A fiduciary is a third party who oversees another person’s assets. Fiduciaries must put the client’s interests ahead of their own and act in the client’s best interest. The following fiduciary accounts in this chapter share that core feature:
A discretionary account gives trading authority - officially called a power of attorney (POA) - to a financial professional. This account type is often used by investors who don’t have the time or knowledge to manage their own assets.
With trading authority, the financial professional can make investment decisions for the client. When a firm or representative has POA over an account, they can place trades without getting the client’s approval for each transaction. The client can revoke POA at any time (there’s no required formal revocation process).
This section focuses on granting POA to financial professionals, but trading authority can be granted to any third party (e.g., a spouse or family member).
**The person granted trading authority is called the attorney-in-fact.
To make appropriate investment decisions, the firm must collect the client’s suitability information during the account opening process. As covered earlier, a client isn’t required to answer suitability questions (e.g., net worth, annual income) to open a basic cash account. However, the firm can only provide recommendations if those questions are answered.
That same principle applies to discretionary accounts: every discretionary trade placed by a financial professional is treated as a recommendation.
Discretionary accounts require added supervision because of the authority they give financial professionals. All transactions placed for clients must be marked as “discretionary” and reviewed by a securities principal promptly after submission.* While most broker-dealer transactions require some level of principal review after submission, discretionary trades require more frequent and more thorough review.
*Options transactions can be reviewed by a Registered Options Principal (Series 4) or a Branch Office Manager (Series 9/10).
A discretionary order is one where the financial professional decides any of the following for the customer:
Many test takers remember this as the “AAA” rule. If the financial professional chooses the asset, action, or amount, the order is discretionary and requires POA.
A financial professional can make certain decisions without the order becoming discretionary. Both of the following may be decided without POA or discretionary status, as long as the trade is executed within one day:
In other words, the professional can choose price and/or time and still keep the order non-discretionary - but only if it’s completed the same day. If execution takes longer than one day, the order becomes discretionary and requires POA.
For example, accepting an order to buy XYZ call options at a premium the professional considers acceptable sometime in the next two weeks would be discretionary and would require POA. Accepting an order to buy XYZ call options at a premium the professional considers acceptable by the end of the day would not be discretionary and would not require POA.
Custodial accounts are opened for minors under age 18. An adult custodian opens the account and manages the assets, but the assets legally belong to the minor. Custodians are often parents or guardians, but any adult can serve as custodian. Only one custodian and one minor are permitted 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.
UGMA was the original custodial account structure. It requires the custodian to transfer control of the assets to the minor at the age of majority (usually 18 or 21, depending on the state). UTMA was created later and allows the custodian to delay the transfer of assets (up to age 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 prohibited in custodial accounts due to the risk involved.
When a person can’t manage their finances, a court may appoint a guardian to oversee that person’s assets. This typically involves mental incapacitation or an inability to manage money. Guardianship accounts are opened by financial firms after they receive the proper court appointment documents. Once established, the account owner’s assets are placed into the guardianship account and may be managed only by the court-appointed guardian.
Like custodial accounts, guardianship accounts must avoid risky strategies involving short sales, margin, and options strategies with unlimited risk potential.
A trust account is created for the benefit of a specific beneficiary. A trust is a legal entity with three distinct parties, each with different responsibilities:
The grantor creates and funds the trust. Creating a trust begins with the grantor using legal services to draft a trust agreement. In that agreement, the grantor specifies the trust’s objectives, how it should be managed, and who the beneficiary or beneficiaries are. Trust objectives vary widely, such as funding a child’s college education, supporting an elderly family member, or managing assets for a charity.
The grantor also names the trustee(s) in the trust agreement. Trustees manage the trust according to the grantor’s instructions. This includes trading securities and handling general transactions (e.g., distributing funds to beneficiaries).
A trust is managed solely for the benefit of its beneficiary(ies), which may be a person, multiple people, or an organization. Beneficiaries don’t have direct control over the trust because the trustees manage it. However, trustees must act for the trust and its beneficiaries. The beneficiary’s role is primarily to receive the trust’s benefits (e.g., cash distributions or assets).
Relevant regulations require fiduciaries to follow these general standards in addition to prioritizing the client’s interests:
No excessive transactions
Fiduciaries shouldn’t place transactions that are excessive in size or frequency. This also connects to FINRA’s quantitative suitability requirement, which is 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 covered above, this is always true for custodial and guardianship accounts. However, fiduciaries of discretionary accounts and trustees of trust accounts may be permitted to use riskier strategies.
If the owner of a discretionary account has a high risk tolerance and can financially withstand losses, the financial professional may allocate funds to speculative strategies. If the trust agreement explicitly permits riskier strategies, the trustee(s) may do so.
The account’s risk level should properly reflect the owner’s suitability
The account should take an appropriate amount of risk based on the owner’s suitability profile. This cuts both ways: it’s a problem if the account takes on too much risk or too little risk.
Supporting documentation is required before exercising authority
Most fiduciary accounts require supporting documentation before authority can be exercised. Discretionary accounts require written POA, guardianship accounts require court appointment documents, and trust accounts require trust agreements. The only exception is the custodial account, which doesn’t require supporting documentation.
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