Policy puzzles of the digital nirvana

by Arjun Rajagopal, Renuka Sane, Somasekhar Sundaresan.

It has been a bad week for Uber. The effect of its automated surge-pricing during the hostage crisis in Sydney and the reaction to this, have exacerbated the publicity surrounding the alleged rape of an Uber customer in Delhi by a driver who was listed on the company's app, and the litigation it faces in San Francisco over not conducting effective background checks on criminal records of drivers. In India, the outrage has been accompanied by bans in New Delhi and calls to ban or suspend Uber in other states.

This is not the first time, or the first geography in which Uber has run into trouble. It has been criticised over its sexism, ethics and bro culture and over its record on passenger safety. The app has been recently banned in Spain and Thailand and has run into trouble with authorities in several other countries, mostly for being at odds with the traditional, regulated taxi companies.

Uber does not have a taxi license in Delhi. It is not a radio taxi service. It does not own the cars or employ the drivers. Fine print on its website suggests that it disclaims the suitability, safety or ability of third-party providers. Uber claims to not be a transportation provider, and only connect riders to drivers through its app. Yet, it claims that its service is a safe and secure one, adopting standards that go way beyond local standards that regulatory authorities may prescribe.

These claims allow one to litigate against Uber with allegations of misleading customers with particular standards of safety when in fact there were none. This is the stuff class action suits are made of. Indian customers could potentially be creative and sue Uber in the US, where control over its operations is headquartered.

However, the furore also raises larger questions on what the appropriate legal or regulatory response should be to such aggregators, and where the liability lies when things go wrong.

Is more required? Liabilities for information aggregators

A defining feature of the early 21st century is businesses becoming powered by software and synonymous with services delivered online. Technology platforms, or aggregators, purely facilitate the sale between buyers and sellers. In this sense, they are neither originators of the product, nor distributors linked to specific manufacturers. Often touted as disruptive innovators, such businesses tread thin on requirements under the licensing and regulatory systems even while competing with similar services provided by the traditional licensed players. This regulatory arbitrage raises important questions on the obligations of such aggregators.

The fundamental question that governments need to ask themselves is what, if any, obligations should be placed on businesses such as Uber. Should a market aggregator be responsible for the quality, or safety of a product that is sold on its technology platform? There are well reasoned views on both sides.

The analogy with a financial exchange

We might make an analogy between Uber and an electronic stock exchange, in which case the exchange aggregates information and enables transactions. The quality of the product being sold (i.e. whether the shares represent a "good" investment) is not guaranteed by the exchange. The transaction is guaranteed. Under this analogy, Uber's job is simply to ensure that double booking of cabs never occurs, and that payment transfers occur reliably and seamlessly.

The analogy with a retailer

We might also make an analogy between Uber and the owner of a neighborhood mall. While a case may be made against regulatory intervention to make the mall owner responsible for quality of the goods and services, there would also be a case for the mall owner being obliged to ensure safety and security in the mall premises, and being liable for a customer injuring themselves on a broken step. Besides, if the mall owner knows that sale of some goods needs a license (for example, alcohol), and turns a blind eye, it would beg the question if the owner can effectively defend against a charge of aiding and abetting a violation of the licensing of sales.

The puzzle

Where does an aggregator fall, on the spectrum? This will determine what aspect of the customer interface the aggregator is held responsible for. For example, companies may make business decisions on where on the safety spectrum they lie, and charge a premium for it. Over time there may emerge expensive aggregator companies and cheap aggregator companies and customers take a call on how much they are willing to pay for what quality of service. Regulators could step in and prescribe minimum standards - in much the same way, product warranties across jurisdictions are spelt out. Rules about information disclosure could help consumers make better decisions.

At the point of entry into the cab, the consumer is held hostage to that cab, and must trust that certain minimum safety and service standards are met. In fact, such requirements were the reasons for entry regulations in the traditional cab industry. The onus for these then lie in the State capacity that gives commercial licenses, and does police verification checks. This requires the State machinery to work, and is independently an issue apart from that of requiring anything of a technology platform that merely brings together buyers and sellers.

Conclusion: Another kind of activism

The problem then, is two-fold. First, there is the tragedy of poor State capacity in preventing and prosecuting crime, which incentivises simply banning certain activities. This is a generic problem that bedevils the working of the Indian economy in numerous contexts. The solution to this issue can only be a long and hard one: of improving the functioning of our public institutions.

The other problem to address is the poor methods for shaping, regulating or nudging commercial conduct. While India is a common law country and action for tort indeed can shape commercial conduct, the problems in delivering timely justice under common law has led to regulators occupying the commercial space in many sectors. However, regulatory interventions with clarity of thought on what can and cannot be done by commercial parties, leaves much to be desired even in sectors that have been regulated for decades. When Uber began its coverage of India, no transport regulator raised as much of a whisper about the status of its regulatory compliance and whether at all intervention was warranted. Now, at the first sight of a crime, the same regulators are quick to consider imposing a complete ban.

Common law remedies coupled with penalties and damages offer recourse to the affected parties, and hit offenders where it hurts: on their balance sheets. Predictable regulations would not only make service providers answerable to society but also would make regulators answerable to the service providers. Is it a substitute for criminal prosecution of heinous crimes? Certainly not. But it is a useful complement. Regulatory activism is not just about ensuring effective prosecution, it also means bringing companies to book if they are lying about what they are providing.

There is an expectation that `software will eat the world', that lightweight businesses like Uber will come to dominate the whole world. Perhaps conditions of State capacity in India will prove to be a bottleneck, both in respect of problems such as obtaining law and order, and in terms of navigating the subtle questions of public economics and coming out with the right answers.

Author: Arjun Rajagopal

• Policy puzzles of the digital nirvana, 19 December 2014
  
• Difficulties with PFRDA's Draft Aggregator Regulations, 2014, 2 July 2014.
• Living within the Handbook: One recent example, 24 May 2014.
• Fixing the Indian capital controls against DR issuance by Indian firms, 15 May 2014.
• Capital controls against FDI in aviation: An example of bad governance in India, 21 April 2014.
• Difficulties with Special Guidance and General Guidance in the IFC, 11 February 2014.

• From clubs to States: The future of self-regulating organisations, 19 December 2013.

