McGill Law Journal ~ Revue de droit de McGill
PRINCIPLES-BASED SECURITIES REGULATION IN THE
WAKE OF THE GLOBAL FINANCIAL CRISIS
Cristie Ford*
The recent global financial crisis contains
cautionary lessons about the risks associated
with principles-based regulation when it is not
reinforced by an effective regulatory presence.
Our response to the crisis, however, should not
be a rush to enact more rules-based regulatory
approaches. On the contrary, principles-based
securities regulation offers more viable solu-
tions to the challenges that such a crisis pre-
sents for contemporary financial markets regu-
lation.
The author draws on the lesson of the
global financial crisis to identify three critical
factors for effective principles-based securities
regulation. First, regulators must have the nec-
essary capacity in terms of numbers, access to
information, and expertise in order to act as an
effective counterweight to industry. Second,
regulation needs to grapple with the impact of
complexity on financial markets and their regu-
lation. Third, increased diversity among regula-
tors and greater independence from industry
are required to avoid conflicts of interest, over-
reliance on market discipline, and groupthink.
The paper calls for a continuing commitment to
principles-based regulation, accompanied by
meaningful enforcement and oversight.
La rcente crise financire mondiale nous
invite tirer une leon de prudence par rapport
aux risques associs une rglementation fon-
de sur des principes lorsque cette rglementa-
tion nest pas renforce par une prsence rgle-
mentaire efficace. Nous ne devrions toutefois
pas nous empresser dadopter davantage de r-
glementations fondes sur des rgles. Au
contraire, la rglementation des valeurs mobi-
lires base sur des principes offre des solutions
plus viables aux dfis que pose une telle crise.
En se basant sur les leons tires de la cri-
se financire mondiale, lauteure identifie trois
facteurs critiques pour assurer lefficacit dune
rglementation des valeurs mobilires fonde
sur des principes. Premirement, les organis-
mes rgulateurs doivent disposer des moyens
ncessaires en termes deffectifs, daccs
linformation et dexpertise sils veulent contre-
balancer lindustrie de faon efficace. Deuxi-
mement, la rglementation doit tre aux prises
avec limpact de la complexit sur les marchs
financiers et sur leur rglementation. Troisi-
mement, une plus grande diversit des orga-
nismes de rglementation et une plus grande
indpendance face lindustrie sont requises
pour viter les conflits dintrts, la confiance
excessive en la discipline du march et la pen-
se de groupe . Larticle appelle un engage-
ment continu envers la rglementation fonde
sur des principes, accompagne dune applica-
tion et dune surveillance significatives.
* Assistant Professor, Faculty of Law, University of British Columbia. Thanks to Julia
Black, Amy Cohen, Sharon Gilad, Donald Langevoort, Saule Omarova, Jim Park, David
Zaring, the anonymous reviewers enlisted by the McGill Law Journal for very helpful
comments on earlier drafts, and to Christina Wolf and Ami Iaria of the B.C. Securities
Commission for stimulating background conversations. Thanks, also, to Sam Cole (J.D.
2010, Faculty of Law, University of British Columbia) for exceptional research assis-
tance.
Citation: (2010) 55 McGill L.J. 257 ~ Rfrence : (2010) 55 R.D. McGill 257
Cristie Ford 2010
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Introduction
I.
II.
III.
Principles and Rules in Theory and Practice
A. A Time for Principles, A Time for Rules
B. Actual Principles-Based Securities Regulation:
Key Characteristics
The Global Financial Crisis
A. Risk and Reward: Devolution of Details to Industry
B. Enforced Self-Regulation and Principles-Based Regulation
Lessons Learned and Steps Forward
A. Four Points on Regulatory Capacity
1. Lesson One: Effective Regulatory Capacity Requires
Adequate Number of Staff
2. Lesson Two: Regulators Must Have Transparent and
Reliable Information about Industry
3. Lesson Three: Regulators Must Independently Scrutinize
Information
4. Lesson Four: Regulators Must Have Healthy Skepticism
about Industry
B. Complexity and Prophylactic Rules
C. Building Independence and Diversity into the Regulatory
Architecture
Conclusion
PRINCIPLES-BASED SECURITIES REGULATION 259
Introduction
These remain early days to try to assess the impact of the global fi-
nancial crisis (GFC) and subsequent regulatory reform efforts on national
and transnational financial markets regulation. That said, it is important
to continue to assess events on the fly given how quickly reform efforts
are evolving, how uncertain the future continues to be, and how pressing
the need is to implement reforms in Canada and abroad.
This paper considers a particular aspect of regulatory design: princi-
ples-based regulation. It seeks to re-examine (and indeed to restate the
case for) principles-based securities regulation, in light of the GFC and re-
lated developments. It argues against an overly hasty rush to more rules-
based formulations. Prior to the onset of the crisis, the concept of more
principles-based financial regulation was gaining traction in regulatory
practice and policy circles.1 In Canada, steps were being taken to develop
more principles-based securities regulation under the leadership of a pro-
posed new national securities regulator. The federal governments Expert
Panel on Securities Regulation (Expert Panel), chaired by the Honourable
Tom Hockin, was struck in February 2008 with a mandate to provide in-
dependent recommendations on how to improve the structure, content,
and enforcement of securities regulation in Canada. It released its final
report on 12 January 2009, recommending inter alia that Canada adopt a
more principles-based approach.2 On 22 June 2009, Doug Hyndman, long-
time Chair of the British Columbia Securities Commission (BCSC), was
appointed to a two-year term as chair of Canadas transition office for a
new national securities regulator.3 Hyndman, along with Vice Chair
1 See U.K., Financial Services Authority, Principles-Based Regulation: Focusing on the
Outcomes That Matter (London, U.K.: Financial Services Authority, 2007), online: Fi-
nancial Services Authority
History of the 2004 B.C. Securities Legislation, online: British Columbia Securities
Commission
New Governance, Compliance, and Principles-Based Securities Regulation (2008) 45
Am. Bus. L.J. 1 at 12, n. 45 [Ford, New Governance]; Julia Black, Martin Hopper &
Christa Band, Making a Success of Principles-Based Regulation (2007) 1 L. & Finan-
cial Markets Rev. 191 [Black, Hopper & Band, Making a Success]. Cf. Lawrence A.
Cunningham, A Prescription to Retire the Rhetoric of Principles-Based Systems in
Corporate Law, Securities Regulation, and Accounting (2007) 60 Vand. L. Rev. 1411
[Cunningham, Retire the Rhetoric].
2 Canada, Expert Panel on Securities Regulation, Creating an Advantage in Capital
Markets: Final Report and Recommendations (Ottawa: Department of Finance, 2009) at
17, online: Expert Panel on Securities Regulation
Panel, Capital Markets].
3 Canada, Department of Finance, News Release, 2009-064 Minister of Finance An-
nounces Launch of Canadian Securities Regulator Transition Office (22 June 2009),
260 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
Brent Aitken, has been the driving force behind the BCSCs principles-
based approach and this experience will inevitably inform his approach to
his new role.
In the interim between the Expert Panels creation and its final re-
port, of course, global credit markets froze, stock market values went into
free fall, Wall Street investment banks collapsed, major financial institu-
tions were bailed out on an unprecedented scale, and financial regulatory
systems internationally were cast into doubt.4 A flurry of ambitious re-
form proposals followed. In March 2009, Lord Adair Turner released the
Turner Review: A Regulatory Response to the Global Banking Crisis in the
United Kingdom,5 and major regulatory reform for financial markets has
been proposed in both the United Kingdom and the United States.6 Sev-
eral major domestic and international policy bodies7 and a number of
scholars8 have contributed to the conversation. Along with such reform
online: Department of Finance Canada
is also seeking a reference opinion from the Supreme Court of Canada on the constitu-
tionality of a national securities regulator. See Steven Chase & Rhal Sguin, Ottawa
sets off constitutional battle over regulator The Globe and Mail (17 October 2009) A1.
4 For a timeline of the crisis, see R.M. Schneiderman, A Year of Financial Turmoil The
(11 September 2009), online: The New York Times
New York Times
5 U.K., Financial Services Authority, The Turner Review: A Regulatory Response to the
Global Banking Crisis (London, U.K.: Financial Services Authority, 2009), online: Fi-
nancial Services Authority
6 See e.g. U.S., Department of the Treasury, Financial Regulatory Reform: A New Foun-
dation: Rebuilding Financial Supervision and Regulation (2009), online: Financial Sta-
bility for the American Economy
the Treasury, Financial Regulatory Reform]; U.K., Her Majestys Treasury, Reforming
Financial Markets (London, U.K.: Her Majestys Stationery Office, 2009), online: Her
Majestys Treasury
7 See e.g. Switzerland, Bank for International Settlements, 79th Annual Report: 1 April
200831 March 2009, online: Bank for International Settlements
Ana Carvajal et al., The Perimeter of Financial Regulation, IMF Staff Position Note
(SPN/09/07), online: International Monetary Fund
8 See e.g. John C. Coffee Jr. & Hillary A. Sale, Redesigning the SEC: Does the Treasury
Have a Better Idea? (2009) 95 Va. L. Rev. 707; Luigi Zingales, A New Regulatory
Framework: Three Agencies, Based on the Three Main Goals of Financial Regulation
City Journal 19:2 (Spring 2009), online: City Journal
Others have sounded more cautionary notes about the rush to reform. See generally
Luca Enriques, Regulators Response to the Current Crisis and the Upcoming Reregu-
lation of Financial Markets: One Reluctant Regulators View (2009) 30 U. Pa. J. Intl L.
1147 (arguing that reforms are driven by public relations concerns); Saule Omarova &
Adam Feibelman, Risks, Rules, and Institutions: A Process for Reforming Financial
Regulation (2009) 39 U. Mem. L. Rev. 881 (raising concerns that reforms initiated dur-
ing a period of crisis management may not be optimal, and suggesting a careful three-
step approach to regulatory reform).
PRINCIPLES-BASED SECURITIES REGULATION 261
proposals came a turn, in some quarters, against principles-based regula-
tion.9
This paper argues that the GFC does not discredit principles-based
regulation, as this form of regulation is properly understood. On the con-
trary, principles-based securities regulation remains a viable and even
necessary policy option: it offers solutions to the practical and theoretical
challenges that the GFC presents to contemporary financial markets
regulation. What the crisis actually demonstrates is how damaging a lais-
sez-faire mindset on the part of the regulators can be to any form of regu-
lation, including principles-based regulation. Adopting principles-based
regulation does not mean doing away with rules. Rather, it is a particular
approach to structuring regulation that includes rules. It gives legisla-
tures the power to set high-level regulatory goals and outcomes, and
leaves the articulation of processes and details to front-line regulators in
collaboration with industry itself. Fundamental to principles-based regu-
lation is the development of a functional and effective interpretive com-
munity that includes industry participants, regulators, and other stake-
holders in ongoing communication around the content of regulatory prin-
ciples.
The experience of the GFC is a lesson about what happens when regu-
lators fail to participate actively and skeptically in that interpretive com-
munity. Principles-based regulation is premised on concepts of co-
regulation, or enforced self-regulation, but the GFC illustrates how
such models can slide into bare self-regulation in the absence of meaning-
ful regulatory oversight and engagement. Our response should not be to
re-embrace more rules-based regulatory approaches. Financial markets
are too fast-moving and complex to be regulated in a command-and-
control manner, and the risk of inviting Enron-style loophole behaviour
associated with rules is too great. Instead, we can draw on the lesson of
the GFC to identify three critical success factors for effective principles-
based securities regulation.
First, regulators need to have the necessary capacity in terms of num-
bers, access to information, expertise, and perspective to act as an effec-
tive counterweight to industry as the content of principles is developed.
Second, regulation needs to grapple with the impact of complexity on fi-
nancial markets and their regulation. Effective regulation should reflect
an appropriately granulated understanding of different kinds of complex-
ity and their effects, and reject the notion that innovation is by definition
9 See e.g. Felix Salmon, The US move to principles-based regulation Reuters (17 June
2009), online: Reuters
room, he is in a minority of one for continuing to advocate for principles-based regula-
tion).
262 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
beneficial. It may also mean considering whether some regulatory re-
quirements (e.g., capital requirements) are best cast as bright-line pro-
phylactic rules, which at least in the short term may limit complexity
and conserve regulatory resources. Finally, this paper suggests that the
lack of diversity and independence among regulators and industry may
have contributed to conflicts of interest, overreliance on market discipline,
and groupthink in the run-up to the GFC. The appropriate response
may be a move away from an expertise-based, technocratic model toward
a more broadly participatory one. The paper closes with a call for a con-
tinuing commitment to principles-based regulation, accompanied by the
indispensable implementation piecemeaningful enforcement and over-
sight.
I. Principles and Rules in Theory and Practice
Principles-based capital markets regulation has been a salient policy
topic in recent years in many jurisdictions including Canada, the United
States, and the United Kingdom.10 In terms of actual practice, the U.K.
Financial Services Authority (FSA) has been a thought leader on princi-
ples-based financial regulation.11 In Canada, the province of British Co-
lumbia tried to promulgate a new, more principles-based Securities Act in
2004. Although that proposed act has not been brought into force, the
10 See e.g. Crawford Panel on a Single Canadian Securities Regulator, Blueprint for a Ca-
nadian Securities Commission, Final Paper,
online: Crawford Panel
tive advantage globally, it is desirable to have as much principles-based regulation as is
feasible at 12) [Crawford Panel, Blueprint]; Task Force to Modernize Securities Legis-
lation in Canada, Canada Steps Up, vol. 1, online: Task Force to Modernize Securities
Legislation in Canada
mending that securities regulation be based at every available opportunity on clearly
enunciated regulatory principles which do not need a detailed set of interventionist
rules for sound implementation at 50); U.S., Department of the Treasury, Blueprint for
a Modernized Financial Regulatory Structure (Washington: Department of the Treas-
ury, 2008) at 106-16 (recommending a merged entity of Commodity Futures Trading
Commission (CFTC) Securities and Exchange Commission (SEC) that adopts the
CFTCs principles-based approach); Committee on Capital Markets Regulation, Interim
Report (30 November 2006) at 8, online: Committee on Capital Markets Regulation
should move to a more risk-based and principles-based process).
11 FSA, Focusing on the Outcomes, supra note 1; Black, Hopper & Band, Making a Suc-
cess, supra note 1; Cristie Ford, Principles-Based Securities Regulation (2009),
online: Expert Panel on Securities Regulation
of the FSA regulatory approach as: a hybrid structure of rules and principles; consisting
of extensive consultation with industry actors; a management-based, outcome-oriented,
and risk-based regulatory approach; and an emphasis on compliance and supervision as
opposed to ex post enforcement.
PRINCIPLES-BASED SECURITIES REGULATION 263
BCSC has since adopted a more principles-based approach to how it ad-
ministers its existing act.12 Derivative products in the United States and
Canada also tend to be regulated in a more principles-based manner.13
Most recently in Canada, as noted above, the Expert Panel chaired by the
Honourable Tom Hockin has recommended that a proposed national secu-
rities regulator adopt a more principles-based approach to securities regu-
lation.14
At the theoretical level, the distinction between rules and principles,
and their relative advantages and disadvantages, have been quite well
canvassed.15 Generally speaking, rules are considered to have the advan-
tages of being more precise and certain, but the consequent disadvantages
of being potentially rigid, reactive, and insensitive to context and there-
fore inevitably over- or underinclusive. They may also promote or permit
loophole behaviour, and be more easily gamed by sophisticated actors.
In comparison, principles are more flexible, more sensitive to context, and
therefore potentially fairer when applied. On the other hand, principles
can be uncertain, unpredictable, and difficult and costly to interpret. Be-
cause they allocate substantial decision-making to front-line decision-
12 See British Columbia, Submission of the British Columbia Securities Commission,
online: British Columbia Securities Commission
mission].
13 See e.g. Walter Lukken, Its a Matter of Principles (Lecture delivered at the Univer-
sity of Houstons Global Energy Management Institute, 25 January 2007), online:
Commodity Futures Trading Commission
Act, 1st Sess., 38th Leg., Quebec, 2008 (assented to 20 June 2008), S.Q. 2008, c. 24
[QDA].
14 Expert Panel, Capital Markets, supra note 2 at 22. The Expert Panel also developed
draft legislation for its national securities regulator. See Draft Securities Act, online:
Expert Panel on Securities Regulation
Securities Act].
