Suitability refers to an ethical, enforceable standard regarding investments that financial professionals are held to when dealing with 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. To determine that, the broker needs to consider certain things about the investor, including the following: Investment goals Investment timeframe Risk tolerance Financial situation and obligations Liquidity needs Current investment portfolio and assets Investment knowledge, sophistication, and experience FINRA's Rule 2111 enumerates three specific kinds of suitability requirements, aka obligations. **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. **Customer-specific:*The broker has to be familiar with the client's age, mindset, financial picture and needs, and investment profile/objectives, in order to feel the investment is suitable for this specific investor.
What Is Suitable (Suitability)?
Suitability refers to an ethical, enforceable standard regarding investments that financial professionals are held to when dealing with clients. Before making a recommendation, brokers, money managers, and other financial advisors have a duty to take steps that ensure the asset or product is suitable — that is, appropriate for — that investor's goals, needs, and risk tolerance. In the U.S., the Financial Industry Regulatory Authority (FINRA) oversees and enforces this standard, outlining suitability requirements in its Rule 2111.
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
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, is inherently suitable or unsuitable for an investor. Instead, its suitability depends on the investor's situation and makeup.
For example, 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.
Types of Suitability Obligations
Rule 2111 lists the three main suitability obligations for broker-dealers and their representatives.
Suitability vs. Fiduciary Requirements
People often confuse the terms suitability and fiduciary. Both seek to protect the investor from foreseeable harm or excessive risk. However, suitability standards are not the same as fiduciary standards — the levels of advisor responsibility and investor care are different.
Fiduciary standards are much more stringent and specific than suitability standards.
An investment fiduciary is any person who has the legal responsibility for managing someone else's money. Investment advisors and money managers, who are usually fee-based, are bound to fiduciary standards. Broker-dealers, customarily compensated by commission, generally have to fulfill only a suitability obligation.
Financial advisors who are fiduciaries have the responsibility to recommend suitable investments while still adhering to the fiduciary requirements of putting 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 any impropriety or appearance of impropriety, the fiduciary will disclose any potential conflicts of interest to the client and then will place the client's interests before their own. Additionally, the advisor undertakes transactions under a "best execution" standard, in which they work to execute the trade or purchase at the lowest cost and with the highest efficiency.
Suitable (Suitability) vs. Best Interest
The mandate to act in the client's best interest, a key part of the fiduciary standard, is noticeably lacking in the suitability standard, though some might argue it's implied. As of 2020, the two have become more officially intertwined.
In June 2019, the Securities and Exchange Commission (SEC) instituted Regulation Best Interest (BI for short). A code of conduct for those who sell and recommend securities, such as brokers, BI states that financial professionals must make investment recommendations that serve the client first and foremost — and to clearly identify any potential conflicts of interest and financial incentives the broker-dealer may have for the sale of those products.
The SEC's Regulation BI is something of a replacement (a weak one, critics charge) for the Department of Labor's Fiduciary Rule of 2017, which would have required that all financial professionals who work with retirement plans or provide retirement planning advice — advisors, broker-dealers, and insurance agents — be legally bound by the fiduciary standard. In June 2018, the U.S. Fifth Circuit Court of Appeals officially vacated the rule, effectively killing it.
In June 2020, FINRA adopted Regulation BI, technically "amending" its Rule 2111 to accommodate it, so that "a broker-dealer that meets the best interest standard would necessarily meet the suitability standard."
While the details of which rule applies when are a little unclear, the bottom line seems to be that a FINRA-registered broker is now required to comply with both Regulation Best Interest and Rule 2111 regarding recommendations to retail investors.
Investment Suitability FAQs
Can a Customer Waive Their Rights Under FINRA 2111?
No, investor clients can't waive their FINRA Rule 2111 rights. FINRA rules contain what is known as “anti-waiver” provisions. These provisions make void any agreements that purport to waive compliance with any FINRA Rules, the Securities and Exchange Act, the Uniform Securities Act, and state blue sky laws.
What Should a Suitability Assessment Consider?
A broker's suitability assessment involves deciding if an investment is appropriate for a particular client before recommending it. To determine that, the broker needs to consider certain things about the investor, including the following:
What Are Suitability Requirements?
FINRA's Rule 2111 enumerates three specific kinds of suitability requirements, aka obligations.
Reasonable basis: The broker has to be reasonably confident that the investment could be suitable for at least some individual investors. Basically, this translates into doing sufficient due diligence on the investment to ensure it is legitimate, and to understand how it works, what its benefits are, and what its risks could be.
Customer-specific: The broker has to be familiar with the client's age, mindset, financial picture and needs, and investment profile/objectives, in order to feel the investment is suitable for this specific investor.
Quantitative: The broker has a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed individually, is not excessive and unsuitable for the customer. This requirement relates to churning an account — making a lot of trades or indulging in a trading pattern primarily to generate commissions.
An associated person is any owner, partner, officer, director, branch manager, or non-clerical or administrative employee of a broker or dealer. read more
A blanket recommendation is a recommendation sent by a financial professional or institution to all clients. read more
Blue Sky Laws
Blue sky laws are state anti-fraud regulations that require issuers of securities to be registered and to disclose details of their offerings. read more
The term broker-dealer is used in U.S. securities regulation parlance to describe stock brokerages because the majority of the companies act as both agents and principals. read more
Churning is excessive trading by a broker in a client's account in order to generate commissions. Discover more about the practice of churning here. read more
A commission, in financial services, is the money charged by an investment advisor for giving advice and making transactions for a client. read more
Conflict of Interest
Conflict of interest asks whether potential bias is risked in actions, judgment, and/or decision-making in an entity or individual's vested interests. read more
A fiduciary is a person or organization that acts on behalf of a person or persons and is legally bound to act solely in their best interests. read more
What does a financial advisor do? Read our complete guide before hiring a financial advisor to ensure that you choose the best financial advisor for your specific needs. read more