Difficulties with PFRDA's Draft Aggregator Regulations, 2014

by Arjun Rajagopal and Renuka Sane.

Recent mis-selling scandals in retail finance in India have brought into focus the dangers of unregulated, or lightly regulated financial intermediation. Financial intermediaries include banking correspondence agents, micro-finance institutions, insurance agents and other such players. They extend the reach of formal finance to a vast under-served population that is dispersed and not yet electronically enabled. Under-served populations with low access to finance are likely to be economically vulnerable, and may also have low levels of financial literacy. This makes them more dependent on the financial intermediaries they interact with, and more vulnerable to mis-selling and outright fraud. Such populations are also likely to have poor access to grievance redress mechanisms, courts and social safety nets.

The micro-finance crisis in Andhra Pradesh in 2010 shows what happens when regulators get it wrong. Loan collection agents in Andhra Pradesh were accused of engaging in large-scale coercive practices. This resulted in a political backlash, from which the industry is still reeling. It is therefore extremely important that India's financial regulators get it right when it comes to regulation of financial intermediation. This includes placing an appropriate emphasis on consumer protection.

Like loan collection agents in the case of micro-finance, aggregators in the pensions industry are a major interface with low income households in the informal sector. Aggregators are used to implement the NPS-Swavalamban (NPS-S) scheme run by the Pension Fund Regulatory and Development Authority (PFRDA). Under this scheme, if a subscriber in the informal sector contributes a minimum of Rs.1000 into her NPS-S account in a financial year, she will receive a co-contribution of Rs.1000 from the government. Aggregators market the scheme, enroll members and continue to service members post enrollment. They also make the investment choice for their customers. Aggregators thus act as execution agents of the NPS-S and as advisors to consumers. This means that aggregators potentially have considerable influence over financial choices of low-income households. Regulators should be very alert to the risk of fraud or mis-selling by these aggregators for three reasons:

1. The consequences of fraud or mis-selling in the case of a product such as the NPS-S will probably only be detected far in the future, at the time of receipt of benefits.
2. Older people are less likely to be able to recover from a sudden loss of income, especially if they have chosen to rely on income from the NPS-S.
3. Public sector involvement in commercial products often gets construed as an official endorsement of the product. This exacerbates the risk of mis-selling.

Any regulation of aggregators must therefore place great emphasis on the goal of consumer protection.

The Draft Aggregator Regulations, 2014

Consumer protection is one of the pillars of the draft Indian Financial Code (IFC). The PFRDA, along with the rest of India's financial sector regulators, has committed itself to voluntarily implementing the consumer protection dimensions of the IFC, as articulated in the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code . The recently released Draft Aggregators Regulation, 2014 are viewed in this context.

The Draft Regulations do recognise the importance of consumer protection as described in the IFC. They set out registration details of the aggregators, their duties and responsibilities and the inspection and disciplinary procedures that the PFRDA may initiate. Schedule VI of the regulations provides the aggregators with a code of conduct. However, we believe the regulations do not go far enough. Here is where the regulations fall short:

• The regulations do not provide well-defined standards of skill and care that aggregators will be expected to exercise towards a customer. The beauty of simple, well-designed products is that they can be sold by agents with even basic financial literacy. However, it is important to specify what that basic level is for a given activity, or at least the standard that will be used to determine that level.
• The regulations do not define what constitutes unfair and misleading conduct by aggregators. The Handbook discusses the need for regulations defining unfair and misleading conduct. India's experience with coercive and unfair practices by intermediaries should highlight the need for such definitions to be carefully researched and well-thought through.
• The regulations do not place obligations on the aggregator regarding protection of consumers' personal information. In the context of digitisation and aggregation of information by private and public entities, it is increasingly important for regulators to specify these obligations.
• The regulations do not provide adequate guidance for avoiding conflicts of interest. Subscribers of the NPS-S often purchase the pension scheme at the time of taking a micro-finance loan. The aggregator may be the intermediary for both these products. This scenario is entirely plausible, and is a foreseeable circumstance in which there may be a conflict of interest. However, the draft guidelines are silent on providing guidance on how aggregators should think about this issue, or the information that they must provide to clarify such conflicts.
• The regulations do not provide adequate guidance regarding disclosures. Most NPS-S sales today rest on the co-contribution by the Government. It is not certain that this co-contribution will continue after 2017. This is information known to the aggregators, which is highly relevant to potential purchasers of the pension scheme. However, the regulations do not contain any details about such initial and continuing disclosures.
• The regulations do not require any suitability or appropriateness checks before selling the NPS-S. The NPS-S is a market-linked, illiquid product. An illiquid product with a minimum contribution may not be appropriate for consumers who require cash in hand in the near future. By extension, investing in the NPS-S and simultaneously taking a micro-finance loan may not be a prudent decision for many consumers. Suitability analysis is an important part of the draft IFC's consumer protection for retail consumers. The regulator may take a view that the NPS-S is not a complex product, and therefore does not require suitability checks. In this case, the regulator needs to articulate the reasons why suitability checks are not mandatory. Absent such a justification, the regulations should feature some guidance on the issue of suitability.

The UK's experience with financial regulation shows that broad principles of consumer protection need to be translated into detailed guidance notes, such that both the regulator and the industry understand what is expected.

PFRDA has not used the appropriate processes for framing regulations.

In addition to the substantive concerns listed above, the regulations fail to abide by the procedural requirements of the Handbook, for framing regulations. The PFRDA should have provided the following:

1. A clear statement of objectives;
   
2. A list of problems the regulation seeks to solve; and
   
3. A cost benefit analysis of each of the provisions.

The Handbook places major emphasis on the process of soliciting public comments via a well-designed web interface. Examples of such interfaces include the US Commodities Futures Trading Commission public comments page. There is as yet no information about the public comments received by the PFRDA.

Conclusion: Re-do with better public participation

The role of the aggregators, and the vulnerability of their customers should have led the PFRDA to accord a high importance to consumer protection when framing these regulations. The PFRDA needs to revisit these regulations and revise them in accordance with the substantive and procedural requirements of the Handbook. In particular, it would be advisable for PFRDA to quickly upgrade its ability to receive and display public comments on draft regulations. The PFRDA might consider extending the period for public commentary, and engaging more actively with the public to obtain high-quality feedback on this important subject.

