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13.8: Ethics and Regulation

Last updated

Apr 10, 2025
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- 13.7: Investing and Trading
- 13.9: Investing Internationally- Risks and Regulations

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Learning Objectives

Discuss the reasons that investing behavior may be unethical.
Identify the key professional responsibilities of investment agents.
Describe practices that investment agents should pursue or avoid to fulfill their professional responsibilities.
Explain how investment agents are regulated.
Debate the role of government oversight in the securities industry.

Financial markets, perhaps more than most, seem to seduce otherwise good citizens into unethical or even illegal behavior. There are several reasons:

Investing is a complex, volatile, and unpredictable process, such that the complexity of the process lowers the probability of getting caught.
The stakes are high enough and the probability of getting caught is low enough that the benefits can easily seem to outweigh the costs. The benefits can even blind participants to the costs of getting caught.
The complexity of the situation may allow some initial success, and the unethical investor or broker becomes overconfident, encouraging more unethical behavior.
Employers may put their employees under pressure to act in the company's interests rather than clients' interests.

Three forces are at work to counteract these realities: market forces, professional standards, and legal restrictions. But before these topics are discussed, it is useful to review the differences between ethical and unethical, or professional and unprofessional, behaviors in this context.

Professional Ethics

Investment intermediaries or agents such as advisors, brokers, and dealers have responsibilities to their clients, their employers, and to the markets. In carrying out these responsibilities, they should demonstrate appropriate professional conduct. Professional conduct is ethical, that is, it is based on moral principles of right and wrong as expressed in the profession's standards of conduct.

Brokers and advisors should always deal objectively and fairly with clients, putting clients' interests before their own. In other words, a broker should always give higher priority to the client's wealth than to their own. When acting on a client's behalf, a broker should always be aware of the trust that has been placed in them and act with prudence and care. The principle of due diligence stipulates, for example, that investment advisors and brokers must investigate and report to the investor every detail of a potential investment.

Professional ethics call for brokers and advisors to disclose any potential conflicts of interest they may have. They also should be diligent and thorough when researching investments and making recommendations, and should have an objective basis for their advice. Investment recommendations should be suitable for the client, and advice should be given with the best interests of the client in mind.

An advisor or broker should

be forthcoming about how the investment analysis was done and the changes or events that could affect the outcome;
not present themselves as a "guru" with a special or secret method of divining investment opportunities;
clearly explain the logic and grounding for all judgments and advice;
not try to pressure you into making an investment decision or use threats or scare tactics to influence you;
communicate regularly and clearly with you about your portfolio performance and any market or economic changes that may affect its performance.

In addition to being loyal to clients, brokers and advisors are expected to be loyal to employers, the professions, and the financial markets. Accepting side deals, gifts, or "kickbacks," for example, may damage a company's reputation, harm colleagues as well as clients, and betray the profession. Loyalty to market integrity is shown by keeping the markets competitive and fair. For example, brokers should only use information available to all. Information from private sources to which others do not have access is insider information, and making trades based on insider information is called insider trading.

Brokers and advisors should not manipulate markets or try to influence or distort prices to mislead market participants. Attempts to do so have become more widespread with the tremendous growth of the internet.

Regulation of Advisors, Brokers, and Dealers

It is said that the financial markets are self-regulating and self-policing. Market forces may be effective in correcting or preventing unprofessional conduct. However, if they don't, professional and legal sanctions are available.

Sanctions provide deterrence and punishment. Registered brokers, advisors, and their firms are typically members of professional organizations with regulatory powers. For example, professional organizations have qualifications for membership and may award credentials or accreditation that their members would not want to lose.

There are many professional designations and accreditations in the investment advising and brokerage fields (Chapter 1). However, keep in mind that no professional affiliation or designation is required to give investment advice.

The U.S. securities industry is formally regulated by federal and state governments. Government sanctions and limits have been imposed gradually, usually after a major market failure or scandal; these form a collection of rules and laws overseen by a variety of agencies.

The Securities and Exchange Commission (SEC) is a federal government agency empowered to oversee the trading of securities and the exchanges in the capital markets. It was created in 1934 in response to the behavior that precipitated the stock market crash in 1929 and the subsequent failure of the banking system.^[1] The SEC investigates illegal activities such as trading on insider information, front-running, fraud, and market manipulation.^[2]

The SEC also requires information disclosures to inform the public about company financial performance and business strategy. Investors must report to the SEC their intention to acquire more than 5 percent of a company's shares, and business executives must report to the SEC when they buy or sell shares in their own company. The SEC then tries to minimize the use of insider information by making it publicly available.

