A Prescription to Retire the Rhetoric of "Principles-Based Systems" in Corporate Law, Securities Regulation and Accounting

This Article corrects widespread misconception about whether complex regulatory systems can be described fairly 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. Users show 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 the 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. INTRODUCTION Many people seem to believe that legal or accounting systems can be either "rules-based" or "principles-based."1 The scandalous era epitomized by Enron Corp. drew worldwide attention to these labels. Many attributed the scandals to weaknesses in the United States accounting system, which they classified as "rules-based."2 The Sarbanes-Oxley Act directed the securities and Exchange Commission ("SEC") to study this claim.3 Within and outside the United States, policymakers seize on these categories to self-classify their legal and accounting systems in order to use these labels as grounds for promotion, reform, or prescription.4 This Article contends that this regulatory enthusiasm for analysis positioned across the rules/principles axis is misplaced. These classifications are too crude to describe or guide the design of corporate law, securities regulation, or accounting systems. Inquiry concerning the nature of rules and principles demonstrates how these labels invariably require sorting individual legal or accounting provisions onto a continuum rather than precisely fitting them into two neat categories. Describing a system as principles-based or rules-based not only would require an inventory of all its provisions along that continuum, but also would account for how they are applied and how they interact. Within large complex regulatory systems, assessment of the application and interaction of individual provisions may result in systemic qualities that differ significantly from one based solely on an inventory of the individual provisions. Moreover, a conscious effort to design a system to be either principles-based or rules-based would require forcing individual provisions toward the poles. To do so interferes with the benefits of the relationship among rules and principles and impairs tailoring the form of articulation to meet desired objectives. …