Kitces: Rogue Brokers Still Not Being Reined In

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By Michael Kitces

Given the intangible nature of financial advice, advisors and their firms rely heavily on perceived trust and their reputation to earn clients. As a result, both advisors and their firms have a strong incentive to distance themselves from the bad apples of the industry.

Yet a newly released study, The Market for Financial Adviser Misconduct, finds that market forces and the industry’s self-regulatory mechanisms are failing to expunge the bad apples. Consequently, 73% of advisors who disclose a material misconduct event on FINRA BrokerCheck are still employed a year later, despite such brokers being a whopping five times more likely to engage in misconduct again.

On one hand, the results of the research emphasize the importance of consumers doing effective due diligence using tools like FINRA BrokerCheck or seeking out services that vet advisors on their behalf. The results also cast a positive light on FINRA’s recent efforts, including the overhaul of the BrokerCheck interface and the requirement of all brokers to include a hyperlink back to their BrokerCheck record on their professional pages and profiles.

At the same time, though, bad brokers have long been able to find safe haven in a subset of brokerage firms with cultures that are unusually permissive toward misconduct. Combined with the SEC improperly allowing those brokers to hold out as financial advisors in the first place, the question arises as to whether the industry’s self-regulatory mechanisms are failing altogether. Even researchers studying advisors and brokers can’t tell them apart. (See this advisor sting study from NBER conducted several years ago.) Is it any surprise, then, that the president and the Department of Labor are pushing for fiduciary regulatory change?


Given financial advice is an invisible, intangible good, it’s difficult for consumers to evaluate what services to purchase and who to hire. When you can’t try a service before buying, unlike with a physical product, the consumer inevitably falls back on evaluating other intangibles, such as the perceived trust and reputation of the advisor and his/her firm.

This dynamic means that advisors and their firms, as trust-based businesses, have a natural incentive toward good behavior, reputation maintenance and creating distance from bad apples who may damage them. Of course, this doesn’t necessarily prevent bad apples from trying to become advisors, but at least it provides a mechanism for market forces to cleanse the industry over time.

You would think so, at least. The adviser misconduct study by researchers Mark Egan, Gregor Matvos and Amit Seru finds that the market and industry mechanisms for advisor self-regulation appear to be failing — at least where FINRA-registered brokers and RIA dual-registrants are concerned, which comprised the study’s focus.

While only 7.3% of all brokers have some form of misconduct in their public FINRA BrokerCheck records, the researchers found that even after misconduct occurs, only 48% of brokers lose their job with their current firm, and a staggering 44% of those become employed by anotherfirm within the same year.

As a result, even after misconduct leads to regulatory action, settlement or an outright award of damages to a harmed consumer, only 27% of these bad-apple broker-advisors have left the industry a year later. And one-third of those, or 9% of brokers, would have already been expected to leave the industry within the year due to natural turnover.

Fortunately, the researchers do find that brokers are somewhat more likely to leave and less likely to be re-employed if the misconduct incident involves an above-average settlement or damages award. And brokers who have to switch firms after a misconduct event on average see a 10% reduction in compensation.

Nonetheless, the fundamental question arises: If advisory and brokerage firms are so reliant on trust and reputation, how can 73% of brokers with serious misconduct events remain employed as advisors a year later?


Given many brokerage firms appear to separate from their brokers after a misconduct event, those firms theoretically shouldn’t be willing to hire brokers who have misconduct events on their records and who were fired from other firms. Yet the rehiring of brokers with misconduct continues.

The researchers find that the industry’s seemingly lax attitude appears to spring from a small subset of firms that disproportionately hires brokers with a history of misconduct. Furthermore, the research suggests that firms which specialize in supporting brokers with a history of misconduct are not only more likely to hire brokers who have prior misconduct, but are also more likely to employ other brokers with misconduct records, and are less likely to fire a broker for subsequent misconduct. Notably, the tendency for misconduct persists over time as well. That is, firms with brokers who engaged in misconduct in the past were more likely to have brokers with misconduct records in the future.

The implication that some firms cultivate more permissive cultures than others is further bolstered by the researchers’ finding that advisor misconduct is 50% more likely in firms where one of the owners or executives had previously been disciplined for misconduct: a clear suggestion that a permissive culture may emanate directly from the top.

In addition, if a brokerage firm dissolves for whatever reason, brokers with records of misconduct are significantly more likely to join new firms that have a higher share of other brokers who engaged in misconduct. The takeaway: Bad apples find each other.


Another significant finding by Egan, et. al., was that foul play was notevenly distributed across the country.

Rather, misconduct is highly concentrated in areas where unscrupulous brokers have the most targets to prey upon. Frequency of broker misconduct rose drastically in counties which had lower education levels (a proxy for unsophisticated investors), higher concentrations of the elderly (a long-standing target for abuse), and higher concentrations of high-income individuals (more lucrative targets for misconduct).