Government regulation of capital markets has long been a contentious issue in the United States. During periods of expansion and rising asset prices, there is less call for regulation and enforcement. Clients and investment agents may have fewer complaints because of investment gains and increasing earnings. However, when a bubble bursts or a true financial crisis occurs, the investors can demand protections and enforcement. While history shows that the kinds of regulation and amount of government oversight vary, there will likely always be a role for federal and state government regulators.

Investor Protection

As an investor, you have recourse if a broker or advisor has been unethical, unprofessional, or criminal in their conduct. If the offending agent is working for a brokerage firm or bank, a complaint to a superior is sometimes all that is needed. The firm would prefer not to risk its reputation for one "bad apple."

If you are not satisfied, however, you can lodge a formal complaint with the professional organization to which your broker or advisor belongs. These self-regulatory organizations (SROs) have standard procedures in place and will investigate your complaint. If necessary, the offender will be punished by a suspension or permanent removal of their professional designation or certification. You can also complain to the SEC or a state or federal consumer protection agency, file suit in civil court, or press for a criminal complaint.

As always, the best defense is to take care in selecting an investment advisor or broker. Most investment agents are chosen based on recommendations from trusted family members, friends, or colleagues who have been satisfied clients. Before you choose, check with the professional organization with which they claim affiliation or certification, and review any records of past complaints or offenses. You can also check with government agencies such as the state attorney general's office.

Your choice of advisor or broker depends largely on your expected use of services, as suggested in Table 13.8.2 .

Table 13.8.2 : Choosing an Investment Advisor or Broker
Your Role	Agent's Role	Type of Firm
You anticipate doing your own research and making your own investment decisions.	You want convenient access and someone to execute trades for you at a secure, accessible, and informative brokerage.	National or international firm with many branches, Internet brokerage available 24/7 Brokerage account at a one-stop shopping bank
You are looking for a lot of personal guidance and investment advice.	You want an advisor to provide independent advice on investment planning and asset allocation, and a separate broker who is willing to discuss research as it relates to your plan and to implement your trades. The advisor and the broker each act as a "second opinion" to the other.	A certified financial advisor A highly rated, stable brokerage firm or discount brokerage

You will be investing over a lifetime. The economic, market, and personal circumstances will change, and your plans and strategies will change, but your advisors and brokers should be able to help you learn from experience and prosper from—or despite—those changes.

Summary

Investing behavior may be unethical because
- its complexity lowers the probability of getting caught,
- the stakes are high,
- initial success may encourage more unethical behavior,
- companies may expect that their interests have priority.
Investment agents have responsibilities to their clients, employers, professions, and markets.
To fulfill those responsibilities, brokers should always put the interests of clients, employers, professions, and markets before their own and should not practice front-running, insider trading, or market manipulation.
Regulation of investment agents comes from
- market forces,
- professional associations and self-regulating organizations,
- state and federal government oversight and enforcement agencies.
Levels of government oversight are politically contentious and subject to change.
Through consumer protection laws, investors have recourse for losses from unprofessional or illegal behavior. The best protection is to make good choices of financial advisors and investment brokers.

Exercises

Read the Securities and Exchange Commission's mission (www.sec.gov/about/mission). In what ways is the SEC your advocate as an investor? Disclosure, fair dealing, and transparency are the SEC's watchwords. To what do they refer? List your answers in your personal finance journal.
Go to the SEC's site on self-regulatory organizations (SROs) of the securities industry (www.sec.gov/rules-regulations/self-regulatory-organization-rulemaking). Click on an SRO and read the new rules it is making. Discuss with classmates how you would comment on them, as you are invited to do.
Debate with classmates about the desirability of government regulation of the financial markets at the federal, state, and organizational levels. What impacts do regulation and deregulation have on the economy, the markets, and you as an investor? What are some concrete examples of those impacts? Write an essay declaring and supporting your position on this issue.

^[1] Gratton, Peter. “Securities and Exchange Commission (SEC) Defined, How It Works.” Investopedia, July 12, 2024. https://www.investopedia.com/terms/s/sec.asp.

^[2] Ibid.

Professional Ethics

Regulation of Advisors, Brokers, and Dealers

Investor Protection

Summary

Exercises

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