The Legal Framework for Financial Advertising: Curbing Behavioural Exploitation

My article offers a normative behavioural finance analysis of the marketing communications regime in Europe’s new Markets in Financial Instruments Directive (MiFID II). The article aims to bridge the gap between empirical insights and normative arguments. It shows how the current investor protection regime can be interpreted in light of empirical insights about how financial advertising exploits investors’ behavioural biases. The article also submits policy proposals that aim to protect investors more effectively from behavioural exploitation.

Policymakers and behavioural finance scholars express growing concern that marketing practices by financial institutions exploit retail investors’ behavioural biases. Investor protection regulation should thus address these practices and include mechanisms curbing behavioural exploitation. The article establishes that the requirements imposed on investment firms by MiFID II are necessary in order to protect investors from behavioural exploitation. The article also demonstrates how a regulatory authority can translate empirical behavioural finance research findings into legal arguments when assessing whether marketing practices can significantly distort a model investor’s decision-making process.

The article presents five well-documented and well-studied behavioural biases of typical retail investors (representativeness bias, availability bias, framing bias, anchoring bias and emotional bias). Empirical studies show that financial advertising is capable of addressing these behavioural biases and, as a consequence, distorting the decision-making process of retail investors, leading to costly decision-making errors. From a legal perspective, financial advertising must be fair, clear and not misleading (art. 24(3) MiFID II). These vague words are further specified by art. 44 MiFID II Delegated Regulation. I demonstrate that both provisions can be interpreted in light of research findings about behavioural exploitation. That is because these findings (a) are compatible with the policy objectives of both provisions, (b) fit into MiFID II’s system of investor protection regulation, and (c) are consistent with the investor model underlying both provisions.

The underlying rationale for regulating marketing practices that address investors’ behavioural biases is based on the premise that third parties ought not to exploit investors’ decision-making errors. This premise is compatible with MiFID II’s advertising provisions that protect an investor’s freedom of choice from distorting external influence. Furthermore, the advertising provisions are receptive to incorporating a regulatory model that aims to prevent marketing material from exploiting investors’ behavioural biases by having in place behaviourally informed, targeted requirements regarding the content, design and presentation of information in advertising. My findings are also compatible with the investor model underlying both provisions, since MiFID II’s advertising regime deviates from a purely rational investor model. An objection raised against incorporating behavioural insights into general investor protection legislation is investor heterogeneity. Yet, tailor-made investor protection is not the approach taken by MiFID II’s information disclosure and advertising regime. The legislature can determine at a general level how vulnerable a model investor is to behavioural exploitation. MiFID II’s advertising provisions contain such policy choices.

Based on these general findings, I show how specific conduct obligations can be interpreted as aiming to prevent marketing material from exploiting investors’ behavioural biases. In this regard, two examples may be used. First, art. 44 MiFID II Delegated Regulation requires that information addressed to (potential) retail clients must be presented in a way that is likely to be understood by the average member of the group to whom it is directed, or by whom it is likely to be received. This comprehensibility requirement aims to prevent marketing material that exploits an investor’s framing bias and availability bias, and in particular the salience bias. A behavioural finance analysis of this requirement leads to the conclusion that the representation (framing) of the risks of the financial instrument in financial advertising must be suitable to give the average investor a realistic and accurate impression of the significance of risk information and the scope of the risks. Second, financial advertising must be ‘sufficient’ for the average member of the group to whom it is directed. I show that this requirement aims to counteract a decision-making process that is solely or too strongly influenced by representativeness bias or emotional bias. Based on this analysis, a regulatory authority can use behavioural insights to determine where the normative border between lawful and unlawful emotional influence on an investor’s decision-making process lies.

Martin Brenncke is Lecturer in Law at Aston Law School.