15 See especially Carol M. Rose, Crystals and Mud in Property Law (1988) 40 Stan. L.
Rev. 577; Kathleen M. Sullivan, The Justices of Rules and Standards, Foreward, The
Supreme Court, 1991 Term, (1992) 106 Harv. L. Rev. 22; Pierre Schlag, Rules and
Standards (1985) 33 UCLA L. Rev. 379; Frederick Schauer, The Tyranny of Choice
and the Rulification of Standards (2005) 14 J. Contemp. Legal Issues 803; Antonin
Scalia, The Rule of Law as a Law of Rules (1989) 56 U. Chicago L. Rev. 1175; Louis
Kaplow, Rules versus Standards: An Economic Analysis (1992) 42 Duke L.J. 557;
Duncan Kennedy, Form and Substance in Private Law Adjudication (1976) 89 Harv.
L. Rev. 1685; Cass R. Sunstein, Problems with Rules (1995) 83 Cal. L. Rev. 953.
Scholars working specifically in securities regulation, accounting, and tax have looked
at how rules or principles affect industry behaviour, and how to choose between rules
and principles in particular situations. See e.g. William W. Bratton, Enron, Sarbanes-
Oxley and Accounting: Rules versus Principles versus Rents (2003) 48 Vill. L. Rev.
1023; James J. Park, The Competing Paradigms of Securities Regulation (2007) 57
Duke L.J. 625; Mark W. Nelson, Behavioral Evidence on the Effects of Principles- and
Rules-Based Standards (2003) 17 Accounting Horizons 91.
264 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
makers, they can also permit arbitrary conduct and regulatory overreach-
ing.
A simple example that has been used to illustrate the difference be-
tween rules and principles involves speed limits.16 A speed limit framed as
a rule will prohibit driving faster than a precise numerical limit (e.g.,
ninety kilometres per hour). The rule sets out, in advance and with preci-
sion, the boundary of acceptable conduct. This leaves very little discretion
to the front-line decision-maker, who needs only to determine whether the
car in question was exceeding that predetermined and non-negotiable
limit. By contrast, a speed limit framed in principles-based terms would
be something like a prohibition on driving faster than is reasonable and
prudent in all the circumstances. This was, in fact, how the state of Mon-
tana framed its speed limits for several years. The non-numerical rea-
sonableness standard has the ability to take contextroad and environ-
mental conditions, time of day, drivers experience, etc.into account. As
a consequence, it also allocates substantial decision-making power to the
front-line decision-maker, who must use her judgment to determine what
reasonable and prudent driving constitutes in all the circumstances. It
should be emphasized that speed limits involve very different background
conditions than securities regulation does in terms of (among other
things) the complexity of the subject matter, the scope for and fluidity of
potential wrongdoing, and the expertise of the front-line decision-maker.17
The two are not really analogous. That said, it is noteworthy that Mon-
tana repealed its principles-based speed limit in 1999, after the Montana
16 See Kaplow, supra note 15 at 559-60; Sullivan, supra note 15 at 58-59.
17 This paper contests the idea that rules are more certain than a principles-based system
that is supported by a well-functioning interpretive community and adequate regula-
tory capacity. See Part III.B (Complexity and Prophylactic Rules) below. However, it
does not contest the idea that rules are more certain and principles more flexible in the
abstract (i.e., in the absence of a mechanism such as a careful, structured, ongoing mul-
tiparty dialogue for working out the content of principles in a responsible manner). Of
course, even under ideal conditions, application will influence theory in direct and indi-
rect ways. For example, through application to real-life situations, principles acquire
specific content on a constant, ongoing basis. Decision makers may interpret a rule up
or down (making it look more like a principle or more like a detailed rule) to make it
fit a specific situation. Principles, as well, when interpreted by multiple human beings
in multiple situations, may lose their high-level character, slide closer to rules, get fuzzy
around the edges, and otherwise drift and change (see e.g. Schauer, supra note 15).
Therefore, whether a regulatory system fosters clarity and predictability, for example,
is not exclusively related to whether it is rules-based or principles-based. The real ques-
tion is whether regulators and regulatees have a shared understanding of what the
regulations entail.
PRINCIPLES-BASED SECURITIES REGULATION 265
Supreme Court held it to be so vague as to violate the Due Process clause
of the state constitution.18
The terms are also useful at the systemic level, for describing practical
regulatory approaches.19 No workable system consists entirely of rules or
of principles, but different systems can be comparatively more rules- or
principles-baseda point the FSA has made by calling its world-leading
approach simply more principles-based.20 Statutory drafters and regula-
tors can choose to regulate the same issues by way of different proportions
of detailed checklists, bright-line rules, or open-ended statements of objec-
tives.21 In the context of statutory drafting, principles-based regulation
means legislation that contains more directives that are cast at a higher
level of generality. A principles-based system looks to principles first and
uses them, instead of detailed rules, wherever feasible. When confronted
with a new situation, a principles-based system first determines whether
it can be regulated under existing principles, and it resists the temptation
to create new, purpose-built rules.22 Yet even within a system that is gen-
erally principles-based, rules will always serve an essential purpose in
enhancing clarity at key junctures, and buttressing ex post enforceability.
18 See State of Montana v. Rudy Stanko, 1998 MT 321, 974 P.2d 1139, 292 Mont. 214. On
the potential vagueness of principles in the securities law enforcement context, see
Ford, Securities Regulation, supra note 11 at 31-34.
19 Cf. Cunningham, Retire the Rhetoric, supra note 1; Ford, New Governance, supra
note 1 at 12, n. 45.
20 FSA, Focusing on the Outcomes, supra note 1 at 4-5. For the sake of simplicity, this pa-
per will simply refer to principles-based and rules-based approaches.
21 See Black, Hopper & Band, Making a Success, supra note 1 (identifying the distinc-
tion between bright-line rules and detailed rules).
22 See e.g. British Columbia Securities Commission, 08/09 Annual Report, online: British
Columbia Securities Commission
GFC as follows:
To the extent that market professionals misrepresented the features or
risks of investment products, or sold unsuitable investments to unsophisti-
cated investors, we already have rules against that type of conduct. Rather
than devising new rules for what is already illegal, we need to maintain and
adapt our compliance and enforcement processes to detect and deter this ac-
tivity.
Any new rule, however, should be based on thorough analysis that shows
it to be the best option for achieving a desired regulatory outcome. All too of-
ten, policymakers start with the presumption that a situation demands new
rules, and they lose focus on other options like enforcing existing require-
ments that could deal with the problem more quickly and effectively (ibid. at
3).
This is not to say that we should not consider rule changes …
266 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
Rules and principles are also best understood as points on a contin-
uum rather than discrete concepts, and there is a good deal of overlap and
convergence among them.23 Any complex regulatory system will be (and
should be) an amalgam of rules and principles. Here, the public percep-
tion of principles-based regulation exhibits considerable confusion. For
example, around eighty-eight per cent of the seventy-five written submis-
sions from stakeholders to the Expert Panel were in favour of principles-
based regulation.24 But of these submissions, a substantial number
seemed to assume that principles-based and rules-based regulation were
at opposite extremes, and that a move to a more principles-based system
meant substantially eliminating rules no matter how efficient or neces-
sary they might be. Several stakeholders argued forcefully against exclu-
sively principles-based or rules-based approaches, even though no such
drastic move was being proposed.
A. A Time for Principles, A Time for Rules
Almost three decades ago, Colin Diver discussed what he called the
optimal precision of administrative rulesmeaning, the degree of speci-
ficity in statutory or regulatory drafting that would best avoid the worst
problems of either imprecision or rigidity.25 He identified three elements
of regulatory precision: transparency (i.e., the words chosen have well-
defined and universally accepted meanings within the relevant commu-
nity); accessibility (i.e., the law can be applied to concrete situations with-
out excessive difficulty); and congruence (i.e., the substantive content
communicated by the words produces the desired behaviour). Not surpris-
ingly, Diver found that no single sweet spot of precision exists. On some
questions, flexibility and sensitivity to a particular context will be more
important than certainty or the need to limit discretion. More general,
principles-based drafting would make sense in that context. Elsewhere, a
different mix would be called for. Diver also pointed out that these quali-
ties are difficult to measure, and there are often direct trade-offs between
23 See e.g. Russell B. Korobkin, Behavioral Analysis and Legal Form: Rules vs. Stan-
dards Revisited (2000) 79 Or. L. Rev. 23; Neil MacCormick, Reconstruction after De-
construction: A Response to CLS (1990) 10 Oxford J. Legal Stud. 539 at 545; Frederick
Schauer, The Convergence of Rules and Standards (2003) N.Z.L. Rev. 303 at 305; Ian
Ayres, Preliminary Thoughts on Optimal Tailoring of Contractual Rules (1993) 3 S.
Cal. Interdisciplinary L.J. 1 at 18.
24 See Written Submissions, online: Expert Panel on Securities Regulation
25 Colin Diver, The Optimal Precision of Administrative Rules (1983) 93 Yale L.J. 65.
Diver does not use the terms rules and principles, but his understanding of precision
maps neatly onto the theoretical rules-versus-principles scholarship discussed above.
PRINCIPLES-BASED SECURITIES REGULATION 267
them. Therefore, settling upon a particular mix between rules and princi-
ples requires that choices be made, and public priorities be established.
In particular, where these lines are drawn depends on public priorities
that the legislator has the mandate to establish. For example, a legislator
who is concerned about regulatory overreach or lack of transparency in a
particular area would see to it that the regulator had very little discretion
(i.e., that expectations are cast as rules rather than principles and are en-
shrined in a statute) when it comes to such things as access to informa-
tion, the handling of complaints, or accountability to Parliament. A legis-
lator concerned about individual rights would limit discretion (i.e., would
craft rules not principles) regarding hearings, procedural fairness, and
participation or consultation rights. A legislator concerned about ensuring
that the regulator can keep up with fast-moving events would give that
regulator principles, not rules, to work with, and would devolve substan-
tial decision-making to the regulators rule-making power. A legislator
concerned about ensuring a high correlation between regulatory goals and
effective application to particular cases would ensure that the regulator
had the power to flesh out the content of principles on a rolling basis,
rather than trying to draft specific details in advance.
Important external considerations also come into play. For example,
how much scope does the legislator want to leave to the interpretation of
regulators, courts, or tribunals? Where does existing regulatory practice
(whether principles-based or rules-based) seem to be well-established, to
be working well, and to have created expectations on which stakeholders
rely?26 Would a particular drafting approach foster harmonization be-
tween existing regulatory regimes, or nudge regulatory practice in a de-
sirable new direction? Are some issues particularly important to the
proper functioning of Canadian capital markets (i.e., regulating effectively
the many small, closely held public companies, or addressing the ru-
moured Canadian market discount27), which call for well-tailored and
26 See e.g. Lawrence A. Cunningham, Principles and Rules in Public and Professional Se-
curities Law Enforcement: A Comparative U.S.Canadian Inquiry in Task Force,
Canada Steps Up, supra note 10, vol. 6, 253 at 299 (finding that in their enforcement
actions, the National Association of Securities Dealers and the IDAnow the Financial
Industry Regulatory Assocation and Investment Industry Regulatory Organization of
Canada (IIROC)invoke certain principles rather than existing rules).
27 For a discussion of the Canadian market discount, see e.g. The Hon. Peter de C. Cory,
& Marilyn L. Pilkington, Critical Issues in Enforcement in Task Force, Canada Steps
Up, supra note 10, vol. 6, 165,; Utpal Bhattacharya, Enforcement and its Impact on
Cost of Equity and Liquidity of the Market in Task Force, Canada Steps Up, supra
note 10, vol. 6, 131; Crawford Panel, Blueprint, supra note 10 at 12. For a review of
some recent research challenging the existence of the Canadian discount, see Ccile
268 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
highly adaptivethat is, principles-basedsolutions? On what specific is-
sues does the political will exist to move decisively away from the status
quo? What messages does Canada, through its regulatory regime, want to
send internationally? All of this requires that policy-makers develop a set
of criteria reflecting policy calculations for deciding when to use rules and
when to use principles.
Context also matters. An appropriate balance between rules and prin-
ciples in securities regulation may look quite different from the appropri-
ate balance in other regulatory arenas. The nature of the industry being
regulated, the roles of the various players in it, and the risks associated
with that area of conduct will inform the regulatory design process.28 It is
relevant that securities regulation is a disclosure-based system that relies
heavily on ensuring reasonable access to information as a means for pro-
tecting investors. This suggests that congruence is important in this con-
text: core definitions of materiality and disclosure should be broad and
principles-based. Preventing fraud and minimizing cosmetic compliance
and loophole behaviour are other areas where the over- or underinclu-
siveness of rules is particularly problematic. This is the rationale for
broad statutory definitions of fraud and commissions sweeping public in-
terest powers.29 Financial markets are also complex, fast-moving envi-
ronments marked by constant product-level innovation. Principles are
preferable in this environment when underpinned by effective informa-
tion-gathering and analytical mechanisms,30 since detailed rules may only
add to complexity and opacity.31 Principles also make sense where a flexi-
ble approach is needed to ensure good corporate conductfor example,
with regard to internal compliance processes, corporate culture, or risk
assessment by management. Like the deference accorded to securities
Carpentier, Jean-Franois LHer & Jean-Marc Suret, On the Competitiveness of the
Canadian Stock Market (2009) 24 B.F.L.R. 287 at 300-303.
28 See also Black, Hopper & Band, Making a Success, supra note 1 at 200-201.
29 See Committee for the Equal Treatment of Asbestos Minority Shareholders v. Ontario
(Securities Commission), 2001 SCC 37, [2001] 2 S.C.R. 132 at para. 41, 199 D.L.R. (4th)
577 [Asbestos Minority Shareholders]; Anita Anand, Carving the Public Interest Juris-
diction in Securities Regulation: Contributions of Justice Iacobucci (2007) 57 U.T.L.J.
293. Even considering the substantial deference to securities commissions, courts (and
commissions through their policies) should establish standards and explicit rationales
for the application of public interest powers to ensure that they are exercised in a pre-
dictable way, as well as to ensure that those applying them consider relevant factors, do
not consider inappropriate factors, and behave fairly.
30 See discussion in Part III.A (Four Points on Regulatory Capacity) below.
31 See Steven L. Schwarcz, Regulating Complexity in Financial Markets (2010) 87
Wash. U. L. Rev. 211 [Schwarcz, Regulating Complexity]. Schwarcz cites the work of
Richard Bookstaber (see ibid. at 224, n. 118).
PRINCIPLES-BASED SECURITIES REGULATION 269
commissions under administrative law,32 principles-based regulation also
reflects legislative faith in regulatory expertise, objectivity, fairness, and
capacity.
One can also identify situations where rules may make particular
sense in securities regulation. Consistency in form is important in disclo-
sure documents, for example, to make it easier for potential investors to
compare investments.33 Prospectus requirements should therefore contain
detailed form requirements. Securities commissions are also powerful
administrative agencies, with broad mandates and the ability to impose
heavy sanctions. To uphold the rule of law, process requirements associ-
ated with investigatory powers and enforcement conduct should be clearly
set out. Provisions around notice, rights to hearings, time limits, and pro-
cedural fairness should presumptively be more rules-based. Rules also
make sense where the sheer cost of applying a principle outweighs the
principles flexibility benefitsfor example, where the regulator needs to
manage large numbers of relatively small matters.34 Accessibility is also
important if lay individuals will be interpreting the law on their own. This
is a concern in capital markets like Canada, within which many small ac-
tors with limited compliance resources operate.35 During a transitional
stage between rules-based and principles-based regulation, for example,
maintaining legacy rules may help keep compliance costs down. Finally,
rules may be appropriate in situations where the regulator or statutory
drafter is confident that it can devise an easy-to-describe, easy-to-verify,
and fairly stable rule-based requirement that will serve as an effective
32 See Pezim v. British Columbia (Superintendent of Brokers), [1994] 2 S.C.R. 557 at 596,
114 D.L.R. (4th) 385 [Pezim]; Asbestos Minority Shareholders, supra note 29 at para. 49.
33 As technology improves (for example through the mandated use of Extensible Business
Reporting Language (XBRL)), consistency in form may be seen as less important than
ensuring the most effective disclosure possible. See An Introduction to XBRL, online:
XBRL International
34 Kaplow, supra note 15. Kaplow also argues that the determining factor should be the
frequency of regulated action. Where frequency is low, standards are preferable; where
frequency is high, the costs of promulgating rules are justifiable (ibid. at 621). Trading
rules are a good example of a rules-based treatment of high-frequency events.
