Financial Gatekeepers and Investor Protection: Evidence from Criminal Background Checks

• DOI: http://doi.org/10.1111/1475-679X.12265
• Date: 01 May 2019
• Author: LILLIAN F. MILLS,KELVIN K. F. LAW
• Published date: 01 May 2019

DOI: 10.1111/1475-679X.12265

Journal of Accounting Research

Vol. 57 No. 2 May 2019

Printed in U.S.A.

Financial Gatekeepers and Investor

Protection: Evidence from Criminal

Background Checks

KELVIN K. F. LAW ∗AND LILLIAN F. MILLS †

Received 21 November 2017; accepted 6 March 2019

ABSTRACT

We examine whether financial advisors with pre-advisor criminal records pose

a greater risk to investors than those without. We find that financial advisors

with pre-advisor criminal records are more likely to receive future customer

complaints. Their complaints are more likely to receive arbitration awards

or settlements and are more likely to involve large settlements exceeding

$100,000. Finally, clients are more likely to suffer service disruptions from

engaging advisors with pre-advisor criminal records, even incremental to the

brokerage firm being high-risk. Although we do not have performance data

∗Nanyang Technological University; †University of Texas at Austin.

Accepted by Haresh Sapra. We appreciate helpful comments of two anonymous referees,

Ray Ball, Mary Barth, Richard Bennett, Thomas Bourveau, Lawrence Brown, Marika Cabral,

Travis Chow, Hans Christensen, Stephen Dimmock, Alejandra Flores, Joseph Gerakos, Craig

Greenway, Jeff Hales, Terri Holbrook, Stephan Hollander, Artur Hugon, Steven Kachelmeier,

Bin Ke, Christian Leuz, An-Ping Lin, Brett Myers, Chris Park, Chul Park, Robert Prentice,

Cheng Qiang, Steven Rosen, Jordan Schoenfeld, Hun Tong Tan, Laurence van Lent, Aida

Wahid, Luo Zuo, and doctoral students and seminar participants at Texas Tech University,

the 2018 Singapore Tri-Uni Junior Faculty Accounting Research Conference, University of

Hong Kong, Carnegie Mellon University, and the 53rd Annual 2018 Journal of Accounting Re-

search Conference participants. Weare also grateful for comments from criminologists Michael

Benson, Olivia Choy, and David Weisburd, who generously provided their insights on white-

collar crime. Law and Mills sincerely appreciate the excellent research assistance of Lu Chen,

Duy Duc Doan, Joey Han, Ryan Hess, Youlin Shen, and Xiaoxu Yu. Law acknowledges finan-

cial support from NTU’s Start-Up Grant. Mills appreciates funding from the Beverly H. and

William P.O’Hara Chair in Business. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

491

CUniversity of Chicago on behalf of the Accounting Research Center,2019

492 K.K.F.LAW AND L.F.MILLS

of individual advisors, mutual funds of those firms that employ advisors with

criminal records do not provide their clients with superior returns nor charge

lower fees, suggesting that there are not compensating benefits to offset the

investor harm. Overall, pre-advisor criminal record serves as an important ex

ante characteristic available to regulators, investors, and employers for risk-

assessment purposes.

JEL codes: D14; D18; G20; G24; G28; K22

Keywords: background check; criminal records; financial advisors; investor

protection; gatekeepers

1. Introduction

Several recent studies in finance and accounting examine misconduct

in the financial advisory industry (Qureshi and Sokobin [2015], Griffin,

Kruger, and Maturana [2017, 2018], Charoenwong, Kwan, and Umar

[2017], McCann, Qin, and Yan [2017], Dimmock, Gerken, and Graham

[2018], Cook et al. [2019], Egan, Matvos, and Seru [2018, 2019], Law

and Zuo [2019]). Specifically, Egan, Matvos, and Seru [2019] document

a surprising prevalence of criminal records among financial advisors.

Although they use criminal records (before or after becoming an advisor)

as one component of their composite measure of advisor misconduct,

we focus on criminal records prior to becoming an advisor because

regulators, investors, and employers can identify this characteristic ex

ante. The potential benefit of earlier identification for investor protection

motivates our study.1Specifically, we examine whether financial advisors

with pre-advisor criminal records pose a greater risk to investors than

those without such records. Further, we assess whether investors receive

compensating benefits like higher returns or lower fees—an important

question that none of the existing papers attempt to answer. Our evidence

that harm is greater, fund returns are no better, and fund expense ratios

are higher suggests that investors who hire an advisor with a pre-advisor

criminal record incur worse outcomes on average.

