Trust is an important part of our financial markets. Scandals, massive incompetence, massive irresponsibility, massive fraud, have shaken trust in the financial markets. Commentators, policy makers, and industry leaders have all recognized the need for trust’s restoration.
Consistent with financial scandals in the past, the public officials are looking for increased regulation to restore trust in the markets. The last round of financial scandals in the Enron-WorldCom era brought us Sarbanes-Oxley.
Professor Colombo thinks the advocates for increased regulation have it half right.
“A critical set of questions should be considered. Can regulation serve to bolster and repair relationships dependent upon trust? And in the absence of trust, can regulation serve as an effective substitute to trust? In short, are there limits to the ability of regulation to resuscitate an economy that has suffocated due to lack of trust?
Conversely, can regulation work to “crowd out” trust, effectively transforming relationships that once were close and trustworthy to arm’s length and legalistic? Could regulation serve to displace relationships of trust with transactions subject merely to the “morals of the marketplace”?”
The Role of Trust in Financial Regulation applies trust scholarship to examine the current U.S. financial regulatory regime and some of the proposed reforms. I focused on a few sections.
Private Offering Regulation
In addressing the difference in treatment between the regulation of public offerings and private offerings, Mr. Colombo thinks the difference can be justified on grounds relating to the issue of trust.
A private offering is more like a personal contract between the issuer and the investor, free of public advertising. Also, a private offering is more likely to have a pre-existing relationship. “Interpersonal relationships and communications are conducive to such trust, and such relationships and communications are often found among the parties to a private offering.”
He concludes that the current regulation of private offering strikes the correct balance from a trust-favoring perspective.
Regulation of Investment Advisers
I found it interesting that Mr. Colombo spends some time focused on the 15 client rule exemption from registration. He finds that much of the investment adviser regulation has developed a heavy band of regulation that “can crowd out trust in a relationship, converting expectations and behavior based upon honor and integrity to those based on the letter of the law.”
Investment advisers with a small number of clients can have “closer, more personal and more lasting relationships with their small number of clients than those advisers with a much larger client base.” The small adviser exemption from regulation when you have fewer than 15 clients facilitates the trust aspect.
The Private Fund Investment Advisers Registration Act, just approved by the House Financial Services Committee, eliminates this exemption.
From a trust perspective, Mr. Colombo thinks the lack of hedge fund regulation seems sensible. As with the world of investment advisers, the hedge fund industry is marked by repeat players. Frequent and historical interactions among the parties can “lay the foundation for affective and generalized trust to develop.” After all, the original legislative intent of the U.S. securities laws was to protect the layperson, unfamiliar with the financial markets, with sophisticated investors fending for themselves. Give the high financial thresholds for investment in private funds, the investors are either sophisticated or have easy access to sophisticated investment advice.
Mr. Colombo does not seem to like the removal of the small adviser exemption from investment adviser regulation. For larger advisers, the increased disclosure and reporting requirements may be a good things.
As for hedge funds he thinks that hedge funds currently operating successfully on the basis of trust, with little regulation, have little to benefit their investors by registering with the SEC and submitting themselves to the regulatory oversight. However, for funds that have not been able to develop that trust, voluntarily registering and submitting themselves to the regulatory oversight could help develop that trust. (I’m skeptical that investors think SEC registration carries any value in the world of private funds.)
The paper concludes that the existing financial regulatory regimes do a pretty good job with our understanding of trust. Greater regulation is imposed upon those sectors of the financial services industry where such regulation is trust enhancing, and lesser regulation is imposed upon those sectors where such regulation is trust defeating.
“In those areas where high quality trust relationships exists (or have the greatest potential to exist), we have, relatively speaking, the lowest levels of regulation: private offerings, investment advisers, and hedge funds. In those areas where only lower quality trust relationships are likely to exist (that is, relationships of cognitive and specific trust), we witness the highest levels of regulation: public offerings, secondary market trading, and banking.”
He also points out the more important areas of the capital markets are more heavily regulated. After all, we cannot wait to see if trust can be developed if the failure will lead to a systemic breakdown. The turbulence after the Lehman collapse was in part caused by the lack of trust. Nobody was sure if they could trust the stated financial stability of their counterparty.
Colombo, Ronald J., Trust and Financial Regulation (October 1, 2009). Villanova Law Review, Forthcoming; Hofstra Univ. Legal Studies Research Paper No. 09-22. Available at SSRN: http://ssrn.com/abstract=1481327
Some other references from The Role of Trust in Financial Regulation:
- Trust and Honesty: America’s Business Culture at a Crossroad by Tamar Frankel
- Claire A. Hill & Erin Ann O’Hara, A Cognitive Theory of Trust, 84 Wash. U. L. Rev. 1717, 1724 (2006).