35 See generally Christopher Nicholls, The Characteristics of Canadas Capital Markets
and the Illustrative Case of Canadas Legislative Regulatory Response to Sarbanes-
Oxley in Task Force, Canada Steps Up, supra note 10, vol. 4, 127. After the transitional
stage, principles may prove much easier to implement than rules for smaller actors.
Nicholls suggests that the small size of Canadian small-cap and micro-cap companies
implies a more flexible regime, rather than a more rules-bound one (ibid. at 162).
270 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
proxy for a broader regulatory goal, such as ensuring good corporate con-
duct.36
B. Actual Principles-Based Securities Regulation: Key Characteristics
In producing a research report on principles-based regulation for the
Expert Panel,37 I reviewed and compared the following statutes with a
view to determine how principles-based regulation differed from more
rules-based regulation at the level of statutory drafting: (1) the Ontario
Securities Act (OSA);38 (2) Bill 38, the proposed British Columbia Securi-
ties Act, and associated proposed securities rules (collectively, the B.C.
Model);39 (3) the Quebec Derivatives Act (QDA);40 (4) the United Kingdom
Financial Services and Markets Act (FSMA);41 and (5) the United States
Commodity Futures Modernization Act (CFMA).42 The OSA was chosen to
represent the legislative status quo across Canada. The Quebec statute
and the B.C. Model are generally understood to be more principles-based.
The FSMA was not explicitly principles-based when it was drafted, but
the FSA adapted its statutory mandate to develop a world-leading model
of principles-based regulation.43
36 Clayton P. Gillette, Rules, Standards, and Precautions in Payment Systems (1996) 82
Va. L. Rev. 181.
Precise directives are more appropriate when we have the greatest confidence
in our capacity to inform target actors (those at whom legal directives are
aimed), to describe antisocial forms of behavior (so that target actors know the
scope of permitted and prohibited activity), and to recognize the occurrence of
such behavior (for purposes of enforcement). Uncertainty about any of these
factors warrants the use of less precise formulations (ibid. at 185).
37 See Ford, Securities Regulation, supra note 11.
38 Securities Act, R.S.O. 1990, c. S.5 [OSA].
39 Bill 38, Securities Act, 5th Sess., 37th Leg., British Columbia, 2004 (assented to 13 May
2004), S.B.C. 2004, c. 43, s. 203 [B.C. Bill 38]; Securities Rules (proposed) (21 June
2004) at Rules 93-104, 114-16, online: British Columbia Securities Commission
40 QDA, supra note 13.
41 Financial Services and Markets Act 2000 (U.K.), 2000, c. 8 [FSMA].
42 Commodity Futures Modernization Act of 2000, 7 U.S.C. 1 (2000) [CFMA]. The report
also occasionally considered the B.C. Securities Act that is in force.
43 See Julia Black, Forms and Paradoxes of Principles Based Regulation (LSE Law, So-
ciety and Economy Working Paper Series, WPS 13-2008, October 2008) at 12, online:
tinguishes among the following: formal principles-based regulation, meaning princi-
ples in the rule books; substantive principles-based regulation, which has some of the
operational elements of principles-based regulations but not principles on the rule
books; full principles-based regulations, exhibiting both principles in the rule books
and a principles-based operational approach; and polycentric principles-based regula-
PRINCIPLES-BASED SECURITIES REGULATION 271
Without claiming to be comprehensive, the report identified some
overarching themes at the level of statutory drafting.44 There were several
commonalities across regulatory schemes, regardless of whether the re-
gime was more rules- or principles-based, and the Draft Securities Act
issued by the Expert Panel (based as it was on the existing Alberta Secu-
rities Act)45 reflects the same choices. For example, disclosure and fraud
provisions tend to be drafted in a more principles-based manner because
these are areas where congruence is essential (i.e., the definition of fraud
must be able to capture even novel forms of fraudulent behaviour), and
loophole behaviour cannot be tolerated. Compliance provisions also tend
to be principles-based, for they require registrants to maintain effective
systems and controls to manage the risks associated with their busi-
nesses, and prevent and detect internal wrongdoing.46 More detailed rules
cover topic areas where power is uneven and transparency is not other-
wise ensured, or where fairness and basic administrative law underpin-
nings are at stake. For example, every securities scheme has provisions
that govern administrative proceedings such as hearings and investiga-
tions, and they are all substantially process-based and rule-oriented.47
The statutes are less detailed in areas that change quickly or that require
specialized expertise. In general, these overarching commonalities accord
tions, which is full principles-based regulations with the additional element of incorpo-
rating third parties into the regulatory process.
44 Note that the report compared statutes only. A comprehensive comparison of these
regulatory regimes is neither feasible nor very helpful, given the number of different
factors that go into the drafting of any statute. Just as importantly, national and multi-
lateral instruments, regulations, and rules play central roles in real-life securities regu-
lation. On this larger plane, this report concurs generally with Professor Stphane
Rousseaus description of which aspects of securities regulation are rule-based and
which are principles-based, as referred to in the Brief submitted by the Autorit des
marchs financiers to the Expert Panel on Securities Regulation. See Autorit des
marchs financiers, Single Regulator: A Needless Proposal (Brief submitted to the Ex-
pert Panel on Securities Regulation, July 2008) at 26-27, online: Autorits des marchs
financiers
45 See Draft Securities Act, supra note 14 at 3; Securities Act, R.S.A. 2000, c. S-4.
46 But see QDA, supra note 13, cls. 26-31, 61-62. See also British Columbia Securities
Commission, Registration Requirements and Exemptions, National Instrument 31-103
(effective 28 September 2009) at 35 (Part 11), online: British Columbia Securities
Commission
47 For the best examples here, see OSA, supra note 38, ss. 3.5, 8-9; B.C. Bill 38, supra note
39, cls. 65, 70(2)-70(3), 75. The FSMA and QDA do not contain direct analogues. Be-
cause the FSMA establishes an independent oversight body, the Financial Services and
Markets Tribunal, it treats administrative proceedings somewhat differently. However,
the process-based, rule-driven structure persists. See e.g. FSMA, supra note 41, s. 13.
The QDA is a more circumscribed statute that borrows many provisions from the Que-
bec Securities Act (R.S.Q. c. V-1.1), though it contains some process-based provisions
(see e.g. QDA, supra note 13, ss. 115-17).
272 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
with the Diver analysis as to where transparency, flexibility, or congru-
ence should be the dominant concerns.
The Expert Panel research report also identified particular ways in
which principles-based and rules-based regimes differ. Some differences
are essentially stylistic. For example, principles-based regulation is con-
sistent with a move toward plain-language drafting. Other differences,
while consistent with a principles-based regulatory philosophy, are not
essential to it. In particular, the proposed B.C. legislation originally imag-
ined much more streamlined processes in its proposals for firm-only regis-
tration and continuous market access.48 Another element common to the
principles-based statutes considered is the inclusion of a small number of
high-level principles guiding the conduct of regulated entities.49 Consis-
tently with the principles-based approach, these principles are left to be
translated into specific business-conduct expectations in context through
techniques such as administrative guidance, enforcement example, the
incorporation and dissemination of good or best practices, and ongoing
communication between regulator and registrant.50
The most profound structural differences between the principles-based
and rules-based statutes are found in two areas: (1) the proportion of deci-
sion-making and interpretive power that is explicitly left to be filled in
through the rule-making function rather than statutory drafting; and (2)
the proportion of outcome-oriented versus process-oriented statutory re-
quirements.
48 See B.C. Bill 38, supra note 39. Bill 38 would have replaced existing prospectus disclo-
sure rules, short form prospectus provisions, the entire exempt market transaction
structure, and existing continuous disclosure obligations (as they then were) with an
overarching Continuous Market Access structure. Continuous Market Access would
have required all companies accessing the British Columbia capital markets simply to
disclose all material information (here, replacing material fact and material
change) on a real-time basis. Other B.C. model innovations included firm-only registra-
tion (which was abandoned before the project as a whole was abandoned), secondary
market liability (which was later resurrected), and enhanced enforcement powers.
49 The FSA refers to its set of principles as the Principles for Businesses. See FSA, Hand-
book (Ref. Code PRIN), online: FSA Handbook Online
Bill 38 would have contained a code of conduct for dealers and advisers. See BCSC, Se-
curities Regulation That Works: The BC Model, Dealers and Advisers Guide, online:
British Columbia Securities Commission
and Advisers Guide]. The CFMA (supra note 42) and QDA (supra note 13) both refer to
their principles as Core Principles for Derivative Markets. Many of the principles con-
tained in B.C.s Code of Conduct have since found their way into the National Instru-
ment 31-103 (supra note 46), though it also contains detailed rules.
50 For a more detailed description of these techniques and their use in ascribing content to
regulatory principles, see Ford, Securities Regulation, supra note 11 at 9-13.
PRINCIPLES-BASED SECURITIES REGULATION 273
All four of the statutes studied grant rule-making power to the regula-
tor in question.51 To be clear, securities law statutes in every jurisdiction
contain notable principles-based provisions.52 In contrast to regulators in
other fields, securities regulators already have extensive notice-and-
comment rule-making powers and enjoy substantial deference from courts
on judicial review.53 As between rules-based and principles-based systems,
however, the difference lies in how much detail is provided in the statute,
and how much is left to be filled in through the Authoritys or Commis-
sions rule-making. The difference between a traditional, rules-based ap-
proach to statutory drafting, and the B.C. version of principles-based
drafting is strikingly illustrated in the Table of Concordance prepared by
BCSC staff in September 2004.54 Large portions of the Securities Act cur-
rently in force simply have no equivalent in the proposed B.C. legislation,
in large part because the proposed legislation allocates the authority over
more context-specific, detailed decision-making to the Commission, pur-
suant to its rule-making power.55
Consider, for example, Canadian prospectus requirements. Both On-
tario and British Columbia (under both the existing Securities Act and the
proposed legislation) require that issuers file a prospectus and obtain a
receipt for it before distributing or offering a security. The statutes over-
arching provisions are quite similar:56
51 See OSA, supra note 38, s. 143; B.C. Bill 38, supra note 39, s. 170; QDA, supra note 13,
ss. 174-75; FSMA, supra note 41, s. 138. Rule-making needs to be distinguished not
only from statutes, but also from regulations, which, though subordinate, must go
through the legislative process rather than be largely or entirely under the control of
the regulator.
52 See e.g. Securities Exchange Act of 1934, 15 U.S.C 78j (2000). See also Rule 10b-5-1, 17
C.F.R. 240.10b-5 (2009) promulgated thereunder.
53 See Pezim, supra note 32; Asbestos Minority Shareholders, supra note 29.
54 See British Columbia Securities Commission, Table of Concordance: Part I (Securities
Act, R.S.B.C. 1996, c. 418 to Securities Act, S.B.C. 2004, c. 43 (not in force)), online: Brit-
ish Columbia Securities Commission
dance].
55 See Securities Act, R.S.B.C. 1996, c. 418 [BCSA]. The other important factor was sub-
stantive reform under the proposed B.C. Model, especially including its Continuous
Market Access approach (B.C. Bill 38, supra note 39).
56 Ibid., ss. 18(1)-18(2); BCSA, supra note 55, ss. 61(1)-61(2); OSA, supra note 38, s. 53(1).
274 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
Bill 3857 (the proposed
B.C. legislation)
B.C. Securities Act58
(in force)
Ontario Securities Act59
18(1) A person must not make an offering of
a security unless a prospectus for the
security has been filed and the commis-
sion has issued a receipt for the pro-
spectus.
61(1) Unless exempted under this Act, a per-
son must not distribute a security
unless
(a) a preliminary prospectus and a
prospectus respecting the security
have been filed with the executive
director, and
(b) the executive director has issued
receipts for the preliminary pro-
spectus and prospectus.
(2) A preliminary prospectus and a pro-
spectus must be in the required form.
53(1) No person or company shall trade in a
security on his, her or its own account
or on behalf of any other person or com-
pany if the trade would be a distribu-
tion of such security, unless a prelimi-
nary prospectus and a prospectus have
been filed and receipts have been issued
for them by the Director.
Where the rules-based and principles-based approaches diverge, how-
ever, is in the additional details provided in the statute itself. In the OSA
and the existing BCSA, the general requirement above is accompanied by
additional provisions concerning, inter alia: amendments to preliminary
and final prospectuses (each of which receives distinct treatment); certifi-
cation requirements for issuers, directors, officers, underwriters, etc.; re-
ceipts; waiting periods; and distribution.60 By contrast, the proposed B.C.
legislation locates many of those issues within its proposed Securities
57 B.C. Bill 38, supra note 39.
58 BCSA, supra note 55.
59 OSA, supra note 38.
60 See ibid., ss. 57 (prospectus amendments), 58 (certificate by issuer), 59 (certificate un-
derwriter), 61 (prospectus receipt), 65 (waiting period), Part XVI (distribution); BCSA,
supra note 55, as at 2004, ss. 66 [repealed] (preliminary prospectus amendment), 67
[repealed] (prospectus amendment), 68 [repealed] (certificate of issuer), 69 [repealed]
(certificate of underwriter), 65 (prospectus receipt), 78 (waiting period), Part XI (distri-
bution).
PRINCIPLES-BASED SECURITIES REGULATION 275
Rules, instead of in the proposed statute.61 A similar shift toward greater
reliance on Commission rule-making powers is evident in the proposed
B.C. legislation around takeover and issuer bids, proxies, continuous dis-
closure, and primary market civil liability.62
The second major distinguishing feature of more principles-based leg-
islation is that it tends to be structured in a more outcome-oriented, as
opposed to process-oriented, manner. The notion of outcome-oriented
regulation is so connected to the principles-based approach that in its
submission to the Expert Panel, the BCSC expressed a preference for the
term outcomes-based rather than principles-based to describe its ap-
proach.63 Outcome-oriented regulation measures performance against
regulatory goals, whereas process-based regulation measures compliance
with detailed procedural requirements.64 For example, both the OSA and
61 See especially BCSC, Securities Rules, supra note 39 at Rules 93-104, 114-16.
62 One of the wrinkles concerns where each principles-based regime locates its core prin-
ciples. See Ford, Securities Regulation, supra note 11 at 60-65. British Columbia and
the FSA issued their Code/Principles through rule-making, while the CFMA (supra
note 42) and the QDA (supra note 13) chose to embed them directly into legislation. It
seems that nothing substantive turns on the choice.
63 BCSC Submission, supra note 12 at 4. See also FSA, Business Plan 2009/10 (London,
U.K.: Financial Services Authority, 2009) at 9, online: Financial Services Authority
outcomes-focused primarily due to confusion around the term principles-based, and
not because they see the terms as interchangeable. Principles-based and outcome-
oriented regulation are different concepts and should not be conflated. For example, one
could have a system that is rule-based and outcome-oriented. However, principles-
based and outcome-oriented regulation share philosophical convictions about the pur-
poses of regulation and the most effective means for achieving regulatory goals.
Secondary market civil liability was not part of the existing BCSA in 2004, when
the proposed legislation was drafted, so we cannot compare the structure there. Note
also that the principles-based regimes diverge in terms of where they locate their core
principles. See Ford, Securities Regulation, supra note 11 at 60-65. British Columbia
and the FSA issued their Code/Principles through rule-making, while the CFMA (supra
note 42), and the QDA (supra note 13) chose to embed them directly into legislation. All
of these Codes/Principles are actually pitched at similar levels of precision (i.e., they are
all cast in terms of high-level principles). There is no intention that they be regularly
amended based on regulatory experience. Therefore purely in terms of regulatory de-
sign they should probably be part of the statute rather than the rules, although there
may have been practical considerations at play as well. It seems that nothing substan-
tive turns on the choice.