It is not obvious that a prior criminal record predicts future professional

misconduct. First, the Financial Industry Regulatory Authority (FINRA)

views youthful indiscretions, such as teenage driving under the influence

(DUI) or drug possession, to have no direct bearing on advisors’ profes-

sional conduct. For example, FINRA’s registration panel has permitted

registrations of advisors with criminal records, saying that these events are

“youthful indiscretions that should not weigh heavily against X here,” and

the registration “does not present an unreasonable risk of harm to the

1Egan, Matvos, and Seru [2019] conclude that “a natural policy response aimed at lowering

misconduct would be to increase market transparency and provide unsophisticated consumers

access to more information.” To the extent that this pre-advisor characteristic is predictive of

other misconduct and investor harm, our evidence could guide such policy responses.

PRE-ADVISOR CRIMINAL RECORDS 493

market or investors” (see Redacted Decision No. SD05006). Even the

American Institute of Certified Public Accountants (AICPA) Section 250

states that auditors should not consider “personal misconduct (unrelated

to entities’ business activities)” when auditing firms’ financial statements.

The Equal Employment Opportunity Commission’s Enforcement Guide-

lines also state that employers should use criminal records in hiring

decisions only when the records are “job related and consistent with

business necessity.” Thus, employers and regulators might already have

evaluated advisors with criminal records before hiring them and decided

that they present minimal risk to investors.

On the other hand, multiple criminology studies of convictions in the

past decades conclude that white-collar criminals are likely to have prior

criminal records. The estimates range from 39% to 78% depending on the

sample.2Further, the literature shows that criminals do not specialize, but

are versatile. Criminal versatility suggests that they can easily move from

non-white-collar crime to white-collar crime.3The widely reported case of

Felix Sater provides a vivid example. Mr. Sater was convicted of first-degree

assault on March 31, 1993, after he violently assaulted another broker in

1991. On December 10, 1998, he pled guilty to racketeering for running

a “pump-and-dump” penny stock scheme bilking investors out of at least

$40,000,000. He was not permanently barred from the securities industry

until February 17, 2000—six years, 10 months after the assault conviction.

The criminology literature also finds that certain personality types are

significantly associated with crime and recidivism. White-collar criminals

are more neurotic, less agreeable, and less conscientious—three of the

five criminal personality characteristics—than other white-collar employees

(Collins and Schmidt [1993], Blickle et al. [2006], Listwan, Piquero, and

van Voorhis [2010]). White-collar criminals have lower levels of self-control

over risky behaviors (Collins and Schmidt [1993]), show less integrity, and

are more hedonic, thus placing a high value on material success (Blickle

et al. [2006]). Walters and Geyer [2004] also find that white-collar criminals

2Weisburd, Chayet, and Waring [1990] find that 43% of 1,090 white-collar criminals from

seven federal judicial districts interviewed from 1976 to 1978 have at least one prior arrest.

Even among criminals who held executive positions or owned significant assets, 28% have at

least one prior arrest (and 10% have prior felony convictions). Benson and Moore [1992]

interview 2,462 inmates convicted of federal white-collar crimes between 1973 and 1978 and

show that 39% of them have prior arrests for any type of offense (such as violent crimes,

property crimes, and minor offenses). Walters and Geyer [2004] examine 57 male inmates

serving time for white-collar crimes (e.g., securities fraud) and find that 68% of them have at

least one prior arrest for a non-white-collar crime. Listwan, Piquero, and van Voorhis [2010]

show that 78% of Indiana inmates convicted of federal white-collar crimes between 1986 and

1988 had a prior record (see also Weisburd and Waring [2001] and Piquero and Weisburd

[2009]).

3Many criminology studies document criminal versatility (Wolfgang, Figlio, and Sellin

[1972], Bursik [1980], Kempf [1987]). Farrington, Snyder, and Finnegan [1988] find only

a small degree of criminal specialization among juveniles, and van Onna et al. [2014] and van

der Geest, Weisburd, and Blokland [2017] show versatility among white-collar offenders.