Trust, guilt, and securities regulation.

• Author: Huang, Peter H.
• Position: Preferences and Rational Choice: New Perspectives and Legal Implications

This Article analyzes the importance of trust in securities investing and how guilt about breaching such trust has implications for securities regulation. Both U.S. federal securities laws and the regulations of the National Association of Securities Dealers impose high standards of professional conduct upon securities professionals. But exactly what are and should be the legal responsibilities of securities professionals remain the subject of much debate. In particular, courts disagree over when broker-dealers are fiduciaries of their clients. A legal consequence of a fiduciary relationship is a duty of fair dealing. This Article is the first to analyze the emotional, moral, and psychological consequences of broker-dealers' being fiduciaries. This Article explains how finding that securities professionals are fiduciaries can alter both expectations about securities professionals' behavior and that behavior itself, as well as cause those professionals to feel guilt from breaching their clients' trust or pride from honoring such trust. This insight has implications for the costs and benefits of finding a fiduciary duty. In particular, there ia an emotional or psychological deterrence effect, in addition to the deterrence effect of monetary fines or legal sanctions, from finding a fiduciary duty. This Article demonstrates how fiduciary law can affect behavior even without extensive enforcement or severe legal penalties.

INTRODUCTION

Most individuals do not have the inclination, knowledge, or time to rely directly upon the companies in which they have interests for the requisite knowledge to make informed investment decisions. (1) Instead, individuals often hire securities professionals for assistance and advice. Individuals who make their own investment decisions do worse on average net of trading commissions than do stock market indices. (2) Even those who invest directly in securities markets usually do so via such financial intermediaries as brokers and dealers. There are well-known incentive problems with such principal-agent relationships. (3) A recent Business Week cover story focused on such problems. (4) Most securities professionals are employed by large organizations, such as financial conglomerates, investment banks, or boiler rooms, in which broker-dealers push certain securities to strangers by making cold calls (high-pressure telephone calls).

Securities professionals face not only behavioral norms and organizational rules of conduct but also industry self-regulation and legal responsibilities. Federal securities laws in the United States impose high standards of professional conduct upon how broker-dealers can and should interact with their clients. But the exact scope of broker-dealers' legal obligations toward investors remains the subject of much debate. There has been pressure for increased federal regulation to govern the conduct of broker-dealers because it is unclear whether an effective regulatory system can rest on the application of such broad-based and well-established securities regulations as Rule 10b-5, (5) promulgated under the Securities Exchange Act. (6) In particular, courts and commentators disagree over when the relationship between broker-dealers and investors is fiduciary in nature under federal or state law and thus when broker-dealers have well-defined duties toward investors. (7)

This Article is the first to analyze the emotional, psychological, and moral consequences of the answers to the questions of when and to what extent broker-dealers are and should be treated as fiduciaries of their clients. Recently, a law and economics scholar normatively evaluated the regulation of securities professionals. (8) His analysis was premised on an economic theory of asymmetric information that does not involve any emotions. (9) In particular, the article did not analyze whether imposing a fiduciary duty of loyalty triggers guilt on the part of securities professionals.

This Article analyzes the interaction between expectations about the behavior of securities professionals and securities professionals' emotions. It considers whether guilt can motivate securities professionals' decisions and the legal implications of guilt for the regulation of securities professionals. The basic notion is that guilt provides an internal mechanism for legal compliance. (10) In other words, guilt provides a multiplier deterrence effect beyond the external mechanisms for legal compliance provided by private litigation, public enforcement, and sanctions. This Article applies the analytical tool of psychological game theory to analyze the interaction between the legal responsibilities of securities professionals toward their clients and the behavioral norms of securities professionals. It concludes that securities law can foster particular behavioral norms and that choosing rules designed to increase the guilt of broker-dealers can foster trust and trustworthy behavior. (11)

This Article focuses on broker-dealers, but its analysis applies more generally to such other financial actors as securities analysts, boards of directors, corporate officers, and managers. (12) The analysis in this Article is based on formal models of trust and so applies to any relationship involving trust. The recent wave of highly publicized corporate and accounting scandals reinforces the importance of investors' trust for well-functioning capital and securities markets. (13) But even though "trust plays a key role in the formation and function of financial markets," (14) it "is an important consideration not often recognized by those considering the role of law in financial markets." (15)

An economic definition of F's being a fiduciary of P is that P's consumption, utility, or wealth must enter into F's utility function at least on a par with F's own consumption, utility, or wealth. F breaches F's fiduciary duty if P's consumption, utility, or wealth does not enter into F's utility function or does so, but only below F's own consumption, utility, or wealth. Finding a fiduciary relationship between investors and broker-dealers implies that broker-dealers owe investors a duty of fair dealing. The existing discourse on the question of when broker-dealers are fiduciaries focuses on the legal consequences of the answer to that question. But in the oft-quoted words of Justice Felix Frankfurter, "to say that a man is a fiduciary only begins [the] analysis." (16)

Once a court determines that particular corporate actors are fiduciaries, the legal, cognitive psychological, moral, and emotional sanctions of such a finding are strengthened by clarifying the precise nature of the duty of loyalty that is involved. (17) For example, some lawyers and commentators have argued that securities analysts at investment banks who make "buy" recommendations for securities to the public owe a fiduciary duty to disclose the role their employers play in the Initial Public Offering (IPO) of those securities. (18) Motivated in part by such concerns, the Securities and Exchange Commission (SEC) issued a publication warning investors about the potential conflicts of interest that securities analysts face in making stock recommendations. (19) On February 6, 2003, the SEC voted unanimously "to require Wall Street stock and bond analysts to vouch that the views expressed in their research reports are genuinely their own." (20)

On June 14, 2001, the U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises held hearings entitled Analyzing the Analysts. (21) In the opening statement of part two of those hearings, on July 31, 2001, Chairman Michael G. Oxley of the Committee on Financial Services stated it should be standard practice for "the news media to require sources to disclose whether they hold any interest in stock, long or short, and whether their firms have business relationships with the company." (22) The Sarbanes-Oxley Act of 2002, signed into law on July 30, 2002 in response to a wave of accounting abuses and corporate fraud, addresses conflicts of interest by securities analysts and auditors. (23) The Act also mandates that the SEC issue rules that require a company to disclose whether or not--and if not, why not--a company has adopted a code of ethics for senior financial officers. (24)

The SEC, on April 25, 2002, launched a formal inquiry, in conjunction with the New York Stock Exchange (NYSE), the National Association of Securities Dealers (NASD), the North American Securities Administrators Association, and New York Attorney General Eliot Spitzer, into whether analysts provided overly optimistic research reports about their investment banking clients. (25) E-mail communications revealed that some analysts misled investors by publicly making positive stock recommendations while privately admitting the poor condition of those stocks. (26) On May 8, 2002, the SEC approved rule changes that the NYSE and NASD had proposed to address research analyst conflicts of interest. (27) On May 21, 2002, Merrill Lynch settled with the New York Attorney General agreeing to "change how it monitors and pays its stock analysts," including decoupling securities analysts' pay from investment banking deals. (28) Some commentators and scholars, however, believe that neither the NYSE and NASD rule changes nor the settlement agreement will do enough to end the fundamental conflict of securities analysts serving two masters: corporations that pay for investment banking services and investors who receive securities recommendations. (29) Holding securities analysts to be fiduciaries of their client investors would be another way to help resolve this conflict. In particular, holding securities analysts as owing their investing clients duties of loyalty and disclosure--much like those financial news columnists owe their audiences--would help to restore investor trust and confidence. (30)

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