Conflict of interests in high-tech investment advisory E-Book

Daniel Favoretto

• Herausgeber: buch & netz
• Kategorie: Fachliteratur
• Serie: Next Generation
• Sprache: Englisch
• Veröffentlichungsjahr: 2024

Seitenzahl: 237

Beschreibung

What are the potential sources of conflict of interests in investment advisory services and how should the law design legal tools of retail investor protection? These are the questions addressed by this book, which explores the new legal challenges of investor protection in the context of digital investment platforms and genAI advisors. The author analyses the investor protection tools provided by competition law, regulatory and private law frameworks, taking Brazil as case study, where investment advisory experienced a unique market change and a major regulatory reform. This book addresses a worldwide audience and concludes with a set of policy recommendations.

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Next Generation

The “Next Generation” series offers a platform for young academics in all areas of law. The aim is to promote the visibility of special talents at an early stage. The volumes in this series are published in Open Access and can therefore be shared and distributed via social media and other channels. Each contribution undergoes a peer review process before it is published.

Conflict of interests in high-tech investment advisory

Daniel Favoretto

About the Authors

Book’s author – Daniel Favoretto

Competition lawyer, Consultant under the United Nations Development Programme (UNDP) and Non-Governmental Advisor (NGA) at the International Competition Network (ICN). Former peer-reviewer for the Brazilian Competition Authority (CADE). In the legal practice, he has worked in leading law firms in Brussels (Belgium) and São Paulo (Brazil). Guest member of Harvard’s 2023 GenAI Working Group (D3 Institute). He holds the legal title of meester from the Dutch Ministry of Education (DUO), a master’s degree (cum laude) in Law & Development and a bachelor’s degree in Law from FGV Law School (Fundação Getúlio Vargas), where he worked as assistant lecturer and researcher. Author of academic works published in Europe and Latin America. Throughout his studies, Daniel has been awarded scholarships for distinguished academic performance.

Guest author (foreword) – Nuno Cunha Rodrigues

Associate Professor of the University of Lisbon School of Law (FDUL) and holder of a Jean Monnet Chair from the European Commission (2018). President of the Portuguese Competition Authority (AdC) and Bureau member of the OECD Competition Committee. Doctor (PhD) in Legal and Economic Sciences, Master in Legal and Business Sciences, and Bachelor in Law from the FDUL. Vice-President of the European Institute of the FDUL. Prior to being President of the AdC, Nuno was a lawyer and arbitrator. Author of books and papers on Competition Law, European Union Law, Public Procurement, Economic Law, Public Finance and Tax Law.

The perspectives presented in this book are solely the author’s and do not necessarily reflect the views of any individual or institution that interacted with the author during the production of this book or the research that preceded it. In addition, the author remarks that, during his professional activities, he has never advised, acted on behalf of or provided services to any investment advisor or brokerage firm, such as those mentioned in this book.

Acknowledgements

For those who make the dreams possible and continuously support students for their individual emancipation. My gratitude to Colégio Franciscano Pio XII, the Presidency of Fundação Getúlio Vargas, and FGV’s Endowment Association, for the scholarships granted from my early school years to my post-graduate phase.

Special thanks to the support provided by Universität Zürich (UZH), which enabled this book to be published in open access, and the friendly team of the Europa Institut of Universität Zürich (EIZ), for the interactions during the production process.

I kindly appreciate Professor Dr. Nuno Cunha Rodrigues, for participating in this project through his foreword, as well as my mentors during the master’s programme, Professors Drs. Caio Mario da Silva Pereira Neto and Viviane Müller Prado. The three of them provided unconditional support during the studies that led to this book.

Special thanks to the experts who also had relevant participation by providing key contributions to earlier drafts of the research that preceded this book, namely, Professors Drs. Marcos Galileu Lorena Dutra, Otávio Yazbek, Isac Costa, and Juliana Baldin. Special thanks also to the B3-BSM team, for their continuous effort to transparency in the securities market. Naturally, the views expressed in this book are my own.

