These FAQs are part of a series of frequently asked questions that address four primary areas of interest to investment advisers:
- Compliance Program Components;
- Daily Operations;
- Client Protection; and
- Registration and Disclosure
Q1: What is an investment adviser’s suitability requirement?
A1: As fiduciaries, investment advisers owe their clients a duty to provide only suitable investment advice. This duty generally requires an investment adviser to determine that the investment advice it gives to a client is suitable for the client, taking into consideration the client’s financial situation, investment experience, and investment objectives.
Q2: How can an investment adviser satisfy the suitability requirement?
A2: An adviser must (i) take adequate steps to be knowledgeable of each client’s financial situation, securities holdings, risk tolerance, asset mix guidelines and other information necessary to make a suitable investment; (ii) thoroughly understand the security being traded by reviewing and considering information and data from reliable sources supporting the trade; and (iii) make an investment only if it advances the specific objectives and financial situation of the client.
Q3: How can an investment adviser demonstrate that it has a policy to obtain (and maintain) sufficient information regarding the client’s circumstances?
A3: It extremely important for investment advisers to document that they made a suitability determination for each and every client. Examples of documents that an investment adviser may use to determine suitability include client questionnaires, fact sheets, investment objectives confirmation letters and investment policy statements.
Q4: What is an investment adviser’s ongoing suitability obligations?
A4: An investment adviser has ongoing obligation to review and update the suitability determinations that it has made for clients. An adviser should:
- Regularly communicate with clients regarding their investment objectives, financial status, and risk tolerance, document such communications and resulting changes and compare objectives to trading activity;
- Systematically review client accounts to ensure that all investments and associated risks are suitable for the client; and
- Periodically conduct performance comparisons of accounts with like objectives to determine consistency of portfolio management.
Q5: What types of records will the SEC request during or prior to an examination?
A5: The Staff of the SEC may request some or all of the following documents and information pertaining to suitability:
- A description of the process for monitoring client investment guidelines, limitations and restrictions.
- A list of any client restrictions or guidelines that must be monitored manually.
Q6: What are some potential compliance risks associated with suitability?
A6: Potential risks include:
- Failing to establish internal controls to ensure that the suitability of client investments is consistent with regulatory requirements, best practices, firm policies and disclosures.
- Lack of procedures to ensure that the investment advice provided to a client is consistent with the client’s circumstances, expectations, restrictions, directions and risk tolerance.
- Lack of procedures to ensure that the investment advice provided to clients is consistent with the information set forth in your firm’s disclosure documents, marketing material and advisory contracts.
- Failing to systematically review client accounts to ensure that all investments are suitable.
- Failing to periodically conduct performance comparisons of accounts with similar objectives to determine the consistency of portfolio management.
- Making investment recommendations that carry a greater or lesser risk than that disclosed to clients.
- Failing to implement an effective due diligence process through which all relevant features and risks associated with a proposed investment are vetted and approved.
- Lack of consistency between the client’s portfolio and investment objectives, risk tolerance and regulatory restrictions.
- Failing to obtain and maintain information regarding each client’s financial circumstances, investment objectives and risk tolerance.
- Client objectives miscommunicated or not clearly understood by portfolio managers.
- Portfolio manager influences a client to accept higher risk than is suitable for the client’s investment profile.
- Investments made in a client’s account are not suitable for that particular client.
- Failing to periodically rebalance a client’s portfolio in accordance with the client’s investment guidelines.
- Failing to monitor account restrictions.
- Failing to ensure that actual client investments are consistent with an approved list of investments.
- Failing to document changes to a client’s investment objectives and account restrictions.
- Failing to draft an investment policy statement for all clients (if drafted for some).
- Failing to adhere to the investment policy statement.
- Failing to periodically update the investment policy statement.
- Failing to follow up on red flags or indications of improper investments.
- Failing to substantiate that your firm obtained all information related to suitability in a timely, accurate, and complete manner.
- Failing to ensure that information related to suitability is preserved for the required period of time and protected from unplanned destruction, loss, alteration, compromise or use.
Q7: What are some compliance tests an investment adviser can conduct to determine whether the adviser’s policies and procedures adequately address suitability and reflect the firm’s actual practices?
A7: Tests an adviser can run include:
- Reviewing your firm’s compliance policies and procedures to determine whether they adequately address suitability and reflect your firm’s actual practices.
- Determining whether your firm’s internal controls ensure that suitability is consistent with regulatory requirements, best practices, firm policies and disclosures.
- Selecting five client accounts (two of which are long-term clients of your firm) and verify that ongoing suitability documentation is retained for each such account.
- Evaluating controls used to ensure compliance with disclosures made to clients regarding portfolio management activities.
- Reviewing trading to determine whether investments are in line with client objectives, risk tolerance and restrictions.
- Calculating portfolio turnover for a sample of client accounts and compare turnover to the account’s stated investment objectives to look for disparities.
- Reviewing documentation of client objectives and restrictions and compare these with the account’s portfolio holdings and transactions.
- Reviewing and reconcile account statements generated internally against those generated by the account custodian.
- Reviewing securities holdings in client accounts to ensure they reflect securities and investment techniques consistent with applicable account restrictions, investment guidelines, client mandates, diversification and liquidity requirements.
- Calculating various risk metrics on client accounts for relevant periods and compare them to appropriate benchmarks to determine if there is any inconsistency with client mandates, risk tolerance or suitability.
- Calculating relevant percentages on holdings in accounts (e.g., how much in various market cap ranges, stocks/bonds/cash, sector and industry concentration, issues diversification, foreign versus domestic, etc.) at various points in time to determine consistency with investment guidelines, client mandates and risk disclosures.
- Reviewing client accounts to determine that such investments are suitable in light of the client’s financial sophistication, risk tolerance, investment objectives and restrictions.
- Substantiating that your firm obtains all information related to suitability in a timely, accurate, and complete manner.
- Ensuring that information related to suitability is preserved for the required period of time and protected from unplanned destruction, loss, alteration, compromise or use.