Beyond Disclosure: A New Way of Examining Securities Regulation

When it comes to the U.S. securities markets, the game has changed. Historically, the U.S. securities markets were dominated by retail investors who engaged in a buy and hold strategy: purchasing stocks as a vehicle to invest in a corporation and, if so inclined, to have a voice in a corporation’s internal governance. To that end, these investors relied heavily on corporate disclosures and filings required under the law and regulated by a number of agencies, including the Securities and Exchange Commission (the “SEC”).

Now, however, the U.S. securities markets are dominated by large institutional investors that, at last count, make up approximately 70 percent of the market activity on Wall Street. Moreover, within this group of institutional investors (including active investors such as pension funds and investment management firms) there is a smaller, but incredibly powerful subset of firms that invest by primarily using algorithmic formulas. These quantitative hedge funds (or “quants,”) do not engage in a long buy and hold strategy. They do not care about the internal governance of a corporation. In some cases, they liquidate their holdings at the end of every day.  As such, the required disclosures matter very little (if at all) to these investors.

This current trend in market activity marks a fundamental paradigm shift in trading habits. Instead of the traditional investor paradigm – the old game where an investor’s purchase of a stock is a reflection of his confidence in the market – we now have a consumer paradigm, where the purchase of stocks is not at all connected to a valuation of the company but rather to the value of the stock itself and its currency within the market. Given this transition, what is needed is a regulatory structure that takes into account this new trading framework by treating stock as a product separate from its underlying corporation. In this way, we can devise a more responsive regulatory configuration that addresses the markets as they exist today, not as they behaved in the 1930s.

As one of the principal regulators of the securities markets, the SEC generally regulates under a disclosure model.  Rather than telling corporations what to do and how to behave (something that would generally be considered anathema to our free market system) the SEC regulates by requiring corporations to disclose their activities and financials in order to allow investors to make choices themselves. As such, the SEC’s disclosure model requires a company to provide investors with a substantial amount of information regarding its operations and financial well-being in the hope that investors will use that information to make sound choices.  However, just as there is a disaggregation between the company as a company and the company as an investment vehicle, there is also a disaggregation between how people are trading in the markets and how the government is regulating the markets. Under a disclosure model, the SEC is regulating the wrong behavior. At its core, the disclosure model focuses on the fundamentals of a company when, in fact, the current securities markets have relatively little interest in those fundamentals.

In a recent book, Professor Karen Kunz and I propose a number of frameworks for regulation under this new paradigm. A central approach of a new system would be to examine who, or what, is being regulated.  Some investors are more powerful and have greater resources than others and thus have more access to and leverage in the markets. How do we maintain a regulatory structure that takes into account all of the different market participants and their ability to affect the market?

The current model emphasizes oversight of corporate disclosure, which allows for easy identification of who is being regulated, but limits oversight to a very narrow spectrum of market participants and seems to ignore what is being regulated.  To rectify that, we offer several proposals for changing the current regulatory structure, two of which are worth mentioning here.  First, we envision treating stocks as products, rather than investments, and regulating them accordingly.   If we are to treat securities as products, then stocks and bonds become just things that companies and municipalities – and yes, even the U.S. Treasury – produce, in the same way that GM produces Jeeps and Apple produces computers. In this model, corporations are, by and large, free from the onerous requirements of the disclosure framework and yet are still able to capitalize and benefit from their products through their sale in the open market.  However, as we note in our book, “a product is only as good as the system that it is designed to work within.”  As such, we also propose a whole market regulatory structure that widens the oversight from its current narrow spectrum.

Under a whole market scheme, the focus shifts from the participants to the markets. Any party (participant) that is seen as interfering with market stability can be subject to regulatory action. This is accomplished through a global view of the financial markets, with an emphasis on the quality of the products available to the public and the platforms through which they trade. Implementation of a streamlined regulatory structure with clear lines of responsibility and enforcement allows the regulators to be nimbler and more proactive. Regulators can engage in any action as appropriate in order to maintain fairness and integrity in the markets.

The securities markets are at the heart of the financial markets in the United States, which are, in turn, at the heart of American economic stability. As such, how the SEC regulates (or fails to regulate) has a direct impact on the stability of Americans. Moreover, the markets that are subject to SEC regulation are arguably undergoing an unprecedented degree of innovation that our current regulatory structure cannot keep pace with, preventing regulators from acting swiftly in the wake of a fast-acting crisis.

There is a strong need in the securities markets for a comprehensive regulatory framework that takes into account the systemic risks of the markets rather than the individual risks of public corporations. Otherwise, we may leave untreated the causes of the 2009 financial crisis. Changing our structure would require an engagement with all pieces from a thoughtful and open viewpoint. Truthfully, there have not been many instances of success with such a fundamental approach. But that doesn’t mean it should keep us out of the game.

This post comes to us from Professor Jena Martin at West Virginia University College of Law. It is based on her recent paper, “Changing the Rules of the Game: Beyond a Disclosure Framework for Securities Regulation,” available here