Arthur F. Burns Fellow Peter J. Wallison

Interest in principles-based regulation and accounting is growing among U.S. policymakers and commentators. This is understandable. The Financial Services Authority styles itself as a principles-based regulator and that looks wonderfully refreshing to individuals and companies that have had to deal with the rigid rules enforcement of the Securities and Exchange Commission. Regrettably, however, the latest flirtation is likely to come to nothing. The political, cultural and legal environment in the U.S. seems unsuitable for a regulatory or accounting regime that works on the basis of principles rather than rules.

The principles-based concept has two elements: principles that govern how regulators act and outcome-oriented principles that might supplant detailed rules as guidelines for auditors and regulated companies. The FSA has both and the concept of restraining regulatory discretion within certain channels, or focusing on certain goals, has real merit. The problem for the U.S. arises with the second element.

One of the characteristic features of U.S. political life is an instinctive distrust of discretionary power. Americans like to be free of controls and a rules-based system accommodates this preference. Although detailed rules may be made by the Financial Accounting Standards Board, the SEC, or the Internal Revenue Service, their interpretation is left to those who must comply with them. This leaves significant room for self-determination. In a principles-based system, how a principle will be applied remains at the discretion of the regulator. Thus, ironically, given any regulation at all, a rules-based system offers more freedom for those who are regulated.

But apart from this, principles-based regulation reduces the rules transparency essential for a competitive market. A rules-based regime tells everyone what is required to enter a field and compete. A principles-based regime is open to interpretation by a regulator and could be used to deny entry to would-be competitors. A recent example is Wal-Mart's effort to acquire a bank-like entity known as an industrial loan company. The U.S. banking industry strongly opposed this and--even though there was no legal authority to do so--the FDIC, under industry and congressional pressure, imposed a one-year moratorium on applicationsby retailers such as Wal-Mart to give Congress time to enact restrictive legislation.

If this is what occurs when there is no authority at all to restrict entry, imagine what would happen in a principles-based environment where a regulator has the discretionary authority to interpret its regulations so as to prevent new competitive entry.

Then, too, the U.S. legal system is--to say the least--not hospitable to principles-based accounting or regulation. A principles-based regime may work if the only enforcer is the regulator and if the regulator--like the FSA--is more interested in achieving compliance than imposing fines and penalties. But public companies and securities companies are subject to civil enforcement actions by the SEC, criminal enforcement by U.S. attorneys, criminal and civil enforcement by state attorneys-general and private class actions in both state and federal courts. Banks and insurance companies are subject to essentially the same array of public and private enforcers. In this unwieldy and enforcement-oriented structure, a principles-based system would open new doors to litigation and liability.

Nor can a compliance-oriented regime like the FSA's work in the presence of the private class action system that continues to flourish in the U.S. By definition, private class actions are outside the range of government or regulatory policy. The courts and Congress have found it almost impossible to restrict the scope and cost of private class actions under a single SEC rule--the famous 10b-5. It is not hard to imagine the mischief that might be done by class action lawyers if they were gifted with a whole series of SEC rules that were similarly broad and malleable.

This raises the final point. A rules-based system, whether for accounting or regulation, has a safe harbour effect. If one complies with the rules there is some degree of absolution. This seems essential in the litigious environment of the U.S. Certainly, as in the case of Enron, rules-based regimes are subject to abuse by those who use the rules as a roadmap for deception, but given the political and legal system that prevails today in the U.S., most U.S. companies would probably prefer a fully transparent and certain system of rules.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Market Studies at AEI.