Living within the Handbook: One recent example

by Arjun Rajagopal.

We recently ran a workshop for India's financial sector regulators, providing a walk-through of the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code. Despite its catchy title, the Handbook is a serious document, outlining the commitments made by India's financial regulators at the Eighth Meeting of the Financial Stability and Development Council (FSDC).

The Handbook places great emphasis on the role of Boards of regulators:

• Boards are to engage in careful deliberation supported by staff research.
  
• Proceedings are to be transparent and participatory.
  
• All decisions are to be clearly communicated through one type of legal instrument.

At the same time Boards are supposed to be responsive and decisive. Taking these requirements together, the implication is that Boards ought to meet more often, and that regulators should make fewer rules. The rules that are made, however, should be detailed and forward-looking, and should derive legitimacy from the fact that the public was consulted as part of the rule-making process.

All very well, we were told. But what does all this look like in action?

For a live example, we might step out of the world of finance for a moment, and look at the contentious and highly technical debate surrounding `net neutrality' in the US. The US Federal Communications Commission (FCC), is the regulator charged with making rules governing the use of the internet, and is in the process of deciding whether it will be permissible for transmission of some users' data to have priority over others'. The issue goes to the heart of the architecture of the internet, and has important implications for rights and commerce in the digital realm. The "Board" of the regulator is made up of five Commissioners; according to the news coverage of the issue, the Commissioners voted 3-2 to open up their proposed rules to extended public debate and commentary. A closer look at this decision, and the public's engagement with the rulemaking process, is a fascinating demonstration of the sound regulatory process in action.

The Notice

The Commission's decision and the proposed rules were published in the form of a comprehensive Notice of Proposed Rulemaking made available on its website. The document begins with a simply stated question: "What is the right public policy to ensure that the Internet remains open?" This is followed by a detailed treatment of the various issues it has identified, as well as the substance of the proposed rules. The document makes detailed reference to prior proceedings, government reports, academic treaties, and of course to the existing legal and regulatory framework, and relevant case law. It is certainly a lot more detailed than than many of the regulatory documents we work with here in India.

Detailed dissent

Statements from all five Commissioners have been published alongside the notice. The statements present the Commissioners' own viewpoints and their arguments. Strangely enough, one of the dissenting statements harshly criticizes the detailed, cogent Notice, saying that it is not detailed or cogent enough! The statement articulates substantive disagreements on the legal and economic issues. According to dissenting Commissioner Michael O'Rielly:

...before taking any action on any issue, the Commission should have specific and verifiable evidence that there is a market failure. The Notice does not examine the broadband market much less identify any failures.

Crucially, he also claims that there have been deficiencies in the rulemaking process:

...to say the cost-benefit "analysis" is woefully inadequate is an understatement. The Notice devotes several pages to a wish list of disclosures, reporting requirements, and certifications that will impose new burdens and carry real costs, but may not even be meaningful to end users... However, there is no attempt to quantify and compare the costs of the proposed new requirements against the supposed benefits - just a single paragraph seeking comment on ways to reduce the burdens. Proposed rules should be accompanied by a fulsome cost-benefit analysis that includes a detailed and extensive review of current law, especially as it applies to other federal agencies that we seek to imitate. The Commission's short-shrift approach to cost-benefit analysis cannot continue, and I intend to spend time improving this important function.

Regardless of the actual merits of the argument, it is nice to see a live debate over rulemaking and cost-benefit analysis (Chapter 4 of the beloved Handbook, for those who are following along) being carried out in public by the Board itself.

Engagement with the public

As with finance, regulation of telecommunications is an area in which sophisticated practitioners and academics have a rich history of commentary and advocacy. Industry groups, as well as advocacy organisations like the Electronic Frontier Foundation pick apart and scrutinise rules and rulings in this sphere. What is most interesting here, is the way that transparency has enabled a broader audience to get into the guts of the debate, nuanced as it is. The tech site "The Verge" has used footage from the open meetings of the Committee to create a video encouraging the public at large to engage directly with the regulator through its public comments submission page. Does this make life miserable for the Commission? Maybe, but this kind of highly public engagement gives disparate and opposing forces a fair chance to make their best arguments.

Links

Background:

• Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code
• New York Times article: "F.C.C. Backs Opening Net Neutrality Rules for Debate" May 15, 2014

Handbook Chapter 4 - Framing Regulations:

• Publication of draft regulations: FCC's Notice of Proposed Rulemaking, May 15, 2014
• System for receiving and responding to public comment: FCC public comments submission page

Handbook Chapter 7 - Transparency in Board Meetings:

• Video published by tech site "The Verge"
• Dissenting statement of Commissioner Michael O'Rielly

Conclusion

Justice Srikrishna's Financial Sector Legislative Reforms Commission, which drafted the Indian Financial Code, worked on two tracks. The first element was writing down the market failures in finance which require a government to do something. The second was establishing good governance practices for how financial agencies should work. Both steps are novel by Indian standards. It is, however, quite easy to obtain intuition on how these things actually work by looking at advanced economies, particularly in contentious episodes such as the net neutrality debate.
The working of regulators is not specific to finance; the IFC and the Handbook can easily scale to other regulators.

Fixing the Indian capital controls against DR issuance by Indian firms

by Pratik Datta and Arjun Rajagopal.

Yesterday, the Ministry of Finance accepted the report of the Sahoo Committee on depository receipts. Depository Receipts, also known as DRs, are financial instruments that are issued on the back of domestic securities, for sale to investors abroad: Indian securities are deposited with a custodian in India, after which a depository institution in a foreign jurisdiction may issue corresponding DRs. Each DR represents one or more underlying Indian securities. In this way, issuers of Indian securities can access the international capital markets and foreign investors can gain exposure to Indian securities without directly holding the Indian securities.

Before we plunge into the details, here are the key links:

• Press Release from MOF
• The Sahoo Committee report.
• A video summarising this in less than 4 minutes from the NIPFPMF channel on youtube.

The importance of DRs

Investors around the world generally over-invest in their home country and under-invest in overseas securities. This is a phenonemon known as home bias. Despite improvements in financial infrastructure and communications technology, it can still be expensive and complicated to invest in foreign securities. DRs help to alleviate the problem of home bias: Though the underlying securities are foreign, the investor can take comfort in the fact that the DR itself is issued in her own jurisdiction, in her own currency and subject to her own jurisdiction's laws and regulations. DRs are thus attractive to investors because they offer a combination of simplicity, protection and flexibility as compared to direct investment in a foreign market.

