Discretion and Third-Party Authority

What discretion is

An order is discretionary if the representative decides any of three things without the customer's specific instruction: the security, the amount, or whether to buy or sell.

Those three — asset, amount, action — are the whole definition, and the exam constructs questions by removing one.

A customer who says 'buy 500 shares of XYZ, you decide when today' has specified the security, the amount and the action. The representative is choosing only the time. That is not discretion.

A customer who says 'buy 500 shares of XYZ at a good price today' leaves only the price to the representative. Also not discretion.

A customer who says 'buy something you like in the technology sector' has specified none of the three. That is discretion and it requires prior written authorization.

The time-and-price exception is limited in a way candidates forget: it is good for that day only. An instruction to buy 500 XYZ at a good price does not survive to tomorrow, and acting on it the next day is unauthorized trading.

Section 3(a)(35) of the Exchange Act defines investment discretion for statutory purposes, covering a person who is authorized to determine what securities are purchased or sold for an account, or who makes decisions as to what is purchased or sold even though another person has responsibility.

Documentation and supervision

FINRA Rule 3260 requires that before exercising discretion, a member obtain prior written authorization from the customer and that the account be accepted in writing by a partner, officer or manager. Both are prior: the authorization must exist before the first discretionary order, not be papered afterwards.

Each discretionary order must be identified as discretionary at the time it is entered, which is why the order ticket carries the field.

A designated supervisor must review discretionary accounts at frequent intervals to detect and prevent transactions that are excessive in size or frequency in view of the customer's financial resources and character.

And Rule 3260 contains a specific prohibition: no member or associated person exercising discretionary power shall effect purchases or sales that are excessive in size or frequency in view of the financial resources and character of the account.

For options accounts, a discretionary authorization must be specifically noted, and the account approval must state that discretionary transactions are permitted — a general options approval does not carry discretion with it.

Discretionary authority terminates on the death of the customer, on revocation by the customer, or on the death or incapacity of the person holding the authority. Death of the customer also freezes the account, cancels open orders and stops any further trading, discretionary or otherwise.

Discretion granted to a registered investment adviser rather than to the representative is a different arrangement: the adviser's authority comes from its advisory agreement with the customer, and the firm's obligation is to verify that authority and to accept instructions only within it.

Powers of attorney and third-party authorization

A trading authorization or power of attorney lets a third party act on the account.

A limited power of attorney permits trading only — entering buy and sell orders — and does not permit withdrawal of cash or securities.

A full power of attorney permits trading and withdrawal, which makes it substantially more dangerous and correspondingly rarer for a non-family third party.

An ordinary power of attorney terminates on the death or incapacity of the grantor. A durable power of attorney survives the grantor's incapacity, which is exactly why it exists, and still terminates on death.

Every one of these terminates at the customer's death. A representative who continues taking instructions from an agent after being told the customer died is acting without authority.

A third-party authorization must be documented in the account record under Rule 4512, and the firm must know the authority of the person acting — Rule 2090 again.

Related, and easy to confuse: the trusted contact person is not an authorization at all. It is a person the firm may contact to confirm the customer's whereabouts and health, or to discuss a suspicion of financial exploitation. A trusted contact may not trade, may not withdraw, and may not instruct.

Churning and quantitative suitability

Churning is excessive trading in a customer's account, conducted primarily to generate commissions rather than to serve the customer's objectives. Three elements are generally required: the representative controlled the trading, the trading was excessive in light of the customer's objectives, and the representative acted with intent or reckless disregard.

Control is why discretionary accounts are the classic setting — the representative plainly controls the trading. But control can also be de facto: a customer who follows every recommendation without independent judgement has effectively ceded control, and the absence of formal discretion is not a defence.

Excessiveness is assessed with reference to turnover — the ratio of purchases to average account equity over a period — and the cost-to-equity ratio, the return the account would have to earn simply to cover its costs. Neither is a bright line; both are evidence.

Quantitative suitability under FINRA Rule 2111, and the corresponding element of Regulation Best Interest's care obligation, reach the same conduct without requiring proof of intent: a series of recommended transactions may be unsuitable in aggregate even where each one, standing alone, is suitable.

Two related practices worth naming. Reverse churning is placing an inactive customer in a fee-based account where they pay far more than commissions would have cost — the same abuse from the other direction. And unauthorized trading is executing any transaction without the customer's authority, in an account where no discretion was granted; it is a violation regardless of whether the trade made money, and a profitable unauthorized trade is still a violation.