Intermediary Commissions and Kickbacks∗

We investigate the role of commissions paid by product providers to information intermediaries who advise customers on product suitability. These commissions and hidden “kickbacks” are widespread and controversial in markets for retail financial products and health services. We show that product providers have an incentive to pay commissions to steer the intermediary’s advice and to counteract the commissions paid by competitors, even though the customer discounts the bias that is induced. We characterize when mandatory disclosure and caps on commissions have unintended consequences for the efficiency of advice. Firms also use commissions to affect the intermediary’s incentives to acquire information. JEL Classification: L15 (Information and Product Quality), L51 (Economics of Regulation), M52 (Compensation and Compensation Methods and Their Effects). ∗Inderst: JohannWolfgang Goethe University, IMFS, Mertonstrasse 17, 60054 Frankfurt amMain, Germany (e-mail: [email protected]); Ottaviani: Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, IL 60208—2013 (e-mail: [email protected]). We are grateful for comments by Simone Galperti, Umberto Garfagnini, Florian Hoffmann, Marcus Opp, Ron Siegel, four anonymous reviewers, and seminar participants at Gerzensee, Institute for Advanced Studies in Vienna, Kellogg School of Management, New York University, University of Bonn, University of Toronto, and University of Zurich. The role of commissions paid to information intermediaries is currently under debate in a number of sectors. In the mortgage industry, high commissions are believed to have led brokers to advise homebuyers to borrow beyond their means, fueling the current crisis.1 In insurance markets, allegations have been brought against insurance providers regarding the provision of hidden kickbacks to supposedly independent brokers.2 In the health care sector, there is considerable concern that the quality of medical advice can be compromised by gifts and other inducements that physicians receive from pharmaceutical companies and other health care suppliers.3 What policy measures should be adopted to address these concerns?4 This paper contributes a modeling framework to investigate the role played by commissions and the effects of policy interventions. In our model, an intermediary agent advises a customer on which product to purchase, based on information about the match between the customer’s needs and the characteristics of the products offered. The agent is compensated through commissions paid by product providers when the customer buys their products. In addition, the agent cares about the customer purchasing the most suitable product, because of liability, ethical, or reputational concerns.5 1For reports by media, consumer groups, and policy makers, see: Liam Pleven and Susanne Craig, “Deal Fees under Fire Amid Mortgage Crisis; Guaranteed Rewards of Bankers, Middlemen Are in the Spotlight,” Wall Street Journal, January 17, 2008; Ernst Keith, Debbie Bocian, and Wei Li (2008); and “Subprime and Predatory Mortgage Lending: New Regulatory Guidance, Current Market Conditions, and Effects on Regulated Financial Institutions: Hearing before the Subcommittee on Financial Institutions and Consumer Credit of the House Committee on Financial Services,” 110th Congress, 2007. See also Consumer Federation of America (2004) on dealer kickbacks for auto loans. 2A recent high-profile case was brought by the former New York State Attorney General, Eliot Spitzer, against US insurance providers, most notably AIG. See David Cummins and Neal Doherty (2006) for a discussion and an empirical analysis of brokerage intermediation in the insurance market. See Howell E. Jackson and Laurie Burlingame (2007) and Daniel Schwarcz (2007) for a legal perspective on the pervasive use of commissions and kickbacks to compensate insurance, investment, real estate, and mortgage brokers. 3Inducements may take the form of consultant fees, educational grants, royalties, funding for clinical trials, or travel grants. See Michael L. Millenson (2003) for an overview of the practice of detailing drugs and physician preference items, such as hip and knee implants, cardiac stents, and mechanical devices used in spinal surgery. Professionals’ self-imposed standards of disclosure to patients are often ineffective, as in a salient recent case involving orthopedic devices for hip and knee replacement, in which physician consultants allegedly received over $800 million from manufacturers between 2002 and 2006. See the agreed settlement between four leading manufacturers of orthopedic devices and the Department of Justice at http://www.usdoj.gov/. 4Over the last decades, a number of prominent prosecutions in the UK have centered on the professional misconduct by intermediaries and advisers in the selling of financial products, ranging from mortgages to pensions. See Julia Black and Richard Nobles (1998) and the website of the Financial Services Authority, www.fsa.gov.uk. For an overview of the role of suitability rules for the retail sale of financial services, see Basel Committee on Banking Supervision (2008). 5As part of their occupational licensing procedures, various US states require mortgage brokers to maintain a minimum net worth or to post a “surety bond,” as documented by Cynthia Pahl (2007). In practice, surety bonds are typically posted through third parties. While these third parties are the