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The Committee on Capital Markets Regulation, named by U.S. Treasury Secretary Henry Paulson, released a report in late November 2006, analyzing important matters in corporate governance, accounting and auditing. The committee prescribes numerous reforms, many worthy and possibly useful. But aspects of the report associated with rules and principles enter a muddle of rhetoric that is both widespread and underanalyzed. The committee complains that “U.S. regulatory practice has been overwhelmingly focused on detailed prescriptive rules.” It prescribes that the system be redesigned in the image of “principles-based rules.” The committee never defines what it means by these terms but writes in the spirit and with the popular vocabulary of “principles-based” systems as a contrast to “rules-based” systems. The reticence to define terms probably reflects that it is foolish to try. In four instances, the report contradicts its premise by urging the abandonment of principles in favor of rules. First, the committee urges the Securities and Exchange Commission (SEC) to abandon its recently stated principle that materiality is not a strictly quantitative concept and return to the erstwhile rule that measured materiality in terms of 5% of income. Second, it urges the SEC to reduce uncertainties associated with the principles underlying Rule 10b-5 by providing more detailed prescriptive guidance. Third, the committee urges the SEC to stop using enforcement actions to establish regulation in favor of rulemaking, an alternative that would produce more rules and fewer principles. Fourth, as to internal-control auditing standards, the committee recommends incorporating existing guidance into the text of the standard, but that practice is a common complaint made by critics of “rules-based” regimes. Confusion over terminology The report contains three illustrations showing confusion about how to conceptualize systems as principles-based versus rules-based. First, it says that proponents of principles-based auditing systems would require that financial statements present a true-and-fair view and minimize “the extensive [Financial Accounting Standards Board (FASB)] rulebook under which the profession operates.” But the current regime requires attestation of both such a view and compliance with the so-called rulebook (which contains extensive principles as well as rules). Second, the report favorably cites the European corporate governance practice known as “comply or explain,” and suggests that this is self-evidently a principles-based approach. It is not. The provision with which a company either complies or explains why it doesn’t could be a principle (such as “having independent directors”) or a rule (such as “independence means x, y and z”). In addition, while the authority to comply or explain is permissive rather than mandatory, this has no bearing on whether a provision takes the form of a rule or a principle. Third, the committee lauds the U.K. Financial Services Authority as a longtime advocate of “a principles-based rather than prescriptive, rules-based regime.” In writing about the authority, the committee appears to classify rules or principles according to their length or size. But a lengthy document can contain the vaguest principles and a short one can contain the least vague rules. The committee signals a preference for two other attributes of provisions that it believes are related to the difference between rules and principles in a similarly mistaken way. First, its preference of a regime “based on” outcomes/results rather than procedures/inputs has no necessary connection to rules versus principles. A rule can be based on outcomes/results, and a principle can be based on something else, including prescribed procedures and inputs. Second, the committee suggests that risk-based systems somehow have more in common with principles-based systems than rules-based systems, but does not explain how. Finally, it is unclear how the committee’s prescriptions would differ in practice from the historical pattern. It advises that the process it prescribes “must . . . start with the enunciation of a set of principles intended to guide proper behavior. These principles would form the foundation on which the new rules approach would be built.” This describes to a T the history of contemporary Generally Accepted Accounting Principles. In the mid-1970s, FASB articulated a conceptual framework � a series of principles � and proceeded for two generations to base subsequent promulgations on those principles. While the committee asserts that “U.S. regulatory practice has been overwhelmingly focused on detailed prescriptive rules,” there is no statement of how this is measured. This deficiency is compounded by how the committee never explains what “detailed prescriptive rules” are, how they differ from “principles-based rules,” how its prescriptions for the latter square with its calls for the former, and how to fit into this framework the numerous additional features of length, outcomes or risk. As it relates to principles and rules, the report is a muddle. Lawrence A. Cunningham is a professor of law at Boston College Law School. His full analysis of rules and principles will appear in Vanderbilt Law Review in October.

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