Finally, I remark and appreciate the support given by ANBIMA, through the XVI Anbima Prize for Scholars, and Fundação Getúlio Vargas, through the scholarship Bolsa Mario Henrique Simonsen de Ensino e Pesquisa, for my research during the master’s programme, in which this book is partially based.

Executive Summary

This book is an adaptation of the author’s master’s thesis, which was approved by an interinstitutional board of four professors in 2022 and awarded the national recognition of the Anbima Prize for Scholars by the Brazilian Financial and Securities Markets Association.

This book investigates what drives biased investment advisory and how to legally address it in the context of digital investment platforms and genAI products. The hypothesis of conflict of interests in advisory services results from the fact that, in the securities market, investment advisors offer their services to both brokerage firms and investors, thus, serving two “kings” whose interests may diverge. Based on the guiding concept of individual suitability and on the method of case study of Brazil, where investment advisory grew unprecedentedly and a major regulatory reform took place in 2023, this book provides an answer to the following research questions: what are the potential sources of conflict of interests in investment advisory services and how should the law design legal tools of retail investor protection?

Based on empirical research of unprecedented sources, chapters II and III of this book conclude that conflict of interests is a multifactorial risk that arises from (i) compensation conditions according to which the advisor’s fee is higher based on specific investment products and/or on the client’s account turnover, (ii) use of attractive goal-oriented standards to shape the advisor’s incentives, (iii) poor transparency of the advisor’s compensation conditions toward the investor, (iv) to a limited extent, burdening fixed costs, and (v) lack of financial education by investors in general, weakening monitoring conditions and favouring adverse selection.

Although the risk of conflict of interests is not per se illegal and does not mean that advisors effectively engage in biased conduct, it raises investors’ costs of surveillance and chances of harm, reason why the law provides various legal tools of investor protection, in the competition law, regulatory, and private law frameworks. Chapter IV of this book concludes that these legal tools lack a preventive approach and suffer from gaps that limit their deterrent and compensatory purposes.

Chapter V of this book proposes some improvements to the design of the legal tools of investor protection, consisting of a combination of strategies with different levels of intervention and, to prevent overenforcement, a primary focus on investor empowerment for alignment of interests and prevention of biased advisory. However, chapter VI demonstrates that generative artificial intelligence is transforming conflict of interests into a not exclusively human risk, meaning that the design of legal tools has to also consider how machines “think” and influence investor behaviour.

Foreword

In 2015, I went to São Paulo, Brazil, to lecture at Fundação Getúlio Vargas a short-term course to which I was invited. At that opportunity, I had the pleasure to teach to a wide variety of international students, among whom was Daniel Favoretto, who quickly stood out among his peers due to his intelligence, brightness, and ability of critical analysis.

Since then, I have been accompanying his brilliant academic and professional path, which includes the publishing of relevant academic papers that, along with his significant professional experience, make Daniel a promising jurist at an international level.

In 2022, Daniel concluded his master’s in law thesis with distinction, under the title “Serving two kings in the securities market: conflict of interests and investor protection in the Brazilian law of investment advisors” (Portuguese version only).

The thesis led to this book, after Daniel’s translation and adaptation, as well as updates regarding the investment advisory’s fast-paced developments. Given the recognition the thesis received in Brazil, manifested by the Anbima Prize awarded to Daniel’s research project, this book is an opportunity for international audiences to get in contact with Daniel’s work.

The book shows that investors have legal protection tools against the possibility of biased advisory in Brazil, but these tools suffer from gaps that limit their effectiveness against advisor’s conflict of interests and create blind spots of investor vulnerability.

In this context, conflict of interests is not an unprecedented issue. It has been long studied in the business law literature as it is underscored in this book. Nevertheless, the recent wave of digital investment platforms widen access to advisory services and, by that, their potential impact to investors. Daniel Favoretto approaches this framework as a multisided market where the advisor serves two kings (the investor and the broker). For this reason, these professionals can serve either as key support to investors or as instruments to occasionally misuse the securities market.