64 In actual practice, there is no necessary disconnect between outcome-oriented regula-
tion and a third approach that some scholars call management-based regulation. See
Cary Coglianese & David Lazer, Management-Based Regulation: Prescribing Private
Management to Achieve Public Goals (2003) 37 Law & Soc’y Rev. 691. However, there
are differences between the two concepts regarding the stage of firm conduct at which
the regulator intervenes, but both place responsibility for detailed decision-making with
276 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
one part of the B.C. Model (its Code of Conduct for dealers and advisers)65
contain provisions that try to ensure that customers receive timely disclo-
sure of trades conducted on their account. The OSA establishes a strict
procedure, whereas the B.C. Code of Conduct specifies only an outcome.66
We see similar differences in their approaches to dealer conflicts of inter-
est.67
Another example is account supervision by broker-dealer firms. In
2004, the BCSC commissioned a regulatory impact analysis that com-
pared the detailed, process-based account supervision requirements estab-
lished by the Investment Dealers Association (IDA) (as it then was) with
the more outcome-oriented requirements imagined under the proposed
B.C. Code of Conduct for dealers and advisers.68 The Code of Conduct
would have required a firm to [m]aintain an effective system to ensure
compliance with this Code, all applicable regulatory and other legal re-
quirements, and [its] own internal policies and procedures, and to
[m]aintain an effective system to manage the risks associated with [its]
business.69 The four firms studied were of the view that the IDA rules,70
which mandated transaction-based daily and monthly reviews, contrib-
uted significantly to their regulatory burden without providing meaning-
ful investor protection. From their perspective, the reviews were duplica-
tive, rigid, and (worst of all) not effective in detecting abuses character-
ized by patterns of behaviourwhere they thought the biggest compliance
risks arose. As a result of these perceived limitations and in response to
what the firms described as concerns about civil liability, reputation, and
good business practice, each of the firms had already, by the time of the
industry actors and give those actors the flexibility to design mechanisms that work for
them based on their greater knowledge about their own businesses.
65 Code of Conduct, being Schedule of the BCSC Securities Rules (supra note 39) [Code
of Conduct]. See also BCSC, Dealers and Advisers Guide, supra note 49 at 32.
66 See OSA, supra note 38, s. 36; Christina Wolf, Strong and Efficient Investor Protection:
Dealers and Advisers under the BC Model, A Regulatory Impact Analysis (24 Novem-
ber
Securities Commission
online: British Columbia
2003)
at
72,
67 See OSA, supra note 38, s. 39. Compare Wolf, Dealers and Advisers, supra note 66 at
66 (Principle 6).
68 Ibid. at 48-57. Of course, primary responsibility for overseeing dealers and advisors is
delegated to self-regulatory organizations (SROs), most prominently the IIROC and the
Mutual Fund Dealers Association of Canada. Those SROs would have to be active par-
ticipants in any change to a more principles-based approach.
69 See Code of Conduct, supra note 65, Principle 19. See also BCSC, Dealers and Advisers
Guide, supra note 49 at 31-32.
70 See generally ibid. at 13-15, 17.
PRINCIPLES-BASED SECURITIES REGULATION 277
study, developed its own parallel risk-based supervisory system.71 The
regulatory impact analysis concluded that relative to the existing system,
British Columbias proposed Code of Conduct would, by permitting firms
to focus their energies on their effective internal risk-management sys-
tems, improve investor protection, allow firms to innovate to achieve regu-
latory objectives in the ways that were most efficient for their businesses,
and reduce compliance costs.
We return to some of the difficulties associated with reliance on inter-
nal risk models below.72 The point here is that outcome orientation has
important implications on how regulators approach their task, and under-
stand their mandate. By definition, outcome-oriented regulation accepts
that there may be more than one means or process to achieve a regulatory
goal. It transfers decision making about process from regulators to indus-
try. The essential assumption underlying both principles-based and out-
come-oriented regulation is that legislators and regulators are in the best
position to develop regulatory goals, but may not be in the best position to
devise process-based means for achieving those goals. One of the reasons
that outcome-oriented regulation is attractive is that it establishes a more
direct relationship between regulatory goals and regulatory requirements.
Outcome-oriented regulation translates regulatory goals directly and
transparently into the outcomes that industry is required to meet. By con-
trast, process-oriented requirements that are developed by regulators in
advance may not be perfectly tailored to regulatory goals, even though
regulators possess less contextual information than industry actors do.
Process-oriented regulation can also permit market participants to abide
by the letter of the law while ignoring its spirit. This is especially the case
when it comes to highly complex instruments, or in areas where events
are fast-moving and regulators on their own could not hope to keep up
with the pace of innovation.
Fundamental to an outcome-oriented system is the existence or devel-
opment of an interpretive community73 that collectively develops, on a
rolling basis, the detailed content of statutory principles. In order to func-
71 For an example of the limitations that the firms found frustrating, see generally ibid. at
14-17.
72 Reliance on internal risk-management analysis in the context of Basel II and the Con-
solidated Supervised Entities Program at the United States Securities and Exchange
Commission are discussed in Part II (The Global Financial Crisis) below.
73 Stanley Fish, Is There A Text in This Class?: The Authority of Interpretive Communities
(Cambridge, Mass.: Harvard University Press, 1980); Julia Black, Rules and Regulators
(Oxford: Clarendon Press, 1997) at 30-37 [Black, Rules and Regulators]; Julia Black,
Talking about Regulation (1998) Public Law 77; Sol Picciotto, Constructing Compli-
ance: Game Playing, Tax Law, and the Regulatory State (2007) 29 Law & Poly 11; Ex-
pert Panel, Capital Markets, supra note 2.
278 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
tion transparently and predictably, a principles-based system must build
in mechanisms that allow regulators to communicate with industry about
their expectations, and that both allow and require industry to speak
openly and regularly with regulators about their processes. Communica-
tion can take place through a number of channels including official ad-
ministrative guidance, speeches, no action or Dear CEO letters, com-
pliance audits, comments on industry standards, or specific enforcement
actions. Over time, such communication can help develop an interpretive
community that understands regulatory expectations, and can usefully in-
terpret regulatory pronouncements about reasonableness or effective-
ness in different situations.
Principles-based securities regulation is thus a particular way of
structuring regulation, not a decision to do away with rules. Principles-
based regulation is based on the conviction that while legislators and
statutory drafters have the public legitimacy to establish broad regulatory
goals, they are not in the best position to develop detailed guidelines for
industry conduct, especially in fast-moving arenas like securities regula-
tion. Those powers are allocated to front-line regulators at the securities
commissions whose expertise derives from their proximity to industry and
whose accountability derives from the notice-and-comment aspect of their
rulemaking powers. Moreoverand this is the crucial point todayeven
those front-line regulators are limited in their access to information by
comparison to the industries they regulate. In order to remain relevant
and informed about fast-moving industry practice, to keep regulation suf-
ficiently flexible, and to avoid inhibiting productive innovation, regulators
need to establish open and perpetual communication lines with industry.
They need to use industrys own good and best practices to add the meat
of detail to the bones of their principles-based regulatory expectations.
Described another way, principles-based regulation is a two-tiered ap-
proach, in which principles-based legislative drafting provides flexibility,
and constantly evolving industry experience and regulatory rules add cer-
tainty on a rolling basis. In this formulation, principles-based regulation,
as applied, avoids the biggest problems associated with both principles
and rules at the level of theory. Moreover, it can produce more effective
regulation by ensuring that the party that has access to the best informa-
tion is the one that provides the detail on any particular issue. What the
GFC may suggest to us is that this beyond theory perspective is still ide-
alized, and that its promise was not achieved in practice. How real-life ex-
perience fell short of expectations is described in the next part of this pa-
per, followed by a discussion of three large lessons learned.
PRINCIPLES-BASED SECURITIES REGULATION 279
II. The Global Financial Crisis
At least three major arguments contend that the GFC does not repre-
sent even a superficial challenge to principles-based securities regulation.
First, the most alarming problems originated with complex securitized
products that were distributed through exempt private-market place-
ments, entirely bypassing the public securities markets where the full
panoply of regulatory safeguards would have applied. Second, the GFC
has to do with gaps in regulation, far more than with drafting choices.
Gaps in regulation, especially around prudential regulation of players in
the so-called shadow banking system of the United States, were surely
the most obvious and consequential aspect of regulatory failure.74 The as-
set-backed commercial paper crisis in Canada in August 2007 revolved
around paper sold under an exemption from securities regulation.75
Credit-rating agencies, which failed utterly as gatekeepers,76 were drasti-
cally underregulated.77 Third, the GFC was a global event. The complex
securitization technology that increased risky lending, decreased trans-
parency, and multiplied and spread risk was not unique to principles-
74 See Department of the Treasury, Financial Regulatory Reform, supra note 6; Patricia
A. McCoy, Andrey D. Pavlov & Susan M. Wachter, Systemic Risk through Securitiza-
tion: The Result of Deregulation and Regulatory Failure (2009) 41 Conn. L. Rev. 1327.
Observers have also pointed out that the SEC, which had primary oversight of most
Wall Street investment bank functions, was not well equipped to conduct prudential fi-
nancial regulation (Coffee & Sale, supra note 8).
75 See Prospectus and Registration Exemptions, National Instrument 45-106, B.C. Reg.
269/2005, s. 2.35. This instrument exempts trades in commercial paper maturing not
more than one year from the date of issue, and having an approved credit rating from
an approved credit rating agency.
76 See Roger Lowenstein, Triple-A Failure The New York Times Magazine (27 April
2008) 36, online: The New York Times Magazine
See especially Frank Partnoy, The Siskel and Ebert of Financial Markets?: Two
Thumbs Down for the Credit Rating Agencies (1999) 77 Wash. U.L.Q. 619.
77 Historically, credit-rating agencies in Canada and the United States have operated
with relatively little regulatory scrutiny. In the United States, oversight has largely
fallen upon the SEC, which has chosen to rely solely on ratings from nationally recog-
nized statistical rating organizations (NRSROs). The SEC imposes stringent require-
ments before an agency can be recognized as an NRSRO. This, coupled with high entry
barriers, has produced a situation in which three agencies dominate the market for
credit ratings. For further information on the regulation of credit-rating agencies in the
United States, see U.S., Securities and Exchange Commission, Report on the Role and
Function of Credit Rating Agencies in the Operation of the Securities Markets: As Re-
quired by Section 702(b) of the Sarbanes-Oxley Act of 2002 (January 2003) at 5-10,
online: Securities and Exchange Commission
cently been proposed in the United States to introduce additional regulatory oversight
and to curb many of the failings associated with the current rating regime. See U.S.,
Bill H.R. 3817, Investor Protection Act of 2009, 111th Cong., 2009.
280 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
based jurisdictions.78 Even within the core concerns of securities regula-
tion, national systems traditionally described as rules-basedspecifically,
that of the United Statesdemonstrably fared no better than the more
principles-based system at the United Kingdoms FSA. While many spe-
cific components of financial and securities regulation (ranging from pru-
dential regulation and systemic risk analysis to the basic usefulness of the
existing disclosure-based model79) are legitimately being re-examined,
they are being re-examined globally.
A. Risk and Reward: Devolution of Details to Industry
Where the GFC should provoke reflection, however, is with regard to
the role of devolution to industry. Here, the GFC does represent a chal-
lenge (though I would argue not a fundamental one) to principles-based
regulation. Principles-based regulation works by devolving the details of
regulation to industry, on the assumption that industry has the best in-
formation and is in the best position to both assess and bear its own risks.
While not essential to principles-based regulation, this devolution is a
central reason for the advantage of principles-based regulation over rules-
based regulation in fast-moving environments. Devolution of the details to
industry, however, went on to play a central role in enabling some of the
most painfully aggravating conditions associated with the U.S. subprime
mortgage meltdown. This need not have been the case. Crucially, devolu-
tion does not automatically imply weak public oversight. Nevertheless,
devolution accompanied by an ideology of self-regulation contributed to
insufficient oversight of the massive expansion of the over-the-counter
market for derivatives within which credit default swaps traded, following
the passage of the CFMA.80 Other past examples of devolution include
Basel II81 and, correspondingly, the United States Securities and Ex-
78 On this technology, see e.g. McCoy, Pavlov & Wachter, supra note 74.
79 Steven L. Schwarcz, Disclosures Failure in the Subprime Mortgage Crisis (2008)
Utah L. Rev. 1109.
80 See Stephen Labaton & Timothy L. OBrien, Financiers Plan to Put Controls on De-
rivatives The New York Times (7 January 1999) C1 (discussing the move towards self-
regulation in derivative markets, prior to the GFC); Christopher Cox, Testimony Con-
cerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Spon-
sored Entities, Investment Banks and Other Financial Institutions (Before the Com-
mittee on Banking, Housing, and Urban Affairs, United States Senate, 23 September
2008), online: U.S. Securities and Exchange Commission
nizing a lack of regulatory oversight in the market for credit default swaps and other
derivative products).
81 Basel Committee on Banking Supervision, International Convergence of Capital Meas-
urement and Capital Standards: A Revised Framework (June 2004), online: Bank for
International Settlements
PRINCIPLES-BASED SECURITIES REGULATION 281
change Commissions (SEC) approval in 2004 of alternative net capital re-
quirements for the leading investment banks under the Consolidated Su-
pervised Entities Program (CSE Program).82 These initiatives allowed
banks and investment banks to maintain capital reserves based on their own
internal risk-assessment models, with very little scrutiny from regulators.
Regulatory faith in industry actors competence, if not literally their
bona fides, proved to have been misplaced to catastrophic effect. George
Soros has charged that the GFC reflects a shocking abdication of respon-
sibility on the part of regulators.83 Investment banks and others engaged
in originating, structuring, and selling financial products engaged in
breathtakingly bad behaviour. There was real dishonesty.84 The firms also
made grave errors in safeguarding even their own interests. In the hands
of in-house financial economists, academic caveats about the limitations of
efficient markets theory models85 as well as limits of valuation models
were ploughed under.86 Predictable psychological irrationalities seem to
have been at work within firms, including groupthink, overconfidence,
self-serving biases, and excessive faith in hard numbers, which were not
accounted for in the regulatory decision to devolve the details to industry.
There is also a strong public-choice narrative: banks had little incentive to
behave prudently in building tranches of consumer debt-based securities
because they sold them to third parties, in a market eager to buy them.87
82 U.S. Securities and Exchange Commission, Alternative Net Capital Requirements for
Broker-Dealers That Are Part of Consolidated Supervised Entities, 69 Fed. Reg. 34,428
(21 June 2004) (to be codified at 17 C.F.R. pts. 200, 201), online: U.S. Securities and Ex-
change Commission
Rule Let Banks Pile Up New Debt The New York Times (3 October 2008) A1 [Labaton,
Agencys 04 Rule].
83 George Soros, The worst market crisis in 60 years Financial Times (23 January 2008)
15.
84 See e.g. Lowenstein, supra note 76; Les Christie, Mortgage fraud still soaring: A crack-
down on underwriting has failed to halt an explosion of fraudulent home loans
CNNmoney.com (26 August 2008), online: CNNmoney.com
85 For a discussion of the future of the efficient-markets hypothesis, see Efficiency and
The Economist
beyond
2009),
online:
The Economist
(16
July
86 See e.g. Joe Nocera, Risk Mismanagement: Were the Measures Used to Evaluate Wall
Street Trades Flawed? The New York Times Magazine (2 January 2009) 24, online:
The New York Times Magazine
oversimplification of the value at risk model in banking practice); Felix Salmon, Rec-
ipe for Disaster: The Formula That Killed Wall Street Wired Magazine (23 February
2009), online: Wired
gaussian copula in banking practice).
87 Ben S. Bernanke, The Global Saving Glut and the U.S. Current Account Deficit (Re-
marks at the Sandridge Lecture, delivered at the Virginia Association of Economics,
282 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
At a structural level, banks may have focused on short-term gain at the
expense of long-term value because they were public corporations, not
partnerships, and because bank CEOs were compensated based on short-
term earnings.88
Regulators also seem to have underestimated the degree to which in-
dustry actors would try to avoid or circumvent regulatory oversight.
Whether out of short-term self-interest, economic pressure, or simple lack
of understanding,89 firms within the CSE Program that applied the alter-
native net capital requirements valued illiquid assets too generously, un-
derestimated long-tail risks, and maintained inadequate capital buffers,
all the while arguing that their behaviour was reducing rather than exac-
erbating risk. Firms innovated in structured products, not only to reflect
increasing sophistication or in order to make their product more attrac-
tive to purchasers, but also sometimes to avoid regulation.90 They avoided
comparability in order to reduce transparency and make it harder for
regulators to understand what they were selling.91
Each of these factors, even in isolation, represents a considerable chal-
lenge to what Julia Black has termed the regulatory Utopia, within
which the self-examining, responsible firm, possessing the greatest con-
Richmond, Va., 10 March 2005), online: Board of Governors of the Federal Reserve Sys-
tem
88 Lucien A. Bebchuk & Holger Spamann, Regulating Bankers Pay (2010) 98 Geo. L.J.
247. See also Michael Lewis, The End Portfolio.com (11 November 2008), online: Port-
folio.com
take investment banks public).
