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Investors beware: Crooked financial advisors can slip through regulatory cracks

SIEPR’s Colleen Honigsberg looks at how loopholes in regulatory monitoring of financial advisors allow bad actors to stay in the business.

In Hollywood movies about money managers gone bad, someone almost always winds up in jail.

The sad reality is that there are financial advisors who cheat investors every day and don’t get caught. Even when they do, pioneering research from Colleen Honigsberg, a faculty fellow at the Stanford Institute for Economic Policy Research (SIEPR), shows how some continue to work as financial advisors — their past misconduct often unknown to investors.

The reason is because government oversight of financial advisors is highly fragmented. As a result, different investments — such as stocks, commodities, or annuities — are overseen by different federal and state regulatory bodies. This enables advisors, good and bad, to choose their regulators and move among them with relative ease.

For example, if advisors are expelled by the primary watchdog overseeing stockbrokers, the Financial Industry Regulatory Authority (FINRA), they can often shift into selling derivatives, which are regulated by the National Futures Association (NFA) or become life insurance brokers under state law.

In one of the study’s most striking insights, Honigsberg — an associate professor at Stanford Law School — finds that the most corrupt financial advisors who remain in the profession often end up in insurance sales, where state laws governing them tend to be lenient.

With more than half of Americans now using a financial advisor, mostly for retirement planning, Honigsberg and her co-authors document how often advisors shift among industry regulators — a practice known as regulatory arbitrage. In their analysis covering a 10-year period, they show for the first time that thousands of advisors with the worst track records under federal regulators became state-registered insurance agents.

The authors suggest policy reforms at the federal and state level to prevent bad actors from exploiting regulatory loopholes. However, they note that reforms may be harder to enact in insurance, where the insurance industry exerts significant influence over state lawmakers. For example, Honigsberg and her collaborators show that 11 percent of state legislators are current or former insurance agents, which they note is unusually high compared to other professions. They also cite one study finding that up to half of all state insurance commissioners work in the industry after leaving government.

Roughly one in 13 financial advisors have a black mark on their records, according to research cited in the study that was conducted by Amit Seru, a professor at Stanford Graduate School of Business and a SIEPR senior fellow. Honigsberg notes that the rates are likely higher given that not all bad behavior gets detected.

“There is a lot of misconduct in financial services, and that misconduct can have really detrimental effects on people — not just as it relates to their finances, but also to other areas of their life,” Honigsberg says. Studies suggest, for example, that victims experience health and relationship problems.

Insurance sales as fallback

For their study, Honigsberg and her collaborators built a novel dataset tracking 1.2 million FINRA-registered advisors as they moved among federal and state regulatory bodies between 2010 and 2020. At the federal level, they follow advisors registered with FINRA, the Commodities Trading Futures Commission (CFTC) and the Securities and Exchange Commission (SEC). They also collected data on state-level insurance registrations.

They find that among former FINRA members who continue to work in financial services, nearly 11 percent  have a history of misconduct — for example, they were fired for improper behavior, criminally sanctioned, or paid to settle a customer dispute. Nearly 8 percent of ex-FINRA members remaining in financial services had committed serious misconduct, a subcategory that excludes cases involving customer settlements.

Honigsberg and her co-authors — Edwin Hu and Robert Jackson, Jr., both of New York University School of Law — also find that former FINRA advisors who committed wrongdoing but continued working under a different regulator were more likely to break the rules again than FINRA brokers with disciplinary records who stayed put.

Of the former FINRA members with disciplinary records who become insurance agents, or “producers” in industry parlance, over 16 percent had a record of misconduct. Almost 12 percent had histories of serious misconduct.

These numbers are especially troubling, Honigsberg says, as the lines between insurance products and traditional investments have blurred in the 12 years since Congress legislated that annuities are not securities — thus causing these products to fall under insurance regulation.

“It’s a well-known secret within the industry that, as the insurance model has shifted to broader, more robust financial planning services, advisors with a history of misconduct are moving to state regulatory regimes,” Honigsberg says.

Impactful research

Fraud in various contexts is a core theme in Honigsberg’s research. For example, she is working with Daniel Ho, a Stanford professor of law and political science and a SIEPR senior fellow, on a project to reduce misreporting of environmental data. Senator Elizabeth Warren, D-Mass., has cited Honigsberg’s research in calling on FINRA, which oversees broker-dealers, to make it harder for its members to expunge records of customer complaints.

And just last month, Honigsberg was appointed to serve on an SEC investor advisory committee charged with helping to protect investors and bolster the integrity of U.S. securities markets.  

According to Honigsberg, FINRA, a self-regulatory body that is overseen by the SEC, recently tightened rules for allowing members with misconduct on their records to remain as broker-dealers. She noted how such changes, although important, can be stymied by the current regulatory landscape.

“FINRA may be tightening the net, but they’re acting alone,” Honigsberg says. “Unless you tighten the rules for all regulatory regimes simultaneously, you risk individuals moving from one regulator to another rather than exiting the system entirely.”

Policy proposals

Honigsberg and her collaborators note that decentralized oversight of financial services makes a lot of sense: The breadth of products and services are so broad, and the needs and risk tolerances of clients vary widely.

Still, the researchers say there are practical steps policymakers can take to better protect consumers. They include requiring regulators to:

  • Create a single, publicly searchable database of all financial advisors registered with FINRA, the NFA, the SEC and state insurance overseers.
  • Report the outcomes of cases that one regulator reports to a sister regulator, including  whether the regulator who received a complaint decides against investigating it and whether an investigation resulted in enforcement.
  • Conduct stricter, ongoing reviews of their registered members. If an individual is disciplined by one regulator, Honigsberg and her collaborators argue that should trigger a review by all regulators with whom the individual is registered.