The Financial Industry Regulatory Authority has robust inspection and enforcement programs for policing bad behavior in the financial services industry. But a recent study by Stanford Law School identified thousands of advisors who continue to provide financial advice after exiting the FINRA system, primarily through state-level insurance regimes. These advisors are disproportionately men with a prior history of serious misconduct and are more likely to commit misconduct in the future.
“Millions of American investors now rely on financial advisors to help them make crucial decisions that shape their futures,” the authors write in the study, titled Regulatory Arbitrage and the Persistence of Financial Misconduct. “Advisor misconduct imposes substantial costs on these investors. But the law governing such misconduct is scattered across a fragmented set of federal, state, and self regulatory institutions, giving advisors with a history of wrongdoing incentives to seek out the regimes in which prior misconduct is least costly.”
The study was co-authored by Colleen Honigsberg, associate professor of law, Stanford Law School; Edwin Hu, research fellow at New York University School of Law Institute for Corporate Governance and Finance; and Robert J. Jackson Jr., the Pierrepont Family professor of law at New York University School of Law and former commissioner of the Securities and Exchange Commission. The findings are based on a dataset of some 1.2 million advisors across four regulatory regimes, including FINRA’s BrokerCheck, the SEC’s IAPD database, the National Futures Association’s BASIC system and state insurance regulator databases.
The researchers found that 395,887 advisors exited BrokerCheck from 2010 to 2020, about 34% of whom continued to provide financial advice under another regime. The most common path was to remain ’40 Act advisors under SEC oversight. Yet over 50,000 registered as state insurance producers, the study found.
And while 4.63% of FINRA brokers have histories of serious misconduct, the rate is much higher among those who exit FINRA and most pronounced among those who go on to become insurance producers. For instance, 16.17% of those who exit FINRA but continue as insurance producers have histories of misconduct, more than double the rate for those who exit the industry altogether (6.99%). Nearly 12% of those who go into the insurance regime have serious misconduct on their records, as compared with 5.8% for those who exit FINRA and come under SEC oversight.
“Taken together, these trends suggest that ‘bad’ advisors in the FINRA broker regime exit but continue to provide consumer financial services. In particular, the evidence shows, many become insurance producers,” the report said.
The study also found that those who exit the FINRA regime and continue to provide financial advice are more likely to be recidivists. For example, an advisor with a history of serious misconduct when exiting BrokerCheck has a 2.64% chance of committing misconduct in each of the following years. The probability that an individual will be registered as an insurance producer increases from 22% to 34% following serious misconduct.
“This means that a nontrivial number of individuals with serious misconduct are opting into the insurance regime after misconduct,” the report said.
The report also found that women are less likely to be given a second chance in this industry, even though they are less prone to incidents of misconduct than their male counterparts. For instance, women with histories of misconduct represent only 10% of the advisors who join other regulatory regimes, and 22% of offenders exit the industry entirely.
The authors make several recommendations to regulators and legislators to help solve the problems outlined in the study. That includes advocating for a single, searchable database of all individuals providing financial advice in the U.S.
“Such a database would benefit both regulators and consumers by significantly improving the ease and quality of monitoring advisors’ work across regimes,” they said.
They also suggest stronger regulatory accountability, including better mechanisms for making referrals regarding advisor misconduct. There’s currently no centralized, systematic way to track these referrals among different regimes.
They also argue for more stringent ongoing review of licensed advisors, not only when they join a regime but also when they exit another regime after misconduct.
Finally, they advocate for stronger regulation of insurance producers, as this is the channel many of these problematic advisors are going into. They suggest insurance firms help regulators more in addressing misconduct and provide firm-specific monitoring and discipline for bad behavior, similar to the way FINRA member firms function.
The authors also suggest structural reforms to insurance producer oversight. That might mean getting a federal regulator involved in overseeing insurance products or creating a national self-regulatory body for the insurance industry, similar to FINRA.
“We acknowledge, of course, that these limited interventions may not be sufficient to address the significant costs imposed by financial-advisor misconduct,” the authors write. “But in light of investors’ increasing reliance on financial advice, our findings suggest that lawmakers should move quickly to pursue straightforward reforms targeted toward the unique problems and incentives raised by the patchwork of regulation in this area.”
