Monday, June 9, 2014

Complexity and Securities Regulation's "Reasonable Investor" Standard

Today, we finished two days of amazingly rich discourse on business law issues at the Association of American Law Schools (AALS) Workshop on Blurring Boundaries in Financial and Corporate Law in Washington, DC.  (Full disclosure:  I chaired the planning committee for this AALS midyear meeting.)  All of the proceedings have been phenomenally interesting.  I have learned so many things and been forced to think about so much . . . .  For those of you who couldn't be there, I tried to faithfully pick up a bunch of salient points from the talks and discussions on Twitter using #AALSBB2014.  Moreover, some of the meeting was recorded.  I will try to remember to let you know when, to whom, and how those recordings are being made available. (Feel free to remind me if I forget . . . .)

One idea shared at the workshop that I am particularly intrigued by is the use of a new standard in federal securities regulation, suggested by Tom Lin in his talk as part of this morning's plenary panel on "Complexity".  He argues for an "algorithmic investor" standard (working off/refining the concept of the reasonable investor) in light of the growth of algorithmic trading.  It's  predictable that I would be interested in this idea, given that I write about materiality in securities regulation (especially insider trading law, in articles posted here and here), in which the reasonable investor standard is central.  (In fact, Tom was kind enough to mention my work on  the resonable investor standard in his talk.)

Tom is not the first to argue for a securities regulation standard that better serves specific investor populations.  Memorable in this regard, at least for me, is Maggie Sachs's paper arguing for a standard focused on the "least sophisticated investor".  But many other fine works contending with materiality or the concept of the reasonable investor in securities regulation also question (among other things) the clarity and efficacy of the reasonable investor standard in specific contexts.

Perhaps it's obvious, but Tom's idea stems from the fact that the investor base in various securities regulation contexts in which the reasonable investor standard may apply is far more diverse than the standard, as defined and used by courts to date, reflects. Moreover, securities trading markets operate in ways that were inconceivable at the time the reasonable investor standard originated (and over much of  the time it has been fleshed out in the courts).  So, in essence, Tom's suggestion is that we enhance the reasonable investor standard to address these realities in investor and market behaviors in an effort to protect all investors better.

Tom's paper is "not yet ready for prime time" (by his own admission to me).  But keep an eye out for it.  And in the mean time, go ahead and read Tom's formative work in this area, including especially his recently released Alabama Law Review piece and his 2013 article in the UCLA Law Review.

Conferences, Corporate Finance, Joan Heminway, Securities Regulation | Permalink


Thank you so much for tweeting, Joan! I missed the meeting and read every single one of your tweets.

You (and Tom) raise a good question about the reasonable investor standard. I am not convinced that it is useful to think about the algorithmic investor. Most algorithmic investors (by trading volume) are HFTs which pick up a on an actual purchaser’s order and trade ahead of it in order to resell those same securities to the purchaser at a marginally higher price. If that’s accurate, then algorithms are intermediaries, like dealers, not investors. Their capital at risk at the end of the day is minimal, if not zero.

But that does not imply that we shouldn’t revisit the standard. You are right that different types of misconduct prey on different classes of investors: buyers of ABACUS 2007 AC-1 tranches are very different from investors targeted in affinity fraud schemes (Ponzi and the like). If so, either the standard needs to be very flexible, or some categories of fraud need a different standard. I find the “least sophisticated investors” standard quite appealing for affinity frauds.

Posted by: Urska | Jun 11, 2014 7:12:59 PM

Sorry you missed the meeting, Urska. You would have enjoyed it, I know. Tom's presentation was just the tip of a veritable iceberg of engaging talks that folks gave during the two days we were in DC together.

I will invite Tom to engage more specifically on his ideas about the content and application of his proposed algorithmic investor standard. I told him that I also need to know more before jumping on his bandwagon. But your comment raises other interesting issues for me, and I will just throw them out there for your consideration in this response.

