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The Evolution of Suitability Principles

Korean Financial Planning Professional Sunho KimBy Sunho Kim, CFP

South Korea’s suitability principle was established by the Financial Investment Services and Capital Markets Act, which was enacted in August 2007, and implemented in February 2009. The new principle calls for investors to be classified into ordinary or professional investors, and requires that investment recommendations are deemed suitable for an ordinary investor in light of his or her investment purpose, status of property and experience.

Details of the suitability principle are contained in the Standard Working Rules on Investment Recommendations, put forth by Korea Financial Investment Association. The Working Rules stipulate that investment recommendations unsuitable for a customer, in light of the customer information, shall not be made, and that a recommendation of a financial product that carries a higher risk than the customer’s investment preferences can bear, shall be prohibited. Furthermore, with regard to the derivatives in the public and over-the-counter markets, a classification of products that can and cannot be recommended shall be made in light of the investor’s age and investment experience. The investor’s investment propensity shall include factors such as age, investment time horizon, types of financial products suitable for investment experience, level of knowledge on financial products, the proportion of investment assets in the entire portfolio, income patterns, and the capacity for loss.

IOSCO’s Suitability Report

In February 2012, The International Organization of Securities Commissions (IOSCO) specified Principle 5 in the “Suitability Requirements with Respect to the Distribution of Complex Financial Products: Consultation Report” as follows:

Whenever an intermediary recommends to a customer that it purchase a particular complex financial product, including where the intermediary advises or otherwise exercises investment management discretion, the intermediary should be required to take reasonable steps to ensure that recommendations, advice or decisions to trade on behalf of such customer are based upon a reasonable assessment that the structure and risk-reward profile of the financial product is consistent with such customer’s experience, knowledge, investment objectives, risk appetite and capacity for loss.

Here, experience and knowledge do not just include the nature, volume and frequency of previous transactions and level of familiarity with certain products and services, but the customer’s profession, former professional experience, and level of financial education, as well. The capacity for loss includes financial situations such as assets and income, as well as general capacity to withstand losses.

While Korea asks about the level of knowledge on financial products, IOSCO addresses the level of financial education. Determining a financial consumer’s financial capacity and providing a service and a product consistent with that, renders the level of financial education more appropriate than the level of knowledge on financial products. Understanding a customer’s financial objectives, goals, distributions, and present and past professions — the factors that are missing in Korea’s suitability principle — will be useful in providing the financial consumer with better products and services.

FINRA Rule, 2111

The new FINRA rule, 2111, that was implemented July 9, 2012, requires that a broker-dealer or associated person “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 associated person to ascertain the customer’s investment profile.” The new rule, then, codifies the following three main suitability obligations that the broker-dealer has to fulfill:

Reasonable-Basis Suitability: “A broker must perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and determine whether the recommendation is suitable for at least some investors based on that understanding.”

Customer-Specific Suitability: “A broker must have a reasonable basis to believe that a recommendation of a security or investment strategy involving a security or securities is suitable for the particular customer, based on the customer’s investment profile.”

Subsequently, the new rule broadens the explicit list of customer-specific factors that firms and associated persons generally must attempt to obtain and analyze when making recommendations to customers, by adding a customer’s age, investment experience, time horizon, liquidity needs, and risk tolerance to the explicit list of the factors from the predecessor rule, i.e., other investments, financial situation and needs, tax status, and investment objectives.

Quantitative Suitability: “A broker who has control over a customer account must have a reasonable basis to believe that a series of recommended securities transactions are not excessive.”

We can see such factors as financial needs, tax status, investment objectives, and quantitative suitability added here, which are still not found in South Korea’s Suitability Principle.

CFP Professional Code of Ethics is More than Enough

Compared with those of IOSCO and the U.S., Korea’s Suitability Rules have room for improvement, but from the perspective of a CFP professional‘s client, no more regulation is necessary. I say this because of the three factors that never fail to be included in the definition of financial planning — the client’s life goals, putting the client’s interest first (the first rule in the code of ethics), and the fiduciary duty to the client. These three standards are more suitable rules for the client than any present or future suitability principles.

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