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A Prescription to Retire the Rhetoric of 'Principles-Based Systems' in Corporate Law, Securities Regulation and Accounting by Lawrence a Cunning Ham

A Prescription to Retire the Rhetoric of 'Principles-Based Systems' in Corporate Law, Securities Regulation and Accounting by Lawrence a Cunning Ham

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This Article corrects widespread misconception about whether complex regulatory systems can be fairly described as either “rules-based” or “principles-based” (also called “standards-based”).

Promiscuous use of these labels has proliferated in the years since the implosion of Enron Corp., with users exhibiting an increasing habit of celebrating systems dubbed principles-based and scorning those called rules-based. While the concepts of rules and principles (or standards) are useful to classify individual provisions, they are not scalable to the level of complex regulatory systems.

The Article uses examples from corporate law, securities regulation and accounting to illustrate this problematic phenomenon. To describe or design systems as principles-based or rules-based, analysis must account for the application and interaction of all provisions. Once these features are accounted for, the labels become facile.

The Article thus concludes that it is neither possible nor desirable to fashion such systems to be “principles-based” or “rules-based” and that such misleading labels should be retired. The Article then explores why the rhetoric extolling “principles-based systems” is flourishing.

It considers three hypotheses:
(1) a regulatory emphasis on discretionary enforcement to induce cautious compliance,

(2) a quest to rejuvenate ethical principles in the practice of corporate law, securities regulation and accounting and

(3) a deflective political strategy in jurisdictional competition to signal product differentiation.

The first and second hypotheses are credible but suffer from both descriptive and normative weaknesses, including how they can backfire by leading to overzealous enforcement. The third is the strongest descriptively but is most troubling normatively. Political effort to differentiate regulatory products using these labels is a form of misleading advertising. This deflection not only underscores the need to retire these labels, it also reveals a routinely overlooked limitation of jurisdictional competition in corporate law, securities regulation and accounting.
This Article corrects widespread misconception about whether complex regulatory systems can be fairly described as either “rules-based” or “principles-based” (also called “standards-based”).

Promiscuous use of these labels has proliferated in the years since the implosion of Enron Corp., with users exhibiting an increasing habit of celebrating systems dubbed principles-based and scorning those called rules-based. While the concepts of rules and principles (or standards) are useful to classify individual provisions, they are not scalable to the level of complex regulatory systems.

The Article uses examples from corporate law, securities regulation and accounting to illustrate this problematic phenomenon. To describe or design systems as principles-based or rules-based, analysis must account for the application and interaction of all provisions. Once these features are accounted for, the labels become facile.

The Article thus concludes that it is neither possible nor desirable to fashion such systems to be “principles-based” or “rules-based” and that such misleading labels should be retired. The Article then explores why the rhetoric extolling “principles-based systems” is flourishing.

It considers three hypotheses:
(1) a regulatory emphasis on discretionary enforcement to induce cautious compliance,

(2) a quest to rejuvenate ethical principles in the practice of corporate law, securities regulation and accounting and

(3) a deflective political strategy in jurisdictional competition to signal product differentiation.

The first and second hypotheses are credible but suffer from both descriptive and normative weaknesses, including how they can backfire by leading to overzealous enforcement. The third is the strongest descriptively but is most troubling normatively. Political effort to differentiate regulatory products using these labels is a form of misleading advertising. This deflection not only underscores the need to retire these labels, it also reveals a routinely overlooked limitation of jurisdictional competition in corporate law, securities regulation and accounting.

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Published by: Customs Street Advisors on Apr 21, 2009
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BOSTONCOLLEGE
LA
 
BOSTON COLLEGE LAW SCHOOLLEGAL STUDIES RESEARCH PAPER SERIES
RESEARCH PAPER 127
March 13, 2007
A Prescription to Retire the Rhetoric of“Principles-Based Systems” in Corporate Law,Securities Regulation and Accounting
Lawrence A. Cunningham
Professor of Law & Business and Libby Scholar, Boston College Law SchoolThis paper can be downloaded without charge from theSocial Science Research Network:
http://ssrn.com/abstract=970646
 
