A who’s who of the securities regulation world gathered in New York last week. The agenda: to debate the merits of rules-based or principles-based enforcement.
The conclusion, such that it was: Anyone hoping regulators will decisively embrace one system or the other should forget about it.
Numerous reports have cropped up in the United States recently calling for a more principles-based system of securities regulation, akin to the “light touch” regulatory regime used by Great Britain. With fewer exacting rules, this camp says, compliance costs will be lower and the United States will be able to maintain its dominance as a center of corporate finance and capital markets.
At last week’s roundtable, held at Cardozo School of Law, various speakers tried to envision how that principles-based system might work. Dan Waters, director of retail policy at the U.K. Financial Services Authority, reminded the audience that such systems are not as simple as they seem. “The FSA has and will always have a mixture if principles, high-level rules, and detailed rules,” he said. (While FSA regulation is based on 11 principles comprised of just 194 words, the FSA also has an 8,500-page rulebook.)
Other panelists included Roel Campos, commissioner at the Securities and Exchange Commission; David Brown, a member of the Public Interest Oversight Board and former chief executive of the Ontario Securities Commission; Richard Ketchum, CEO of NYSE Regulation; Walter Lukken, commissioner of the U.S. Commodity Futures Trading Commission; Giovanni Prezioso, former SEC general counsel and now a partner at the law firm Cleary, Gottlieb, Steen & Hamilton; and moderator Eric Pan, a professor at the Cardozo School.
The principles-versus-rules debate is the broad canvas for numerous governance reforms percolating at the SEC and elsewhere. Groups like the Committee on Capital Markets Competitiveness (better known as the Paulson Committee, after Treasury Secretary Hank Paulson) frame their calls for reform of Sarbanes-Oxley and corporate litigation as part of that movement, to encourage better governance outcomes that comply with the spirit of regulation, rather than slavish adherence to the letter of it.
Waters stressed that the FSA’s move toward more principles-based regulation “is not about lowering standards,” and “doesn’t mean less enforcement.” Rather, he said, “It’s about regulating with a greater emphasis on the regulatory outcomes we want firms to achieve.”
Brown
Other speakers noted that a principles-based system poses a number of challenges and risks. PIOB member David Brown said principles-based regulation raises “serious issues” for compliance and enforcement. “The issues aren’t difficult when conduct is at the center of a principle or way outside; the problem is when it’s at the margins,” he said. He wondered whether “some form of the business judgment rule” that exists for boards would be developed for compliance under such a system.
Indeed, Brown said, a principles-based system might actually stifle innovation, since companies would want to be conservative out of fear of being second-guessed. “It’s difficult to have evidence to show whether you’re inside or outside of a broadly worded principle,” said Brown.
Brown also cited “lack of clarity” as another challenge in a principles-based system. Just as in a rules-based system of regulation, he said, “where there are gaps, people will exploit them.” Moreover, he added, “If regulation doesn't delineate the margins, the courts will fill the gap.”
Where Principles Might Work
Lukken at the CFTC said his agency, which regulates the trading of commodities, has used a principles-based system for seven years. The flexibility of that system has helped the CFTC function in today’s globalized marketplace for commodities, he said. One of the difficulties with rules is knowing whether regulators overseas have a similar structure if their rules are different, he explained. “With principles, we have a benchmark to figure out outcomes and compare them to foreign jurisdictions.”
Lukken
Yet, while principles bring flexibility, “rules have the legal certainty,” Lukken admitted. The challenge is to find the optimum balance, he said, adding that, “We’re going there no matter what. We have to be more flexible to do our job.”
Prezioso, however, countered that, “People want specificity, for legal liability and other reasons.” He also wondered whether a push to a principles-based system would cost money and resources better spent elsewhere, or would distract executives from running their businesses as SOX is often criticized as doing.
Waters, who previously worked in enforcement in the United States at the CFTC, cited a major difference between American and British enforcement environments: attitude.
“In the U.K., the starting assumption is that firms are trying to do the right thing,” he said. “When I was in the U.S., it always seemed like there was somebody out there doing something wrong and we’re going to find it. That’s a very different starting point.”
Campos congratulated the FSA for embracing a principles-based approach and noted that the United States is trying to adopt its own principles-based approach in certain ways. As examples, he cited the SEC’s recent new rules to ease the way for foreign private issuers to exit U.S. listings and pending changes to encourage a more risk-based, top-down approach in auditing internal controls over financial reporting.
Campos
But, Campos added, “We’re never going to be like the U.K.” The American regulatory system “has to be different,” because its markets are different from those of Great Britain, he said; British companies are often owned by institutional investors with large controlling blocks, while U.S. companies are almost all diversely held.
Campos also noted that the United States has the largest retail investor market in the world, so its focus on retail investor protection is a hallmark of American regulation. “I believe we have nothing to apologize about in our particular system,” he said. “The FSA has a great thing going. It works for them. We don’t have to be alike.”
“My view is that if you focus on investors and capital first, everything follows from that,” he said. “We are principles-based in our own way.”
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