KYC, objectives, and suitability

Know your customer (KYC)

Under FINRA Rule 2090, every member firm must use reasonable diligence, when opening and maintaining an account, to know and retain the essential facts about each customer and about the authority of each person acting on the customer’s behalf, such as someone with power of attorney or trading authorization over the account. This due diligence also includes complying with the firm’s customer identification program (CIP) under the USA PATRIOT Act, which requires verifying a customer’s true identity as part of the firm’s broader anti-money laundering (AML) compliance program.

We must always make sure to have as complete an investment profile as possible before we can make any type of suitable recommendation. It may be difficult or impossible to get all of the information, but we need to try and get as much as possible to make the best recommendations. The investment profile will contain things like:

• Age
• Financial situation
• Financial needs and timelines
• Other liquidity needs
• Investment objectives
• Investment time horizon
• Other investments
• Tax status
• Risk tolerance
• Any other facts/information obtained from the customer that could be useful in making recommendations for them.

Investment objectives

There are several primary reasons people invest: objectives for the money they are giving your firm. Growth and income are 2 of the primary objectives people think and talk about. There are some people who are looking simply to keep what they have, pass it down to the next generation, and preserve their capital.

Growth is the objective of investing today with the goal of withdrawing larger amounts in the future - buying low and selling higher later. Common stock is most often the investment for people with a growth objective. Growth is generally a more aggressive approach, though a growth-oriented portfolio can still be built conservatively.

Income is generally what people think of when they’ve grown their money over their working lives and now want to live off it, drawing regular income on a recurring basis. Income is generally a more conservative objective, though a growth or income portfolio can be built at any point along the risk spectrum. Bonds and preferred stock are generally the investments thought of for income, with high-yield bonds being more aggressive and government bonds and higher-rated corporate bonds being more conservative. REITs, DPPs, and some other more exotic investments are also purchased for income, with varying degrees of risk. An income bond is not what its name suggests: it is typically issued in a reorganization, such as a bankruptcy, and pays interest only if the issuer earns enough to pay it. Because that interest isn’t promised, an income bond doesn’t suit a customer who needs dependable income or wants to preserve capital, any more than a high-yield (junk) bond does.

Some people may be concerned about their income being too high and having excessive taxes applied. Municipal bonds, or other tax-exempt investment products, are likely to be useful to consider for these clients. Municipal bond interest is generally exempt from federal income tax. To also avoid state and local tax, the investor usually needs to buy a bond issued in their own state of residence (a triple tax-exempt bond).

Preserving capital is the objective of people who don’t want to lose their money. They are concerned about safety and not losing money. We aren’t talking about burying money in the backyard or in the mattress; they will get small return, small interest. That just isn’t what their goal is. Treasuries and money markets are primarily for this objective. The longer term treasuries for those who want to preserve their capital for longer periods, and get a larger return for it.

Additional customer considerations

There are many considerations the customers may have. Many times we divide the considerations and facts into financial and non-financial. Basically, if it involves a dollar sign, it is financial; if it doesn’t, it’s non-financial. How much income the client makes, how much they need for their kids’ college, how much they owe in credit card debt; all of those are financial considerations. Their marital status, at what age do they plan to retire, what are their thoughts on industry A, industry B, or industry C, how long have they been investing; these are all non-financial considerations.

Risk tolerance is a measure of how much risk in loss is a client able and willing to accept. Some people are willing to accept a great deal of risk in exchange for the higher return potential, while others, like those with the preservation of capital objective, want very low to basically zero risk, and therefore are willing to accept much lower returns. The way we do this is by using a risk assessment questionnaire. Pretty simple, ask 6-12 questions, score the answers, and read the results.

Time horizon is another important non-financial concern, in that the longer the time until money is needed, the more risk the investor is generally able to tolerate in the account. The shorter the time until the money is needed, the less risk the investor is generally able to tolerate in the account.

Liquidity is how quickly and easily an investment can be turned into cash without a significant loss in value or a significant cost or penalty (FINRA Regulatory Notice 11-25). A customer’s liquidity needs limit what can be recommended: money the customer may need soon doesn’t belong in an investment with a surrender charge or no ready market.

Suitability

There are multiple standards that representatives or advisors will have to use to justify the recommendations and advice they give.

