When issuers draft prospectuses for their bond offerings, the EC has proposed that they no longer go the traditional disclaimer route and list general risks to the investments they’re offering.
Normally, a prospectus would have a few pages dedicated to outlining very generic risks, including credit risk, liquidity risk, operational risk, regulatory risk, legal risk, misconduct risk and even mentioning the competitive nature of the financial services industry as a risk, for example.
But the EC wants bond issuers to start outlining more "material and specific" risks to their businesses, with the aim of curbing “the tendency of overloading the prospectus with generic risk factors which obscure the more specific risk factors that investors should be aware of, and only serve to protect the issuer or its advisors from liability”.
Issuers will now have to classify those risks into two or three buckets of graded "materiality", for which the European Securities and Markets Authority will draft guidelines.
Of course, issuers will be petrified to identify any given risk factor as low. Imagine how many funders would have listed a Russian invasion of Ukraine as a low risk factor only two years ago. Perhaps more to the point, an entire generation of investors believed, until 2008, that the US housing market was, as a whole, never going to see a downturn.
Identifying a risk as low on the spectrum of materiality may well make issuers liable when that very risk materialises down the road. It is, after all, a risk, so it’s possible. But, as experts in their own businesses, regulators seem to think issuers should be able to commit themselves with confidence to predictions of the future.
That's basically what ratings agencies are meant to do, and we all remember how that turned out back in 2008.
Let’s remember that policymakers and regulators eviscerated ratings agencies for misrepresenting the credit risks of bonds during the crisis, which has set them on the impossible task of perfectly aligning their incentives with those of bond buyers, while maintaining their impartiality.
So, if regulators and policymakers don’t trust ratings agencies to come up with accurate risk assessments of issuers and their bonds, surely they can rely on the issuers of bonds themselves, right?
Unless the European Securities and Markets Authority comes up with a magical set of guidelines ensuring that no issuer who simply misunderstood a risk, or who ended up being materially affected by a genuinely low probability event, would be held as intentionally misrepresenting it, then guess what? Some borrowers are surely going to make dishonest or intentionally specious risk assessments.
By requiring issuers to make specific assessments of this kind, regulators may only be increasing the risk that investors will be fleeced. In trying to make prospectuses clearer and more understandable, the EC is giving investors just one more thing to rely on in lieu of due diligence.
Investing is a risky business. Risk is the very lifeblood of the market. It is the different perceptions of risk and return that make markets. As a result, the given risk of any factor to absolutely anything is up for constant debate.
And even if there were an objective way of representing risks, the EC would still be asking the one party in a transaction not incentivised to do so to give a complete and accurate picture of the risks they could suffer.
We should all support attempts to help investors understand risks and to stamp out the obfuscation or mis-selling of risk. But PD III runs the risk of achieving the exact opposite.