Regulatory Arbitrage and the Persistence of Financial Misconduct.

AuthorHonigsberg, Colleen

Table of Contents Introduction I. The Economics of Financial-Advisor Misconduct A. The Importance of Financial Advisors B. The Costs of Financial-Advisor Misconduct C. Institutional Bias in Advisor Discipline D. Financial Advisors and Regulatory Capture II. The Law of Financial-Advisor Misconduct. A. Regulation of Broker-Dealers B. Regulation of Investment-Adviser Representatives. C. Regulation of Commodity and Futures Dealers D. State Regulation of Insurance Producers. III. Evidence on the Costs of Federalism in Financial Advice A. Financial-Advisor Record Extraction B. Dataset Assembly. C. Evidence on Flow Across Regulatory Regimes 1. Exit from FINRA oversight and misconduct rates. 2. Exit from FINRA oversight by gender. 3. Advisors and recidivism 4. The unique role of insurance producers. 5. Dual registrants IV. Implications for Investors and Policymakers A. Regulatory Coordination and Accountability 1. Unified database. 2. Regulatory accountability B. Institutional Design of Licensing Regimes C. Insurance Regulation. 1. Limited firm-imposed discipline 2. Regulatory capture Conclusion. Introduction

In March 2017, the brokerage industry imposed a permanent bar on Frank Black, a longtime Financial advisor. (1) Industry authorities concluded that over the previous decade alone, Mr. Black had fabricated and produced false documents, given false testimony, failed to supervise his employees, engaged in excessive trading in his customers' accounts, and recommended unsuitable securities to clients--all claims that Mr. Black denied. (2) Despite this regulatory sanction, Mr. Black continued to be registered as an insurance producer with the State of North Carolina, (3) and the firm he founded ultimately grew to eighty-five financial advisors across forty-eight states. (4) Until 2020, his firm's website described his decades-long brokerage career, making no mention of his lifetime ban. (5) Instead, the firm advertised its services by touting Mr. Black's long experience--and his claim that when it comes to giving investment advice, "[c]lient[s come] first, end of story." (6)

American workers increasingly rely on professional advisors like Mr. Black to plan their financial futures, so advisor misconduct can have dire consequences--especially for vulnerable investors. (7) Advocates have thus sought to strengthen federal law governing advisor misconduct. (8) But like Mr. Black, many advisors can choose to be regulated at either the federal or state level, incentivizing advisors--particularly those with a history of misconduct--to seek out laxer state regulatory regimes. (9) Despite extensive academic and legislative debate over the regulation of financial advice, those incentives have received scant attention. (10)

This Article presents the first study of financial advisors who exit federal oversight after committing serious misconduct yet continue to advise investors. We identify thousands of these advisors and show that they are disproportionately likely to proceed under more lenient state-level regulation, thereby exposing investors to harm in the future. (11) We also document a significant gender disparity in this phenomenon: These advisors are mostly male. By contrast, female advisors are far less likely to commit misconduct. (12) And if they do commit misconduct, they are more likely to exit the financial-advisory profession altogether than to continue working under a different regulatory regime. (13)

Our findings offer insights for lawmakers now engaged in vigorous debate over the regulation of financial advice. Because advisors can essentially choose to be regulated under either federal or state law, tightening legal standards in one regime can create incentives for advisors to switch to another. (14) And although labor markets can discipline advisors who commit misconduct, that effect can be muted if advisors avoid discipline by changing regimes. (15)

We offer lawmakers policy alternatives to mitigate the incentives that low-quality advisors have to select lax regulators, and we propose policies to improve market mechanisms for protecting investors. We argue that any regulatory policy must consider not only the risk that increased federal oversight will push bad actors toward state-level regulation, but also the risk of regulatory capture at the state level. (16) For example, we show that 7.5% of state lawmakers who sit on legislative committees overseeing insurance regulators are currently insurance producers, and that 11% of state lawmakers are now, or once were, in the business of selling insurance--a far higher fraction than for comparable professions. (17)

This Article proceeds as follows. Parti provides background on the increasingly important role of financial advisors in household investment decisions. Part II analyzes four separate regulatory regimes that license Financial advisors and explains why state-level insurance regimes may be particularly vulnerable to regulatory capture. Part III describes our dataset and provides evidence on advisors' incentives to seek out a laxer regulatory regime. Part IV discusses alternatives for policymakers seeking to address the costs of financial-advisor misconduct.

