Asymmetric Information
The primary method of retail investor protection is information disclosure.
Law has focused upon correcting information asymmetries upon the assumption, that informed investors are protected investors. In the abstract, this thesis is appealing. In practice, the assumption is dubious. For example, providing a retail investor with a prospectus upon which to base a decision to invest is likely ineffective, due to the fact that a prospectus requires skills to read and often a retail investor cannot read financial statements or perform the necessary calculus to produce a range of financial ratios to compare different investment products. The retail investor then is left to rely upon professional advice or make conservative investments that may not be in the best long run interest of the investor. In short, “information asymmetry refers to the client’s limited knowledge vis-à-vis the intermediary with regard to the investment activity [parenthetical information omitted], the information surrounding the investment product in which the client may be interested [parenthetical information omitted], and the intermediary’s self-interest in the client’s activity” (Ibid, Chiu, supra at 309 – see reference list).
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Proceeding form the abstract to the concrete demonstrates the faulty assumption that “disclosure” corrects “information asymmetry” in financial markets. Take one equity and one debt example to make this point. Assume a decision to purchase IBM common stock is subject to fundamental analysis based upon “Graham” criteria. The likelihood of an investor, even supplied with the information, having the ability to compute the ratios necessary to follow the criteria is rare, if not, non-existent (Benjamin Graham, The Intelligent Investor (1949). The Graham analysis contains the following criteria: (1) Sufficient size, (2) Strong financial condition, (3) Earnings stability, (4) Dividend record, (5) Earnings growth, (6) Moderate P/E ratio, and (7) Moderate Price to Assets Ratio. Applying the Graham criteria to IBM yields a negative correlation between the company’s fundamentals and Graham’s criteria. Therefore, the recommendation would be “not buy.” Regardless of whether the recommendation is correct, as it is probably not, the fact remains that a retail investor is not in a position to evaluate one stock never mind alternative purchases. Appendix B contains a work out of the Graham criteria to IBM). The answer: IBM fails to meet the Graham criterion. However, if we look at Price to Assets, the conclusion may differ. The total assets are 120,432,000 [in thousands] and the price is 120.47 demonstrating a moderate price in relation to total assets, and therefore producing a different conclusion. Debt poses equally difficult problems, whether the investor is interested in the debt of a single corporate issuer or a diversified portfolio of different issuers, as the following simple example illustrates.
The price of bonds is inversely related to interest rates, the latter term being equally beyond the comprehension of the retail investor in its construction. In any event it is essential, when comparing bond prices to know the annual return, as displayed by the following table.
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| Bond | Par Value | Coupon Interest Rate | Time to Maturity | Required Return | Value |
| A | $1,000 | 14% | 20 years | 12% | $1,149.46 |
| B | $1,000 | 8% | 16 | 8% | $1000.02 |
| C | $100 | 10% | 8 | 13% | $85.61 |
| D | $500 | 16% | 13 | 18% | $450.95 |
| E | $1000 | 12% | 10 | 10% | $1,122.90 |
These values were derived using standard bond mathematics based on the following formula: B0=c/(1+i)n + M/(1+i)n where c = annual return based on coupon rate, [i] = required rate of return, n = number of years and M = par value at maturity. The question presented: is it realistic to expect investors, fully armed with information, to perform the type of equity and/or debt analysis required to make informed decisions in the marketplace regarding which debt instrument among thousands to purchase. The answer is an unequivocal: no. Therefore, parity of information is an illusion (While it is true that “A critical barrier stands between issuers of common shares and public investors is asymmetric information”, most legal scholars do not dig deeper than this self-evident statement. As demonstrated, information parity is probably unattainable and should not constitute the primary mechanism of creating trust in markets. See Bernard S. Black, The Legal and Institutional Preconditions for Strong Securities Markets, 48 UCLA L. Rev. 781, 786 (2001) – see reference list)
In spite of this conclusion, virtually all jurisdictions require the provision of a prospectus prior to the issuance of securities to the public (Professor Black places a slightly different spin on resolving the problem of asymmetrical information. He states,
Some counties, including the United States, have partially solved this information asymmetry problem through a complex set of laws and private and public institutions that gives investors reasonable assurance that the issuer is being (mostly) truthful. Among the most important institutions are reputational intermediaries – accounting firms, investment banking firms, law firms, and stock exchanges. These intermediaries can credibly vouch for the quality of particular securities because they are repeat players who will suffer a reputational loss, if they let a company falsify or unduly exaggerate its prospects, that exceeds their one time gain from permitting the exaggeration. The intermediaries’ backbones are stiffened by liability to investors if they endorse faulty disclosure, and by possible government or criminal prosecution of they do so intentionally.
Three key factors are introduced to support reliance upon the value of “reputation”: (1) an influential financial regulator, (2) a strong judicial system, and (3) procedural rules to permit private enforcement actions).
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The European Union is no exception, progressively enlarging the required scope of information to be contained in a prospectus (Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003 on the prospectus to be published when securities are offered to the public or admitted to trading, am’d Directive 2008/11/EC of 11 March 2008). In addition, though a bona fide prospectus satisfies listing requirements, an exchange may require additional information.
