by
Shubho
Roy and Ajay Shah.
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 sets out the processes which a regulated entity is
supposed to comply with, and is not directly concerned with the consequent outcome. Firms 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 statutory warnings on cigarette boxes. The
rules require that the font in which the statutory warning is
printed should have a minimum 'height'. Firms get around this by
printing the warning in the required height, but reducing the width of the
characters to a ridiculously low size, so that it is very difficult
for readers to decipher. Thereby, they are able to comply with the
directive for statutory warnings, yet defeat the purpose of warning
buyers.
Recently, the rules asked that cigarette packets must contain
a picture of a pair of lungs with cancerous growth. In response, firms forced down the resolution of the
pictures so 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; he must also know
that the light blotch in the dark blotch represents a potentially fatal cancerous growth.
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.
The alternative to rules-based regulation is principles-based regulation. 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 mechanism for acceptance. 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: regulations can be repeatedly
changed, unlike laws drafted by Parliament which are very hard to change. However, the full benefits in terms of heightened
malleability are obtained when the very subordinate legislation is
principles-based. Rigidity is the greatest with rules-based law, it is reduced with rules-based subordinate legislation accompanied by a high quality rule-making expert body, and it is minimised when both laws and regulations are 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 reveal a 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. (emphasis added).
Instead of mandating that the warning should be at least 5 seconds
long, as would have been done with rules-based regulation, it is stated that that it must be audible, clear, understandable. 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: MFs in India are going to buy an array of new instruments in India and abroad. 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 that their fund holds.
Assessment
We do not know what forms of media the mutual funds of the future will use: billboards will go 3D, holograms will be used, mobile
phones will carry rich targeted advertising. Mutual funds will
also invest in new financial instruments in global markets. As
long as they provide warnings in a clear and understandable manner
and value their assets in a fair and truthful system, they will be
compliant with SEBI regulations and can innovate freely.
Principles based regulations have two major advantages over a rules
based system:
- The regulations require the regulated to strive towards an
outcome and not mechanistic compliance.
- 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 organisational and staff capabilities at SEBI, the
Securities Appellate Tribunal (SAT), and the Supreme Court.
