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Sunday, March 11, 2012

Movement at SEBI towards principles-based regulation

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.


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:

  1. The regulations require the regulated to strive towards an outcome and not mechanistic compliance.
  2. 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.


  1. When i read the new regulations, i thought they were different as they gave examples and used words like 'fair' etc and wondered why it was not clear. Didnt even know that there are two types of laws in the first place !. Thanks.

  2. I am not as optimistic. The issue with the administration of regulations by our regulators has in fact been the lack of predictability and clarity in what the regulator desires. Malleability can only be for nitty-gritty and the fine detail - like the change of technology you allude to, the regulatory purpose sought to be achieved cannot be malleable for principles-based regulation to be effective.

    For example, in all the P-note related proceedings that arose because of enforcement action from SEBI, it was SEBI's stance that it was following the principle of "know your client" to state that every FII should be able to certify that there was no ultimate beneficial owner in any counterparty of the FII that was an NRI. When asked how SEBI could ask for such a requirement that is impossible to ascertain, reliance was placed on the fact that the words "know your client" in simple English meant that this level of detail should be recorded by every FII.

    Expectation of an impossibility - akin to asking the Unit Trust of India to certify that every unitholder was compliant with te laws applicable to it when it invested in UTI's units - is bad application of power in enforcing a principle. A complete departure to such a regime would be replete with hardships for the market. Contrary to expectation, litigation will not flourish. Litigation against the regulator would in fact come down since the wider and more ambiguous the power of the regulator, greater will be the hesitation to incur its wrath. This will lead to poor development of case law - even appellate decisions would be fact-specific and applicable to the case before the appellate court, and would not have widespread precedent value. This is why litigation in relation to SEBI (ICDR) Regulations (earlier SEBI DIP Guidelines) has been minimal - one does not lightly fight the regulator on whom one is entirely dependent for success of a transaction. As a result, in every single IPO transaction, merchant bankers have to keep talking to the regulator and beseech dispensations that have no precedent value for the next IPO they handle. On the other hand, a primarily-rule based regulation like the takeover regulations has led to clarity in appreciation and assertion of rights by society, requiring that even the law-maker is bound by the law.

    Our regulators have always argued that we should let them decide when and how to act on a principle, rather than bind them with rules. This can be similar to the joke about a young boy asking a priest if he could smoke while praying. Disappointed with the negative response, he changes his question. He then asks if he could pray while smoking, to which the priest had to say: "yes, one should pray at all times." The same action can seem compliant or non-compliant depending on how one reads the principle.

  3. The Contract Act had the support of common law principles and judicial pronouncements to guide the judiciary. In the absence of a developed judge made law and precedents, principle based regulations may fall to the peril of incessant litigations, which may not be a viable option considering the considerable backlog that already exists.

    A principle based regulation are often blamed for its ambiguity and need of further clarifications. Such power in hands of the regulator without having proper infrastructure to support the same may turn such a regulation redundant.

    1. Yes, we need to see common law / principles based regulation as going hand-in-hand with high quality courts, judges, court procedure, staff in courts, etc.

      In the case of SEBI, most of us would agree that SAT is a high quality court. The judges in SAT have high quality domain knowledge. They are steeped in a small piece of law (securities law). There is no real backlog to speak of at SAT.

      So in the case of SEBI, we can say that conditions are more favourable for a movement towards common law / principles based regulation.

    2. Without questioning the quality of decisions at SAT, please appreciate that all 'contentious' decisions would inevitably be challenged at the Supreme Court. Subhkam being a case in point.

      Why not thus have a rule based regulation, till such time that the jurisprudence has developed to support a principle based regulation.

      I agree with you when you say that the movement towards a more pragmatic and principle based regulation are favourable, but maybe the timing isnt right yet.

      Why allow soverign's command to be the law at such a stage of development?


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