Does Regulation Actually Clean Up Bad Behavior?

The article “Does Regulation Actually Clean Up Bad Behavior?” was originally published on Alpha Architect blog.

Regulation is meant to clean up bad behavior. But what if it just pushes it around? This paper explores how FINRA’s efforts to discipline “bad brokers” often lead to regulatory leakage—problematic advisors leaving one firm only to resurface elsewhere. The results reveal that misconduct doesn’t always end when regulators act; instead, it migrates. The study sheds light on why enforcement alone may not be enough to protect investors.

Regulatory leakage among financial advisors: Evidence from FINRA regulation of “bad” brokers

• Honigsberg, Hu, and Jackson
• Journal of Financial Economics, 2025
• A version of this paper can be found here
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Key Academic Insights

Regulation triggers broker migration, not elimination
When FINRA sanctions firms with high misconduct rates, those firms often close or lose licenses but many advisors previously disciplined simply relocate to less regulated or more tolerant firms. Roughly 30% of sanctioned brokers remain active in the industry within two years.

Contagion effects follow the brokers
The authors find that these relocated brokers often bring their problematic behavior with them. The new firms that hire such individuals experience a 25% higher future misconduct rate than peers that don’t, suggesting that cultural or incentive structures travel with the offenders.

Regulatory “spillovers” distort competition
Firms that inherit migrating bad brokers temporarily gain market share, likely due to aggressive sales tactics or lax compliance. But the effect reverses as misconduct and client complaints accumulate, eroding reputation and profitability over time.

Better screening mitigates leakage
Firms with stronger compliance infrastructure and more selective hiring practices are significantly less likely to experience leakage. The research suggests that robust background checks and tighter licensing rules can sharply reduce the persistence of misconduct in the industry.

Practical Applications for Investment Advisors

Strengthen internal screening and compliance
Hiring history matters. Firms should review not only individual disciplinary records but also prior firm-level cultures. Repeated patterns of migration from sanctioned firms can be a red flag.

Design compensation that discourages misconduct
Commission-heavy pay models correlate with higher migration of problematic brokers. Shifting toward client-aligned fee structures can lower both reputational and regulatory risk.

Understand cultural contagion
Misconduct isn’t just an individual problem—it spreads through culture. Firms that onboard advisors from high-risk environments should implement onboarding and supervision protocols to prevent transmission of bad norms.

Use regulatory data as an early warning system
FINRA’s BrokerCheck and enforcement disclosures contain predictive signals. Monitoring these datasets can help identify emerging patterns of “regulatory leakage” before they affect clients or the firm.

How to Explain This to Clients

“Regulators work hard to protect investors, but bad actors don’t always disappear—they often just move. Research shows that when firms with compliance issues are sanctioned, some of their brokers resurface elsewhere and carry the same risky behaviors with them. The best defense is strong due diligence—choosing firms that vet their advisors carefully and enforce strict ethical standards.”

The Most Important Chart from the Paper

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Abstract

We create a single database containing four categories of financial advisors: (1) brokers regulated primarily by FINRA, (2) investment advisers regulated by the SEC, (3) investment advisers regulated primarily by state regulators, and (4) insurance producers. There is significant overlap across the categories; more than 40% of the advisors are registered with more than one regulator. We examine how this regulatory fragmentation intersects with regulatory discipline by studying two FINRA rules designed to nudge “bad” brokers out of FINRA’s regulatory regime. Although the rules caused thousands of high-risk brokers to exit the FINRA broker regime, 98% of those who exited are currently registered with state regulators as insurance producers.