There are two basic models of regulatory system which is the supervision framework for securities market which is a merit based regulation and disclosure based regulation. These regulation systems are important to provide adequate investor protection and regulate business practices or codes of conduct that reduce systemic risks.
Merit Based Regulation (MBR)
A securities regulator is needed, which control all matters relating to securities and to take all reasonable measures to preserve the confidence of investors in the securities market by ensuring sufficient security for such investors. The securities regulator has the discretion to approve the proposals with such revisions and subject to such terms and conditions as it deems fit. The securities regulator also has the power to reject corporate proposals if it is reasonably satisfied that these proposals are not in the best interest of the public company and/or the investing public.
Authorities regulate securities offering – Under the MBR, The authorities regulate the securities offering by protecting and shielding the investor by ensuring that the offering of the securities of the companies is judged by the authorities to be fair, just, and equitable. Under this approach, the regulators or the authorities would make an assessment regarding the company’s viability, quality, and capabilities of the company’s management, its suitability for listing, and taking regard of the public interest before approving any issuance proposal regarding the company’s securities.
Issuers and advisers disclose to authorities – Under the MBR model, the issuers and advisers disclosed all information regarding the company’s business to the authorities or the market regulators. These are because under this type of model, the market regulator needs to approve first the securities before the investor can be allowed to invest in the companies. This is for the purpose to protect the investor.
Authorities’ reviews investment merits of offering – Regulators review each transaction according to its perceived merits. The evaluation is completed in two stages are first, adequacy of disclosure is assessed then, and the merits of the transaction are subjected to value judgment. Merit-based regulation assumes that the market regulators are better informed than investors and can better decide the merits of transactions on their behalf. These merit judgment is the indication of whether the companies can provide safe securities in making business in order to protect the investment made by the investor.
Advantages of MBR Model
In merit based regulation, it is a paternalistic attempt to improve or to develop the fairness between the relationship between the sellers and buyers of the securities in the capital market. These models also act as a shield to protect the public investors from the risks involved in acting on impulse. This is because the authorities had made deep valuation and merits regarding the company’s business in order to approve the securities issued by the company.
This model or regulatory system is particularly suitable to be adopted for developing countries emerging capital market which has a large proportion of financially unsophisticated retail investors. This also reduces or minimizes the possibility of promoters of public companies exploiting these less sophisticated investors to use as to their own advantages.
In the securities market, the regulatory system is also able to ensure that mechanism in place is working well in order to prevent unscrupulous and unethical practices in the issue or offer of the securities by the companies. By ensuring that the mechanism place is working, the investor would have minimized the risk of losing their investment by the unscrupulous and unethical practices of some company’s that would provide false or inadequate information regarding their business.
But, the ultimate decision still lies within the investor. This is because the decision and the evaluation of the security offered to lie with the investing public. The securities commission will not give a guarantee that the investment made by the investor would get a return or profit.
The regulatory system has the power to check and ensure that the securities that are offered by the issuers are fairly and reasonably priced.
Disadvantages of MBR Model
This is in regards to the public interest where the public investor would make their decision in investing their money in the company’s based on the regulatory system. The approach of MBR posed a problem of moral hazard. This is because when the market regulators or the regulatory system gives their approval of the merits of a particular company, it exists the danger that investors will perceive that the corporation will be a good investment as the regulatory system had given their approval after making some merits regarding the business of the company’s. This would lead to an impression whereby the investor did not need to individually evaluate the merits or risk of investing in that company. The investor would totally leave it to the market regulator to make the research.
By using these models, the regulatory approach of MBR restricts entrepreneur’s and investor’s choices in making decisions in choosing the right company to invest in by limiting the scope of investment that is offered to them. This is because only the regulatory system will give and provide the necessary approval in order to make the issued security to be approved. If the companies do not comply with the guideline given and the regulatory system does not approve the issue offered, thus limiting the option available to the investor in investing their money.
This approach also denies certain ventures access to public funds unless the issuer of securities agrees to modify their offering according to the pre-requisite set by the regulatory system. The issue that always arises is that the regulatory system and the issuers of securities tend to have conflicting views as to how and the extent to which a proposed venture or transaction will be beneficial to investors in general.
The regulatory system is also known to be more conservative in its judgment and normally will not approve highly risky securities to be offered to the public. The merit based regulation also provided that by giving much protection to the investor, this will take the bargaining power from the securities offeror or issuers and the power will be switch to the investor instead. The protection is significant because the issuers of the securities need to raise funds at a substantial discount from the actual price of their securities. From this market philosophy, this “over-protection” of the investing public had compelled issuers to raise funds at a substantial discount from the actual value of their securities or add to the perception of initial investors that they would be “guaranteed” a premium when the corporate body is launched onto the marketplace.
