Commentary: The Perils of Principle-Based Regulation
Traders Magazine Online News, March 24, 2009
In recent years, the SEC has been making a move toward more "principles-based" regulation, in which regulatory guidance provides broad compliance principles and leaves regulated firms to figure out how to apply those principles to their own circumstances.
This effort has been spurred, at least in part, by convergence, as the SEC has become more familiar with the International Financial Reporting Standards ("IFRS") and with the rule-making of the Financial Services Authority ("FSA") in the United Kingdom, both of which tend to be principles-based. Historically, the SEC's rule-making has been "rules-based," meaning that its regulations have tried to prescribe specific and detailed rules for reporting or other obligations.
For a response to this commentary by Gary DeWaal, click here.
Is principles-based regulation better than rules-based regulation? The proponents of principles-based regulation point out that it enables regulators and regulated firms to tailor regulatory obligations to specific situations, which may be unique to particular entities or industries, and which bright-line rules may fail to capture. Rules-based regulations may lead to rote or "boilerplate" responses, which fail to include the detail or specificity that properly reflects a firm's unique characteristics.
Regulators cannot conceive of every possible situation that may be important to investors, especially in the context of unique companies, so specific rulemaking runs the risk of leaving out valuable information. In addition, rules-based regulation may lag behind changing circumstances, if financial innovation or market conditions cause firms to adapt quickly and promulgation of rules does not keep up with the pace of change.
However, a look at some of the FSA's enforcement actions suggests that although principles-based regulation may be better for regulators, it's not necessarily a good deal for regulated firms.
The FSA's inside information disclosure rules (the Disclosure and Transparency Rules or "DTR") is the UK's functional equivalent of the SEC's Form 8-K disclosure rules. The DTR require that, unless an exemption applies, issuers notify a regulatory information service of any inside information that directly concerns the issuer without delay. Being principles-based rules, the DTR do not detail specific events that constitute inside information or that expressly require disclosure.
Rather, inside information is broadly defined as information that would likely be used by a reasonable investor as part of the basis for the investor's investment decision and, therefore, could have a significant effect on the price of financial instruments. The FSA's only additional guidance is a non-exhaustive list of items that the FSA believes are "likely to be considered relevant to a reasonable investor's decision." Even that guidance is fairly general and broad, including such items as "information which affects the assets and liabilities of an issuer."
By contrast, the SEC's Form 8-K is much more specific. Issuers must report events specified on Form 8-K within 4 business days (or sooner, depending on the event). Form 8-K divides the reporting events into eight distinct categories, which are further broken down into specific items. For example, the category for events that concern an issuer's business and operations are broken down into specific items, which include entry into or termination of a material definitive agreement; the category for events that concern an issuer's financial information includes the completion of an acquisition and the disposition of a significant amount of assets; and Item 5.02 of Form 8-K requires that an issuer disclose the election or departure of certain specified officers.
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