RISKY BUSINESS: 

PORTFOLIO RISK, INSTITUTIONAL 

INVESTING, AND THE SECURITIES ACT 

Charles K. Whitehead 

The Securities Act of 1933 is tied to transactions in 

securities, rather than the risk of those securities, an approach 

that reflects the risk management of the times. Managing risk 

through diversification did not occur until twenty years later, 

and a further twenty years passed before new instruments were 

created to facilitate the transfer of discrete portions of financial 

risk. For much of the capital markets, this shift resulted in a 

separation between the risk associated with individual 

securities and the securities themselves. The idiosyncratic risk 

of individual securities now matters less than its impact on a 

portfolio’s total risk. 

In response, SEC disclosure requirements increasingly 

have facilitated cross-company comparisons and portfolio-

level investment decisions. Nevertheless, the growing 

separation between risk and the instruments evidencing that 

risk, and the ability today to manage and transfer risk by itself, 

prompts a question: Should we begin reconsidering the 

Securities Act’s approach to regulation, moving from 

requirements tied to transactions in securities towards 

requirements that reflect the management and transfer of risk? 

There is certainly merit to doing so, but we may be limited 

by the practical difficulty of tracing risk in today’s capital 

markets. For now, regulation’s practical reach may fall short 

of contemporary investment and risk management strategies. 

While regulatory responses are possible, there is likely to 

 

   Myron C. Taylor Alumni Professor of Business Law, Cornell Law 

School. I appreciate the excellent research assistance provided by Nicholas 

Dugas, H. Anthony Park, and Junda Yu. I also appreciate the comments 

and feedback from participants at the Columbia Law School Future of 

Securities Regulation Conference. Any errors are the author’s alone. 



   

No. 3:1396] RISKY BUSINESS 1397 

continue to be a tension between the requirements of the 

Securities Act and the risk-based approach to investing taken 

by institutions whose investments comprise most of the 

transactions subject to the Securities Act. 

 

I. Introduction ...................................................................... 1397 
II. The New Risk Management .......................................... 1401 

A. Portfolio Risk and Diversification ....................... 1405 
B. Value-at-Risk ........................................................ 1411 
C. New Risk Instruments ......................................... 1416 

III. Risk Trading .................................................................. 1420 
A. Ships and Planks .................................................. 1420 
B. Distributing Risk .................................................. 1422 

IV. The SEC’s Response to Risk Trading .......................... 1428 
A. Disclosure and Portfolio Risk .............................. 1428 
B. Risk vs. Instruments? ........................................... 1433 

V. Conclusion ....................................................................... 1435 
 

I. INTRODUCTION 

Is the Securities Act of 1933 (Securities Act) focused 

principally on regulating transactions in securities or 

transactions in the risk associated with securities?1 Until 

recently, that question would have posed a distinction with no 

significant difference. Historically, the risk of buying and 

selling securities has run with the securities themselves. 

Securities holders have been both risk takers and suppliers of 

capital precisely because the instruments evidencing their 

investment have included the risk of that investment.2 

Consequently, by mandating basic levels of disclosure 

 

1 Risk, in this context, refers both to uncertainties that can harm value, 

as well as to uncertainties that can be profitable. See René M. Stulz, Risk 

Management, Governance, Culture, and Risk Taking in Banks, FRBNY ECON. 

POL’Y REV., Aug. 2016, at 43, 43 (noting that “any firm” must consider both 

“danger” and “ex ante profitable” risks). 
2 See ADOLF A. BERLE & GARDINER C. MEANS, THE MODERN CORPORATION 

AND PRIVATE PROPERTY 300–01 (Routledge 2017) (1932) (“[T]he security 

holders and in particular the stockholders, performs the function of risk 

takers and suppliers of capital[.]”). 



  

1398 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

regarding an issuer and its securities, a principal effect of the 

Securities Act was to lower the specific (or “idiosyncratic”) risk 

associated with investing in those securities.3 The greater 

information required by the Securities Act did not 

significantly increase the average returns earned by new-

issue investors, but it did substantially lower the dispersion 

of excess returns.4 

That approach reflected the risk management of the times. 

The standard method of valuing stocks (and stock portfolios) 

was based on the expected present value of a share’s future 

dividends.5 Greater disclosure regarding an issuer and its 

securities could help in that calculation; it did not, however, 

account for the risk of the investment and the benefits of 

diversification.6 The shift toward managing risk across a 

diversified portfolio of securities—the benefits of which were 

certainly known, if only intuitively, before 19337—did not 

occur until almost twenty years later when Harry Markowitz’s 

seminal article was published in 1952.8 More recently, mainly 

in response to changes in how businesses manage risk, an 

array of new derivatives and other capital markets 

instruments were created to facilitate the transfer of financial 

risk from the holders of that risk to those who, through 

 

3 See Carol J. Simon, The Effect of the 1933 Securities Act on Investor 

Information and the Performance of New Issues, 79 AM. ECON. REV. 295, 313 

(1989) (finding the “dispersion of abnormal returns . . . [was] significantly 

lower following the Securities Act. . . . [and] [r]eductions in investor error 

may be linked to post-Act improvements in the quantity and quality of 

available financial information”). 
4 Id. 
5 See Harry M. Markowitz, The Early History of Portfolio Theory: 1600–

1960, FIN. ANALYSTS J., July–Aug. 1999, at 5, 8. 
6 See id. 
7 For example, as early as in the 16th century, Antonio happily declared 

in Shakespeare’s The Merchant of Venice, “My ventures are not in one 

bottom trusted, / Nor to one place; nor is my whole estate / Upon the fortune 

of this present year; / Therefore my merchandise makes me not sad.” 

WILLIAM SHAKESPEARE, THE MERCHANT OF VENICE, act 1, sc.1, ll. 43–46, at 8 

(The Floating Press 2008) (1600). 
8 See infra notes 35–41 and accompanying text. 



   

No. 3:1396] RISKY BUSINESS 1399 

diversification or otherwise, could better manage it.9 The 

result, in both cases, was a separation between the risk 

associated with individual securities and the securities 

themselves—through a growing reliance on portfolio-level 

risk management, which emphasizes total portfolio risk 

rather than the risk of individual securities,10 as well as the 

rise of new instruments that facilitate the ability to transfer 

risk to someone else.11 

This growing separation was recently highlighted by 

special purpose acquisition company (SPAC) transactions. In 

a statement regarding potential liabilities in SPAC and de-

SPAC transactions,12 John Coates, Acting Director of the 

 

9 See Ronald J. Gilson & Charles K. Whitehead, Deconstructing Equity: 

Public Ownership, Agency Costs, and Complete Capital Markets, 108 

COLUM. L. REV. 231, 245–47 (2008). 
10 For discussion, see infra Section II.A. 
11 Take, for example, total return swaps (TRS). In basic terms, a TRS is 

a financial contract in which one counterparty pays the other an amount 

equal to, in the case of a TRS on equities, the total return of a share or 

basket of shares, including any dividends and capital appreciation. The 

other counterparty pays an amount equal to any capital depreciation on the 

share or basket, plus a fixed or floating rate payment. The TRS can be 

settled upon termination of the contract or periodically over its life. The TRS 

buyer is subject to substantially the same economic risks as if it owned the 

referenced equity or basket, but without actually owning those instruments. 

The TRS seller has transferred the economic risks of the equity or basket to 

the TRS buyer. If the TRS seller owns the equity or basket, it will have 

reduced or eliminated the risk it bears without selling the corresponding 

instruments. In effect, a TRS “splits the atom,” with the economic risk being 

transferred to the TRS buyer, while the shares (and related voting rights) 

remain with the TRS seller. See Total Return Swap, CORP. FIN. INST., 

https://corporatefinanceinstitute.com/resources/knowledge/finance/total-

return-swap-trs/ [https://perma.cc/J9VE-W9GK] (last visited Nov. 28, 

2021); see also Henry T.C. Hu & Bernard Black, The New Vote Buying: 

Empty Voting and Hidden (Morphable) Ownership, 79 S. CAL. L. REV. 811, 

816 (2006) (describing an equity swap). 
12 John Coates, SPACs, IPOS and Liability Risk under the Securities 

Laws, SEC. & EXCH. COMM’N (Apr. 8, 2021), 

https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-

securities-laws [https://perma.cc/E8N7-LEZ5]. A SPAC is formed to raise 

capital in an initial public offering (IPO) with the purpose of acquiring one 

or more unspecified private companies with which it merges and brings 

public. SPACs raise capital, identify a merger target, and through the 



  

1400 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

Securities and Exchange Commission (SEC), Division of 

Corporation Finance, addressed the question of whether an 

initial public offering (IPO) occurs at the time a SPAC publicly 

issues shares or later when the SPAC merges with a private 

operating company to become a public operating company. 

Director Coates noted: 

To be sure, an ‘IPO’ is generally understood to be 

the initial offering of a company’s securities to the 

public, and the SPAC shell company initially offers 

redeemable equity securities to the public when it first 

registers to raise funds in order to look for and later 

acquire a target. However, it is also commonly 

understood that it is the de-SPAC—and not the initial 

offering by the SPAC—that is the transaction in which 

a private operating company itself ‘goes public,’ i.e., 

engages in its initial public offering. Economically, 

and practically, the private target of a SPAC is a 

different organization than the SPAC itself.13 

Director Coates’ point was that IPOs should be understood 

in their economic sense, based on changes in the economic risk 

borne by investors, not simply tied to the SPAC’s issuance of 

shares. Even if a SPAC raised capital in an IPO, Director 

Coates contended, the de-SPAC transaction, rather than the 

SPAC’s prior public offering of shares, should be treated in 

substance as the IPO, since that is when investors first 

became exposed to the economic risk of an operating 

company.14 

This Article argues that Director Coates’ focus on the 

transfer of economic risk, rather than instruments that 

 

merger facilitate the target’s access to the public capital markets. A “SPAC 

transaction” is when the SPAC initially raises capital through an IPO, and 

a “de-SPAC transaction” is when the SPAC later merges with a target 

company. For a more detailed description of SPAC and de-SPAC 

transactions, see Michael Klausner, Michael Ohlrogge & Emily Raun, A 

Sober Look at SPACs 6–11 (Eur. Corp. Governance Inst., Working Paper 

Fin. No. 746/2021, Apr. 2021), 

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3720919 (on file with 

the Columbia Business Law Review). 
13 Coates, supra note 12 (emphasis omitted). 
14 Id. 



   

No. 3:1396] RISKY BUSINESS 1401 

historically evidenced that risk, reflects a division between 

“risk” and “instruments” that springs from a sea change in 

how risk is managed and transferred in the capital markets. 

Part II explains how advances in technology have changed 

how risk is managed and how investment decisions are made. 

The approach taken at the time the Securities Act was 

adopted no longer resembles most of the investment processes 

today. Part III illustrates some problems that can result—in 

particular, the ability to transfer the risk of a security without 

the benefit of the Securities Act’s protections. Part IV then 

considers whether and how the SEC should respond to those 

changes. Here, an adequate response may be limited by the 

practical difficulty of tracing risk in today’s capital markets. 

For the time being, regulation’s reach may fall short of current 

trading and risk management strategies. While regulatory 

responses are possible, and some proposals are recommended, 

the result is likely to be a continued tension between the 

requirements of the Securities Act and the risk-based 

approach to investing taken by institutions that enter into a 

majority of the transactions that benefit from the Securities 

Act’s protections. 

II. THE NEW RISK MANAGEMENT 

A principal goal of the Securities Act is minimizing 

investment risk through accurate and meaningful 

disclosure.15 When introduced in 1933, mandatory disclosure 

requirements increased share price accuracy, lowering the 
 

15 See Securities Act of 1933, Pub. L. No. 73-22, pmbl., 48 Stat. 74, 74 

(codified as amended at 15 U.S.C. §§ 77a–77aa) (describing the Securities 

Act as an act “To provide full and fair disclosure of the character of securities 

sold in interstate and foreign commerce and through the mails, and to 

prevent frauds in the sale thereof, and for other purposes.”); Herman & 

MacLean v. Huddleston, 459 U.S. 375, 383 (1983) (stating one of the basic 

purposes of the Securities Act is “to provide greater protection to purchasers 

of registered securities”); JOHN C. COFFEE, JR., HILLARY A. SALE & CHARLES 

K. WHITEHEAD, SECURITIES REGULATION: CASES AND MATERIALS 93 (14th ed. 

2021) (stating that the basic objectives of the Securities Act are “to provide 

investors with material financial and other information concerning new 

issues of securities offered for sale to the public and [] to prohibit fraudulent 

sales of securities.”). 



