Suitability takes on new meaning with client-focused reforms

This means you must have met the enhanced know-your-client (KYC) standard by having a thorough understanding of the client, their financial and personal circumstances, their risk profile, and their goals. You must also have a thorough understanding of the securities you’re recommending, based on the due diligence you conducted to meet the enhanced know-your-product (KYP) requirements.

Then, to make a recommendation, you must consider what’s suitable for the client based on their KYC information and your KYP knowledge, and finally apply the “client’s interest first” standard. Some securities that meet the current suitability standard may not meet the new “client’s interest first” standard. While this does not mean that there will always be only one option to recommend, it is likely to mean that some otherwise suitable products will no longer be appropriate to recommend in a particular client’s circumstances.

Put differently, suitability alone is no longer enough. Advisors must put the client’s interest first when selecting from multiple suitable options available to the client, and they must document the basis for their recommendation.

Here are next steps for advisors when making a suitability determination under the CFRs.

1. Put the client’s interest first

Putting the client’s interest first is a new standard, applied on top of the current suitability standard. While there may be a range of possible suitable recommendations, the regulators state that putting the client’s interest first means putting their interest ahead of competing considerations, such as a higher level of remuneration or other incentives. This puts a focus on the exercise of an advisor’s professional judgment when opting for one recommendation from among several suitable options.

While the enhanced suitability requirements do not represent a fiduciary standard and many advisors have worked to put clients’ interests first for years, the new regulations will require better documentation — and more of it — backing up your advice. Practically speaking, it will further emphasize the importance of documentation and note-taking to capture the reasoning behind a recommendation.

2. Assess the potential and actual impact of costs on the client’s overall return

Although many advisors have been making this assessment, this is a new requirement from the regulators. As costs can have a significant impact on a client’s return over time, you must assess the relative costs (both initial and ongoing) and consider their impact on the client when making a suitability determination. The regulators call out that this must include all compensation paid, directly or indirectly, to the dealer or advisor.

It is not necessary to recommend the lowest-cost product; just to be sure to consider the impact of costs. However, where most elements of several comparable products are equal, it will be more difficult to justify recommending a higher-cost product without a good rationale.

3. Review concentration and liquidity

Concentration and liquidity are also a focus for the regulators in the CFRs. The regulations indicate that the higher the concentration is in a particular type of security, sector or industry, the more steps the advisor should take to demonstrate that the investment meets the enhanced suitability standard — which means regulators will expect more documentation. They also call out the impact of over-concentration on both the risk and liquidity of a client’s investments.

Following the usual principles of diversification should be sufficient to meet the suitability standard in this area.

4. Keep suitability current

Suitability must be re-assessed in the following circumstances:

• The advisor becomes aware of a material change to a product in the client’s account that could result in the account becoming unsuitable
• The advisor becomes aware of a change in the client’s KYC information that could result in the account becoming unsuitable
• If neither of the other circumstances has occurred, no more than three years after the last KYC update

Regardless of the requirement to update a client’s KYC information every three years, a best practice is to have regular client meetings or conversations to be aware of important changes in a client’s life. If there are no significant changes, a KYC update is not required unless you are at the end of the three-year update cycle.

5. Consider account-type suitability

A suitability assessment must include the type of account recommended, the dealer/ advisor compensation option, and the nature of the services offered to a client. They must be suitable and put the client’s interest first. The CFRs require that the advisor explain the features and associated costs of different types of accounts available to the client and recommend the type of account that puts the client’s interest first.

6. Ensure that a “no change” recommendation is suitable

When you are re-assessing suitability, it’s possible you may recommend that a client continue to hold the securities in their account. Under the CFRs, the regulators clarify that even a “no change” recommendation is a recommendation, and all of the enhanced KYC, KYP and suitability obligations must be met.

7. Document, document, document

Finally, as I’ve indicated in the other articles in this series, the regulators have increased the focus on documentation and note-taking. The regulators expect you to be able to demonstrate that you met the enhanced standard and put the client’s interest first when making a suitability determination. Ensure that you capture your rationale for recommending products to a client in your notes for each advice conversation.