The Market for Financial Adviser Misconduct
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NBER WORKING PAPER SERIES THE MARKET FOR FINANCIAL ADVISER MISCONDUCT Mark Egan Gregor Matvos Amit Seru Working Paper 22050 http://www.nber.org/papers/w22050 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 February 2016, Revised September 2017 We thank Sumit Agarwal, Ulf Axelson, Jonathan Berk, Jörn Boehnke, Douglas Diamond, Steve Dimmock, Alexander Dyck, Michael Fishman, Mark Flannery, Will Gerken, Erik Hurst, Anil Kashyap, Brigitte Madrian, Robert MacDonald, Lasse Pedersen, Jonathan Sokobin, Amir Sufi, Vikrant Vig, Rob Vishny, Luigi Zingales, and the seminar participants at the Becker Friedman Institute Industrial Organization of the Financial Sector Conference, the NBER Corporate Finance, NBER Summer Institute, NBER Household Finance, NBER Risk of Financial Institutions, CSEF-EIEF-SITE Conference on Finance and Labor, Mitsui Michigan Conference, LBS Summer Symposium, Society for Economic Dynamics Meetings, the University of California Berkeley, Boston College, Columbia University, the University of Chicago, Harvard Business School, London School of Economics, London Business School, the University of North Carolina, the Massachusetts Institute of Technology, the University of Minnesota, New York FED, New York University, FINRA, Oxford University, SEC DERA, SEC Enforcement, Stanford University, University of Virginia, Wharton, and Yale. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2016 by Mark Egan, Gregor Matvos, and Amit Seru. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. The Market for Financial Adviser Misconduct Mark Egan, Gregor Matvos, and Amit Seru NBER Working Paper No. 22050 February 2016, Revised September 2017 JEL No. D14,D18,G24,G28 ABSTRACT We construct a novel database containing the universe of financial advisers in the United States from 2005 to 2015, representing approximately 10% of employment of the finance and insurance sector. We provide the first large-scale study that documents the economy-wide extent of misconduct among financial advisers and the associated labor market consequences of misconduct. Seven percent of advisers have misconduct records, and this share reaches more than 15% at some of the largest advisory firms. Roughly one third of advisers with misconduct are repeat offenders. Prior offenders are five times as likely to engage in new misconduct as the average financial adviser. Firms discipline misconduct: approximately half of financial advisers lose their jobs after misconduct. The labor market partially undoes firm-level discipline by rehiring such advisers. Firms that hire these advisers also have higher rates of prior misconduct themselves, suggesting “matching on misconduct.” These firms are less desirable and offer lower compensation. We argue that heterogeneity in consumer sophistication could explain the prevalence and persistence of misconduct at such firms. Misconduct is concentrated at firms with retail customers and in counties with low education, elderly populations, and high incomes. Our findings are consistent with some firms “specializing” in misconduct and catering to unsophisticated consumers, while others use their clean reputation to attract sophisticated consumers. Mark Egan Amit Seru Harvard Business School Stanford Graduate School of Business Baker Library 365 Stanford University Boston, MA 02163 655 Knight Way [email protected] ¸˛Stanford, CA 94305 and NBER Gregor Matvos [email protected] McCombs School of Business University of Texas at Austin 2110 Speedway, Stop B6600 CBA 6.724 Austin, TX 78712 and NBER [email protected] 1 Introduction American households rely on nancial advisers for nancial planning and transaction services. Over 650,000 registered nancial advisers in the United States help manage over $30 trillion of investible assets, and represent approximately 10% of total employment of the nance and insurance sector (NAICS 52; Coen 2015).1 As of 2010, 56% of all American households sought advice from a nancial professional (Survey of Consumer Finances, 2010). Despite their prevalence and importance, nancial advisers are often perceived as dishonest and consistently rank among the least trustworthy professionals (e.g., Edelman Trust Barometer 2015, Prior 2015, Zingales 2015). This perception has been largely shaped by highly publicized scandals that have rocked the industry over the past decade. While it is clear that egregious fraud does occur in the nancial industry, the extent of misconduct in the industry as a whole has not been systematically documented. Moreover, given that every industry may have some bad apples, it is important to know how the nancial industry deals with misconduct. In this paper we attempt to provide the rst large-scale study that documents the economy-wide extent of misconduct among nancial advisers and nancial advisory rms. We examine the labor market consequences of misconduct for nancial advisers and study adviser allocation across rms following misconduct. Lastly, we provide an explanation that is consistent with the facts we document. To study misconduct by nancial advisers, we construct a panel database of all nancial advisers (about 1.2 million) registered in the United States from 2005 to 2015, representing approximately 10% of total employment of the nance and insurance sector. The data set contains the employment history of each adviser. We observe all customer disputes, disciplinary events, and nancial matters reported by FINRA from advisers' disclosure statements during that period. The disciplinary events include civil, criminal, and regulatory events, and disclosed investigations, which FINRA classies into twenty-three disclosure categories. Because disclosures are not always indicative of wrongdoing, we conservatively isolate six of the twenty-three categories as misconduct including regulatory oenses, criminal oenses, and customer disputes that were resolved in favor of the customer. In the rst part of the paper, we document the extent of nancial misconduct among nancial advisers and nancial advisory rms. We nd that nancial adviser misconduct is broader than a few heavily publicized scandals. One in thirteen nancial advisers have a misconduct-related disclosure on their record. Adviser misconduct results in substantial costs; the median settlement paid to consumers is $40,000, and the mean is $550,000. These settlements have cost the nancial industry almost half a billion dollars per year.2 Relative to misconduct frequency, misconduct is too concentrated among advisers to be driven by random 1We will use the term nancial adviser throughout the paper to refer to representatives registered with the Financial Industry Regulatory Authority (FINRA). FINRA is the largest self-regulatory organization that is authorized by Congress with protecting investors in the U.S. Our denition, similar to FINRA's, includes all brokers and the set of investment advisers on BrokerCheck who are also registered as brokers. FINRA reports that the term nancial advisor is a generic term that typically refers to a broker (or to use the technical term, a registered representative). [http://www.nra.org/investors/brokers and http://www.nra.org/investors/investment-advisers]. 2We calculate the total cost to the industry as the sum of all settlements granted per year in our data. 2 mistakes. Approximately one-quarter of advisers with misconduct records are repeat oenders. Past oenders are ve times more likely to engage in misconduct than the average adviser, even compared with other advisers in the same rm, at the same location, and at the same point in time. The large presence of repeat oenders suggests that consumers could avoid a substantial amount of misconduct by avoiding advisers with misconduct records. Furthermore, this result implies that neither market forces nor regulators fully prevent such advisers from providing services in the future. We nd large dierences in misconduct across nancial advisory rms. Some rms employ substan- tially more advisers with records of misconduct than others. More than one in seven nancial advisers at Oppenheimer & Co., Wells Fargo Advisors Financial Network, and First Allied Securities have a record of misconduct. At USAA Financial Advisors on the other hand, the ratio is roughly one in thirty-six. We nd that advisers working for rms whose executives and ocers have records of misconduct are more than twice as likely to engage in misconduct. Dierences across rms are persistent and survive after conditioning on a rm's business model, such as whether advisers are client facing or not, rm structure, and regulatory su- pervision. Therefore, rms and advisers with clean records coexist with rms and advisers that persistently engage in misconduct. After documenting basic dierences in the prevalence of misconduct across nancial advisers and nancial advisory rms, we explore the labor market consequences of nancial adviser misconduct. What punishment should we expect for misconduct? One benchmark is extreme punishment of misconduct at the rm and industry levels. Firms, wanting to protect their reputation for honest dealing,