Disclosure of risk factors

I have long felt that the risk factors that are disclosed in most offer documents are next to useless in assessing the risk of a security. In utter frustration, I have often wondered whether it would better to replace all that legalese with a simple empirical fact embellished with a nice skull and crossbones symbol:

☠   Numerous studies covering many different countries have shown that over the long term, initial public offerings tend to underperform the rest of the stock market. Subscribing to these offerings can therefore be injurious to your wealth.

Of course, the same studies also document a large positive initial return to investors who sell immediately after listing, but that is not a risk factor!

Tom C. W. Lin has a different idea in his paper, “A Behavioral Framework for Securities Risk” (34 Seattle University Law Review 325 (2011)).

In order to better capture the advantages of disclosure-based risk regulations given the behavioral tendencies of investors, this Article proposes a behavioral framework for Risk Factors built on (1) the relative likelihood of the risks and (2) the relative impact of dynamic risks. This framework makes risk disclosures more accessible and meaningful to investors and would serve as the new default for public firms. An important feature of the new default is that firms will be able to opt out of the new framework if they believe that the existing Risk Factors requirements are more appropriate. But these firms would need to explain to investors why they opted out. This new default framework would be spatially, optically, and substantively superior to the current framework for investors.

Tom Lin phrases the entire proposal in terms of behavioural finance, but nothing in the proposal depends on behavioural finance. Classifying risks on the basis of likelihood (or frequency) and impact is perfectly rational, and is in fact standard practice in risk management. Thanks to the Basel regulations for operational risks, at least the financial sector has plenty of experience doing this. So it cannot be claimed that it is not feasible.

I think this is definitely worth trying out, and if it works, we may not need the skull and crossbones after all.

Posted at 1:42 pm IST on Wed, 2 May 2012         permanent link

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