For recommendations to retail customers, Regulation Best Interest (Reg BI) is the governing standard: the firm and representative must act in the retail customer’s best interest when making a recommendation, without placing their own financial interests ahead of the customer’s. FINRA’s suitability standard (Rule 2111) continues to apply where Reg BI doesn’t - most notably, recommendations to institutional customers.

The suitability standard requires a reasonable basis to believe that the securities or strategies are suitable for the customer, appropriate for their given goals and current position. This must be done before the representative can recommend the security or strategy. The objectives of the client, their experience, time horizon for the account, liquidity needs, risk tolerance, and any other disclosed information must all be taken into account for this.

Reasonable basis suitability

We must have a reasonable basis to believe, with reasonable diligence, that the recommendation is suitable for at least some investors. Think of it as “this could certainly be suitable for some investors, so I will keep this arrow in my quiver if I need it”.

Customer-specific suitability

We must have a reasonable basis to believe, with reasonable diligence, that the recommended security is suitable for a specific customer. Think of it as “which specific arrows in the quiver should I pull out and show the client”. Being an accredited investor doesn’t settle this. Accredited status decides who may buy certain private offerings (Regulation D); meeting its income or net worth test is only one factor in the analysis, and the representative must still be satisfied that the customer understands the risks and can bear them (FINRA Regulatory Notice 10-22). Recommending the same security to all of our customers without weighing each one’s investment profile is a blanket recommendation, and it fails the customer-specific obligation no matter how good the security is.

Quantitative suitability

Little tricky to explain, but basically don’t churn accounts. We must have a reasonable basis to believe that a series of recommendations is not excessive. Not only are the individual transactions appropriate, but the transactions as a whole, when looked at all together, are also appropriate. It might be suitable to sell the client 100 shares of ABC, and it also could be suitable to sell them 1000 shares of ABC, but it is not suitable to sell them 100 shares 10 times, even though each individual transaction might be appropriate, the whole has 10 sales charges, and that would be considered churning and not suitable.

Suitability for institutions

Institutional investors have different rules for suitability; they are far more knowledgeable and sophisticated than normal retail investors, even accredited ones. Institutional accounts include banks, insurance companies, registered investment companies, registered investment advisers, and any other person or entity with total assets of at least $50 million. Some institutions have managed money for decades, or even over a century, and currently manage billions, while others have only recently crossed the $50 million threshold and may need more guidance.

When trying to figure out the precise level of suitability required for institutional investors:

1. The firm and its reps have to have a reasonable basis to believe the customer can independently evaluate and understand the risks of investing, both in the individual products involved, along with the more complicated strategies employed.
2. The investor has to agree; the institutional investor agrees they can and will exercise independent judgment in evaluating recommendations from the firm.

If both of these apply to the institutional investor, then the member firm is exempt from the customer-specific suitability obligation. Being a qualified institutional investor does not exempt the firm or the reps from the reasonable basis and quantitative suitability obligations. They still apply.

Concerns with recommendations

As supervisors, we will need to make sure representatives and principals have been trained on watching for potential problems with recommendations. There are several industry potential conflicts we need to make sure to watch for, and to train representatives to avoid when possible, and disclose the rest of the time. Each of these behaviors can have a legitimate business reason behind it, which is why they call for scrutiny rather than an automatic assumption of wrongdoing.

• Certain products pay more than others. Is the representative consistently recommending product B over competitor A because B pays a higher commission, or because B is genuinely the better choice?
• Recommending mutual funds in a way that costs the client more - for example, by spreading purchases across different fund families - can generate more commissions for the representative.
• Recommending margin to clients where it isn’t the best fit can generate more commissions from larger trades.
• Promoting proprietary mutual funds (funds created by the representative’s own firm) is especially worth watching, since it can inflate the fund’s size or reflect higher internal commissions rather than the client’s best interest.

The timing differs by role. The representative’s best-interest or suitability analysis comes before the recommendation is made. The supervisor’s review usually comes after the trade: a registered principal reviews the firm’s transactions under its written supervisory procedures (FINRA Rule 3110(b)(2)). A few products need a principal’s approval before the order is processed, such as a recommended deferred variable annuity (FINRA Rule 2330).