89 See David Brooks, Greed and Stupidity The New York Times (3 April 2009) A29 (con-
trasting two theories explaining decision-making failures at financial institutions). Pre-
cisely why financial institutions managed risk so poorly is an important question, the
answer to which is also multifactorial and varies from one firm to another.
90 This may be the least of it. As Martin Wolf has pointed out, an enormous part of what
banks did in the early part of this decadethe off-balance-sheet vehicles, the deriva-
tives and the shadow banking system itselfwas to find a way round regulation: Re-
form of regulation has to start by altering incentives Financial Times (24 June 2009)
15.
91 See Julia Hoggett, Crossing the Atlantic: Can Covered Bonds Gain Real Penetration in
the United States? in Jonathan Golin, ed., Covered Bonds beyond Pfandbriefe: Innova-
tions, Investment and Structured Alternatives (London, U.K.: Euromoney Books, 2006)
320 at 323 (indicating the lack of legislation in the American market for covered bonds,
which produces products that lack the standardization and comparability of their
European counterparts). Recent legislative initiatives have shown an interest in stan-
dardizing certain over-the-counter (OTC) derivative products, in an effort to mitigate
systemic risk. See e.g. Patricia White, Over-the-Counter Derivatives (Testimony be-
fore the Subcommittee on Securities, Insurance, and Investment, Committee of Bank-
ing, Housing, and Urban Affairs, 22 June 2009), online: Board of Governors of the Fed-
eral Reserve System
PRINCIPLES-BASED SECURITIES REGULATION 283
textual information, helps to elaborate the content of principles-based
regulation through ongoing dialogue with a flexible and outcome-oriented
regulator, in the service of the mutual goal of optimized regulation.92
What follows below is a dissection of the ways in which the self-regulatory
regimes that gained so much traction in the past decade differ from prin-
ciples-based regulation when buttressed by an active regulatory presence.
Only after we have a sense of the underlying structure of the principles-
based project can we assess what it has slipped to in recent practice, and
what aspects of it remain vital.
B. Enforced Self-Regulation and Principles-Based Regulation
Principles-based regulation is not the same thing as self-regulation.
Nevertheless, the distinction between principles-based regulation and
self-regulation has not always been adequately emphasized. Competition
between jurisdictions for increasingly mobile global capital played a role
in obscuring this distinction. Large financial firms ability to relocate to
more competitive regulatory environments provoked regulators and pol-
icy-makers to focus on the costs of substantive regulation. The rhetoric of
principles-based regulation became enmeshed with the rhetoric of effi-
ciency and the need to control the regulatory burden. Arguments in fa-
vour of principles-based regulation from Henry Paulsen, for example,
tended to emphasize the free-market benefits and the reduced regulatory
burden associated with the FSA approachnot its asserted regulatory
oversight benefits.93 Some, concerned about Londons increased capital
market share in the last few years, asserted that its success with princi-
ples-based approach was the result of lower standards and lax oversight
under principles-based regulation, especially in its junior market.94 Lon-
don-based regulators naturally disputed this assessment.95
92 Black, Forms and Paradoxes, supra note 43 at 10.
93 See Department of the Treasury, Remarks by Treasury Secretary Henry M. Paulson
on the Competitiveness of U.S. Capital Markets, Economic Club of New York (Press
Release No. HP-174, 20 November 2006), online: Department of the Treasury
taining New Yorks and the US Global Financial Services Leadership (McKinsey Re-
port, 22 January 2007) at 13, online: NYC.gov
heavy regulatory burden in the United States for the shift in business to London).
94 See John Gapper & David Blackwell, NYSE Chief says AIM must raise standards Fi-
nancial Times (26 January 2007) 8.
95 See e.g. Clara Furse, SOX is not to blameLondon is just better as a market Finan-
cial Times (18 September 2006) 19; John Tiner, Better Regulation: Objective or Oxy-
moron (Speech delivered at the SII Annual Conference, 9 May 2006), online: Financial
Services Authority
284 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
The March 2009 Turner Review insightfully describes the regulatory
world view that failed to anticipate the problems identified above.96 Lord
Adair Turner, now FSA Chairman, was commissioned by the Chancellor
of the Exchequer in October 2008 to review the causes of the financial cri-
sis and to make recommendations about regulatory changes. According to
the Turner Review, the FSA did not fail because it embraced principles-
based regulation. Indeed, principles-based regulation is barely men-
tioned.97 Instead, Lord Turner ascribes blame to flaws in FSA philoso-
phythat is, to a hands-off, market-based regulatory approach that as-
sumed that: markets were generally self-correcting; market discipline
could be trusted to contain risk; the primary responsibility for managing
risk lay with senior management, not regulators, because senior man-
agement had better information; and consumers were best protected
through unfettered and transparent markets, not product regulation or
direct intervention.98
Lord Turner is correct to draw a distinction between the FSAs stance
in favour of industry self-regulation and its principles-based approach. To
equate principles-based regulation unequivocally with self-regulation
would be to misunderstand both. The two are not inconsistent, nor are
they synonymous. Self-regulation refers to the degree of public interven-
tion in private industry. Neither principles-based nor rules-based regula-
tion guarantees any particular stance toward self-regulation. Principles-
based regulation is a particular regulatory approach that may or may not
be highly interventionist, depending on how it is implemented, even
though its effectiveness relies on pulling industrys own experience and
information into regulatory expectations. Indeed, some opponents of prin-
ciples-based regulation are primarily concerned about the possibility that
such an approach would allow regulators to overreach, especially in the
enforcement context.99 Whether a principles-based approach amounts to
lax regulation, overzealous regulation, or (impossibly) pitch-perfect regu-
lation is a function of how, and how well, it is implemented.
96 Turner Review, supra note 5.
97 This is notwithstanding premature and ultimately inaccurate reports by credible U.K.
media sources that principles-based regulation would be abandoned. See Peter Thal
Larsen & Jennifer Hughes, Sants Takes a Fresh View of Regulators Principles, Fi-
nancial Times (13 March 2009), online: Financial Times
98 Equally fundamental, but best put in the category of regulatory gaps rather than regu-
latory approaches, was the failure in the oversight of systemic risk. See Turner Review,
supra note 5 at 52.
99 See e.g. Briefing from Freshfields Bruckhaus Deringer, FSA Principles-Based Regula-
tion: What Should Firms Be Doing Differently? (Briefing, February 2007) at 2, online:
Freshfields Bruckhaus Deringer
PRINCIPLES-BASED SECURITIES REGULATION 285
Principles-based regulation as properly understood inevitably requires
a robust and capable public role, including meaningful enforcement.100
Principles-based regulation is not code for a position that promotes allow-
ing industry to do an end run around the regulator. It is a conceptually
consistent outgrowth of the loose group of regulatory perspectives vari-
ously known as new governance,101 co-regulation,102 enforced self-
regulation,103 or responsive regulation.104 New governance and its vari-
100 Ford, New Governance, supra note 1. [A] credible enforcement function writ large
(meaning both compliance oversight and prosecution where needed) is a necessary
component of principles-based and outcome-oriented regulation (ibid. at 32). See also
Cristie L. Ford, Toward a New Model for Securities Law Enforcement (2005) 57
Admin. L. Rev. 757 (arguing for continued focus on enforcement within new governance
scholarship).
101 Ford, New Governance, supra note 1 (arguing that principles-based securities regula-
tion is a new governance innovation). The term principles-based regulation is the
dominant one in securities regulation, likely for path-dependent reasons stemming
from post-Enron concerns about whether the GAAP (Generally Accepted Accounting
Principles) in the United States were too rules-based. However, some scholars would
argue that new governance methods transcend the rules-versus-principles debate. See
Kathleen G. Noonan, Charles F. Sabel & William H. Simon, Legal Accountability in
the Service-Based Welfare State: Lessons from Child Welfare Reform (2009) 34 Law &
Soc. Inquiry 523 at 536-37, 554-56 (arguing that new governance or experimentalist
practice resolves the rules/standard antimony debate through a simultaneous em-
phasis on articulation and flexibility). In spite of differences in terminology and em-
phasis, the fully articulated version of what I call principles-based regulation is not in
tension with what Noonan, Sabel, and Simon describe. These authors find it most use-
ful to frame the phenomenon as a pragmatic, practical method that bypasses an unpro-
ductive theoretical conversation. I find it most useful to focus on principles-based regu-
lation as a first-order decision that reflects an appreciation of the relative capacities of
legislative drafters, regulators, and industry actors. Nevertheless, my version of princi-
ples-based regulation calls for careful attention to implementation mechanisms that
pull detailed industry knowledge into the articulation of those principles in a way that
is strongly similar to what Noonan, Sabel, and Simon describe. See also Ford, New
Governance, supra note 1 at 30, n. 111.
102 Edward J. Balleisen & Marc Eisner, The Promise and Pitfalls of Co-Regulation: How
Governments Can Draw on Private Governance for Public Purpose in David Moss &
John Cisternino, eds., New Perspectives on Regulation (Cambridge, Mass.: Tobin Pro-
ject, 2009) 127.
103 John Braithwaite, Enforced Self-Regulation: A New Strategy for Corporate Crime Con-
trol (1982) 80 Mich. L. Rev. 1466.
104 Ian Ayres & John Braithwaite, Responsive Regulation: Transcending the Deregulation
Debate (Oxford: Oxford University Press, 1992). I am not suggesting that these perspec-
tives are coterminous in terms of precisely how top-down or bottom-up they are de-
signed to be, among other things. For a description of the difference between co-
regulation and (enforced) self-regulation in the European Union, see e.g. Linda Senden,
Soft Law, Self-Regulation and Co-Regulation in European Law: Where Do They
Meet?, online: (2005) 9:1 Electronic Journal of Comparative Law
A full dissection of the differences is beyond this papers scope. The point for present
purposes is that each of these approaches, like principles-based regulation, tries to
286 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
ants are not the same as self-regulation.105 According to its proponents,
new governance scholarship exists explicitly for the purpose of making the
public state more, not less, central and relevant.106 To use Jerry Mashaws
recent formulation, new governance represents a different balance be-
tween the available public, market, and social mechanisms for ensuring
accountability, putting greater emphasis on the latter two.107 It imagines
a different role for the regulator than rules-based, command-and-control
regulation does. However, it does not suggest that public accountability,
in the form of state action, could ever be ignored.
How exactly to best enforce self-regulatory models is a matter of some
debate. Different models exist. Ex post enforcement actions play a much
larger role in U.S. securities regulation than they do in the United King-
dom, where the focus is more on ex ante supervision and compliance
work.108 The impact of civil liability also needs to be considered.109 When it
identify an effective regulatory method located between rigid and unresponsive com-
mand-and-control regulation on one hand, and voluntary self-regulation on the other.
105 See e.g. On Amir & Orly Lobel, Stumble, Predict, Nudge: How Behavioral Economics
Informs Law and Policy, Book Review, (2008) 108 Colum. L. Rev. 2098 at 2132-36.
106 See e.g. Michael C. Dorf & Charles F. Sabel, A Constitution of Democratic Experimen-
talism (1998) 98 Colum. L. Rev. 267; Jody Freeman, The Private Role in Public Gov-
ernance (2000) 75 N.Y.U. L. Rev. 543; William H. Simon, Optimization and its Discon-
tents in Regulatory Design (unpublished paper on file with author). But see Martha
Minow, Public and Private Partnerships: Accounting for the New Religion (2003) 116
Harv. L. Rev. 1229; Donald F. Kettl, Government by Proxy: (Mis?)managing Federal
Programs (Washington, D.C.: CQ Press, 1987); H.W. Arthurs, The Administrative
State Goes to Market (and Cries Wee Wee Wee all the Way Home) (2005) 55 U.T.L.J.
797.
107 Jerry L. Mashaw, Accountability and Institutional Design: Some Thoughts on the
Grammar of Governance in Michael W. Dowdle, ed., Public Accountability: Designs, Di-
lemmas and Experiences (Cambridge, U.K.: Cambridge University Press, 2006) 115.
108 John C. Coffee Jr., Law and the Market: The Impact of Enforcement (Columbia Law
and Economics Working Paper No. 304, March 2007), online: Columbia Law School
Center for Law & Economic Studies
magnitude of its enforcement actions); Howell E. Jackson & Mark J. Roe, Public and
Private Enforcement of Securities Laws: Resource-Based Evidence (2009) 93 J. Finan-
cial Econ. 207 at 236.
109 Some have also argued that principles-based regulation is not viable in the United
States because of the extraordinary civil liability risks in this jurisdiction. See Peter J.
Wallison, Fad or Reform: Can Principles-Based Regulation Work in the United
States? (Financial Services Outlook, June 2007), online: American Enterprise Institute
for Public Policy Research
Canada. There may be a risk, however, that courts will become closely involved in defin-
ing the meaning of principles, if civil liability becomes the driving force for such inter-
pretations. This will affect the regulators ability to develop those principles within the
regulatory sphere. See Ford, Securities Regulation, supra note 11 at 24-25.
PRINCIPLES-BASED SECURITIES REGULATION 287
comes to principles-based regulation, Black is probably correct when she
writes that principles need enforcement to give them credibility but over-
enforcement can lead to their demise.110 A growing body of scholarship
considers how to make enforced self-regulatory systems effective and
credible using supervision, outcome-oriented problem solving, negotiated
compliance, and firm penetration through compliance audits.111 Enforce-
ment in a principles-based system (including referral for criminal prose-
cution if necessary) likely works best as the culmination of a series of such
interactions with an industry actor, ratcheted up through an enforcement
pyramid approach.112 Once at the enforcement stage, especially when
dealing with cases based on violation of a principle alone, successfully
bringing enforcement actions calls for substantial confidence and fortitude
on the part of regulators. Enforcement staffers must also be watchful for
potential procedural fairness concerns.113
The GFC represents an important lesson for some new governance
scholarship, some of which has not always been particularly interested in
how theory plays out in practice.114 Indeed, the shortfall between the
promise of an inspiring theoretical model and its application to real-life
regulation makes the problem more (not less) important to solve. What
was missing from many aspects of financial regulation, in retrospect, was
meaningful accountability. The pressing questions now are why pre-GFC
systems did not incorporate adequate public accountability mechanisms,
and how principles-based securities regulation in Canada might avoid
similar pitfalls. What follows are three recommendations for charting a
path forward for principles-based regulation in Canada in the wake of the
GFC. These recommendations take as a starting point that principles-
based regulation must be buttressed by meaningful regulatory oversight,
and then they move beyond that to a closer review of what accountability
110 Black, Forms and Paradoxes, supra note 43 at 29.
111 See e.g. Malcolm K. Sparrow, The Regulatory Craft: Controlling Risks, Solving Prob-
lems, and Managing Compliance (Washington, D.C.: Brookings Institution, 2000) (de-
scribing problem-solving techniques in enforcement); Ayres & Braithwaite, supra note
104; Robert Axelrod, The Evolution of Cooperation (New York: Basic Books, 1984) (on
tit-for-tat). Comply-or-explain protocols, such as those on corporate governance under
the E.U. Combined Code, may also be instructive, along with the historical story of the
evolution of compliance analysis following the Barings Bank disaster. See Janet Dine,
The Regulation of Derivatives: Identifying Difficulties and Creating Models of Regula-
tion in Alastair Hudson, ed., Modern Financial Techniques, Derivatives and Law (Lon-
don, U.K.: Kluwer Law International, 2000) 135 at 151-54.
112 Ayres & Braithwaite, supra note 104.
113 See Ford, Securities Regulation, supra note 11 at 32-34.
114 Amy J. Cohen, Negotiation, Meet New Governance: Interests, Skills, and Selves
(2008) 33 Law & Soc. Inquiry 503 at 514-15, 529-30.
288 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
demands. The recommendations focus on problems of complexity and ca-
pacity, and the compromising effect that a lack of diversity and independ-
ent-mindedness can have on effective regulatory oversight.
