Compensation, Custody and Discretion

Compensation

The standard: it is an unethical practice to enter into a transaction with or for a customer at a price not reasonably related to the current market price of the security, or to receive an unreasonable commission or profit. And it is unethical to charge unreasonable and inequitable fees for services — collection of principal, dividends or interest, exchange or transfer of securities, appraisals, safekeeping, custody, and other services related to the securities business.

FINRA Rule 2121 sets the federal counterpart: a member buying or selling as principal must deal at a price that is fair considering all relevant circumstances, and commissions charged as agent must be fair and not unreasonable. Its interpretive material sets out the 5 percent policy, which is a guideline rather than a rule — it does not authorize a 5 percent charge and does not forbid exceeding one. Relevant circumstances include the type of security, its availability, its price, the size of the transaction, the disclosure made, and the pattern of the firm's markups. The policy does not apply to securities sold from a prospectus.

The capacity matters. Acting as agent, the firm charges a commission disclosed separately. Acting as principal, it takes a markup or markdown inside the price, which is why disclosure of capacity on the confirmation is required. A firm cannot act as both on the same transaction.

Disclosure of compensation is the other half. Where the amount or type of compensation creates a conflict — a higher payout on a proprietary product, a sales contest, a revenue-sharing arrangement — the conflict must be disclosed. Regulation Best Interest requires more than disclosure for conflicts creating incentives for associated persons: those must be mitigated, and sales contests, quotas, bonuses and non-cash compensation based on the sale of specific securities within a limited period must be eliminated.

Wrap fee programs, named on the study guide's testable list, bundle advice, execution and custody into a single asset-based fee. The suitability question is whether the customer's activity justifies the fee: a customer who trades rarely may pay far more than commissions would have cost, which is reverse churning.

And one prohibition specific to agents: dividing or splitting commissions, profits or other compensation from securities transactions with any person not also registered as an agent for the same broker-dealer, or for a broker-dealer under direct or indirect common control. FINRA Rule 2040 says the same thing from the federal side — no transaction-based compensation to a person who is required to be registered and is not.

Custody of customer property

The NASAA statement of policy is blunt about agents: it is a dishonest or unethical practice for an agent to engage in the practice of lending or borrowing money or securities from a customer, or to act as a custodian for money, securities or an executed stock power of a customer.

Read the second clause carefully, because it is broader than people expect. An agent may not hold a customer's cheque overnight, may not keep a customer's certificates, and may not hold a signed but undated stock power. The convenience of doing so is exactly the problem — an executed stock power in an agent's desk is an instrument that can move the customer's securities.

The firm-level rules are the counterpart. It is unethical for a broker-dealer to fail to segregate customers' free securities or securities held in safekeeping, and to hypothecate a customer's securities without a lien absent a properly executed written consent. SEC Rule 15c3-3 — the customer protection rule — requires the firm to maintain possession or control of fully paid and excess margin securities and to maintain a reserve account for the benefit of customers, so that customer property survives the firm's failure.

Commingling customer funds or securities with the firm's own is prohibited, and conversion — taking them — is the extreme case.

For investment advisers the parallel rule is NASAA's Custody Requirements model rule, which conditions holding client funds or securities on notice to the Administrator, use of an independent qualified custodian, account statements to clients, and a surprise examination. An adviser that has custody is subject to more requirements, higher net worth and often a bond, which is why many advisers structure their business to avoid custody entirely.

SIPC sits behind all of it as the last resort: if a member broker-dealer fails and customer property is missing, SIPC returns securities and cash up to $500,000 per customer, of which no more than $250,000 may be for cash claims, measured per separate capacity. It never covers loss of market value — the scope of SIPC coverage is on the study guide's testable list precisely because customers and new agents both misunderstand it.

Discretion and trading authorization

It is an unethical practice to exercise any discretionary power in effecting a transaction for a customer's account without first obtaining written discretionary authority from the customer, unless the discretionary power relates solely to the time and price for executing orders.

That sentence contains the whole rule and its exception.

Discretion means someone other than the customer decides the security, the amount, or whether to buy or sell — the three elements. Deciding only when to execute, or only what price to accept, is not discretion.

The time-and-price exception is narrow in a way candidates forget: it covers a specific order given by the customer, and it is good for that day only. An instruction to buy 500 shares of a named security at a good price today does not survive to tomorrow.

Written authority must be obtained first. This is a point of difference from the margin agreement, which may be obtained promptly after the initial transaction — discretionary authority may not.

Under FINRA Rule 3260, a firm must also accept the discretionary account in writing through a partner, officer or manager, each discretionary order must be identified as such when entered, and a supervisor must review such accounts frequently to detect transactions excessive in size or frequency given the account's resources and character. For an options account, discretion must be specifically authorized — a general options approval does not carry it.

A limited power of attorney permits trading only; a full power of attorney also permits withdrawal. All such authority terminates on the customer's death, which also freezes the account and cancels open orders.

Executing a transaction on behalf of a customer without authorization is separately enumerated as an unethical practice, and it is a violation whether or not the trade made money.

The Uniform Prudent Investor Act, on the study guide's testable list, supplies the standard for a fiduciary managing someone else's money: the trustee must invest as a prudent investor would, considering the purposes, terms and distribution requirements of the trust; must diversify unless the purposes are better served otherwise; is judged on the portfolio as a whole rather than on individual investments; and may delegate investment functions with care in selection and monitoring. That whole-portfolio standard replaced the older approach of judging each investment in isolation.

The standard of care

Two standards operate together and the statement of policy names both.

The suitability standard: it is unethical to recommend the purchase, sale or exchange of any security without reasonable grounds to believe the recommendation is suitable for the customer, based on reasonable inquiry concerning the customer's investment objectives, financial situation and needs, and any other relevant information known to the firm. FINRA Rule 2111 restates it federally with three obligations — reasonable-basis, customer-specific and quantitative suitability.

The best interest standard: the statement of policy's 2022 amendment makes it unethical, when making a recommendation to a retail customer, to place the financial or other interest of the broker-dealer or agent ahead of the interest of the retail customer; to recommend an investment strategy or the sale or purchase of any security without a reasonable basis to believe the recommendation is in the retail customer's best interest based on the customer's investment profile and the potential risks, rewards and costs; or otherwise to fail to comply with Regulation Best Interest.

That is a state-law adoption of a federal standard, and it means a Reg BI failure is also a state ethics violation. Regulation Best Interest's four component obligations are disclosure, care, conflict of interest and compliance, and its care obligation expressly requires consideration of cost — so where two products would both do the job, the more expensive one needs a reason.

The customer investment profile both standards refer to includes age, other investments, financial situation and needs, tax status, objectives, experience, time horizon, liquidity needs and risk tolerance. Missing information is not a defence: reasonable inquiry is the obligation, and a customer who declines to answer constrains what can be recommended rather than freeing the agent to recommend anything.