An Introduction to the Law on Financial Investment

Iain G MacNeil

• Publisher: Hart Publishing
• Year: 2012
• Print ISBN: 9781849460507
• eBook ISBN: 9781847318749
• Edition: 2
• Topic: Law
• Subtopic: Financial Law
• Index: Law

Since the publication of the first edition of this book in 2005, the world of financial investment has experienced an unprecedented boom followed by a spectacular bust. Significant changes have been proposed and in some cases implemented in areas such as the structure of regulation, the organisation of markets, supervision of market participants and the protection of consumers. The second edition takes account of these developments, integrating them into an analytical framework that enables the reader to develop a critical overview of the role of general legal rules and specialised systems of regulation in financial investment. The framework focuses on the role of contract, trusts and regulation as the primary legal influences for financial investment. The first part explores the relationship between investment, law and regulation. The second part examines the nature of investments and investors, both professional and private. The third part discusses the central role of corporate finance and corporate governance in linking investors with enterprises that require external capital. The fourth part examines the nature, operation and regulation of markets and the participants that support the functioning of the markets. The objective remains to provide a broadly-based and critical account of the role of law in financial investment. "MacNeil's eloquent and informative distillation of the regulatory fundamentals of investment law gives his book much international relevance…a timely contribution to help readers decipher the seemingly inextricable maze of financial regulation…Practitioners and legal policy advisers will..welcome it. They should find enlightening the book's careful scrutiny of the trust and contractual foundations of investment law and practice."
Benjamin J Richardson
Journal of International Banking Law and Regulation, Vol 22 Issue 1, 2007
…a fascinating and informative book…thoroughly recommended as a learned but at the same time very readable introduction to the law of financial investment
Gerard McCormack
Banking and Finance Law Review, Volume 21 No 2, June 2006
...very informative tool that introduces in a very friendly and accessible manner the nearly inextricable world of financial investment laws.
Fadi Moghaizel
International Company and Commercial Law Review, Vol. 17 No 2, February 2006

Part 1

Investment, Law and Regulation

1

The Nature of Investment

What is investment? The answer to that question depends on the context in which the term is being used. It is possible to identify three distinct meanings that are commonly given to the term. The first is what can be termed an economic definition of investment.

According to this view, investment means that individually, as a company or as a country we forgo the consumption of goods today in order to achieve greater consumption in the future. On this view, investment can take any form and has no particular association with the manner in which an economy is organised or the mechanisms through which investment occurs. Buying a spade with which to plant potatoes in one’s garden is, from this perspective, as much ‘investment’ as buying a potato future in the commodities market or a share in a company that operates as a potato merchant. This approach also distinguishes investment from saving, which simply transfers consumption from one period to the next.

The economic approach to investment also distinguishes investment in real assets (such as land or machinery) from investment in financial instruments such as shares and bonds. Investment decisions relating to real assets (sometimes termed ‘direct investment’) are most often made within an enterprise and focus on the extent to which wealth can be created by using existing and future resources to produce goods and services now and in the future with greater value than the resources consumed. Investment decisions relating to financial instruments are generally made by investors outside these enterprises and are primarily concerned with providing finance to fund the direct investment projects of enterprises.¹ Investment in financial instruments is termed ‘portfolio investment’ because investors generally aim to diversify their holdings of financial instruments across a portfolio.

Portfolio investment is the main focus of this book. Its focus differs from what has become known as the law of ‘finance’ or ‘banking’, both of which are focused much more on the operation of credit markets, the techniques of debt finance and the role of banks. This book is focused more on the activities of asset managers, such as pension funds, insurance funds, professional fund managers, pooled investment funds and financial advisers. Of course, a number of factors mean that there is a substantial overlap between all three areas: increasingly ‘supermarket’-type financial conglomerates span all three types of activity; products in one area can increasingly be regarded as substitutes for those in another; and evolution in markets has opened up possibilities in taking and hedging risk that were not generally available in the past. Thus, the focus is not based on any clear demarcation that can be observed between the three fields; rather, it is built more around the primary legal and regulatory concerns that facilitate, shape and limit the practices associated with portfolio investment.

