Principles-based rules won’t be a panacea for financial services and, in fact, could create more regulatory risk, some industry observers say.
The concept of flexible rules is being pushed hard by business interests and regulators as the way to improve and modernize regulation.
IRVINE, Calif. — Principles-based rules won’t be a panacea for financial services and, in fact, could create more regulatory risk, some industry observers say.
The concept of flexible rules is being pushed hard by business interests and regulators as the way to improve and modernize regulation.
Washington-based NASD and NYSE Group Inc. of New York are moving toward principles-based regulations in harmonizing their rule books. And New York Governor Eliot L. Spitzer just last month created a commission to study financial services regulation and reportedly to consider principles-based approaches.
In theory, compliance with fundamental principles would be easier than meeting specific requirements.
But in reality, a principles-based system could leave industry participants begging for guidance and give enforcers room to interpret rules in arbitrary ways.
“If you have ambiguity, you’re going to be second-guessed,” said Peter Chepucavage, general counsel at Plexus Consulting Group LLC in Washington and a former Securities and Exchange Commission lawyer.
“The risk is that you don’t have enough certainty with a principles-based approach,” said David Rosedahl, a shareholder at Briggs & Morgan PA in Minneapolis. He is the former chief regulatory officer of the Pacific Exchange in San Francisco and served as general counsel at Piper Jaffray Cos. Inc. in Minneapolis.
Mr. Rosedahl isn’t opposed to a more flexible approach, but he worries that any new principles-based regulations simply will be added to the existing rule book, giving regulators that much more ammunition.
The Financial Services Institute Inc. of Atlanta also supports the concept of regulatory flexibility but is worried that “in attempting to comply with principles, examiners [will] end up with their own version of the rule book,” said Dale Brown, the trade group’s chief executive and executive director.
“The critical thing needed ... would be that those [officials] charged with overseeing examiners and enforcement people truly understand the business,” he said.
“The challenge for enforcement people will be to give [the industry] notice of what the interpretations [of principles-based rules] will be,” said Thomas Gorman, a partner at Porter Wright Morris & Arthur LLP in Washington and a former special trial counsel at the SEC.
Despite the mantra that principles-based regulation is the way to go, the effort could be more form than substance.
“I’m confused” by all the talk of principles-based regulation, said Alan Wolper, an attorney at Sutherland Asbill & Brennan LLP of Atlanta and a former NASD district director.
“Does it mean examiners have discretion? Theoretically, they’ve always had a good deal of discretion,” he said.
“We already have principles-based regulation,” Elisse Walter, senior executive vice president for regulatory policy at NASD, said at a compliance conference last month.
“Just and equitable principles of trade [under NASD Rule 2110] is as principles based as could be,” she said.
The broad scope of that rule makes it a good tool for regulators.
Rule 2110 is a “fallback violation” for enforcers, Mr. Wolper said.
It is a rule “you use [as a regulator] when you can’t find anything else,” Mr. Rosedahl said. “It’s [a] pretty rubbery” standard.
But even hard-and-fast rules aren’t always easy to apply, Mr. Gorman said.
Specific rules “are often difficult to apply in practice,” he said.
Meanwhile, small firms in particular should be wary of the “remarkable unity” behind the push for principles-based rules, Mr. Chepucavage said.
Such a regulatory scheme requires continuing legal analysis, which is difficult for small firms, he said.
“If you have a high-priced law firm that can look at a situation, call up regulators and get an interpretation [of a principles-based rule], you’re probably going to be OK,” Mr. Chepucavage said. “But if you’re a small broker-dealer [without that access], you’re going to get second-guessed.”
Mr. Rosedahl agrees that more-flexible rules can be difficult for small firms.
As general counsel at Piper Jaffray, “I had access to a lot of folks who could give me comfort in how the rules need to be applied; there were four or five lawyers I could call,” he said.
The smaller firms he represents now as outside counsel don’t always have the same resources, Mr. Rosedahl said.
But Mr. Wolper said that all types of firms might benefit from a principles-based approach.
“It gives an opportunity to have a dialogue” with regulators, he said. “It should benefit everybody if you can push back and ... explain the circumstances” to show that a principle wasn’t violated.
“On balance, with principles-based rules, you have a better opportunity to apply them to a particular situation,” Mr. Gorman said, which should help the industry improve compliance and achieve best practices.
