Leib v. Merrill Lynch, Pierce, Fenner & Smith

• Decision Date: 30 October 1978
• Docket Number: Civ. A. No. 5-71591.
• Citation: 461 F. Supp. 951
• Parties: Joel LEIB, Trustee for the benefit of Sheldon Leib, and Sheldon Leib, Plaintiffs, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., and John Kulhavi, Defendants.
• Court: U.S. District Court — Western District of Michigan

461 F. Supp. 951

Joel LEIB, Trustee for the benefit of Sheldon Leib, and Sheldon Leib, Plaintiffs, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., and John Kulhavi, Defendants.

Civ. A. No. 5-71591.

United States District Court, E. D. Michigan, S. D.

October 30, 1978.

Harry D. Hirsch, Jr., Southfield, Mich., for plaintiffs.

Douglas G. Graham, Richard P. Saslow, Butzel, Fruhauf, Keidan, Simon Myers & Graham, Detroit, Mich., for Merrill Lynch, etc.

Gerald C. Davis, Cummings, McClorey, Davis & Acho, P.C., Livonia, Mich., for John Kulhavi.

OPINION

FEIKENS, District Judge.

I. INTRODUCTION

In August 1975 Sheldon Leib (Leib, also hereinafter designated as plaintiff) with his brother Joel Leib, as trustee, brought suit against Merrill Lynch, Pierce, Fenner & Smith, Inc. (Merrill Lynch) and John Kulhavi (Kulhavi), a stockbroker employed by Merrill Lynch, alleging as his first claim that these defendants "churned" his securities account. Plaintiff also submitted a second claim — that Kulhavi had breached his fiduciary duty by allowing Leib to pursue a course of heavy trading which could not possibly have resulted in a profit. Tied to this claim is plaintiff's contention that Kulhavi, as the broker in charge of the account, should have thoroughly explained to Leib the consequences of his pattern of trading, particularly with respect to the amount of commissions which would be generated as compared to the amount of profits which could be realized.

II. THEORIES OF THE PARTIES AND THE APPLICABLE LAW

Churning occurs "when a broker, exercising control over the volume and frequency of trading, abuses his customer's confidence for personal gain by initiating transactions that are excessive in view of the character of the account." Carras v. Burns, 516 F.2d 251, 258 (4th Cir. 1975). It is a deceptive device actionable under Section 10(b) of the Securities Exchange Act and Rule 10b-5 of the Securities and Exchange Commission. See generally, Note, Churning by Securities Dealers, 80 Harv.L.Rev. 869 (1967). In order to evaluate plaintiff's second claim it is necessary to examine generally the duties owed by a stockbroker to his customer. Plaintiff argues that a broker has a fiduciary duty to his customer similar to that owed by an attorney to his client. Defendants contend that a stockbroker has a limited duty to serve his customer's financial interest within the framework of a single transaction only. Neither position is entirely accurate.

Defendants' limited definition of a broker's duty to his customer is correct so long as the customer has a non-discretionary account with his broker, i. e., an account in which the customer rather than the broker determines which purchases and sales to make. In a non-discretionary account each transaction is viewed singly. In such cases the broker is bound to act in the customer's interest when transacting business for the account; however, all duties to the customer cease when the transaction is closed. Duties associated with a non-discretionary account include: (1) the duty to recommend a stock only after studying it sufficiently to become informed as to its nature, price and financial prognosis. Cash v. Frederick and Co., 57 F.R.D. 71 (E.D.Wis.1972); Hanly v. S.E.C., 415 F.2d 589 (2d Cir. 1969); (2) the duty to carry out the customer's orders promptly in a manner best suited to serve the customer's interests, Richardson v. Shaw, 209 U.S. 365, 28 S.Ct. 512, 52 L.Ed. 835 (1908); Robinson v. Merrill Lynch, 337 F.Supp. 107 (N.D.Ala.1971), aff'd, 453 F.2d 417 (5th Cir. 1972), and cases cited therein; (3) the duty to inform the customer of the risks involved in purchasing or selling a particular security, Hanly v. S.E.C., supra; Cash v. Frederick and Co., supra; (4) the duty to refrain from self-dealing or refusing to disclose any personal interest the broker may have in a particular recommended security, Chasins v. Smith Barney & Co., 438 F.2d 1167 (2d Cir. 1971); S.E.C. v. Capital Gains Bureau, 375 U.S. 180, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963); (5) the duty not to misrepresent any fact material to the transaction, Carras v. Burns, supra; Shorrock v. Merrill Lynch, CCH Fed.Sec.L. Rep. ¶ 96,251 (D.Or., Nov. 18, 1977); and (6) the duty to transact business only after receiving prior authorization from the customer, Robinson v. Merrill Lynch, supra.

