Financial Advisors

FINRA Targets Recidivist Brokers—But Its Reach Goes Only So Far

When it comes to protecting investors from broker misconduct, all eyes are focused on whether the SEC will amend Regulation Best Interest, which requires brokers to act in the best interest of their customers when making recommendations. Meanwhile, FINRA, the self-regulatory organization for broker-dealers, has taken less-noticed steps of its own to protect investors from recidivist brokers. 

One of the new rules, implemented in September, effectively requires FINRA’s approval for a firm to hire a broker with a significant history of misconduct. FINRA defines significant misconduct as at least one “final criminal matter” or two “specified risk events” over the past five years, such as investment-related civil judgments or arbitration awards of at least $15,000.

FINRA has a mandate to design rules to prevent future wrongdoing, and it points to two studies in support of the new rules. A 2015 study by its own economists shows that a broker’s disciplinary record and certain other disclosures have “significant power to predict future investor harm,” and a 2019 academic study finds that one in four brokers with misconduct records was a repeat offender.

“Past offenders are five times more likely to engage in misconduct than the average adviser, even compared with other advisers in the same firm, at the same location, and at the same point in time,” according to the academic study. “The large presence of repeat offenders suggests that consumers could avoid a substantial amount of misconduct by avoiding advisers with misconduct records.”

Every industry has some bad apples, but they seem particularly prevalent in the financial industry. Of more than 600,000 registered brokers, the academic study found that one in 13 (7.28%) had a record of misconduct (and that only counts the ones who were caught). 

Surprisingly, though, brokerages are pretty strict on broker behavior. Nearly half (48%) of the brokers found engaging in misconduct lose their jobs. But other brokerages then hire 44 percent of these dismissed brokers within a year. The new firms pay less and have a relatively high share of brokers with past misconduct records. In other words, these brokers become matched with firms with a greater tolerance for misconduct. 

This pattern suggests a two-tier system. Clean firms do not tolerate misconduct, and they rely on reputation to attract sophisticated customers. Other firms and their advisers, in contrast, persistently engage in misconduct and appear to target vulnerable customers. Misconduct is more prevalent in places with elderly and less educated populations, two groups often associated with less sophisticated investors. Misconduct is also more common in counties with higher incomes, an attribute that typically serves as a proxy for investor sophistication. The study suggests that wrongdoers target the wealthy because it is profitable.

The firms with higher percentages of broker misconduct have substantially less revenue and assets under management. But why doesn’t reputation do more to weed out bad firms? After all, financial advisors’ disciplinary records are available for all to see on two websites—FINRA’s BrokerCheck and the SEC’s Investor Adviser Public Disclosure website—that have combined their search results. FINRA requires brokers to tell customers about BrokerCheck, and the SEC has conducted public service campaigns to “check out your investment professional.”

Nonetheless, some investors do not use or even know about the sites. By focusing on these unsophisticated investors, firms can mitigate the consequences of a poor reputation. 

This suggests a market failure. Firm discipline, reputation, market forces—and years of increasing pressure from FINRA—have not been enough to protect investors. Hence FINRA’s new rules. The message for the brokerage industry? Listen to the memorable title of one law firm memoThrough the Issuance of New Rules Aimed at Recidivist Brokers and the Firms That Hire Them, FINRA Loudly Exclaims to its Membership Can You Hear Me Now???”

But FINRA and firm oversight can go only so far. Brokers with a record of serious misconduct are 25 percent more likely to move to other parts of the financial services industry beyond FINRA’s reach. Once there, ex-brokers with a history of misconduct are more than 40% more likely to engage in new misconduct compared to brokers with a record of misconduct who stay in the brokerage industry. These troubling conclusions come from a 2021 study, “Wandering Financial Advisors,” co-authored by former SEC Commissioner Robert J. Jackson Jr. and two other academics.

 “Wandering advisors who already have a record of misconduct when they exit the FINRA regime are much more likely to reoffend than brokers currently registered with FINRA who also have a record of misconduct,” the study finds.

The study singles out the insurance industry, where a disproportionate number of ex-brokers with misconduct records end up. Of the more than 50,000 ex-brokers who work as insurance producers, more than 13% have a history of serious misconduct. (These figures should not tar the majority of ex-brokers working in the insurance industry who have clean records.)

The study paints a picture of “highly fragmented” insurance regulation at the state level. Many insurance agents operate independently, and insurance companies have far less control over insurance agents than brokerage and investment adviser firms exercise over their employees. Nor is there a consumer-friendly website with a nationwide database of the records of insurance producers.

None of this is meant to denigrate FINRA’s new rules to protect investors from recidivist brokers. But the rules will not extend to financial advisors who switch hats in a game of regulatory arbitrage. It will take Congress to craft a more comprehensive solution.

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

Stephen Deane

Stephen Deane, CFA, is Senior Director, Legislative and Regulatory Outreach, at CFA Institute.

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