  1. The Economics of Financial-Advisor Misconduct

    Financial advisors play an important role in individuals' investment decisions. In this Part, we document the broadening scope of financial advisors' responsibility--and the corresponding costs arising from advisor misconduct.

    1. The Importance of Financial Advisors

      A 2019 survey found that 56.5% of American families relied on a financial advisor for assistance in making borrowing and investment decisions. (18) Although such advice can be expensive, the costs of investing without an advisor can be even higher--especially for unsophisticated consumers. (19) Consumers often turn to advisors to help manage retirement assets, a sector that has grown significantly over the past two decades, from $11.6 trillion in 2000 to $39.4 trillion as of December 31, 2021. (20) The growth in retirement assets, now representing roughly one-third of all household assets, helps to explain why the number of financial advisors is projected to increase. (21)

      Yet unlike doctors or lawyers, financial advisors are not legally required to have a particular professional qualification or license. To be sure, there are some scattered professional designations regulated by organizations, such as Certified Financial Planner (CFP) and Chartered Financial Analyst (CFA), (22) and many advisors are required to obtain a particular license to engage in specific tasks. (23) But while millions of individuals work as professional financial advisors, there is no single degree or designation that qualifies one to do that work. Of course, given that advisors provide services ranging from retail life-insurance sales to the ongoing management of state pension funds, the fragmented structure of the modern financial-services industry may not be surprising. Different clients have different financial needs and risk tolerances, and advisors will require different levels of sophistication and kinds of expertise to serve these clients.

      The problem is that consumers do not understand these distinctions. Most Americans experience financial advice as an undifferentiated product, making no distinction between the individuals who execute their stock trades, advise them on their 401(k) investments, and sell them life insurance linked to the performance of a stock-market index--even though each of these three functions is subject to different legal oversight. (24) Even though regulators are increasingly aware that consumers do not understand the distinctions between different types of financial advisors, (25) lawmakers have historically enacted distinct regulations for each particular regulatory classification. (26)

      This fragmented approach to regulation may contribute to consumers' wariness of the financial-advice profession. One recent survey concluded that the financial-services sector is the least trusted industry in the national economy; (27) another survey asked consumers to rank the relative trustworthiness of various professions and found that consumers viewed Uber drivers as more trustworthy than financial advisors. (28) The regulatory patchwork may contribute to this mistrust: Anecdotal evidence indicates that consumers believe that their advisors owe them a higher duty of loyalty than the law in fact requires. (29) This leads to potential conflicts and distrust, as a consumer who mistakenly believes her advisor is a fiduciary may feel cheated upon later learning that the advisor did not adhere to a fiduciary standard in their interactions. (30)

      But there's another reason that financial advisors are unpopular with consumers: widespread misconduct. In the next Subpart, we address advisor misconduct in more detail, drawing from the literature documenting the costs misconduct imposes on investors.

    2. The Costs of Financial-Advisor Misconduct

      According to a recent study, one in thirteen financial advisors has allegations of misconduct. (31) Among advisors with allegations of misconduct, approximately 25% are repeat offenders. (32) These statistics, while striking, probably understate the actual degree of advisor misconduct. (33)

      Because advisors provide a wide range of services, the term "misconduct" spans a wide range of activities. At one extreme is fraud: forging client signatures, stealing client assets, and the like. But most financial-advisor misconduct is less obviously improper. (34) Consider, for example, excessive trading on a client's behalf to maximize an advisor's sales commissions. (35) Because there is nothing inherently wrong with an advisor making trades for a client, identifying misconduct requires analyzing whether the trades were intended to benefit the client or maximize commissions. Similarly, although there is evidence that advisors steer clients toward investments that earn...

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