Of course the precise manner in which a broker performs these duties will depend to some degree upon the intelligence and personality of his customer. For example, where the customer is uneducated or generally unsophisticated with regard to financial matters, the broker will have to define the potential risks of a particular transaction carefully and cautiously. Conversely, where a customer fully understands the dynamics of the stock market or is personally familiar with a security, the broker's explanation of such risks may be merely perfunctory. See in this regard, Moscarelli v. Stamm, 288 F.Supp. 453 (E.D. N.Y.1968); Shorrock v. Merrill Lynch, supra; Weiser v. Shwartz, 286 F.Supp. 389 (E.D.La.1968). In either case, however, the broker's responsibility to his customer ceases when the transaction is complete. A broker has no continuing duty to keep abreast of financial information which may affect his customer's portfolio or to inform his customer of developments which could influence his investments. Although a good broker may choose to perform these services for his customers, he is under no legal obligation to do so. Robinson v. Merrill Lynch, supra.

Remarkably absent from the above list is the duty, on the part of the broker, to engage in a particular course of trading. So long as a broker performs the transactional duties outlined above, he and his customer may embark upon a course of heavy trading in speculative stocks or in-out trading as well as upon a course of conservative investment in blue chip securities.

Unlike the broker who handles a non-discretionary account, the broker handling a discretionary account becomes the fiduciary of his customer in a broad sense. Such a broker, while not needing prior authorization for each transaction, must (1) manage the account in a manner directly comporting with the needs and objectives of the customer as stated in the authorization papers or as apparent from the customer's investment and trading history, Rolf v. Blyth Eastman Dillon & Co., Inc., 570 F.2d 38 (2d Cir. 1978); (2) keep informed regarding the changes in the market which affect his customer's interest and act responsively to protect those interests (see in this regard, Robinson v. Merrill Lynch, supra); (3) keep his customer informed as to each completed transaction; and (5) explain forthrightly the practical impact and potential risks of the course of dealing in which the broker is engaged, Stevens v. Abbott, Proctor and Paine, 288 F.Supp. 836 (E.D.Va.1968).

Although no particular type of trading is required of brokers handling discretionary accounts, most concentrate on conservative investments with few trades — usually in blue chip growth stocks. Where a broker engages in more active trading, particularly where such trading deviates from the customer's stated investment goals or is more risky than the average customer would prefer, he has an affirmative duty to explain the possible consequences of his actions to his customer. This explanation should include a discussion of the effect of active trading upon broker commissions and customer profits:

The defendant, Winston's relationship with his uninformed customer was one of special trust and confidence, and the Court finds that he was because of this position, under a duty to frankly and forthrightly explain to plaintiff the nature of the commissions, concessions, losses and profits which were being generated in her account.

Stevens v. Abbott, Proctor and Paine, supra, at 846. As the court further stated in Stevens, the broker who acts in this capacity owes a special duty to his customer:

In view of the Court's finding, it is apparent that a fiduciary relationship in law existed between the plaintiff and Winston which placed upon him the duty of acting in the highest good faith toward the plaintiff.

Stevens, supra at 847.

Between the purely non-discretionary account and the purely discretionary account there is a hybrid-type account which plaintiff claims existed in this case. Such an account is one in which the broker has usurped actual control over a technically non-discretionary account. In such cases the courts have held that the broker owes his customer the same fiduciary duties as he would have had the account been discretionary from the moment of its creation.

In Hecht v. Harris, 430 F.2d 1202 (9th Cir. 1970), the plaintiff, a 77 year old widow, opened a non-discretionary account with a major brokerage firm. Consistent with the practice in such accounts plaintiff received confirmation slips of each transaction and monthly statements on the status of her account. In addition, she spoke personally with the defendant broker several times a week. Nonetheless, the court held that the broker was liable to plaintiff for churning her account on the ground that he had traded excessively without informing plaintiff of the potential hazards involved in such a course of trading. Since the plaintiff was informed, for the most part, of the individual transactions in her account, the court's holding assumed that the defendant owed plaintiff the additional fiduciary duty to explain the risks of pursuing a particular course of trading. That assumption derived from the court's finding that the broker had taken full control over the plaintiff's account and thus owed her those fiduciary duties normally associated with discretionary accounts. See also, Carras v. Burns, supra; Stevens v. Abbott, Proctor and Paine, supra.

In determining whether a broker has assumed control of a non-discretionary account the courts weigh several factors. First, the courts examine the age, education,...