A PRESCRIPTION TO RETIRETHE RHETORIC OF “PRINCIPLES-BASED SYSTEMS” INCORPORATE LAW, SECURITIES REGULATION AND ACCOUNTING
 Lawrence A. Cunningham
*
 
60 V
ANDERBILT
L
AW
R
EVIEW
___ (Oct.-Nov. 2007)Abstract
This Article corrects widespread misconception about whether complexregulatory systems can be fairly described as either “rules-based” or “principles-based”(also called “standards-based”). Promiscuous use of these labels has proliferated in the years since the implosion of Enron Corp., with users exhibiting an increasing habit of celebrating systems dubbed principles-based and scorning those called rules-based.While the concepts of rules and principles (or standards) are useful to classify individual provisions, they are not scalable to the level of complex regulatory systems. The Articleuses examples from corporate law, securities regulation and accounting to illustrate this problematic phenomenon. To describe or design systems as principles-based or rules-based, analysis must account for the application and interaction of all provisions. Oncethese features are accounted for, the labels become facile. The Article thus concludesthat it is neither possible nor desirable to fashion such systems to be “principles-based”or “rules-based” and that such misleading labels should be retired.The Article then explores why the rhetoric extolling “principles-based systems” is flourishing. It considers three hypotheses: (1) a regulatory emphasis on discretionaryenforcement to induce cautious compliance, (2) a quest to rejuvenate ethical principles inthe practice of corporate law, securities regulation and accounting and (3) a deflective political strategy in jurisdictional competition to signal product differentiation. The first and second hypotheses are credible but suffer from both descriptive and normativeweaknesses, including how they can backfire by leading to overzealous enforcement. Thethird is the strongest descriptively but is most troubling normatively. Political effort todifferentiate regulatory products using these labels is a form of misleading advertising.This deflection not only underscores the need to retire these labels, it also reveals aroutinely overlooked limitation of jurisdictional competition in corporate law, securitiesregulation and accounting.
Approximate Word Count: 30,000
*
Professor of Law, Boston College (through 2006-07) and George Washington University (effective 2007-08). Thanks to Bernard Black, William Bratton, Phyllis Goldfarb, Joan Heminway, Renée Jones, DoreenMcBarnet, Judith McMorrow, Lawrence Mitchell, Frederick Schauer and Lawrence Solum; and toparticipants in faculty workshops at Boston College Law School, George Washington University LawSchool, University of Illinois College of Law, and University of Tennessee College of Law.
 
A PRESCRIPTION TO RETIRETHE RHETORIC OF “PRINCIPLES-BASED SYSTEMS” INCORPORATE LAW, SECURITIES REGULATION AND ACCOUNTING
 Lawrence A. Cunningham
I
NTRODUCTION
.............................................................................................................3
 
I.
 
T
HE
D
YNAMICS OF
R
ULES
-
AND
-P
RINCIPLES
...........................................................6A.
Treatment of Individual Provisions
..................................................................71. Labels........................................................................................................72. Classification.............................................................................................83. Trade-Offs...............................................................................................11B.
Treatment of Entire Systems
...........................................................................131. Threshold................................................................................................132. Applications............................................................................................153. Interactions..............................................................................................164. Benefits...................................................................................................18II.
 
A
 
S
URVEY OF THE
S
YSTEMS
.................................................................................20A.
 Existing Systems
.............................................................................................201. Corporate Law.........................................................................................202. Securites Regulation...............................................................................283. Accounting..............................................................................................35B.
Proposed Systems
...........................................................................................391. Emerging Economies and Corporate Law..............................................402. Canada and Securities Regulation...........................................................423. United States and Accounting.................................................................45III.
 
T
HEORIES AND
I
MPLICATIONS OF THE
R
HETORIC
................................................47A.
 Regulatory
.......................................................................................................481. Trends Favoring Rules............................................................................482. A Need for Principles..............................................................................49B.
 Ethical
..............................................................................................................511. Hortatory ................................................................................................522. Qualifications..........................................................................................54C.
Political
............................................................................................................541. Jurisdictional Competition......................................................................552. Limitations..............................................................................................60C
ONCLUSION
..............................................................................................................62
2

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