Stockbroker Secrets

People have a hard time finding high-quality financial advice. To promote trust and deter low-quality advice, regulators disclose to the public information about advisers who’ve been complained about, sued, or have other regulatory red flags. Securities law encourages retail investors to “do their homework” by looking up an adviser on a national database. But this “BrokerCheck” solution to the search-for-quality problem has a well-known accuracy problem: brokers routinely secure the expungement of information about previous customer complaints and settlements that others would find useful in selecting a financial advisor on the basis of quality. This has real stakes for markets and for investor protection. Recent scholarship has found that brokers who receive expungement are more likely to get in trouble again. Drawing on literature about the tradeoff between adjudication and error costs in institutional design, we offer a unique theoretical justification for regulators to switch expungement from an arbitration to an administrative forum. As arbitration law prevents regulators like the SEC from intervening in this process to correct errors, this forum generates significant and socially costly errors. Brokers with dirty records can mimic those with clean ones, competing for potentially more valuable customers. It redirects capital allocation toward less productive uses. And in the case of false negatives— including where the SEC perhaps should intervene but can’t, it may impose undesirable reputational consequences to brokers. We assess the policies behind this disclosure solution, and potential impediments to monitoring for quality in the market for financial advice. We also consider the value of stakeholder participation in the processes of constructing and gatekeeping access to capital markets. This topic is timely, with the brokerage industry’s self-regulatory organization, FINRA, having recently instituted more modest tweaks to the system than we have proposed. We expect that these changes—which the SEC has approved—will also prove insufficient. This timely article argues that regulators should head back to the drawing board. Our theoretical framework for thinking about expungement counsels in favor of a doctrinal fix that would address arbitration’s overproduction of false-positive and - negative expungements, and promote public participation and oversight. FINRA should carry out expungement only in a hearing panel procedure that can guarantee robust error correction and public participation through the Securities and Exchange Commission and the federal courts. The article ends with some comments on the uncertainty facing stock market regulation at a time of anti-administrativism in the federal judiciary.