Balancing regulatory approaches

The use of both principle- and rule-based approaches in regulatory frameworks has its challenges, but the latter may be problematic for tech-driven activities

The debate over whether regulators should follow a principle-based or rule-based approach (PBA or RBA) in framing regulations is never-ending. The discussion about the “ease of doing business” is often interrelated to this issue. Maintaining a proper balance between the two approaches is tricky and requires substantial regulatory expertise.
 

The PBA involves providing broad guiding factors in regulations while giving flexibility to regulated entities to work out operational nitty-gritty. As against this, the RBA is prescriptive, listing out possible scenarios and detailing specific penal consequences for violations.
 

On the face of it, the PBA appears to be a better option. It sounds more in line with free market philosophy, while the RBA appears intrusive and smacks of a control and command approach.
 

While it is difficult to draw any definitive conclusions, generally speaking, in developed countries with mature markets, wherein the reputational risks are taken seriously and the law enforcement mechanisms are robust, the PBA is likely to find favour. For instance, in the US, a few tough orders passed by the Securities and Exchange Commission or the Department of Justice might prove to be sufficient in sending out the right message and bringing in the desired market discipline. The regulator need not spend time and energy in specifically listing out the prohibited activities in its regulations.
 

The developing economies, however, lack market maturity and tend to have relatively lax law enforcement. Framing and enforcing effective regulations, which stand the test of the time, could prove to be challenging in an ever-evolving environment. The possibility of different interpretations of the regulatory provisions by the tribunals and courts could add to the regulators’ worries. The regulators may feel more comfortable with the regulations that appear robust and wholesome, at least on paper, and may therefore be more inclined to follow the RBA.
 

For the purpose of this column, let’s focus on the regulation of financial markets in India. While the examples given relate to the Securities and Exchange Board of India (Sebi), the situation is not likely to be much different with other regulators.
 

Sebi follows a well-established procedure in drafting various regulations. There are subject-specific committees, headed by experts and having different stakeholders as members, which make recommendations. The same are made publicly available for comments before the finalisation or modification of regulations. The changes in regulations are generally influenced by implementation experiences, tribunals’/ courts’ rulings, and changes in the underlying parliamentary laws.
 

However, framing regulations is only one part of the regulator’s job; often the more challenging part is their effective implementation. The regulator doesn’t operate in a vacuum; there are many other actors in the ecosystem, driven by different considerations. The industry lobbies for less regulation; miscreants are on the lookout for regulatory loopholes; professional service providers have to find workable solutions that could pass muster with the regulatory requirements; and the tribunals/courts have to provide credible forums for legal recourse.
 

Many times, even a simple and straightforward commonsensical provision under the regulations may create trouble. For instance, the intermediaries registered with Sebi have to be necessarily a “fit and proper person”. When one thinks of this requirement, principles like integrity, reputation and character naturally come to the mind. These principles are accordingly stated in the Sebi (Intermediaries) regulations. However, the difficulty in defining these attributes — objectively and uniquely — has led to litigation in the past.
 

The regulator, often criticised for “over-regulation”, finds itself isolated and cornered in case of a market mishap or scam. The “investor protection” mandate, which is the primary function of the regulator, takes centre stage. This leads to reactionary responses from the regulator, invariably to make the regulations more rule-based so as to err on the right side. This could have the unintended consequence of discomforting even the hitherto law-abiding entities.
 

“Fraud” is defined differently under the Sebi (Prohibition of Fraudulent and Unfair Trade Practices, or PFUTP) regulations, the Indian Contract Act, the Companies Act, and the Indian Penal Code or IPC (the code defines fraudulently). The definition is most terse under the IPC and most expansive in PFUTP regulations. While the IPC’s definition is concise and of 1860 vintage, Sebi’s (PFUTP) regulations came out in 1995. Originally, the definition of fraud was borrowed from the Indian Contract Act; the same has undergone several amendments since then. The present definition in PFUTP regulations is much wider in size and scope, though it continues to have an element of the PBA, as it has not been found practical to list out all possible modes of fraud in the securities market.
 

The regulator’s penchant for having expansive regulations is visible even in other matters. How far they have been able to contain the wrongdoings is anybody’s guess. Insider trading is arguably the most serious offence in the securities market. Insider trading regulations have been amended several times (8 to 10) just during the last 10 years. To date, there hasn’t been a single conviction in any insider trading case in a criminal court.
 

So what is the near- to medium-term future outlook and the way forward? Given the overall scenario, the financial sector regulators in India are likely to continue favouring the RBA. This may be particularly problematic for technology-driven regulated activities, where the regulations would find it difficult to keep pace with rapid technological changes. For instance, fintechs require a lot of innovation and therefore their regulatory oversight mechanism should be guided by the PBA to the extent possible. The regulators would need to be more nimble-footed, quick in moving up the learning curve and take timely corrective actions.
 

The entire ecosystem needs to support and encourage the development of a responsive and effective regulatory system; regulators alone cannot achieve this. If the industry prefers principle-based regulations, they would need to go beyond merely seeking “ease of doing business”, and demonstrate maturity, responsible behaviour and self-discipline. The same applies for the market intermediaries and professionals. The industry associations and professional bodies should prioritise this. The tribunals/courts dealing with financial sector cases need significant strengthening in terms of trained manpower and infrastructure.

The writer is a retired IAS officer and former Sebi chairman