The Sophisticated Investor and the Global Financial Crisis

CORPORATE GOVERNANCE FAILURES: THE ROLE OF INSTITUTIONAL INVESTORS IN THE GLOBAL FINANCIAL CRISIS, James P. Hawley, Shyam J. Kamath, and Andrew T. Williams, eds., University of Pennsylvania Press, 2011

30 Pages Posted: 14 Mar 2011 Last revised: 31 Oct 2013

Date Written: April 1, 2011

Abstract

The financial instruments and risky practices that caused the global financial crisis of 2008 were enabled by decades of deregulation and anemic government enforcement efforts. The elements that combined to create the crisis were subprime mortgage securities, credit default swaps, highly leveraged hedge funds, and excessive short-term borrowing at investment banks. They flourished without government oversight, transparency, or limits because proponents contended that “private ordering” of financial markets, instead of government intervention, was ideal.

The champions of private ordering contended government interference was inappropriate for sophisticated investors (SIs) who had the expertise and incentives to properly assess risk, and to select and monitor complex investment options. They believed that by acting in their own interests, SIs would keep the market safe and ensure the efficient allocation of capital to businesses and individuals who would make the most productive use of the money. Sophisticated investors include, for example, government, corporate, and union pension funds, mutual funds, hedge funds, endowments, broker-dealers, insurance firms, banks, and sovereign funds. They also include individuals who earn as little as $200,000 per year. While many experts warned about the dangerous consequences of deregulation, Congress and regulators accepted the conventional perspective that sophisticated market participants would police and avoid irrational conduct.

When a sophisticated institutional investor makes poor choices, this harms the ultimate investors, the people whom the securities laws were designed to protect. Former president Bill Clinton recently recognized this problem. He explained that the justification for the failure to regulate complex instruments was that: “these things are expensive and sophisticated and only a handful of investors will buy them and they don’t need any extra protection, and any extra transparency. . . And the flaw in that argument was that first of all sometimes people with a lot of money make stupid decisions and make [them] without transparency . . . And secondly, the most important flaw . . . was even if less than 1 percent of the total investment community is involved in [these investments] so much money was involved that if they went bad, they could affect 100 percent of the investments, and indeed 100 percent of the citizens in countries.”

In other words, reliance upon the sophisticated investor ignores reality; the entities the law deems to meet the definition are largely neither sophisticated enough to match the complexity of the instruments or lack of data nor the actual investors who have placed their capital at risk.

Looking back on the global financial crisis, it is clear that reliance upon SIs was misguided. There are numerous examples of how SIs were not able to make good choices. And, these incidents were not on the fringes but central to the crisis. As more information emerges concerning the creation and sale of toxic securities, it is clear that reliance upon SIs provided the rationalization for sharp if not illegal practices. Firms like Goldman Sachs invoked the SI concept while defending against securities fraud allegations that it created and sold some sophisticated clients bonds that were designed to fail while allowing others who helped create the bonds to bet against them.

In addition, lobbyists and legislators continue to rely upon the sophisticated investor framework to shield certain financial institutions and instruments from government oversight. In this fashion, the SI concept continues to be trumpeted by those who seek carve-outs from reform efforts. Despite the reliance on the SI concept, little attention has been paid to the importance of the SI failure. Accordingly, an examination of the incapacity of sophisticated investors to monitor unregulated investment options and of the role sophisticated investors play in creating systemic risk is a necessary prerequisite to restoring financial safety and economic stability.

Suggested Citation

Taub, Jennifer, The Sophisticated Investor and the Global Financial Crisis (April 1, 2011). CORPORATE GOVERNANCE FAILURES: THE ROLE OF INSTITUTIONAL INVESTORS IN THE GLOBAL FINANCIAL CRISIS, James P. Hawley, Shyam J. Kamath, and Andrew T. Williams, eds., University of Pennsylvania Press, 2011. Available at SSRN: https://ssrn.com/abstract=1784299

Jennifer Taub (Contact Author)

Vermont Law School ( email )

164 Chelsea Street
South Royalton, VT 05068

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