  

1402 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

dispersion of market-adjusted returns on publicly-traded 

securities,16 perhaps due to the increase in valuable 

information that became available to investors.17 Likewise, 

following adoption of the Securities Act, the risk that issuers 

would default declined across the entire spectrum of publicly-

issued bonds.18 Although the value of mandatory disclosure 

has been debated,19 it is generally agreed that the original 

effect of the Securities Act was issue-specific, tied to 

individual securities and issuers.20 

My purpose is not to revisit the question of mandatory 

disclosure.21 Rather, it is to highlight the changes, between 

 

16 See Simon, supra note 3, at 308–10 (noting that, following the 

adoption of the Securities Act, “investors enjoyed significantly less exposure 

to issue-specific risk”); Gregg George J. Stigler, Public Regulation of the 

Securities Markets, 37 J. BUS. 117, 122 (1964) (finding the variance of price 

ratios to be much larger in the 1920s than the 1950s). 
17 See Simon, supra note 3, at 313 (“Reductions in investor error may be 

linked to post-[Securities] Act improvements in the quantity and quality of 

available information.”). But see Stigler, supra note 16, at 122 (attributing 

the decline in variance of price ratios between the 1920s and the 1950s to 

the “exclu[sion of] new companies”). 
18 See Gregg A. Jarrell, The Economic Effects of Federal Regulation of 

the Market for New Security Issues, 24 J. L. & ECON. 613, 658 (1981) (finding 

that “bonds issued after 1934 and registered with the SEC had lower default 

rates and lower default-risk premia than their pre-SEC counterparts, after 

accounting for . . . market variance.”). 
19 See, e.g., Merritt B. Fox, Retaining Mandatory Securities Disclosure: 

Why Issuer Choice is Not Investor Empowerment, 85 VA. L. REV. 1335, 1418 

(1999) (arguing that a mandatory disclosure regime is “the best approach 

for getting issuers to disclose at the socially optimal level”); Roberta 

Romano, Empowering Investors: A Market Approach to Securities 

Regulation, 107 YALE L.J. 2359, 2401 (1998) (promoting a market approach 

to securities regulation); John C. Coffee, Jr., Market Failure and the 

Economic Case for a Mandatory Disclosure System, 70 VA. L. REV. 717, 721 

(1984) (justifying a mandatory disclosure regime). 
20 See Simon, supra note 3 at 310–11; see also Romano, supra note 19, 

at 2377; Fox, supra note 19, at 1379 n.108 (quoting Romano, supra note 19, 

at 2377). 

21 Although this Article argues that the Securities Act increasingly has 

been eclipsed by a sea change in investment decision making since the 

1930s, it does not necessarily follow that mandatory disclosure does not 

have real social benefits. See Fox, supra note 19, at 1356–68; Coffee, supra 

note 19, at 722–23. The question is whether the calculus around those 



   

No. 3:1396] RISKY BUSINESS 1403 

1933 and today, in how the vast majority of investment 

decisions are made and the effect of those changes on the 

reach of the Securities Act. Since the 1930s, the U.S. securities 

markets have shifted from retail to institutional.22 

Notwithstanding efforts to democratize retail investing,23 

institutional investors now account for approximately seventy 

percent of total trading in today’s U.S. stock market.24 Over 

the same period, a similar shift toward institutions has 

 

benefits, in light of the costs of complying with the securities laws, has 

shifted as a result of change in the capital markets. See Coffee, supra note 

19, at 720 n.12 (noting “the probability that the securities markets have 

changed dramatically since the 1950’s so as to call into question the 

relevance of any prior conclusions about the impact of the [Securities 

Exchange Act of 1934].”). That calculus should also take into account the 

value of disclosure in calculating a portfolio’s risk-adjusted performance. 

See infra notes 155–157 and accompanying text. 
22 See COFFEE, SALE & WHITEHEAD, supra note 15, at 33 (documenting 

the rise of institutional investors). 

23 See Charlotte Gifford, Democratising Finance, WORLD FIN. (Jan. 25, 

2021), https://www.worldfinance.com/special-reports/take-from-the-rich-

give-to-the-poor [https://perma.cc/2X2G-W5A4] (describing the Robinhood 

platform and other efforts to “democratize” access to the capital markets); 

see also Mary O’Sullivan, The Expansion of the U.S. Stock Market, 1885-

1930: Historical Facts and Theoretical Fashions, 8 ENTER. & SOC. 489, 532–

34 (2007) (describing the growth of retail investment into stocks in the 

1920s). 
24 See COFFEE, SALE & WHITEHEAD, supra note 15, at 33; FINRA Staff, 

Institutional Investors: Get Smart About the “Smart Money”, FIN. INDUS. 

REGUL. AUTH. (Dec. 2, 2015), http://www.finra.org/investors/institutional-

investors-get-smart-about-smart-money [https://perma.cc/UP2Z-5HHH]. 



  

1404 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

occurred in the bond market,25 notwithstanding periodic 

attempts to increase retail activity.26 

As a result, institutional investors execute the vast 

majority of today’s securities transactions. Mom and Pop 

participate less directly than they did fifty or more years ago. 

Moreover, institutions’ techniques for investing in securities 

today did not exist when the Securities Act was adopted. First, 

the management of portfolio risk (rather than the individual 

risk of a security) developed in the 1950s and 1960s.27 Second, 

significant growth in instruments that permit the buying and 

selling of risk arose in the 1970s.28 And, third, the most 

common method of measuring risk, known as Value-at-Risk 

(VaR), became popular only in the 1990s.29 Consequently, an 

 

25 See Hendrick Bessembinder, Chester Spatt & Kumar 

Venkataraman, A Survey of the Microstructure of Fixed-Income Markets, 55 

J. FIN. & QUANT. ANAL. 1, 15 (2020) (“Institutional-sized trades (greater than 

$1 million) account for most of the dollar volume of trades, in particular, 

88% of customer trading volume between 2014 and 2016” and “[r]etail-size 

trades (less than $100,000) account for between 60% and 70% of reported 

customer transactions, but only 2% of customer trading volume during the 

same period”); Bruno Biais & Richard Green, The Microstructure of the 

Bond Market in the 20th Century, REV. ECON. DYNAMICS, July 2019, at 250, 

260–61, 263–64 (detailing the shift in bond trading toward institutional 

investors, beginning in the 1920s). 
26 See, e.g., O’Sullivan, supra note 23, at 533 (describing U.S. 

government bond drives during World War I). 
27 See Betty Simkins & Steven A. Ramirez, Enterprise-Wide Risk 

Management and Corporate Governance, 39 LOY. U. CHI. L.J. 571, 579 

(2008). 
28 Id. at 580. 

29 See JAMES LAM, ENTERPRISE RISK MANAGEMENT: FROM INCENTIVES TO 

CONTROLS 127 (2d ed. 2014); Although it is the most common, VaR is not the 

only risk measure that institutional investors use. See Charles K. 

Whitehead, Destructive Coordination, 96 CORNELL L. REV. 323, 345 (2011) 

(noting that “[f]irms . . . supplement VaR with simulations (‘stress tests’) 

that, in theory, reflect a portfolio’s individual risks.”); Arwin G. Zeissler & 

Andrew Metrick, JPMorgan Chase London Whale C: Risk Limits, Metrics, 

and Models, 1 J. FIN. CRISES, iss. 2, 2019, at 75, 84–87 (describing other risk 

measures adopted by JPMorgan Chase). More recently, alternative forms of 

VaR have been developed to address perceived shortcomings with VaR, such 

as conditional Value-at-Risk (CVaR). See R. Tyrell Rockafellar & Stanislav 

Uryasev, Optimization of Conditional Value-at-Risk, J. RISK, Spring, 2020, 



   

No. 3:1396] RISKY BUSINESS 1405 

institutional investor today is less focused on the value of 

individual securities and more focused on the effect of a 

purchase or sale on the aggregate risk and returns of its 

investment portfolio. As far as investment decisions go, 

managing and transferring risk—as distinguished from 

transferring a security—have become a critical part of what 

investors do. 

A. Portfolio Risk and Diversification 

Institutional investing is often categorized by the types of 

instruments that are traded, such as equities (for stocks), 

fixed income (for bonds), and derivatives (for financial 

products whose value is based on the value of an underlying 

asset).30 Within each category, financial firms are likely to 

have numerous “trading desks” that buy and sell a single or 

multiple related types of securities, or adopt particular 

investment strategies.31 Typically, one or more trading desks 

comprise a trading unit (such as Equities or Fixed Income), 

which forms part of the firm’s overall investment business.32 

A common misconception is that institutions buy and sell 

securities based on assessing the quality of each security and 

 

at 21, 21. As witnessed in 2008, VaR can be misleading if it has a fat tail in 

the distribution of expected losses—that is, if the largest losses are much 

larger than what a normal distribution would predict. See Tobias Adrian & 

Markus K. Brunnermeier, CoVaR, 106 AM. ECON. REV. 1705, 1705 (2016). 

To mitigate that problem, other risk measures, such as Conditional-Value-

at-Risk (CoVaR), were created to focus on tail risk. See Anna Chernobai, 

Svetlozar T. Rachev & Frank J. Fabozzi in Composite Goodness-of-Fit Tests 

for Left-Truncated Loss Samples, in HANDBOOK OF FINANCIAL ECONOMETRICS 

AND STATISTICS 576 (Cheng-Few Lee & John C. Lee eds., 2015). The analyses 

in this Article related to VaR also apply to CVaR, CoVaR, and other 

variations of VaR that are used to optimize investment portfolios. 
30 See TERRI DUHON, HOW THE TRADING FLOOR REALLY WORKS 66 (2012). 
31 DAVIS W. EDWARDS, RISK MANAGEMENT IN TRADING: TECHNIQUES TO 

DRIVE PROFITABILITY OF HEDGE FUNDS AND TRADING DESKS 2 (2014). 
32 See Prohibitions and Restrictions on Proprietary Trading and 

Certain Interests in, and Relationships With, Hedge Funds and Private 

Equity Funds, 79 Fed. Reg. 5536, 5590 (Jan. 14, 2014) (to be codified at 12 

C.F.R. pts. 44, 248, 251, 351 and 17 C.F.R. pt. 255). 



  

1406 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

issuer.33 Within that framing, an investor may decide that 

Company A’s stock is undervalued, so she buys more of it, or 

she may decide that Company B’s shares are overpriced, so 

she sells her holdings. Yet, without more, that framing is 

deceptive. It is accurate for Mom and Pop investors, and it 

describes investing in the 1930s, but it oversimplifies what 

institutions do today. Instead, financial firms are more likely 

to manage (and restrict) trading activity based on the 

aggregate risk of a portfolio, trading desk, or trading unit, as 

well as at the firm level.34 

The theoretical basis for this approach originated with 

Harry Markowitz, who received the Nobel Prize in Economics 

in 1990 for demonstrating that the idiosyncratic risk of a 

portfolio of securities can be mitigated if the portfolio’s 

holdings are diversified across securities whose correlations 

are low.35 In that case, individual variations in returns from 

one security will, as likely as not, be canceled by variations in 

the returns of other securities.36 

The benefits of diversification are the crux of modern 

portfolio theory. Markowitz’s breakthrough laid the 

groundwork for fellow Nobel Prize winner William Sharpe, 

who is widely known for the Capital Asset Pricing Model 

(CAPM) of financial asset price formation.37 In application, 

the CAPM assists investors in calculating portfolio risk and 

 

33 See PAUL MLADJENOVIC, STOCK INVESTING FOR DUMMIES 95 (5th ed. 

2016). 
34 See LAM, supra note 29, at 51. Managing trading activity reflects the 

agency problems that financial firms often face from traders (and their 

managers) who have personal incentives to maximize risk and realize 

inflated short-term gains potentially at the cost of long-term losses incurred 

by the firm. See Simone M. Sepe & Charles K. Whitehead, Paying for Risk: 

Bankers, Compensation, and Competition, 100 CORNELL L. REV. 655, 659–

60 (2015). 
35 See Myles E. Mangram, A Simplified Perspective of the Markowitz 

Portfolio Theory, 7 GLOB. J. BUS. RSCH., no. 1, 2013, at 59, 59–60. 
36 See Harry Markowitz, Portfolio Selection, 7 J. FIN. 77, 89 (1952). 
37 Eugene F. Fama & Kenneth R. French, The Capital Asset Pricing 

Model: Theory and Evidence, J. ECON. PERSPECTIVES, Summer, 2004, at 25, 

26 (2004). 



