The Timing and Source of Regulation

• Publication year: 2013

SEATTLE UNIVERSITY LAW REVIEWVolume 37, No. 2, Winter 2014

The Timing and Source of Regulation

Frank Partnoy(fn*)

I. INTRODUCTION

The distinction between specific concrete rules and general abstract principles has engaged legal theorists for decades.(fn1) This rules-principles distinction has also become increasingly important in corporate and securities law, as well as financial market regulation. One prominent example is the contrast between U.S. rules-based accounting-which attempts to specify in detail what parties should disclose-and European principles-based accounting-which sets forth only general notions of disclosure.(fn2)

This Article adds two important variables to the rules-principles debate: timing and source. Although these two variables are relevant to legal theory generally, the specific goal here is not to address and engage the rules versus principles literature directly. Rather, the goal here is to ask whether the debate about financial market regulation might benefit from a more transparent analysis of temporal and legal source variables. That is, the when and where of the application of both rules and principles.

From capital requirements, to investment restrictions, to disclosure rules, much modern financial market regulation is focused on ex ante regulation.(fn3) This focus on ex ante regulation is especially true outside the United States and England, particularly in Asia, where regulators rely less on the private attorney general role of the plaintiffs' bar.(fn4) In contrast, decades ago, regulators throughout the world, but particularly in the United States, took more of an ex post approach. These regulators emphasized adjudication or regulatory assessment after-the-fact based on general principles rather than specific rules.(fn5) This Article seeks to provide a framework for understanding and assessing the shift from ex ante to ex post and from principles to rules.

In theory, rules or principles can be either specified in advance or applied after-the-fact, and can be applied both by private or public means. For example, either a regulator or private party might favor principles that are established early and then adjudicated later. Alternatively, a regulator or private party might favor principles that are established later, only after a dispute occurs. Likewise, a regulatory approach might specify rules in advance of a transaction, or it might do so later on in the event of a dispute. In a dispute involving either principles or rules, the ex post adjudicator might be private or public: either an arbitrator or a judge.

The complexity of modern markets has led to the proliferation of ex ante rules, which purport to provide greater certainty to regulators and market participants.(fn6) In some cases, that certainty is important and welcome. In other cases, it has deleterious consequences. The proliferation of rules raises numerous policy questions, including whether financial markets would be better served by greater regulatory uncertainty. Market participants, then, would be less able to calculate the expected benefits and costs of complying with regulation based on anticipated probabilities and magnitudes.

This Article does not seek to comprehensively answer the central questions about the optimal regulatory approach in financial markets, but instead, it poses a new way to ask those questions. For example, might ex ante principles act as an information-forcing mechanism and create incentives for private actors to internalize the costs of their behavior? Might the twin pillars of securities law-disclosure and enforcement-be better supported by a less certain regulatory approach that specifies broad principles ex ante, and then provides for adjudication of compliance ex post? Might there be advantages to simply banning "proprietary trading" as a general principle and then leaving the specific definitional challenges and issues for adjudicators to resolve and formulate in future disputes, instead of attempting to specify the categories of permitted activity ex ante in a rules-based approach such as the Volcker Rule?(fn7) Should parties be permitted to avoid fraud-related claims by including broad non-reliance provisions in contracts? Should judges scrutinize disclaimers based on the actions of a party with superior information or sophistication?

These are difficult questions, but they can be made more tractable by framing them in terms of the timing and the source of the relevant legal rules and principles. The goal here is to provide an analytic model to assess crucial aspects of these questions by focusing on the different types of ex ante and ex post regulatory approaches, and the relative advantages and disadvantages of each in modern, complex financial markets. The normative conclusions of this Article will necessarily be tentative, but my suggestion is that in many cases, there is wisdom in the historical approach based on after-the-fact assessment. Thus, regulators and policy makers might benefit from considering the advantages of moving away from ex ante regulation in the direction of ex post adjudication.

II. THE TIMING AND SOURCE OF LEGAL RULES AND PRINCIPLES

The 2x2 diagram below illustrates the analytic structure offered here and the four polar approaches to regulation. Essentially, the four divisions are based on answers to two questions. First, how much regulatory substance should be specified upfront, before or at the time of a transaction, as opposed to in the future? Second, who should do the specifying? In other words, what is the timing and source of regulation?

	Ex Ante	Ex Post
Private	Contract	Arbitration
Public	Regulation	Adjudication

The Article's positive claim is that regulation can be situated in, evolved along, or moved toward four different paths, depending on the timing and source of applicable legal rules. The applicable legal rules can be generated either ex ante or ex post, from entities that are either public or private.

A. Contract

The upper left quadrant-"Contract"-houses regulation that is specified in advance by private actors. This form of private "regulation" is increasingly prevalent. For example, one notable use of such private ordering in the financial markets is in over-the-counter derivatives, where hundreds of trillions of dollars of notional value of transactions are governed by documents created by the International Swaps and Derivatives Association, a trade group known as "ISDA." U.S. corporate law also generally allows for extensive private ordering through ex ante specification of default rules.

Private ordering through contract has obvious benefits, particularly when market participants are engaged in repeat play and there are reputa-tional consequences to breaches. Ex ante contract rules are most likely to be optimal when transaction and agency costs are low, when there is parity of...