GUEST BLOG: A Pulitzer Prize for Risk Disclosures? by Aegis J. Frumento Esq

November 8, 2018

A Pulitzer Prize for Risk Disclosures?

We've come to believe that, in securities law at least, disclosure cures all. So it was amusing to read Dalia Blass's keynote address to the Investment Company Institute's annual Securities Law Conference. Blass is the Director of the SEC's Division of Investment Management, which has the thankless task of reading and commenting on registered investment fund disclosure documents. Director Blass must have struggled through some especially dense prose two weeks ago, because when she finally broke free of it, she took the opportunity to lace into an audience of securities lawyers for drafting unreadable risk disclosures. 

Blass made a plea for clarity and simplicity that, in general, I endorse. As she put it, "lawyers are not masters of the plain-spoken. We excel at careful writing and detail, but not simplicity and clarity." Her main point is that risk disclosures are so comprehensive, including everything that could conceivable go wrong, no matter how improbable, and ranked alphabetically rather than by some more substantive measure, that the "real" risks are buried in the minutiae.

Blass's comments are both right and beside the point. Disclosure documents are terrible, and risk disclosures are the worst. But we lawyers couldn't have gotten into law school if we were bad writers. Our risk disclosures are more Hegel than Hemingway because they aren't really written to warn investors of anything. They are written to protect fund managers from investors when the investment goes bad.

Who, besides the Division of Investment Management, even reads risk disclosures? Most investors read the business plan so they can rationalize their decision to invest. They read the managers' bios so that they can feel warm and fuzzy that the managers aren't thieves or nincompoops. And they read the projections so that they can fantasize about how much money they're going to make. But the risk disclosures just sit there, all caps and boldfaced, like fortress walls defying to be scaled. They are like the narrator of every drug commercial. While the ad hypes the benefits of a Xarelto or a Chantix with uplifting music and video, the narrator drones on that the stuff could kill you. We remember the four-hour erection thing only because we can't decide if it's risk or hype.

That's why, in the real world, disclosure statements are only important after the investment has gone to hell in a bucket. They are used primarily in court or arbitration to prove that whatever happened, the investor was warned. Since it's a pure defense mechanism, it will of course mention every possible thing that could happen, because there's no way to predict which one will.

The basic problem here is that we humans are just terrible at assessing risks. Risks written in prose especially, because risk can only really be measured mathematically. And even the math can be deceptive. Do you believe the probability of a coin toss landing heads is 50%? Good. Then try this experiment. Make two columns. In the first, imagine yourself tossing a coin a hundred times, and jot down your imagined result, heads or tails. If you tabulate the results, about half will be heads and half tails, as you would expect. Then go ahead and toss a real coin 100 times, and note the results. You will still end up with about half heads, half tails. However, the real coin tosses will show something that the imaginary coin tosses won't: several streaks of 5 or more heads or tails in a row. The calculated probability against tossing five heads in a row is about 97%. Our intuition tells us they shouldn't happen. And yet, there they will be, several of them, in fact, over the course of a hundred real coin tosses. Real randomness is weirder than we imagine.

So weird that we humans are not mentally equipped to handle it, not even if we are given the mathematical odds. We can only make decisions by mentally collapsing probabilities into certainties. If someone tells us an event has a low probability, we act as if it won't happen. If someone tells us an event is probable, we act as if it will happen. And yet, improbable things happen all the time. Hillary Clinton had a 75%+ probability of winning, and still lost. The odds-makers weren't wrong. It's just that no matter how improbable, anything can still happen, like the black swan, the perfect storm, the five heads in a row. We've always known this to be true. "The race is not to the swift," says Ecclesiastes, "nor the battle to the strong . . . but time and chance happeneth to them all."

All of this makes the very idea of investment-specific risk disclosures pretty dubious. I think the SEC could draft a uniform risk disclosure and require it included in all prospectuses, like the standard warning on a ski ticket. Consider this:

All prospectuses should have two main components. There is a proposed plan of action (be it an investment strategy for a fund or a business plan for an enterprise). And there is a projection of how the plan will perform in the future. Each of the plan and the projection is based on a set of assumptions built on facts and opinions. The assumptions behind the projections also build on opinions about how present facts will change (or not) in the future. The prospectus should simply list out in detail (a) all the assumptions on which the plan and the projections depend, and (b) all the facts and opinions on which the assumptions depend.

That being done, these risk disclosures can apply to any endeavor:

1. As to each and every fact stated above, it is possible that (a) we are lying about it; (b) we have been misinformed about it; (c) we have misunderstood what we have been told about it, and (d) there are other facts that are more correct and/or more relevant that we have ignored or of which we are unaware. 

2. As to each and every opinion stated above, it is possible that (a) we don't really believe it, (b) we don't have any reasonable basis for it, (c) we could be totally wrong in our belief in it, and (d) there may be opinions that are more reasonable and/or more relevant that we have ignored or of which we are not aware. 

3. As to all assumptions stated above, it is possible that (a) we have misstated it or are not really applying it, (b) whatever we have assumed about the present may be incorrect, (c) whatever we have assumed will happen in the future doesn't happen, and (d) there may be other assumptions that are more reasonable and/or relevant that we have ignored or of which we are not aware. 

4. Because of any one or more of the above possibilities, it is possible you will lose part or all of your entire investment.

What other risks could there be? And if you think that's all obvious, well that's my point! Any investor who needs detailed risk disclosures has no business investing. The risk is always no more nor less that the whole thing is just a crapshoot that will end up rolling snake eyes. If that reduces every investment decision to a leap of faith -- well, duh!

So, Dalia, stop torturing yourself (and us) over meaningless risk disclosures. You'd do better to pick up Kierkegaard's Fear and Trembling, and read the section describing the Knight of Faith. It's no model of clarity either, but it's truer than any risk disclosure I've ever written or you've ever read.


Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters. Mr. Frumento has also represented clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of Blog.