Social Justice for Investors: what about complex financial products?

Over the weekend I saw an interview with Dutch journalist Joris Luyendijk who, in the past two years, has been working for the Guardian in London seeking to uncover the workings of ‘The City’ the financial heart of Londen. For a while therefore Luyendijk published on the BankingBlog and now published some of his findings in a book with the illustrative title “This cannot be true” (‘Dit kan niet waar zijn’ in Dutch, soon to be translated into English). In the past years Luyendijk has been seeking to City employees and former employees about their work, their experiences and their own fears. In the television programme (in Dutch) to promote his book, Luyendijk gave a few anecdotes to illustrate what we are talking about. This concerned illustrations of ‘the bubble’ in which some people in the financial world are trapped that removes them from reality.

A very interesting anecdote in this respect concerned a man completely focused on profiting from the market effects after 9/11 only to realize at the end of the business day he actually knew a lot of people in the World Trade Centre in New York City. However another Luyendijk story sparked my interested:

He explained that in his book he distinguishes various types of people, one of which he calls the cool frog (‘koele kikker’). One of these, in conversation with him, stated that all that she did was completely legal and to get off her back for asking poignant questions about it. Luyendijk then continued to explain that in the financial services word there are products made by specialists that are so complex that, although the makers understand what they are doing (most of the time), the client that purchases these products, i.e. investors, do not have a clue. These can be very profitable products, but in cases of losses the losses are for the investor and not for the bank. Luyendijk actually warns for the complexity of these products and foresees some of these to go wrong in the future in such a way as to cause another financial crisis.

In fact, that is the premise of the book: there is nothing done about the banking behaviour except some marginal remedies. Another banking crisis can therefore be imminent unless we respond properly. Although Luyendijk signals the problem in his book, in the interview he provided a solution by suggesting we increase the financial buffers banks need to have to cover their losses.

It was the immensely complex financial product that triggered me. This is contract law and a bit of property law (in case securities are involved, such as in mortgage or asset backed security (MBS/ABS) and other securitization transactions. Luyendijk explained how some of the cool frog-types use the adagium of ‘caveat emptor’ (buyer beware) to defend themselves. In other words, if these clients are stupid enough to sign, it is their responsibility as they become bound by the terms of the contract.

However, we use exceptions to the caveat emptor principle. Perhaps reluctantly, but still, also English lawyers accept that there are situations in which the relationship between two parties are so unequal that it is worth protecting the weaker party. I am speaking of course about consumer contract law in which consumers are protected by increasing their available remedies, such as withdrawal rights, but also increasing the information duty of the provider, so that the informational deficiency of the consumer can be remedied somewhat. In financial service-terminology this information duty takes to the shape of a prospectus with standard calculus examples and a warning (‘warning, borrowing money costs money’ and the like).

We interfere in the contracting process, because we consider it unfair that a multi-national company with an army of lawyers can take advantage of a poor individual consumer. We do this, in other words, because of our objectives achieving (or at least maintaining a degree of) social justice.

However, as soon as we leave the B2C (business-to-consumers) realm and move in the B2B (business-to-business) area, we are in the area of commercial law. In commercial law caveat emptor rules the game and there is no room for protection of any party. Rationale is of course that every party can obtain legal advice at its own costs if necessary.

For some commercial parties, most notably small and medium-sized enterprises (SMEs) there is increased attention (http://ec.europa.eu/enterprise/policies/sme/index_en.htm), as is may not be desirable that the caveat emptor doctrine applies in full to those. The now revoked proposal for a Common European Sales Law (CESL) therefore also pays attention to SMEs (http://ec.europa.eu/justice/contract/files/common_sales_law/regulation_sales_law_en.pdf).

But in case of complex financial transactions, aren’t most – if not all – other parties in a comparable weaker position to an SME dealing with a multi-national company. Even if they would get specialist legal advice, it may – following Luyendijk’s explanation – be almost impossible to (1) understand the content of the transaction, (2) oversee the consequences of the transaction and (3) oversee the future effect that such a transaction may have. An increased financial buffer of the bank will not remedy the fact that the bank has limited its liability.

Perhaps we should therefore re-think the framework of contract law that applies to these transactions to build in more protection for the weaker party. Especially if such a weaker party is a pension fund, i.e. representing investment on behalf of thousands and sometimes millions of people, social justice may call for interference in the market here. And even when we are dealing with a specialist investment fund, we can still not be sure that all three of the above aspects of the transaction are completely clear.

It seems to me that the current toolbox of withdrawal rights may not be suitable, but perhaps we can further investigate the information duty of the supplier to remedy some of the harsh effects of the caveat emptor doctrine.

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