III. Lessons Learned and Steps Forward
A. Four Points on Regulatory Capacity
It turns out, though there was no doubt, that how principles are im-
plemented is at least as important as how legislation is drafted.115 As ob-
served earlier, certainty in a principles-based regulatory regime has less
to do with how a particular provision is drafted and more to do with the
development of an interpretive community that defines the content of that
provision.116 What is required is a regulator who is capable of functioning
as an independent and credible member within that interpretive commu-
nitythat is, a regulator who has a clear sense of her distinct role as a
voice on behalf of the public interest. Moreover, because so much interpre-
tive discretion rests in the regulators hands, regulatory capacity, train-
ing, judgment, and philosophy are critically important to effective imple-
mentation. It is therefore crucial to think carefully about the structure
through which principles will be translated into regulatory practice.
Working well with principles-based regulation requires considerable
changes to traditional regulatory culture. Moving to a new model would
take time and training.117 A principles-based regulator focuses on defining
broad themes, articulating them in a flexible and outcome-oriented way,
accepting input from industry, and managing incoming information effec-
tively. This requires expertise, a more ongoing communicative relation-
ship with industry, restraint in providing administrative guidance, and
the continued use of notice-and-comment rule-making where appropri-
115 Indeed, implementation may be more important than optimal statutory design, given
that both the FSA (U.K.) and the BCSC have adopted more principles-based ap-
proaches, notwithstanding enabling statutes that are not particularly principles-based.
See FSA, Focusing on the Outcomes, supra note 1 (discussing the FSA regulatory phi-
losophy); BCSC, 2004 B.C. Securities, supra note 1 (Although the 2004 act is not in
force, the BCSC has moved ahead with changing [its] regulatory processes and ap-
proach in much the same way [it] would have done under the 2004 act).
116 Black, Rules and Regulators, supra note 73. See also Expert Panel, Capital Markets,
supra note 2.
117 See Robin Ford, Principles-Based Regulation: Financial Services Authority (U.K.) in
Task Force, Canada Steps Up, supra note 10, vol. 7, 101 at 105-108, (describing the
former BCSC Commissioners experience with change management at the FSA, includ-
ing obstacles the FSA faced in implementing an outcome-oriented, principles-based sys-
tem and the tools the FSA used to help staff adjust).
PRINCIPLES-BASED SECURITIES REGULATION 289
ate.118 Principles-based regulation relies on good and best practices emerg-
ing from industry to help define the content of principles-based regulatory
requirements. Using good and best practices (which evolve) as opposed to
potentially static industry standards allows regulatory expectations to
evolve and remain flexible. It also builds in a learning process for both
regulators (who are learning from industry about what works in different
contexts) and regulatees (who are learning from each other). This shift in
emphasis does not, however, require that regulators roll over and play
dead in the face of industry demands.
1. Lesson One: Effective Regulatory Capacity Requires Adequate
Number of Staff
At the first and most fundamental level, regulatory capacity in this
new environment requires an adequate number of staff. As Black has
pointed out, principles-based regulation (like risk-based regulation) may
be more hands-off in its approach to the details, but this does not mean
that it requires fewer regulatory resources. Depending on choices about
implementation, principles-based regulation may actually require inten-
sive interaction with firms, at least around certain issues or situations.119
Yet, as the Northern Rock debacle in the United Kingdom highlighted,
the FSA was far from adequately staffed.120 Its Major Retail Groups Divi-
sion was reduced by some twenty staff between 2004 and 2008, notwith-
standing the divisions responsibility for substantial and complex FSA
priorities such as Basel and the Treating Customers Fairly initiative, in
addition to its core firm risk-assessment work.121
The example of the SECs CSE Program is even more striking.122 Its
Division of Trading and Markets had only seven staffers and no executive
118 See e.g. Black, Hopper & Band, Making a Success, supra note 1.
119 See ibid. (describing U.K. Treat Customers Fairly rules, which require registrants to
demonstrate that they are in fact treating customers fairly at every stage).
120 The FSA acknowledged extraordinarily high turnover of FSA staff directly supervising
the bank, inadequate numbers of staff, and very limited direct contact with bank execu-
tives among the reasons for its unacceptable regulatory performance. See FSA Inter-
nal Audit Division, The Supervision of Northern Rock: A Lessons Learned Review
(March 2008), online: Financial Services Authority
Northern Rock].
121 Ibid.
122 This is also a story of a regulatory gap. The CSE Program was voluntary, reportedly de-
signed as a response to the fact that no U.S. agency had regulatory authority over cer-
tain investment-bank holding companies. See SECs Oversight of Bear Stearns and Re-
lated Entities: The Consolidated Supervised Entity Program, Report No. 446-A, (Chair-
man Coxs comments, 25 September 2008) at 81, online: Securities and Exchange
Commission
290 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
director, yet since March 2007, it was charged with overseeing five other-
wise unregulated major broker-dealer firms that formed the backbone of
the American-based shadow banking industry, based on an alternative
capital adequacy method. One of the effects of understaffing was that
Trading and Markets staff had not completed any inspections of the divi-
sions subject firms in the eighteen months prior to the collapse of Bear
Stearns in September 2008.123 This lack of oversight would have been
problematic in any event, but it was even more catastrophic in an out-
come-oriented system where so much of the detailed procedural design for
achieving regulatory goals had been delegated to industry. As we all now
know, the firms models, which assessed largely illiquid assets operating
in the absence of both price discovery and backstop prudential regulation,
proved woefully inadequate.
2. Lesson Two: Regulators Must Have Transparent and Reliable
Information about Industry
Second, regulators must have the ability to obtain transparent and re-
liable information about the industry actors they oversee. Even today,
there can be no disputing that industry actors have better and more up-
to-date information on their operations than regulators could hope to ob-
tain. The larger firms also have far superior resources. Yet these same ac-
tors have an interest in casting facts to their advantage, in making their
products look as attractive as possible, and in reducing regulatory over-
sight where possible. Again, as hard experience at the FSA and the SEC
demonstrates, simple information collection is a crucial first step. The
post-mortem account of regulatory failure in the Northern Rock case iden-
tified a number of instances in which the FSA failed to collect, or did not
have access to, the information necessary to assess accurately the risk
that the bank posed. Supervisors were found not to have been proactive
in ensuring there was a robust process allowing them a complete picture
of issues.124 The post-mortem analysis of the CSE Program recorded simi-
lar weaknesses. Among other things, the analysis identified instances in
which the CSE staff failed to adequately track material issues in regu-
lated firms, approved changes to capital requirements before completing
full inspections, and failed to exchange information with other SEC divi-
123 Ibid. at 49-50.
124 FSA, Northern Rock, supra note 120 at 7. The findings of an internal audit into the
FSAs conduct in the Northern Rock affair demonstrated a level of engagement and
oversight by supervisory line management below the standard we would expect for a
high impact firm (ibid. at 4). But see Norma Cohen & Chris Giles, War game saw run
on Rock Financial Times (30 May 2009) [Cohen & Giles, War game] (reporting that
the FSA had conducted war games in 2004 that identified the systemic risk that
Northern Rock posed).
PRINCIPLES-BASED SECURITIES REGULATION 291
sions.125 In a system where information is power, such as in the regulation
of the sale of complex derivative instruments, a regulator without the
ability to obtain direct information effectively cedes the field to those it
regulates.
Principles-based regulation in conditions of complexity requires that
regulators have and use robust investigatory powers where necessary,
and that they conduct regular and adequate compliance audits. Like staff-
ing adequacy and information-gathering capability, effective compliance
mechanisms are even more central in a principles-based environment.
Compliance efforts give regulators access to essential, fine-grained infor-
mation about particular firms, and promote regulatory credibility and en-
gagement with industry. They are an important tool for developing and
communicating the precise content of principles-based requirements to
industry actors. As noted above, they are also part of a coordinated, multi-
faceted oversight approach for public companies and regulated entities,
based on a carefully designed enforcement pyramid approach that also
includes other supervisory strategies, as well as civil and criminal en-
forcement.126
125 SEC Oversight, supra note 122 at 37-41. The SECs failures in oversight do not appear
to be limited to the CSE Program. That agencys review of its failure to detect and pre-
vent Bernard Madoffs fraud also records that Mr. Madoffs funds were overseen by in-
experienced or unsuitably skilled staff who conducted inadequate examinations, failed
to verify information, and failed to respond to red flags. Additionally, investigations
were delayed, questions were left unresolved, and SEC offices failed to communicate
with each other. See Investigation of Failure of the SEC to Uncover Bernard Madoffs
Ponzi Scheme: Report of Investigation Case, Report No. OIC-509, Public Version, (31
August 2009), online: Securities and Exchange Commission
[SEC, Investigation of Failure]. The SECs post-Madoff reforms include many of the ini-
tiatives recommended here, such as conducting surprise exams, recruiting staff with
specialized experience, improving staff training, and seeking more resources. See The
Securities and Exchange Commission Post-Madoff Reforms, online: Securities and Ex-
change Commission
failings around the Madoff scandal sympathetically (though by no means optimistically)
as a function of chronically inadequate resources. See Don C. Longevoort, The SEC and
the Madoff Scandal: Three Narratives in Search of a Story Mich. St. L. Rev. [forthcom-
ing in 2010].
126 Ayres & Braithwaite, supra note 104. See also Ford, New Governance, supra note 1.
Consistent with the so-called enforcement pyramid, the BCSCs Capital Markets Regu-
lation Division uses a risk-based matrix to assess the risks presented by different in-
dustry actors, and it accords more leeway to firms that have demonstrated compliance
bona fides (ibid. at 54, n. 170). See also Poonam Puri, Enforcement Effectiveness in
the Canadian Capital Markets: A Policy Analysis (Presentation given to Capital Mar-
kets Institute, Rotman School of Management, University of Toronto, 14 June 2005),
online: Rotman School of Management
292 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
3. Lesson Three: Regulators Must Independently Scrutinize Information
Third, regulators in a principles-based system must have the capacity
to scrutinize information independently.127 This requires considerable ca-
pacity in terms of information management systems. It also calls for
quantitative expertise and industry experience. The FSAs responses to
Northern Rock, and its challenges in meeting them, may be instructive to
Canadian securities regulators as they contemplate moving toward more
principles-based regulation. The FSA plans to enhance its supervisory
teams through increased staff, better training, a mandatory minimum
number of staff per high-impact institution, and closer contact between
senior staff and the biggest firms. It also plans to improve the quality of
its staff, hiring risk specialists to support front-line supervision teams by
focusing on the complex models used by banks to gauge financial risk.128
As one commentator observed, the regulator will now be pursuing the
same PhD rocket scientists the banks are chasing. … As Northern Rock
shows, its not just about evaluating the problems, but having the people
who can follow them up and forcefully make the case to the bank.129
The need to hire PhD rocket scientists may seem peculiar, given that
flawed quantitative analysis by in-house bank economists so drastically
exacerbated the GFC in the first place.130 The fact that quantitative analy-
sis has been abused, misapplied, and overgeneralized in the past, how-
ever, does not mean that banks will not use it in the future. In spite of its
theoretical limitations and the recent catastrophe, quantitative analysis
continues to have substantial predictive value, and it will continue to
serve as a central tool for financial industry actors. Securitization has
brought too many benefits, and too much profit in good times, for modern
financial markets to eschew it in the future. Indeed, financial innovation
127 See Ford, Securities Regulation, supra note 11 at 23.
128 The FSA implemented a supervisory enhancement program in response to the failure
of Northern Rock. See Hector Sants, The FSAs Supervisory Enhancement Pro-
gramme, in Response to the Internal Audit Report on Supervision of Northern Rock
(26 March 2008), online: Financial Services Authority
Turner Review, supra note 5 (describing the FSAs new approach as intensive supervi-
sion at 88). Lord Turner describes intensive supervision as entailing significantly
greater resources devoted to the supervision of high-impact firms, more intense focus on
business strategies and system-wide risks, more focus on technical competence of FSA
supervisors, more focus on the details of bank accounting, and greater willingness to
reach judgments about the overall risks that firms are running.
129 Jennifer Hughes, FSA admits failings over Northern Rock Financial Times (26 March
2008), online: Financial Times
130 See Nocera, supra note 86; Salmon, supra note 86.
PRINCIPLES-BASED SECURITIES REGULATION 293
continues.131 A regulator who does not have the capacity to challenge
firms models will not have the capacity to engage in an important ongo-
ing conversation.
4. Lesson Four: Regulators Must Have Healthy Skepticism about
Industry
Finally, in addition to having the numbers, the information, and the
analytical skills, regulatory staffers must have sufficient confidence in
their own judgment and a healthy degree of skepticism about industry.
This difficult problem is discussed further below.132
B. Complexity and Prophylactic Rules
One of the striking lessons of the GFC has been the impact of complex-
ity on the financial markets, and the degree to which existing regulatory
structures failed to manage those effects. Steven Schwarcz even suggests
that complexity is plausibly the greatest financial market challenge of
the future.133 He first describes the complexity in the assets that underlie
modern structured financial products, which are overladen with complex-
ity in the design of the structured products themselves and exacerbated
by complexity in modern financial markets. He then examines how these
multiple complexities can lead to inappropriate lending standards, fail-
ures of disclosure, a lack of transparency and even comprehensibility,
andperhaps most difficult to managethe creation of a complex system
characterized by intricate causal relationships and a tight coupling
within credit markets, where events tend to amplify each other and move
rapidly into crisis mode.134 Prior to the GFC, there was a general failure
by all concerned to appreciate the myriad interrelated ways in which com-
plexity can impair markets and financial regulation.
It is unrealistic to think that we can now unwind complexity from our
financial markets. Instead, we must develop a more comprehensive and
fine-grained understanding of how complexity manifests and for what rea-
sons. Schwarczs incisive analysis of the sources of complexity is a first
step. We should also be evaluating varieties of complexity in terms of
131 One post-GFC innovation in securitization is based on life settlements. See Jenny
Anderson, New Exotic Investments Emerging on Wall Street The New York Times (6
September 2009) A1.
132 See Part III.C (Building Independence and Diversity into the Regulatory Architec-
ture) below.
133 Schwarcz, Regulating Complexity, supra note 31 at 2-3.
134 Ibid. at 7-32.
294 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
their costs and benefits, both to real economies and financial markets as a
whole and to various constituencies.
Some of the complexity deriving from innovation in structured product
design is the result of increasing sophistication and fine-tuning, and has
considerable beneficial effects for investors. After a certain point, how-
ever, either by design or in effect, the overall benefits flowing from ever-
increasing complexity become outweighed by their overall costs. As sug-
gested in the Turner Review, the GFC has challenged the underlying as-
sumption of financial regulation in the US, the UK and across the world
… that financial innovation is by definition beneficial, since market disci-
pline will winnow out any unnecessary or value destructive innova-
tions.135 In retrospect, some recent forms of financial innovation delivered
few benefits but permitted rent-seeking and contributed to significantly
increased systemic risk.136 As noted in the Turner Review,
it seems likely that some and perhaps much of the structuring and
trading activity involved in the complex version of securitised credit
[over the last ten to fifteen years], was not required to deliver credit
intermediation efficiently. Instead, it achieved an economic rent ex-
traction made possible by the opacity of margins, the asymmetry of
information and knowledge between end users of financial services
and producers, and the structure of principal/agent relationships be-
tween investors and companies and between companies and individ-
ual employees.137
One of the common arguments in favour of principles-based regulation
is that it supports innovation. While this continues to be an important
value, more thought needs to go into precisely how it supports innovation,
to what point innovation confers net benefits, and to whom those benefits
flow. A fundamental risk associated with principles-based regulation is
that, in the absence of the (at least putatively) immovable markers that
rules represent, there will be creep around the meaning of a term.138
Without regulatory oversight to ensure that terms are interpreted in a
reasonable and accountable manner, self-interested actors can be ex-
pected to define terms in their own interest. Where there is already un-
derlying uncertainty (e.g., around a new or extraordinarily complex prod-
135 Turner Review, supra note 5 at 47.
136 Ibid. at 109.
137 Ibid. at 47.
138 The argument is reminiscent of Ronald Dworkins defence of a written constitution as
building strong fences around fundamental rights. See Ronald Dworkin, A Bill of
Rights for Britain (London, U.K.: Chatto & Windus, 1990). I believe that rules are only
putatively immovable. More precisely, rules can provide temporary or superficial clar-
ity, but under the surface they are as much the subject of contestation and change as
are principles. See Dorf & Sabel, supra note 106 at 446-52.