   

No. 3:1396] RISKY BUSINESS 1407 

the investment returns they should expect.38 Under the 

CAPM, idiosyncratic risk is eliminated through 

diversification,39 so it is of minimal concern to investors whose 

portfolios are diversified and who are thus not compensated 

for bearing such risk. Rather, a portfolio’s return is calculated 

based on the remaining systematic risk (“market risk” or 

“beta”) that diversification cannot mitigate.40 An investor who 

invests in only one stock is still exposed to systematic and 

idiosyncratic risk. Yet, her expected return reflects only the 

systematic risk she bears. Consequently, an institution’s 

investment decision typically rests on the systematic (or “non-

diversifiable”) risk to which its portfolio is exposed.41 

Beta reflects the effect on the value of a diversified portfolio 

of market-wide events, including changes in interest or 

foreign exchange rates, political news, natural disasters, and 

events of national importance.42 A beta of 1 means that the 

value of a portfolio is expected to change in perfect correlation 

with changes in overall market value.43 A portfolio with a beta 

 

38 See William F. Sharpe, Capital Asset Prices: A Theory of Market 

Equilibrium Under Conditions of Risk, 19 J. FIN. 425, 441–42 (1964); 

RICHARD A. BREALEY, STEWART C. MYERS & FRANKLIN ALLEN, PRINCIPLES OF 

CORPORATE FINANCE 205–06 (13th ed. 2020). 

39 See BREALEY ET AL., supra note 38, at 178–79, 181. 
40 See, e.g., Markowitz, supra note 36, at 89; CHRISTIAN SZYLAR, 

HANDBOOK OF MARKET RISK 110 (2013); BREALEY ET AL., supra note 38, at 181 

(describing “market risk”). Notwithstanding questions that have been 

raised about the reliability of the CAPM, see, e.g., Halliburton v. Erica P. 

John Fund, Inc., 573 U.S. 258, 288–92 (2014) (Thomas, J., concurring), and 

significant variations in how beta is calculated, see, e.g., Paul Draper & 

Krishna Paudyal, Empirical Irregularities in the Estimation of Beta: The 

Impact of Alternative Estimation Assumptions and Procedures, 22 J. BUS. 

FIN. & ACCT. 157, 157–58, 175 (1995); Diana R. Harrington, Whose Beta is 

Best?, 39 FIN. ANALYSTS J., July–August 1983, at 67, 67–68, beta remains 

the standard that investors use to calculate market risk. See Eugene F. 

Fama, Efficient Capital Markets: II, 46 J. FIN. 1575, 1593 (1991) (noting that 

“market professionals (and academics) still think about risk in terms of 

market β.”). 
41 See SZYLAR, supra note 40, at 111–12 (describing why there is “reward 

for bearing market risk but not for taking additional unique risk”). 
42 Id. at xxv–xxvi, 110. 
43 Id. at 110. 



  

1408 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

greater than 1 is more volatile than the market, and a 

portfolio with a beta less than 1 is less volatile.44 According to 

the CAPM, in an efficient capital market, the risk premium 

and the expected return on a portfolio will vary in proportion 

to its beta value. The relations are generated by equilibrium 

price formation within an efficient capital market.45 

Institutional investors, however, seek to maximize their 

portfolio’s returns relative to the risks they bear. A common 

measure is the Sharpe ratio.46 That measure enables a 

comparison of returns across portfolios relative to different 

levels of systematic risk.47 The Sharpe ratio helps assess 

whether a portfolio’s returns are due to investment decisions 

or result from exposure to excessive risk.48 It can be used to 

evaluate past performance based on actual returns, or it can 

act as a measure of future performance based on projected 

returns.49 The greater an investment’s Sharpe ratio, the 

better its risk-adjusted performance.50 Thus, because greater 

diversification decreases portfolio risk without sacrificing 

returns, it is likely to increase a portfolio’s Sharpe ratio.51 

Consequently, rather than investing based on the value of 

an individual security, institutional investors often buy and 

 

44 Id. 
45 See Sharpe, supra note 38, at 441–42. 
46 Developed by William Sharpe, the Sharpe ratio measures risk-

adjusted performance by subtracting the risk-free rate of return (typically, 

U.S. Treasuries) from the rate of return for an investment and dividing the 

result by the standard deviation of the investment’s return. See SZYLAR, 

supra note 40, at 275; William F. Sharpe, The Sharpe Ratio, J. PORTFOLIO 

MGMT., Fall, 1994, at 49, 50. A similar measure of risk-adjusted returns, 

known as the Treynor ratio, had been developed the prior year by Jack 

Treynor. It uses a portfolio’s beta to measure risk. See, e.g., Saeid Tajdini, 

Mohsen Mehrara & Reza Tehrani, Hybrid Balanced Justified Treynor 

Ratio, 47 MANAGERIAL FIN. 86, 87–88 (2020); Jack L. Treynor, How to Rate 

Management of Investment Funds, 43 HARV. BUS. REV. 63 (1965). 
47 SZYLAR, supra note 40, at 275. 

48 Id. 
49 See, e.g., Sharpe, supra note 46. 
50 SZYLAR, supra note 40, at 275. 
51 Risk-adjusted performance may also be assessed using a portfolio’s 

Value-at-Risk measure. See infra notes 67–70 and accompanying text. 

https://www.investopedia.com/articles/07/sharperatio.asp


   

No. 3:1396] RISKY BUSINESS 1409 

sell securities based on their marginal contribution to the risk 

and return of the portfolio.52 Of course, institutions—similar 

to Mom and Pop—may trade based on individual, expected 

returns, and some institutional traders (such as event 

arbitrageurs) may buy and sell securities based on a 

particular company’s circumstances.53 We can characterize 

this as a “bottom-up” approach to investing, where the risk 

and return of each investment are considered separately on 

their own merits, totaling an aggregate portfolio of 

securities.54 But for most institutions, the greater focus is on 

portfolio risk—managing the aggregate risk and return of a 

portfolio of securities, rather than focusing on individual 

investments. Firms segment risk by portfolio and trading 

division, with a hierarchy of risk limits extending from the 

entire firm to each trading unit, trading desk, and trader.55 

Compliance with those limits rests with a risk management 

function, often an entire department that monitors aggregate 

risk across the firm. This is a “top-down” approach to 

investing, where a portfolio’s aggregate risk and return 

 

52 See FRANCISCO JAVIER POBLACIÓN GARCÍA, FINANCIAL RISK 

MANAGEMENT 69 (2017); Frank J. Fabozzi, Francis Gupta & Harry M. 

Markowitz, The Legacy of Modern Portfolio Theory, J. INVESTING, Fall, 2002, 

at 7, 7. 
53 An “event arbitrageur” profits from specific events—such as merger 

& acquisition (M&A) deals or natural disasters—that can create a profitable 

arbitrage in the market. For example, merger arbitrage is driven by the 

event risk that a merger may not be completed successfully. See THOMAS 

KIRCHNER, MERGER ARBITRAGE: HOW TO PROFIT FROM GLOBAL EVENT-DRIVEN 

ARBITRAGE 10 (2d ed. 2016). 
54 See A Top Down Investment Approach, FISHER INVS., 

https://www.fisherinvestments.com/en-us/services/investment-

approach/top-down [https://perma.cc/PH3X-TKUK] (last visited Nov. 28, 

2021). 

55 See GLYN A. HOLTON, VALUE-AT-RISK: THEORY AND PRACTICE §1.5 (2d 

ed. 2014) (ebook); see also Robert Litterman, Hot SpotsTM and Hedges, 23 J. 

PORTFOLIO MGMT. 1996, at 52, 65 (“[W]e find it useful to decompose the 

firmwide risk of Goldman Sachs into that contributed by the divisions, the 

divisional risk into that contributed by business units, and so on.”). 



  

1410 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

characteristics affect the particular securities an investor will 

buy and sell.56 

For example, to Mom and Pop, “equity risk” relates to the 

uncertainty around a particular stock’s returns due to 

potential changes in share price and dividends on the shares 

they buy and sell.57 The bottom-up approach explains that 

they may choose to diversify as part of their trading strategy 

to reap the benefits of diversification.58 By contrast, top-down 

investors are required to diversify as a result of enterprise-

level decisions and limits.59 Not doing so means the investor 

will fail to maximize her profits at a given level of risk. In 

other words, diversification’s ability to lower risk is so 

significant60 that an investor who chooses not to diversify is 

unlikely to invest in a portfolio that will yield an optimal 

return.61 

 

56 See A Top Down Investment Approach, FISHER INVS., supra note 54; 

see also John C. Coffee, Jr., The Future of Disclosure: ESG, Common 

Ownership, and Systematic Risk, 2021 COLUM. BUS. L. REV. 602, 615–30 

(2021) 10–26 (Eur. Corp. Governance Inst., Working Paper No. 541/2020, 

2021) (describing a similar divergence between institutional and retail 

investors). 
57 See GARCÍA, supra note 52, at 41–42. 
58 See, e.g., Peter V. Letsou, Implications of Shareholder Diversification 

on Corporate Law and Organization: The Case of the Business Judgment 

Rule, 77 CHI.-KENT L. REV. 179, 186 (2001) (“[D]iversification allows the 

investor to eliminate risk without sacrificing financial return. . . . And 

indeed, diversification appears to be the strategy that most investors follow, 

as illustrated by the present-day popularity of mutual funds.”); Herbert A. 

Whitehouse, Diversification into the Entire Economy: The Moral Imperative 

of the Super Efficient Portfolio on the Efficient Frontier, 22 ANN. REV. 

BANKING & FIN. L. 443, 453 (2003) (fiduciaries may “decide to diversify” for 

various reasons). 
59 See Whitehead, supra note 29, at 342 (2011) (“Financial firms 

regularly impose VaR limits on managers and portfolios. Before exceeding 

a limit, the manager must obtain approval or reduce the portfolio’s 

exposure, typically by diversifying its holdings or reducing their size.”). 
60 See André F. Perold, Capital Allocation in Financial Firms, 17 J. 

APPLIED CORP. FIN., Spring, 2005, at 110, 113. 
61 In one instance, a New York-based dealer’s failure to take account of 

diversification resulted in its failure as a firm to utilize more than seventy 

percent of its total risk capital. See Tanja Dresel, Robert Härtl & Lutz 

Johanning, Risk Capital Allocation Using Value at Risk Limits: 



   

No. 3:1396] RISKY BUSINESS 1411 

B. Value-at-Risk 

Since the early 1990s, most institutions have relied on a 

volatility-based risk measure, known as Value-at-Risk (VaR), 

to manage risk.62 VaR was widely adopted due to its ability to 

sum up risk correlations across different asset classes 

(including equity and fixed income assets) and integrate 

different market risk types into a single snapshot view of a 

portfolio’s (or firm’s) aggregate risk exposure.63 VaR measures 
 

Incorporating Unpredictable Correlations Between Traders’ Exposures 2 

(2003) (unpublished manuscript), https://www.cofar.uni-

mainz.de/dgf2003/paper/paper143.pdf [https://perma.cc/3SRW-DE7N]. 

