As a result of the SEC calling itself the “investors’ advocate”, a dangerous myth has taken hold in the global financial system. The myth is the disclosure required by the SEC or its counterparts in other countries is adequate so an investor can know what they own. This myth is false.
Proof this myth is false can be found by looking at the large opaque areas revealed by the global financial crisis that began in 2007. At the heart of the financial crisis were structured finance securities and in particular, subprime mortgage-backed securities. It was exposure to these opaque securities that bought down Bear Stearns and Lehman Brothers. Another opaque area was revealed when the interbank lending market froze because banks with deposits to lend didn’t have the information they needed to determine if the banks looking to borrow could repay them.
Why don’t disclosure requirements always mean there is adequate disclosure of information so an investor can know what they own? Disclosure requirements reflect the result of a political process heavily influenced by security issuers, Wall Street and its army of lobbyists and lawyers. By definition, this process is prone to requiring too little disclosure.
For example, in the run-up to the financial crisis, the SEC created Regulation AB to set minimum levels of disclosure for structured finance securities. This minimum level was set after the industry spent tens of millions of dollars lobbying the SEC and resulted in issuers being able to issue the opaque mortgage-backed securities at the heart of the crisis.
Furthermore, disclosure requirements do not create a legal barrier preventing the disclosure of more information. This is a very important point. There is nothing that prevents investors from demanding more disclosure than issuers are currently providing. Regulators use this fact to rationalize away setting inadequate disclosure requirements. After all, they reason, investors aren’t forced to buy the securities and can always demand more disclosure. The Transparency Label Initiative takes advantage of this fact.
Perhaps the most important lesson from the financial crisis is investors cannot outsource to government regulators the responsibility for forcing issuers to disclose sufficient information so investors can do their own due diligence and know what they own. The regulators have shown for whatever reason they are not up to the task and hence they are not fit for purpose.
This is where the Transparency Label Initiative comes in. It effectively coordinates the buy-side in demanding the necessary disclosure of information so investors can know what they own. The Initiative does this by using a simple label. Where the label exists, investors know they can do their own due diligence and know what they own. These securities will attract investors. Where the label is absent, investors know buying or selling these securities would simply be blindly gambling. These securities will only be attractive to the limited pool of capital engaged in blindly gambling and hence will be much more expensive for issuers to issue. It is this expense that gives issuers an incentive to provide the necessary disclosure so investors can know what they own.