INVESTORS TAKE NOTE: COMPLEXITY AND DISCLOSURE EFFICACY CONCERNS AMID A STRUCTURED NOTES RENAISSANCE

This Note examines how increasing complexity fueled by financial innovations can impair mandatory disclosure as an investor-protection mechanism. It focuses on structured notes, a type of debt security that has transformed significantly since the global financial crisis. This Note highlights several financial innovations that have fueled an unprecedented increase in structured note issuance volume by expanding access and catering to more idiosyncratic investor preferences, such as the proliferation of digital platforms and proprietary indexes. It considers how these innovations have made structured notes more complex and how increased complexity might make crucial information more expensive and more difficult for issuers to express and for investors and regulators to understand through disclosure documents. In addition to discussing the potential effects of increasing complexity, this Note conducts a brief analysis of the readability of a novel data set of structured note prospectuses filed with the Securities and Exchange Commission and shows that structured note disclosure has become more difficult to read over time. This Note argues that mandatory disclosure rules may not be enough to protect investors as structured notes continue to grow in popularity and evolve in substance, and it suggests several improvements to the current disclosure regime, such as interactive digital calculators, to combat informational hurdles that investors in increasingly complex structured notes might face in the years ahead.

The full text of this Note can be found by clicking the PDF link to the left.

* J.D. Candidate 2023, Columbia Law School. Thank you to Professor Kathryn Judge for her invaluable guidance, Professor Eric Talley for his insight, and the Columbia Law Review staff for their editorial assistance. Special thanks to my fiancée, Lauren, and my parents, Judy and Robert, for their constant support.

Introduction

Today, regulation of securities offerings in the capital markets arguably faces no greater threat than increasing complexity and information loss. 1 See, e.g., Kathryn Judge, Fragmentation Nodes: A Study in Financial Innovation, Complexity, and Systemic Risk, 64 Stan. L. Rev. 657, 658, 661–63 (2012) [hereinafter Judge, Fragmentation Nodes] (finding that complexity can—and, in the 2007 to 2009 financial crisis, did—give rise to a “pervasive loss of information” that in turn “contribute[s] to systemic risk”); Steven L. Schwarcz, Protecting Financial Markets: Lessons From the Subprime Mortgage Meltdown, 93 Minn. L. Rev. 373, 405 (2008) [hereinafter Schwarcz, Protecting Financial Markets] (“Solving problems of financial complexity may well be the ultimate twenty-first century market goal.”). Yet, after decades of technology-driven financial innovation, 2 See Douglas W. Arner, Jànos Barberis & Ross P. Buckley, FinTech, RegTech, and the Reconceptualization of Financial Regulation, 37 Nw. J. Int’l L. & Bus. 371, 373 (2017) (“[T]echnological developments are changing the nature of financial markets, services, and institutions in ways completely unexpected prior to the 2008 Global Financial Crisis . . . .”); Kathryn Judge, Investor-Driven Financial Innovation, 8 Harv. Bus. L. Rev. 291, 292 (2017) [hereinafter Judge, Investor-Driven Financial Innovation] (“The current excitement around ‘fintech’ is merely the most recent iteration of an ongoing process of innovation that has fundamentally transformed the structure of the financial system.”). financial regulation continues to rely primarily on the mandatory disclosure of information to investors. 3 See What We Do, SEC, https://www.sec.gov/about/what-we-do#section1 [https://perma.cc/7X32-8H82] [hereinafter SEC, What We Do] (last modified Nov. 22, 2021) (“[The SEC] require[s] public companies, fund and asset managers, investment professionals, and other market participants to regularly disclose significant financial and other information so investors have the timely, accurate, and complete information they need to make confident and informed decisions about when or where to invest.”). This Note examines the effectiveness of disclosure in the context of the complexity and information loss threats through the lens of a financial instrument currently undergoing a profound transformation—structured notes.

