## Friday, April 15, 2011

### Legal process in rule-making: A success story in an unexpected place

by Shubho Roy and Deepaloke Chatterjee.

### Rule-making process: A critical component of the rule of law

A despotic king has absolute power. When a society matures, the rule of law emerges in two stages. First, the despotic ruler writes down a set of rules, and the main body of government implements the law. So the interface between citizen and State is now governed by law, but a despotic king has the god-given power to enact new law.

The next stage of the evolution of the rule of law is where the very law-making process is enveloped in checks and balances. It is useful to think of three levels:

1. In the worst scenario, there is only the command of a few men that purports to be the law of the land. Governments can act capriciously, violate stated laws, and courts (if they exist at all) are no help.
2. The next step up, in history, was the despotic rulers of Continental Europe who preserved the absolute right of the king to make law, but built a fairly sophisticated system of civil servants, judges and courts through which citizens faced the consistently applied rule of law. At the same time, the ruler retains unbridled power in changing laws. With the high quality judges who hear cases at the the Dubai International Financial Centre (DIFC), we may now place DIFC in this league.
3. The next step up is a liberal democracy, where legitimacy is won because the very rule making process is governed by checks and balances; is enveloped in the rule of law.

### The rule-making process in independent regulators

In this post, we focus on independent regulators, which are a fascinating combination of law-making and law-enforcement. Parliament empowers them to write law. At the same time, this does not mean that a regulator is a despotic king who can issue law based on any whim and fancy. Democratic accountability requires that the very process through which an independent regulator writes law should also be enveloped in a system of checks and balances.

### The Indian situation

While the above is well understood in developed countries, in India this is still very new terrain. Most finance practitioners would not be surprised if they are surprised by the newspapers with a completely new regulation issued by a financial regulator. In the field of financial regulation, the best practices in India are usually found at SEBI. However, on this issue -- the rule-making process -- SEBI remains relatively weak. At other financial regulators, rules are often issued like fatwas.

We recently came across a remarkably good arrangement in an unexpected place: the Airports Economic Regulatory Authority (AERA). In this blog post, we describe this process. While this is not yet state of the art by world standards, we think this is state of the art by Indian standards.

### The rule-making process in AERA

AERA was established in 2008. As with all regulators, it has to set out regulations governing the stake-holders in its domain. The steps AERA undertakes before making regulations display a level of transparency and organization rarely seen in Indian regulators.

The AERA Act requires the regulator to maintain transparency through the following mandates:

1. Hold consultation with all stake-holders.
2. Allow all stake-holders to make submissions.
3. Document and explain all decisions.

One of the first actions of the AERA was to establish its approach and philosophy towards regulation. This was done through the method mentioned above. Let us look at the steps AERA went through:

1. A white paper was released in December 2009. It contained major issues impacting formulation of a regulatory philosophy and approach.
2. An opportunity was given to stake-holders to consider the issues highlighted and provide feedback, comments and suggestions.
3. AERA considered all the submissions and released a consultation paper in February 2010. This consultation paper contained not only the submissions received for the White Paper (the relevant paragraphs were annotated) but also detailed responses from AERA to each submission. Apart from the response, it also provided reasons for the approach taken (and the economic rationale where possible).
4. After the release of the consultation paper, another meeting was held where comments were received. The minutes of the meeting were uploaded on the Authority's web page.
5. AERA finalised its regulatory approach (for determination of tariffs) and issued an Order in January 2011. The order stated that the guidelines would be drafted in consonance with the consultation paper.
6. The AERA then issued the draft guidelines in February 2011. The stake-holders were again given an opportunity to comment, and another meeting was held with the stakeholders.

### Analysis

This process is important for the healthy functioning of democracy. As Robert Conquest wrote in his article Downloading Democracy in The National Interest in Winter 2004-05:

A civic society is a society in which the various elements can express themselves politically, in which an articulation exists between those elements at a political level. A civic society is not a perfect social order - which is in any case unobtainable - but a society that hears, considers and reforms grievances. It is not necessarily democratic, but it contains the possibility of democracy.

Most regulators in India invite comments from stake-holders. What is unique about AERA is the level of documentation and detail it provides in response to the comments. The entire procedure is available publicly. The parties who provided comments may not agree with the position of the regulator but they know that their comments were heard and considered. This helps create the incentive for the larger community to engage with the regulator in future consultations. A sure sign of difficulty in the rule-making process at a regulator is the event of a `consultation process' that attracts a negligible amount of comments: that tells us that the wider community has lost confidence in the regulator.

The entire process is not a one-off incident. AERA has created a detailed guideline on how it will go about inviting comments and involve stake-holders in their discussion. This creates benefits for both the regulator and the regulated as:

• The regulator can now clearly state that it is fulfilling its requirements for meeting the mandate of transparency and consultation as required under its parent legislation.
• The regulated entities/ stake-holders are clearly aware of process that goes into the drafting of regulations.

The legal process surrounding rule-making at AERA takes away arbitrary and discretionary power in the hands of the senior staff of AERA to issue rules based on whim or fancy, and thus reduces the chances of mistakes being made or of rules being hijacked through ignorance or corruption.

Economists and the Ministry of Finance are generally confident that some of the best governance in India happens on their watch (e.g. SEBI). It may come as a surprise to see sophisticated legal process in an unexpected place: AERA. As we attempt to build more sophisticated regulators in finance and infrastructure, AERA's work needs to be studied, emulated and improved.

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