What does suitability mean?
Generally, suitability means the appropriateness of one thing towards another. This definition is also applicable to trading and investments. Suitability is an ethical standard applied to investments that hold financial professionals when engaging with clients. Financial professionals like brokers, money managers, financial advisers, and the like need to consider steps to ensure that the asset is suitable or appropriate with the investor’s goals, risk tolerance, and needs before making a recommendation. The FINRA or Financial industries regulatory authority is the entity that oversees and enforces a standard that outlines suitability requirements in the US. It can be seen in its Rule 2111.
Entities that deal with investors should always think first whether an investment is suitable for them or not. More than that, they should have a legal and reasonable basis or massive confidence that the offered security to the investor matches his objectives. For example, it should match with his needs and goals enumerated in the investment profile.
Financial advisors and broker-dealers have a suitability obligation to their clients. It refers to consistent recommendations that put first the best interest of the investor. FINRA ensures that both financial advisors and broker-dealers are regulated, and they do their duty to give suitable recommendations to their clients. But what about brokers and broker-dealers? They work under the broker-dealer firm. Hence, investors should fully understand the concept of suitability to protect them from people who take advantage.
FINRA’s Rule 2111
This rule says that no investment is permanently suitable or unsuitable for clients. However, outright scams are out of the question since they are automatically wrong, and no one wants to have them. On the other hand, an investment’s suitability depends on his situation and makeup. In Rule 2111, we will find three significant suitability obligations for broker-dealers with their representative, and they are:
- Reasonable-basis suitability
- Customer-specific suitability
- Quantitative suitability
The confusion between fiduciary requirements and suitability
Some people mistake fiduciary requirements as suitability and vice versa. They might have similarities, but they are entirely different things. While they both aim to protect investors from risks, fiduciary and suitability standards are not the same. First, fiduciary standards are stricter. An investment fiduciary is legally responsible for managing another person’s money. For example, investment advisors follow fiduciary standards. Their payments are usually fees. On the other hand, broker-dealers who usually earn by commission fees have suitability obligations.
For example, financial advisors should not buy financial securities for themselves until they recommend or buy them for their client’s accounts. Why? Because they are fiduciaries who need to put their clients’ best interests first, even before theirs. Fiduciary standards also do not allow trades that may lead investors to pay more commission to the advisor or investment firm.
Let us wrap it up.
There are more things to say about suitability but let us summarize things that we learned today. Suitability is an ethical and applicable standard involving investments that hold financial professionals when dealing with clients. FINRA Rule 2111 consists of suitability requirements that investments must meet before a fiduciary recommends it to the investor. Also, suitability standards are different from fiduciary requirements. Suitability will always depend on an investor’s position based on the FINRA guidelines.