SAN DIEGO: 9 May 2013 - Modern financial market regulation has focused on ex ante regulation, from capital requirements to specific investment restrictions to detailed disclosure rules. Decades ago, regulators took more of an ex post approach, emphasizing adjudication or regulatory assessment after the fact. This article argues that there is wisdom in the prior regime, particularly given the complexity of modern markets, and that regulators should move away from ex ante regulation in the direction of ex post.

More specifically, the article advocates that arguments in favor of principles over rules would be strengthened by adding a temporal element favoring principles that are established early and adjudicated later. Ex ante principles could be an information forcing mechanism and create incentives for private actors to internalize the costs of their behavior. The article further argues that ex post regulation and adjudication should be governed more by public, rather than private, specification of legal principles and rules. The goal of the article is not so much to advance, or even meaningfully contribute to, the core rules vs. principles literature, but to add temporal and legal source variables to that discussion and debate, with a focus on financial market regulation.

The 2x2 diagram below illustrates the analytic structure of the article, 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, as opposed to later? Second, who should do the specifying? The article’s positive claim is that regulation can evolve along four different paths, depending on the timing and source of applicable legal rules. Applicable legal rules can be generated either ex ante or ex post, from entities that are either public or private.

Accordingly, the upper left quadrant, labeled “Contract,” houses regulation that is specified in advance by private actors. This form of “regulation” is increasingly the dominant one. The most widespread form of such private ordering in the financial markets is in over-the-counter derivatives, where hundreds of trillions of dollars of transactions are governed by documents created by the International Swaps and Derivatives Association, a trade group.

The upper right quadrant, labeled “Arbitration,” involves the assessment of parties’ conduct after the fact, typically based on generalized principles. Broker-client disputes are perhaps the most prominent example of this form of regulation. Interestingly, ISDA documentation typically specifies that disputes involving over-the-counter derivatives will be resolved in federal court in New York or under British law in London, but not through arbitration.

The lower left quadrant, labeled “Regulation,” includes most modern financial and securities regulation. This body of legal rules has grown exponentially in recent years, as Congress and federal regulators have specified numerous detailed requirements for disclosure, conduct, capital requirements, and other substantive decisions and actions. The increasing specification of legal rules ex ante has created opportunities and incentives for value-destroying regulatory arbitrage, particularly in areas related to tax, accounting, and credit ratings, and also has distorted markets by creating “regulatory licenses,” entitlements that enable oligopolistic private actors to influence and determine compliance with regulation.

Meanwhile, the lower right quadrant, labeled “Adjudication,” has grown smaller, particularly in the most complex parts of the financial markets, even while it remains prominent in other areas where, not coincidentally, the legal principles and rules are less certain: these areas include insider trading, deal litigation, “plain vanilla” securities class actions, and, periodically, scandal-related litigation (e.g., options backdating and subprime-related fraud). The notion that financial disputes should be governed by the common law has been seriously eroded in the most sophisticated areas of financial practice. The Holmesian notion of law as a prediction of what a judge will do has been steadily disappearing, particularly in securities and financial enforcement.

This article argues that the shift from ex post to ex ante, and from public to private, has had serious deleterious consequences. It argues that the certainty generated by this shift is a negative development, and that the financial markets would be better served by greater regulatory uncertainty, so that market participants would be less able to calculate the expected benefits and costs of complying with regulation based on anticipated probabilities and magnitudes. Specifically, the twin pillars of securities law – disclosure and enforcement – would be better supported by a less certain regulatory approach in which broad principles are specified ex ante and compliance is adjudicated ex post.