Discretionary Authority

With the rules on custody and safekeeping established, this section covers discretionary authority: when a securities professional can make investment decisions on behalf of a client without getting approval for each trade.

What Constitutes Discretion

An agent or adviser exercises discretion when they make investment decisions on behalf of a client (choosing the security, the amount, or whether to buy or sell) without obtaining the client's prior approval for each specific transaction.

Discretion covers decisions about:

  • Which security to buy or sell
  • How many shares or the dollar amount
  • Whether to buy or sell (the action itself)

Memory Aid: AAA

An order is discretionary if any of these is missing:

  • Asset (which security)
  • Action (buy or sell)
  • Amount (number of shares)

Time and price-only direction is NOT discretion.

Think of it this way: If the professional is deciding what to buy or sell, or how much, that's discretion. If they're only deciding when and at what price to execute a trade the client already chose, that's not discretion.

Written Authorization Required

Under the NASAA Statement of Policy on Dishonest or Unethical Business Practices, exercising discretion requires:

  • Written discretionary authorization from the customer (a signed power of attorney or trading authorization)
  • Acceptance of the account as discretionary by the broker-dealer (the firm must approve)
  • The authorization must be obtained before the first discretionary trade is executed
  • An oral authorization is not sufficient for ongoing discretionary trading; written authorization is mandatory

Time and Price Discretion: When Written Authorization Is Not Required

A broker-dealer agent may exercise time and price discretion without written authorization if all of the following conditions are met:

  1. The customer has directed a specific trade (e.g., "buy 100 shares of XYZ")
  2. The agent's discretion is limited to deciding when to execute the trade and at what price
  3. The order is executed by the end of the business day on which the customer granted the discretion

This is sometimes called a "not held" order. The customer gives the agent flexibility on timing and price but has already made the investment decision.

Key rule: If the time-and-price order is not executed by the end of the business day, the authorization expires and a new instruction from the customer is required.

Exam Tip: Gotchas

  • The key test for discretion is who decides what to buy or sell and how much.
  • "Buy 100 shares of XYZ when you think the price is right" = time-and-price discretion (no written authorization needed if executed same day).
  • "Invest $10,000 in something appropriate" = the agent is choosing the security, which is discretion requiring written authorization.

Prohibition on Unauthorized Trading

Effecting a securities transaction in a customer's account without the customer's prior authorization is an unauthorized trade and constitutes a dishonest or unethical business practice.

  • Even in a discretionary account, the agent must act within the scope of the discretionary authorization; exceeding the authority granted is unauthorized trading
  • Unauthorized trading violates:
    • The NASAA Statement of Policy on Dishonest Practices
    • Uniform Securities Act (USA) Section 101 (antifraud) if done in connection with the purchase or sale of a security
    • Potentially criminal under USA Section 409 if willful

Exam Tip: Gotchas

  • "Within scope" matters. A discretionary authorization for conservative investments does NOT cover speculative options trades. Trading outside the granted scope is unauthorized trading even if the account is generally discretionary.

Supervision of Discretionary Accounts

A broker-dealer that permits discretionary accounts has heightened supervisory obligations:

  • A principal or supervisor must review discretionary accounts regularly for:
    • Excessive trading (churning), the hallmark violation in discretionary accounts
    • Trades that are unsuitable for the client
    • Activity that exceeds the scope of the discretionary authorization
  • The firm must have written supervisory procedures governing discretionary accounts