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 specifies the security, quantity, and side, leaving only execution time and price to the rep, the time-and-price exception may apply. Choosing just one of those terms does not reserve the other investment decisions to the customer.

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
• The rep is choosing only when to execute and at what price within the customer's stated parameters

Time and price discretion lasts through that business day by default. It may extend under specific, signed and dated written instructions. A separate exception permits qualifying institutional not-held good-till-canceled orders. Without an applicable extension or exception, the rep needs fresh authority after the day ends.

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

• One business day is the default, not an absolute maximum. Check for specific signed and dated contrary instructions or the qualifying institutional order exception before deciding whether fresh authority is needed.
• 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 separates authorization before trading from approval of each order:

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. It operates alongside the applicable recommendation standard. Regulation Best Interest governs covered retail recommendations; the FINRA suitability rule does not also apply to those recommendations.

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

Evaluate these measures in the context of the customer's profile, strategy, account activity, and costs. No single turnover or cost-equity number proves that trading is excessive. Investigate suspicious patterns, 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 applicable recommendation standard, including Regulation Best Interest for covered retail recommendations
• 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 pattern of excessive trading can support multiple violations when the elements of each applicable rule are established.

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.
• Several duties can apply to the same conduct. Identify the applicable recommendation standard, discretionary-account duties, supervision requirements, and any federal antifraud elements supported by the facts.

Special Rules for Reps With Discretion Over Their Own Family Accounts

The ordinary discretionary-account requirements apply to a family member's account. Additional personal-account requirements depend on the rep's beneficial interest, applicable relationship presumptions, the account's location, and firm procedures. An adult relative's account does not automatically create a separate regulatory approval requirement solely because of the relationship.

Exam Tip: Gotchas

• Family ties do not waive discretionary-account documentation. Apply any additional personal-account requirements only when their conditions or the firm's procedures apply.

What Should You Check on Exam Day?

• Can you distinguish prior customer authority and firm acceptance from prompt written approval of each order?
• Can you state the one-day default for time and price discretion and recognize its written-extension and institutional-order exceptions?
• Can you explain why oral customer authorization is never sufficient to establish a discretionary account?
• Do you know why excessive trading in a discretionary account can be charged under the SEC's discretionary-account anti-fraud rule, not just FINRA rules?