Unauthorized Trading

Overview

With limited exceptions, a financial advisor must gain approval from the investor before he can recommend a trade (i.e. the purchase or sale of a security) in a brokerage account.

Unauthorized trading that cause investor losses can lead to civil liability in a FINRA arbitration. FINRA rules expressly prohibit unauthorized trading. And investors should understand the correct process to approve transactions in their accounts to protect against unauthorized trading.

The difference between discretionary accounts and non-discretionary accounts

Unauthorized trading only applies to non-discretionary accounts. It does not apply to discretionary accounts. Therefore, to understand unauthorized trading, investors must understand the difference between a discretionary account, and a non-discretionary account.

A discretionary account is one that gives the broker “discretion” to make securities transactions in a brokerage account without the investor’s approval. Discretionary accounts require extensive written authorization from customer permitting a broker to use discretion. Additionally, the broker-dealer (the broker’s employ) must also approve the broker’s use of discretion, and properly mark the account eligible for discretionary trading as part of its duty to supervise.

Non-discretionary accounts on the other hand, require same-day verbal approval from the customer before the broker can place any recommended trade. That typically means, the broker must call the customer on the same day that he intends to place the recommended trade, receive verbal approval from the customer, and then place the trade the same day he receives approval.

Written approval of a trade in a non-discretionary account is insufficient.

Generally, a financial advisor may not place a trade based on written approval from the customer. Therefore, a text or an email approving a transaction (for example) does not constitute appropriate approval.

The trade must be placed on the same day as the verbal approval.

Suppose a financial advisor calls a client at 4:55 p.m. to recommend that the client purchase shares of XYZ stock. And suppose the client provides their verbal approval, but the financial advisor cannot place the trade before the market closes. The financial advisor may not place the trade the following morning. Do so constitutes what FINRA calls improperly taking “time and price discretion.”

Why does same day, verbal approval matter?l.

Same-day, verbal approval matters for two general reasons.

First, the customer must give verbal approval so the financial advisor knows that the customer (or the account holder) is the one providing the approval—and not someone else.

Second, the trade must occur on the same day because prices of securities often fluctuate—sometimes wildly. Therefore, if the financial advisor places a trade on a day different than the day on which he receives approval from the customer, he might expose the customer to a price for the recommended security substantially different than its price when the financial advisor made the recommendation.

How might unauthorized trading impact how a financial advisor gets paid?

A nefarious financial advisor or investment firm might use unauthorized trading—which left unchecked, can escalate to excessive trading or churning—to serve as path to improperly generate commissions if the account is commission as opposed to fee based.

*The Law Offices of Patrick R. Mahoney is a full service law firm with extensive experience litigating cases involving a host of securities-related issues. This page is for information purposes only and does not constitute legal or investment advice; nor is it a comprehensive explanation of all unauthorized trading issues. If you believe you have a claim, you should speak to competent counsel to better understand your options. Or, contact us.*

The investor’s risk tolerance.
The investors investment objective.
The investor’s time horizon.
Any other factors that might impact a client’s investment decisions.

If the brokerage firm determines that the investment is suitable for the specific investor, it can move to step three.

Step 3

Quantitative Suitability refers to the suitability assessment of an investment while also considering the investment strategy as a whole.

Investors can best understand quantitative suitability through examples.

Example 1- Quantitative Suitability Issues Stemming from Churning or Excessive Trading.

Excessive trading and churning refer to the practice of placing trades to generate commissions; compared to placing trades for the investor’s benefit. The individual trades might suitable when viewed in isolation. But the trades are unsuitable when viewed collectively because the broker placed them solely to generate commissions.

Example 2-Quantitative Suitability Issues Stemming from Improper Asset Allocation.

Asset allocation refers to the distribution of an investor’s capital across different asset classes.

Suppose the investor is 5 years away from retirement. Therefore, he wants a low-risk portfolio heavily weighted in low-risk investments. With the help of the financial advisor, the investor agrees to a recommended investment portfolio to with 75% traditionally conservative investments (cash and municipal bonds, for example), and 25% in stocks.

Suppose the broker then invests 50% of the investor’s portfolio stocks. The individual stock transactions, when viewed in isolation, might be suitable because the investor agreed that he wanted some stocks. But when the stock trades are viewed collectively, they are unsuitable because the broker overexposed the investor to stock.

*The Law Offices of Patrick R. Mahoney is a full service law firm with extensive experience litigating cases involving a host of securities-related issues. This page is for information purposes only and does not constitute investment or legal advice, nor is it a comprehensive explanation of all unsuitability issues. If you believe you have a claim, you should speak to competent counsel to better understand your options. Or, contact us.*

Unauthorized Trading