What Is the Shingle Theory?

The shingle theory describes the behavior of a theoretical broker-dealer who maintains good ethics and high conduct when transacting securities. The shingle theory concerns the standards of professional conduct of broker-dealers and informs the regulation of financial markets in the United States. The theory purports that, once they begin advertising their services to the public, broker-dealers are responsible for adhering to the best practices of the financial services industry.

Specifically, these best practices require broker-dealers to fully disclose all relevant information to their customers regarding the securities they sell—especially as it relates to the pricing of those securities and any special compensation received by the broker for its sale.

Key Takeaways

  • The shingle theory is a legal doctrine that concerns the standards of professional conduct of broker-dealers.
  • It requires that broker-dealers operate in accordance with industry best practices, particularly as it relates to the pricing and disclosure of the products they sell.
  • The shingle theory has ongoing influence in the financial services sector, as it has been repeatedly cited and upheld in litigation.

Understanding the Shingle Theory

The word "shingle" in the term shingle theory is derived from an analogy that is relevant to traditional retail businesses: If a retail store "hangs a shingle" to show that it is open for business, customers of that business can expect that the store will deal fairly with its customers and abide by all necessary laws and regulations.

By extension, broker-dealer firms that "hang a shingle" in the financial services marketplace are also expected to behave in an ethical and transparent manner.

The first use of the term arose in a 1939 legal case involving the Securities and Exchange Commission (SEC). This case involved a broker-dealer that was found to have acted unethically by overcharging its customers and failing to educate them about the prevailing market prices of the securities it sold. The judge, in this case, sided with the SEC, upholding the SEC's decision to revoke the broker-dealer's license to operate.

This initial judgment has been replicated in several subsequent court cases. For this reason, the shingle theory continues to be relevant in the financial markets today.

In order to avoid the appearance or accusation of wrongdoing, broker-dealers should ensure that the prices charged to their clients are within a reasonable range, compared to the general market price of those securities, and that their clients are aware of those general market prices.

Shingle Theory and Fiduciary Duty

In essence, the key lesson of the shingle theory is that broker-dealers should always act as though they have a fiduciary duty toward their customers (even in instances where they may not technically be their clients' fiduciaries).

A fiduciary is a person or organization that acts on behalf of another person or persons, putting their clients' interests ahead of their own, with a duty to preserve good faith and trust. Being a fiduciary thus requires being bound both legally and ethically to act in the other's best interests.

Finance professionals who are fiduciaries are expected to act in the best interest of their customers and also give honest and responsible suggestions relating to securities. 

Example of the Shingle Theory

Edward is the owner of an unscrupulous brokerage firm called XYZ Securities. He carefully designed his office space and professional marketing to project the appearance of integrity and high professional standards. However, he does not act in a professional or ethical manner when dealing with customers.

Specifically, Edward deliberately seeks to attract customers with very limited financial education. When quoting those customers on potential securities to buy, he is careful to restrict their access to information about similar alternative products in order to overcharge his customers for those products as much as possible.

Moreover, Edward regularly seeks to earn special commissions, kickbacks, and other such forms of compensation without clearly or fully informing his clients as to those arrangements.

If Edward's firm were to be sued by one of his customers, there is a good chance that he would be found to be in violation of the shingle theory. Based on similar cases in the past, it seems likely that Edward could lose his license to operate as a broker-dealer.