Speech by SEC Commissioner:
Principles v. Rules
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
Luxembourg Fund Industry Association and
the American Chamber of Commerce
June 14, 2007
Good evening. I want to start out by thanking Bill Lockwood for inviting me here today to participate in this discussion. It's been very informative so far, and I very much look forward to hearing what my colleagues have to say on this topic. Before I begin, I must remind you that the comments I make today are my own and do not reflect the opinions of the staff or the other Commissioners of the SEC.
Let me begin by making a quick point about the principles vs. rules debate. In short, the very words - "principles vs. rules" - convey a value judgment. After all, who doesn't want to be a "person of principles" as opposed to a "person of rules"? A person of rules seems to be someone who is narrow, rigid, constrained, ideological and unable to think creatively about an issue. So, of course, everyone wants to be principles-based - that is, creative, broad-minded, reasonable and insightful. The bottom line is that the very terminology of the principles vs. rules debate conveys a value judgment, and one that essentially roars out with the question: well, why aren't you principles based? So, I think we need to be careful to not get caught up with loaded terminology.
With that said, let me move to the substance of my remarks. Most importantly, I do not consider the principles vs. rules debate to be something that should characterized as merely what is better: rules or principles. Rather, I think we should be asking ourselves the following questions: Does a principles-based oversight regime - as opposed to a more rules-based regime - provide a more effective regulatory approach for the particular jurisdiction at issue? Further, does a principles-based oversight regime promote comparability and convergence among different international jurisdictions in this global technological age?
These issues and questions are especially important now, as discussions about mutual recognition and cross-border frameworks are reaching critical mass. (As an aside, we at the SEC are very serious and committed to this issue, and in fact, we held a roundtable on mutual recognition just two days ago.) So, I think we need to get past the loaded question of whether one's particular jurisdiction is principles-based. Rather, we need to look at both the nature of the particular jurisdiction and also what is necessary for convergence and mutual recognition among different jurisdictions. And we should try to determine what sort of regime protects investors and promotes capital formation.
II. Are We So Different?
With that said, let me make a few specific points about the principles vs. rules debate. First, I think it's pretty clear that the dichotomy between the supposed U.S. rules-based approach and the U.K. principles-based approach is overblown. Certainly, I do not think it is a matter of choosing one over the other. I challenge anyone to name a market that can solely be run by principles, and similarly, to find a market that does not enact its rules based on broad overarching principles.
The United States. I would also like to dispel the notion that the United States and the SEC are strangers to a principles-based regulatory approach. In fact, the concept of principles-based regulation is not at all new. Broad principles have been set forth in the 1933, 1934 and 1940 Acts as well as in numerous rulemakings. Where possible, we in the U.S. use principles to guide our actions. Then, our system of enforcement and the court system develop these principles into enforceable rules and standards over time.
For example, take our famous anti-fraud provisions: Exchange Act Section 10(b) and Rule 10b-5. I suppose in one sense these are rules - after all, we do call it Rule 10b-5 - but in another sense they're principles-based statements. Section 10(b) generally prohibits the use or employ a "manipulative or deceptive device . . . in contravention of" the SEC's rules. And Rule 10b-5 basically says: (1) you can't employ any device, scheme or artifice to defraud; (2) you can't make any untrue statement of a material fact or to omit to state a material fact; and (3) you can't engage in any act or practice that operates as a fraud or deceit upon any person. Together, these two sections are 227 words long. Now, I don't have exact statistics for you, but I would guess that a majority of the SEC's enforcement cases are based primarily on these 227 words. Not bad for an allegedly rules-based regime.
United Kingdom. Meanwhile, the FSA has been cited by many as the paradigm of the modern regulator, with its principles-based structure. The FSA pursues four over-arching objectives and has adopted eleven principles for firms doing financial business. Streamlined as this may appear, the reality is somewhat different. In addition to the eleven principles, enforced by FSA via disciplinary actions and fines, the FSA also has an entire book of rules that - as Callum McCarthy pointed out in January - is over 8500 pages long. By contrast, I'm pretty sure that the SEC's rules and regulations are nowhere near 8500 pages long. Admittedly, the SEC deals only with securities laws, but still, our rulebook is relatively modest in comparison, especially in relation to those civil code jurisdictions.
