What is Suitable (Suitability)?

An investment must meet the suitability requirements outlined in FINRA Rule 2111 prior to being recommended by a firm to an investor. In most parts of the world, financial professionals have a duty to take steps that ensure the investment is suitable for a client. For example, in the United States, the Financial Industry Regulatory Authority (FINRA) oversees and enforces these rules. Suitability standards are not the same as fiduciary requirements.

Key Takeaways

  • An investment must meet the suitability requirements outlined in FINRA Rule 2111 prior to being recommended by a firm to an investor.
  • Suitability depends on the investor's situation based on the FINRA guidelines.
  • Suitability standards are not the same as fiduciary requirements.

Understanding Suitable (Suitability)

Any financial firm or individual dealing with an investor must answer the question, "Is this investment appropriate for my client?" The firm, or associated person, must have a legally reasonable basis, or high degree of confidence, that the security that they are offering to the investor is in line with that investor's objectives, such as risk tolerance, as stated in their investment profile.

Both financial advisors and broker-dealers must fulfill a suitability obligation, which means making recommendations that are consistent with the best interests of the underlying customer. The Financial Industry Regulatory Authority (FINRA) regulates both types of financial entities under standards that require them to make appropriate recommendations to their clients. However, a broker, or broker-dealer, also works on behalf of the broker-dealer firm, which is why the concept of suitability needed to be defined to safeguard investors from predatory practices.

FINRA Rule 2111 states the customer’s investment profile “includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity 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, are inherently suitable or unsuitable for an investor. Suitability depends on the investor's situation based on the FINRA guidelines. To illustrate, for a 95-year-old widow who is living on a fixed income, speculative investments, such as options and futures, penny stocks, etc., are extremely unsuitable. The widow has a low risk tolerance for investments that may lose the principal. On the other hand, an executive with significant net worth and investing experience might be comfortable taking on those speculative investments as part of their portfolio.

No matter the investor type, suitability requirements cover abnormally high transaction costs and excessive portfolio turnover, called churning, to generate commission fees.

Suitability vs. Fiduciary Requirements

People may confuse the terms suitability and fiduciary. Both seek to protect the investor from foreseeable harm or excessive risk. However, the standards of investor care are different. An investment fiduciary is any person who has the legal responsibility for managing someone else's money. Investment advisors, who are usually fee-based, are bound to fiduciary standards. Broker-dealers, customarily compensated by commission, generally have to fulfill only a suitability obligation.

A financial advisor has the responsibility to recommend suitable investments while still adhering to the fiduciary standards. The standards require advisors to put their client's interests above their or their firm's interests. For example, the advisor cannot buy securities for their account before recommending or buying them for a client's account. Fiduciary standards also prohibit making trades that may result in the payment of higher commission fees to the advisor or their investment firm.

The advisor must use accurate and complete information and analysis when giving a client investment advice. To avoid conflict of interests, the fiduciary will disclose potential conflicts to the client, and then will place the client's interests before their own. Additionally, the advisor initiates trades under a best execution standard, where they work to execute the transaction at the lowest cost and with the highest efficiency.