Unauthorized Trading

Unauthorized trading refers to transactions made by a broker in a customer’s account without the customer’s knowledge, authorization, or consent. A broker executing unauthorized trades in a customer’s account violates FINRA Rule 2010, requiring that financial advisors observe high standards of commercial honor and just equitable principles of trade.

The question of unauthorized trading often comes down to whether a broker is exercising discretion over a customer’s account. Under FINRA Rule 3260, any discretionary power in a customer’s account must be given in writing prior to a broker executing any purchase or sale transaction. The brokerage firm must also approve the account for discretionary trading, which must be evidenced by the firm’s written authorization. Even if a broker has trading authority, the transactions in the account must not be excessive in either size or frequency, and the account must be reviewed by the firm or the broker at frequent intervals. Oral permission from a customer to execute a trade absent prior written authorization is not sufficient.

The rule provides an exception for brokers to decide the price or the time to execute a customer’s order so long as the broker executes the transaction the same day the client granted the discretion for a specific security and amount. A broker may also execute trades to comply with the terms of a margin agreement between the brokerage firm and the customer.

Improper use of discretion may be signaled by changes in trading patterns and volume of trades in a customer’s account. Investors should review their monthly account statements and trade confirmations to monitor any unauthorized trading.

Discretionary accounts require that a customer sign a discretionary disclosure to allow an authorized broker to buy and sell securities without the customer’s consent for each trade. The most important aspect of a discretionary account is that the investor allows the broker to manage and make decisions on the investor’s behalf. Discretionary or “managed” accounts may present benefits such as active management or quick trade execution. The ability to make trade decisions without the need to obtain approval for each trade may allow the broker to take advantage of market opportunities in pricing. Discretionary accounts, however, come with higher fees, higher investment minimums and may not be appropriate for investors who either do not feel comfortable with someone else making decisions on their account or who want a more active role managing their own account.

A key consideration for investors is how much control to cede to their broker and how that discretion is exercised. In some instances, there may be unauthorized trading even if a customer has granted discretionary power to the broker. Unauthorized trading may arise in the context of a broker ignoring a customer’s express instructions or limits in the broker’s trading. For example, if the investor instructed that their portfolio include a mix of stocks, bonds, and mutual funds, but the broker concentrates the account only in bonds. Another example would be if the customer’s discretionary disclosure restricted the broker’s equities trading to domestic large-cap stocks only, but the broker decides to buy stocks in small-cap companies from emerging markets.

Under FINRA rules, if a broker with discretionary power failed to sell a security, a customer would generally not have been able to bring a claim on suitability grounds. However, the rule would have still applied to explicit recommendations from the broker to the customer to hold a security in a discretionary account. Given the enhancements brought on by the SEC’s Regulation Best Interest (Reg BI), a broker managing a discretionary account on a customer’s behalf must apply the best interest standard to any securities transaction or investment strategy in the account.

Non-discretionary accounts are accounts in which the customer retains discretion and makes decisions about each trade. In other words, a broker must first obtain the customer’s permission before executing a trade. An advantage for customers is that non-discretionary accounts have lower fees and investment minimums. Although a customer maintains decision-making authority about executing each trade, it is important to understand the relationship between a customer with a non-discretionary account and a broker providing advice in light of new obligations under Regulation Best Interest. For example, the broker must still act in the customer’s best interest when making a recommendation to a customer to buy or sell a security or follow an investment strategy in a non-discretionary account. Furthermore, if the broker agrees to monitor or to perform quarterly reviews in a non-discretionary account, the broker is undertaking an obligation to review and make recommendations. Any resulting recommendations will be subject to Reg BI, as will be a lack of recommendations (i.e., silence from the broker after agreeing to review the account), which are deemed implicit hold recommendations under Reg BI.

A downside of non-discretionary accounts is that an investor may be unable to act as quickly as a broker with discretionary power in sizing market opportunities. Some firms do not allow a brokerage account to be traded on a discretionary basis if the account is commission-based.