The book adopts regulatory and private law perspectives along with competition law insights – note, for example, the parts dedicated to analysing market structure and investment platform dominance –, focused mainly on Brazilian law.

However, the book interests any international reader who looks for a relevant analysis and critical perspective used for investor protection – here, it is worth to read chapters II, III and IV –, due to its universal dimension. Despite focusing on Brazilian law, this book provides pertinent comparisons with European law and, most importantly, serves as an interesting case study under a comparative perspective, as well as providing relevant insights to foreign investors in Brazil.

At the end, the book presents some recommendations of legal improvement for better investor protection – chapter V –, which can serve as lessons for other jurisdictions worldwide, along with important and fresh reflexions on generative artificial intelligence – chapter VI.

It will certainly be of interest to any practitioner who works in the securities market and readers interested in the novelties of digital investment platforms and genAI tools.

This is, once more, an excellent academic work of this young scholar who already holds solid recognition, worth being read carefully and, due to its great quality, legitimately raises our expectations for Daniel Favoretto’s future works.

Lisbon, 24 April 2023

Nuno Cunha Rodrigues

Associate Professor at Law,Faculty of the University of LisbonJean Monnet Chair

Table of Content

IntroductionResearching Brazil’s investment advisory market: Navigating on turbulent and unmapped watersDifficulty in accessing information about the advisory marketFast-paced transformation and investor behaviour in the securities marketServing two kings: The role of investment advisorsThe roles of advisors in the securities marketHiring and payment conditions of investment advisorsConflict of interests in investment advisory servicesLegal tools of investor protectionCompetition lawRegulatory frameworkRegulation by the Brazilian Securities Commission and the National Monetary CouncilMarket regulation by the Stock Exchange Oversight BoardPrivate lawTort lawContract lawIntermediary conclusionImprovements to the legal tools of investor protectionThe roles of generative AI in biased advisoryConcluding remarksReferences

Introduction

You worked hard for years throughout your life and, after saving some of your income, you decide to invest, while thinking on your future retirement, next generations and even becoming close to what you once thought yourself as being rich. You realized that earning a living is not as simple as you thought it was when you were at school, so why not try to make at least a small portion of your current money replicate itself in favour of your dreams, your loved ones, and the causes you find worth fighting for in the long term? Regardless of the motive that leads one to make an investment, an investor is an everyday person, hardly the cliché tycoon who seats in an office at the top of Wall Street.

However, you do not have enough expertise to explore investment products without feeling at least a bit uneasy about putting some of your hardworking savings to market risk. Therefore, you decide to hire the services of an investment advisor. How costly would it be to later discover that your advisor has incentives occasionally conflicting to yours? What mechanisms and legal remedies do you have to prevent conflict and protect yourself from those incentives?

Attending to various interests, some occasionally conflicting between themselves, is a natural challenge of anyone living in society. Thus, it is reasonable to assert that conflict of interests is a natural human phenomenon. However, on the other hand, impartiality is an intrinsic requirement to the rule of law, which demands unbiased positions from institutions and agents alike in certain situations. The securities market is no different, since it is governed by the law to protect investors from, among other risks, the conflict of interests of market players, which can promote an exploitative effect and induce the market into a crony environment. In other words, conflict of interests is both a human phenomenon and a legal issue.

This book investigates this phenomenon in investment advisory services. As further detailed, many jurisdictions have in their securities market at least one figure that fulfils the role of investment advisory; for example, in the European Union (“EU”), investment advisory can be performed by the so-called tied agents, while, in Switzerland, client advisors are the equivalent party, as regulated by the Swiss Financial Services Act of 2018 and, in Brazil, investment advisors were traditionally known as “autonomous investment agents” until the recent enactment of Law nº 14.317/2022 by Congress and Regulation nº 178 of February 2023, issued by the Brazilian Securities Commission (Comissão de Valores Mobiliários or “CVM”, for its Portuguese acronym).

