1. Principles-Based Securities Regulation
2. Proportionate-Based Securities Regulation

Both principles-based and proportionate-based approaches to regulation are to some extent already reflected in existing securities regulation in Canada. The focus of this section is to assess whether the use of these regulatory approaches should be expanded in Canada and, if so, under which securities regulatory structure, the passport system or the single securities regulator model.

I. Principles-Based Securities Regulation⁸

a) Overview

Moving towards a more principles-based approach to securities regulation has received considerable attention in recent years. Businesses are attracted to its promise of lowering unnecessary compliance costs. Regulators believe that it might improve regulatory outcomes and help to strengthen enforcement. Policymakers suggest that it could create a distinct competitive regulatory advantage relative to other jurisdictions. In general, a more principles-based approach is thought to be an appropriate response to the current securities regulatory environment that many believe has become too heavily reliant on rules, focused more on process than on achieving effective regulatory outcomes.

Principles-based regulation is not about replacing rules with principles or leaving businesses to their own devices, without regulatory guidance or oversight. It is a distinct, regulatory approach that contrasts with the rules-based approach. No regulatory system is entirely based on either the rules-based or principles-based approach; there is a continuum between the two extremes and regulatory systems fall somewhere in the middle. The key question is whether there is merit in moving the securities regulatory system toward a more principles-based approach.

Principles-based regulation establishes high-level principles for business conduct, which articulate desired regulatory outcomes. Businesses are given greater freedom to develop and manage internal compliance systems to achieve those outcomes. Regulators work more with businesses to provide guidance on appropriate regulatory practices. 

Under the rules-based approach, businesses must adhere to a strict body of rules to achieve compliance. Businesses have less freedom to organize their regulatory affairs. Regulators are thereby focused on ensuring that businesses comply with the rules and are prone to a more adversarial role. The emphasis of regulatory efforts may be more on compliance with the rules and process rather than on the broader objectives and outcomes.

A number of regulators in Canada and internationally have been advancing principles-based regulation. The FSA in the United Kingdom is considered to be a leader in principles-based financial services regulation. The FSA has established 11 regulatory principles for business, which all regulated entities must meet. It provides significant guidance to businesses and works closely with stakeholders in the financial sector to find mutually beneficial solutions to regulatory issues.

The British Columbia Securities Commission has been developing an outcomes-based approach to securities regulation, a label that it believes more properly describes principles-based regulation. The Commission is committed to intervening less and working more with businesses by encouraging them to do the “right thing” in whatever manner they choose, in order to achieve desired regulatory outcomes.

The regulation of derivatives has also attracted the use of principles-based regulation, in large part because of the speed of innovation in this area of finance. For example, the Commodity Futures Trading Commission in the United States operates in a principles-based manner, and the new Quebec Derivatives Act is substantially principles-based and represents one of the first attempts internationally to regulate a full range of derivatives.

Some commentators are of the view that a more principles-based approach could improve securities regulation in a number of ways. First, capital markets are becoming increasingly more sophisticated and dynamic. In this environment, principles-based regulation might achieve better regulatory outcomes since it would give businesses greater flexibility to adapt compliance practices to the latest innovations in the capital markets. Second, under principles-based regulation, businesses, when confronted with an ambiguous situation, would no longer be bound by strict rules. They would be responsible for actively developing and managing compliance practices to achieve the desired regulatory outcomes. Market conduct, in turn, might improve because businesses would have to pay greater attention to achieve desired compliance outcomes rather than simply applying rules and procedures prescribed by regulators. Finally, principles-based regulation might facilitate better enforcement actions by being able to hold businesses accountable for rule infractions as well as actions that, although technically compliant, violate the public interest.

There are, however, possible risks to a more principles-based approach that must be carefully considered, balancing the need for some rules with the desire to build on principles. There is a general concern that the regulatory burden on businesses might actually increase due to the need to develop and monitor internal compliance controls to achieve the desired regulatory outcome. This burden could be particularly acute for smaller businesses, which generally have limited resources and expertise for these purposes. In addition, a principles-based approach could reduce the regulatory certainty for market participants, while allowing enforcement actions to be conducted without any violation of a guideline or rule.

b) Consultations

The stakeholders in our consultation meetings were generally supportive of moving to a more principles-based approach to securities regulation. They thought that it might be an effective way to address the current overly prescriptive nature of securities regulation, and they suggested that its flexibility would help make regulation more responsive to the accelerating pace of financial innovation.