DRs are also an important mechanism by which an economy can achieve competitive neutrality. The principle of competitive neutrality is a key component of a liberalised trade system. The principle mandates that foreign and domestic inputs be treated identically. India made large steps towards competitive neutrality in its real economy when it allowed domestic firms to purchase inputs from international markets at competitive global prices. When an Indian firm issues a DR abroad to be puchased by a foreign investor, it is seeking to procure another input - capital - at a competitive global price.

Why regulate DRs, and how?

In a market economy, any intervention by the State must be justified by the identifying market failures, and demonstrating that the proposed intervention addresses the identified market failure. The FSLRC report and the IFC identify four areas where regulation is legitimate: consumer protection, micro-prudential regulation, (regulation of individual firms), systemic risk regulation and resolution (orderly exit of failing firms). None of these four problems are present with DR issuance by Indian firms.

The investors in DRs are not participants in the Indian securities market. These investors are protected by the authorities and laws of the jurisdiction where the DRs are issued. For example, for an American DR (ADR) issued in the US against Indian securities, US laws provide for protection of investors in such ADRs in US. Indian laws need not provide additional protections to such investors for three reasons. First, such protection is already being provided by US laws. Second, Indian laws do not require an Indian regulator to protect foreign investors in foreign securities in a foreign country. Third, additional protection, if provided by Indian laws, will impose additional costs on the Indian issuer.
However, the DR mechanism can be utilised as part of a conspiracy to achieve market abuse and money laundering in the Indian securities market. This requires learning how to handle such problems through effective law enforcement. This approach has informed the Committee's decision to permit issue of DRs only in IOSCO and FATF compliant jurisdictions. (See Table 5.1, page 60, Sahoo Committee Report).

The need for reform

Prior to the Sahoo Committee, DRs are primarily regulated by the FCCB and Ordinary Shares (Through Depository Receipt Mechanism) Scheme 1993. In addition, DRs are subject to:

• the existing capital controls regime (under FEMA) as administered by RBI;
• regulations administered by SEBI;
• companies law as administered by the Ministry of Corporate Affairs; and
• the laws on taxation as administered by the Department of Revenue, Ministry of Finance.

In 2013, the Government felt the need to review the Scheme, primarily because of vast changes to the legislative landscape affecting the financial sector since 1993. Three new pieces of legislation had been introduced: the Companies Act, 2013; the Securities Laws Ordinance, 2013; and the Takeover Regulations, 2011. Along with these legislative developments, the macroeconomic and financial landscape had changed as well. The thinking underpinning the 1993 Scheme was no longer well-suited to the needs of Indian firms. The existing framework was riddled with interventions that could not be justified by the objective of identifying and addressing market failures. Further, two decades of incremental modifications to the Scheme had resulted in increased legal risk.

The Sahoo Committee's Recommendations

The report calls for the government and the other regulators to clarify certain critical aspects of the current regulations, in particular the fact that non-capital raising DRs, and both listed and unlisted DRs are all to be permitted. The report also recommends important changes such as:

1. Unsponsored DRs should be allowed;
2. There will be no restrictions under Indian law on who can serve as a foreign depository;
3. DRs on the back of Indian securities must only to be issued in FATF and IOSCO compliant jurisdictions;
4. A broader category of Indian securities should be allowed to serve as the underlying for DRs; and
5. Listed voting DRs on the equity shares of a listed Indian company are to form part of the minimum public shareholding of the Indian company under Indian law.

The report is clarifies that it is not the government's job to promote the use of DRs but merely to remove impediments to their efficient use in the market based on the decisions made by private players. However, given the size of the DR market around the world, and the variety of strategic benefits that DRs provide to firms and investors, it is likely that these reforms will expand choice and liquidity in the market.

Participatory process, coherent output

Much of India's policy work is done behind closed doors, with the final recommendations or decisions being tersely communicated through press releases or circulars. Opacity and low public participation diminish the quality of policy outputs, and the legitimacy of any resulting regulations. In order to avoid these problems, the Sahoo Committee drew its members from the public and private sectors, as well as from academia, and held several in-depth consultations with market participants.
The report endeavours to provide a concise overview of the legal and economic context of its work, as well as an outline of the intellectual framework from which its recommendations flow. The report presents holistic recommendations in an accessible Q&A format that is targeted at practitioners and at a wider public who may not be familiar with the intricacies of the subject matter. It also provides a list of recommended specific technical changes to current laws and regulations, and presents these in the form of a draft Scheme that is ready for implementation.

Peering into the future

The Sahoo Committee report has been accepted by the Ministry of Finance. The changes to regulations that are required in implementing this are likely to take place in coming months. Once fully implemented, we may conjecture:

• Legal risk surrounding DRs will go down.
  
• Employees of government and financial agencies will spend less time on interventions which lack an economic justification.
  
• The cost of doing business in India will go down.
  
• The income of lawyers per unit DR issuance will go down.
  
• More Indian firms will issue DRs.
  
• The domestic Indian securities market will face greater competitive pressure as Indian firms and their investors will have a choice of meeting each other through exchanges outside India.
  
• Home bias against Indian firms will go down.
  
• Indian firms will obtain a reduction in the cost of capital for both equity and debt.

Capital controls against FDI in aviation: An example of bad governance in India

by Anirudh Burman, Ajay Shah and Arjun Rajagopal.

FDI in aviation was liberalised by the Reserve Bank of India on September 21, 2012 through a change in the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (link). Following that change, private players began putting together a number of complex transactions between Indian and foreign companies such as Jet-Etihad, AirAsia-Tata, and Tata-Singapore Airlines.

On November 20, 2013, the Directorate General of Civil Aviation (DGCA) revised its `Civil Aviation Requirements' or "CAR" (CAR 4.1.5 to 4.1.16) to state that a domestic airline company cannot enter into an agreement with a foreign investing entity (including foreign airlines) that may give such foreign entity a right to control the management of the domestic operator ( link). This change in regulations has major consequences for some of the transactions which are in progress.
There are two important deficiencies in this action by DGCA:

1. The CAR makes repeated mention of the requirement of control, without clarifying what the term `control' means. This creates legal risk for transacting parties.
   