These service providers do more than simply provide specialised advice to investors, whereas their role includes prospecting clients to investment firms (i.e., brokers) and transmitting clients’ orders to the securities market. Investment advisory can, therefore, be understood as a broad concept that encompasses different forms of assistance to investors, although the provision of specialised advice, in the sense of guiding investors in their decisions, is the main focus of this book.

Conflict of interests in corporations or in financial services has been widely debated, especially in the United States and in European jurisdictions. Despite decades of academic and corporate debate over it, three recent elements brought new shades to this subject, particularly for investment advisory services, namely, globalisation, digitalisation, and generative artificial intelligence (“genAI”).

Regarding the first element, as economies became growingly interlinked, options of foreign investments grew, as well as cross-border operation of investment advisors. This bigger complexity of the securities market brought new challenges to enforcement agencies in charge of supervising it, given that potential conflict of interests became simply harder to trace. An example is a recent supervisory briefing report issued by the European Securities and Markets Authority – ESMA (2022) (“ESMA report”), where the European agency mentioned that investment firms should avoid and assess whether the tied agents who they appoint have close links with non-EU entities that could “exercise inappropriate influence over the way in which the tied agent carries out the activities on behalf of the firm”.

The second element – digitalisation – also played a key role in shaping conflict of interests in investment advisory services. Due to the use of digital platforms operated by investment brokers, investing became easier and less costly, allowing a wider reach of investment services, including advisory ones. This implicates an equally wider reach of the conflict-of-interest problem, in case of biased advisory services. Furthermore, clients (i.e., investors) have easier access to information through digital tools, meaning they could be more equipped to identify a conflict of interests.

Finally, regarding genAI, this type of product became a global trend in the last year or so, and, though not unprecedented, its use to provide services in many market sectors has become a tendency, including advisory services (Finra, 2020). Though still under debate, the fact that genAI produces content equivalent to human creations brings a new question: how can genAI impact the risk of conflict of interests in investment advisory services?

One can argue that, by replacing humans in at least part of the supply chain of advisory services, genAI can reduce the risk of conflict of interests, which, as mentioned above, is a human phenomenon. On the other hand, one can also argue that the client’s lack of deep expertise about the inputs and algorithm functioning of genAI products may actually make biased advice harder to identify, along with the fact that genAI can replicate biased inputs quicker and in wider scale than humans. Thus, the overall expected effect of genAI is ambiguous.

In summary, conflict of interests has recently entered a new moment. Whether this is a new era or a new phase of a known era is a theoretical question that this books sets aside. Pragmatically, law enforcers and policy designers need to understand the peculiarities of this moment and continuously verify if the current legal tools of investor protection are sufficient. Hence, this book proposes a case study about investor protection against biased investment advisory based on Brazil, where the investment advisory market experienced an unprecedented growth in the recent years and a major regulatory reform about investment advisors took place in 2023.

This subject has also been under close attention in the EU. Historically, tied agents were regulated under a 2004 directive (Directive 2004/39/EC), currently known as the “Markets in Financial Instruments Directive I” or “MiFID I”, where the EU granted Member States the option to implement tied agent regimes and allow investment firms to operate with tied agents in their respective jurisdictions[1]. In 2014, MiFID I was revoked by MiFID II (Directive 2014/65/EU), which, differently from the previous legal framework, requires Member States to accept operation of tied agents in their securities markets and, thus, implement a tied agent regulatory regime[2]. Moreover, the ESMA report in 2022 also indicates that tuning the right regulatory approach towards tied agents across the EU is a present European concern.

Regarding conflict of interests specifically, there is significant awareness on the topic at the EU level. While MiFID II regulates the matter by imposing obligations over the investment firm that uses tied agents to provide its services, the ESMA report sets its supervisory expectations toward Member States about, among other topics, the way firms should assess and address potential conflict of interests when appointing and operating with tied agents in the European common market.

