The present regulatory orthodoxy in protecting individual investors from ‘bad’ investments is to create and enforce a robust disclosure regime. Many jurisdictions therefore require issuers of financial products (eg share issues, bonds, financial products) to create a lengthy prospectus. It is a costly exercise, but is seen as necessary, in order to ensure that investors have sufficient information to make financial decisions.
Our paper, forthcoming in Singapore Journal of Legal Studies, argues that this approach is inadequate for investor protection when dealing with the complex and fast-moving financial world today.
We address several questions. Why, in jurisdictions which employ this model, do some individuals attract the protection of the disclosure regime, and others not? What are the problems that individual investors face which regulation should address? Is there a sound dividing line between the two categories of individual investors? Have regulators considered these issues, and how should they address them?
We consider the rationale for having a two-tiered regulatory model which treats some individuals differently from others. Individual investors are viewed as in need of protection as ‘consumers’ in the financial markets. However, some individuals—particularly wealthier ones—may well be more sophisticated, have access to expert advice, or have the risk appetite and capacity to fall outside a ‘consumer’ paradigm. A mandatory disclosure regime will generally apply to products marketed to the former category, but not to the latter.
However, the shortcomings of such a regulatory model have been of concern to regulators in recent years. The lessons from behavioural finance suggest that disclosure in itself may be unhelpful. An unsophisticated individual investor is likely to face information overload; mandatory disclosure has backfired. The events surrounding the 2008 financial crisis, in particular the collapse of a number of structured finance products, also suggest that investors were simply not equipped to understand the complexity of the products despite all the features of these structured products being fully disclosed. Again, we find that a disclosure regime is not a silver bullet.
We then proceed to a case study of Singapore, Hong Kong, and Australia. These three jurisdictions proposed or enacted reforms of their investor protection regimes following the 2008 financial crisis. Further, non-retail individual investors, to whom the disclosure-based protections do not apply, also suffered from their lack of understanding of the complex products being sold to them. It was common to all three jurisdictions that regulators believed retail and non-retail investors should be better protected.
We find, however, that these jurisdictions have shied away from making fundamental changes in their treatment of retail and non-retail individual investors; an individual investor may be classified as financially sophisticated simply through the application of a wealth test: a sufficiently wealthy investor is deemed financially sophisticated. Needless to say, this does not necessarily reflect their true knowledge and financial sophistication. Efforts by regulators to introduce dividing lines which better reflect the true knowledge of investors have been stalled by industry pushback; financial intermediaries (eg banks) are reluctant to assess customer knowledge. Regulators have only managed to make incremental changes (if any) to this scheme. This is an obstacle to reforming their regimes to promote better investor understanding.
In light of these difficulties that regulators have faced, we propose a regulatory framework to assist individual investors to understand better what is being sold to them. As a preliminary step, the ‘retail’ and ‘non-retail’ distinction should be abolished. Individual investors share common problems in making investing decisions regardless of wealth levels due to simply not being able to understand the information presented. A major problem is the lack of consistency and transparency in the information being presented to them by financial product issuers regarding more complicated financial products.
We propose the following framework to mitigate this problem. The regulator should first pre-approve categories of products, eg shares and vanilla bonds, which are inherently uncomplicated. All other products will require a risk and complexity rating based on a template created by the regulator. This template should be designed in order to present information on product risks and complexity clearly and accurately to investors, keeping in mind the lessons from behavioural finance. An independent rating agency, funded by industry as a whole (to avoid the moral hazard generated by regulators’ control and other sources of bias) should be tasked with rating these products using the template, with a mandate of explaining product features and risks clearly to investors, but also with no mandate to either encourage or discourage any product in particular. The increased costs to industry associated with this should be offset by a reduction in disclosure requirements; the point of such an approach is to reduce unnecessary over-disclosure. Finally, regulators may wish to consider a supplemental test to permit investors to purchase complex products that have been rated. Possible criteria include self-certification of investor experience with the category of product they intend to purchase, or a wealth/portfolio diversification test.
Wai Yee Wan is Professor at the School of Law, City University of Hong Kong. The paper was written when she was at the School of Law, Singapore Management University.
Andrew Godwin is Associate Professor and Director of the Transactional Law Group, the Graduate Program in Banking and Finance Law and the Associate Director of the Asian Law Centre at the Melbourne Law School, University of Melbourne.
Qinzhe Yao is a Research Associate at the School of Law, Singapore Management University.