2. No rationale has been offered to justify the use of the coercive power of the State via the CAR; no estimates of the costs or benefits of this regulatory action have been provided.

What does `control' mean?

Rule 4.1.8 of the CAR (link) states:

A Scheduled Air Transport Service/Domestic Scheduled Passenger Airline shall not enter into an agreement with a foreign investing institution or a foreign airline, which may give such foreign investing institution or foreign airlines or others on behalf of them, the right to control the management of the domestic operator.

However, the `right to control the management' has not been defined. This lack of clarity is compounded by two other regulatory requirements: (a) the directors appointed by the foreign entity cannot exceed more than one-third of the total (CAR 4.1.7), and (b) the substantial ownership and effective control of a domestic operator has to be vested in Indian nationals (CAR 3.1).

The new requirements must mean that `the right to control the management' involves a form of control over and above these two earlier requirements, but no definition of that form of control is offered. Such lack of precision in drafting of laws results in increased legal risk and should be avoided.

Lack of transparency

When the coercive power of the State is wielded by the executive, this should be accompanied by appropriate checks and balances. Good practice in regulatory governance requires that when regulators wish to make changes to regulations, and thus affect the rights of private parties, the regulators must furnish reasons for making those changes. This increases transparency, predictability, and accountability.

In the case of investments, an investor who commits resources would want an element of control in order to ensure his money is not stolen or wasted. A substantial investment in a company is thus often accompanied by rights regarding management and control of the company. If a regulatory requirement interferes with these rights of investors, the onus is on the regulator to explain why. The changes to the CAR affect the rights of investors and potential investors in the aviation industry, but DGCA has not furnished any reasons for its revisions.

Regulatory actions must not be arbitrary acts of God. They must be steeped in the rule of law. The Draft Indian Financial Code, when enacted, will ensure financial sector regulators make qualitatively better regulations by blocking these kinds of mistakes. All draft regulations will have to be accompanied by reasons for the proposed regulations, as well as a cost-benefit analysis of the proposed regulations. These will be made available for public comment, before the final regulations are adopted. This regulation-making process will result in clearer and better regulations, and will enhance the legitimacy of the regulations and of regulators. The adoption of a similar process by DGCA would have led to a better outcome.

Barriers to international economic engagement: A strategic view

Consider trade barriers. The Indian State has the power to introduce customs duties. A number of government bodies undoubtedly have a major stake in the design of customs duties, and may even have critical expertise in the matter. Nonetheless, the power to introduce and modify customs duties is vested in a single authority -- the Ministry of Finance. The Ministry of Textiles, for example, has no power to change the customs duty on imported cloth. This is a healthy arrangement: The Ministry of Finance is responsible for maintaining a unified strategic outlook on the question of trade barriers. The Ministry of Textiles can engage with the Ministry of Finance and suggest changes in tariffs, but responsibility for formulating and promulgating a coherent policy ultimately rests exclusively with Ministry of Finance.

This same strategy is required in the field of capital controls. If multiple regulators or government departments set about writing capital controls, we will have a balkanised mess.

Indeed, the current capital controls based framework is just such a balkanised mess. In the absence of a single governing law for foreign investment, a number of agencies have prescribed foreign investor regulations. The types of capital control restrictions and their rationale can be outlined as:

1. Entry restrictions by financial regulators such as RBI and Ministry of Finance, usually to promote monetary policy and financial stability (under the Foreign Exchange Management Act, but not restricted to it);
   
2. Entry restrictions imposed by DIPP and Ministry of Finance on grounds of national security (may include consideration of factors listed under FEMA as well); and
   
3. Regulatory restrictions (including on control and ownership) imposed by sectoral regulators.

This multiplicity of regulations also leads to uncertainty of regulatory objectives. Investors have no idea of what criteria is used to assess their investments, and grant them business permissions. It is important to recognize that the justifications used to impose regulatory restrictions for relying on the distinctions between private and public, or domestic and foreign entities, is that these distinctions are reasonable proxies for the other characteristics (national security, systemic risk) that are a valid basis for differential treatment. As in so many areas of regulation, the misapplication of easy proxies for characteristics that are difficult to assess becomes a glaring reminder of regulatory uncertainty. It is important that regulatory objectives be identified clearly in relevant statues and regulations.

In addition to the legal and regulatory uncertainty created by such a multiplicity of regulators and regulations, the regulations themselves may violate India's obligations under various multilateral and bilateral investment treaties: Many, if not, most such agreements provide for national treatment of investment once it has been allowed to enter the domestic market. Regulators should not be allowed to impose regulatory restrictions after foreign investment has already entered the domestic market. Under this principle of competitive neutrality, there should be no difference in the conditions imposed on the State Bank of India and those imposed on Etihad, when they invest in Jet Airways.

This requires more than administrative changes. A reform of the legal framework is essential. For example, the restrictions in the CAR appear to be grounded in the expansive powers granted to DGCA under the Aircraft Act, 1934. Section 5 of the Act (link) states:

Power of Central Government to make rules. - (1) Subject to the provisions of section 14, the Central Government may, by notification in the Official Gazette, make rules regulating the manufacture, possession, use, operation, sale, import or export of any aircraft or class of aircraft and for securing the safety of aircraft operation.

Those same powers could ground preferential treatment in other areas of regulation. To the extent that other regulatory bodies with responsibilities for other sectors have similar powers, those sectors too are vulnerable to violations of the principle of competitive neutrality.

The report of the FSLRC proposes a cleaner, clearer regulatory framework for foreign investment, one which is consistent with these obligations. Section 2.5 of the report states:

The Commission envisages a regulatory framework where governance standards for regulated entities will not depend on the form of organisation of the financial firm or its ownership structure. This will yield 'competitive neutrality'. In this framework, the regulatory treatment of companies, co-operatives and partnerships; public and private financial firms; and domestic and foreign firms, will be identical.

The draft Indian Financial Code, which encodes the principles articulated in the report, explicitly requires all regulators to maintain competitive neutrality while framing regulations. Section 84 (Principles of consumer protection) and section 141 (Principles of prudential regulation) contain the following identical language:

[C]ompetition in the markets for financial products and financial services is desirable in the interests of consumers and therefore... there should be competitive neutrality in the treatment of financial service providers;

This will ensure that sectoral regulators in the financial sector will not be able to discriminate against foreign and domestic firms/investment.