As a result, while the overall broker misconduct rate was about 7%, and some counties were as low as 2% to 3%, many counties in California, Florida and New York had broker misconduct rates as high as 15% to 20%, meaning a remarkable one in five brokers would have a history of material misconduct.


One of the most striking findings was that among brokers with misconduct disclosures in their disciplinary records, a whopping one-third were repeatoffenders. A broker with at least one misconduct event is five times more likely to be busted for subsequent misconduct. The risk is of course even higher for advisors operating in certain geographic areas, within firms that count other offenders, and if the firm’s leadership has a history of misconduct as well.

Also notable is the finding that consumer complaints against brokers are not mere happenstance, or an inevitability that every broker may one day suffer. To illustrate their point, the researchers note that the incidence rate of malpractice among doctors is similar to rates of misconduct among brokers. However, more than half of doctors have at least one instance of medical malpractice on their records, implying that malpractice charges are somewhat random and that “sooner or later, most doctors are entangled one way or another.”

By contrast, advisor misconduct is much more concentrated. Though there may be a wider range of complaints, when it comes to findings of guilt (or settlement damages that show some misconduct occurred), bad behavior is concentrated among 7% of brokers, with one-third of those being regular or repeat offenders. (Notably, the researchers only looked at complaints that led to findings of guilt and/or damages/awards to consumers, which kept the data clear of specious complaints that were dismissed.)

In other words, it appears there really are some bad apples who are simply far more prone to misconduct — andthe industry is not eliminating them. The study finds that misconduct is sopersistent that brokers who engaged in misconduct over 10 yearsago are stillsignificantly more likely to have another event in the future.


Notwithstanding all the issues that Egan, Matvos and Seru found in their research, it’s also notable that if anything, the study almost certainly materially understatesthe frequency of misconduct among brokers serving retail consumers.

Why? To perform their analysis, the researchers drew everyname from the FINRA BrokerCheck database: a considerable 644,277 people currently registered with FINRA in some capacity, plus another 638,528 who were previously registered at some point in the last 10 years. (The BrokerCheck data set was drawn from 2005 to 2015).

Of course, many people registered with FINRA are not actually consumer-facing advisors at all. Cerulli has previously estimated there were only about 285,000 total (retail) advisors. The other FINRA registrants churned up by BrokerCheck may be stock or bond traders working on internal trading desks at broker-dealers, or may work in a division serving institutional clients rather than retail consumers, or may be in a registered position of supervisory oversight. And people in such positions will simply not have the opportunity to engage in the kind of consumer misconduct that was most commonly disclosed in the FINRA BrokerCheck system — such as recommending unsuitable investments, or misrepresenting or omitting key facts about an investment. Those categories accounted for more than 50% of the total complaints.

This means that the researchers’ aggregate statistics on the rate of broker misconduct may be heavily watered down by the inclusion of a large number of FINRA-registered individuals who not only aren’t really “financial advisors” but aren’t even consumer-facing with the opportunity to engage in such misconduct. And in fact, the researchers found that a broker working with retail investors would be associated with a sizeable one-third increase in his/her likelihood of engaging in misconduct, after controlling for other factors.

It’s also notable that research from the Public Investors Arbitration Bar Association has previously shown that a significant number of brokers have been able to successfully expunge the misconduct reports from their FINRA BrokerCheck records. The expungement rate was a whopping 90% in the 1,625 cases in which it was mentioned between 2007 and 2011, and remained at 87.8% in the next 460 cases between 2012 and 2014. Had those misconduct incidents been included in the researchers’ BrokerCheck data set, the rate of misconduct among retail-facing brokers would have been even higher.

On the other hand, this mixture of data — brokers who primarily work with the public; dual-registered brokers who also have an RIA affiliation; and broker-dealer employees who work with institutional clients — makes it impossible to effectively evaluate or compare the data on misconduct of standalone registered investment advisors who are subject to a fiduciary standard, versus brokers who are subject to a suitability standard.

And the researchers’ use of “financial advisors” to refer entirely to those who are registered as brokers, and even to use the “adviser” spelling from the Investment Advisers Act of 1940 (despite the fact that brokers aren’t subject to the ’40 Act), further highlights the authors’ own confusion about how to evaluate the overall advisor community (similar to the errant NBER “advisor sting” study from several years ago, whose authors sought to evaluate advisors with a methodology that exclusively analyzed non-RIA brokers).


