in connection with a securities transaction. Id. at 472, 97 S. Ct. at 1300. See generally Note, Suits for Breach of Fiduciary Duty Under Rule 10b-5 After Santa Fe Industries, Inc. v. Green, 91 Harv.L.Rev. 1874 (1978). In light of the Supreme Court's more restrictive view of Rule 10b-5 in Santa Fe, the defendants assert that the early churning cases must be reexamined in light of that later case. Reply Memorandum at 9.
The defendants' position relies upon the premise that churning amounts only to a breach of fiduciary obligations and does not involve deception. This is a misconception. Churning "is in the nature of a constructive fraud and constitutes a deceptive scheme under Rule 10b-5." Gleit v. Shearson, Hammill & Co., Inc., Fed.Sec.L.Rep. P 95,799 at 90,889 (S.D.N.Y. 1976). As stated in the seminal case of Hecht v. Harris, Upham & Co., 283 F. Supp. 417, 432-33 (N.D.Cal.1968), aff'd, 430 F.2d 1202 (9th Cir.1970):
Where a customer so relies upon the recommendations of the broker that the broker is in a position to control the volume and frequency of transactions and the broker, abusing the confidence reposed in him, recommends and induces an excessive number of transactions, involving multiple trading in the same security and switches from one security to another, on which commissions and profits are taken without regard to the needs and objectives of the customer, then there is a device, scheme or artifice to defraud within the meaning of [Rule 10b-5].