Suitability standards

FINRA Rule 2111 requires financial professionals to follow certain suitability guidelines when recommending securities to customers. Representatives must follow this three-step process to ensure appropriate investment guidance is being given:

• Reasonable-basis obligation
• Customer-specific obligation
• Quantitative obligation

Reasonable-basis obligation

Reasonable-basis suitability requires a broker to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. Reasonable diligence must provide the firm or associated person with an understanding of the potential risks and rewards of the recommended security or strategy.

The quoted language above is directly from FINRA Rule 2111. In plain English, two things must be accomplished in this step. First, a representative must fully understand the benefits and risks of any security they recommend. If a product is too difficult or complex to understand, the representative should not offer it to their clients.

Once the representative has a broad understanding of the security, they must be able to argue it’s suitable for at least some of their customers. If a product is so risky that it wouldn’t suit any of their clients, the representative should forget about it. If it is suitable for some of their customers, they’ll move on to the next step.

Customer-specific obligation

Customer-specific suitability requires that a broker, based on a particular customer’s investment profile, has a reasonable basis to believe that the recommendation is suitable for that customer. The broker must attempt to obtain and analyze a broad array of customer-specific factors to support this determination.

Once a security is deemed suitable for at least some investors, the representative must determine if it’s suitable for the specific investor they will make the recommendation to. This can be determined by analyzing the information provided by the investor on their account form. This information includes:

• Investment objective
• Risk tolerance
• Investment experience
• Investment goals
• Annual income
• Net worth
• Tax status
• Liquidity needs
• General financial situation

Determining if an investor is suitable for a product or security is part art, part science. Certain principles always apply; for example, elderly investors living on small fixed incomes should generally avoid the stock market. However, what if your client is an elderly millionaire with “play money” for the market? The representative’s job is to assess the “big picture” and determine suitability on a holistic level.

One exception to this philosophy is looking for red flags (anything not seeming normal). For example, what if an investor specifies a speculative (very risky) investment objective, but has very little money to lose and significant liabilities (bills) to pay off monthly? In this scenario, it’s essential the representative acts in a fiduciary capacity and avoids exposing their client to high levels of risk, even if it results in the representative losing commissions*.

*Speculative strategies can be complex and involve high commission costs for the investor, leading to more pay for the representative.

If the representative determines the security is unsuitable for their client, they’ll disregard it and look for a better-suited investment. If they find it suitable, they’ll move on to the final step.

Quantitative obligation

Quantitative suitability requires a broker with actual or de facto control over a customer’s account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, is not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile.

Although a security may be suitable for a client, it cannot be recommended in excessive quantities. For example, a covered call may be suitable for an investor, but it would not be a great idea to invest all of the investor’s capital in one strategy. The representative is responsible for determining not only if a security is suitable, but also what allocation into that security is reasonable.

Additionally, this rule prohibits investors from recommending suitable investments to produce commissions, from which many representatives benefit financially. When a representative trades excessively in a customer’s account to enrich themselves, they engage in the prohibited practice of churning.

If a representative is accused of churning, the broker-dealer (and maybe even FINRA) will investigate the matter. For example, FINRA investigated a California broker who engaged in excessive trading, generating $2.2 million in commissions while causing $2.2 million in losses for his clients. This led to a $50,000 fine, a restitution payment of $115,000, and an 18-month suspension. If trades are frequent and seemingly unrelated to the investor’s overall investment objective, representatives are subject to penalties and fines. Additionally, firms may be held liable as well if there was a clear supervision failure that enabled the representative’s actions.