Pending the introduction of the Code, it would be helpful to incorporate its underlying principles into the existing regulatory framework. For example, the BJP has suggested that they will block FDI in retail but they will remove all capital controls against FDI in other sectors. Any government wishing to carry out such a change would need all capital controls be defined at only one place, where a single policy decision is taken. After this, it should not be possible for any other department of government or a regulatory agency to introduce capital controls.

The required single-window system should have the following characteristics:

1. A comprehensive definition of foreign investment;
   
2. A rule-of-law based mechanism for the government to allow/prohibit entry of foreign investment in specific sectors;
   
3. A single regulatory barrier for foreign investment before it can enter the domestic market. Currently FIPB is an example of such a barrier;
   
4. Clear documentation of approval of foreign investment that must be binding on all government authorities;
   
5. Clear enumeration of reasons for which foreign investment can be restricted, and who can impose these restrictions (without any catch-all provisions like "for any other reason");
   
6. A positive obligation on the government to ensure competitive neutrality, OR a restriction preventing the government from discriminating against foreign investment once the investment has been allowed to enter India; and
   
7. A review mechanism where foreign investors whose investment has either (a) been rejected, or (b) been subjected to discriminatory treatment compared to a domestic investor, can seek redressal.

Conclusion

There is great outrage in India today, against a capricious State that is a major source of risk for firms. These failures on capital controls are one important component of that problem. It is the right of politicians to interfere with international economic integration - e.g. to block FDI in retail or not or to have tariffs on import of apples or not. But there should be a single-barrier where this political decision is made.

Difficulties with Special Guidance and General Guidance in the IFC

by Anirudh Burman, Pratik Datta, Suyash Rai, Arjun Rajagopal, Shubho Roy.

Administrative and regulatory agencies in India currently use multiple legal instruments to regulate. This creates multiple problems for those regulated:

1. Identifying all applicable subordinate legislation;
2. Reconciling sometimes overlapping and inconsistent subordinate legislation; and
3. Distinguishing between binding and non-binding statements/regulations.

For example, a person investing through the FDI route has to reconcile the applicable FEMA regulations, FDI Press Notes and the Consolidated FDI Policy. All of these have been communicated via legal instruments, but there is uncertainty over which instrument is operative in any given situation. This increases compliance costs and legal uncertainty.

The draft Indian Financial Code (IFC) proposed by the Financial Sector Legislative Reforms Commission introduces a completely new way of thinking about regulatory governance in India. Perhaps the most critical component of this framework of regulatory governance is the proposal that regulators will regulate only through ``regulations''. The use of a single instrument to regulate (instead of the present plethora of circulars, orders, letters, instructions etc.) will ensure legal clarity for regulated entities and therefore facilitate a rule-of-law framework in financial regulation.

However, two provisions in the IFC have the potential to upset this carefully constructed framework. Section 56 (General Guidance) allows regulators to issue ``general guidances'' with respect to the operation of the IFC and regulations made under it, the operation and objectives of the regulator, and other matters on which the regulator wants to provide information or advice. Section 57 (Special Guidance) allows any person to ask for a ``special guidance'' with regard to transactions or activities governed by the IFC. The provision on special guidances is similar to the existing system of advance rulings under the Income Tax Act. It should be noted that a need for a system of advance rulings under the Income Tax Act exists because of the lack of clarity of our taxation regime. If the U.S. experience with such guidances is any indication, both these provisions have huge potential to dilute regulatory certainty.

U.S. experience with guidances

The US Administrative Procedures Act contains uniform administrative procedures to be followed by all federal administrative agencies. Section 553 of the APA requires a public notice and comment procedure to be followed whenever an agency makes a ``rule''. However, this requirement does not apply when an agency issues ``interpretative rules, general statements of policy, or rules of agency organization, procedure, or practice''. This exception has been used by agencies to regulate through interpretative rules and policy statements. (For more reading on the subject, see: Anthony (1992); Recommendations of the Administrative Conference Regarding Administrative Practice and Procedure (1992); and Rakoff (2000)). As interpretative rules and statements of policy do not require a public notice and comment procedure to be followed, an agency finds it less costly to regulate through these instruments than to frame rules. As an example, the number of US Food and Drug Administration regulations adopted in accordance with the APA reduced 50 percent in mid-90s compared to early 1980's (Rakoff (2000)). Anthony (1992) and Rakoff (2000) point out that interpretative rules and statements of policy become de facto binding for the following reasons:

1. The staff of the agency starts relying on the interpretative rule or statement of policy in its work. This happens even though some agencies explicitly state that interpretative rules are not binding statements.
2. The language of the interpretative rule or statement of policy indicates that the agency will follow it.
3. The language of the interpretative rule or statement of policy indicates that it is of a binding nature, or will be regularly applied against regulated entities.

U.S. Courts have tried to counter this development by stating that: ...as a general rule, an agency can declare its understanding of what a statute requires without providing notice and comment, but an agency cannot go beyond the text of a statute and exercise its delegated powers without first providing adequate notice and comment. (Fertilizer Institute v. EPA F.2d 1303), Courts however, do not provide a good solution to this problem for two reasons:

1. Judgements are case-specific, and it is difficult to enunciate a broad principle that substantially whittles away agency discretion, and
2. In many instances, it is difficult to determine which exact parts of an interpretative statement or statement of policy are in effect, a disguised regulation, and those that are not.

One alternate method of ensuring some restraint on regulation through interpretative rules (and that also functions as a feedback loop) is that of ``petitions''. Section 551 of the APA defines a ``rule'' to include interpretative statements and statements of policy. Section 553 allows any person to petition for the issuance, amendment or repeal of a rule. This provision has been used to petition for changes to the interpretative rules. The US Supreme Court has held that agencies can deny a request made in a petition only on reasons grounded in statutory law.

What should we change in the IFC?

The U.S. experience clearly shows the pitfalls of giving agencies powers to ``explain'' their objectives and operations. Granting agencies the power to issue communications without following a defined legal process opens the door to chaos in regulatory governance. It incentivizes over-regulation (as regulation without notice and comment is cheap) and leads to a breakdown of the rule of law. The power to request and grant special guidances only exacerbates this problem. It is therefore important that a regulator's power to issue guidances be restricted.

