OSC Burden Reduction Initiative – Rules-based versus principle-based regulation

This is the second in a series of blog posts examining the Ontario Securities Commission’s (“OSC”) Burden Reduction Initiative.

As the Ontario Securities Commission (“OSC”) considers how best to implement its burden reduction initiative, there has been significant support for moving away from rules-based regulation towards a principle-based approach. The OSC, in line with a general trend in Canadian law and regulation, is increasingly emphasizing a more principled approach.

We favour a more principle-based approach. But what precisely would such a revised approach look like? Are market participants prepared to embrace a more flexible regulatory response to evolving market conditions and expectations at the expense of the greater certainty associated with prescription? Understanding the difference between these approaches is key to understanding how coming regulatory changes will affect issuers, investors, and the capital markets more generally.

Rules-based approach

A rules-based approach lays out detailed prescriptions for regulatory compliance. Advocates for rules-based approaches emphasize that specific, detailed rules can lead to clarity in compliance standards and predictability in enforcement. Rules also limit the amount of discretion left to the regulator, which can help ensure fair and consistent application.

However, even when individual rules are clear, the combined application of multiple rules has been criticized for producing uncertainty and duplicated efforts. In securities regulation, this has been especially criticized in cases where regulated entities are subject to regulation from different sources, leading to overlapping systems which each have different precise requirements.

Detailed rules can provide incentives for “loophole behaviour,” where the experienced and well-advised “game” the system. In practice, rules often lead to more rules and more complicated rules, as legislators attempt to patch over loopholes.

The primary criticism is that complicated rules undermine regulatory goals when they privilege detail over substance.

Principle-based approach

A principle-based approach to regulation is built on core underlying values, such as, protecting investors, fostering fair and efficient capital markets, and reducing systemic risk. These values can still be part of a rules-based approach, but a principled approach puts them front and centre. This emphasis is often reflected in the legislative drafting style, which tends to be concise and written in plain English. For instance, a statute might set out a general requirement to disclose all relevant information instead of listing a precise series of requirements with various conditions and exceptions.

Unlike specific rules, which can be slow to change, principled approaches are more open-ended, which allows them to address novel and unexpected developments while still remaining consistent with core values and goals. Principled approaches are often employed as part of efforts to foster innovation and are held up as being particularly well-suited to areas of rapid change and growth.

A principled approach is most effective when there is consensus shared by regulators and those they regulate on collective fundamental values and a commitment from all parties to interpret and apply these principles in a reasonable way. A principled approach cannot work well if parties engage in “cat and mouse” tactics.

A chief concern with principled approaches is that because principles are not prescriptive, they afford greater discretion to regulators, which has the potential to open the door to arbitrary enforcement, regulatory overreach, or an abdication of regulatory responsibility. Where principles are uncertain or unpredictably enforced, there is a risk of “over-compliance” by those who are regulated, out of fear of strict interpretations by regulators. This conservatism can restrict innovation.

There have also been criticisms of the principled approach for delegating too much interpretive power to industry, essentially establishing self-regulation. These critiques were especially severe in the context of the 2008 financial crisis, which some commentators blamed in part on the rise of principled approaches to regulation.

These criticisms highlight the importance of communication and cooperation between regulators and those they regulate. In principle-based systems, industry must engage actively in compliance issues alongside the regulator.  

Take-aways going forward

Although rules and principle-based approaches are often positioned as competing approaches, all regulatory systems rely on both rules and principles. The choice is not between rules and principles, but a matter of emphasis and degree.

The OSC’s burden reduction initiative seeks to reduce duplication and unnecessary complexity. The trend away from the “checklist” style of a rules-based approach in favour of a principle-based approach promises to increase efficiency, flexibility, and innovation. This could provide a great opportunity for investors and issuers to help shape how principles apply in practice, especially in new and innovative approaches. However, a principled approach also demands increased communication with regulators to ensure a shared understanding and avoid compliance issues.

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Editors

Lawrence E. Ritchie

Partner, Litigation

Alexander Cobb

Partner, Litigation

Shawn Irving

Partner, Litigation

Kevin O’Brien

Partner, Litigation

Lauren Tomasich

Partner, Litigation

Lia Bruschetta

Associate, Litigation