Brokers barred by the Financial Industry Regulatory Authority because of misconduct may be tossed out of the brokerage industry, but many set up shop in insurance — often in annuity sales — where they continue to misbehave, according to a new research paper.
The paper, "Regulatory leakage among financial advisors: Evidence from FINRA regulation of ‘‘bad’’ brokers," was penned by former SEC Commissioner Robert Jackson along with Edwin Hu, a former Securities and Exchange Commission economist who's now a professor at University of Virginia School of Law, and Colleen Honigsberg, professor at Stanford Law School. It was published in the Journal of Financial Economics.
"This paper confirms that enforcement by FINRA does not remove bad actors from financial services," Adam Gana, president of the Public Investors Advocate Bar Association, told ThinkAdvisor Friday in an email. "Enforcement and barring brokers simply displaces them into the insurance channel. Barred and high-risk brokers overwhelmingly reappear as insurance producers, investment advisors, and annuity marketers, where oversight is weaker and consumer harm can persist outside FINRA’s jurisdiction."
From Securities to Insurance
According to the paper, of the 456,906 individuals who withdrew their FINRA brokerage licenses between 2012 to 2022 and remain outside FINRA's regime, roughly 26.5% are registered with another financial regulator. "This contradicts a common assumption in academic literature that an exit from FINRA registration is akin to exiting the financial services industry," the authors state.
Of the individuals who exit FINRA’s broker regime, 79% were jointly registered in insurance upon exiting FINRA. "This could be efficient if it reflects bad actors who transition to lower risk work, but our evidence shows that these advisors continue to engage in financial planning after they move to the insurance side, as over 90% maintain licenses to sell annuities," the paper states.
"Moreover, those who committed misconduct when regulated by FINRA continue to have heightened levels of misconduct in insurance."
An Ineffective Crackdown
Two rules proposed by FINRA in 2018 and 2019 to nudge “bad” brokers out of the industry didn't work, the authors find.
In 2018, FINRA proposed "that brokerage firms obtain FINRA’s approval (a costly and time-consuming process) before hiring brokers with a substantial history of misconduct," the authors state.
Then, in 2019, FINRA proposed "to designate firms with an unusually high number of previously disciplined brokers as 'restricted,' and to require some of those firms to maintain a reserve account with assets available for aggrieved customers — a penalty so severe that one industry blog likened it to expelling the firms in question," the paper states.
The rules were adopted largely as written in 2021.
"Assuming that the rules were effective at pushing bad actors out of FINRA’s regime, it is unclear whether the effect of the rules would be to force bad actors out of financial services entirely — or to force bad actors into less regulated areas of financial services," the authors wrote.
While the proposals caused thousands of high-risk brokers to exit the FINRA broker regime, "the majority of these individuals did not leave financial services — 98% are currently registered with state regulators as insurance producers."
The current regulatory framework "invites self-selection, as 'bad’ advisors are incentivized to seek the most lax regulatory regime," the authors contend.
High-Risk Work
The fragmentation also has potential benefits, the paper states, "as it may allow higher risk advisors with a history of misconduct to transition to lower-risk work, while preserving their human capital."
But the research finds that most do not.
"An advisor who leaves the broker regime and transitions to insurance may sell products like car insurance (low risk) or products like variable annuities (high risk)," according to the paper. "The sale of either product allows the broker to make use of prior skills rather than finding a new industry altogether, but they pose differing risks to consumers."
As to the products sold by former FINRA brokers who operate in insurance, the paper found that 92% are licensed to sell annuities; 76% are licensed to sell variable annuities specifically.
"Fewer than 15% have the authority to sell personal or casualty products (e.g., home insurance)," the paper states. "In sum, these former FINRA brokers appear to be operating on the asset management side of insurance rather than the traditional risk reduction side."
Continued Misconduct
Also, individuals with a history of insurance misconduct have a high rate of recidivism, the paper finds.
Using public data from Texas on complaints against insurance producers, the researchers found that "former FINRA brokers are both more likely to have customer complaints filed against them than currently registered FINRA brokers and to be repeat offenders."
Those with a history of misconduct in either FINRA's BrokerCheck or the insurance database were 12 times as likely to reoffend as the average producer.
In addition, "individuals are more likely to withdraw their FINRA registration and work in insurance when the state insurance regulator is more lenient (as measured by the regulator’s budget and total fines relative to the number of producers in that state), and in states with a smaller salary gap between brokers and insurance producers (brokers typically earn more than insurance producers)," the authors state.
"Jointly, these tests suggest that former brokers with a history of misconduct who transition to insurance continue to engage in similar behavior."
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