So what does this mean? The bottom line is that the FSA and the SEC are not as different as you might think. Both rely upon principles and rules to regulate their market places. In truth, I would guess that the SEC likely relies more upon rules than principles, and perhaps vice versa with respect to the FSA. But the point is that each regulatory model is a combination of the two.
III. How Did We Get Here?
Having argued that the principles vs. rules dichotomy is somewhat overblown, there are profound differences between the UK and other European markets and the U.S. market. In my opinion, these differences drive the dichotomy between the principles-based and rules-based systems.
Retail vs. Institutional. For example, the U.S. has the largest and deepest retail markets in the world, while the U.K. is more dominated by institutional and controlling shareholders. Given this, it seems obvious that there should be different approaches to regulation. In the U.S., we need more specific rules and regulations that apply with clarity so that the less sophisticated individual investors can understand them. By contrast, in the U.K., the large institutions are better able to cope with more general principles.
Let me explore this in a little more detail. In the U.S., the form of regulation that Congress designed is based upon keeping retail investors in the game. Retail investors are generally concerned that they are "dumb money" and worry that investing is a game for the technically competent and those in the know. And so, when large scale fraud occurs - for example, Enron, WorldCom or Adelphia - there is a danger that the retail sector will flee and invest elsewhere. This could distort the health of the markets.
Accordingly, the U.S. system depends an intensive and comprehensive enforcement regime, which includes remedies such as civil penalties and disgorgement of ill-gotten gains. In this way our retail markets are reassured that there is a high price to pay for those who commit fraud. Consequently, our retail investors generally are confident that they will not be cheated by those who have inside information or those who manipulate markets. However, this regime requires rules to provide notice of what conduct is and is not appropriate. If the U.S. didn't have a large retail sector, then we might be in the position to provide basic principles and do less enforcement. That, however, is not the world we live in.
Private Litigation. In addition, the level of private litigation in the U.S. far outstrips that of the U.K. Given this, it's not surprising that there are specific rules and regulations in the U.S.. Individuals, companies and regulated entities want to know what's permissible and what's not so they can tailor their conduct accordingly. The rules, in many instances, provide a safe harbor from litigation. In this regard, I should note that market participants often want these rules, to protect them from litigation. The SEC and the FASB don't generally sit around trying to figure out how to impose more rules on the market; rather, we're most often responding to what the market wants.
In any event, these differences are why it's an academic exercise to argue about whether principles-based or rules-based regulations are better. The underlying market realities drive the differences.
IV. Marketing and Competition
Finally, I want to make a specific point that may be misinterpreted by some. But I'll try to say it as cogently as I can. I believe that much of the current discussion about principles vs. rules is driven by the commercial competitiveness among the financial centers in the world today. I don't think we can ignore that London, as a financial center, has a very aggressive marketing machine - which is not a bad thing - that has promoted the city of London as an ideal place in which to do business. This is the case with respect to attracting hedge funds, issuers to list on the London Stock Exchange, or other financial services intermediaries. This is not limited to London. New York is competing as well, and so are Hong Kong, Singapore and Tokyo. But I believe that London, in particular, is also using the local regulator and the regulator's approach as a selling point.
Now, let me be very clear, I am not saying that the FSA is condoning this. I think Callum McCarthy was very clear in a recent speech when he said that the FSA is not a light-touch regulator and certainly it is not a "no touch" regulator. I take Sir Callum at his representations. The FSA certainly considers itself to be a strong enforcement agency.
But, what is happening, I believe, is that the commercial interests for the City of London are promoting the principles-based nature of the FSA's regime to gain to gain a competitive advantage. I think there is a danger in this regard. Regulators should not be viewed as biased toward any particular jurisdiction. In my view, this is not a good place for the regulator to be, and it could lead to a regulatory race to the bottom. Regulators, I hope, will not get caught up in this commercial competitiveness, because their role potentially could be compromised.
In summary, I think the issue of principles vs. rules deserves serious consideration and debate. But this debate should not be held in a vacuum and should not to devolve to mere sound bites about which is better. Rather, any discussion about this topic must be placed in context with the particular jurisdiction at issue, in order to better understand the real world effects of how principles-based and rules-based systems work. Further, we should also have this debate in the context of mutual recognition and the growing globalization of markets. If the various international jurisdictions can use broad principles to bridge differences and promote convergence, then perhaps investors everywhere can benefit.
Thank you for having me, and I look forward to further discussion on these topics.