However, one notes from the ESMA report and the MiFID II that, in the EU level, conflict of interests in investment advisory services is commonly attributed to the investment firm’s or the tied agent’s capital ownership structure or to “other legal or economic relationships (…) so close as to pose a risk of impairing the independent basis of the advice provided”[3]. A third-party entity other than the tied agent, therefore, is considered as the main source of risk of a biased investment advisory service[4]. However, as the case study of Brazil demonstrates, such perspective may be insufficient to provide reasonable investor protection in the EU.

Given the above, this work provides a case study of investment advisors in the Brazilian securities market[5], particularly on how Brazilian law designs investor protection against conflict of interests in investment advisory services and the gaps that exist in this legal framework. As further discussed, the investment advisor is an intermediary services provider in the securities and financial markets, who performs the role of agent of an investment firm (broker) in distributing investment products to clients[6]. While advisors can perform a relevant role of disseminating financial education to investors in general and enabling safer investments in complex operations, the possibility of conflict of interests can harm the securities market’s stability and welfare.

The choice to study the legal challenges surrounding this market player from a Brazilian perspective should not be read out of context. Conflict of interests in investment advisory has been a trending topic in Brazil over the last years and served as one of the stepstones for a regulatory reform conducted by the Brazilian Securities Commission in 2023, not long after Brazilian investors said they have been “abandoned” by the regulator in the pursuit of damages for defective intermediary services in the securities market (Racy, 2022).

Significant debate has taken place in the country about investment advisors, such as the Brazilian Securities Commission’s public hearings to reform the regulatory framework concerning investment advisors[7], the many mergers and acquisitions involving investment advisory firms[8], and the repercussion of critics made by Brazil’s largest private bank toward these service providers[9]. Competition has been intense between digital investment platforms in a race to hire certain investment advisory firms, suggesting that these agents play a key role in a successful business model of investment product distribution[10].

In addition, the massive rise on the number of investment advisors operating in the Brazilian market, over the last years, serves as another element to suggest the relevance of this topic in that jurisdiction. According to information available in the database of Brazil’s investment advisory’s official licensing entity[11], the number of certified advisors increased from 4.935 in June 2016 to 22.037 in December 2022 – in other words, the number of investment advisors in Brazil basically quadruplicated in a little over five years.

Among the legal issues concerning Brazilian investment advisors[12], this work focuses on this agent’s risk of conflict of interests. Some argue that the fact that the advisor attends investors and, concurrently, is remunerated by brokerage firms can generate conflict of interests, potentially harming its duty to integrity, good faith, and professional ethics, as provisioned in article 23 of Reg. 178[13].

For the purposes of this study, as further detailed in chapter III, conflict of interests is a situation in which an agent has incentives that diverge, either partially or completely, with the interests of the person he or she represents or advises – i.e., to whom the agent should subordinate its interests –, deviating the fiduciary relation between both parties[14]. A widely known example of conflict of interests is one that may exist between corporate managers and shareholders: is the manager operating in the best interest of the company and the shareholders that (s)he represents?

Therefore, when conflict of interests is evoked in this book, it is not being said that advisors necessarily seek to harm their clients, only that they have incentives (embraced or not) to attend to their own interests or to those of third parties in detriment of the investor. This is a key remark, since studying conflict of interests can sometimes lead to the wrong assumption that the agent under study is necessarily ill-intentioned.

In the case of investment advisors, various situations can configure conflict of interests, including managing the client’s investment account, operating without licensing, manipulating stock prices, among other conducts prohibited by EU law and Brazil’s regulation as well. However, this book focuses on a softer form of conflict of interests, specifically, one in which the dully licensed advisor recommends investment strategies (either buying or selling) that are incompatible with the client’s risk profile (thus, without direct interference into the client’s actions, such as an illegal account management). It is the influence over the investor that counts for this book.

