One way to check out the character of a stockbroker in the United States is to log on to BrokerCheck, a website operated by the Financial Industry Regulatory Authority. It offers free information about all advisers and any known instances of misconduct. There is a lot to wade through though: in 2017, there were 3,726 broker-dealers in the US, employing more than 630,000 advisers registered with FINRA.
There is one approach to begin narrowing the field of potential broker-dealers, according to the Public Company Accounting Oversight Board’s Jonathan Aaron Cook, Notre Dame’s Zachary T. Kowaleski, Chicago Booth’s Michael Minnis, MIT’s Andrew Sutherland, and University of Wisconsin at Madison’s Karla M. Johnstone, and that is to learn which CPA firm is auditing the brokerage. The researchers find that an auditor’s track record of accepting high-misconduct stockbroker clients, which tends to predict their new clients’ future misconduct, is closely tied to the reputation of the auditor.
This is a huge issue to household investors. They carry out more than $40 trillion in transactions a year using broker-dealers. And scandals in the wealth-management divisions of financial institutions such as Wells Fargo indicate there are plenty of bad actors out there.
Previous research suggests that brokerage clients select auditors based on size, industry expertise, and audit quality. The researchers explored the idea that auditors protect their reputations by screening the clients they accept and keep in their portfolios.
Broker-dealers are regulated by the Securities and Exchange Commission and are required to submit audited annual reports. The study used research company Audit Analytics’ database on brokerages, which compiles company, financial-statement, and audit-report information from the SEC’s EDGAR database. The certified-public-accounting firms reported as auditors by brokerages ranged from sole proprietors to the Big Four (Deloitte, Ernst & Young, KPMG, and PwC).
The researchers also combed through the BrokerCheck database of all registered advisers employed in the US as of January 2018 as well as individuals employed as many as 10 years earlier. They examined misconduct records—including civil, criminal, and regulatory actions, customer dispute resolutions, and departures of employees accused of misconduct—between 2001 and 2017.
Using regression analysis, the researchers find a positive correlation between an auditor’s previous record of accepting high-misconduct clients and the likelihood that new clients would engage in future misconduct. Although the researchers’ primary focus was on the brokerage industry, they extended their analysis to all US public companies. They find a similar correlation, leading them to conclude that auditors’ track records of accepting high-misconduct clients predict their new clients’ future misconduct.
This behavior may be explained by two drivers: one is the tendency of parties to match up with their peers, and the second is simple self-interest—high-reputation auditors are concerned that their image could be tarnished by associating with too many low-reputation clients.
Unfortunately for investors, there’s no objective listing of auditor quality; that may have to wait for an innovative entrepreneur. Until then, there’s a useful proxy on the easily searchable Accounting and Auditing Enforcement Releases page on the SEC website. Enter the auditor’s name, and the search engine will return a list of reports of related enforcement actions as well as notices and orders involving the auditor. The list isn’t exhaustive, but it does appear to be a good indicator of auditor quality. A high level of activity may be a warning sign.
One comforting note: auditors with clients making initial public offerings appear to be less willing to accept high-misconduct brokerages, the researchers find. These clients are particularly sensitive to an auditor’s reputation because of information-asymmetry issues and litigation risk. And when a mismatch does occur between a brokerage with a high misconduct rate and a high-reputation auditor, the relationship doesn’t last long.
The researchers’ findings could provide a useful reference point for the 56 percent of American investors who rely on financial advisers.