'Fiduciary' vs. 'Suitability'

Art by Tim BowerAs the Department of Labor (DOL) attempts to move more retirement accounts to a fiduciary or “best interest” standard, advisers who currently operate under a suitability standard should consider what it means to work as a fiduciary or under a fiduciary-like standard of conduct. Additionally, advisers should evaluate how the two standards differ and in what ways such a change might affect their compliance procedures and business methods. The purpose of this article is to give advisers a high-level overview of these standards of conduct and to highlight some differences and similarities.

Advisers and their supervising firms often operate under a suitability standard as required under applicable Financial Industry Regulatory Authority (FINRA) rules. FINRA Rule 2111 requires that an adviser “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or [adviser] to ascertain the customer’s investment profile.” FINRA goes on to provide for three suitability determinations: 1) “reasonable basis suitability”; 2) “customer-specific suitability”; and 3) “quantitative suitability.”

To meet the reasonable-basis suitability requirement, the adviser must have a reasonable basis to believe, based on due diligence, that the recommendation is suitable for at least some investors. Effectively, this is a threshold test that should be made before a recommendation is made to any client. The customer-specific suitability and quantitative suitability requirements, however, will apply to only particular customers.

In the case of customer-specific suitability, the adviser must determine whether the recommendation is suitable for the client given his investment profile. The adviser should look to facts such as the client’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance and other relevant factors. Quantitative suitability requires an analysis regarding whether a reasonable basis exists for believing that a series of recommended transactions, even if suitable when viewed in isolation, is not excessive or otherwise unsuitable for the specific client based upon his investment profile.

On the other hand, the Employee Retirement Income Security Act (ERISA) provides for what has become known as the “prudent expert” standard. ERISA’s duty of prudence requires that a fiduciary discharge his duties “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

Pursuant to guidance issued by the DOL, the fiduciary must give “appropriate consideration” to those facts and circumstances that, given the scope of its investment duties, the fiduciary knows or should know are relevant to the particular investment or investment course of action involved. These include the role the investment or investment course of action plays in the portion of the plan’s investment portfolio regarding which the fiduciary has investment duties. The DOL points specifically to: 1) making a determination that the particular investment or investment course of action is reasonably designed, as part of the portfolio, to further the purposes of the plan, taking into account the risk of loss and the opportunity for gain, or other return, and 2) considering factors such as the composition of the portfolio with regard to diversification, the liquidity needs of the portfolio, and the projected return of the portfolio relative to the funding objectives of the plan.

The DOL’s desired best interest standard—introduced in its “conflict of interest” proposal—that is applicable to individual retirement accounts (IRAs) provides that a representative “act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person would exercise based on the investment objectives, risk tolerance, financial circumstances and needs of the retirement investor, without regard to the financial or other interests of the adviser, financial institution or any affiliate, related entity or other party.” This looks like the ERISA standard but includes components of what a suitability analysis might look like. In any event, the DOL likely will expect the best interest standard to be interpreted in accordance with ERISA case law and guidance.

On the surface, the ERISA and FINRA standards are different. ERISA requires that an adviser act as a “prudent expert” when making a recommendation, while FINRA requires that the adviser “have a reasonable basis to believe” that a recommendation is “suitable.” However, there is commonality between the two regulators’ guidance in terms of what factors might be considered in determining whether a recommendation is prudent or suitable.

David Kaleda is a principal in the Fiduciary Responsibility practice group at the Groom Law Group in Washington, D.C. He has an extensive background in the financial services sector. His range of experience includes handling fiduciary matters affecting investment managers, advisers, broker/dealers, insurers, banks and service providers. He served on the DOL’s ERISA Advisory Council from 2012 through 2014.