To identify whether such influence over the investor was undue, this book uses the concept of investor suitability, i.e., the advisor’s duty to recommend an investment product that mostly fits the client’s investment profile. Suitability is something commonly present in legal frameworks of securities regulation, such as the MiFID II in the EU and Directive CVM nº 30/2021 in Brazil[15]. The basic idea is that, given the client’s lack of extensive expertise in investment products, the firm assisting the client must work towards providing the products that are compatible with the client’s profile and interests. To use a simple daily example: if a person asks for a simple low-cost vehicle to a car dealer, suitability would be violated if the car dealer recommends the acquisition of a brand-new cutting-edge sports car. However, the securities market is not as simple as that.

In practice, many brokerage firms in Brazil use three categories of risk profiling (conservative, moderate and bold) to define their clients’ suitability[16]. Naturally, classifying millions of investors and investment products in only three categories tends to be an excessive simplification of the market, failing to promote an assertive suitability between the investment product and each investor’s individual risk profile. Thus, the conflict of interests that matters to this book is the one that deviates the investor’s individual suitability – i.e., a tailored suitability approach between each product and the client’s individual profile –, which may occur even if the general suitability concepts commonly used by brokerage firms are attended.

Going back to the car dealer example, an individually suitable product would be one that considers not only whether the car is a simple low-cost vehicle, but also, e.g., the client’s experience in driving automatic or manual transmission vehicles, the level of safety features or car crash risk the client accepts to bear, the client’s interest in environmentally sustainable cars, among other possible characteristics.

Although the concept of individual suitability that guides this study does not correspond to the technical concept of suitability currently in force in Brazil, it serves as a reasonably objective criterion to identify investor interests and those that may be conflicting with it. When an investor seeks advisory services, he or she legitimately expects to have a tailored service according to his/her individual characteristics. This does not mean that there is one investment product for each investor in the market and that investment advisory is a game of finding the single correct product. However, it does mean that current suitability standards are overly broad for adequate investor protection.

In summary, based on the guiding concept of individual suitability and on the method of case study of Brazil, this book seeks to provide an answer to the two following questions: what are the potential sources of conflict of interests in investment advisory services and how should the law design legal tools of retail investor protection? Some brief clarifications are worth making about the concepts present in these conducting research questions.

Firstly, the questions are delimited to the retail segment of the securities market because retail investors tend to be more information-deficient than professional or institutional investors[17] and, thus, are presumably more vulnerable to harm from intermediary service providers, including conflicts of interests in advisory services. Secondly, the “design” of legal tools encompasses not only legislative lawmaking, but, also, policymaking and law enforcement, given that these latter activities also shape tools of investor protection.

The question of how tools should be designed seeks minimizing “gaps” of investor protection, i.e., situations in which the application of the law is ineffective or insufficient to allow investors to (i) plainly inform him/herself, (ii) promote an alignment of interests with the advisor, and (iii) be repaired from damage occasionally suffered due to conflict of interests. Thus, for the purposes of this study, conflict of interests is not considered adequately addressed by the law if the investor is plainly informed of the risk of conflict of interests in its advisory services, but lacks effective tools to obtain damages and promote alignment of interests.

To provide an answer to these conducting questions, the research for this book was based on the methods of academic literature review, review of corporate documents, interview of market players and regulators, mapping of State norms, and administrative and judicial case-law research[18].

To layout the research findings, this book is structured in the following chapters. Chapter II presents the practical challenges faced by the author in gathering information about the Brazilian market, while describing the methodology behind this study, and describes the structure and functioning of the investment product supply chain and the investment advisory market, revealing the challenges of regulating it. A work’s methodology reveals a lot about the path taken along the research and the criteria used to analyse the object of study. Therefore, far beyond a mere technical description, chapter II reveals the challenges to investigate the Brazilian investment advisory market and how open it is for outsiders.

Chapter III presents whether the usual hiring conditions of investment advisors in Brazil have the potential to generate conflict of interests. This chapter was divided in three sections.

The first section details the role of investment advisors and their duties to other market participants, explaining their position of “serving two kings” and using the perspectives of agency costs and transactions costs. Afterwards, through an empirical study of primary sources, such as corporate documents, the second section details the compensation conditions of investment advisors commonly adopted in Brazil.