The recently adopted SEC rules governing broker dealer behavior (Regulation Best Interest or BI) are intended to enhance investor protections. As stated by the SEC press release, the regulation is “designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers.’
As noted in a prior blog post (SEC Finalizes New Standards for Broker Dealers), Regulation BI relies heavily on disclosure, by broker dealers, of key aspects of the broker dealers’ relationship with investors. The disclosure includes “[a]ll material facts relating to the scope and terms of the relationship with the retail customer, including … material fees and costs that apply to the retail customer’s transactions … [and all] material facts relating to conflicts of interest that are associated with the [broker’s] recommendation.”
The SEC’s reliance on disclosure is premised on the belief that such disclosure will serve as a curb on certain broker dealer behaviors — especially regarding conflicts of interest– and that investors will be better able to assess broker dealers’ recommendations if the investors understand these conflicts. After all, investors should understand that when a broker makes a recommendation, the broker makes money only if the investor buys or sells securities. In effect, the SEC is relying on disclosure as a primary tool to warn investors of the inherent conflict of interest between the broker and the investor. So far, so good. Reliance on disclosure is a common feature in federal law–from prospectuses for stocks to summary plan descriptions for employer sponsored retirement and health care plans.
However, there is some research that creates some questions about the value of disclosure in situations when there is a conflict of interest between the disclosing party and the recipient of that disclosure. A 2005 article based on a study from researchers at Carnegie Mellon University (The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest) raises some important questions about the impact of disclosure–on both the disclosing party and the recipient–in conflict of interest situation.
The design of the study is detailed in the article and will not be detailed in this blog post. In summary, the researchers divided participants into two groups–advisors and estimators. Estimators were rewarded for their ability to accurately estimate the value of jars of coins–while advisors (after receiving additional information about these jars) made suggestions to the estimators and were rewarded differently–some (we’ll call them “non-conflicted advisors”) were rewarded for the estimators’ accuracy and other advisors (we’ll call them “conflicted advisors”) were rewarded for how high the estimators’ estimates were. And, in a final wrinkle, some estimators were then told how their advisors were rewarded (in effect, whether they were receiving advice from conflicted advisors or from non-conflicted advisors).
The experiment generated some interesting results–and theories behind those results. Most significantly:Advisors earned more –and estimators earned less– when the advisors were conflicted (rewarded for how high the estimates were). Correspondingly, estimators earned more and advisors earned less when advisors were non-conflicted
• Conflicted advisors (in “personal” estimates shared with the researchers) gave higher estimates than non-conflicted advisors. The authors believe this “hints at the possibility that advisors may, to some degree, have been persuaded by their own suggestions” and [p]erhaps, convincing themselves that the jars were worth more somewhat assuaged their guilt about providing elevated estimates to estimators.”
• When conflicts were disclosed, advisors provided more biased advice–and estimators discounted this biased advice, but not enough to offset the increase in bias. The authors believe that estimators simply did not have enough information to assess the impact of the (disclosed) conflict.
• Conflicted advisors made more money with disclosure than without disclosure — and estimators earned less money when conflicts of interest were disclosed than when they were not disclosed. The authors anticipate this result was produced for a number of reasons:.
When conflicts are disclosed “advisors might be tempted to provide even more biased advice to counteract the diminished weight that they expect estimators to place on the advice.”
Disclosure provides advisors “moral license” to exaggerate–“disclosing conflicts of interest can potentially backfire by reducing advisors’ feelings of guilt about misleading estimators and thereby giving advisors moral license to bias advice even further than they would without disclosure. …While most professionals might care about their clients, disclosure regulation can encourage these professionals to exhibit this concern in a merely perfunctory way.”
One should be cautious about extrapolating the research behind this article to broker dealers’ activities, which are governed by federal law and extensive regulatory oversight. And, Regulation BI does not rely solely on disclosure to protect investors from brokers whose behaviors are (at least in part) driven by the broker’s economic interests. Nonetheless, disclosure is a major component of Regulation BI’s investor protections and this research provides data and perspectives that could lead one to question whether the SEC’s heavy reliance on disclosure is misplaced.