Innovation, “Pure Information,” and the SEC Disclosure Paradigm

My article, Too Complex to Depict? Innovation, ‘Pure Information,’ and the SEC Disclosure Paradigm, published in June in the 2012 symposium issue of the Texas Law Review, offers a new conceptualization of the SEC disclosure paradigm that has been in place since the Depression, shows how that paradigm has been undermined by the modern process of financial innovation, and offers possible ways ahead. Since its creation, the SEC’s totemic philosophy has been to promote a robust informational foundation. As a necessary corollary, the SEC’s approach has been incremental, generally not venturing into substantive decision-making (as to stock prices or otherwise).

The article starts by suggesting that this disclosure philosophy has always been largely 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 depictions to be accurate and complete. “Information” is conceived of in terms of, if not equated to, such depictions.

The article’s primary thesis is that the longstanding intermediary depiction model is increasingly undermined by modern financial innovation and that the disclosure paradigm must metamorphosize to comprehend what I term “pure information” models—as well as the full spectrum of possibilities between these polar models. Modern financial innovation is creating objective realities 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. Given such rudimentary tools and the complex realities, the depictions may sometimes offer little more than shadowy, gross outlines of the objective reality.

Financial innovation sometimes poses a second roadblock to depictions: even a well-intentioned intermediary either may not truly understand (i.e., suffer from what can be termed “true misunderstandings”) or may not function as if he understands the reality he is charged with depicting (i.e., suffer from what can be termed “functional misunderstandings”). This second roadblock can flow both from complexities of financial innovation and from organizational complexities associated with the intermediary itself.

The article illustrates these problems with the intermediary depiction model—and the potential of “pure” or “moderately pure” information models—primarily in two contexts: (a) the depictions offered to shareholders by major money center (“too big to fail”) banks heavily involved in financial innovation-related activities; and (b) the depictions offered by issuers of asset-backed securities (ABS). For instance, the article shows that depictions of such TBTF banks can suffer from both roadblocks. Such a bank’s activities may be too complex relative to existing depiction tools, and the financial innovation-related activities and the organization of the bank itself may be so complex that the bank may suffer from both true misunderstandings and functional misunderstands of the objective reality it is in.

As the article was in final stages of editing in mid-May, the JPMorgan Chase Chief Investment Office (aka “London Whale”) derivatives problems started unfolding. An afterword at Section IV(C)(3) was added to show how this JPMorgan situation illustrated the foregoing themes (and possible solutions) based on the facts that were publicly known as of the end of May.

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 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, and free from possible intermediary biases and misunderstandings. 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.

The article shows that a disclosure paradigm relying on both the intermediary depiction model and the pure information model—and the full spectrum of strategies between these extremes—is necessary. For instance, as to such TBTF banks, 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 TBTF 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 patterns.

The article’s secondary thesis is that challenges to the SEC disclosure paradigm extend to the paradigm’s philosophy itself, particularly, the philosophy’s incrementalist component. Recent departures from incrementalism have been extraordinary in number and nature, even leaving aside the departures arising from TARP and Dodd-Frank. I analyze the implications of departures such as the 2008 SEC short-selling ban for the matter of regulatory goals, in particular my concerns over the possible sacrificing of price efficiency for short-term financial stability. I also discuss some implications of the modern microstructure of the equity market, a microstructure that involves such phenomena as high frequency trading. On the one hand, this microstructure is contributing to improvements in market quality by some measures but, on the other hand, may be contributing to the increased possibility of sharp price discontinuities such as occurred with the 2010 “flash crash” and subsequently.

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 full text of the article is available here.