Protecting the Institutional Investor - Jungle Predator or Shorn Lamb?

Abstract

One of the most striking developments in financial markets during the latter half of this century has been the growing dominance of the institutional investor. The expanding role of large, institutional investors has been accompanied by demands for lessened regulation of these entities, because institutions are said to have the sophistication to protect themselves from fraud and overreaching. Consequently, many institutional traders have been freed of the regulatory shackles imposed in markets where the proverbial widows and orphans invest. The result amounts to a virtual two-track regulatory system: one set of rules governs trading by sophisticated institutions, and another more restrictive set of rules governs trading by unsophisticated “retail” customers.

Recent events have called into question the appropriateness of this two-track system. Many institutions trading in highly complex over-the-counter derivative instruments have suffered staggering losses. Some of these institutions now claim that they did not have the ability to appreciate the risks of derivative instruments. They further assert that banks or other firms who sold them did not take into account the institutions' lack of suitability.

This Article examines the regulatory and legal issues raised by such claims. It proposes some limited measures to better assure that institutions trading in derivative instruments have the requisite expertise to understand the risks involved. These proposals seek to assure that, once an institution accepts the regulatory benefits of institutional status, the derivative dealers with whom it transacts will be protected from after-the-fact claims that the institution lacked knowledge and sophistication. Part I of the Article traces the growth of the institutional investor and the development of a two-track regulatory system for institutional and retail investors. Part II examines the phenomenon of claims by “unsophisticated” institutions who assert that they were sold unsuitable investments or that they were not otherwise protected from substantial losses. Part III of the Article then proposes some solutions to the dilemma of the unsophisticated institution. Specifically, the Article proposes a risk disclosure document requirement. This requirement would preserve the efficiencies of a two-track regulatory system, while assuring that end users of derivatives are aware of the risks they are facing and that dealers are on notice as to the level of sophistication of the institution with which they are dealing.

Keywords: Institutional Investor, Deregulation, Regulation, Traders, Trading, Two-Track Regulatory System, Unsophisticated Retail Customers, Derivative Instruments, Risks, Derivative Dealers, Claims, Risk Disclosure Document