Today, regulation of securities offerings in the capital markets arguably faces no greater threat than increasing complexity and information loss.
Yet, after decades of technology-driven financial innovation,
financial regulation continues to rely primarily on the mandatory disclosure of information to investors.
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).
Dodd–Frank required “eleven different federal agencies . . . to undertake 243 separate rulemaking processes and conduct sixty-seven studies,”
and many of its reforms persist today.
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.
The resulting landscape, as the Financial Stability Oversight Counsel (FSOC) found, is one of elevated uncertainty, volatility, and widening gaps in market data.
Accordingly, concerns abound about the continued ability of mandatory disclosure to protect investors.
Structured notes, debt securities sold by financial institutions to raise capital,
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,”
and advancements in modeling and methodological capabilities have allowed notes to cater to more idiosyncratic investment preferences.
Dovetailing these innovations is a record of explosive growth. After declining by almost 30% during the GFC,
the market for structured notes “bounced back with ferocity.”
Less than a decade later, the global structured notes market surpassed two trillion dollars,
and the U.S. market alone reached seventy-two billion dollars, a 100% increase from 2009.
And these trends show no signs of slowing. Monthly U.S. sales reached decade highs during the 2020 COVID-19-induced stock market crash,
digital note platforms ended 2021 with record business,
and U.S. sales continued to increase in the first quarter of 2022.
This renaissance is poised to test the limits of the legacy disclosure scheme in the years ahead and, accordingly, warrants renewed scrutiny.
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.
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.