Securities disclosure is under fire, with professors and politicians launching two basic criticisms against it. The first is that it causes “information overload:” Investors cannot process all the disclosure that securities rules require. The idea can be traced back to a 2003 paper by then-professor, and now former SEC commissioner, Troy Paredes, and it is built on research in behavioral economics. Information overload has recently caught fire, being cited by former Securities and Exchange Commission Chair Mary Jo White, two other SEC Commissioners, SEC staff, and members of Congress as a rationale for the SEC’s Disclosure Effectiveness initiative, for rethinking the bedrock concept of “materiality,” and for legislation and other proposals to limit or cut back on mandatory securities disclosure rules. The Disclosure Effectiveness initiative has, in turn, generated fierce criticism from Senator Elizabeth Warren and others.

The second criticism is that disclosure does not adequately describe the complexity of modern securities, a view shared by scholars such as Steven Schwarcz and Henry Hu. Criticisms of mandatory disclosure, of course, have a long intellectual history, one that meshes with contemporary scholarly critiques of disclosure as a tool in consumer protection. Together, the information overload and complexity critiques may appear to put mandatory disclosure in a vice: existing disclosure rules cannot adequately convey information on complex financial products and firms, and, if rules attempted to require the provision of more information, then investors would be overwhelmed.

In my recent article, available here, I examine and question these two criticisms, asking how much bite they have given the efficient markets hypothesis. Retail and even some institutional investors may be daunted by information overload and complexity, but, in an efficient market, sophisticated investors processing mandated disclosure will cause that new information to be reflected in a security’s price. Of course, as I have written elsewhere, the markets for many securities are not efficient, and other markets can suffer from bouts of inefficiency. The problem, however, for the overload and complexity critiques is that less efficient markets, including the markets in which many asset-backed securities trade, tend to be subject to fewer mandatory disclosure rules.

Moreover, the information overload critique does not provide much empirical evidence to indicate those types of information that investors struggle to process. Without this empirical basis, policymakers have little to guide them in knowing which disclosure rules need to be rethought and how much regulatory “pruning” needs to be done. We look for empirical evidence to substantiate new rules. We also ought to insist on empirical evidence for major changes or rollbacks of rules.

On the other hand, modern financial instruments and firms are indeed becoming more complex, but that characteristic is not well defined. My article defines three types of complexity with which disclosure must grapple:

• contractual complexity, which describes the intricate contractual terms or structural features that financial instruments may have;
• derivative complexity, which describes how certain securities derive their value from other assets or multiple layers of assets; and
• systemic complexity, which describes how the value and risks of any security may depend not only on underlying assets, but also on changes elsewhere in financial markets.

In formulating what I call the “complexity critique,” professors Schwarcz and Hu focus on securitization. However, they also downplay the fact that the complexity of securitization can be by design, including to mislead investors or to engage in regulatory capital arbitrage (another subject on which I have written recently). If, as Henry Hu writes, reality may be “too complex to depict,” that can sometimes stem from the fact that issuers and intermediaries intentionally constructed the reality of an issuer to be complicated.

Even as mandatory disclosure has faced renewed criticism, the SEC has launched initiatives to leverage technology to improve disclosure. My article investigates whether existing initiatives (such as the XBRL rules and loan-level data tagging in securitizations) and more ambitious proposals (such as moving towards real time and interactive disclosure) can help investors navigate these three types of complexity without overloading them.

The article concludes that improving more traditional disclosure of the purposes for certain securities issuances, the due diligence performed by issuers and intermediaries, and the incentives of those parties might be far more effective in improving investor understanding and in disciplining issuers and intermediaries than either rollbacks of disclosure regulations or hi-tech disclosure solutions. The information failures in markets at the heart of the financial crisis were more than just technological. They also stemmed from bad incentive structures of market intermediaries like investment banks and credit rating agencies to serve all-important “gatekeeping” functions, including to perform due diligence for securitizations and their underlying assets. Again, from the era of the Enron accounting scandals on, some securitizations were designed to hide the true purposes of those transactions – from fraud to regulatory capital arbitrage. In short, financial crises and scandals as well as securities disclosure and other financial regulation are largely about intermediaries and their incentives.

Disclosure Effectiveness may be one policy from the Mary Jo White era that new SEC Chair-designate Jay Clayton follows through on. We can hope that, in writing rules, the SEC staff is guided by empirical data and emphasizes the need for improving bread-and-butter disclosures related to the incentives of market intermediaries.

This post comes to us from Professor Erik F. Gerding at the University of Colorado Law School. It is based on his recent article, “Disclosure 2.0: Can Technology Solve Overload, Complexity, and Other Information Failures?,” available here.