Douglas Szempruch (CRD# 4159318), previously a stockbroker in Melville, New York, was sanctioned by the Financial Industry Regulatory Authority over...Read More
FINRA Rule 2111 mandates that financial advisors and brokerage firms only recommend investments or investment strategies that are suitable for the client. When making the suitability determination, the financial advisor must take into account the investor’s risk tolerance, age, investment objectives, investment experience, financial situation and needs, investment time horizon, other investments, and tax status.
Under Rule 2111, there are three types of suitability analyses the advisor must conduct: reasonable-basis, customer-specific, and quantitative. Below is a discussion of each:
The reasonable-basis rule for suitability mandates that a financial advisor must possess a “reasonable basis” to conclude, based on “reasonable diligence,” that the investment being recommended is “suitable for at least some investors.” Under the reasonable diligence standard, the investment firm or financial advisor must have knowledge of the risks associated with the security or investment strategy. This standard is quite low, as most investment opportunities are suitable for at least some investors. However, because the rule also requires firms to understand the potential risks of the investment, a firm who fails to conduct due diligence into an investment and understand those risks is in breach of the suitability rule.
Customer-specific suitability mandates that a financial advisor have a “reasonable basis” to believe that the investment being recommended is suitable for that specific customer, given that customer’s investment profile. The financial advisor has an obligation to understand the customer’s investment profile. This is typically done with a new account form, which asks the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance.
Quantitative suitability mandates that a financial advisor with control over the trading in a client’s account have a “reasonable basis” for believing that the trading, as a whole, is not excessive or unsuitable. This means that even though the purchase of a single stock may be suitable, it may be unsuitable given the rest of the customer’s holdings. This also means that the financial advisor should not engage in the practice of churning, which is when an advisor trades too much in an account, causing oversized commissions to be charged to the customer.
Below is an analysis of each factor that a financial advisor must consider when performing a suitability analysis:
An investor’s age is an important factor when determining suitability. Investors at or near retirement may not be able to withstand fluctuations within their portfolio if their assets do not exceed what is needed to support them in retirement. On the other hand, a young investor may be able to withstand larger fluctuations in his or her portfolio if the funds will not be needed until later in life. This is a similar concept to investment time horizon (see below).
Other investments may be a relevant factor when determining suitability of an investment recommendation. For example, if an investor has the majority of his or her net worth in stocks, it may be unsuitable for a financial advisor to recommend additional stocks, instead of diversifying into other asset classes.
Financial Situation and Needs
An investor’s financial situation and needs refers to the customer’s income, net worth and financial needs or expenses. This information must be factored when determining what investments are suitable for the customer. For instance, it may be unsuitable for a financial advisor to recommend risky investments to a person who only needs a three percent return to sustain their desired lifestyle.
Occasionally an investment may be unsuitable based on the taxation of that investment to the specific investor. For example, it would be unsuitable for a financial advisor to recommend a taxable security when there is a non-taxable equivalent available to residents or non-residents of certain jurisdictions.
An investor’s investment objectives are probably the most important factors in determining whether an investment is suitable or not. When an investor opens a new account with a brokerage or investment advisory firm, the investor is typically asked to choose (or rank) from the following investment objectives: Preservation of Capital; Current Income; Growth and Income; Capital Appreciation; and Aggressive Growth.
A financial advisor is then only allowed to recommend investments that fit within those objectives. For example, if an investor’s objectives are Preservation of Capital and Current Income, it would be unsuitable for a financial advisor to recommend a portfolio of stocks because stocks are typically subject to mild to heavy fluctuations and lower levels of current income (unless the stocks are high dividend paying stocks).
The idea behind investment experience as it relates to suitability is the notion that only experienced investors should take on risky investments. For example, someone who has not invested in stocks for a long time may have never experienced a crash (or even dip) in the market, and may not appreciate the risks of the stock investment compared to someone who has been investing for many years and has witnessed many market crashes first hand.
As another example, someone who has only invested in municipal bonds may not appreciate the risks involved in junk bonds. For those reasons, financial advisors should only recommend investments that are in line with the investor’s experience or understanding.
Investment Time Horizon
If an investor needs to spend their investment funds during a downward fluctuation in the market, the portfolio has no chance of recovering the losses because the funds will be used and not reinvested. For that reason, if an investor needs access to their funds in a short period of time, the investor cannot afford to take risk and have fluctuations in their portfolio. This is why time horizon is so important when determining the suitability of investments. In other words, someone who does not need access to their funds for 10, 20, or 30 years may hypothetically be able to take more risk (if they desire) than someone who needs their money in 1, 5, or 7 years. Even though the stock market has proven to always rise in the long term, markets can decline in the short term.
Liquidity needs are an important factor to suitability. Liquidity means the ability to convert your investments to cash quickly and at a fair price. Investors may need to maintain certain levels (or high levels) of liquidity to finance their retirement, purchase of a home, pay taxes, etc.
Some investments are known for being illiquid. Examples include real estate (including certain Real Estate Investment Trusts), many private placement securities, promissory notes, private equity investments and funds, and venture capital investments and funds. If an investor needs liquidity, illiquid investments would be considered unsuitable.
Risk tolerance is likely the most important factor when determining whether an investment is suitable for an investor. Some investors are risk averse, and do not have an appetite for risk or losses. Some investors cannot afford a loss financially, because they need the money for their support. Other investors, even if they can financially afford to take a loss, still do not have an appetite for risk, and are risk averse. A financial advisor is required to understand the client’s risk tolerance, and only recommend investments that are suitable given the investor’s risk tolerance.
Financial advisors are only permitted to sell suitable investments. Investors are able to recover from financial advisors and wealth management firms when unsuitable investments are recommended to them. Not only is the sale of unsuitable investments a violation of FINRA Rule 2111, but it is also a breach of fiduciary duty and a form of negligence.
Please contact us for a free and confidential case evaluation if you believe you have been sold unsuitable investments.