The Untouchables of Self-Regulation

Andrew Tuch is Associate Professor of Law at Washington University School of Law.

The conduct of investment bankers often arouses suspicion and criticism. In Toys “R” Us, the Delaware Court of Chancery referred to “already heightened suspicions about the ethics of investment banking firms” [1] ; in Del Monte, it criticized investment bankers for “secretly and selfishly manipulat[ing] the sale process to engineer a transaction that would permit [their firm] to obtain lucrative … fees”; [2] and, more recently, in Del Monte, it criticized a prominent investment banker for failing to disclose a material conflict of interest with his client, a failure the Court described as “very troubling” and “tend[ing] to undercut the credibility of … the strategic advice he gave.” [3] While the investment bankers involved in the cases inevitably escaped court-imposed sanctions, because they were not defendants, they also escaped sanctions from the Financial Industry Regulatory Authority (FINRA), the regulator primarily responsible for overseeing their conduct.

An under-appreciated feature of the regulation of investment bankers is that they must register with, and comply with rules promulgated by, FINRA. The self-regulatory body for broker-dealers, FINRA (and its predecessor organization, the NASD) was formed on the principle that self-regulation is more effective than direct government regulation in governing the ethics of its broker-dealers. Investment bankers generally fall within the definition of broker in federal securities laws because of the functions they perform and their compensation structure. Investment bankers must therefore comply with FINRA rules, including the requirement to “observe high standards of commercial honor and just and equitable principles of trade.”

The self-regulation of investment bankers has been largely overlooked in legal literature. Important strands of literature consider the self-regulation of various professionals, including lawyers and accountants, but not of investment bankers. Some scholars have examined the obligations of broker-dealers, focusing on their traditional roles of executing client trades and producing research reports—but not their role in investment banking. Some scholarship considers FINRA regulation and enforcement generally, praising its vigor, but without separately considering FINRA’s treatment of investment bankers.

In my paper, The Untouchables of Self-Regulation, which is forthcoming in the George Washington Law Review, I examine FINRA’s regulation of investment bankers. More specifically, the paper assesses the effectiveness of the self-regulation of investment bankers in deterring misconduct. It regards investment bankers as those who advise corporations, or other business entities, on mergers and acquisitions, reorganizations, or securities offerings. Misconduct includes matters relating to the service of client interests, the protection of client confidences, the exercise of skill and diligence, and the accuracy and completeness of communications.

Based on a unique data set of every disciplinary matter by FINRA during the period January 2008 to June 2013, this study shows that the intensity of FINRA’s enforcement activity against investment bankers is remarkably weak. During the 66-month period under investigation, FINRA imposed sanctions in 4,116 matters against individuals and 1,645 matters against firms. Of the individuals sanctioned, 18 were investment bankers, and only 10 of these were sanctioned for misconduct toward their clients (rather than toward other actors, such as their firms). During the period, no investment banker was sanctioned for her conduct in advising on a public merger or acquisition deal or a registered securities offering—the most important transactions on which investment bankers advise. Of the 1,645 matters against firms, only seven involved the misconduct of their investment bankers.

Applying optimal deterrence theory, the paper argues that the self-regulation of investment bankers offers no credible deterrence against misconduct. It reasons as follows.

First, the number of disciplinary matters is low in number.

Second, empirical evidence—concerning the skewing of advice and misuse of non-public client information—as well as specific instances of reported investment banker misconduct indicates that investment bankers engage in significantly more misconduct than FINRA punishes. This data, together with the sheer volume of US investment banking activity, indicates in turn that the probability of sanction of investment bankers’ misconduct by FINRA is low.

Third, a review of the sanctions imposed by FINRA on investment bankers shows modest sanctions, or sanctions commensurate with the harms imposed. Nothing suggests the magnitude of the sanctions is sufficient to offset the low probability of sanction to achieve optimal deterrence.

Fourth, a review of the disciplinary matters involving investment bankers shows that just three matters involve firms of any real prominence and only one appears to have been reported in the financial press. None involved high profile investment bankers or landmark transactions. Accordingly, it is unlikely that investment bankers might have perceived that the probability of sanction was higher than it was, in fact.

Finally, nothing suggests that the cost of further deterring investment bankers’ wrongdoing would be higher than the benefit to doing so. Rather, the opposite is far more likely.

The paper thus argues that self-regulation of investment bankers under-deters investment bankers’ wrongdoing and, in fact, does not credibly deter misconduct by investment bankers. Moreover, since the costs of self-regulation likely exceed its benefits (measured in terms of deterrent force), the paper concludes that the self-regulation of investment bankers should be considered a failure.

The paper attributes FINRA’s failure to a range of factors, including its lack of institutional expertise, the generality of its rules, its regulatory priorities, its investigative approach, and the exalted status that it accords investment bankers. A combination of these factors is likely to explain—but not justify—FINRA’s weak enforcement and the resultant under-deterrence.

The paper also reaches the preliminary conclusion that other deterrence mechanisms, including private and SEC enforcement, likely under-deter misconduct by investment bankers. Reputational constraints, while effective in some contexts, fail to ensure banker propriety due to the opportunities for misconduct, the massive rewards on offer, and the opacity of the circumstances in which misconduct occurs. Moreover, many investment banking clients, even those that are generally sophisticated, cannot be expected to adequately police their investment bankers. As Delaware courts acknowledge, many boards have little or no experience in sale transactions; the same would be true of initial public offerings. While shareholders can be expected to be vigilant in calling investment bankers to account and Delaware courts have shown increased focus on investment banking misconduct, especially regarding conflicts of interest, it is too early to tell the deterrent force these developments will have. Finally, the paper advances the preliminary view that SEC enforcement is unlikely to adequately deter the full breadth of investment banker misconduct because of its focus on fraud, rather than misconduct falling short of fraud, which is the type of conduct on which FINRA focuses.

The paper concludes by exploring various proposals for reform. It argues that the task of regulating investment bankers should be given either to a newly established, dedicated self-regulatory body—an investment bankers’ regulatory authority—or to a newly-formed and staffed unit within FINRA. Self-regulation offers important advantages over other techniques for regulating professional responsibilities and should be maintained for the reasons it was initially adopted. But the new regulator must have expertise in investment banking and be tasked with developing specific canons of professional responsibility, which FINRA has generally failed to do, and enforcing them robustly. The SEC must also discharge its oversight duty, determining in the first instance whether FINRA is discharging its statutory obligation of enforcing its rules against all broker-dealers, including investment bankers.

The full paper is available for download here.


[1] In re Toys “R” Us, Inc. S’holder Litigation, 877 A.2d 975, 1055 (Del. Ch. 2005)
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[2] In re Del Monte Foods Co. S’holders Litig., 25 A.3d 813, 818 (Del. Ch. 2011).
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[3] In re El Paso Corp. S’holder Litig., 41 A.3d 432, 442 (Del. Ch. 2011).
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