Ideally, a move to prin-ciples-based securities regulation would empower innovation and enhance competition in the Canadian capital markets. But such a fundamental philosophical shift in the substance of regulation may be impossible, given the current wonky structure.

The considerable merits of principles-based regulation were on display at a summit hosted by the B.C. Securities Commission in Vancouver in late September. The panel for the meeting included people who have witnessed the advantages of principles over rules first-hand: Stephen Bland, director of small firms and retail intermediary sector leader at Britain’s Financial Services Authority; and Walter Lukken, commissioner at the U.S. Commodity Futures Trading Commission.

Both the FSA and the CFTC have adopted more principles-based regulation in recent years. The result has been increased flexibility in how firms organize their businesses and comply with their regulatory requirements; in short, it has provided more choice and presented an opportunity for greater innovation among industry players. That’s why the FSA accelerated its move to principles-based regulation two years ago. “[It was] the biggest single thing we could do to help our firms,” Bland says.

The primary attraction for firms in doing away with prescriptive rules is the opportunity to lower compliance costs. But there are also benefits for investors, Lukken notes.

One of big effects the CFTC has seen, he says, is an increase in competition. Because companies no longer have to comply with a set of rigid requirements and can look for clever new ways of meeting their obligations, the move has favoured the innovative and aggressive firms that can devise ways to do things more efficiently, lowering their compliance costs. Although innovative firms can boost their margins over those of their more pedestrian rivals in the short run, fatter margins don’t tend to last in a highly competitive business. Ultimately, these cost savings flow through to clients as firms compete for custom.

A further benefit of a more principles-based approach, added another panelist, Paul Bourque, senior vice president of member regulation at the Investment Dealers Association of Canada, is that it causes firms to work more closely with their regulators to ensure they are onside. This means the regulators have more data on the firms and more insight into their operations — which may lead to more effective regulation.

Indeed, Lukken points out, the fear that, in a principles-based world, a “race to the bottom” would ensue has not been realized. Instead, he notes, Britain is one of the best regulated markets in the world. With a principles-based approach, it has just implemented that regulation more efficiently.

In Canada, prospects for principles-based regulation are mixed, at best. The most probable candidate is the derivatives area, in which both the Ontario Securities Commission and the Autorité des marchés financiers have proposed new regulatory regimes that would largely be principles-based.

The prospects for reform of mainstream securities regulation are decidedly less certain, for the oft-cited reason: Canada’s provincially fragmented regulatory system.

At the BCSC conference, Can-ada’s primary regulators expressed different levels of comfort with the idea of principles-based regulation — with British Columbia the biggest advocate, Alberta playing the skeptic and Ontario somewhere in between.

Although Alberta Securities Com-mission chairman Bill Rice concedes a principles-based approach would be “desirable,” he questions whether it is feasible in the current environment. “I wish it would work,” he says. “But I’m skeptical.

“I question whether there is a level of sophistication necessary to make the principles-based system work. I wonder whether there is a sense of responsibility on the part of a sufficient percentage of players to make the system work,” Rice adds. “I don’t think it’s a political issue; it’s a market issue — and it’s a professional issue. It would require a pretty substantial change of approach and view to make it work in our environment.”

ATTRACTIVE ON PAPER

Rice isn’t alone in his concerns. OSC chairman David Wilson calls principles-based regulation a “very attractive proposition on paper” but cautions that it must be accompanied by rigorous enforcement, compliance and disclosure regimes, otherwise it would be “a formula for real trouble.”

Bourque agrees that effective enforcement is probably the biggest issue in moving to a principles-based system. He says one way to approach enforcement would be to take disciplinary action on the more egregious abuses and take a public disclosure approach for less serious breaches of principles (by announcing to the market that certain conduct is offside and must stop, for example).

@page_break@In Britain, Bland reports, the FSA takes a risk-based approach to enforcement and compliance; the extent to which the regulator trusts senior management of a firm reflects how risky it believes them to be. Firms in which it has more confidence enjoy less scrutiny and intervention by regulators. “We try to give incentives for good management, as well as disincentives for bad management,” he says.

