A fiduciary is a third party overseeing another person’s assets. Fiduciaries must put their client’s interests before their own and act in their best interest. The following fiduciary accounts in this chapter share this characteristic:
A discretionary account grants trading authority, known officially as power of attorney (POA), to a financial professional*. Investors without the time or knowledge necessary to manage their own assets are typically suitable for this account type. Trading authority allows a financial professional to make investment decisions on behalf of their clients. When a firm or representative maintains POA over an account, they can make proactive investment decisions without prior client approval. However, the client always maintains the right to revoke POA (no official revocation process required).
*While this section covers granting POA to financial professionals, trading authority can be granted to any third party (e.g., spouses, family members).
**The person granted trading authority is known as the attorney-in-fact.
For a firm or representative to make appropriate investment decisions, clients must answer all suitability questions posed by the firm during the account opening process. As we learned previously, suitability questions (e.g., net worth, annual income) are not required to be answered to open a basic cash account. However, a client can only be provided with recommendations if they are answered. The same rule applies to discretionary accounts. Every discretionary trade placed by a financial professional is considered a recommendation.
Discretionary accounts require added supervision due to the power they give financial professionals. All transactions placed on behalf of clients must be marked as ‘discretionary’ and reviewed by a securities principal promptly after being submitted*. While virtually all broker-dealer transactions require some form of review by a securities principal after submission, discretionary trades must be reviewed more often and thoroughly.
*Options transactions can be reviewed by a Registered Options Principal (Series 4) or Branch Office Manager (Series 9/10).
A discretionary order is defined as one where the financial professional is making a decision on behalf of the customer about any of the following:
Many test takers remember this as the “AAA” rule. If the financial professional chooses the asset, action, or amount for a trade, the order is considered discretionary and requires a POA to be submitted.
Financial professionals can make some choices for clients and avoid the trade being considered discretionary. Both of the following can be decided without POA or discretionary status if performed within one day:
Financial professionals can choose a transaction’s price and/or time without the trade being considered discretionary. Regardless, the trade must be completed within one day to maintain its non-discretionary status. If it takes over one day to complete, the order reverts to discretionary status and requires a POA. For example, a professional accepting an order to buy XYZ call options at a premium they deem acceptable in the next two weeks would be a discretionary transaction requiring POA. Conversely, a professional accepting an order to buy XYZ call options at a premium they deem acceptable by the end of the day would not be a discretionary transaction or require POA.
Custodial accounts are opened for minors under the age of 18. An adult custodian must open the account and manage account assets, but the account is the minor’s property. Custodians are typically parents or guardians, but any adult can serve this role. Only one custodian and minor are allowed per custodial account.
The two types of custodial accounts - UGMA (Uniform Gifts to Minors Act) and UTMA (Uniform Transfer to Minors Act) - are named after the laws that created them. The UGMA was the first version of a custodial account, which requires custodians to give control of the assets to the minor at the age of majority (usually 18 or 21 depending on the state). The UTMA was established later and allows custodians to delay the transfer of assets (up to the age of 25, depending on the state).
Custodians must avoid certain aggressive investment strategies in UGMA and UTMA accounts. In particular, short sales, margin, and options strategies involving unlimited risk (short naked calls and covered puts) are forbidden in custodial accounts due to the risk involved.
When a person cannot manage their finances, a court-mandated guardian may be appointed to oversee that person’s assets. Typically involving mental incapacitation or an inability to manage money, guardianship accounts are opened by financial firms when proper court appointment documents are received. At that point, the account owner’s assets are placed into a guardianship account and can only be managed by the court-appointed guardian.
Similar to custodial accounts, guardianship accounts must avoid risky investment strategies involving short sales, margin, and options strategies with unlimited risk potential.
A trust account is created for the benefit of a specific beneficiary. Trusts are legal entities involving these three distinct parties with varying responsibilities:
The grantor is responsible for creating and funding the trust. The first step to creating a trust involves the grantor utilizing legal services to construct a trust agreement. The grantor specifies the objectives, management styles, and the trust’s beneficiary or beneficiaries in this agreement. Trust objectives vary widely, including funding a child’s college education, supporting an elderly family member, or managing assets on behalf of a charity.
The grantor also names trustees in the trust agreement, who manage the trust according to the instructions provided by the grantor. In particular, trustees manage assets by trading securities and performing general transactions (e.g., distributing funds to beneficiaries).
A trust is managed for the sole benefit of its beneficiary(ies), which could be a person, persons, or an organization. Beneficiaries don’t have any legitimate power over the trust, as the trustees are in control. However, the trustees serve the trust and its beneficiaries. The role of a beneficiary is minimal - they exist to receive the “benefits” of the trust (e.g., cash distributions, assets).
Relevant regulations require fiduciaries to follow these general standards in addition to prioritizing the client’s interests:
No excessive transactions
Fiduciaries should not place transactions that are excessive in size or frequency. This rule also correlates with FINRA’s quantitative suitability requirement, which will be covered in a future chapter.
High-risk strategies should generally be avoided
Fiduciary accounts should generally avoid placing account assets into high-risk or speculative strategies. As we covered above, this rule is true for any transaction placed in a custodial or guardianship account. However, fiduciaries of discretionary accounts and trustees for trust accounts may be able to engage in riskier strategies.
If the account owner of a discretionary account maintains a high risk tolerance and can financially withstand losses, the financial professional may allocate funds towards speculative strategies. If the trust agreement explicitly states the trustees may engage in riskier strategies, the trustee(s) can follow suit.
The account’s risk level should properly reflect the owner’s suitability
An appropriate amount of risk should be taken based on the account owner’s suitability profile. This goes both ways; it’s a problem if too much or not enough risk is assumed.
Supporting documentation is required before exercising authority
Most fiduciary accounts require some form of supporting documentation before authority is exercised. Discretionary accounts require written POA, guardianship accounts require court appointments, and trust accounts require trust agreements. The only exception is the custodial account, which does not require supporting documentation.
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