First, I will note that (of course) intermediaries may also be principals in trades. They may trade for their own financial benefit while also serving as conduits. You seem to acknowledge this by referring to dealers (rather than, e.g., brokers). Do you mean to convey that all intermediaries are not investors and therefore do not warrant differential protection under the securities laws? I can see a potential case for protecting algorithmic investors differently in certain respects than other investors. If, for example, algorithmic trading decreases the operation of cognitive biases and other behavioral phenomena on trading transactions, then those traders using it may or may not warrant different protection from that received by other investors. But it's worth discussion.

Second, although I am no expert, it seems fair to say that not all algorithmic trading is HFT. And here's where Don Langevoort's keynote at the conference comes in. In his remarks, he urged us all to pay more attention to the "buy side" in trading transactions. Since institutional investors use algorithmic trading (as I understand it) as a risk reduction mechanism, Don's exhortation seems appropriate to mention here.

Third, as a general matter, I remain dubious about varied conduct and liability standards in securities regulation. I pushed back at Maggie Sachs when she was writing the "least sophisticated investor" piece, for example. More specifically, I am convinced that we need to focus more on why we protect investors before we make these kinds of reform arguments. If we protect investors as a means of better promoting capital formation through the establishment of robust trading markets, e.g., then that helps focus our task. But not everyone agrees on the policy objectives underlying federal securities law generally or specific aspects of that body of law (including the rules pertaining to securities fraud). The more refined we can be in stating our policy objectives, the more guidance we have in how to fashion the appropriate standards for use in individual circumstances.

OK. I have said enough for now. i will step off my soapbox and give Tom a chance to respond.

Posted by: joanheminway | Jun 12, 2014 6:40:39 AM

Urska and Joan, thank you both for sharing your thoughtful comments on my working idea. Here are some of my preliminary thoughts:

First, the suggestion of an algorithmic investor typology is not intended to replace or reduce the current reasonable investor standard. Rather, it is intended to create greater flexibility in thinking about investor protection efforts in light of recent developments in the capital markets.

Second, like Joan, I believe algorithmic investing is a critical driver for many investors beyond high frequency traders. For instance, money managers, large and small, like BlackRock and Wealthfront, use algorithmic investing in their operations.

Third, part of the objective for introducing a new investor category is to better match financial regulation with financial reality. An impetus behind the working idea is to encourage a shift in conceptions of investors from a profoundly seductive singular model of reasonable investors to a more pragmatically realistic model of diverse investors.

There remains much work to be done on the idea, and I appreciate your insights as I continue to work on it.

Posted by: Tom | Jun 12, 2014 12:01:26 PM

Thank you, both, for responding. I am certain that I would have enjoyed the meeting – it sounds fascinating.

Like many after reading Flash Boys, I have a current fascination with algorithmic trading, so I appreciate your willingness to engage with me in a conversation. I concede that not all algorithmic investing is by HFTs. But measured by trading volume – as I suggested in my original post – it is fair to say that most trading by algorithms happens by HFT algorithms. So to my mind, it would be useful to distinguish trading algorithms that have no exposure at the end of the day and are essentially akin to broker-dealers who trade on customers’ behalf (I used the term dealers in the OP which was in error), and algorithms used to make investment choices and hold bought securities for longer than a few microseconds, like BlackRock’s algorithm.

I agree with both that the latter category should affect and inform our understanding of reasonable investor standards, but I am having a difficult time imagining how the former would be affected by the materiality standard if all they are doing is standing between buyers and sellers and collecting a fee. To me, this is more than an academic debate because treating HFTs as investors distorts our understanding of investors. In discussions about market structure, one often hears the argument that trading volumes have nearly doubled and that the median holding period is now measured in seconds, not months. The implication drawn is sometimes that may be no such thing as long-term investing and that things like corporate governance and securities laws are passé. If we were to filter out all HFT trading, my sense is that the market has changed in profound ways in the last 10 years, just not in the ways that raw trading data would suggest.

Posted by: Urska | Jun 13, 2014 12:22:53 PM

No disagreement from me on anything you've said, Urska, but I would want to fact-check some of your underlying premises (since, as I earlier indicated, I am no expert on algorithmic trading). We can talk more about your sources offline, if you're willing.

Posted by: Joan Heminway | Jun 13, 2014 1:22:27 PM

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