Suitable (Suitability) Definition

What is appropriate (adequacy)?

Suitability refers to an ethical and enforceable standard regarding investments that finance professionals are required to meet when dealing with clients. Before making a recommendation, brokers, fund managers and other financial advisers have a duty to take steps to ensure that the asset or product is suitable, i.e. fit for purpose, to the needs and risk tolerance of that investor. In the United States, the Financial Sector Regulatory Authority (FINRA) oversees and enforces this standard, outlining the proficiency requirements in its Rule 2111.

Key points to remember

  • Suitability refers to an ethical and enforceable standard regarding investments that finance professionals are required to meet when dealing with clients.
  • An investment must meet the suitability requirements outlined in FINRA Rule 2111 before it is recommended by a firm to an investor.
  • Suitability depends on the investor’s situation based on FINRA guidelines.
  • Adequacy standards are not the same as fiduciary requirements.

Appropriate understanding (adequacy)

Any financial firm or person dealing with an investor must answer the question: “Is this investment appropriate for my client?” » The company, or associated personmust have a legally reasonable basis, or a high degree of confidence, that the security they provide to the investor is consistent with that investor’s objectives (such as risk tolerance) as indicated in their investment profile.

Both financial advisors and brokers must fulfill a suitability obligation, i.e. make recommendations consistent with the best interests of the underlying client. The Financial Industry Regulatory Authority (FINRA) regulates both types of financial entities according to standards that require them to make appropriate recommendations to their customers. However, a broker, or broker-dealer, also works on behalf of the broker-dealer firm, which is why the notion of suitability had to be defined to protect investors against predatory practices.

FINRA Rule 2111

FINRA Rule 2111 states that the client’s investment profile “includes, but is not limited to, client’s age, other investments, financial situation and need, tax status, investment goalsinvestment experience, investment temporary horizonliquidity needs, [and] risk tolerance”, among other information. An investment recommendation by a broker, or any other regulated entity, would automatically trigger this rule.

No investment, other than outright scams, is inherently appropriate or inappropriate for an investor. Instead, its suitability depends on the investor’s situation and makeup.

For example, for a 95-year-old widow living on a fixed income, speculative investments, such as options and futures contracts, penny stocks, etc., are extremely unsuitable. The widow has a low risk tolerance for investments that can lose capital. On the other hand, an executive with significant net worth and investment experience might be comfortable accepting these speculative investments as part of their portfolio.

Types of adequacy obligations

  • Reasonable relevance requires a broker to have a reasonable basis to believe, based on due diligence, that the recommendation is suitable for at least some investors. Due diligence should provide the company or associated person with an understanding of the potential risks and rewards of the stock or recommended strategy.
  • Customer-specific adaptation requires that a broker, based on the investment profile of a particular client, has a reasonable basis to believe that the recommendation is suitable for that client. The broker should attempt to obtain and analyze a wide range of client-specific factors to support this determination, including the client’s age, risk tolerance, liquidity needs and investment time horizon.
  • Quantitative adequacy requires that a broker having effective or de facto control over a client’s account has a reasonable basis to believe that a series of recommended trades, even if appropriate in isolation, are not excessive and inappropriate for the client when taken together in light of the client’s investment profile. This obligation aims to cover transaction costs and excessive portfolio turnover, called churningto generate commissions.

Adequacy vs fiduciary requirements

People often confuse the terms relevance and fiduciary. Both aim to protect the investor from foreseeable harm or excessive risk. However, adequacy standards are not the same as fiduciary standards; the levels of responsibility of the adviser and attention to the investors are different.

An investment trustee is anyone who has the legal responsibility to manage someone else’s money. Investment Advisors and fund managers, who are generally paid on commission, are bound by fiduciary standards. Broker-dealers, usually paid on a commission basis, generally only have to fulfill a suitability obligation.

The SEC’s Regulation BI is somewhat of a (weak, critics say) replacement for the Department of Labor. Trust rule of 2017, which would have required that all financial professionals who work with pension plans or provide advice on retirement planning – advisers, brokers and insurance agents – be legally bound by the fiduciary standard. In 2018, the United States Court of Appeals for the Fifth Circuit officially rescinded the ruleeffectively killing him.

Financial advisors who are fiduciary have a responsibility to recommend appropriate investments while adhering to the fiduciary requirements of placing the interests of their clients above their interests or those of their business. For example, the advisor cannot buy securities for his account before recommending them or buying them on behalf of a client. Fiduciary standards also prohibit carrying out transactions likely to result in the payment of commission fees to the advisor or his or her investment company.

The advisor must use accurate and complete information and analysis when providing investment advice to a client. To avoid any impropriety or appearance of impropriety, the Trustee will disclose any possible conflicts of interest to the client and will then put the interests of the client before their own. Additionally, the advisor undertakes trades on a “best execution” standard, in which they work to execute the trade or purchase at the lowest cost and with the greatest efficiency.

Appropriate (adequacy) vs best interest

The mandate to act in the best interest of the client, a key element of the fiduciary standard, is clearly missing from the suitability standard, although some might say it is implicit. As of 2022, the two have become more officially linked.

In June 2020, FINRA adopted Regulation BI, technically “modifying” its Rule 2111 to adapt it, so that “a broker who meets the best interest standard would necessarily meet the suitability standard”.

Although the details of which rule applies when are unclear, the gist seems to be that a FINRA-registered broker is now required to comply with both the Best Interest Rule and Rule 2111 regarding recommendations to retail investors.

Can a client waive their rights under FINRA 2111?

No, investor clients cannot waive their rights under FINRA Rule 2111. FINRA rules contain what are known as “anti-waiver” provisions. These provisions supersede any agreement to waive compliance with FINRA rules, the Securities and Exchanges Actthe Uniform Securities Actand state blue sky laws.

What should a suitability assessment take into account?

Assessing a broker’s suitability involves deciding whether an investment is appropriate for a particular client before recommending it. To determine this, the broker must take into account certain elements concerning the investor, including the following:

  • Age
  • Investment objectives
  • Investment deadline
  • Risk tolerance
  • Financial situation and obligations
  • Liquidity needs
  • Current investment portfolio and assets
  • Investment knowledge, sophistication and experience
  • Tax status

What are the aptitude requirements?

FINRA Rule 2111 lists three specific types of fitness requirements:

Reasonable basis: The broker must be reasonably convinced that the investment could be suitable for at least some individual investors. Basically, this translates to doing enough due diligence on the investment to make sure it’s legit and to understand how it works, what its benefits are, and what its risks might be.

Customer specific: The broker needs to know the age, mindset, financial situation and needs of the client, as well as their investment profile/objectives, in order to feel that the investment is suitable for that specific investor.

Quantitative: The broker has reasonable grounds to believe that a series of recommended trades, even if suitable individually, are not excessive and inappropriate for the client. This requirement is about churning an account – making many trades or engaging in a trading pattern primarily to generate commissions.

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