What Is the Suitability Standard?
Brokers must follow the suitability standard when they recommend investments for clients. Here’s how it works and why it’s important.
Financial advice can have significant ramifications on your bottom line. For this reason, professionals in the field must adhere to ethical standards and rules to protect clients and remove conflicts of interest. The suitability standard is one such policy. It applies to broker-dealers who register with the Financial Industry Regulatory Authority (FINRA).
While somewhat similar to the more known fiduciary duty, the suitability standard is more flexible and governs broker-dealers. These are advisors who point you toward various investments and products in hopes of earning a commission. Unlike the former, which requires advisors to only recommend products that are in your best interest, the latter allows brokers to recommend anything “suitable” for the investor.
In this article, we’ll explain what the suitability standard means and how it works. You’ll also learn how it differs from the fiduciary duty. Finally, we’ll answer frequently asked questions on the topic.
Suitability Standard Definition
The suitability standard is a FINRA rule that controls the interactions between broker-dealers and their clients. It exists to protect investors and maintain ethical practices between each party. The policy stipulates that a firm or individual acting as a broker must only recommend products or investments involving securities that are suitable for the investor.
But what makes an investment or product suitable for a client? FINRA explains that a customer’s “investment profile” informs whether a security or strategy is right for them. A client’s investment profile takes the following factors into account (but isn’t limited to them):
- Other investments in their portfolio
- Time horizon
- Risk tolerance
- Need for liquidity
According to FINRA, to adequately follow the rule, a broker must have a “firm understanding” of the client and the products they recommend. Without either, they wouldn’t know whether a given security or product is appropriate for a client. If a firm or individual fails to display this understanding, they will violate the suitability standard.
Three Types of Suitability
FINRA’s suitability standard outlines three types of suitability. Each dictates a firm’s or individual’s ability to determine whether a product or investment is the right fit for a client. Here’s a breakdown of each type:
With this obligation, brokers must reasonably believe a recommendation is suitable for some or all investors. FINRA says there must be “reasonable diligence” done beforehand, which identifies potential risks and rewards. Without it, one cannot gauge whether a product is appropriate for a given investor.
Customer-specific suitability requires brokers to make recommendations based on a client’s investment profile. As mentioned above, this includes key details regarding an investor’s risk tolerance, age, time horizon, and more. All of this informs whether a security is right or appropriate for a given person.
The quantitative obligation applies to brokers who wield control over a client’s portfolio. It requires them to have a “reasonable basis” for “believing” that transactions they recommend are suitable for a client and not “excessive,” per FINRA’s website. This reasonable basis should be dependent on an investor’s profile.
Fiduciary vs. Suitability Standard
Both the fiduciary and suitability standards are policies that regulate financial institutions and advisors; however, there are notable differences between the two. The fiduciary duty applies to investment advisors, especially those registered with the SEC as a registered investment advisor (RIA). The latter dictates the types of investments or products broker-dealers that register with FINRA make to clients.
Under the fiduciary standard, an advisor must act in their clients’ best interest at all times, including when they suggest products, services, or investments. Therefore, because it often tends to present conflicts of interest, fiduciary professionals typically don’t collect commissions.
On the other hand, the suitability standard only requires brokers to make recommendations that are appropriate for a client based on their investment profile. This means that, even if a security isn’t necessarily in a customer’s best interest, a professional may still recommend it. Brokers may also collect a commission from clients upon purchase of products they suggest.
Which Is Better?
There is no question that the fiduciary standard is stricter for professionals than the suitability standard. In this way, if you work with a fiduciary, you can rest assured that you have more protection from outside influences or extra costs. However, when you work with a broker, fees may be cheaper or non-existent due to the commissions they charge. If you do end up working with someone who only follows the suitability standard, be cautious and ensure you agree with their recommendations.
What Is a Broker-Dealer?
Broker-dealers are individuals or firms that trade securities on behalf of clients, as well as for their own accounts. They’re typically registered with the SEC and a self-regulatory organization (SRO), such as FINRA. Firms with the broker-dealer classification may also be registered as an RIA with the SEC.
At a minimum, broker-dealers must adhere to the suitability standard. Whenever they recommend a security, it must be appropriate for the client based on their investment profile. However, they must also follow the SEC’s regulatory best interest rule, which we’ll break down further later in this article.
How FINRA Regulates Broker-Dealers
Many broker-dealers follow regulations, such as the suitability standard, imposed by FINRA. Whenever there is a regulatory action against them, such as a criminal proceeding, they must report it to FINRA as a disclosure. You can verify a company’s or individual’s disclosures, as well as their credentials using FINRA’s BrokerCheck search tool.
Brokers Must Also Follow the Regulatory Best Interest Rule
FINRA requires broker-dealers to follow both the suitability standard and the SEC’s regulatory best interest (RBI) rule. With the RBI rule, individuals and firms must act in the best interest of “retail customers” without putting the financial needs or goals of the firm ahead of clients. This means that a firm may not recommend a product simply because it will generate a higher commission for them if another security is in the best interest of the client.
Frequently Asked Questions
Is the suitability standard more stringent than the fiduciary standard?
No, it isn’t as strict as the fiduciary duty. This is because it only requires a professional or firm to suggest securities that are “suitable” for clients based on details like their risk tolerance, time horizon, and other investments. Conversely, fiduciaries must only recommend or buy products that are in their client’s best interest.
How do I know if a firm is a broker with FINRA?
To check if a firm is registered with FINRA, you can use the BrokerCheck tool. Here, it’ll outline a company’s disclosures, key information, and registration status.
How is suitability assessed?
A security is suitable for a client if it is conducive to their investment profile. This is a set of details about an investor that tells brokers a story about the types of investments that would be appropriate for them. Here’s what generally makes up a client’s investment profile:
- Other investments in their portfolio
- Time horizon
- Risk tolerance
- Liquidity needs
A firm or individual professional will breach the suitability standard if they don’t attempt to consider any of the above before recommending products or investments.
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