The regulatory environment around securities offerings is ripe for reevaluation. The global financial crisis (GFC) that spanned 2007 to 2009 kicked off a “rulemaking frenzy” that culminated in the 2010 passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank). 4 Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified as amended in scattered sections of 12 U.S.C. and 15 U.S.C.); see also Dan Awrey & Kathryn Judge, Why Financial Regulation Keeps Falling Short, 61 B.C. L. Rev. 2295, 2296 (2020); Tamar Frankel, The Failure of Investor Protection Disclosure, 81 U. Cin. L. Rev. 421, 422 (2012). One of the GFC’s proximate causes was the U.S. subprime mortgage crisis. Housing prices precipitously declined after the collapse of the U.S. housing bubble in 2006 and 2007. As home values dropped, adjustable-rate mortgages on those homes began to reset at significantly higher interest rates. Unable to afford their higher monthly payments, homeowners, especially subprime borrowers, began to default on their mortgages. As defaults rose, mortgage-backed securities (MBSs)—bonds secured by pools of mortgages—and collateralized debt obligations (CDOs)—many of which derived income from MBSs—cratered in value. See Schwarcz, Protecting Financial Markets, supra note 1, at 378–79.
The GFC laid waste to the U.S. economy. Americans lost nearly ten trillion dollars in wealth, the stock market lost almost eight trillion dollars in value, and the number of unemployed Americans doubled. See Renae Merle, A Guide to the Financial Crisis—10 Years Later, Wash. Post (Sept. 10, 2018), https://www.washingtonpost.com/
business/economy/a-guide-to-the-financial-crisis–10-years-later/2018/09/10/114b76ba-af10-11e8-a20b-5f4f84429666_story.html [https://perma.cc/W4VY-MFE9]; Civilian Unemployment Rate, U.S. Bureau of Lab. Stat., https://www.bls.gov/charts/employment-situation/civilian-unemployment-rate.htm [https://perma.cc/2TBD-W4LV] (last visited Nov. 5, 2021). The effects are still felt today. See John W. Schoen, Financial Crisis of 2008 Is Still Taking a Bite Out of Your Paycheck 10 Years Later, CNBC (Sept. 12, 2018), https://www.cnbc.com/2018/09/11/financial-crisis-of-2008-still-taking-bite-out-of-your-paycheck-report.html [https://perma.cc/EP6P-5RG2] (describing the GFC’s lasting impact on national gross domestic product and household income). Dodd–Frank required “eleven different federal agencies . . . to undertake 243 separate rulemaking processes and conduct sixty-seven studies,” 5 Awrey & Judge, supra note 4, at 2297. and many of its reforms persist today. 6 See, e.g., Dodd–Frank Wall Street Reform and Consumer Protection Act § 165(i), 124 Stat. at 1430–31 (requiring stress-testing of financial institutions); id. § 913(g), 124 Stat. at 1828–30 (updating standards of conduct for industry professionals); id. § 942(b), 124 Stat. at 1897 (enhancing oversight of the capital markets). But much has changed in the twelve years since Dodd–Frank. Financial innovations—in particular, innovations in financial technology (fintech) and the rapid proliferation of fintech firms—have since disrupted established financial institutions, diffused financial markets, and diversified the array of financial instruments to which retail investors have access. 7 See infra notes 86–96 and accompanying text. The resulting landscape, as the Financial Stability Oversight Counsel (FSOC) found, is one of elevated uncertainty, volatility, and widening gaps in market data. 8 See Fin. Stability Oversight Council, 2021 Annual Report 10, 16–17 (2021), https://home.treasury.gov/system/files/261/FSOC2021AnnualReport.pdf [https://perma.cc/2PD5-SWQ7]. Accordingly, concerns abound about the continued ability of mandatory disclosure to protect investors. 9 See, e.g., William Magnuson, Financial Regulation in the Bitcoin Era, 23 Stan. J.L. Bus. & Fin. 159, 161–63 (2018) (arguing that recent innovations in financial technology “render the conventional tools of financial regulators largely ineffective by increasing the cost of identifying, monitoring and sanctioning market participants”).

