Customer Accounts - The Prudent Man Rule
This begs the question: What can a registered representative legally and ethically do with her discretionary authority? The answer is governed by the Prudent Man Rule which dates back to an 1830 Massachusetts civil court ruling stating that: "a fiduciary shall exercise the judgment and care, under the circumstances then prevailing, which men of prudence, discretion, and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds."
Historically, this has been interpreted strictly, with preservation of capital apparently construed as the only goal of someone with a fiduciary responsibility. However, there is a couple of obvious problems with this:
- First, people who have trusted their financial decisions to another are not necessarily in the phase of life in which capital preservation ought to be their primary objective. Many of these account holders are minors, who should have their portfolios managed for growth rather than income - a goal which requires taking on more risk than the Prudent Man rule, with its "not in regard to speculation" language, apparently allows.
- This brings up the second problem: portfolio analysis. You have already seen that options, for example, can be risky on their own but can act as a virtual insurance policy when viewed as part of a portfolio. The Prudent Man Rule, as historically interpreted, looks at investments on an individual basis and does not consider how risks in a portfolio net out.
As a result, accounts over which a third party has discretion have not produced the level of returns that they otherwise could.
Transformation of the Rule
Over the past few decades, the Prudent Man Rule has undergone a transformation and has morphed into the less archaic-sounding Prudent Investor Rule, or Prudent Expert Rule. Fortunately, there is more to the change than just political rectitude.
According to ERISA, the definition of the standard of care was expanded to include: "... that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims ... by diversifying the investments of the plan so as to minimize the risk of large losses [italics added] ..." By specifying that the fiduciary must act in a way familiar with financial markets and that diversification is a good thing, this update of the old Prudent Man Rule frees the individual who exercises her discretion over another's account to make more rational choices.
Muddying the waters, however, is the fact that an individual state might have its own interpretation of prudence that must also be followed by registered representatives doing business there.
The Series 7 exam might not include specific questions about the Prudent Investor Rule simply because it is still a work in progress. What is important to know is that, regardless of the standard, the fiduciary who incurs losses in violation of the rules is personally liable to restore those losses. It is also important to know that, unless otherwise specified in a market order, the timing and pricing of an individual transaction is completely up to the discretion of the registered representative. After all, that is your job.
BrokersIndependent broker-dealers are a great choice for experienced, self-starter planners who have established practices.
Personal FinanceRIAs and brokers are held to different standards when providing investment advice. Here's how they differ.
Trading Systems & SoftwareLaunching your own broker-dealer is a lot of work, but the potential payoff is great, both personally and financially.
ProfessionalsLearn how to answer option questions on the Series 7 exam. Pass your Series 7 exam with the help of these tips.
ProfessionalsFINRA Series 55 Exam Guide
ProfessionalsFINRA Series 62 Exam Guide
ProfessionalsFINRA/NASAA Series 99 Exam Guide
ProfessionalsFINRA/NASAA Series 65 Exam Guide
ProfessionalsFINRA Series 6 Exam Guide
ProfessionalsFINRA/NASAA Series 63 Exam Guide
- No results found.
The Financial Industry Regulatory Authority (FINRA) offers a variety of licenses that must be obtained before conducting ... Read Full Answer >>