Managing a fixed income portfolio is more complex. Among the additional 

risks, fixed income investors are subject to the risk that a borrower’s credit 

quality will decline. For corporate bonds, this is referred to as “credit spread 

risk.” The “credit spread” is reflected in the difference between the interest 

rate of a corporate bond and a government bond with the same maturity. It 

evidences the market’s perception of the likelihood the corporate issuer will 

default. A corporate bond, therefore, declines in value as its credit spread 

widens. Thus, credit spread risk is the risk a corporate bond portfolio will 

decline in value due to widening credit spreads. See SZYLAR, supra note 41, 

at xxv. Like with stocks, however, investors can rely on diversification as 

one means to manage the credit spread risk of the bonds they hold. See 

Charles K. Whitehead, The Evolution of Debt: Covenants, the Credit Market, 

and Corporate Governance, 34 J. CORP. L. 641, 655–56 (2009). Fixed income 

portfolios are also subject to interest rate risk, namely, the uncertainty 

around future changes in interest rates that may raise or lower the value of 

an instrument. See DONALD R. VAN DEVENTER, KENJI IMAI & MARK MESLER, 

ADVANCED FINANCIAL RISK MANAGEMENT 27 (2d ed. 2013). Duration is the 

most common measure of interest rate risk. See LELAND E. CRABBE & FRANK 

J. FABOZZI, MANAGING A CORPORATE BOND PORTFOLIO 79 (2002). It 

incorporates an asset’s yield, interest rate, and maturity into a single 

number that indicates how sensitive its value is to changes in interest rates. 

Id.at 79–82. The higher the duration, the more responsive the value is to 

interest rate movements. See ESMÉ FAERBER, ALL ABOUT BONDS AND BOND 

MUTUAL FUNDS 39–40 (2d ed. 2000). In that light, duration is similar to 

beta—it reflects changes in the market that affect a fixed income asset’s 

value, rather than individual changes in the assets or borrowers 

themselves. 

62 See supra note 29 and accompanying text. 
63 See Whitehead, supra note 59, at 341. In addition, institutional 

investors must calculate and report VaR in response to regulatory 

requirements. VaR is a cornerstone of financial regulation due to its 

endorsement by regulators. Id. at 342. 



  

1412 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

the maximum expected loss of a portfolio of assets at a 

specified probability during a defined period of time.64 For 

example, suppose a firm’s one-day 95% VaR is $10 million. 

This means, at the time VaR was calculated, the firm could 

expect to lose a maximum of $10 million in one day 95% of the 

time.65 If VaR is too high, a firm can adjust what it buys and 

sells to lower its risk.66 

The ability to aggregate and disaggregate VaR is an 

essential risk management tool. At the aggregate level, VaR 

permits a firm to allocate risk to different investment 

activities. Financial firms impose VaR limits at the trading 

desk, trading unit, and firm levels as one means to manage 

aggregate risk exposure.67 One limit (a “soft” limit) indicates 

the target size of an investment portfolio; another limit (a 

 

64 See SZYLAR, supra note 41, at 169. 
65 See SIMON HUBBERT, ESSENTIAL MATHEMATICS FOR MARKET RISK 

MANAGEMENT 4 (2012). 
66 See Charles K. Whitehead, Size Matters: Commercial Banks and the 

Capital Markets, 76 OHIO ST. L.J. 765, 786–87 (2015). 
67 See Whitehead, supra note 59, at 341–42. Banks set VaR limits to 

comply with Basel Accord standards. Portfolio managers must not exceed 

these limits. See BASEL CMT. ON BANKING SUPERVISION, REVISIONS TO THE 

MINIMUM CAPITAL REQUIREMENTS FOR MARKET RISK 1 (2019), 

https://www.bis.org/bcbs/publ/d457.pdf [https://perma.cc/9N7W-TDV9]; see 

also Charles K. Whitehead, What’s Your Sign?—International Norms, 

Signals, and Compliance, 27 MICH. J. INT’L L. 695, 709–10, 722–724 (2006) 

(explaining that, even though Basel Accord standards do not legally bind 

governments outside local legislation, a number of factors, including peer 

pressure and threat of reputational loss, cause banks and regulators to 

comply with those standards). Pension plans and mutual funds may use 

VaR measures somewhat differently. Investment managers are concerned 

they will underperform the benchmark against which their returns are 

measured. At the same time, they may decide to invest in a portfolio whose 

composition differs from the benchmark as one means to outperform the 

benchmark. Since performance is tied to the benchmark, investment 

managers may also measure a portfolio’s risk against the risk represented 

by the benchmark. See Katerina Simons, The Use of Value at Risk by 

Institutional Investors, NEW ENG. ECON. REV., Nov.–Dec. 2020, at 21, 22; 

Katerina Simons, Risk-Adjusted Performance of Mutual Funds, NEW ENG. 

ECON. REV., Sept.–Oct. 1998, at 33, 37. Using VaR to assess the risk-

adjusted returns on multiple portfolios is consistent with the use of the 

Sharpe ratio. See supra notes 46–51 and accompanying text. 



   

No. 3:1396] RISKY BUSINESS 1413 

“hard” limit) indicates the maximum VaR the portfolio can 

contain.68 Disaggregation permits a firm to understand the 

main sources of risk and the marginal increases in risk that 

may arise from different investment activities.69 Doing so also 

permits investors (and risk managers) to understand the risks 

to which the firm is exposed, the risks that should be managed 

(for example, by transferring them to a third party), and the 

incremental change in potential losses from adding or 

removing a particular investment.70 

VaR also takes account of the diversification benefits of 

multiple assets and portfolios. An individual investment may 

have a high VaR, but if its VaR is negatively correlated with 

the portfolio, it may contribute a much lower level of risk than 

it would if measured by itself.71 Assume, for example, a 

hypothetical portfolio with only two investments. Each of 

potential investments A, B, and C has a VaR of $500, and each 

has an expected return of 20% on the principal of $1,000 

(equal to $200 over the year). If the portfolio’s manager selects 

any two of them, the total annual return will be $400, and the 

aggregate of the VaRs, $1,000, will reflect the portfolio’s 

aggregate risk but without taking account of any benefit from 

diversification. Depending on the correlation among A, B, and 

C—that is, how much each of A, B, and C changes in value 

relative to changes in the other two investments—the total 

VaR, for example, of A and B together may be $750 while that 

of B and C may be only $650. The decline in aggregate VaR 

below $1,000 reflects the benefits of diversification.72 All else 

 

68 See DAVIS W. EDWARDS, RISK MANAGEMENT IN TRADING: TECHNIQUES 

TO DRIVE PROFITABILITY OF HEDGE FUNDS AND TRADING DESKS 141 (2014). 
69 See RISKMETRICS GROUP, RISK MANAGEMENT: A PRACTICAL GUIDE 6, 

https://www.msci.com/documents/10199/3c2dcea9-97be-4fb4-befe-

a03b75c885aa [https://perma.cc/H6WL-VL2Q]. 
70 See id. 
71 See id. at 14. 
72 See Perold, supra note 60, at 112–13. Aggregate VaR usually is less 

than the sum of VaR due to the benefits of diversification. See LINDA ALLEN, 

JACOB BOUDOUKH & ANTHONY SAUNDERS., UNDERSTANDING MARKET, CREDIT, 

AND OPERATIONAL RISK: THE VALUE AT RISK APPROACH 13–16 (2004); 

Litterman, supra note 55, at 61–62 (describing how the addition of a 

noncorrelated investment to a portfolio tends to reduce portfolio risk). 



  

1414 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

being equal, the manager will favor a portfolio of B and C due 

to the lower incremental increase in VaR. Critical, however, is 

that, even though risk has declined, the total expected return 

of B and C, which is $400, remains unchanged.73 This is 

consistent with the earlier-described approaches taken by 

Markowitz and Sharpe74—namely, that optimal portfolio 

selection is based on the portfolio’s overall risk-reward 

characteristics, rather than simply aggregating the individual 

characteristics of different securities.75 For an institutional 

investor, what matters more is how much assets within a 

portfolio move in relation to each other, not how much each 

individual asset fluctuates on its own.76 

In that light, suppose a portfolio manager wishes to invest 

in equities to generate a higher return. Typically, to increase 

returns, the manager must assume greater risk.77 The 

identity of the particular stocks will be important, but the 

aggregate risk of the portfolio and the marginal effect on that 

risk of buying or selling shares will be critical.78 Depending on 

investments made by other managers in the firm, the decision 

to buy or sell a particular stock may cause a spike in total VaR 

 

73 See Mangram, supra note 35, at 66 (“risk reduction can be achieved 

without compromising returns.”). 

74 See supra text accompanying notes 35–51; see also Fabozzi et al., 

supra note 52, at 19 (“The now widely used value-at-risk framework (VaR) 

for the measurement and management of market risk for financial markets 

is based on the concepts first formalized in [modern portfolio theory].”). 
75 See Markowitz, supra note 36, at 89. “Hence, the essential aspect 

pertaining to the risk of an asset is not the risk of each asset in isolation, 

but the contribution of each asset to the risk of the aggregate portfolio.” 

Press Release, Royal Swedish Academy of Sciences, The 1990 Alfred Nobel 

Memorial Prize in Economic Sciences (Oct. 16, 1990), 

https://www.nobelprize.org/prizes/economic-sciences/1990/press-release/ 

[https://perma.cc/K9XK-N8MJ]. 
76 See Mangram, supra note 35, at 64–65. 
77 See Eric Ghysels, Pedro Santa-Clara & Rossen Valkanov, There is a 

Risk-Return Trade-off After All, 76 J. FIN. ECON. 509, 511 (2005) (finding a 

“positive and statistically significant relation between risk and return.”). 
78 See Litterman, supra note 55, at 59 (“[T]he total risk of the portfolio 

is not the sum of the risk of individual positions[;] it is in fact the sum of the 

marginal impacts on portfolio risk from small percentage increases in each 

of the portfolio positions.”). 



   

No. 3:1396] RISKY BUSINESS 1415 

of which the manager is not immediately aware.79 

Consequently, aggregate firm risk—beyond an individual 

manager’s assessment of the quality of a particular security 

or issuer—may affect the decision to buy or sell a security.80 

That decision may be tied less to the manager’s view of the 

value of a security and more to the risk correlation between 

that security and her other investments or other investments 

made within the firm. The higher the correlation between the 

VaRs of two portfolios (such as between two trading desks), 

the more likely a transaction will affect the firm’s overall VaR 

due to the lower diversification benefits.81 Conversely, the 

lower the correlation between the two VaRs, the more likely 

the transaction will lower the firm’s aggregate VaR.82 In 

short, the standalone characteristics of a security often matter 

less than the effect of buying or selling that security on a 

portfolio’s or firm’s risks. The manager is likely to be as 

concerned with a stock’s impact on VaR as she is with whether 

the particular stock is IBM or Microsoft and the number of 

shares she buys.83 

 

79 See Philippe Jorion, In Defense of VaR, DERIVATIVES STRATEGY (1997), 

https://merage.uci.edu/~jorion/oc/ntalib2.html [https://perma.cc/Q43L-

2GE6] (“Suppose a portfolio VAR suddenly increases by 50%. This could be 

due to a variety of factors. Market volatility could have increased overnight. 

Or, a trader could be taking inordinate risks. Or, a number of desks could 

be positioned on the same side of a looming news announcement. . . . Any of 

these factors should be cause for further investigation, which can be 

performed by reverse engineering the final VAR number.”). 

80 For a model of how VaR limits are budgeted and aggregated across 

thirty independent traders, see Robert Härtl & Lutz Johanning, Risk 

Budgeting with Value at Risk Limits, in RISK MANAGEMENT: CHALLENGE AND 

OPPORTUNITY 143, 150–53 (Michael Frenkel, Ulrich Hommel & Markus 

Rudolph eds., 2d ed. 2005). 
81 See RISKMETRICS GROUP, supra note 69, at 14. 
82 See id. 

83 Cf. EDWARDS, supra note 68, at 142–148 (“On a trading desk, a 

common use for VAR is to describe the size of investments. . . . VAR has 

largely replaced position limits and capital requirements based on the 

concept of number of shares, number of contracts, and other measures of 

size.”). 



  

1416 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

C. New Risk Instruments 

Beginning in the 1970s, capital markets participants 

(including banks, broker-dealers, and insurance companies) 

saw an opportunity to promote new financial instruments in 

response to a growing demand for tools to assist businesses in 

managing and sharing risk.84 Over time, instruments 

covering new types of financial risk were developed and 

marketed as one way to manage risks that could not be 

addressed through diversification.85 The result was a menu of 

new instruments to transfer beta risk, including swaps, 

options, financial futures, and securitized assets,86 later 

extended to other types of risk, including weather and natural 

disaster risk.87 

 

84 See Gilson & Whitehead, supra note 9, at 245–46; Kevin Buehler, 

Andrew Freeman & Ron Hulme, The Risk Revolution 6 (McKinsey, Working 

Paper on Risk No. 1, 2008), 

https://www.mckinsey.com/~/media/mckinsey/dotcom/client_service/ 

risk/working%20papers/1_the_risk_revolution.pdf [https://perma.cc/Z22N-

JMUX]. The growth in new financial instruments partly reflected 

managers’ interests in transferring risks they could not manage directly. 