This approach means the FSA worries more about larger firms than smaller ones because larger firms can do more damage when they are offside. “If it’s a medium-or a large-sized firm and we don’t trust management, we’re going to be all over it,” Bland says.

In Canada, small firms abound, as does concern about their well-being. Rice worries that principles-based regulation and regulatory innovations such as use of CEO certification are supposed to be less burdensome to industry players but actually create more costs than they remove, especially for small firms. Allowing more flexibility also imposes a bur-den, particularly on small firms as they figure out how to comply.

Rice suggests that, even though the instinct is to believe that more flexible regimes favour small firms, he has come to believe that they may actually be better off with hard-and-fast rules that allow them to ensure they are compliant in a straightforward way.

Indeed, the regulatory uncertainty of a system without many rules is the industry’s chief concern. However, those who have worked within the model say some of these concerns are overblown. They note that the U.S. and Britain industries have developed a range of responses to this environment.

Some innovative firms dream up ways of complying with the principles more efficiently, and work closely with the regulator to ensure they are onside. This sets a prece-dent for other firms, and both regulators and industry trade associations have a role in educating the rest of the industry about alternative arrangements that will satisfy them.

The FSA will soon start confirming industry guidance as a way of giving firms that don’t want to test the limits a minimum standard they can use to ensure compliance. Firms that are less adventurous or have resources constraints can stick to models that are clearly onside. More aggressive firms can continue pushing the envelope to find ways of doing things more efficiently and at lower cost. There is also a bigger role for advisors, such as compliance consultants, to ensure firms are operating according to regulators’ expectations.

In Canada, uncertainty is exacerbated by the multiple provincial regulators. In a heavily rules-based system, market players are already subject to different approaches to and interpretations of their regulatory requirements. The fear is that a move to principles from rules would bring even more uncertainty to the regulatory regime. In Canada, that uncertainty would be magnified by the multiplicity of regulators, with their different priorities and agendas.

An attendee at the BCSC conference, Ian Russell, president and CEO of the Investment Industry Association of Canada, is pessimistic about the outlook for a move to principles-based regulation, given the fragmentation of the Canadian system.

INVESTING PUBLIC A LOSER?

He says there seems to be no consensus about whether Canada should move to a principles-based system. And even if there was, it would be difficult to come to a consensus about what the principles themselves should be.

“The losers in all this will be our markets, the investing public and our issuing companies,” Russell says, noting that a small player such as Canada has to be innovative if it is to compete effectively against much larger markets.

He points to the London Stock Exchange’s Alternative Investment Market as an example of the innovation that can emerge in a principles-based regime. Even the highly prescriptive U.S. Securities and Exchange Commission fosters more innovation than the Canadian regime, he says, because the SEC has the power to issue “no action letters,” which allow it to suspend rules that are stifling innovation. Canadian regulators tend to be slower to accept change.

That said, Rice notes that Ca-nadian Securities Ad-ministrators members generally favour moving toward a more principles-based regime but question how much of a priority it should be and what resources regulators can commit to it. Pessimism is the wrong outlook, he says, but there are serious, practical obstacles. When it comes to rule-making at the CSA level, agreeing on principles underlying the rules is often more difficult than agreeing to the rules themselves.

The OSC’s Wilson says it would be a tall order for multiple regulators to provide a consistent application and interpretation of principles on the ground — during compliance reviews, for example.

“It’s impossible to move in that direction. But if there is a move, it will be slow and arduous,” he says. “I wouldn’t say I’m pessimistic. But we’re not going to make a fast, evolutionary move without something more dramatic, such as the Crawford blueprint [for the creation of a single national regulator], being adopted.”

Canadian regulators are not known for evolutionary progress. If their history is any indication, movement to a principles-based approach could fall victim to inertia, status quo and stagnation. IE