Principles v rules: the big debate at the Financial Services Authority

The future of the FSA’s City regulation is being thrashed out. By Margaret Taylor



As the Financial Services Authority (FSA) presses ahead with its move from rules-based to principles-based regulation, concerns remain about the impact this could have on UK plc and, by extension, its lawyers.

While a principles-based system is widely welcomed, there are feelings in the legal community that, by not being prescriptive in its regulation, the FSA risks being inconsistent in the way it operates. Meanwhile, worries remain that, as the watchdog has an enforcement division in place to ensure companies abide by its regulatory standards, prescription cloaked in principles could steal its way in via the back door.

Given that the regulator must have an enforcement division, can its regulatory activity legitimately work without the back-up of a black and white book of rules? If it can, what challenges does this present for lawyers trying to guide clients through the regime in the absence of that book?Clifford Chance dispute resolution partner Carlos Conceicao, who was formerly head of the FSA’s wholesale group in enforcement, believes principles-based regulation can work. Indeed, he thinks it can be particularly attractive because it means the regulator gives the companies it monitors space to meet specific outcomes in their own way. Assuming that means the route to the outcome will be tailored to individual business interests, Conceicao feels the process should theoretically be better than handing down a set of one-size-fits-all rules.

“The sheer speed at which the market is developing on both the wholesale and retail side makes it difficult for rules-based regulations to keep up with the pace,” says Conceicao. “If people focus on outcomes, they’re much more likely to get the right sort of results. With the rules-based approach people can sometimes concentrate solely on how to get around the rule.”

Conceicao points out that, handin-hand with this considerable pro, there are a number of inevitable cons inherent in principles-based regulation.

“When you have something as vague as a principle saying you must treat customers fairly or apply proper standards of market conduct, there’s a lot of space to fill in,” he says. “If we ask people how they would interpret a principle, there’s room for a spattering of opinion; with a rule, you’ve either broken it or you haven’t. That makes it more challenging for lawyers and companies to work out what’s required by the regulator under the principle.”

A further downside of this, he adds, is that the vagueness gives the FSA considerable leeway in terms of coming up with its own definition of what a certain principle should mean. That, he says, puts the regulator in an extremely powerful position.

DLA Piper financial regulatory partner John Ahern agrees with Conceicao that principles-based regulation could work well for the market as a whole, particularly because it will make senior management teams take a greater interest in how they shape their companies.

“In the absence of prescriptive rules, senior management will need to become far more engaged in the compliance process of how the firm does business,” he says. “That can be a good thing, because in many places the compliance burden can fall on the compliance department and the legal team.”

However, more definition will be required around what is expected of regulated firms.

“As a practitioner, the concern is that there’s likely to be a lesser degree of certainty on what we need to do to meet regulatory standards,” Ahern argues. “It’s fine in principle to say you should behave with integrity or treat customers fairly, but that’s quite a high level. Under that there needs to be some more prescriptive guidance on what that means to businesses.”

However, accessing the guidance, which can be in the form of discussion papers or speeches, can be a problem because the FSA’s website is not particularly user-friendly. This leads companies to turn to their legal advisers more frequently. The legal advisers in turn have their work cut out under this system, given the absence of strict regulatory guidelines to refer to.

“The more high level the regulatory regime, the more room there is for the regulator to take a less than consistent approach, and that means lawyers have to read the mind of the regulator,” says Ahern. “I’m not sure this will make for consistency. Under the previous system lawyers were used to providing advice based on rules.”

That said, FSA director of retail policy Dan Waters points out that, while the principles-based system revolves around 11 core principles for business, the FSA still relies on its 8,500-page rulebook.

“The reality is that the FSA has, and will always have, a mixture of principles, high-level rules and some more detailed rules,” he says.

For Herbert Smith litigation and arbitration partner David Mayhew this mix can cause problems when it comes to enforcement, as enforcement based on principles could actually bring in more rules in disguise.

“The theory behind principles-based regulation is that senior management decide how to run their business, and that makes sense,” he says. “The problem comes when the regulator also has an enforcement arm that says businesses should have done something in a specific way, because then it’s starting to prescribe what people should be doing. That’s not the best way of prescribing what people should do.”

The FSA says it is committed to finding the right balance between the mix of principles, high-level rules and detailed regulations, although it admits that this is not easy to do. One of the difficulties, says Waters, is the constant flow of rules from the EU, some of which replace existing UK rules.

Waters adds: “Firms and trade associations, even when they’re committed in theory to principles rather than detailed rules, in practice often show a stubborn attachment to particular rules that the FSA seeks to abolish. And within firms we often find that increased reliance on principles is supported by chairmen and CEOs, but opposed by compliance officers and lawyers, who prefer the supposed certainty of prescriptive rules.”

Even the most conservative of lawyers must have at least thought ‘rules were made to be broken’ in their rebellious teenage years. While most of us come to realise that this really is not the case, for lawyers the fun bit of the job surely lies seeing exactly how far the rules can go. Ultimately, as Ahern points out, a regulatory regime based on principles should work because it gives businesses less ‘wiggle room’ to take a view on a rule.

And, as a cynic might say, if businesses need more help to steer themselves towards satisfactory principles-based practices, that will surely result in increased work.