Rogue brokers and their counterparts among registered investment advisers—overall a relatively small but persistent cohort among securities-market professionals—defraud their clients, execute unauthorized transactions, and otherwise betray the trust clients necessarily repose in them. Many rogues are recidivists: fired by one firm, they move to another and often engage in new misconduct; in this context, prior misconduct is a good (if not perfect) predictor of future misconduct. Firms that appear to welcome rogues may enhance risks of harm imposed on clients and inflict adverse reputational consequences on the industry and its regulators. Written as a chapter in the forthcoming Handbook of Investor Protection (ed Arthur B Laby, Cambridge Univ Press), my paper introduces the vocabulary and doctrines of common law agency as a framework to examine structural features that underlie the challenges posed by individual rogues. This framework also helps to situate the distinct role played by securities-market regulation. The paper incorporates the results and implications of other scholars’ recent quantitative inquiries into securities-market rogues as well as other cohorts daunted by recidivism, in particular law-enforcement officers and insurance producers.
A securities-market rogue links two distinct types of agent-principal relationships: (1) between an individual representative and the firm with which that professional is associated; and (2) between the firm and the clients or customers with whom the representative interacts on the firm’s behalf. Both types of relationships are characterized by asymmetries that work to the disadvantage of investors, especially so for unsophisticated retail investors. This is because an individual rogue and the firm represented by the rogue have access to material information unavailable to the investor, in particular textured information about the rogue’s history and present propensities as well as the firm’s own practices. Separately, a firm’s powers of control over its representatives exceed an investor’s powers of control as a principal in an agency relationship once the investor engages the broker or adviser.
Although agency law doctrine accounts for both asymmetries, its responses operate only retrospectively once a client suspects problems with an account. In contrast, regulation can deploy distinct strategies for proactive intervention, including periodic examinations inside firms conducted by expert regulatory personnel. Regulation also can expand liability to encompass firm personnel charged with supervisory responsibilities. Within this framework, the paper examines recent proposals from the Financial Industry Regulatory Authority (FINRA)—which regulates broker-dealer firms and their broker representatives—to address persistent concerns with individual rogues and broker-dealer firms that employ them.
The diverse array of regulatory structures and licensing requirements that characterize the overall landscape may enhance risks of recidivism. This is because individual rogues may exit the brokerage industry—and FINRA’s purview—while remaining registered with the SEC as investment advisers, or may exit the securities industry altogether to work as state-registered insurance producers and sell insurance products linked to the value of securities, like annuities. But insurance producers often maintain relationships with multiple insurers, no one of which bears responsibility for the producer comparable to that of a broker-dealer or investment-advisory firm.
Although it can be tempting to see firms that appear congenial to rogues as ‘bad barrels’ that attract and retain ‘bad apples,’ the firm—understood as a principal in a distinct agency relationship with its customer-facing representatives—is also a focal point for reducing risks otherwise posed to the clients served by its employees. Insurance producers lack a comparable focal point. For broker-dealer and investment-advisory firms, the common law backdrop suggests an additional doctrinal avenue toward reform that would sharpen firms’ incentives in selecting and monitoring their agents. Hiring a broker or investment adviser with a significant disciplinary history is often a precursor to future misconduct; this may warrant a presumption of negligence on the part of the firm in hiring or supervision when new misconduct occurs. That past misconduct is often a precursor of future misconduct might also warrant a comparable presumption under statutory frameworks imposing liability on firms and immediate supervisors for failure reasonably to supervise the firm’s brokers or investment advisers. Formalized in tort law under the familiar slogan of res ipsa loquitur, the doctrine creates incentives for defendants to come forward with probative evidence demonstrating the exercise of reasonable care and to manage personnel with that prospect in mind. A res ipsa-like presumption or inference of negligence would not outlaw hiring securities-market professionals with problematic histories but could discourage the practice or strongly signal the need to couple it with appropriate precautions.
Deborah A DeMott is the David F Cavers Professor of Law, Duke University School of Law.