Structured notes, debt securities sold by financial institutions to raise capital, 10 See Stephen A. Ross, Randolph W. Westerfield & Bradford D. Jordan, Fundamentals of Corporate Finance 216 (12th ed. 2018). For a more detailed description of structured notes, see infra section I.A. are one such instrument class that has transformed in scope and substance since the GFC. The emergence of digital structured notes platforms has “lower[ed] costs, [sped up] execution times and increased price transparency,” 11 Carolina Wilson, Electronic Note Services Proliferate in the U.S., Structured Notes: Technology Issue (Bloomberg LP, New York, N.Y.), Apr. 2017, at 5, 5, https://www.bbhub.io/
brief/sites/4/2017/04/04-2017_STN_Quarterly.pdf [https://perma.cc/VM3Q-P29C]. and advancements in modeling and methodological capabilities have allowed notes to cater to more idiosyncratic investment preferences. 12 See, e.g., infra note 107 and accompanying text. Dovetailing these innovations is a record of explosive growth. After declining by almost 30% during the GFC, 13 Matthew Goldstein, Insight-Structured Notes Start to Overcome the Lehman Taint, Reuters (Mar. 29, 2010), https://www.reuters.com/article/structurednotes/insight-structured-notes-start-to-overcome-the-lehman-taint-idUSN2925219720100329 [https://perma.cc/T7RP-W6LC] (noting a decline in U.S. sales of structured notes in the first two years of the GFC from around fifty billion to thirty-five billion dollars). the market for structured notes “bounced back with ferocity.” 14 Luis A. Aguilar, Comm’r, SEC, Regulators Working Together to Serve Investors (Apr. 14, 2015), https://www.sec.gov/news/speech/regulators-working-together-to-serve-investors.html [https://perma.cc/G3RS-ZA74]. Less than a decade later, the global structured notes market surpassed two trillion dollars, 15 See Structured Notes Infographic, Halo Investing (Aug. 31, 2022), https://haloinvesting.com/blog/what-is-a-structured-note-infographic/ [https://perma.cc/LPD2-MZUC]. and the U.S. market alone reached seventy-two billion dollars, a 100% increase from 2009. 16 See Aguilar, supra note 14 (noting thirty-four billion dollars in structured note sales in 2009); Evie Liu, Structured Notes Saw Record Demand in a Volatile 2020. Investors Should Mind the Fine Print., Barron’s (Feb. 24, 2021), https://www.barrons.
com/articles/structured-notes-saw-record-demand-in-a-volatile-2020-investors-should-mind-the-fine-print-51614124699 (on file with the Columbia Law Review) (noting seventy-two billion dollars in total structured note sales in 2020, more than twice the 2009 figure). And these trends show no signs of slowing. Monthly U.S. sales reached decade highs during the 2020 COVID-19-induced stock market crash, 17 See Gunjan Banerji & Julia-Ambra Verlaine, The Reach for Yield Survives Coronavirus Market Shock, Wall St. J. (Apr. 27, 2020), https://www.wsj.com/articles/the-reach-for-yield-survives-coronavirus-market-shock-11587979802 (on file with the Columbia Law Review) (“[S]ales of so-called structured products geared toward individual investors—including bets on stocks repackaged into bonds—hit a decade high in March [2020].”). Between February 12 and March 23, 2020, the Dow Jones Industrial Average dropped 37%. This period included the three worst single-day market drops in history. See Liz Frazier, The Coronavirus Crash of 2020, and the Investing Lesson It Taught Us, Forbes (Feb. 11, 2021), https://www.forbes.com/sites/lizfrazierpeck/2021/02/11/the-coronavirus-crash-of-2020-and-the-investing-lesson-it-taught-us/?sh=326b235346cf (on file with the Columbia Law Review). digital note platforms ended 2021 with record business, 18 Amélie Labbe, SRP in Brief: Ending on a High, SRP (Nov. 29, 2021), https://www.structuredretailproducts.com/news/details/77770 [https://perma.cc/
HHN3-89LE] (“US platform Simon has announced record increases in its structured investment broker-dealer volumes . . . . Simon distributed just over 3100 structured products . . . in 2021 to-date worth US$11 billion.”). and U.S. sales continued to increase in the first quarter of 2022. 19 Spotlight On . . . Top Issuers in the US (Q1 2022), SRPInsight, May/June 2022, at 13, 13 (“Some US$26.6 billion was collected from 8,561 structured products (an average of US$3.1 per product) in [Q1] 2022—a slight increase from Q1 2021 (US$26.3 billion from 8,085 products). Sales and issuance were also up compared to Q4 2021 when US$24.6 billion was collected from 8,054 products.”). This renaissance is poised to test the limits of the legacy disclosure scheme in the years ahead and, accordingly, warrants renewed scrutiny. 20 The market’s transformation has produced a spirited discussion among market participants about the merits of structured notes as investments. Some describe structured notes as “a robust investment and asset allocation strategy,” Structured Products, HSBC, https://www.gbm.hsbc.com/solutions/markets/structured-products [https://perma.cc/6ZRE-BR6F] (last visited Oct. 31, 2021), and “the missing piece of your portfolio,” Evan J. Mayer, Why Structured Notes Are One of the Most Innovative Options to Come Out Since the Mutual Fund, Worth (Nov. 19, 2020), https://www.worth.
com/structured-notes-innovative-option-mutual-fund-investing/ [https://perma.cc/7ZMP-KVY7]. Others warn that structured notes “spring from the dead to devour investor dollars,” John F. Wasik, Why You Should Avoid Zombie Structured Notes, Forbes (Oct. 24, 2014), https://www.forbes.com/sites/johnwasik/2014/10/24/why-you-should-avoid-zombie-structured-notes/ [https://perma.cc/45RN-7T8U], and that investors should “take a pass,” Amy C. Arnott, A 13% Yield: What Could Go Wrong?, Morningstar (June 1, 2020), https://www.morningstar.com/articles/986847/a-13-yield-what-could-go-wrong [https://perma.cc/TA5Y-27Y2]. This Note does not wade into this debate.