PRINCIPLES-BASED SECURITIES REGULATION 295
uct or line of business) or where there is no metric for evaluating some-
thing across institutions (e.g., a compliance program, a product, or a risk),
the problem can be exacerbated.139 [R]isky shift can occur,140 especially
when markets are experiencing a bubble or when competitive pressures
push actors toward greater risk-taking.141 Without countervailing, inde-
pendent-minded regulatory power to push back against self-interested in-
dustry conduct, the creep may run downwardstoward more risk, less
transparency, less systemic stability, and less consumer protection.
Meaningful regulatory oversight is therefore an important considera-
tion, and complexity makes that oversight harder to achieve. We know
now that our financial regulatory approaches were not built to handle the
effects of complexity and constant innovation that characterize modern fi-
nancial markets. Principles-based and collaborative regulation is, of
course, a response to those very phenomena. But as Jack Coffee and
Hillary Sale have argued, even an optimal regulatory model will not work
if it is too complex for regulators to implement.142 In terms of the rules-
versus-principles debate, this means taking into account both theory and
implementation when deciding how to structure particular regulatory
provisions. Ease of implementation by regulators may be an important
consideration. This consideration may weigh especially heavily where we
can identify that additional complexity resulting from structured product
design innovation is of diminishing marginal utility. There may be con-
texts in which (subject to the caveats below) rules greater ability to con-
tain complexity helps justify a rules-based formulation over a principles-
based one, notwithstanding the significant costs to flexibility, innovation,
congruence, and prospectivity.
Capital requirements are a concrete example of where firms with
more rigid requirements weathered the acute phase of the fall 2008 credit
139 William S. Laufer, Corporate Liability, Risk Shifting, and the Paradox of Compliance
(1999) 52 Vand. L. Rev. 1343 at 1390-91.
140 Risky shift is part of a broader phenomenon of group polarization, referred to as
choice shift in more recent academic work, though in this case the narrower term
risky shift applies. See e.g. James H. Davis, Group Decision and Social Interaction: A
Theory of Social Decision Schemes (1973) 80 Psychological Review 97 at 107-10. See
also Sushil Bikhchandani, David Hirshleifer & Ivo Welch, A Theory of Fads, Fashion,
Custom, and Cultural Change as Informational Cascades (1992) 100 J. Political Econ.
992.
141 See Michiyo Nakamoto & David Wighton, Bullish Citigroup is still dancing to the beat
of buy-out boom, Financial Times (10 July 2007) 1 (quoting Charles Prince saying, as
long as the music is playing, youve got to get up and dance).
142 Coffee & Sale, supra note 8 at 55 (indicating that optimal rules may be beyond the ef-
fective capacity of many bureaucracies to implement).
296 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
crisis better.143 As has been well documented, Canadian capital require-
ments for financial institutions are comparatively high, and tend to be
even exceeded by the actual practice of Canadian banks. Asset-to-capital
ratios are capped at a comparatively low level.144 Canadian financial insti-
tutions overall success in weathering the GFC has been often attributed
to these regulatory restrictions.145 Another example, beyond the rules-
versus-principles conversation, is contract term standardization. Espe-
cially with respect to derivative contracts, standardization can help rein
in complexity, subject innovation to a degree of price discovery and over-
sight, and make derivatives easier to regulate.146
To use Colin Divers terms, capital requirements may be an area in
which, taking into account all the factors (e.g., poor regulatory oversight,
gaps in regulation, etc.), transparency and accessibility prove to be more
important than perfect congruence. In other words, if there is no clear and
forceful regulatory voice in the interpretive community around a regula-
143 Andrea Beltratti & Ren M. Stulz, Why Did Some Banks Perform Better During the
Credit Crisis?: A Cross Country Study of the Impact of Governance and Regulation
(European Corporate Governance Institute, Finance Working Paper No. 254/2009),
online: European Corporate Governance Institute
banks in countries with stricter capital requirement regulations and more independent
supervisors performed better in the July 2007December 2008 period).
144 See e.g. Kevin G. Lynch, Public Policy Making in a Crisis: A Canadian Perspective
(Speech delivered to the Hertie School of Governance, Berlin, Germany, 7 May 2009),
online: Privy Council Office
145 But see Lev Ratnovski & Rocco Huang, Why Are Canadian Banks More Resilient?
(IMF Working Paper WP/09/152, July 2009) at 4, online: International Monetary Fund
having a larger base of insured retail depositors). Other factors contributing to the suc-
cess of Canadian banks include steadier housing prices, a more unified regulatory
structure, and the fact that mortgage lenders in Canada tend to hold the mortgages
they extend. See Lynch, supra note 145; Ratnovski & Huang, supra at 16-18; Fareed
Zakaria, Worthwhile Canadian Initiative Newsweek Magazine 153:7 (16 February
2009) 31.
146 Most OTC derivative contracts are documented under standard forms, known as Mas-
ters, created by the International Swaps and Derivatives Association, Inc. (ISDA)
(online: ISDA
cently presented a bill to Congress that would significantly augment private standardi-
zation initiatives. The Treasurys bill would allow bank regulators to establish margin
and capital requirements for banks entering into derivatives contracts, require stan-
dardized OTC derivatives contracts to be cleared by a derivatives-clearing organization
regulated by the CFTC or the SEC, and require banks to have their standardized con-
tracts centrally cleared and traded over regulated exchanges. Dealers would no longer
be able to directly trade standardized derivatives contracts among themselves. They
would be required to use an exchange or equivalent trading platform. See Department
of the Treasury, Press Release, TG-261, Administrations Regulatory Reform Agenda
Reaches New Milestone: Final Piece of Legislative Language Delivered to Capitol Hill
(11 August 2009), online: Department of the Treasury
PRINCIPLES-BASED SECURITIES REGULATION 297
tory principle, then the (ultimately superficial) certainty provided by (in-
evitably imperfect) rules will still prove more valuable than the flexibility
and contextuality provided by principles. This is especially the case when
one considers to whom benefits have flowed. The benefits of flexibility will
flow to those in a position to apply the principles. When there is no close
conversation with regulators about, for example, what constitutes mean-
ingful disclosure with respect to complex structured products in the retail
market, then firms developing those products will decide on the meaning
of disclosure principles in light of their own interests.
We should also consider the role that particular regulatory require-
ments play in overall systemic stability and efficiency. Rules around capi-
tal requirements, like much of prudential regulation, are so fundamental
to effective functioning of the system that they should not necessarily be
subject to contestation, innovation, and potential creep through collabo-
rative regulatory practice. The analogy in democratic theory would be to
participation rights, which are seen by some to be so fundamental to de-
liberation that they should not themselves be subject to the risk of erosion
in the process of that deliberative exercise.147
We should be careful not to overstate the lesson here. The fact that
systems with rigid, mandatory capital requirements performed better
during the financial crisis does not mean that such capital requirements
will necessarily be better than a more flexible alternative, or that we can
generalize from capital requirements to other areas of financial regula-
tion. We did not learn that rigid capital requirements are better than any
mechanism we could possibly imagine. They may not even be better than
the CSE Program might have been, had it been buttressed by adequate
regulatory capacity. Rigid requirements impose costs, too. What we
learned is that rigid capital requirements worked better than the flawed
147 See e.g. Joanne Scott & Susan Sturm, Courts as Catalysts: Re-Thinking the Judicial
Role in New Governance (2007) 13 Colum. J. Eur. L. 565 at 576-78; Lisa T. Alexander,
Stakeholder Participation in New Governance: Lessons From Chicagos Public Hous-
ing Reform Experiment (2009) 16 Geo. J. on Poverty L. & Poly 117 at 127-28, 180-84;
Douglas NeJaime, When New Governance Fails (2009) 70 Ohio St. L.J. 323. There is
an analogous debate in new governance scholarship about the degree of hard-law
background measures needed (or assumed to exist) to safeguard participatory rights or
to address power disparities. On one end of the spectrum are those who believe that,
human nature being what it is, substantial participation- and equality-oriented hard-
law protections are essential preconditions to the proper functioning of any deliberative
model. On the other end are those who worry that hard-law principles are fundamen-
tally inconsistent with the deliberative project, if not actually meaningless, and are not
necessarily in the long-term best interests of equality-seeking groups. See e.g. Cohen,
supra note 114 at 543, n. 47. Even assuming that capital requirements and other pru-
dential measures are of this fundamental nature in relation to financial markets opera-
tion, a range of reasonable opinions could exist as to their optimal degree of flexibility in
real-life applications.
298 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
and basically unaccountable capital adequacy system that was in place
under, for example, the SECs CSE Program.
It is helpful to see our current struggles with complexity as epistemo-
logical ones.148 Complexity is worrisome right now in part because, as was
the case in the frozen credit markets in the autumn of 2008, we do not
know what we do not know. In time, based on greater understanding, we
may be able to develop a more sophisticated approach to complexity (with
more and different safeguards in place) that does not seem to force us to
choose so starkly between flexibility and systemic stability. In other
words, existing bright-line capital requirements should be seen as pro-
phlylactic, not permanent, rules. Prophylactic rules are clear and gener-
ally overdrawn requirements, like the Miranda rights-reading require-
ment for police in the United States, which serve as placeholders to pro-
tect an important interest until and unless a better, more tailored method
for achieving the same end can be implemented.149 A better approach to
capital requirements would have to improve flexibility and congruence,
but not at the expense of the transparency, accountability, and ease of ap-
plication that rigid requirements provide in this crucial aspect of financial
markets regulation.150
Prophylactic rules are helpful in keeping essential systems function-
ing and in conserving regulatory resources. However, under conditions of
underlying factual uncertainty, rigid rules cannot resolve that uncer-
tainty. Rigid rules will paper over uncertainty, forcing difficult interpreta-
tions undergroundor alternatively forcing rule revisions through legis-
148 Jeffrey M. Lipshaw, The Epistemology of the Financial Crisis: Complexity, Causation,
Law, and Judgment (2010) 19 S. Cal. Interdisciplinary L.J. 299.
149 The term derives from American constitutional law theory and is controversial in that
context. Miranda v. Arizona held that certain warnings must be given before a suspects
statement made during custodial interrogation could be admitted in evidence (384 U.S.
436, 86 S. Ct. 1602 (1966)). The decision invited legislative action to protect the consti-
tutional right against coerced self-incrimination, but it stated that any legislative alter-
native must be at least as effective in appraising accused persons of their right of si-
lence and in assuring a continuous opportunity to exercise it (ibid. at 467). The
Miranda warning requirement was upheld in Dickerson v. United States, but its pro-
phylactic nature was severely narrowed and the warning requirement was constitu-
tionalized (530 U.S. 428, 120 S. Ct. 2326 (2000) [Dickerson]). For a new governance per-
spective on prophylactic rules, see Dorf & Sabel, supra note 106 at 452-59.
150 In Dickerson (supra note 149), arguments concerning costs and workability for law en-
forcement personnel were successfully made in support of upholding the Miranda
warning requirements, notwithstanding the undeniabl[e] instances in which the exclu-
sionary rule of Miranda imposes costs on the truth-seeking function of a trial, by de-
priving the trier of fact of what concededly is relevant evidence: Dickerson v. United
States, 530 U.S. 428, 120 S. Ct. 2326 (2000) (Brief for the United States), online: United
States Department of Justice
PRINCIPLES-BASED SECURITIES REGULATION 299
lative processes that are far too cumbersome to be serviceable in live,
fast-moving systems. Principles-based regulation is a more promising
long-term response to extreme complexity and consequent uncertainty,
because it allows us to examine and discuss its effects explicitly, directly,
and openly. New governance generally is about designing the problem-
solving architecture required for handling situations of extreme uncer-
tainty, in which neither the precise ultimate goal nor the means for
achieving it can be determined in advance.151 This is the kind of environ-
ment in which it makes sense to enlist the context-specific knowledge of a
broad band of stakeholders in a collective, comparative, learning-by-doing
regulatory project, while not being nave about the impact of self-interest
and power.
To summarize this papers recommendations thus far, principles-
based regulation requires considerable regulatory capacity in order to be
credible. It requires greater regulatory capacity in terms of numbers, re-
sources, and expertise than has been allocated to it in some of the infa-
mous examples of regulatory failure in the past two yearsthe failure of
Northern Rock in the United Kingdom, and of the SECs CSE Program in
the United States. At the same time, one should be realistic about regula-
tory capacity when designing a regulatory regime. One should not design
a system that is too complex for actual regulators to implement. Bright-
line prophylactic rules, along with contract term standardization and
other similar techniques, can help to conserve regulatory resources. Such
rules around capital requirements, for example, will be useful in the near
future as we continue to grapple with the implications of complexity in
the financial markets. Over the long term, however, a credible, principles-
based, collaborative structure will be more robust and effective.
C. Building Independence and Diversity into the Regulatory Architecture
A principles-based approach also has repercussions for the deep struc-
ture of regulation. For many, the GFC represents a fundamental chal-
lenge to the efficient market hypothesis, and indeed to the very place of
economic theory in developing public policy.152 This paper suggests that
we should instead consider recent lessons about macro-level regulatory
design. The task now (the completion of which is beyond the scope of this
151 See Charles F. Sabel & William H. Simon, Destabilization Rights: How Public Law
Litigation Succeeds (2004) 117 Harv. L. Rev. 1016 at 1019-20; Dorf & Sabel, supra note
106.
152 See Turner Review, supra note 5 at 39 (challenging the efficient market hypothesis);
Edmund L. Andrews, Greenspan Concedes Error on Regulation The New York Times
(24 October 2008) B1 (testimony of Alan Greenspan, observing a mistake in assuming
rational actors); Efficiency and beyond, supra note 85.
300 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
paper) is to identify the structural and dialogical components that are es-
sential to ensuring that the principles-based regulatory architecture is ro-
bust and credible. Chief among these components are mechanisms to en-
sure parties accountability and to validate information.
Principles-based regulation replaces many tightly defined, statutorily
entrenched, and hard-to-revise legislative requirements with an ongoing,
information-based, pragmatic dialogue about good practices and regula-
tory goals.153 The shift itself is not determinative of choices between, for
example, industry self-regulation or intensive supervision.154 Neverthe-
less, it has practical implications for these policy choices. Under princi-
ples-based regulation, many of the bulwarks of detailed statutory law are
replaced by more easily revisable requirements. Recall the Table of Con-
cordance155 between British Columbias existing and proposed Securities
Acts. It serves as a clear illustration of the volume of detailed decision-
making that is moved out of the statute and into rule-making under a
principles-based approach. At its best, principles-based regulation there-
fore makes possible a more sophisticated, informed, collaborative, flexible,
and transparent development of regulatory goals and means. At the same
time, such a deliberative, iterative process increases the number of mov-
ing parts, and makes the act of law-making more porous to external so-
cial forces and trends. What must replace detailed statutory precommit-
ments is serious attention to the capacities, predispositions, and situation
of front-line decision-makers, and to how the various participants in the
interpretive community can be expected to function together.
One way to think about the GFC is as a product of the marginalization
of overarching regulatory design considerations in favour of overly broad
faith in market discipline. There were obvious gaps in shadow banking
industry regulation. Great weight was placed on the shoulders of credit
rating agencies, without adequate thought to ensuring that those agencies
were impartial and accountable.156 Regulators were not an effective coun-
terweight to the banks in the Northern Rock157 and CSE Program exam-
153 This is the case whether the replacement happens through explicit statutory drafting or
through choices at the level of implementation. See supra note 50 and accompanying
text.
154 See discussion in Part II.B (Enforced Self-Regulation and Principles-Based Regula-
tion) above.