The second meaning of investment is what can be termed its legal definition. This focuses on investment as property and the legal rules associated with ownership of that property. The legal view of investment is intrinsically liked with the economic view because the objective of the legal rules is to create a link between the forgoing of consumption today and the delivery of greater consumption in the future. If legal rules do not provide a sufficiently strong link between the two, it is unlikely that investment (in the economic sense) will occur. In other words, legal rules must be devised so that investors have confidence in their ability to enforce their claims at some point in the future. This means that the law must make clear the nature of the claim held by the investor and make available enforcement procedures that will provide consistent enforcement of those claims over the long term.²

The third meaning of investment is what can be termed the process of investing. This focuses on the procedures, institutions and legal rules that are associated with investment (in the economic sense). This view encompasses matters such as the role of markets and financial institutions in channelling savings into investment as well as the regulation of markets and their participants. Investment is more likely to occur when investors believe that they are treated fairly during the process of investment. This can be understood in different ways in different contexts. For example, it can refer to the information provided by a company when it invites the public to buy its shares. Equally, it can be taken to refer to the extent to which financial markets are ‘clean’, meaning that they are free from manipulation and insider dealing. For private investors, it will often relate to the quality of information and advice provided at the time of making an investment decision, as well as the suitability of investments that are sold to them.

Each of these three aspects of investment is central to what follows in the book. The discussion below provides a brief overview of some of the main issues, while much of the detail is dealt with in later chapters.

1.1 The economic nature of investment

The central feature of the economic nature of investment is the forgoing of current consumption in the expectation of achieving greater consumption in the future. A willingness to forgo current consumption in favour of investment is normally only possible when spare resources exist that are not required for current consumption. In such circumstances, surplus resources or savings will be present in the financial system and will in principle be available for investment. That is not to say that they will be automatically invested. Whether they are invested or not will depend on many different factors, two of which are particularly important. The first is the risk associated with investments and the risk preferences of the potential investors who have savings to invest. The second is the extent to which financial institutions perform the function of financial intermediation.

1.1.1 Risk

The risks associated with a particular investment can be classified as:³

• Uncertainty of income (sometimes referred to as project or business risk). This risk arises when an investment, such as a company share, does not have a fixed income.

• Default risk. This risk arises in respect of debt securities (which are essentially loans raised by enterprises) and is the risk that a loan will not be repaid at the due date.

• Interest rate risk. The valuation of investments is sensitive to the prevailing level of interest rates and therefore changes in interest rates cause changes in market values.⁴

• Inflation risk. This is the risk that the return on an investment that carries a fixed income (eg government securities) will be less in real terms than expected at the time of purchase as a result of higher than expected inflation.

Different investments involve different levels or risk and offer different types of return.⁵ A basic distinction can be drawn between equity-based investments and fixed interest investments. The main feature of equity-based investments is that they offer no guarantee in respect of either return of capital or income. In that sense, they are risk capital. Fixed interest investments (such as bank deposits, government and corporate bonds), on the other hand, offer a guarantee in respect of both return of capital and income. In that respect, they are safer investments than equity-based investments, but holders nevertheless face the risk of default (eg if the borrower becomes insolvent) as well as the risk of inflation.

Modern portfolio theory focuses on how to construct a portfolio of investments by reference to its degree of risk. It recognises the categories of risk mentioned above, but distinguishes between those risks that can be avoided and those that cannot.⁶ Specific risk relates to particular events relevant to particular investments, such as a company losing its main customer. Those events are specific to individual companies and are not dictated by general movements in the economy as a whole. Specific risk can be reduced through diversification, which has the effect of balancing out across many investments the specific risk attached to each. In this sense, diversification reduces the overall risk of a portfolio. Market risk refers to the risks arising from general movements in the economy, for example a recession. Within a single-country portfolio this risk cannot be avoided, but for an international portfolio, diversification can reduce the risk. The availability of data on historic price movements of specific investments by comparison with the market as a whole (the beta coefficient) now enables investors to measure the relative degree of risk in their portfolios by comparison with the market as a whole.⁷ That exercise enables the construction of investment portfolios in which the degree of risk is taken into consideration along with other factors that may be relevant (for example, in the case of a pension fund, the liabilities that the fund is required to pay).

