Academic

Schwarcz on Principles-Based Regulation

By Lawrence Solum

Steven L. Schwarcz (Duke University - School of Law) has posted The 'Principles' Paradox on SSRN.  Here is the abstract:

Although principles-based regulation is thought to more closely achieve normative goals than rules, the extent to which that occurs can depend on the enforcement regime. A person who is subject to unpredictable liability is likely to hew to the most conservative interpretation of the principle, especially where that person would be a potential deep pocket in litigation. This creates a paradox: Unless protected by a regime enabling one in good faith to exercise judgment without fear of liability, such a person will effectively act as if subject to a rule and, even worse, an unintended rule.

And from the text:

In order to avoid this paradox, the risk of unpredictable liability must be reduced. In concept, there are at least two ways to accomplish this.31

One way of reducing the risk of unpredictable liability is to grant a measure of discretion to parties attempting to comply with the regulatory principle. In the trust indenture context, for example, I recently argued that the liability of indenture trustees under the prudent-man standard should be interpreted by a business judgment rule, to encourage indenture trustees to exercise their judgment.32 In the corporate governance context, a business judgment rule is intended to protect directors who take calculated risks in attempt to maximize corporate value.33 Courts examine a corporate director?s decision ?only to the extent necessary to verify the presence of a business decision, disinterestedness and independence, due care, good faith, and the absence of an abuse of discretion.?34 The business judgment rule is justified by the duty of corporate directors to maximize value for shareholders, which requires the exercise of discretion. Similarly, the duty of an indenture trustee after default is (unlike the duty of traditional trustees to merely preserve existing value) to maximize recovery for bondholders, again requiring the exercise of discretion.35 An indenture trustee?s duty to act prudently therefore should be tempered, as in corporation law, by a business judgment rule.

Granting a measure of discretion to parties attempting to comply with regulatory principles may not always work, however. Discretion works well when the parties are subject to overall community norms, as should be the case for the relatively small community of professional institutional indenture trustees.36 But when such norms are lacking, granting discretion to parties subject to principles-based regulation can become a blank check for abuse. It is less obvious, for example, that servicers of mortgage-backed securities, who are often smaller and less well-established companies in a relatively new area of financing,37 should be granted the same measure of discretion38 when complying with their servicing duties.

Another possible way of reducing the risk of unpredictable liability is to provide interpretive guidelines for complying with the principle.39 For example, many questions of commercial law in the United States turn on the seemingly-vague principle of ?commercial reasonableness,? but this principle is well-defined through the Uniform Commercial Code?s detailed Official Comments40 as well as custom and usage of trade.41 There are also other sources of interpretive guidance. Outside the context of financial regulation, for example, the ?reasonable man? standard of negligence law in the United States benefits from centuries of interpretive guidance through court decisions,42 making negligence liability reasonably predictable.43

Very interesting paper.  Recommended.

Full post as published by Legal Theory Blog on April 21, 2008 (boomark / email).