155 See BCSC, Table of Concordance, supra note 54.
156 See Lowenstein, supra note 76; Partnoy, supra note 76.
157 See FSA, Northern Rock, supra note 120. See also supra note 124 and accompanying
text. The internal audit into the conduct of the FSA during its supervision of Northern
Rock identified a number of situations in which FSA staff failed to challenge and scru-
tinize appropriately the information provided by Northern Rock. For example, the audit
PRINCIPLES-BASED SECURITIES REGULATION 301
ples.158 In retrospect, programs like the CSE are paradoxes. On one hand,
regulators delegated risk assessment to firms explicitly because they did
not and could not possess the knowledge those firms had about their own
operational risks. Yet, the compensatory steps that might have reduced
the knowledge gap and ensured more meaningful oversightcompliance
audits, close supervision by adequate numbers of well-trained staffwere
not taken. Whether because the regimes regulator-level architects ac-
cepted too unthinkingly the laissez-faire ethos of recent years,159 or be-
cause they had no choice given their lack of regulatory mandate from leg-
islators160 (and these two are connected), regulatory programs like the
SECs CSE Program lacked a commitment to a robust public role in either
design or implementation.
Both the conflict of interest story and the overreliance on market dis-
cipline point to a troubling question that applies not only to the Northern
Rock failure or the CSE Program, but also to much of the bond and securi-
ties markets. The question is: from which quarter, exactly, was the inde-
pendent critical thinking supposed to come? Jack Coffees memorable in-
sight that the gatekeepers were one of the weak links that led to the En-
ron debacle resonates again today,161 but it needs to be generalized. These
are industries that are tightly enmeshed with their regulators and repu-
tational intermediaries. Credit rating agencies were remunerated hand-
somely for giving good ratings to mortgage-backed securities. British
regulatory and financial services communities are characterized by con-
siderable social overlap.162 Much has been written in the United States
identified a number of instances in which supervisors failed to conduct a comprehen-
sive analysis of the risks inherent in the [Northern Rock] business model (FSA, North-
ern Rock, supra 120 at 30). See also Turner Review, supra note 5 (discussing intensive
supervision at 88-89).
158 See SEC Oversight, supra note 122. See also supra note 125 and accompanying text.
159 See Turner Review, supra note 5 (criticizing the FSA for adopting a laissez-faire men-
tality); Stephen Labaton notes that [t]he commissions decision effectively to outsource
its oversight to the firms themselves fit squarely in the broader Washington culture of
the last eight years under President Bush (Labaton, Agencys 04 Rule, supra note
82).
160 SEC Oversight, supra note 122 at 81-82 (Chairman Coxs Comments justifying the CSE
Program on the basis that it was voluntary and the SEC did not otherwise have a man-
date to regulate the CSE).
161 John C. Coffee Jr., Gatekeepers: The Professions and Corporate Governance (Oxford: Ox-
ford University Press, 2006).
162 John Armour & David A. Skeel Jr., Who Writes the Rules for Hostile Takeovers, and
Why? The Peculiar Divergence of U.S. and U.K. Takeover Regulation (2007) 95 Geo.
L.J. 1727 at 1730, 1767-77; Donald C. Langevoort, The SEC, Retail Investors, and the
Institutionalization of the Securities Markets (2009) 95 Va. L. Rev. 1025 (arguing, con-
302 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
about the positions of public power occupied by individuals formerly work-
ing in the private sector, and the potential adverse effects on public pol-
icy.163
In a provocative article in The Atlantic magazine, Simon Johnson has
argued that one of the causes of the financial crisis in the United States
was that the financial industry was dominated by oligarchs with ties to
government.164 Drawing on his experience working with developing na-
tions at the International Monetary Fund, Johnson predicted that the
power of the oligarchs would also impede economic recovery because the
necessary bold steps to regulate industry would not be taken. The author
concludes that a destabilizing total collapse could be the cleanse we need
and that piecemeal steps taken to avoid confrontation with the oligarchs
would only prolong the pain. Without accepting that a cleanse is the
necessary course, Johnsons experience underscores how damaging the
lack of an external, skeptical perspective can be when operating on an in-
dustry-wide (or even economies-wide) scale.
This paper does not argue that individuals with industry experience
should be barred from assuming positions of responsibility overseeing
those industries. The benefits of employing regulators with industry ex-
perience (in terms of expertise), perceived legitimacy with industry, and
persuasive force are irreplaceable. Nor does this paper focus on the possi-
bility that industry-regulator ties will consistently compromise prosecu-
tions and enforcement actions.165 Beyond these important arguments
trary to this paper, that light touch regulation is more likely to be successful in small
and socially interconnected sectors).
163 Alumni of the investment bank Goldman Sachs have occupied key government posi-
tions not only in the United States, but also at the Bank of Canada (e.g., Governor
Mark Carney), and the World Bank (e.g., President Robert Zoellick). See Jenny Ander-
son & Landon Thomas Jr., Goldman Sachs Rakes In Profit in Credit Crisis The New
York Times (19 November 2007) A1 [Anderson & Thomas, Goldman Sachs]. The
Obama administration has not been immune from allegations that it was not aggres-
sive enough in its reform of the financial industry as a result of overly close ties to that
industry. See e.g. Heidi Przybyla, Obama Embrace of Wall Street Insiders Points to
Politic Reforms Bloomberg
online: Bloomberg
2009), online: New York Magazine
(19 November
2008),
164 Simon Johnson, The Quiet Coup The Atlantic (May 2009), online: The Atlantic
165 But see Stavros Gadinis, The SEC and the Financial Industry: Evidence from En-
forcement against Broker-Dealers (Harvard Law and Economics Discussion Paper No.
27, August 2009), online: Social Science Research Network
(finding that the SEC favours defendants associated with big firms compared to defen-
dants associated with smaller firms, and hypothesizing that either resource constraints
or a desire to favour prospective employers may explain this systematic bias); Maria M.
Correia, Political Connections, SEC Enforcement and Accounting Quality (Rock Cen-
PRINCIPLES-BASED SECURITIES REGULATION 303
about agency capture is a subtler worry about perspective. As Joseph E.
Stiglitz has observed, [i]f those who are supposed to regulate the finan-
cial markets approach the problem from financial markets perspectives,
they will not provide an adequate check and balance.166 Neither gate-
keepers nor regulators will serve their function effectively if they are not
firmly rooted in an independent source of authority and meaning that is
in active tension with their allegiances within the circle of those they
oversee. Such anchors help them resist the pull of groupthink, cascades,
and collective confusion that can take hold within a particular commu-
nityphenomena that are especially dangerous in principles-based regu-
lation because of the degree of built-in fluidity.
An absence of diversity in perspective may also have implications for
an industrys ability to self-regulate. Leaving aside regulatory failure, one
may ask why investment banks themselves did such a poor job of quanti-
fying and managing the risks they were running. In multiple and intri-
cately connected ways, firm culture can affect the degree to which a firm
is capable of acting independently in the face of competitive pressures and
behavioural cascades. Goldman Sachs famously managed to avoid some of
the worst excesses in mortgage-backed securities, arguably as a result of
its culture of contrary thinking relative to the rest of its industry.167 In-
ternal diversity may also influence a firms stance toward risk-taking, as
suggested by Michael Lewiss analysis of Icelandic banks and culture,168
as well as studies of the influence of gender in the financial services in-
dustry.169 Enforced self-regulation also stands the best chance of success
ter for Corporate Governance, Stanford University, Working Paper No. 61, 1 July 2009),
online: Social Science Research Network
with low accounting quality have greater political expenses on average, and that politi-
cally connected firms may face less SEC enforcement action and lower sanctions). Note
the findings of the Office of the Inspector General in the Madoff case: the Office of the
Inspector General found no evidence of improper influence or inappropriate relation-
ships with Madoff, but noted that SEC staffers awareness of Madoffs stature played an
ancillary role in their work See SEC, Investigation of Failure, supra note 125 at 373-89.
166 Joseph E. Stiglitz, Principles for a New Financial Architecture (Reference Document
for the Commission of Experts of the President of the UN General Assembly on Reforms
of the International Monetary and Financial System), online: United Nations
167 See Anderson & Thomas, Goldman Sachs, supra note 163; Przybyla, supra note 163
(suggesting that Goldman Sachss behaviour has been contrary to that of its competi-
tors, but that its internal culture is actually conformist and homogeneous).
168 Michael Lewis, Wall Street on the Tundra Vanity Fair (April 2009), online: Vanity
Fair
169 Linda McDowell, Capital Culture: Gender at Work in the City (Oxford: Blackwell, 1997);
Paola Sapienza, Luigi Zingales & Dario Maestripieri, Gender Differences in Financial
Risk Aversion and Career Choices Are Affected by Testosterone (24 August 2009),
online: Proceedings of the National Academy of Science
304 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
when industry actors genuinely care about their broader reputations,
which requires commitments and allegiances beyond ones own firm and
industry.170 All of this should lead us to wonder whether institutions that
draw on a broader range of perspectives may be better able to maintain
some cognitive distance from group pathologies to both their own advan-
tage and the advantage of an enforced self-regulatory approach.
This suggests a few specific reform recommendations. To begin with,
careful thought needs to be given to how the various pieces of a principles-
based regulatory approach will function together, where each actors
strengths and vulnerabilities lie, who is or is not participating in the in-
terpretive community, and what is required to build checks and balances
into the systems functioning.171 Credit rating agencies are an obvious ex-
ample. If they are to continue to fulfill a central role as reputational in-
termediaries, they need to be more independent and better regulated than
they recently have been. Regulators should also consider making hiring
decisions based not only on applicants relevant industry and legal exper-
tise, but also on whether applicants seem to have sufficient confidence
and independence of mind (however obtained) to keep them mindful of
their distinct public role in the face of well-resourced and coordinated ac-
tion from industry. Regulators in a principles-based or enforced self-
regulatory regime should also watch for groupthink and behavioural cas-
cades within their industry, and they may want to give additional recogni-
tion or leeway to the views of industry outliers when a cascade appears to
be developing.172 This may ultimately call for a richer description of the re-
lationships between capital markets actors and the other crucial social,
institutional, and historical milieus in which they are embedded, to un-
derstand which actors might keep their heads and how to ensure their
participation to that end.
Finally, a diversity of perspectives is important to principles-based
regulation at the macro level. Principles-based regulation will not func-
tion well if it is purely technocratic, closed, and expertise-based. Technical
170 Balleisen & Eisner, supra note 102 at 131. Balleisen and Eisner describe the other pre-
requisites to effective co-regulation as: the relevance of flexibility in regulatory detail
(ibid.), the existence of sufficient bureaucratic capacity and autonomy on the part of
nongovernmental regulators (ibid.), the degree of transparency in the regulatory proc-
ess (ibid.), and the seriousness of accountability (ibid.).
171 For an example that assesses American institutions along these lines, see Jeffrey J.
Rachlinski & Cynthia R. Farina, Cognitive Psychology and Optimal Government De-
sign (Symposium, Getting Beyond Cynicism: New Theories of the Regulatory State)
(2002) 87 Cornell L. Rev. 549.
172 Regulators in a principles-based system can influence industry behaviour in a variety of
ways, such as public recognition of good practices or reduced regulatory oversight for
firm-developed approaches that carry indicia of reliability.
PRINCIPLES-BASED SECURITIES REGULATION 305
expertise is not necessarily politically or socially neutral, and expertise-
based models can shut down useful discussion. By contrast, principles-
based regulation is a system whose evolution depends not on modelling,
but on ongoing dialogue with stakeholders based on their real-life experi-
ence. Principles-based regulation is actually a different model from that
based on technical expertise: it derives its legitimacy from its collabora-
tive, dialogic experience, and it operates on the basis that pragmatic,
learning-by-doing experience is a more reliable foundation than abstract
theory for regulatory policy development.173 The quality of the decisions
that emerge from its collaborative process, as well as the basic legitimacy
of that process, require broad participation. It also matters whether the
interpretive community that is engaged in filling in the details around a
principles-level regulatory requirement is sufficiently inclusive and di-
verse. That community must have enough common ground that its con-
stituent parts can speak to each other and a certain degree of trust can
exist. At the same time, too much homogeneity limits the range of imag-
inable possibilities.174 This calls for a regulatory architecture that specifi-
cally builds in opportunities for all key stakeholders to participate.
For Julia Black, principles-based regulation at its fullest is a polycen-
tric process that pulls in a wide variety of stakeholders.175 For the Expert
Panel as well, principles-based regulation needs to be supported by
greater investor participation guarantees in the form of an independent
investor panel and dedicated investor issues groups.176 Broader stake-
holder participation does not guarantee good regulatory outcomes, of
course. The FSAs Consumer and Practitioner Panels did not prevent the
Northern Rock debacle.177 Stakeholder participation also introduces its
own significant challenges.178 At the same time, one may ask what might
173 Amar Bhid makes a persuasive case for common sense, experience-based decision-
making over make-believe models: Amar Bhid, An Accident Waiting to Happen
(2009) 21 Critical Review 211 at 212.
174 See e.g. Jon Elster, ed., Deliberative Democracy (Cambridge, U.K.: Cambridge Univer-
sity Press, 1998).
175 Black, Forms and Paradoxes, supra note 43 at 23-24. In this article, Black particu-
larly mentions trade associations and industry representatives, nominated advisers
(NOMADs) on the London Stock Exchanges junior market, the Alternative Investment
Market (AIM), and consultants and advisors, including lawyers.
176 Expert Panel, Capital Markets, supra note 2 at 36-37. Elsewhere, Black has also em-
phasized the importance of consumer voice. See Julia Black, Involving Consumers in
Securities Regulation in Task Force, Canada Steps Up, supra note 10, vol. 6.
177 The FSMA requires the FSA to consult practitioners (i.e., registrants) and consumers,
to establish a Practitioner Panel and a Consumer Panel, and to consider their represen-
tations. See FSMA, supra note 41, ss. 8-11.
178 Poorly managed, participatory processes can degenerate into interest-group politics and
unprincipled horse-trading, as well as reproducing existing power imbalances. Exper-
306 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL
have happened had the secret war games that revealed the risks that
Northern Rock posed to systemic stability been made public back in
2004.179
Conclusion
The GFC contains cautionary lessons about the risks associated with
principles-based regulation when it is not reinforced by a meaningful
regulatory presence. However, the response cannot be a knee-jerk rever-
sion to either a more rules-based or a more command-and-control ap-
proach. Principles-based regulation accompanied by input from industry
was a direct response to a situation where regulators were underin-
formed, always playing catch-up, and made fools not only by Enron-style
corporations engaging in loophole behaviour, but also (to harken back to
the negative image of 1970s bureaucracies) by their own rigid, seized-up
processes. The costs of a system that is too rule-based are also consider-
able: it can stifle innovation, create loopholes and loophole-oriented be-
haviour, drive uncertainty underground and make problem-solving less
explicit, and impose costs related to inflexibility. Principles-based regula-
tion needs to be understood as a response to those very real problems.
Furthermore, we should not imagine that a return to older regulatory
strategies will avoid future frauds. There is no hope of putting the genies
of financial innovation and complexity back into the bottle. Under condi-
tions of such extreme uncertainty, ongoing interpretation of underlying
principles is the only feasible option. Facially straightforward rules can-
not make a complex situation simple. Detailed rules will be out-of-date by
the time they are drafted. Principles are attractive because they can
adapt to emerging events, and can adapt in a transparent and account-
able way. By contrast, rules must evolve either through time-consuming
statutory amendment, or through selective or no enforcement that con-
ceals the exercise of substantial regulatory discretion.
tise and information can serve as an important counterweight to these urges. While
success is not easy to achieve, an ever-growing body of scholarship and practice around
deliberative decision-making has helped to identify critical success factors and best
practices. An internationally significant experiment in deliberative democracy took
place in British Columbia in 2004, around electoral system redesign. See Mark E. War-
ren & Hilary Pearse, eds., Designing Deliberative Democracy: The British Columbia
Citizens Assembly (Cambridge, U.K.: Cambridge University Press, 2008).
179 Cohen & Giles, War game, supra note 124. According to this article, FSA regulators
concluded at the time that they could not force Northern Rock and HBOS to change
their practices. Actively pulling in other stakeholders may also have enhanced existing
regulatory capacity.
PRINCIPLES-BASED SECURITIES REGULATION 307
However, thought needs to be given to how principles-based regulation
perpetuates or even amplifies existing structural flaws in regulation. To
be effective, principles-based regulation must increase regulatory re-
sources, develop a thoughtful response to complexity (including a place for
prophylactic rules), and consciously incorporate a broader and more inde-
pendent range of perspectives into the regulatory discussion. As Canadas
Expert Panel well appreciated, careful implementation and meaningful
enforcement are everything in building a strong principles-based ap-
proach to securities regulation.180
180 Expert Panel, Capital Markets, supra note 2 at 19-22.