To achieve this, certain changes need to be made to the IFC.

Remove Section 57 on special guidances

The U.S. experience with respect to ``general'' interpretative rules highlights how giving agencies an option to avoid regulation making in fact leads to regulatory chaos. This problem is only going to be exacerbated with a system of special guidances.

Every time a regulator issues a special guidance it interprets the law and applies it to the facts present in the application for guidance. This interpretation will, in many if not most cases, be taken as evidence of how a regulator applies the laws to specific facts. In a good rule of law system, any such interpretation should then be applicable generally to all regulated entities. The lack of general applicability creates legal inconsistency and reduces clarity. This is bad for any system of regulatory governance.

Restrict the use and content of general guidances

The purpose of guidances is to aid regulators in explaining regulations to regulated entities and consumers. They should not become substitutes for regulation-making. In an ideal world, there would be no need for a guide to regulations as they would be self-explanatory. Guidances should therefore function as ``regulatory guides''.

At present, Section 56 of the IFC provides that general guidances can be used for the following purposes:

1. The operation of this Act and any regulations made under it;
2. Any matters relating to functions of the Financial Agency;
3. Meeting the objectives of the Financial Agency; or
4. Any other matter about which the Financial Agency finds it appropriate to provide

All of the above provisions leave scope for a regulator to ``legislate'' regulations through general guidances, in the same way as agencies in the U.S. have done. Unlike the practice mandated under the U.S. APA, financial regulators under the IFC will have to go through a notice-comment procedure even for general guidances. However, they do not have to prepare a cost-benefit analysis of the same. Therefore, ``regulation'' through guidances is still a less costly proposition than framing regulations. Moreover, guidances in India are likely to become binding in India in the same ways as interpretative rules and statements of policy in the U.S:

1. The staff of the regulator starts relying on the guidance and treats it as binding;
2. The language may indicate to regulated entities that the regulator will implement the guidance; and
3. The language indicates that it is of a binding nature, or will be regularly applied against regulated entities.

Guidances should therefore be used only as regulatory guides i.e. they should only aggregate and present existing regulations and publicly available orders of regulators for the benefit of regulated entities. For example, regulators may prepare a regulatory guide aggregating and summarizing all applicable regulations and approval/decision orders for say, a person who wishes to get an approval for starting a mutual fund business. For doing this, the following legal framework is proposed:

1. Guidances/regulatory guides should be published by regulators for the sole purpose of enhancing the readability of regulations to regulated entities or specific classes of regulated entities.
2. Guidances/regulatory guides may contain clearly distinguishable additional text only for the following purposes:
   1. For introducing the subject of the guidance and the relevant regulations/orders; and
   2. For connecting portions or extracts of orders to enhance the document's readability.
3. The guidance/regulatory guide should contain a clear disclaimer stating the following:
   1. Any additional text contained in the guidance/regulatory guide does not constitute legal advice and is not binding on regulated entities.
   2. The regulator will not rely on the additional text in the guidance/regulatory guide in dealing with regulated entities.

This will:

1. Prevent regulators from accidentally or deliberately adding ``binding'' content in guidances, and
2. Consequently create greater incentives for regulators to write high quality regulations that are clear and comprehensive.

It will also force regulators to think of how to develop world-class websites where different regulations, orders, and even relevant FSAT judgements can be presented to a user seamlessly. A good example of a financial regulator's website performing this function is the page on ``Regulations guidance and licensing'' of the Monetary Authority of Singapore (link).

Create a system of review for `disguised regulation'

There should be a review mechanism to prevent against regulators accidentally or deliberately adding binding content to guidances. In the U.S., courts have declared invalid interpretative rules that are ``legislative'' in nature and bind regulated entities. A similar power to review guidances should be given to the FSAT. The FSAT should be able to direct the regulator or directly redact portions of guidances if:

1. The communication is couched in mandatory language;
2. The communication indicates that the regulator will treat the communication as binding in its interaction with regulated persons;
3. The language of the communication strongly evidences a binding intent; or,
4. Regulated persons are led to believe that adverse consequences will follow in case the communication is not complied with.

Create a framework for petitioning regulators for changes in regulations and guidances

In the U.S. petitions have served as an instrument to force agencies to review their rules, interpretative rules and policy statements. We envision a similar role for petitions under the IFC. Additionally, a framework for petitioning regulators can create a legitimate and transparent feedback mechanism through which regulated entities and consumers can talk to regulators. While in the U.S., courts review the denial of petitions, we envision a system of petitions that is softer in nature and focuses on ensuring a functioning communication mechanism between regulators, consumers and regulated entities.

Any person should be allowed to petition for the issuance, modification or repeal of a regulation or guidance. Regulators should allow for petitions to be submitted through their website and on paper. All petitions should be made available on the regulator's website, and the regulator should respond to every petition on its website in a time-bound manner. The regulator may agree to the request made in the petition, or deny it. However, the denial should be on limited, legally defined grounds:

1. The petition requires the regulator to do something it has no legal power to do;
2. The petition does not require the issuance, amendment or repeal of a regulation;
3. There is no way, in spite of reasonable efforts being made, to verify factual claims made in the petition that form the basis of the request to issue, amend or repeal a regulation;
4. The regulation to be amended or repealed, or the subject matter of a new regulation is under review before the FSAT or any other court; or
5. The regulator agrees with the substance of the petition, but does not have the resources to implement the petition. In case the regulator denies the petition on this ground, the regulator must state when it proposes to act on the petition.

From clubs to States: The future of self-regulating organisations

by Ajay Shah, Arjun Rajagopal, Shubho Roy.

This post is based on talk at the 2013 National Convention of the Institute of Company Secretaries of India.

India's governance environment is undergoing rapid changes, and this will drastically re-shape the role of Company Secretaries. As a professional body, ICSI needs to understand and anticipate these changes, in order to ensure that its members are equipped to fulfill their critical role. While the ideas here pertain to ICSI, they also apply more generally to other self-regulating organisations.

