Henry T.C. Hu
90 Texas L. Rev. 1601
Since the Depression, the Securities and Exchange Commission’s totemic philosophy has been to promote a robust informational foundation for private decision makers, thereby furthering efficiency and corporate governance. As a necessary corollary, the SEC’s approach has been incremental. The SEC has generally not ventured beyond the realm of information to that of substantive decision making, as to stock prices or otherwise.
This disclosure philosophy has always been substantially implemented through what can be conceptualized as an “intermediary depiction” model. An intermediary—e.g., a corporation issuing shares—stands between the investor and an objective reality. The intermediary observes that reality, crafts a depiction of the reality’s pertinent aspects, and transmits the depiction to investors. Securities law directs that depictions are to be accurate and complete. “Information” is conceived of in terms of, if not equated to, such depictions.
This Article’s core thesis is that the longstanding intermediary depiction model is increasingly undermined by innovations in financial theory and practice, and that the disclosure paradigm must metamorphosize to comprehend a spectrum of what can be referred to as “pure information” models. Modern financial innovation has resulted in objective realities that are far more complex than in the past, often beyond the capacity of the English language, accounting terminology, visual display, risk measurement, and other tools on which all depictions must primarily rely. This Article illustrates this in part by focusing on the crafting of depictions of the risk–return characteristics of asset-backed securities (ABS), an important financial innovation whose informational problems helped cause the global financial crisis. The Article shows that such characteristics can be so complex that even “objective reality” is subject to multiple meanings. Given such rudimentary tools and such complex realities, the depictions may offer little more than shadowy, gross outlines of the objective reality, however that reality might be conceived.
Financial innovation can sometimes pose a second, more fundamental roadblock to good depictions: even a well-intentioned intermediary either may not truly understand or may not function as if he understands the reality he is charged with depicting. This second roadblock can flow both from complexities of financial innovation (what can be called “true misunderstanding”) and organizational complexities associated with the intermediary itself (what can be called “functional misunderstanding”).
The Article shows that depictions of major banks involved in financial innovation activities can suffer from both roadblocks, thus helping explain the severity of the bank disclosure problems that also helped cause the financial crisis. Such a bank’s activities may be too complex relative to existing depiction tools, and the activities and the organization of the bank itself may be so complex that the bank may suffer from both true misunderstandings and functional misunderstandings of the objective reality it is in. An afterword (at Section IV(C)(3)) uses the just-unfolding derivatives problems involving JPMorgan Chase and its Chief Investment Office to illustrate both roadblocks.
If complexities related to financial innovation are creating problems for the disclosure paradigm, technological innovation may contribute to a solution. With advances in computer and Internet technologies, it is no longer essential to rely exclusively on intermediary depictions of reality. The intermediary need not always stand between the investor and an objective reality, recounting to the investor what the intermediary sees. Figuratively, if the intermediary steps out of the way, the investor may now be able to see for himself, to download the objective reality in its full, gigabyte richness. Such “pure information” can be more granular and accurate than the intermediary’s depiction. Moreover, with this “disintermediation,” investors will have information freed from possible intermediary biases and misunderstandings embodied in the depictions. However, at the same time, disintermediation will also leave investors bereft of the benefits of an intermediary’s efforts to analyze and distill objective reality and incorporate the resulting insights in the intermediary’s depiction.
A disclosure paradigm that relies on both the intermediary depiction model and the pure information model—and the full spectrum of disclosure models between these opposite extremes—can help investors triangulate the truth. The Article illustrates the potential of this more comprehensive approach to information in both the ABS and major bank contexts. Further, the Article outlines some possible models along the spectrum, including strategies that would generate “moderately pure” information as well as strategies involving the “simplification of reality” itself. Such an analytical framework for information may implicate issues of a substantive nature. If, for instance, a major bank is “too complex to depict” and pure information-type models are insufficient, should we consider if it is also “too complex to exist”? The Article also suggests that such a metamorphosis in the SEC disclosure paradigm, while needed, would also need to be accompanied by changes in the longstanding regulatory architecture.
The Article also suggests, as a secondary matter, that challenges to the SEC disclosure paradigm extend even to the paradigm’s philosophy, in particular, the philosophy’s incrementalist component. Recent departures from incrementalism have been extraordinary in number and nature, even leaving aside the departures arising from the TARP program and the derivatives-related provisions of the Dodd-Frank Act. Departures such as the 2008 SEC short-selling ban illustrate not only the need to enhance SEC independence, but also the need to begin systematically considering the proper relationship between the paradigm’s traditional goals of promoting efficiency and governance and the truly rare situations in which such matters as short-term financial stability ought to also be considered. Other departures, such as interventions to address the 2010 “flash crash,” suggest the need to consider more urgently and comprehensively how complex innovations now dominating the microstructure of equity markets may conflict with the paradigm’s traditional goals.
To remain vital, the SEC disclosure paradigm must be able to encompass in a meaningful and systematic way the vast complexities of modern markets and institutions. A fundamental and comprehensive rethinking is essential.
The above abstract is an excerpt from Professor Hu’s article, and is subject to:
Copyright © 2012 by Henry T. C. Hu. All rights reserved.