This Note’s core assertion is that increasing complexity and information loss in the structured notes market may impair the efficacy of disclosure as an investor-protection mechanism. Specifically, this Note highlights several trends and innovations that may increase complexity in the structured notes market and the securities themselves. Increased complexity heightens the informational burden placed on parties that engage in structured note transactions. This heightened burden could, in turn, impair the construction and comprehension of disclosure, reducing the efficacy of disclosure as a means of informing and protecting investors.

This Note progresses in four Parts. Part I explains the mechanics of structured notes as investment securities and details the disclosure regime that regulates the public offering of structured notes to investors. Part II details the conceptual framework shaped by a number of legal scholars following the GFC that links financial innovation, complexity, and information loss. 21 See, e.g., Dan Awrey, Complexity, Innovation, and the Regulation of Modern Financial Markets, 2 Harv. Bus. L. Rev. 235 (2012) (arguing that the post-GFC regulatory regimes governing derivatives markets disregard the regulatory challenges generated by financial innovation); Judge, Fragmentation Nodes, supra note 1 (showing how the complexity of fragmentation nodes gives rise to two phenomenon—information loss and stickiness—that in turn may give rise to systemic risk); Steven L. Schwarcz, Regulating Complexity in Financial Markets, 87 Wash. U. L. Rev. 211 (2009) [hereinafter Schwarcz, Regulating Complexity] (examining how complexities of investment securities and of modern financial markets can lead to and exacerbate failures of investing standards and financial-market practices). This Note relies on several other strands of post-GFC scholarship. One strand analyzes regulatory challenges specific to structured notes; another strand debates the merits of mandatory disclosure in financial regulation. Compare Michael Bennet, Complexity and Its Discontents: Recurring Legal Concerns With Structured Products, 7 N.Y.U. J.L. & Bus. 811, 813 (2011) (examining “two of the key legal issues relevant to the structured products market: investor suitability and conflicts of interest”), and Ann Morales Olazábal & Howard Marmorstein, Structured Products for the Retail Market: The Regulatory Implications of Investor Innumeracy and Consumer Information Processing, 52 Ariz. L. Rev. 623, 627 (2010) (arguing that the use of numerical examples to illustrate possible investment returns in structured notes “encourages issuer abuse of investors’ known cognitive biases”), with Robert P. Bartlett, III, Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures During the Financial Crisis, 36 J. Corp. L. 1, 57 (2010) (“[T]he results of this study indicate that the traditional disclosure model aimed at simply disseminating information to the public domain is unlikely to have significant efficacy when it comes to disclosures pertaining to complex credit derivatives.”), and Henry T.C. Hu, Too Complex to Depict? Innovation, “Pure Information,” and the SEC Disclosure Paradigm, 90 Tex. L. Rev. 1601, 1713 (2012) (showing that “current depiction tools cannot capture the risk–return characteristics of [asset-backed securities]” and that “[s]imilar depiction problems afflict the disclosures of major financial institutions”). It then situates today’s structured notes landscape within that framework by identifying several potential sources of complexity that may fuel information loss in the creation and comprehension of structured note disclosure documents. Part III conducts a brief empirical analysis of the readability of structured note disclosure documents. This Part recognizes the limitations inherent in the theoretical framework discussed in Part II and attempts to measure disclosure efficacy through the proxy of readability over the course of the recent structured notes renaissance. Part IV asserts that the recent innovations in the structured notes market warrant the reevaluation by financial regulators of the disclosure rules that are designed to communicate information to investors. It then highlights some potential ex ante reforms that may help to ameliorate the informational issues of disclosure in the coming years.