Among other reasons, firms were concerned about costs arising from 

bankruptcy risk. By transferring financial risk to others who were better 

able to manage it, a firm was less likely to fall into financial distress. See 

Gilson & Whitehead, supra note 9, at 250; Franklin Allen & Anthony M. 

Santomero, The Theory of Financial Intermediation, 21 J. BANKING & FIN. 

1461, 1475–76, 1479 (1998). In addition, new financial instruments lowered 

earnings volatility, which permitted firms to rely on internally generated 

funds rather than more costly external funding. See Gilson & Whitehead, 

supra note 9, at 249–50; Allen & Santomero, supra, at 1476–77; Kenneth A. 

Froot, David S. Scharfstein & Jeremy C. Stein., Risk Management: 

Coordinating Corporate Investment and Financing Policies, 48 J. FIN. 1629, 

1630–31 (1993). 
85 See Gilson & Whitehead, supra note 9, at 245–46; see also Franklin 

Allen & Anthony M. Santomero, What Do Financial Intermediaries Do?, 25 

J. BANKING & FIN. 271, 286 (2001). 
86 See Allen & Santomero, supra note 84, at 1467, 1471; Buehler et al., 

supra note 84, at 7. 
87 See Gilson & Whitehead, supra note 9, at 246–47. 



   

No. 3:1396] RISKY BUSINESS 1417 

Financial institutions drew on their risk management 

skills to support this new business,88 trading risk to facilitate 

their clients’ risk management efforts.89 The financial 

markets had always provided a means to transfer risk, such 

as the credit risk of a stock or bond, but new instruments 

enabled the transfer of discrete risks, separate from the 

securities to which they traditionally were tied. In the case of 

common stock, for example: 

[A] company’s equity is a basket option in which its 

various risks are pooled: Each shareholder is exposed 

to a tiny fraction of the risk to which the company is 

subject. A simple, but useful way to think about a 

company’s balance sheet, therefore, is to see its equity 

as a cushion against the risk of performing badly. The 

risk that its market value will go down is borne by the 

shareholders. . . . Managers can therefore add value 

by separately and more cheaply hedging some of the 

risks ordinarily managed by the equity cushion. . . . 

[S]ome companies are better than others at managing 

particular risks. If risks can be priced and traded it 

makes sense for companies to try to lay off the 

categories of risk in which they have no comparative 

advantage. This approach allows them to reserve their 

(expensive) equity capital for risks that would cost 

more to transfer than to manage directly.90 

As a result, the financial markets evolved into a risk 

clearinghouse,91 enabling business originators to transfer risk 

to holders who could manage that risk at lower cost.92 New 

risk transfer instruments assisted in unbundling a portfolio’s 

 

88 See Buehler et al., supra note 84, at 8–9 (“Many of the more 

sophisticated [financial] players (generally securities houses and 

investment banks) realized that their ability to describe and manage risk 

was a core competence[.]”). 
89 Allen & Santomero, supra note 84, at 1470. 

90 Kevin Buehler, Andrew Freeman & Ron Hulme, The New Arsenal of 

Risk Management, HARV. BUS. REV., Sept. 2008, at 93, 96; see also Gilson & 

Whitehead, supra note 9, at 247–51. 
91 Buehler et al., supra note 84, at 8–9. 
92 See Gilson & Whitehead, supra note 9, at 245. 



  

1418 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

risk profile,93 with the ability to lower its systematic risk94 

and its risk as measured by VaR.95 Institutions could target 

different risk levels with derivatives, often at a lower cost than 

buying and selling the underlying securities themselves.96 For 

example, the manager of a fixed income portfolio could decide 

what amount of credit risk to retain and what amount to 

transfer using credit default swaps (CDS)97 as one means to 

 

93 See, e.g., Daniel N. Deli & Raj Varma, Contracting in the Investment 

Management Industry: Evidence from Mutual Funds, 63 J. FIN. ECON. 79, 

80 (2002) (concluding that funds that use derivatives “do so to reduce the 

cost of maintaining a certain risk exposure”); Joseph F. Sinkey, Jr. & David 

A. Carter, Evidence on the Financial Characteristics of Banks that Do and 

Do Not Use Derivatives, 40 Q. REV. ECON. & FIN. 431, 446 (2000) (finding 

that “banks with a higher probability of financial distress are using 

derivatives to hedge risk.”). 
94 See, e.g., Yong Chen, Derivatives Use and Risk Taking: Evidence from 

the Hedge Fund Industry, 46 J. FIN. & QUANTITATIVE ANALYSIS 1073, 1075 

(2011) (noting for hedge funds that “fund risks between derivative users and 

nonusers is more substantial for market-related systematic risk than for 

idiosyncratic risk”); Buehler et al., supra note 84, at 11 (“The growth in 

credit derivatives, greater depth and liquidity in the secondary market for 

corporate loans, and securitization have transformed the management of 

credit risk by hugely expanding the scope for risk transfer.”); Mukesh K. 

Chaudhry et al., The Risk of Foreign Currency Contingent Claims at US 

Commercial Banks, 24 J. BANKING & FIN. 1399, 1415 (2000) (finding that 

banks use currency swaps as a tool to hedge against foreign exchange 

fluctuations). 
95 See, e.g., Dong-Hyun Ahn et al., Optimal Risk Management Using 

Options, 54 J. FIN. 359, 374 (1999) (demonstrating a put option strategy that 

reduces VaR). 
96 Jennifer Lynch Koski & Jeffrey Pontiff, How Are Derivatives Used? 

Evidence from the Mutual Fund Industry, 54 J. FIN. 791, 805 (1999) (arguing 

that the use of derivatives permits a fund manager to implement trades at 

lower cost). 
97 A CDS enables a bondholder to hedge its exposure to the issuer. By 

entering into a swap contract, and paying a premium for credit default 

protection to the swap counterparty, the swap counterparty becomes 

obligated to pay the bondholder the value of the bond in the event of a credit 

event (typically, the issuer’s bankruptcy or a default on the bond). 

Depending on the CDS’s terms, the CDS counterparty will pay the 

bondholder an amount equal to the decline in value of the bond or it will buy 

the bond at full value from the bondholder. See Credit Default Swap, CORP. 

FIN. INST., 



   

No. 3:1396] RISKY BUSINESS 1419 

manage portfolio exposures.98 By separating a bond’s funding 

obligation from its credit risk, a CDS could permit the transfer 

of all, or only a part, of a bond’s credit risk without 

transferring the bond itself.99 The greater ability to transfer 

risk meant investors could more easily diversify the risks to 

which their portfolios were exposed.100 Similarly, portfolio 

managers began to use interest rate derivatives to manage 

their exposure to interest rate fluctuations as one means to 

lower systematic risk.101 

* *   * 

A principal goal of the Securities Act has been to assist 

investors in managing the idiosyncratic risk of the individual 

securities they purchase. Managing risk through a diversified 

portfolio did not occur until almost twenty years after the 

Securities Act was passed.102 It took another twenty years 

until new capital markets instruments were introduced to 

facilitate the management and transfer of discrete portions of 

financial risk. This shift in risk management resulted in a 

separation between the risk associated with an individual 

security and the security itself. The idiosyncratic risk of 

 

https://corporatefinanceinstitute.com/resources/knowledge/finance/credit-

default-swap-cds/ [https://perma.cc/EDS2-L9C2] (last visited Nov. 29, 

2021). 
98 See Buehler et al., supra note 84, at 11. 
99 Whitehead, supra note 34, at 657; see also In re WorldCom, Inc. Sec. 

Litig., 346 F. Supp. 2d 628, 651 (S.D.N.Y. 2004) (noting that the defendant 

underwriters had tried to reduce their exposure to risk from holding 

WorldCom debt “by engaging in hedging strategies, such as credit default 

swaps”). 

100 See Credit Risk Transfer Instruments: Their Use by German Banks 

and Aspects of Financial Stability, DEUTSCHE BUNDESBANK MONTHLY 

REPORT, Apr. 2004, at 27, 36, 

https://www.bundesbank.de/resource/blob/706424/b8fdca684d6b47 

db536944204a7ca8be/mL/2004-04-credit-risk-transfer-data.pdf 

[https://perma.cc/WY3P-7SHN] (“Separating credit risk off from loans 

makes diversification much easier.”). 

101 See Elijah Brewer III, Bernadette A. Minton & James T. Moser, 

Interest-Rate Derivatives and Bank Lending, 24 J. BANKING & FIN. 353, 354 

(2000). For an example of a fixed-for-floating interest rate swap, see COFFEE, 

SALE & WHITEHEAD, supra note 15, at 353–54. 
102 See Markowitz, supra note 5, at 5. 



  

1420 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

individual instruments began to be less relevant for investors 

than their contribution to a portfolio’s overall risk. Likewise, 

the growth of new instruments to transfer risk reflected a 

growing interest in buying and selling specific types of risk, 

rather than transacting in a security as a whole. 

Consequently, the traditional approach to regulating 

transactions in securities may matter less today than 

regulating the risk associated with those securities. The “top-

down” process of managing and transferring risk means that 

the decision to buy or sell a security is typically tied less to an 

investor’s view of the merits of an individual security and 

more to the risk correlation between that security and other 

investments in a portfolio. No doubt, this shift in trading 

activity has made its way into the public disclosures published 

under the Securities Act. Increasingly, SEC disclosure 

requirements are tied to cross-company comparisons, perhaps 

as one way to assist in assessing the risk of an individual 

investment within a portfolio of investments.103 However, this 

shift in risk management, for a majority of trading in the 

capital markets, still raises a basic question: Should 

regulators begin to reconsider the focus of the Securities Act, 

moving from requirements tied to transactions in individual 

securities towards requirements addressing the transfer of 

risk relating to those securities? 

III. RISK TRADING 

A. Ships and Planks 

Some readers may recall the story of Theseus, the mythical 

king of Athens.104 For many, Theseus is best known for 

slaying the Minotaur, a half-man, half-bull who devoured 

children sent to Crete in tribute to King Minos.105 According 

to the historian Plutarch, Theseus’s ship remained in Athens 

 

103 See discussion infra Section IV.A. 
104 See Plutarch, Life of Theseus in 1 PLUTARCH’S LIVES (Bernadotte 

Perrin trans., William Heinemann 1914). 
105 Id. at 37. 



   

No. 3:1396] RISKY BUSINESS 1421 

harbor as a memorial to his bravery for centuries after his 

return.106 To preserve the ship, caretakers replaced old 

planks, sails, and ropes with new ones when the originals 

rotted or wore away.107 Little by little, new materials were 

substituted for old. Over the years, it became unclear how 

many of the ship’s original components remained, prompting 

Plutarch to ask, was the ship in Athens’s harbor still 

Theseus’s ship?108 Writing centuries later, the philosopher 

Thomas Hobbes added a further wrinkle to the question. He 

asked what would happen if the original materials were stored 

as they were replaced and then, years later, used to build a 

second ship.109 In that case, which ship—the first or the 

second—would be Theseus’s?110 

Theseus’s story helps frame the change in today’s capital 

markets. Recall that the Securities Act was drafted when 

investing typically involved an assessment of each security 

and issuer,111 and measuring and managing risk through 

diversification was in its infancy.112 Investing, however, has 

evolved since the 1930s.113 Institutions now manage 

investment activity based on aggregate risks and returns.114 

To increase returns, an investor is more likely to manage the 

risk of her entire portfolio, not just the returns on an 

individual stock or bond. She can adjust portfolio risk and 

return by buying and selling securities or, more recently, by 

trading more-targeted instruments that permit her to 

transfer some or all of the discrete risks that comprise a 

security without transferring the security itself.115 Stated 

 

106 Id. at 49. 

107 Id. 
108 Id. 
109 ROBERT M. CHISHOLM, PERSON AND OBJECT: A METAPHYSICAL STUDY 

89–90 (Routledge, 2013) (quoting THOMAS HOBBES, ELEMENTS OF 

PHILOSOPHY, THE FIRST SECTION, CONCERNING BODY 100 (1656)). 
110 Id. 

