Discretionary and Fiduciary Accounts in Securities: Comprehensive Guide

4.2.8 Discretionary and Fiduciary Accounts

Understanding discretionary and fiduciary accounts is essential for any aspiring securities professional. These accounts are pivotal in the financial industry, providing avenues for investment management while imposing significant responsibilities on those who manage them. This section delves into the definitions, requirements, regulatory considerations, and potential risks associated with these accounts, equipping you with the knowledge needed for the SIE Exam and your future career.

Discretionary Accounts

Definition

A discretionary account is a type of brokerage account where the customer grants a registered representative (RR) or investment adviser representative (IAR) the authority to make investment decisions on their behalf. This authority allows the representative to buy and sell securities without obtaining the customer’s consent for each transaction. Discretionary accounts are designed to provide flexibility and efficiency in managing investments, especially for clients who may not have the time or expertise to make day-to-day trading decisions.

Requirements

Written Authorization

To establish a discretionary account, the customer must provide written authorization. This is typically done through a discretionary authorization form or a trading authorization document, which must be signed by the customer. This document specifies the scope of the discretionary authority granted to the RR or IAR.

Principal Approval

Broker-dealers are required to approve discretionary accounts. A principal of the firm must review and approve the discretionary authority before any trades can be executed. Additionally, the firm must have procedures in place to monitor the activity in discretionary accounts to ensure compliance with regulatory requirements and to protect the customer’s interests.

Types of Discretion

• Limited Discretion: This grants the RR or IAR the authority to make investment decisions and execute trades but does not allow them to withdraw funds from the account. Limited discretion is the most common form of discretionary authority.

• Full Discretion: This allows the RR or IAR to make trades and withdraw funds from the account. Full discretion is rare and requires additional authorization due to the increased risk and potential for abuse.

Regulatory Considerations

FINRA Rule 3260

FINRA Rule 3260 governs the use of discretionary accounts. It requires that proper written authorization is obtained from the customer and that the account is supervised by a principal of the firm. The rule also mandates that discretionary accounts are subject to regular review to ensure that all transactions are suitable and in the best interest of the customer.

Suitability and Best Execution

Registered representatives must ensure that all trades executed in discretionary accounts are suitable for the customer, taking into account the customer’s financial situation, investment objectives, and risk tolerance. Additionally, RRs must strive to achieve best execution, ensuring that trades are executed at the most favorable terms available.

Risks and Potential for Abuse

Churning

Churning refers to the excessive trading of securities in a discretionary account to generate commissions for the RR or IAR. This practice is unethical and illegal, as it prioritizes the interests of the representative over those of the customer.

Unauthorized Transactions

Unauthorized transactions occur when an RR or IAR makes trades beyond the scope of their authority or without the customer’s consent. Such actions can lead to significant financial losses for the customer and legal repercussions for the representative.

Fiduciary Accounts

Definition

Fiduciary accounts are managed by individuals or entities who have a legal duty to act in the best interest of another person or entity, known as the beneficiary. Fiduciaries are entrusted with managing assets and making investment decisions that align with the beneficiary’s needs and objectives.

Types of Fiduciaries

• Trustees: Individuals or entities responsible for managing assets held in a trust on behalf of beneficiaries. Trustees must adhere to the terms of the trust agreement and act in the best interest of the beneficiaries.

• Executors/Administrators: These fiduciaries handle the estate of a deceased individual, ensuring that the estate’s assets are distributed according to the will or, in the absence of a will, according to state law.

• Guardians: Appointed to manage the assets of minors or individuals who are incapacitated. Guardians must act in the best interest of the ward, ensuring that their financial needs are met.

• Receivers in Bankruptcy: Appointed by the court to manage the assets of a bankrupt entity. Receivers must act in the best interest of creditors and other stakeholders.

Responsibilities

Prudent Investor Rule

Fiduciaries are required to manage assets with care, skill, and caution, adhering to the prudent investor rule. This legal standard mandates that fiduciaries make investment decisions that a prudent person would make under similar circumstances, considering the needs of the beneficiaries and the purpose of the account.

No Commingling

Fiduciaries must keep fiduciary assets separate from their personal assets. Commingling of assets can lead to conflicts of interest and potential legal issues.

Legal Documentation

Fiduciaries must provide appropriate legal documents, such as a trust agreement or court appointment, to open and manage accounts. These documents outline the fiduciary’s authority and responsibilities, ensuring that they act within the scope of their duties.

Regulatory Considerations

Suitability and Fiduciary Duty

Investment decisions made by fiduciaries must align with the best interests and objectives of the beneficiaries. Fiduciaries must consider the beneficiary’s financial situation, risk tolerance, and investment goals when making decisions.

Restrictions

Fiduciary accounts may have limitations on the types of investments or strategies that can be employed. These restrictions may be outlined in governing documents, such as a trust agreement, or imposed by laws and regulations.

Discretionary and Fiduciary Accounts and the SIE Exam

For the SIE Exam, it is crucial to understand the distinctions between discretionary and fiduciary accounts. This includes recognizing the legal and regulatory requirements for each, as well as being familiar with the risks, responsibilities, and potential for abuse. Mastery of these concepts will not only aid in exam preparation but also provide a strong foundation for a career in the securities industry.

Glossary

• Discretionary Account: An account where the broker or adviser has authority to make investment decisions without prior customer approval for each trade.
• Fiduciary: An individual with a legal obligation to act in the best interest of another party.
• Prudent Investor Rule: Legal standard requiring fiduciaries to invest with care and due diligence.

References

• FINRA Rule 3260: Discretionary Accounts
• SEC Guidance on Fiduciary Duty: Investment Advisers and Fiduciary Obligations
• Investopedia: Understanding Discretionary Accounts

SIE Exam Practice Questions: Discretionary and Fiduciary Accounts

By understanding these concepts, you will be well-prepared for questions related to discretionary and fiduciary accounts on the SIE Exam. This knowledge is also crucial for ensuring ethical and compliant practices in your future career in the securities industry.