Discretionary Accounts

Discretionary trading is high-risk because the customer cannot evaluate each individual recommendation. The rulebook compensates with rigid documentation requirements (three writings) and ongoing supervisory review (frequent intervals). The Series 24 exam tests the documentation requirements as a memorizable checklist and the supervisory duty as a supervision-and-discretion-rule overlap.

Definition of a Discretionary Account

A discretionary account is one in which the customer has authorized a member or registered representative to make decisions about:

• Which security to buy or sell
• Quantity of the security
• When to buy or sell
• Whether to buy or sell

without the customer's specific instruction for each trade.

If the customer makes any of these decisions, even a delayed or imprecise instruction ("buy 100 shares of XYZ sometime next week"), and the rep is only choosing the precise execution moment within the customer's parameters, the trade may not be discretionary.

Time and Price Discretion Exception

"Time and price discretion" alone is NOT considered discretionary trading. Time and price discretion exists when:

• The customer has already specified the security and the action (buy or sell)
• The customer has already specified the quantity (or specified an unsolicited order's stated price)
• The rep is choosing only when to execute and at what price within the customer's stated parameters

Time and price discretion is good for that single business day only. After the close, any unfilled portion of the order requires fresh customer authorization.

Think of it this way: Discretion under the FINRA discretion rule is about what to trade and whether to trade. Time and price discretion is only about when and at what level. A customer who says "buy 100 XYZ at the best available price today" has not given full discretion; the rep is only timing the execution. A customer who says "buy whatever bonds you think are appropriate for me" has given full discretion, and the three-writings rule attaches.

Exam Tip: Gotchas

• Time and price discretion is good for one business day only. A rep cannot stretch a "buy at best price" instruction across multiple days; after the close, any new authorization is required.
• The customer's instruction must specify security, action, and quantity for time and price discretion to apply. If the rep is choosing the security or the size, the trade is fully discretionary and the three-writings rule attaches.

The Three Required Authorizations

The discretion rule requires three distinct writings before any discretionary trading can occur:

A rep cannot exercise discretion based on oral customer authorization. All three writings are required. Missing any one is a discrete violation.

Exam Tip: Gotchas

• All three writings are required: customer authorization, firm acceptance, and principal approval of each order. Missing any one is the violation. The exam tests this as: "What is the minimum documentation for a discretionary trade?" The answer is the three writings.
• Principal approval of each discretionary order must be PROMPT and IN WRITING. Daily review batches that include discretionary trades may not satisfy the "prompt" standard; principal sign-off should occur as soon as practicable after the trade.
• Oral customer authorization is never sufficient. A rep cannot rely on a phone call from the customer authorizing discretion; the customer's authorization must be in writing.

Periodic Supervisory Review

The principal must review all discretionary accounts at frequent intervals to detect and prevent transactions that are:

• Excessive in size given the customer's profile
• Excessive in frequency given the customer's profile

This is the anti-churning function of the discretion rule. The principal's review is parallel to the quantitative-suitability obligation and Reg BI's Care Obligation. Excessive trading in a discretionary account is presumptively a violation because the customer cannot evaluate each trade individually.

The metrics for evaluating excessive trading are the same ones used for quantitative suitability:

• Turnover rate: total purchases (or sales) divided by average equity over a period
• Cost-equity ratio: total commissions and costs as a percentage of average equity
• In-and-out trading: rapid buying and selling of the same or similar securities

A discretionary account with a turnover rate above 4 or a cost-equity ratio above 15-20% annualized is a presumptive red flag. The principal must investigate, document the inquiry, and escalate where appropriate.

Exam Tip: Gotchas

• Frequent supervisory review of discretionary accounts is not the same as the daily principal approval of each order. The two duties stack: each order is approved promptly, AND the account as a whole is reviewed at frequent intervals for excessive trading patterns.
• A failure to detect excessive trading in a discretionary account is a supervision/discretion-rule violation. It is independent of the underlying quantitative-suitability or churning violation by the rep.

Federal Anti-Fraud Backstop

The SEC's discretionary-account anti-fraud rule layers federal anti-fraud liability on top of the FINRA discretionary-account rules. Conducting any transaction in a discretionary account that is excessive in size or frequency given the customer's profile is deemed to be a manipulative, deceptive, or fraudulent device under the Exchange Act.

This means excessive discretionary trading can be charged under:

• The quantitative-suitability obligation
• The discretion-rule supervisory duty
• The general supervisory-system requirement
• The SEC's discretionary-account anti-fraud rule
• The Exchange Act's general antifraud provisions (if specific manipulation is shown)

A single pattern of churning can support violations of all five rules simultaneously, with overlapping civil, regulatory, and (in egregious cases) criminal exposure.

Exam Tip: Gotchas

• The SEC's discretionary-account anti-fraud rule makes excessive discretionary trading a federal anti-fraud violation. The Exchange Act, not just FINRA rules, prohibits the conduct. This elevates churning from a regulatory violation to a fraud claim, with corresponding remedies and penalties.
• The same conduct can be charged under multiple rules simultaneously. Churning in a discretionary account triggers the suitability rule, the discretion rule, the supervisory-system requirement, the SEC's discretionary-account anti-fraud rule, and possibly the Exchange Act's general antifraud provisions. The exam tests this layering as a "which rule applies" question.

Special Rules for Reps With Discretion Over Their Own Family Accounts

The personal-account approval and outside-business-activity rules (covered in other units) govern outside accounts of associated persons and outside business activities. When a rep has discretion over a family member's account, the firm must:

• Be informed of the relationship under the personal-account approval rule
• Approve the rep's discretionary authority in writing
• Apply normal discretion-rule documentation requirements

A rep cannot exercise discretion over a family member's account at the firm without the firm's written acceptance and principal approval of each order. The family relationship does not eliminate the documentation requirements; it adds a personal-account-disclosure layer on top.

Exam Tip: Gotchas

• Discretion over a family member's account still requires the three writings. The family relationship does not waive the documentation requirements; it adds disclosure under the personal-account approval rule.