Key Findings From an ACFE Research Institute Study

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Liza Ayres
Contributing Writer

A key component of any fraud investigation is the effort to uncover the reason for the fraudulent activity. Anti-fraud professionals are constantly seeking to understand the motivators of fraud, and this 2015 study, funded by the ACFE Research Institute, titled “Is Fraud Contagious? Career Networks and Fraud by Financial Advisors” explores the propensity to commit fraud due to influence by career networks and financial advisors.

In the U.S., the financial advisory industry has a huge impact on the national economy. The industry advises trillions of dollars in assets and generates billions in revenues. Additionally, the industry employs hundreds of thousands of people, many of whom play a pivotal role in the financial well-being of households nationwide. Unfortunately, with such a large role comes inevitable fraud.

Evidence suggests that fraud by financial advisors is relatively common. The Financial Industry Regulatory Authority (FINRA) reports thousands of incidents each year, with hundreds of millions of dollars in fines, settlements and arbitration awards.

The study’s methods

The purpose of the study, authored by Stephen G. Dimmock, William C. Gerken and Nathaniel P. Graham, was to determine whether fraud is transmitted through career networks. In the report, an advisor’s career network is defined as the co-workers employed at the same branch of a firm at the same time. The researchers obtained data on financial advisors’ characteristics, employment histories and fraud from the Registered Representative database produced by Meridian-IQ.

To avoid questions of endogenous network formation, the study focused on behavior before and after mergers of financial advisory firms. While mergers occur at the firm level, changes in co-worker networks occur within firms at the branch level. The empirical tests conducted for this study explored cross-branch variation and the impact of combining branches during a merger, thereby removing any variation common to all branches of a pre-merger firm.

Despite the economic importance of the financial advisor profession and the large losses suffered due to fraud within the industry, there have been very few academic studies of financial advisors. This 2015 report documented the results of the first large-scale academic study of fraud by financial advisors.

Key findings

Many financial advisors who commit fraud are linked to each other through their employment histories. The results of the study show that fraudulent co-workers affect the propensity to commit fraud.

After a merger, advisors are 38% more likely to commit fraud if they are merged into a new branch that includes individuals with a history of fraud, relative to advisors from the same firm who are merged into a branch with no history of fraud.

Following the social transmission of crime model, advisors whose pre-merger co-workers committed fraud in the pre-merger period are more likely to have also committed fraud in the pre-merger period. Given their history of fraud, they are once again more likely to commit fraud in the post-merger period. If an advisor did not commit fraud in the pre-merger period, the exposure to new co-workers following the merger increases the probability that they might commit fraud post-merger.

Alternative explanations and variables

The researchers conducted tests that explored potential alternative explanations or variables in their data, such as:

Difference in personality of supervisors across branches
Variation in branch-level policies or internal controls
Relative size of the merging branches
Geographical variation in branches
Similarity of age or ethnic background of co-workers

By including merger-firm fixed effects and placebos in their research, they were able to demonstrate that fraudulent co-workers affect the propensity to commit fraud. That result holds true even when controlling for the advisor’s own history of fraud, the fraudulent behavior of the advisor’s pre-merger co-workers, individual characteristics such as age, experience and assets under management, as well as firm-level effects.

While those variables did not affect the likelihood of fraudulent behavior, the researchers did find that demographics and size of the branches did. Post-merger co-workers who have similar ages or the same ethnicity tend to feel the effects of career networks more strongly and are thus more likely to follow the influence of one another in either positive or negative directions. Additionally, when merged, advisors from the larger branch have more influence on the behavior of advisors from the smaller branch than vice versa, indicating that the relative size of the merged branches matters.

Recognizing the relation between career networks and fraud, the researchers note that FINRA has additional regulatory requirements for any advisory firm that employs a significant number of alumni from other firms.

The authors of the study conclude that the penalty for fraud committed by financial advisors should reflect not only the harm of the event itself, but also the consequences of influencing such behavior in others. An advisor’s fraud harms not only their own clients, but also the clients of any other advisors they influence.

The ACFE Research Institute (ARI) is a multidisciplinary research center that is dedicated to research and education regarding the prevention of fraud, corruption and other white-collar crime. The ARI works with academics and industry experts worldwide to generate research projects that explore the latest fraud trends and developments affecting individuals, businesses and governments.

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