Published July 10, 2009

When quality matters more than quantity

By R SIVANITHY

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IT IS tempting to call for increased regulation in the aftermath of the collapse of the structured products segment. For sure, more needs to be done to protect the public interest and to ensure investment scandals are minimised. But when it comes to financial instruments and investment recommendations, is more regulation really the answer, or would public interest be better served if regulatory focus is more targeted?

In other words, assuming that the disclosure-based model is to be retained, is the way forward a greater quantity of regulations or just better quality regulation?

The problem with the disclosure model in practice today is not that it is flawed or has to be buttressed with more rules, but that financial intermediaries, brokers and their agents have been allowed to hide behind the 'caveat emptor' maxim and profit from a natural human tendency to read only the headlines and maybe the first few paragraphs of various publications, whether they are research reports, newspapers, prospectuses or advertising brochures.

One of the best (or worst, depending on your point of view) examples of this is the prospectus for Lehman's failed Minibonds. All relevant information relating to the true nature of the product was actually presented within its voluminous tome - that it was, in essence, an insurance policy taken out by Lehman on its US mortgage instrument portfolio, that the attractive annual 5 per cent interest that investors received was, in reality, Lehman's insurance premium and that if any one of the related parties failed during the instrument's life span, all investment money could be lost.

There was even a section deep inside the prospectus which warned that the more banks or financial institutions there were connected to the Minibonds, the greater the risk of loss. Despite all this, investors were cleverly led to believe they were buying a bond-like instrument (which, because of the word 'bond' in the headline, implied some degree of safety) and that the more institutions there were, the greater the diversification benefits and thus the lower the risk.

This was because the cover or first page did not contain any of the investment-critical information about the substantive nature of the instrument. In fact, nowhere was this the case - the instrument's substance could only be deduced by reading various sections which were not juxtaposed together.

If the first page had described in simple terms what exactly everyone was buying into, things would surely had been very different.

This practice of placing the most critical investment information anywhere in the disclosure document but on the first page extends to many other financial market-related areas, such as stockbroking reports.

For example, in a 'buy' on a well-known technology stock listed here, a foreign broker based its recommendation on a long-term forecasting model that peered 18 years into the future. While it is conceivable that there are people today who possess sufficient precognitive powers to be able to foretell what the world would be like in 2027, most reasonable investors would take such claims with plenty of scepticism. No matter though, in a market governed by 'caveat emptor', it should be up to readers to make up their own minds whether to bet their money on such recommendations - provided, of course, all the information is made readily available.

Like the Minibond example, the operative word, of course, is 'readily'. In this case, the long time horizon was only given on the fourth page of the report, while no details of what inputs and assumptions that went into the model were disclosed. In other words, the information was there - but only the bare minimum was presented and even this was not upfront.

This practice of burying important assumptions or data in the inside pages is common in research reports. However, if the authorities are serious about enhancing investors' interests, they should make it compulsory for all investment-critical information to be disclosed on cover sheets in simple, straightforward English. It is a relatively easy idea to grasp and doesn't require much new regulation - simply make investment product sellers state upfront in uncomplicated language what they are peddling and if they don't, make it such that severe sanctions could follow.

This way, quibbling over whether there was mis-selling or misrepresentation would be minimised and sellers (whether they are brokers, underwriters or investment banks) will be forced to cut to the chase and remove superfluous literature that their marketing/legal departments had devised to divert attention away from important risks.

While they're at it, the authorities should also put a stop to the distasteful practice of presenting legal disclaimers and important information in fine, eye-straining print. They should even go so far as to specify minimum font sizes for investment-critical information - admittedly an extreme suggestion but one that's wholly necessary given just how much relevant information sellers tend to hide in minuscule text.

Whatever the steps chosen, the important point to note is that the disclosure-based approach to governance has actually not failed. It has, however, been bypassed or marginalised by clever marketing that relied and capitalised on people not reading beyond the headlines or first page. Since it is difficult to alter human nature and people's reading habits, a much better approach would be to change the rules to suit those habits.