Legal Definitions - churning

The term churning refers to two distinct concepts in law, one related to securities and the other to tax.

In Securities Law:

Churning is an unethical and illegal practice that occurs when a stockbroker or financial advisor, who has control over a client's investment account, makes an excessive number of trades solely to generate higher commissions for themselves, rather than to benefit the client. This practice abuses the client's trust and is considered a form of fraud under federal securities laws because the trading activity is disproportionate to the client's stated investment goals and the nature of their account.

• Example 1: Conservative Retirement Account

  Mrs. Eleanor Vance, a 75-year-old retiree, explicitly tells her financial advisor that her primary goal is capital preservation and generating modest, stable income from her investments. She emphasizes her low-risk tolerance. Over the next year, her advisor executes dozens of trades, frequently buying and selling different mutual funds and bonds, resulting in high transaction fees and commissions that significantly erode her account's value, despite market stability. The advisor's actions constitute churning because the excessive trading volume and frequency are inconsistent with Mrs. Vance's conservative, income-focused objectives and appear designed to maximize the advisor's earnings rather than her financial well-being.

• Example 2: Long-Term Growth Portfolio

  Mr. David Kim, a 40-year-old professional, instructs his broker to manage his portfolio for long-term growth over the next 20 years, with a moderate risk tolerance. He expects his investments to be held for several years to compound returns. However, the broker frequently buys and sells various stocks and exchange-traded funds (ETFs) on a monthly basis, often holding positions for only a few weeks before liquidating them. This rapid turnover generates substantial trading commissions for the broker but results in minimal net gains for Mr. Kim due to the constant transaction costs. This scenario illustrates churning because the high volume of short-term trades contradicts Mr. Kim's long-term growth strategy and primarily serves the broker's financial interests.

• Example 3: Trust Fund for Education

  A trust fund established for a child's future college education, managed by an appointed financial advisor, has a clear mandate for steady, moderate growth with a focus on capital preservation over a 15-year horizon. Despite this, the advisor engages in frequent speculative options trading and short selling, leading to volatile returns and significant brokerage fees. The advisor's aggressive and frequent trading strategy is inconsistent with the trust's conservative, long-term educational funding objective and suggests that the advisor is prioritizing commission generation over the trust's intended purpose, thus demonstrating churning.

In Tax Law:

In the context of tax law, churning refers to a transfer of property that does not result in a significant change in the actual ownership, control, or use of that property. The primary purpose of such a transfer is typically to gain a tax advantage, such as making the property eligible for new amortization deductions or a more favorable method of depreciation.

• Example 1: Inter-Company Asset Transfer

  A large corporation owns a valuable piece of intellectual property (a patent) that has been fully depreciated for tax purposes. To potentially restart the depreciation clock and claim new tax deductions, the corporation "sells" the patent to one of its wholly-owned subsidiaries for a nominal amount. The subsidiary then immediately licenses the patent back to the parent company for continued use. This is an example of churning because there is no substantive change in who controls or benefits from the patent; the transfer is primarily an internal accounting maneuver designed to create new tax benefits.

• Example 2: Family Property Re-titling

  Mr. and Mrs. Garcia own a commercial rental building that has been fully depreciated. To potentially qualify for new depreciation benefits under a revised tax law, they "sell" the building to their adult children for a price significantly below market value, with the understanding that the children will continue to manage it in the same way and distribute profits back to the parents. This situation could be considered churning because the effective control and economic benefit of the property remain largely with the original owners, despite the formal change in title, indicating the transfer's main purpose is tax manipulation rather than a genuine change of ownership.