111 See supra note 20 and accompanying text. 
112 See supra notes 7–8 and accompanying text. 
113 See supra Part II. 
114 See supra note 34 and accompanying text. 
115 See supra Part II. 

http://en.wikipedia.org/wiki/Thomas_Hobbes


  

1422 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

differently, an investor today is less concerned with the merits 

of an individual security—the “ship” in Plutarch’s story—and 

more concerned with managing the risks comprising that 

security—the “planks.” The question is whether (if at all) to 

address that change in the Securities Act. 

B. Distributing Risk 

The tension between “ships” and “planks” was highlighted 

in a series of SEC actions brought against short sellers in 

2008. In general, under the Securities Act, every sale of a 

security in the United States must be registered with the SEC 

or exempt from registration.116 The Securities Act does not 

provide a transactional exemption for the offer or sale of a 

security by an “underwriter.”117 Therefore, whether or not a 

transaction is by an underwriter is critical in determining 

whether SEC registration is required. The term “underwriter” 

includes “any person who has purchased [securities] from an 

issuer with a view to . . . the distribution of” those 

securities.118 “Distribution,” however, is not defined in the 

Securities Act,119 although it is understood to be analogous to 

 

116 COFFEE, SALE & WHITEHEAD, supra note 15, at 93–94. The sale must 

be by “means or instruments of transportation or communication in 

interstate commerce or of the mails.” Securities Act of 1933 § 5(a)(1), 15 

U.S.C. § 77e(a)(1) (2018). 
117 See Securities Act of 1933 § 4(a)(1), 15 U.S.C. § 77d(a)(1). 
118 Securities Act of 1933 § 2(a)(11), 15 U.S.C. § 77b(a)(11). An 

“underwriter” is also defined as “any person who . . . offers or sells for an 

issuer in connection with [a] distribution . . . or participates or has a direct 

or indirect participation in any [distribution];” or “any person who . . . 

participates or has a participation in the direct or indirect underwriting of 

any [distribution].” Id. 
119 See Securities Act of 1933 § 2, 15 U.S.C. § 77b. 



   

No. 3:1396] RISKY BUSINESS 1423 

“public offering,”120 as that term is interpreted in the 

Securities Act’s private placement exemption.121 

The SEC has struggled to apply these underwriter 

requirements to funds that transact in the risk associated 

with securities, rather than the securities themselves. 

Consider a series of SEC actions in which a short sale of 

publicly-traded shares took place contemporaneously with the 

short seller purchasing an equal number of restricted shares 

in a private placement by the issuer.122 A simplified version of 

these facts appears in Figure 1 below. “Issuer” is a public 

company whose outstanding shares trade freely on the Stock 

Exchange, and “Fund” is a hedge fund that invests in common 

stock.123 

In (1), Issuer privately issues restricted shares to Fund. 

Fund cannot resell the restricted shares on the Stock 

Exchange unless an exemption from SEC registration is 

 

120 See Rutherford B. Campbell, Jr., Resales of Securities Under the 

Securities Act of 1933, 52 WASH. & LEE L. REV. 1333, 1338 (1995); Carl W. 

Schneider, Section 4(1-1/2)—Private Resales of Restricted on Control 

Securities, 49 OHIO ST. L.J. 501, 503–04 (1988). Certain transactions, 

however, are not considered to be a distribution. See, e.g., SEC Rules 133, 

144, 17 C.F.R. §§ 230.133, 230.144 (2021). 
121 Securities Act of 1933 § 4(a)(2), 15 U.S.C. § 77d(a)(2). For a 

discussion of related concepts that have grown out of the private placement 

jurisprudence, see COFFEE, SALE & WHITEHEAD, supra note 15, at 377–78, 

383–86. 
122 “Restricted securities” are securities acquired in an unregistered, 

private sale from the issuer or an affiliate of the issuer. The securities may 

not be resold in the public markets unless they are registered with the SEC 

or exempt from registration. See Rule 144: Selling Restricted and Control 

Securities, U.S. SEC. & EXCH. COMM’N (Jan. 16, 2013), https://www. 

sec.gov/reportspubs/investor-publications/investorpubsrule144htm.html 

[https://perma.cc/KYX6-DL6A]; see also SEC Rule 144, 17 C.F.R. § 

230.144(a)(3). 
123 This summary is derived from several U.S. district court cases. See 

SEC v. Berlacher, No. 07 Civ. 3800, 2010 WL 3566790 (E.D. Pa. Sep. 13, 

2010); SEC v. Lyon, 529 F. Supp. 2d 444 (S.D.N.Y. 2008); SEC v. Mangan, 

No. 3:06-CV-531 2007 WL 4102743 (W.D.N.C. Oct. 24, 2007). In each case, 

the court granted the defendants’ motion to dismiss SEC claims that section 

5 of the Securities Act had been violated. But see Zacharias v. SEC, 569 F.3d 

458, 463–68 (D.C. Cir. 2009) (per curiam), whose facts are described infra 

note 129. 



  

1424 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

available or Issuer files a registration statement with the SEC 

that is declared effective. 

 

Figure 1: Purchase of Restricted Shares and Contemporaneous 

Sale of Freely-Tradable Shares 

 

  

 

   

 

 

 

 

 

     

 

 

Due to their limited liquidity, Fund buys the restricted 

shares at a discount below the price at which the freely-

tradable shares trade on the Stock Exchange.124 If Fund had 

contemporaneously resold the restricted shares on the Stock 

Exchange, it would have engaged in a “distribution” of shares 

as an “underwriter” in violation of the Securities Act. 

In (2), Fund short sells freely-tradable shares on the Stock 

Exchange, and then in (3), it borrows freely-tradable shares 

from Custodian to settle its short sales. Custodian held those 

shares for third-party clients and, as part of its stock lending 

business, was authorized to loan shares to others against the 

deposit of collateral.125 Matching the sale of the freely-

tradable shares with the restricted shares permits Fund to 

minimize the portfolio risk of holding the restricted shares 

and lock-in a profit—the difference between the Stock 

 

124 For an explanation of the discount in PIPE transactions, see Richard 

E. Gormley, Overview: An Emerging Market, in PIPES REVISED AND 

UPDATED EDITION: A GUIDE TO PRIVATE INVESTMENTS IN PUBLIC EQUITY 22 

(Steven Dresner & E. Kurt Kim eds., 2d ed. 2006). 
125 A description of the mechanics of securities lending appears in MARK 

C. FAULKNER, AN INTRODUCTION OF SECURITIES LENDING 13–18 (4th ed. 

2007). 

Freely-tradable  

shares 
Restricted 

shares 

(2) 

 

(4) 

Issuer Fund Stock Exchange 

Bank Depositary C 

 
3 

Newly-registered  

shares 
Freely-tradable  

shares 

(3) 

Custodian 

(1) 



   

No. 3:1396] RISKY BUSINESS 1425 

Exchange price and the restricted share price. Absent an 

effective registration statement, Fund still cannot sell the 

restricted shares on the Stock Exchange or use those shares 

to settle its short sales. 

In (4), Issuer files a registration statement with the SEC, 

and the SEC declares the registration statement effective. 

Since the shares that Fund bought from Issuer are now 

covered by an effective registration statement, Fund can 

return freely-tradable shares to Custodian and terminate the 

lending relationship. 

Focusing on the substance of the transactions, the SEC 

argued that a distribution of the restricted shares began with 

the Fund’s short sale of publicly-traded shares and, therefore, 

the restricted shares should have been registered.126 

According to the SEC, Issuer’s sale to Fund was no longer 

“private” but rather was the first step in a public distribution, 

causing Fund to be engaged in an underwriting that required 

an effective registration statement.127 In effect, the SEC 

attempted to expand the concept of “underwriter” on the basis 

that Fund had begun to participate in a distribution of 

shares128—shares that, at the time of the Fund’s short sales, 

 

126 See Complaint at 15–16, SEC v. Mangan, 598 F.Supp 2d. 731 

(W.D.N.C. 2008). 
127 See id.; Anna T. Pinedo & James R. Tanenbaum, Over the Worst of 

It, INT’L. FIN. L. REV., June 2008, at 2, 4. 
128 In that respect, the courts have construed what constitutes an 

“underwriter” in broad terms. In SEC v. Chinese Consol. Benevolent Ass’n, 

120 F.2d 738 (2d Cir. 1941), for example, the defendant violated the 

Securities Act simply by soliciting offers to buy securities. Even though the 

defendant did not own the securities and was not compensated for its 

solicitation, the court held that whether the “issuer authorized the 

solicitation, or merely availed itself of gratuitous and even unknown acts on 

the part of the defendant” was irrelevant to the Securities Act analysis. Id. 

at 740. “In either case,” the court concluded, “the solicitation was equally 

for the benefit of the [issuer] and broadly speaking was for the issuer in 

connection with the distribution of the [securities].” Id. The defendant, 

therefore, was an underwriter. Id. at 741. Nevertheless, even under this 

broad reading, it would be difficult to find that Fund’s return of borrowed 

shares to Custodian was a distribution of those shares and, therefore, that 

Fund was an underwriter. But see Zacharias, 569 F.3d at 458, described 

infra note 129. 



  

1426 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

were restricted even though they were fully-registered when 

Fund later returned shares to Custodian. 

The district courts disagreed.129 They concluded that the 

restricted shares were different instruments from the shares 

that Fund short-sold on the Stock Exchange, and this 

difference should be reflected in their regulatory treatment.130 

In other words, what triggered the Securities Act was the 

 

129 Contrast Zacharias, where the D.C. Circuit affirmed an SEC order 

that found two officers and directors (Zacharias and Carley) of Starnet 

Communications, and a group of unaffiliated third parties (the “Peeper 

Entities”), to be engaged in a scheme to sell unregistered Starnet shares in 

violation of the Securities Act. Zacharias, 569 F.3d at 462. Zacharias and 

Carley held options to purchase Starnet stock. Id. at 463. The options were 

registered with the SEC, but not the underlying shares. Id. As a result, the 

court noted, resales by Zacharias or Carley “would have been illegal” 

without a separate, effective registration statement covering those resales. 

Id. The Peeper Entities, however, owned millions of Starnet shares that 

“they could lawfully resell to the public” without a registration statement. 

Id. at 462–63. They also held warrants to purchase several more millions of 

shares. Id. In the first step, the Peeper Entities sold their Starnet shares to 

the public (including shares received upon exercise of the warrants). Id. at 

462. The court concluded that, absent any other facts, the sales by the 

Peeper Entities would have been legal. Id. As part of the second step, 

Zacharias and Carley exercised their options and privately sold shares to 

the Peeper Entities shortly after the first step was completed. Id. at 463. 

The shares that Zacharias and Carley sold to the Peeper Entities equaled 

the number of shares the Peeper Entities sold publicly. Id. The court 

concluded that, by itself, the second step was also legal. Id. The purpose of 

the two transactions was to enable Zacharias and Carley to sell their shares 

without an effective registration statement, but at little or no liquidity 

discount. Id. at 462–63. In the original proceeding, the SEC concluded that 

the two transactions should be collapsed into one. As a result, Zacharias, 

Carley, and the Peeper Entities were found to be underwriters that had 

engaged in a distribution of Starnet shares without an effective registration 

statement in violation of the Securities Act. Id. The court agreed with the 

SEC that a person does “not have to be involved in the final step of the 

distribution to have participated in it,” but rather that a person who is a 

“necessary participant” or “substantial factor” in a distribution is an 

underwriter. Id. at 464. Praising the SEC’s decision as “a triumph of 

substance over form,” the court affirmed the SEC order that found the two 

steps of the transaction—even though they would have been legal if 

considered by themselves—to have violated the Securities Act. Id. at 463, 

469. 
130 See supra note 123. 



