8.5 Suitability & Know Your Customer
Investment advisers have a duty to understand their clients and make recommendations appropriate for each client's unique situation. This obligation goes beyond merely avoiding unsuitable recommendations - it requires acting in the client's best interest.
Know Your Customer (KYC) Requirements
Information Gathering Framework
Investment advisers should collect comprehensive information in three categories:
Financial Information
- Income: Current salary, bonus, other income sources, stability
- Net Worth: Assets, liabilities, liquid vs. illiquid
- Tax Status: Federal/state brackets, tax-advantaged account capacity
- Cash Flow: Monthly surplus, large upcoming expenses
- Existing Investments: Current holdings, cost basis, concentration
- Debt: Mortgages, loans, credit cards, student loans
Personal Information
- Demographics: Age, marital status, dependents
- Employment: Status, stability, benefits, retirement plans
- Health: General health, insurance coverage, special needs
- Education: Investment knowledge, financial sophistication
- Life Events: Upcoming retirement, marriage, children, inheritance
Investment Profile
- Objectives: Growth, income, preservation, speculation
- Time Horizon: When will funds be needed?
- Risk Tolerance: Psychological comfort with volatility
- Liquidity Needs: Emergency fund, planned purchases
- Special Constraints: Ethical restrictions, concentrated positions
Investment Objectives
Primary Objectives Spectrum
From most conservative to most aggressive:
- Preservation: Goal: Protect principal; Typical Investor: Retirees, short horizon; Risk Level: Lowest
- Income: Goal: Generate cash flow; Typical Investor: Retirees, income-dependent; Risk Level: Low-Moderate
- Growth & Income: Goal: Balanced appreciation + cash flow; Typical Investor: Mid-career professionals; Risk Level: Moderate
- Growth: Goal: Capital appreciation; Typical Investor: Long time horizon investors; Risk Level: Moderate-High
- Speculation: Goal: Maximum returns; Typical Investor: High risk tolerance, money can afford to lose; Risk Level: Highest
Balancing Competing Objectives
Most clients have multiple objectives that create trade-offs:
- Safety vs. Return: Conservative Choice: CDs, Treasuries; Aggressive Choice: Equities, alternatives
- Income vs. Growth: Conservative Choice: Dividend stocks, bonds; Aggressive Choice: Growth stocks
- Liquidity vs. Yield: Conservative Choice: Money markets; Aggressive Choice: CDs, bonds held to maturity
Suitability vs. Fiduciary Standard
Understanding the distinction between these standards is critical for the Series 65.
Suitability Standard (Broker-Dealers)
The traditional FINRA Rule 2111 suitability standard has three components:
1. Reasonable-Basis Suitability
- The investment must be suitable for at least SOME investors
- Adviser must understand the product being recommended
2. Customer-Specific Suitability
- The investment must be suitable for THIS particular client
- Based on client's profile and circumstances
3. Quantitative Suitability
- The quantity of transactions must be suitable
- Prohibits excessive trading (churning)
Fiduciary Standard (Investment Advisers)
Investment advisers are held to a HIGHER standard - fiduciary duty:
- Duty of Care: Provide advice in client's best interest; seek best execution; provide advice and monitoring
- Duty of Loyalty: Put client's interests ahead of your own; eliminate or fully disclose conflicts
- Full Disclosure: Disclose all material facts and conflicts of interest
- Best Interest: Recommend what's BEST for client, not just what's suitable
Key Differences
- Timing: Suitability Standard: At time of recommendation; Fiduciary Standard: Ongoing relationship
- Level: Suitability Standard: Must be suitable; Fiduciary Standard: Must be in best interest
- Conflicts: Suitability Standard: Must be disclosed; Fiduciary Standard: Must be eliminated or disclosed
- Whose Interest: Suitability Standard: Must be fair; Fiduciary Standard: Must put client FIRST
- Applies To: Suitability Standard: Broker-dealers; Fiduciary Standard: Investment advisers
Regulation Best Interest (Reg BI)
In 2020, the SEC implemented Regulation Best Interest, enhancing broker-dealer obligations.
Reg BI Four Obligations:
1. Disclosure: Provide Form CRS; disclose material facts
2. Care: Exercise reasonable diligence, care, and skill
3. Conflict of Interest: Establish policies to identify and mitigate conflicts
4. Compliance: Establish policies reasonably designed to achieve compliance
Note: Reg BI is HIGHER than old suitability but still NOT a full fiduciary standard.
Red Flags and Warning Signs
Suitability Red Flags
- Aggressive investments for conservative clients
- Illiquid investments for clients needing liquidity
- Complex products for unsophisticated investors
- High-cost products when lower-cost alternatives exist
- Concentrated positions without justification
- Excessive trading (churning)
- Recommendations inconsistent with stated objectives
Documentation Best Practices
- Use standardized intake questionnaires
- Document client responses in writing
- Update profiles at least annually
- Note any changes in circumstances
- Record rationale for recommendations
- Keep records of client communications
On the Exam
Series 65 frequently tests:
- The difference between suitability and fiduciary standards
- That fiduciary duty is ongoing, not just at time of recommendation
- KYC information categories (financial, personal, investment profile)
- Matching investment objectives to client characteristics
- Red flags indicating unsuitable recommendations
Key Takeaways
1. KYC requires gathering financial, personal, AND investment profile information
2. Fiduciary standard requires acting in client's BEST interest, not just suitable
3. Fiduciary duty is ONGOING; suitability applies at time of recommendation
4. Investment advisers must put client interests AHEAD of their own
5. Always document client information and recommendation rationale
6. Red flags include mismatched risk levels, illiquidity for those needing liquidity, and excessive costs