What’s the fate of principles-based regulation?

Rumours that the global financial crisis would kill off principles-based regulations appear somewhat exaggerated.

At a recent Capital Markets Institute Forum in Toronto, Cristie Ford, co-director for the National Centre for Business Law at the University of British Columbia, promoted a system that utilized the benefits of a principles-based regulatory system, while providing bright-line guidance when required.

The primary benefit of deferring to principles, as opposed to establishing cut and dried rules, is that they define the outcome society is looking to achieve. It’s difficult for anyone to argue with principles that encourage others to “treat the client fairly” or “provide clear information to customers.”

Ford painted the idea of a continuum, explaining that rules and principles shouldn’t be construed as occupying different ends of the spectrum. An appropriate system doesn’t choose between the two; it will have components of both.

“Rules are more detailed and bright-lined, while principles are more general,” noted Ford. “Rules are generally thought to promote precision and predictability, while principles have the capability to adapt to changing circumstances.”

Ford supports the philosophies of the U.K.’s Financial Services Authority (FSA), and believes a similar system will find success in Canada.

The constant state of change in the financial markets means regulators require the ability to respond quickly. And a flexible system allows complex issues to be addressed quickly. Eliminating the complexity associated with prescriptive rule regimes makes accessibility and compliance easier.

Implementation

Academics have expressed concern about the lack of certainty principles can create for regulated participants; the amount of legal and political accountability that will be required; and the ability to both monitor and achieve the desired outcomes of the principles-based system.

Despite recent finger pointing at the FSA’s failure to prevent financial meltdown, many have pointed out that the rules-based regulation used in the U.S. has an equally poor track record. Rules-based schemes were in place in Canada and failed to stop Portus. And bright-line regulations in the U.S. were no match for the manipulative accounting practices at Enron.

Indeed, the failures of a rules-based system make the idea of a fully functional principles-based approach appealing. Writing more generic rules gives regulators the option to adapt them to changing circumstances, and creates flexibility for the firms that must incorporate them into their practices.

Of course, credibility is a concern. “There’s a time for rules, but in order to function effectively, enforcement and regulatory credibility is essential,” says Ford. And regulators will have to behave both reasonably and predictably. Without that, it will be impossible to ensure effective working relationships with individuals in the industry.

Bill Rice, chair of the Alberta Securities Commission, told the forum that provincial securities commissions need to move quickly in making their cases. “People generally know where the bad behaviour is,” says Rice. “There’s a need for greater marketplace responsibility. Many of the bad players are known. There seems to be a tolerance for bad behavior in the business community.”

Enforcement

While noting the positive attributes of a principles-based system, forum participants did express concern over the inherent uncertainty of a principles-based structure and the associated costs. “In the short term, when there is no shared understanding of what the principle involves, market participants will require time, case law and regulatory decisions to ascertain what the principle means,” said Anita Anand, associate professor and associate dean at the University of Toronto Law School.

Anand also has concerns about the ability to enforce principles. Complying with laws and regulations requires registered persons to know what the law is. In this context, “the breach must be clear in order for market participants to know if they are offside,” said Anand. “Clear drafting is essential.” The general and discretionary nature of principles makes it difficult to comprehend how such powers will be effectively enforced.

Ford, meanwhile, noted “principles-based regulations, when properly implemented, can provide better regulation at a lower regulatory burden and is a more responsive system that can respond to the industry and industry wrongdoing.” The impetus behind the change in regulatory observance is to prevent violations of the spirit of the law.

“Principles remain attractive because they can adapt to emerging events. Rules cannot do that,” she argues. “The only way you can get around a rule is through statutory amendment or through selective non-enforcement, which is not a transparent approach, and leads to accessibility problems.”

(07/22/09)