   

No. 3:1396] RISKY BUSINESS 1427 

transfer of shares, not the transfer of their risk. No interest in 

the restricted shares was transferred when Fund short sold 

shares, and how Fund chose to cover its short sales did not 

alter the nature of the short sales themselves.131 

Yet, what was fundamentally troubling about Fund’s short 

sales was that they were intended to transfer the economic 

risk of the restricted shares to the general public. The sale of 

restricted shares to Fund would not have occurred unless 

Fund could short sell the publicly-traded shares on the Stock 

Exchange; both were integral to the total transaction. Fund 

was interested in enhancing its returns on the restricted 

shares while minimizing the risk of holding them. Combining 

the two permitted Fund to transfer its economic risk—the 

“planks”—to the general public, while continuing to own the 

restricted instruments—the “ships.” From an aggregate risk 

perspective—which is likely how Fund assessed the 

transaction132—Fund’s short sales on the Stock Exchange 

were economically the same as if the restricted shares were 

sold directly to the public. 

 

131 See, e.g., SEC v. Lyon, 529 F. Supp. 2d 444, 455 (S.D.N.Y. 2008) 

(“Consider an investor who shorts the common stock of a company and then 

covers his short position by converting convertible bonds into the common 

stock owed. . . . [F]rom the Court’s perspective, a short sale of a security 

constitutes a sale of that security. How an investor subsequently chooses to 

satisfy the corresponding deficit in his trading account does not alter the 

nature of that sale.”). The SEC also argued that Fund materially 

misrepresented to Issuer that it intended to hold the shares and engaged in 

insider trading by short selling shares before Issuer’s private placement was 

publicly announced, in each case in violation of Section 10(b) of, and Rule 

10b-5 under, the Securities Exchange Act of 1934. Id. at 448. The SEC’s 

alternative theories had limited success. See, e.g., SEC v. Berlacher, Civ. 

No. 07-3800, 2010 WL 3566790, at *16 (E.D. Pa. Sept. 13, 2010) (finding 

that the SEC, in some transactions but not in others, established that the 

defendants made material misrepresentations amounting to fraud); Lyon, 

529 F. Supp. 2d at 453 (denying defendants’ motion to dismiss insider 

trading claims); see also Jeffrey T. Hartlin, Despite Recent Setbacks in the 

Courts, the SEC Remains Focused on Short Sales in PIPE Transactions, 37 

SEC. REGUL. L.J. 162, 169–72 (2009) (describing the SEC’s limited success 

in challenging these transactions). 
132 See supra notes 59–61 and accompanying text. 



  

1428 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

The courts’ decisions raise a basic concern. If a primary 

purpose of the Securities Act is to ensure proper disclosure to 

investors,133 what should trigger that obligation—the transfer 

of an instrument (such as a share of stock) or the transfer of 

the economic risk of that instrument? Clearly, the short-sold 

freely-tradable shares were different instruments from the 

restricted shares Fund had purchased. Permitting Fund, 

however, to transfer the economic risk of the restricted shares 

to the public before a registration statement was effective 

arguably robbed the later disclosure of its value.134 After the 

registration statement became effective, some months after 

the short sale of the shares, the now-registered instruments 

were simply returned to Custodian.135 

IV. THE SEC’S RESPONSE TO RISK TRADING 

A. Disclosure and Portfolio Risk 

The “top-down” process of managing and transferring risk 

suggests that the idiosyncratic risk of an individual 

instrument now matters less than its contribution to a 

 

133 See COFFEE, SALE & WHITEHEAD, supra note 15 and accompanying 

text. 
134 This concern is analogous to what Director Coates highlighted in 

connection with SPAC and de-SPAC transactions. See supra notes 12–14 

and accompanying text. 
135 One could argue that the result is a distinction without a difference. 

Since Issuer was already a public company, information about Issuer was 

publicly available, and the purchasers of the publicly-tradable shares had 

access to that information. That critique, while not without merit, is more 

properly aimed at the registration process in general, not this particular 

situation. The same point would apply, as well, to a regular registered 

distribution of the securities of a public company. See generally Robert B. 

Thompson & Donald C. Langevoort, Redrawing the Public-Private 

Boundaries in Entrepreneurial Capital-Raising, 98 CORNELL L. REV. 1573, 

1585–86 (2013) (critiquing the gaps and pitfalls in the registration process 

under the Securities Act). So long as the current process remains, the 

distribution of securities—of a newly public or currently public company—

triggers the SEC registration requirements. See Securities Act of 1933 §5(a), 

15 U.S.C. § 77e (2018). This includes liability for material misstatements or 

omissions. See Securities Act of 1933 § 11, 15 U.S.C. § 77k (2018). 



   

No. 3:1396] RISKY BUSINESS 1429 

portfolio’s overall risk. From that perspective, the decision to 

buy or sell a security is tied less to the unique merits of that 

security and more to its correlation with other investments in 

the portfolio. Institutional investors applying this portfolio-

level approach must assess issuers and securities against each 

other. Perhaps for that reason, the SEC has increasingly 

encouraged disclosures that permit cross-company 

comparisons, facilitating a portfolio-level assessment of risk 

across issuers and industries.136 Providing greater and more 

consistent financial information, and enhancing 

comparability, limits the risk to which investors would 

otherwise be exposed if information were limited or more 

costly to obtain or process. The risks arising from less-

complete disclosure cannot be diversified by a portfolio of 

securities that raise the same informational barriers.137 In 

fact, the quality of a firm’s disclosures affects how the market 

assesses its future cash flows relative to those of other 

firms.138 If disclosure is incomplete, the risks borne by less-

informed investors, who may not properly assess the value of 

one security against another, become non-diversifiable.139 

 

136 See, e.g., SEC, Business and Financial Disclosure Required by 

Regulation S-K 327-30, Securities Act Release No. 10,064, Exchange Act 

Release No. 77,599, 81 Fed. Reg. 23,916, 24,006 (Apr. 26, 2016) (“By 

requiring structured data, the Commission has sought to make disclosure 

easier for investors to access, analyze and compare across reporting periods, 

registrants, and industries.” (footnote omitted)); see also Amir Amel-Zadeh 

& George Serafeim, Why and How Investors Use ESG Information: Evidence 

from a Global Survey, FIN. ANALYSTS J., Dec., 2018, at 87, 92–93 (“The 

reliability and lack of audit of ESG data also concern large investors 

significantly more than small investors (47% versus 16%, p-value < 0.01), 

and consistent with this finding, so does the lack of reporting standards 

(52% versus 39%, p-value < 0.05).”). 
137 See Gus de Franco, S.P. Kothari & Rodrigo S. Verdi, The Benefits of 

Financial Statement Comparability, 49 J. ACCT. RSCH. 895, 897 (2011). 
138 Richard Lambert, Christian Leuz & Robert E. Verrecchia, 

Accounting Information, Disclosure and the Cost of Capital, 45 J. ACCT. 

RSCH. 385, 410 (2007). 
139 See id. at 410–11; David Easley & Maureen O’Hara, Information 

and the Cost of Capital, 59 J. FIN. 1553, 1554 (2004) (“This higher return 

reflects the fact that private information increases the risk to uninformed 



  

1430 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

Institutional investors also regularly rebalance their 

portfolios. Doing so, within VaR limits, requires an ability to 

estimate the effect of a purchase or sale on portfolio value 

relative to future changes in total market value.140 Moreover, 

because investors are focused on risk-adjusted returns,141 

financial and business information is relevant to the investor’s 

decision to buy or sell a security.142 For that reason, as 

additional firm-specific information becomes available at 

lower cost, investors can use that information to more 

precisely manage portfolio risk through diversification,143 

which, in turn, translates into a drop in the cost of equity144 

and the pricing of credit risk.145 

The SEC’s focus on comparability is perhaps best 

evidenced by its April 2009 requirement that public 

 

investors of holding the stock because informed investors are better able to 

shift their portfolio weights to incorporate new information.”). 

140 See Section II.B; see also Coffee, supra note 19, at 750 (“[I]nvestors 

are constantly confronted with the need to revise their portfolios. . . . [and] 

they must estimate the impact of a new individual security upon the overall 

beta of their portfolio.”). 
141 See supra notes 46–51 and accompanying text. 
142 See, e.g., Khrystyna Bochkay & Carolyn B. Levine, Using MD&A to 

Improve Earnings Forecasts, 34 J. ACCT. 458, 460 (2019) (finding that 

disclosure in the MD&A portion of a registration statement improves the 

accuracy of earnings forecasts beyond traditional financial variables); Cathy 

J. Cole & Christopher L. Jones, The Usefulness of MD&A Disclosures in the 

Retail Industry, 19 J. ACCT., AUDITING & FIN. 361, 363 (2004) (finding that 

MD&A disclosure is significantly and positively associated with future 

revenue and earnings growth and contemporaneous stock returns). 
143 See Yi Dong et al., Does Information-Processing Cost Affect Firm-

Specific Information Acquisition? Evidence from XBRL Adoption, 51 J. FIN. 

& QUANTITATIVE. ANALYSIS 435, 441 (2016) (“Given the potential that XBRL 

adoption reduces information-processing cost . . . and thereby enhances the 

incorporation of firm-specific information into stock prices . . . an important 

implication is that XBRL adoption facilitates firm-specific information 

production and thus reduces stock return synchronicity.”). 
144 See Oliver Zhen Li, Yupeng Lin & Chenkai Ni, Does XBRL Adoption 

Reduce the Cost of Equity Capital? 29–30 (Aug. 17 2012) (unpublished 

manuscript), https://ssrn.com/abstract=2131001 (on file with the Columbia 

Business Law Review). 
145 See Seil Kim, Pepa Kraft & Stephen G. Ryan, Financial Statement 

Comparability and Credit Risk, 18 REV. ACCT. STUD. 783, 785–86 (2013). 



   

No. 3:1396] RISKY BUSINESS 1431 

companies report their financial statement data using 

eXtensible Business Reporting Language (XBRL).146 The final 

rules were the culmination of a multi-year evaluative process 

to promote the use of interactive data, in line with other U.S. 

and foreign regulators.147 Interactive data files are included 

as exhibits that supplement, but do not replace, the financial 

statements required to be filed with the SEC.148 In that 

format, financial statement information can be downloaded 

directly into spreadsheets, analyzed using commercial off-the-

shelf software, and used within investment models in other 

software formats.149 

A stated purpose of XBRL is to reduce the informational 

divide between smaller and larger investors “with greater 

financial resources.”150 Institutional investors, however, also 

benefit from the reduced cost of collecting data.151 One 

concern with XBRL has been in the comparability of “tags” 

used by issuers to identify similar types of financial 

information and the ability to customize tags (referred to as 

“extensions”) to meet the needs of particular issuers.152 

Inconsistent tagging may result in a decline in comparability. 

 

146 Interactive Data to Improve Financial Reporting, Securities Act 

Release No. 9002, Exchange Act Release No. 59,324, Investment Company 

Act Release No. 28,609, 74 Fed. Reg. 6776 (Feb. 10, 2009) (to be codified in 

17 C.F.R. pts. 229, 230, 232, 239, 240, 249). 
147 Id. at 6779–80. 
148 Id. at 6777 
149 Id. at 6778–79. 
150 Id. at 6803. 
151 See Elizabeth Blankespoor, Brian P. Miller & Hal D. White, Initial 

Evidence on the Market Impact of the XBRL Mandate, 19 REV. ACCT. STUD. 

1468, 1470, 1497 (2014) (“Although the SEC argues that XBRL provides 

more benefits to small investors than it does to large investors, the potential 

for large traders to use their superior processing capabilities to leverage the 

new technology for informational gains may actually disadvantage small 

investors.”). 
152 See, e.g., CLEARY GOTTLIEB, SEC ADOPTS RULES REQUIRING FILING OF 

FINANCIAL STATEMENTS IN INTERACTIVE XBRL FORMAT 2–3 (2009), 

https://www.clearygottlieb.com/-/media/organize-

archive/cgsh/files/publication-pdfs/sec-adopts-rules-requiring-filing-of-

financial-statements-in-interactive-xbrl-format.pdf 

[https://perma.cc/PQ5A-TKNM]. 



