KYC, objectives, and suitability

Know your customer (KYC)

All member firms, and their associated persons who work with clients, must use appropriate due diligence to determine the essential facts relating to each customer, client, every order, cash or margin account, and every person with power of attorney or trade authorization over the account.

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 primary idea that many people (at least younger ones), think about when they think about investing. Buying low, selling high later, making the money, yolo or whatever the cool young persons are saying these days. Trying to grow the money in the account, investing today, and withdrawing larger amounts in the future. Common stock is most often the investment for people with a growth objective. This objective is also generally a more aggressive approach, but it doesn’t have to be.

Income is generally what we think of “older” people investing for. They have grown their money over their working lives, they now want to live off the money, and start getting income on a regular basis that they can now live off. Income is generally a more conservative investment objective, but similarly, how growth is generally more aggressive, it doesn’t have to be. You can have conservative growth, and aggressive income. Bonds and preferred stock are generally the investments thought of for income, with high-yield bonds being more aggressive, government, and higher rated corporated bonds being more conservative. REIS, DPPs, and some other more exotic investments are also purchased for income, with varying degrees of risk in them as well.

Some people may be concerned about their income being too high and having excessive taxes applied. Municipal bonds, or other tax-exempt investment product are likely to be useful to consider for these clients. Municipal bonds would have to be issued and purchased in the same state of issue, so that is something to pay attention to.

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. How many houses they have, 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.

Suitability

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

The biggest one is the suitability standard, in that we must have 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.

Institutional accounts will be considered customer-specific suitability provided that the representative and firm have a reasonable basis to believe they are capable of evaluating investment risks, and would therefore be a “sophisticated investor”.

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”.

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. There are different types of institutions, ones that have for decades, or even over a century have been managing money, and currently are managing many billions. You also have the institutions with 100-250m in investable assets (closer to the bottom of the definition), who only recently got to this position, 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.

• Certain products pay more than others. That is well known. Is the representative consistently recommending the same product B over competitor A, because B pays more? Or because B is better?
• Recommendations in mutual funds in such a way that would cost the client more money, thus generating more commissions for the representative. This would generally be done by purchasing funds in different fund families. There could be good reasons for that however.
• Representatives could recommend margin to clients where it isn’t appropriate for, maybe not bad, but not the best idea. The purpose would be to generate more commissions from larger trades. There could be good reasons for the client to open a margin account, it really depends on the situation, but is a potential concern.
• Representatives could be promoting proprietary mutual funds, ones made by their firm. This is a very important one to watch out for. It could be done to increase size of the mutual fund, to make it look better on the market. It could be done because the firm pays higher commissions on internal sales. It could also be done because it is the best recommendation for the client. As said, concern in the supervision arena.