Broker-dealers and investment advisers: a behavioral-economics analysis of competing suggestions for reform.

• Author: Demina, Polina

For the average investor trying to save for retirement or a child's college fund, the world of investing has become increasingly complex. These retail investors must turn more frequently to financial intermediaries, such as broker- dealers and investment advisers, to get sound investment advice. Such intermediaries perform different duties for their clients, however. The investment adviser owes his client a fiduciary duty of care and therefore must provide financial advice that is in the client's best interests, while the broker-dealer must merely provide advice that is suitable to the client's interests--a lower standard than the fiduciary duty of care. And yet these divergent standards are not necessarily evident to the average investor. As a result, investors run the risk of being placed into suboptimal investments by broker-dealers.

Two competing solutions to this issue have been proposed: a higher fiduciary standard for both broker-dealers and investment advisers and a less burdensome disclosure standard in which broker-dealers would inform their clients that they are not fiduciaries. This Note analyzes these potential reforms using a traditional economics analysis as well as new behavioral-economics research. It concludes that a fiduciary standard more effectively protects investors and that a disclosure standard would actually have the perverse effect of making investors more susceptible to behavioral biases that can impair their ability to invest properly.

TABLE OF CONTENTS INTRODUCTION I. CURRENT DIFFERENCES BETWEEN INVESTMENT ADVISERS AND BROKER-DEALERS AND AN ANALYSIS OF THE UNDERLYING POLICY OF INVESTOR-PROTECTION LAWS A. Investment Advisers and Broker-Dealers: Services and Products Provided, Compensation Structures, and Relationships with Clients B. Differences in the Legal and Regulatory Structures Governing Investment Advisers and Broker-Dealers C. From What Should the SEC Protect Retail Investors, and How Can It Achieve These Goals? II. THE SEC STAFF'S RECOMMENDATION FOR REFORM AND SIFMA'S ALTERNATIVE RECOMMENDATION A. The SEC Staff s Recommendation for a Uniform Fiduciary Standard That Is No Less Stringent Than the Current Standard Under the Advisers Act B. SIFMA's Recommendation for a Disclosure Regime Instead of a Heightened Fiduciary Standard, Criticism of This Recommendation, and the SEC's Potential Endorsement of SIFMA's Alternative III. A BEHAVIORAL-ECONOMICS PERSPECTIVE ON DISCLOSURE VERSUS PROHIBITION A. A Traditional Economics Analysis of the Two Proposals Is Helpful but Remains Incomplete B. A Behavioral-Economics Analysis of the Disclosure and Fiduciary Standards Provides a More Complete Picture and Shows That a Fiduciary Standard Is Superior to a Disclosure Standard C. Two Further Behavioral-Economics Arguments in Support of a Fiduciary Standard and Against a Disclosure Regime CONCLUSION INTRODUCTION

People often must rely on the relative expertise of others in making decisions. 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 unavoidable. They are also beneficial, because they save time and promote efficiency--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 advisers and broker-dealers operate under very different regulatory regimes governing their relationships with their clients. Moreover, they have different financial incentives, which often diverge from the interests of their clients. But neither of these differences is readily apparent to retail investors, who consequently do not understand how the differences impact them. (2) Investment 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, investment 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. Consequently, they have incentives to sell such products. (4) Even though these products are suitable for clients, they may not be optimal for their investment needs. This reality stems in part from the fact that broker-dealers' commission 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 providing 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 already 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 representatives and even encouraging] customers to think of the registered representative 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 Commission ("SEC" or "Commission") to conduct a study evaluating "the effectiveness 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 recommending 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 knowledge, 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 investor 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 companies (15)--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 efficient markets, and facilitate capital formation." (17) As a result, the two competing suggestions for reform should be analyzed for their effectiveness as an investor-protection tool. Which of these reforms would have a more pronounced 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 behavioral heuristics to assess the effectiveness of laws and policies, offers a useful method of examining the competing suggestions for reform. Behavioral economics 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 fiduciary-duty standard. The behavioral-economics analysis of the two proposed reforms supports this conclusion by demonstrating that, in contrast to fiduciary standards, disclosure standards can actually exacerbate investors' heuristics. Part I summarizes the differences between investment advisers and broker-dealers...