So what are the big takeaways from all this research on advisor misconduct? First and foremost, it reallyemphasizes why services like FINRA BrokerCheck, or third-party options like BrightScope, are so critical for doing broker and advisor due diligence. The single greatest predictor of whether a broker — or likely any advisor — will engage in misconduct is whether he/she has engaged in any prior misconduct. At minimum, then, consumers should be urged to check BrokerCheck or BrightScope for any public disciplinary actions, and/or go through services like Paladin Registry that vet advisors for any misconduct disclosures before listing them on the site. Indeed, simply verifying that a broker or advisor does not alreadyhave a history of misconduct is a very material consumer protection.

On the other hand, the value of having misconduct disclosures — including ones where the broker paid a settlement while avoiding an outright admission of wrongdoing, which the researchers found was still predictive of future misconduct — also emphasizes whyPIABA is right to raise concerns about the rate of brokers expunging settlements from their BrokerCheck records. In other words, it really isimportant for consumers to have access to this data, and FINRA’s laxity in maintaining the integrity of BrokerCheck data may well be causing additional consumer harm. Furthermore, FINRA provides no means for consumers to retrieve data about the regulatory history of entire firms, despite the study clearly demonstrating that some firms have a greater propensity for their advisors to engage in misconduct.

On the plus side, FINRA overhauled the BrokerCheck interface for consumers in 2015, making it easier to search for brokers and discover important regulatory disclosures about prior discipline and misconduct. And effective June 6, FINRA Rule 2210 on communication with the public will be expanded to require firms with brokers who serve retail investors to include a hyperlink directly from their website or professional pages back to BrokerCheck. This should further help consumers follow through on the due diligence of vetting their advisors.

FINRA also announced earlier this year in its Examination Priorities letter that it would take a fresh look at whether and how brokerage firms maintained a culture of compliance. Given the researchers’ observations that a subset of firms seemed to attract brokers with misconduct records and fomented a culture of tolerating such behavior, a crackdown on that subset could theoretically have a positive effect on cleaning up the industry overall. It’s enough to make one wonder if FINRA made broker-dealer culture a priority because the agency had been warned that the results of this research study were looming…


Notwithstanding the real progress made, though, it’s still notable that FINRA waited until 2015 to finally revamp its web-based BrokerCheck system into a more usable format for consumers. At the same time, painfully outdated anti-testimonial rules have made it difficult for third-party advisor review sites to gain traction as well. In other words, FINRA both maintains a near monopoly on the ability to produce meaningful consumer data on broker and advisor misconduct, and has been slow to improve its quality and lax in maintaining the data’s integrity from specious expungement requests. Is this an outright failure of the industry’s self-regulatory structure, where FINRA’s board of directors is comprised of the very broker-dealer firms about which FINRA is failing to provide transparency?

More generally, the low suitability standard from FINRA has made it even easier for both bad brokers and the broker-dealers who accommodate them to persist. Though many firms are quick to fire brokers who engage in misconduct and avoid hiring those who do, allowing a small subset of firms to flourish as a safe haven for bad brokers perpetuates consumer harm. And of course, this still ignores brokers who are barred from FINRA, who for years have simply acquired state insurance licenses instead and just continued their misconduct in the form of abusive sales practices with fixed and equity-indexed annuities. Consequently, the scourge of bad apples is not just a failing of FINRA, but a broader failure to control the term “financial advisor” in the first place, and instead allow it to be used interchangeably with “salespeople.”

Ultimately, the process of vetting an advisor should include more than just identifying priorharm and misconduct; rather, it should emphasize identifying the skillsets, credentials and other characteristics that increase the likelihood that someone will actually be a goodadvisor. (To wit, see the CFP Board’s recent Certified = Qualifiedpublic awareness campaign.) And while the Market for Financial Adviser Misconduct study makes a compelling case that Big Data canbe used to potentially identify areas of greater risk (e.g., advisors at certain firms with a history of misconduct, or geographically located in certain counties with more at-risk populations), the industry recently fought back FINRA’s own CARDS Big Data initiative.

As a result of these challenges, the fundamental problem remains: The brokerage industry, and the advisor community at large, is failing to clean up its own messes, and a lack of transparency or credible tools for consumers to identify bad-apple brokers has only exacerbated the issue. Fortunately, recent efforts by FINRA, including an overhaul of BrokerCheck and coming mandates to increase the service’s visibility, should at least partially mitigate the situation.

Nonetheless, given the industry’s general failing in effective self-regulation, is it any wonder that momentum has grown for a new fiduciary regulatory solution from the Labor Department that may finally force broker-dealers to engage in some real change, and that fiduciary planners are the ones leading the charge to raise standards for all brokers and advisors?

Michael Kitces, CFP, is a Financial Planning contributing writer and a partner and director of research at Pinnacle Advisory Group in Columbia, Md. He’s also publisher of the planning industry blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.

This article was originally published at OnWallStreet.com.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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