The citizen-government interface is changing

The development of the government-citizen interface of a country can be divided into two phases. In the first phase, the interface is characterised by poorly written regulations, wide variation in practice and very bad infrastructure. Each government office uses its own unique processes and practices, and requires physical filings on forms that are difficult to fill. Different branches of government collect the same information in different ways, the same function and form are widely different in different states.

In such contexts, professionals invest time in learning to ``work'' the system, and create a valuable niche for themselves as indispensable intermediaries between citizens and the state. Twenty years ago filing a personal income tax return was challenging and often required professional help. This culture persists in many government offices: forms have `unique' requirements which only `experienced' persons know. This knowledge/experience comes from being a member of the professional organisation (the club) and the club prevents this knowledge from falling into the hands of non-members. As a result citizens and businesses are `forced' to approach the club members to comply with laws.

The second phase of development occurs when the State-Citizen interface improves. This is occurring in India through computerisation and standardisation of processes and forms on the one hand, and increased empowerment of citizens on the other. The internet is changing the interface in two ways:

1. Many government services are moving on to the internet. While India has only 18% internet penetration, around 39% of railway tickets are sold online.
2. Even with poor systems, the internet is helping citizens deal with poor state interface through HOWTO documents, computerised services, etc.

As a result, consumers of professional services begin to demand more of their service providers, and professionals are faced with an existential crisis.

The profession's response

Professional organisations have two choices:

1. The knee-jerk reaction to defend their turf, fight to keep systems closed and inaccessible, try to increase the complexity of systems, and create and sustain non-transparent institutions.
2. The enlightened response to focus on long-term survival by aligning itself with the interests of the consumer and industry they serve.

The knee jerk reaction causes frustration among customers and clients. This leaves the profession vulnerable to being side-lined by cost-driven innovations in the economy. An example of this is the rise of Legal Process Out-sourcing (LPO), which has allowed clients to access a broad range of legal services without hiring expensive lawyers. Worse, a profession can spiral into a vicious cycle of defensive and unethical behaviour, in which members to put the interests of the profession above those of their clients and customers, and in which standards of competence and conduct begin to suffer. In extreme cases, persistent self-interested or indisciplined conduct can invite a devastating response from the political establishment, as occurred when the Government took over management of the Medical Council of India in 2010.

By contrast, an enlightened response to a changing environment would try to preempt such crises and focus on the long-term survival of the profession. In the long-term, the profession will only survive if its interests are aligned with those of its clients, and if it provides a useful service to society at large. Strategically, it would make sense for the profession to focus on those roles in which it is truly irreplaceable, re-focussing its attention on its highest value services. And institutionally, the profession's governing body should move from being a ``club'' to being a ``state''.

The way forward

The state model recognises that modern professional organisations are like regulators, in that they incorporate the broad functions of the modern state: legislative, executive and judicial. As such, they ought to be designed with the same internal safeguards and processes as the modern state. These include, most critically, defining and separating out these functions. A good SRO will carry out its legislative functions by making codes of conduct and defining conditions of entry into the profession. It will carry out its executive functions by holding exams to restrict entry into the profession to qualified individuals, and by investigating complaints against its members. And it will carry out the judicial function of disciplining its members.

The record on performance of these functions in India is mixed. We have sometimes been successful in defining codes of conduct and entry conditions, sometimes not. In terms of executive functions, Indian SROs have paid extreme attention to maintaining entry barriers, often at the cost of efforts to investigate complaints against the profession. In terms of the judicial function, Indian SROs are highly averse to disciplining their members in public, fearing that this will be seen as a sign of failure of the SRO. It is possible to bolster each of these functions, and ensuring the long-term survival of the profession requires that this be done.

In order to exercise its legislative function effectively, a modern SRO must:

• make detailed codes of conduct;
• make these codes of conduct available to the public;
• make these codes of conduct readable and comprehensible, through plain English guidance notes, FAQ pages, etc.;
• provide information about how grievances can be addressed.

In order to exercise its executive functions effectively, a modern SRO must:

• ensure that the entrance exams it runs are performing their function correctly. This requires analysis of test results and periodic review of the design and content of the tests, to ensure that they are relevant and of an appropriate level of difficulty;
• engage in continuing professional education of its members, as opposed to voluntary and occasional seminars, and ensure that this continuing education reflects the rigour of the selection process for entry;
• ensure that complaints against the profession are taken seriously, and investigated, and that the investigations are time-bound, and that the complainants are informed about the status of the investigation.

Too often in India, entrance tests are just a reflection of the person taking the exam and not the person who organised the exam. We do not bother to think whether the exam was fair. A recent data analysis of ICSE and ISC exams (high school exams) shows statistical evidence of poor exam design and manipulation of marks.

In a ``club'', standards of conduct are enforced by norms, not rules. Those norms are flexible, and defaulters are treated kindly. Clubs work well for small groups of professionals, who must rely on each other in an uncertain and unpredictable environment, which itself must be managed with a high degree of flexibility and discretion. A club is thus an appropriate model for a SRO in an early stage of its development. But as the environment changes, as processes become technologised and standardised, and customers become empowered, the club model will have to give way to a ``state'' model, which is less discretionary, less cosy, and less forgiving to defaulters.

Regarding the judicial function of a modern SRO, the organisation must:

1. have an impartial and effective judiciary;
2. have a fair system for addressing complaints;
3. have a detailed procedure for adjudication;
4. make rules allowing the complainant to participate;
5. ensure that adjudication proceedings are time bound.

Achieving this requires three ingredients: The first is a law, which will clearly set the bounds within which the SRO will operate. This law should be ``anti-professional'' in that it must be designed to protect the interests of society rather than the interests of the profession. Punishments should not only be meted out but publicly shown to have been meted out. In 2012, the New York city Disciplinary Committee publicly disciplined 65 lawyers (See pg. 32) which include 13 disbarments. Many jurisdictions even go to individual practitioner level information about disciplinary actions. We rarely see any comparable level of disciplinary actions against professionals in India. The ones that do happen are usually after a big `scandal' like the Satyam failure and soon die out of public memory. No comparable data is publicly available for Indian professional organisations. They seem to hide the data about disciplinary actions and therefore should be presumed to have not carried out much.
India is going through an interesting time. The nature of the state is changing. RTI, Lokpal, E-governance, etc., are just examples of a move to a more perfect republic. SRO's have a choice, get in the way or join the change.