Security Recommendations and the Liabilities of Broker-Dealers

In the United States, investors often receive investment advice from two types of financial intermediaries: broker-dealers and investment advisers. Regulatory agencies and self-regulatory agencies have the responsibility to examine broker-dealers and investment advisers, investigate potential violations of securities laws, and bring enforcement actions.  Investors can also bring claims against a broker-dealer or an investment adviser. For broker-dealers, the rules of self-regulatory organizations require the arbitration of disputes if requested by the customer or required by a written agreement.

In a recent paper (available here), I investigate the liabilities of broker-dealers when providing security recommendations. The primary question of the paper is whether the liabilities of broker-dealers can be greater when the securities they recommend are more difficult to evaluate (or ‘opaque’) and investors are therefore at a greater risk of harm. Recent research finds that securities that are more difficult to evaluate are often sold to investors at significant premiums, and relates the increase in the number and the opacity of financial products to the incentive of financial intermediaries to maximize information rents. The secondary question of the paper is whether the liabilities of broker-dealers are dependent on the violations investors assert as part of the claim. Investors are not limited in the violations they can assert, and bring claims to arbitration asserting a broad range of violations including violations of the broker-dealer regulatory regime, violations of the investment adviser regulatory regime, and violations of state law. 

Using the full sample, I find that investor awards are more positive when the securities at issue are opaque. For example, I find that investor awards are 9.6% (51.0% to 41.4%) more likely to be positive when the claims involve opaque securities than when the claims do not involve opaque securities. I also find that the violations investors assert can be determinants of investor awards, and in particular investor assertions of a fiduciary duty or a suitability violation. Relative to when claims involve non-opaque securities, investors are 9.2% to 11.6% (11.8% to 13.5%) more likely to receive a positive award when they assert a fiduciary duty violation (suitability violation) and the securities at issue are opaque. Lastly, I find that the length of arbitration, a measure of the legal fees and other expenses to broker-dealers from arbitrating instead of directly settling a dispute, is greater for arbitrations involving opaque securities than for claims not involving opaque securities.

The longer arbitrations for claims involving opaque securities suggest that these claims had more uncertain outcomes, and thus were more difficult to directly settle prior to arbitration.  Assuming that arbitration outcomes are more uncertain as claim size increases and, as such, more difficult to settle (potentially as a result of a greater difficulty to evaluate the violations investors assert), I partition the sample into large and small claims to control for differences in the selection of claims for arbitration.  In general, I find that the more positive awards when the securities at issue are opaque, and when the securities are opaque and investors assert a fiduciary duty or a suitability violation, primarily relate to large claims and not to small claims.  This evidence is consistent with broker-dealers having additional liabilities from arbitration from the set of claims that were more uncertain and thus more difficult to directly settle.

The results of the paper indicate that the security recommendations made by broker-dealers do not occur in a vacuum; broker-dealers can have additional liabilities or potential costs to resolve disputes when they recommend securities that are more difficult to evaluate and investors are therefore at a greater risk of harm.  The liabilities or potential costs relate not only to the arbitration awards and to the additional expense from arbitrating a dispute, but also to the inability of broker-dealers to reduce their risks by directly settling disputes and avoiding the uncertainty of award decisions.  Hence, although financial intermediaries have incentives to recommend securities that are more difficult for investors to evaluate, financial intermediaries can also have additional liabilities or potential costs to recommend these securities.

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Matthew Kozora is a Financial Economist at the Division of Economic and Risk Analysis of the U.S. Securities and Exchange Commission.