  

1432 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

To date, the SEC has not required a formal audit or review of 

an issuer’s interactive data file, raising the possibility of 

inconsistency across issuers.153 Nevertheless, the adoption of 

XBRL has enabled investors to acquire and compare more 

data, including risk-related information, at lower cost.154 

 

153 See Interactive Data to Improve Financial Reporting, 74 Fed. Reg. 

at 6796. 
154 See Vicky Arnold et al., The Impact of Tagging Qualitative Financial 

Information on Investor Decision Making: Implications for XBRL, 13 INT’L 

J. ACCT. INFO. SYS. 2, 17–19 (2012). More recently, the SEC has increased 

attention on climate-related disclosure, with a view to providing new 

guidance as part of a growing focus on environmental, social, and 

governance (ESG) metrics. See Allison Herren Lee, Statement on the Review 

of Climate-Related Disclosure, SEC. & EXCH. COMM’N (Feb. 24, 2021), 

https://www.sec.gov/news/public-statement/lee-statement-review-climate-

related-disclosure [https://perma.cc/KQZ2-JMUY]. These calls for greater 

ESG disclosure reflect concerns that the existing guidance is too general 

and does not permit a level of comparability across disclosures that 

investors require. See SEC. & EXCH. COMM’N, Commission Guidance 

Regarding Disclosure Related to Climate Change, Securities Act Release 

No. 9106, Exchange Act Release No. 61,469, 75 Fed. Reg. 6290 (Feb. 8, 2010) 

(to be codified at 17 C.F.R. pts. 211, 231, 241); SEC. & EXCH. COMM’N, INV. 

ADVISORY COMM., RECOMMENDATION FROM THE INVESTOR-AS-OWNER 

SUBCOMMITTEE OF THE SEC INVESTOR ADVISORY COMMITTEE RELATING TO 

ESG DISCLOSURE (2020), https://www.sec.gov/spotlight/investor-advisory-

committee-2012/recommendation-of-the-investor-as-owner-subcommittee-

on-esg-disclosure.pdf [https://perma.cc/F959-DDLY] (recommending that 

the SEC require “material, comparable, consistent” ESG disclosure). There 

have also been proposals to tag new ESG disclosures using XBRL 

technology. See, e.g., Allison Herren Lee, Remarks at the XBRL US Investor 

Forum: The Promise of Structured Data: True Modernization of Disclosure 

Effectiveness, SEC. & EXCH. COMM’N (Nov. 17, 2020), 

https://www.sec.gov/news/speech/lee-structured-data-2020-11-17 

[https://perma.cc/NU6M-GDQ4]. From a portfolio perspective, this makes 

sense. Some financial risks arising from climate change are broadly 

systematic and will affect the undiversifiable risk an investor must manage 

or transfer from her portfolio. See Allison Herren Lee, Regulation S-K and 

ESG Disclosures: An Unsustainable Silence, SEC. & EXCH. COMM’N (Aug. 26, 

2020), https://www.sec.gov/news/public-statement/lee-regulation-s-k-2020-

08-26 [https://perma.cc/N244-TUW5] (stating that “[c]limate risk, writ 

large, cannot be diversified away[.]”). Others are idiosyncratic risks, tied to 

an individual firm’s profitability and credit risk, that an investor must 

consider when deciding a portfolio’s optimal risk-and-return tradeoff. See, 

e.g., Larry Fink, Larry Fink’s 2021 Letter to CEOs, BLACKROCK (Jan. 30, 



   

No. 3:1396] RISKY BUSINESS 1433 

B. Risk vs. Instruments? 

Greater comparability supports portfolio-level risk 

management, but it does not address the more fundamental 

question of what should trigger Securities Act disclosure. 

Adopting an analysis that looks through the instruments to 

the economic risks of the transaction would be consistent with 

the approach reflected in the vast majority of investment 

activity today.155 It would also be consistent with a core 

purpose of the Securities Act—to require disclosure as one 

means for investors to assess and manage the risk of their 

investments.156 This remains true even in light of the benefits 

of portfolio-level diversification.157 On that basis, tying 

Securities Act disclosure to transfers of risk—rather than 

transfers of instruments—may more accurately reflect how 

most investors rely on Securities Act disclosures today. 

As appealing as this sounds, tying the Securities Act to 

transfers of risk raises practical concerns. The transactions in 

Figure 1 were fairly straightforward. Fund transferred the 

economic risk of restricted shares to the general public. It 

would not have purchased the restricted shares unless it could 

short sell the freely-tradable shares on the Stock Exchange. 

Both were integral to the total transaction, and their 

combination replicated the substance of a public distribution 

of securities that would have required SEC registration. 

But what if we changed the facts? For example, assume 

that Fund had short sold publicly-tradable shares equal to 

110% of the restricted stock it purchased. Would it make sense 

to treat an amount equal to 100% of the restricted stock as 

part of a distribution (requiring SEC registration) and the 

remaining 10% as secondary trading (exempt from 

registration), and if so, which shares should receive which 

treatment? 

 

2021), https://www.blackrock.com/us/individual/2021-larry-fink-ceo-letter 

[https://perma.cc/8D8W-QFA3] (stating that “climate risk is investment 

risk” and that the market will price climate risk into securities values). 
155 See supra notes 23–29, 77–83 and accompanying text 
156 See supra notes 15–20 and accompanying text. 
157 See supra notes 137–145 and accompanying text. 



  

1434 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

Alternatively, what if Fund had purchased restricted high-

yield bonds from Issuer, but (as in Figure 1) 

contemporaneously short sold freely-tradable Issuer shares on 

the Stock Exchange? In general, the prices of high-yield 

instruments move in tandem with the share prices of the same 

issuer.158 As before, Fund’s motivation to short sell Issuer 

shares would be to transfer the economic risk of the restricted 

high-yield bonds to the general public before a registration 

statement was effective. Considering the economic substance 

of the transaction, should Fund’s short sale of publicly-traded 

shares be treated as part of a plan to distribute the restricted 

high-yield bonds? Should it matter (as was the SEC’s position 

in Figure 1) that, instead of covering the short with registered 

Issuer shares, the proceeds from selling the Issuer high-yield 

bonds, after the bonds are registered, are used to buy freely-

tradable Issuer shares to cover the short? 

Finally, how would a risk-based approach to regulation 

address a traditional “pairs trade”? At its basic, a pairs trade 

involves two stocks whose prices are historically correlated.159 

When the difference in prices widens, an investor will short 

the stock whose price has gone up and buy the stock whose 

price has dropped.160 Over time, the prices of the two stocks 

are expected to converge, and in that case, the investor will 

earn a profit.161 Such a strategy, based on price dynamics and 

simple contrarian principles, has been a standard of large 

Wall Street investors for some time.162 Note that, in a pairs 

trade, the identity of the two stocks is largely irrelevant; only 

their relative value is important to an investor. If Fund buys 

GM and shorts Ford (or buys Netflix and shorts Amazon),163 

 

158 See David V. Ceryak, Using Risk Analysis to Classify Junk Bonds as 

Equity for Federal Income Tax Purposes, 66 IND. L.J. 273, 287 (1990). 
159 Evan Gatev, William N. Goetzmann & K. Geert Rouwenhorst, Pairs 

Trading: Performance of a Relative-Value Arbitrage Rule, 19 REV. FIN. STUD. 

797, 797 (2006). 

160 Id. 
161 Id. 
162 Id. at 797, 799. 
163 See George Pipis, Example of Pairs Trading, PREDICTIVE HACKS (Jan 

30, 2021), https://predictivehacks.com/example-of-pairs-trading / 



   

No. 3:1396] RISKY BUSINESS 1435 

much of the idiosyncratic risk will be eliminated (since the two 

stocks historically trade in tandem), with Fund managing a 

portion of the GM risk to which it is exposed through its short 

sale of Ford. Clearly, the transaction was entered into solely 

for Fund to take advantage of differences in the GM and Ford 

share prices. Should the Securities Act integrate the purchase 

of GM stock with the transfer of GM risk through the short 

sale of Ford stock? 

Here, we may be reaching the practical limitations of a 

risk-based approach to the Securities Act. With Theseus, we 

could trace each plank to the original ship.164 In today’s 

capital markets, the problem is that tracing planks—tying a 

transfer of risk to a decision to assume risk—may not always 

be possible. And, since risk taking is often managed at the 

portfolio level, it may be difficult to tie any one transfer of risk 

to a particular instrument. So, for the time being, regulation’s 

reach may fall short of today’s trading and risk management 

strategies. In other words, although most trading is tied to 

portfolio risk, for the moment, the Securities Act’s 

architecture must remain tied to individual securities, and its 

application must be triggered by the transfer of instruments 

rather than their risk. The result is likely to be a continued 

tension between the requirements of the Securities Act and 

the risk-based approach to investing taken by the majority of 

those who benefit from the Securities Act’s protections.165 

V. CONCLUSION 

Director Coates’ analysis of SPACs and de-SPACs reflects 

a basic tension within the federal securities laws. Before 

widespread adoption of portfolio risk management, investors 

principally focused on the individual instruments they bought 

and sold. That is no longer true today for much of the capital 

markets. Consequently, like in Director Coates’ analysis, it 

 

[https://perma.cc/G9YF-T9LJ] (using Netflix and Amazon in an example of 

pairs trading). 
164 See supra Section III.A. 
165 See Coffee, supra note 56, at 41 (noting the divergent interests of 

institutional and retail investors regarding Securities Act disclosures). 



  

1436 COLUMBIA BUSINESS LAW REVIEW [Vol. 2021 

may make increasing sense for the protections of the 

Securities Act to be tied to the economic risk of a transaction 

rather than to the instruments. 166 

For now, as a first step, and in light of the practical 

limitations of risk-based regulation, the SEC should adopt a 

concept release that begins to analyze and take account of 

changes in how risk is managed and their impact on securities 

regulation. As this Article has illustrated, some aspects of a 

regulatory approach based on economic substance may be 

easier to justify than others, at least based on existing 

limitations on the ability to trace risk. At the very least, such 

a release would help support an analysis based on the 

economic substance of the transaction, as Director Coates 

urged. It would also provide support for enforcement against 

clear abuses, as in the short-sale cases, where the transaction 

was able to arbitrage differences between how the Securities 

Act was drafted and how investors manage and transfer risk 

today. 

Over the longer term, the shift in risk management may 

argue in favor of a more fundamental change in the Securities 

Act’s approach to regulation. Writing over fifty years ago, 

Milton Cohen, in “Truth in Securities” Revisited,167 an article 

that set the path for modern disclosure requirements, noted 

that if the Securities Act had been adopted at the same time 

as or before the Securities Exchange Act of 1934, which 

regulates the disclosure obligations of public companies, then 

 

166 New technology may offer one solution. As the individual risks that 

comprise a security are identified and transferred, blockchain may provide 

one means to track and record that transfer. A blockchain is a system for 

validating, clearing, settling, tracking, and recording the ownership of 

assets as they are traded in each block. See William Mougayar, The 

Blockchain is the New Google, TECHCRUNCH (May 11, 2016), 

https://techcrunch.com/2016/05/11/the-blockchain-is-the-new-google/ 

[https://perma.cc/6Z2V-2A9Q]; Craig A. de Ridder, James M. Grosser & 

Marco A. Santori, Blockchain Basics: A Primer, PILLSBURY WINTHROP SHAW 

PITTMAN LLP (May 2, 2016), 

http://www.pillsburylaw.com/publications/blockchain-basics-a-primer 

[https://perma.cc/H7CM-EKMB]. 
167 Milton H. Cohen, “Truth in Securities” Revisited, 79 HARV. L. REV. 

1340, 1340 (1966). 



   

No. 3:1396] RISKY BUSINESS 1437 

public-offering disclosures under the Securities Act would be 

based on the periodic disclosures mandated for public 

companies.168 Perhaps, in light of changes in risk 

management, it is time to pick up where Mr. Cohen left off 

and offer one more reason to revisit the creation of a reporting 

system whose obligations are not triggered by transactions in 

securities, but instead is based on company registration and 

periodic disclosures (except an issuer’s initial offering into the 

public capital markets).169 Doing so would sidestep the 

“instrument versus risk” tension that this Article illustrates, 

although other issues that have traditionally accompanied the 

capital-raising process would remain unresolved.170 

 

 

168 Id. at 1341–42. 

169 See John C. Coffee, Jr., Re-Engineering Corporate Disclosure: The 

Coming Debate Over Company Registration, 52 WASH. & LEE L. REV. 1143, 

1155–58 (1995). 
170 Id. at 1156–57; see also Thompson & Langevoort, supra note 135, at 

1580, 1585.