Disclosure Based Regulation
The basic principle of DBR is the need for the issuers and intermediaries offering securities to provide investors with sufficient, accurate, and timely disclosure of all relevant information regarding the company’s business, prospects, finances, and the terms of the securities in order to allow investors to better evaluate the risks and merits of their investment. This is to allow the investor to make their own informed investment decisions. Usually is done through the use of prospectus which focuses on whether the companies comply with the standard of disclosure required.
Authorities regulate disclosure of information in a securities offering – Under DBR, the regulation of the disclosure or the standard of the disclosure in a securities offering is on the authorities where the authorities will provide the guidelines for the company in disclosing the relevant information pertaining to the company’s business, finances, prospects and terms of securities. The burden is put on the issuers of the securities and advisers and not on the authorities.
Issuers and adviser disclosed to the investor – Under the model of DBR, the issuers of the securities will provide sufficient information according to the regulatory system regarding the disclosure of information regarding their business. The advisers which are normally experts or professionals such as accountants, lawyers, and other technical experts need to have played their role in the preparation of prospectus for the investing public. These are because each of these advisers or experts can be held liable for a defective prospectus under the DBR. The due diligence process is for the purposes of preparing a good and complete prospectus and involves performing reasonable investigation work in order to determine that the prospectus does not contain any material omission or false information. Financial advisers and experts, in particular, are expected to have a very high standard of reasonable care. An adviser has an obligation to make a reasonable investigation not just for the purpose of its own due diligence defense but also as a duty to the investing public who will be relying on the opinion and recommendations of the advisers. In order to minimize their potential risk, expert professionals must make due diligence inquiries.
Investors determine investment merits of offering – In the DBR System, the investor cannot expect that the securities regulator to protect them forever. In order to invest, the investor cannot invest blindly. The investor must make their own research and collect data and information regarding the company’s business. Investors have to evaluate and assess the merits of any security being issued or offered before making any investment decision.
It would become more apparent that investors would have to change their laid-back attitude. They can no longer take for granted that securities being issued or offered have already passed the regulators’ investment merit review. Instead, the information necessary for the investors themselves to evaluate the investment merit of a security will be available. Investors must also take a more active interest in the companies they invest in emphasis should always be placed on fundamentals and long-term performance rather than short-term profit. Investors should be concerned about ensuring that their rights and interests as shareholders are protected and that greater transparency and accountability are shown by the directors or principal officers of the companies concerned.
Under a disclosure-based regulation, investment analysts and financial journalists would have access to more relevant information to enable them to make a more detailed analysis, research, and assessment of each security issue or offering and can conclude at a better finding and recommendation. This is of particular importance in developing countries in view of the large proportion of retail investors, some of whom lack the technical expertise and or the time needed to evaluate the web of information disclosed by issuers of securities. These investors may need to rely on the analysis disseminated by investment analysts and financial journalists to make better-informed investment decisions.
Advantages of DBR
There are several advantages of the DBR regulatory model system. Basically, this would result in a more transparent and informed market whereby companies have to improve their quality of disclosure to facilitate potential decision-making by potential investors. By upgrading the quality, the investors have more choice and more information pertaining to the business and the finances of the companies before making any investment in the companies.
Investors must know and get the information given by the issuer of securities because the investor will hold the burden of all the responsibility towards their investment decision.
One of the major advantages of DBR, the companies can raise more funds at a lower or cheaper cost. This is because it is based on the assumption that the higher level of transparency will lead to a greater evaluation risk by underwriters which would then contribute to a lesser cost in raising the fund which gives the issuer’s companies the power to price its assets at higher premium rates.
Another advantage under the DBR is where the role of the regulator is to ensure that the structure of the market is consistent and efficient for the market In order for the investor to make a decision. The regulators will ensure that the information given by the companies is disclosed so that the investor will become the judge in making the judgment of the merits of alternative investment so that the regulator would only emphasize disclosure and eradication of fraud.
According to analysis, by shifting towards the disclosure based regulation, the benefit that the securities market will enjoy is that the increased efficiency of the capital market by removing the barriers to the competitiveness that is present in the old merit regulatory system.
A higher standard of disclosure by the companies is ensuring by the regulatory bodies. This is because the companies are expected to follow the guidelines of disclosure of the information according to the regulatory system. This would give more chances to the investor in making their own research of the accountability of the companies before making any investment.