The extent to which investors are willing to assume risk depends on their risk preferences. Risk preferences are measured by reference to the utility (subjective satisfaction) that an investor derives from an increase in wealth at any given level of wealth. It is generally assumed that investors are risk averse, meaning that as wealth increases they derive less utility from further increases in wealth.⁸ This means that investors generally require additional expected return for taking on additional risk.⁹ The specific additional return required by a particular investor in respect of a particular investment will depend on the particular utility of wealth characteristics of that investor. While that is not capable of precise expression, it underlies investment decision-making by risk-averse investors, who attempt to achieve either the highest return for a given level of risk or the lowest risk for a particular desired return.¹⁰

1.1.2 Financial intermediation

The second factor that determines whether funds available for investment are invested is the role played by financial intermediaries. Included in this category are banks, investment management firms, insurers, unit trusts and investment trusts.¹¹ They act as intermediaries in the sense that they take money from their customers and in turn provide their customers with a financial instrument (such as a deposit, unit trust, life policy or share). That process has a fundamental effect on investment because it allows the intermediary to create investments with characteristics that could not be created by an investor acting alone.¹²

This transformation occurs in relation to maturity and risk. The first refers to the ability of intermediaries (such as banks) to borrow short and lend long. For example, a bank that takes short-term deposits from customers is able to lend that money on a long-term basis (eg in the form of a mortgage) because not all the depositors will want to be repaid at the same time. In this sense, financial intermediation in the form of the provision of credit helps to stabilise the cash flow of households and firms who can use credit to make long-term investment plans, such as the purchase of property, that would not be possible if credit were not available.

The second form of financial intermediation refers to the role of an intermediary in changing the risk faced by an investor. A pooled investment fund, for example, is able to transform risk because a single unit in the fund offers diversification across the entire portfolio held by the fund, whereas a single share in a company leaves the investor with a high degree of specific risk. In effect, the fund is able to offer a financial product to the investor that would not be available if the investor were to deal directly (on an individual basis) with a company. For some investors, it will be possible to replicate the diversification that can be offered by a fund, but for others (and especially the private investor) it will be more difficult to do that as well as to match the investment and administrative expertise of a fund.

Another feature of financial intermediation is that it offers a solution to the problem of asymmetric information in financial markets. This refers to circumstances in which there is an imbalance in the information available to parties who may potentially enter into a contract. Investors (particularly private investors) often face this problem as they may lack either relevant information or the ability to interpret that information. If this problem is left unresolved, it has the potential to hold back the growth of financial markets as, if investors lack the information needed to distinguish good investments from bad, they are likely to pay only average prices for all securities, with the result that high-quality issuers are likely to be deterred from raising capital.¹³ Intermediaries can resolve this problem at relatively low cost by selecting and monitoring investments on behalf of a group of investors.

Finally, a distinction should be drawn between financial intermediation in the sense that the term is used here and ‘intermediation’ in the sense of an agent employed by a principal to carry out a transaction or series of transactions. An example of simple agency would be the employment of a financial adviser by an investor. The essence of financial intermediation is its capacity to change the nature of the financial product or service that is offered to the investor. Simple agency does not do that, even though it imposes an intermediary (agent) between the principal (investor) and the investee company, and brings into play obligations that arise from the law of agency and related regulatory rules. This distinction is significant because it is often the case that financial intermediation in the first sense does not represent an agency relationship in the legal sense: for example, in most instances a bank accepting a deposit from a customer or making a loan acts on an ‘arm’s length’ basis in concluding the contract and will not be bound by the higher standards that arise from the fiduciary duties imposed on agents in the legal sense. As will be seen, the issue of identification of circumstances in which a financial intermediary acts as an agent in the legal sense when dealing with a customer, and what obligations should be attached to that role, is one of the basic problems that has been encountered in the law and regulatory rules associated with investment.

1.2 The legal nature of investment as contract and property

The fundamental challenge for the law is to devise rules that will allow investment to occur. In essence, this means devising rules that will provide legal rights to potential investors (surplus economic units) that will encourage them to become investors. The purpose of such rules is to determine the rights and obligations of an investor in relation to the entity in which the investment is made, other investors and the outside world. Without such legal rights, surplus resources or savings are unlikely to be channelled in...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Table of Cases
• Table of Legislation
• Part 1—Investment, Law and Regulation
• Part 2—Investments and Investors
• Part 3—Finance and Governance
• Part 4—Markets and Participants
• Index