Suitability Obligations

Suitability is one of the most important concepts in securities regulation. Representatives must have a reasonable basis to believe that any recommendation is appropriate for the customer based on their investment profile.

FINRA Rule 2111: Suitability

FINRA Rule 2111 requires that a firm or associated person have a reasonable basis to believe that a recommended transaction or investment strategy involving securities is suitable for the customer.

This determination is based on information obtained through reasonable diligence to ascertain the customer's investment profile.

The Three Components of Suitability

Rule 2111 is composed of three main obligations:

1. Reasonable-Basis Suitability

Example: Before recommending a leveraged ETF, the rep must understand how daily rebalancing works and that it's only suitable for sophisticated, short-term traders - not for most buy-and-hold investors.

2. Customer-Specific Suitability

Example: Even if high-yield bonds are suitable for some investors, they may not be suitable for THIS customer who needs capital preservation and low risk.

3. Quantitative Suitability

Key factors for quantitative suitability:

• Turnover rate - How frequently the portfolio is traded
• Cost-equity ratio - Trading costs relative to account value
• In-and-out trading - Short-term buying and selling

Key Point: A series of recommendations that are individually suitable can still violate quantitative suitability if, taken together, they result in excessive trading or costs.

Customer Investment Profile

Suitability is based on the customer's investment profile, which includes:

Regulation Best Interest (Reg BI)

Effective June 30, 2020, Regulation Best Interest establishes a higher standard for recommendations to retail customers:

Reg BI Standard: Act in the best interest of the retail customer at the time the recommendation is made, without placing the financial interests of the broker-dealer ahead of the customer.

Reg BI vs. Suitability

Key Point: Compliance with Reg BI satisfies Rule 2111 suitability requirements, but not vice versa. Reg BI is the higher standard.

The Four Reg BI Obligations

1. Disclosure Obligation

Must disclose in writing:

• Material facts about the relationship
• Fees and costs
• Type and scope of services
• Conflicts of interest
• Whether firm is a broker-dealer or investment adviser

Form CRS: A standardized relationship summary required for all retail customers.

2. Care Obligation

Exercise reasonable diligence, care, and skill to:

• Understand risks, rewards, and costs of recommendations
• Have a reasonable basis to believe recommendation is in customer's best interest
• Have a reasonable basis to believe the recommendation is suitable
• Consider reasonably available alternatives

3. Conflict of Interest Obligation

Establish written policies to:

• Identify all conflicts associated with recommendations
• Disclose or eliminate conflicts
• Mitigate conflicts that create incentives to put firm's interest ahead of customer
• Eliminate sales contests, quotas, bonuses based on specific products

Key Point: Some conflicts can be mitigated through disclosure. Others are so acute they must be eliminated entirely.

4. Compliance Obligation

• Establish, maintain, and enforce written policies and procedures
• Reasonably designed to achieve compliance with Reg BI
• Applies to the broker-dealer entity

Documentation Requirements

Best practices for documenting suitability:

• Customer investment profile information
• Rationale for the recommendation
• Alternatives considered
• How recommendation fits customer's objectives
• Customer acknowledgment of risks

Key Exam Points

1. Three suitability components - Reasonable-basis, customer-specific, quantitative
2. Reasonable-basis - Suitable for at least some investors
3. Customer-specific - Suitable for THIS particular customer
4. Quantitative - Series of transactions not excessive
5. Reg BI - Higher "best interest" standard for retail customers
6. Four Reg BI obligations - Disclosure, care, conflict of interest, compliance
7. Reg BI satisfies 2111 - But not vice versa