Movement at SEBI towards principles-based regulation

A milestone for SEBI in its rule-making function

SEBI is a modern financial regulator in that it issues `subordinate legislation’ (i.e. regulations) which constitute law. These laws embed intricate domain knowledge where Parliament does not have the capacity for detail. This separation — where Parliament sets up SEBI and gives it the power to write subordinate legislation — is the hallmark of modern regulatory arrangements. This needs to be accompanied by sophisticated arrangements through which such regulatory agencies are independent, accountable and free of conflicts of interest. While SEBI has many problems, it is the most sophisticated arrangement of this nature found in India today.

From 1996 onwards, SEBI has issued regulations for mutual funds. On 21 February, they published regulations (”SEBI (Mutual Funds) (Amendment) Regulations, 2012″) that govern advertisements of mutual funds, and the methods by which the mutual funds value their assets and consequently the units that they issue.

These regulations are a major milestone in the evolution of Indian financial regulation, in the shift away from rules to principles.

Rules versus principles

The two major approaches to regulation are ‘rules based’ and ‘principles based or outcome based regulations’. Rules based regulation set out the processes by which a regulated entity is supposed to comply with, and is not directly concerned with the outcome. Rules based system of a major shortcoming: Firms will then try to find clever ways to comply with the letter of the law, but defeat the purpose of the rules.

As an example, consider the statutory warnings for cigarettes. The rules required that the font in which the statutory warning was
printed should be of a minimum ‘height’. Firms got around this by printing them in the required height but reducing the width of the
characters to a ridiculously low size, so that it was very difficult for readers to decipher. Thereby, they were able to comply with the
directive for statutory warnings, yet defeat the purpose of warning buyers.

The rule was recently modified to require cigarette packets contain a picture of a pair of lungs with cancerous growth. The companies
again complied with the requirement. However, the resolution of the pictures is so low that they look like two blotches of ink to a
normal viewer. These blurry pictures cannot be interpreted by anyone lacking in good knowledge about human anatomy. The person must not only know what a pair of lungs looks like but also must know that the light blotch in the dark blotch represents cancerous growth which may kill him.

Rules based regulation draws regulators into an endless arms race, where the industry will always tend to invent ways to circumvent the rules. It creates an unhealthy tension in the relationship between regulators and the industry. In addition, rules tend to rapidly become obsolete with the constant evolution of technology and processes. Government has to keep modifying the rules, catching up
with new thinking in the industry. If this is not done, Government holds back progress by preventing such evolution.

Law based on principles is not new. A large number of our older laws have been based on principles. These laws do not specify a
method or process that an entity must approach but lay down the guiding principle that it must follow. A beautiful example of this
is the Indian Contract Act, which was written in the late 19th century. It is principles-based law that has stood the test of time.

As an example, the Contract Act defines acceptance of a contract to be complete when information of acceptance reaches the person who offered the contract. This definition in no way requires a specific formact for sending the information of acceptance. Whether it is oral or through a letter, it is valid. When the Contract Act was written, telephones or email had not been imagined. However, the
principles-based text of the Contract Act has withstood 150 years of technological change.

An expert body, like SEBI, which studies the market and issues subordinate legislation, yields greater malleability. Rules-based regulation can be repeatedly changed. However, the full benefits in terms of heightened malleability are obtained when the very subordinate legislation is principles-based.

Principles-based law is integral to common law and is part of our legal heritage. In recent decades, when India became socialist and when staff quality in government agencies declined, there was an insiduous shift to detailed, prescriptive, micro-management. Principles-based regulation and laws was put back on the financial policy agenda by the Percy Mistry report in 2007.

The new principles-based SEBI regulations

The new SEBI regulations on advertisement show the shift towards principles-based regulation. For example a regulation reads:

In audio-visual media based advertisements, the standard warning in visual and accompanying voice over reiteration shall be audible in a clear and understandable manner. For example, in standard warning both the
visual and the voice over reiteration containing 14 words running for at least 5 seconds may be considered as clear and understandable.

Instead of mandating that the warning should be at least 5 seconds long, it has stated that that it must be clear and audible. The 14
words in 5 seconds is now not a legal requirement: it is only an illustration of how the principle can be satisfied.

On valuation, the new regulations say:

The valuation of investments shall be based on the principles of fair valuation i.e. valuation shall be reflective of the
realizable value of the securities/assets. The valuation shall be done in good faith and in true and fair manner through appropriate valuation policies and procedures.

This regulation recognises that there are many different types of assets a mutual fund may acquire, stocks, securitisation papers, derivatives, bonds, etc. Each of them may have different forms of valuation. More importantly the list of assets mutual funds may buy is not exhaustive: as the Indian financial markets develop there may be other instruments that mutual funds may purchase. The principle however, will hold true for different assets and valuation
methods. The objective of the regulation is to ensure that the investors get a fair picture of the assets their fund holds.

Assessment

We do not know what forms of media the mutual funds will use in the future: billboards will go 3D, holograms will be used, mobile
phones will explode with targeted advertising. Mutual funds will also invest in new financial instruments in global markets. As
long as the provide warnings in a clear and understandable manner and value their assets in a fair and truthful system, the will be
compliant with SEBI regulations and can innovate freely.

Principles based regulations have two major advantages over rules based system:

  1. The regulations require the regulated to strive towards an outcome and not mechanistic compliance.
  2. The regulations allow for innovation to be absorbed quickly by the industry as long as they meet the objective of the
    regulation. Imagine if the Contract Act had specified that all acceptance of contracts should be done by letters. All the
    innovation of e-commerce, mobile telephony based commerce, telephonic negotiation and trading would have been illegal till the statute was amended. This would have required Indian law-makers to constantly update the Contract Act.

Moving to a principles based system is a crucial step forward, away from the command and control mindset that many regulators
suffer from. Instead of prohibiting malpractices, all too often, laws in India micro-manage the regulated business. This is a recipe
for stagnation.

However, principles based financial regulation also has costs. Rules are black and white – there is legal certainty. With principles based regulation, the precise nature of a government response to a new idea by the private sector is less predictable.

More complex behaviours are, then, required of the regulator. More litigation will arise. This will impose a greater burden on staff in regulators, courts and law firms. They will need to understand principles (and their underlying drafting intent), alongside practical knowledge about how the real world works, so as to be able to intelligently apply the principles. This requires a great deal of understanding of technology, business and regulatory objectives. Moving towards a principles based system requires commensurate strengthening of staff capabilities at SEBI, the Securities Appellate Tribunal (SAT), and the Supreme Court.

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