Broker-Dealers and Investment Advisers: A Behavioral-Economics Analysis of Competing Suggestions for Reform

AuthorDemina, Polina

Introduction

People often must rely on the relative expertise of others in making deci- sions. People rely on the advice of a waiter for good dishes at a restaurant, and they rely on their doctor to recommend a course of treatment when they have fallen ill. These situations are different, of course, but they both present a person with the fundamental decision of whether to trust another person's relative expertise. Such interactions are ubiquitous and unavoida- ble. They are also beneficial, because they save time and promote effi- ciency- just imagine having to learn every skill needed to make these decisions. Similarly, investors rely on expert advice when consulting their financial advisers. For example, retail investors, who are investing to save for retirement, college funds, or a home purchase, often possess little knowledge of investment strategies or products and therefore must trust others to help them make these decisions.1

Investment advisers and broker-dealers both provide retail investors with expert financial advice. Despite this similarity, however, investment ad- visers and broker-dealers operate under very different regulatory regimes governing their relationships with their clients. Moreover, they have differ- ent financial incentives, which often diverge from the interests of their cli- ents. But neither of these differences is readily apparent to retail investors, who consequently do not understand how the differences impact them.2 In- vestment advisers are bound to offer investments that they believe are in the best interests of their client, and they are generally paid a fee regardless of whether the client buys or sells a particular investment. As a result, invest- ment advisers do not have any incentive to "sell" the investor on particular financial products.3 Not so with broker-dealers. They are bound only to find investments that are suitable for their clients-a lower standard-and they are generally paid commission on the sale of a financial product. Conse- quently, they have incentives to sell such products.4 Even though these prod- ucts are suitable for clients, they may not be optimal for their investment needs. This reality stems in part from the fact that broker-dealers' commis- sion on a product is tied to its riskiness, which means that a riskier product yields a higher commission, a situation that creates divergent incentives for broker-dealers and their clients.5

These two financial intermediaries have different standards of care with respect to their clients. Investment advisers are fiduciaries, charged with pro- viding investments that are in the best interests of their clients.6 Broker- dealers, by contrast, are salesmen of financial instruments who may provide personalized financial advice but are not fiduciaries. Instead, they are charged simply with providing investments suitable to their clients' needs.7 While investment advisers and broker-dealers serve many similar purposes for investors today, the difference in these standards of care stems from their historically different roles.8 Broker-dealers were originally exempted from the regulatory regime governing investment advisers because they were al- ready regulated under their own legal regime and because the services they provided were readily distinguishable from those provided by investment advisers.9 In the 1980s and 1990s, however, that distinction blurred as more broker-dealers started offering advising services and "us[ing] titles such as 'adviser' or 'financial adviser' for their broker-dealer registered representa- tives and even encourag[ing] customers to think of the registered representa- tive more as an adviser than a stockbroker."10

As part of its package of reforms, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act") mandated a study on the regulation of investment advisers and broker-dealers. Section 913 of the Dodd-Frank Act required the Securities and Exchange Commis- sion ("SEC" or "Commission") to conduct a study evaluating "the effective- ness of [these] existing legal or regulatory standards of care" for broker- dealers and investment advisers and identifying any "gaps, shortcomings, or overlaps ... in the protection of retail customers."* 11 The SEC Staff released a study in January 2011 ("SEC Study") outlining its findings and recom- mending potential rulemaking and policy changes.12 A major finding of the study was that retail investors "do not understand the differences between investment advisers and broker-dealers or the standards of care applicable to broker-dealers and investment advisers."13 Because investors lack this knowl- edge, they are more likely to accept broker-dealers' self-interested advice about suboptimal investments. The study therefore recommended unifying the standards of care required for broker-dealers and investment advisers by making both fiduciaries to their clients-a change that would minimize in- vestor confusion and better protect investors.14 In contrast, an alternative proposal from the Securities Industry and Financial Markets Association ("SIFMA")-a major securities-industry trade group representing securities firms, banks, and asset-management companies15-recommended adopting a unified standard of care focused on disclosure as opposed to a heightened fiduciary standard that relies on prohibitions.16 The SEC has so far not adopted either suggestion.

The SEC's goal is "to protect investors, maintain fair, orderly, and effi- cient markets, and facilitate capital formation."17 As a result, the two com- peting suggestions for reform should be analyzed for their effectiveness as an investor-protection tool. Which of these reforms would have a more pro- nounced effect on retail investors' investment decisions? Sound investor decisionmaking has positive effects not only for individual investors who get better returns but also for the market as a whole because increased investor confidence leads to stronger capital markets.18

A behavioral-economics analysis, which uses well-documented behav- ioral heuristics to assess the effectiveness of laws and policies, offers a useful method of examining the competing suggestions for reform. Behavioral eco- nomics has become an increasingly popular tool of legal analysis because it provides something more than traditional economics, which looks to the rational actor in analyzing the effects of laws.19 More specifically, behavioral economics examines whether scientific evidence supports the assumptions of traditional economics analysis.

Using such a behavioral-economics analysis, this Note argues that, from an investor-protection standpoint, the better approach to help investors make effective long-term investment decisions would be imposing a fiduci- ary- duty standard. The behavioral-eco no mies analysis of the two proposed reforms supports this conclusion by demonstrating that, in contrast to fidu- ciary standards, disclosure standards can actually exacerbate investors' heuristics. Part I summarizes the differences between investment advisers and broker-dealers, examines the current regulatory structures applicable to each, and outlines the underlying policy debate on investor protection. Part II explores the two suggestions for reform and breaks them down into a fiduciary-standard approach and a disclosure approach. Finally, Part III evaluates the two competing suggestions, first using a traditional economics analysis and then employing a behavioral-economics approach. Based on these analyses, this Part concludes that the original SEC Staff proposal- collapsing the standards of care into a single heightened fiduciary stan- dard- is superior to an approach that focuses on disclosure.

  1. Current Differences Between Investment Advisers and Broker-Dealers and an Analysis of the Underlying Policy of Investor-Protection Laws

    Investment advisers and broker-dealers provide similar services to inves- tors, and therefore they look the same from an investor's point of view.20 This misleading similarity puts investors at risk when they think they are getting advice from an investment adviser but are actually getting advice from a broker-dealer.21 The different regulatory structures governing the ac- tivities of broker-dealers and investment advisers explain their divergent in- centives when advising clients and demonstrate how this difference in incentives harms investors. Section I.A details the services and financial products that these financial intermediaries offer. It also provides an over- view of the compensation structures for investment advisers and broker- dealers and explains the nature of their respective client relationships. Sec- tion I.B then looks more closely at the differences in the legal and regulatory regimes governing investment advisers and broker-dealers. Finally, Section I.C examines the underlying policy question of what the SEC should be pro- tecting retail investors from and how it can best achieve those goals. This analysis leads to a discussion in Part II of the competing suggestions for reforming the regulatory oversight of broker-dealers and investment advisers.

    1. Investment Advisers and Broker-Dealers: Services and Products Provided, Compensation Structures, and Relationships with Clients

      Investment advisers and broker-dealers serve distinct but overlapping functions for investors. From the client's perspective, either a broker-dealer or an investment adviser will provide him with access to the financial mar- kets in order to make investments, and each can offer advice in order to help with investment decisions.22 Despite this initial similarity, investment advis- ers and broker-dealers have different compensation structures, and the di- vergent incentives that result can affect their relationships with clients. More specifically, broker-dealers, unlike investment advisers, need to sell some- thing to their clients in order to generate a commission.23...

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