Some stakeholders did, however, express a number of caveats. They emphasized the need to provide sufficient guidance to market participants about compliance requirements in order to maintain certainty and confidence in regulatory practices. They also noted that principles-based regulation requires a strong but skilful approach to enforcement. Enforcement must provide credible deterrence against wrongdoing, but it must not be too aggressive so as to undermine the flexibility and innovation that is the bedrock of principles-based regulation. Some stakeholders also noted that a more principles-based approach would be difficult to properly implement in the absence of a single securities regulator. The idea of having a set of principles being interpreted in 13 different ways was described as unworkable.

c) Implementation Considerations

We understand that there are opportunities and risks in moving to a more principles-based approach to securities regulation. According to our study on this subject, risks may be mitigated and opportunities maximized if a number of factors are met in implementing a more principles-based system. A number of these critical success factors merit discussion.

i) Reducing Uncertainty

Principles-based securities regulation must be implemented and advanced in a manner that reduces uncertainty and enhances predictability. In this regard, the regulator must establish mechanisms to communicate its expectations to industry. The regulator can do so by providing official guidance, conducting specific enforcement actions, or commenting on industry standards. The regulator can also collaborate with businesses and work closely with industry to develop standards. The FSA, for example, routinely works with trade associations to find solutions to regulatory issues. The goal of these efforts is to create an “interpretive community” that understands regulatory expectations, and can effectively interpret regulatory pronouncements in different situations over time. It is imperative that the development of this community be nurtured under principles-based regulation to enhance certainty and predictability.

ii) Rethinking Enforcement

A well-conceived and vigorous enforcement approach will encourage regulatory innovation and discourage activities that compromise the integrity of the regulatory system. Enforcement cannot be too aggressive, since it will cause businesses to quickly revert to the safety of rules and detailed guidance, and it cannot be too lax, since it will allow wrongdoers to take advantage of the freedoms afforded by principles. To work toward finding the right balance, there must be a measured, well-considered response to rule violations and other forms of alleged wrongdoing. The securities regulator must examine the situation and determine whether there is wrongdoing or simply an attempt to achieve compliance using an innovative, albeit misguided, approach. In the case of wrongdoing, the full force of the law should be applied; otherwise, the regulator should work with the business in question (perhaps in conjunction with industry) to bring its practices in line with a more accepted standard. The overriding goal should be to support, rather than suppress, innovative regulatory practices.

Enforcement actions must also be conducted with special care if based solely on a breach of one or more principles. This is an area that is particularly prone to concerns of overreaching. For example, there is a well-documented concept in this regard known as “hindsight risk.” This can occur when the regulator, dissatisfied with a particular regulatory outcome, and without a clear rule violation, uses the benefit of hindsight to conduct enforcement actions based solely on a breach of principle. This can be unfair because it may only be in the presence of full information at the conclusion of an activity or transaction that the true extent of the risk becomes clear and the desired ex ante regulatory approach presents itself. Under these circumstances, businesses, which acted in the best interests of the market and investors, using the information available at the time, should likely not face enforcement actions. There are a number of ways to reduce hindsight risk, including using prior rules (i.e., quasi-safe-harbour rules) and the use of notice-and-comment mechanisms for rulemaking. In general, ways to reduce the risk of overreaching in this area must inform the approach to enforcement under principles-based regulation.

iii) Meeting the Distinct Needs of Small Public Companies

Small public companies (i.e., small reporting issuers) pose unique challenges under any regulatory approach, since many lack the expertise and resources necessary to foster the development of proper internal controls. The principles-based approach, however, has the potential to make these challenges more acute, since small public companies would lose the certainty of rules and be required to apply often limited resources to developing their own approaches to compliance.

There are a number of ways possible to minimize the risk of compliance burden imposed on small public companies. First, principles-based regulation should be complemented by proportionate-based regulation (discussed in the next section). Proportionate-based regulation will help to harness the regulatory flexibility of principles-based regulation to tailor regulation appropriately to small public companies. Second, the securities regulator should work closely with the management of these companies and their industry representatives to develop guidelines, best practices, and expedite the overall development of an interpretive community. Third, small public companies should be allowed to use pre-existing, quasi-safe-harbour rules as a baseline for a transitional period. Given the large number of small public companies in Canada, these methods should be part of a larger strategy that works to support their transition to a more principles-based approach.

iv) Engaging Investors

A benefit of principles-based regulation is that it is flexible and allows the content of regulation to evolve over time. A disadvantage of this flexibility is that larger, more sophisticated parties could come to have greater power to influence the development of regulatory content over time. These parties might be in a better position to persuade, or even pressure, regulators to advance their interests at the expense of others. This could, for example, cause investor protection to be eroded in order to enhance regulatory efficiency.

The nature of principles-based regulation is such that it must be informed properly by a broad range of stakeholders, but particularly investors that have traditionally been given less of a voice in informing regulatory content. For principles-based regulation to be a success, real opportunities must be afforded to all investors to contribute to the development of regulation. The securities regulator must actively seek input and develop relationships with organizations and individuals that operate on behalf of investors.⁹ More must be done to promote investor education so that investors can effectively represent their views on securities regulation. Securities regulators must be transparent in decision-making, articulating how regulatory changes reflect the input and the overall interests of stakeholders in Canada’s capital market.

d) Structure and Enforcement

We believe that a more principles-based approach would be best advanced under a single securities regulator. Although it could be developed within the current securities regulatory structure, we find that the degree of coordination required across the 13 securities regulators to consistently interpret principles, develop guidance, foster interpretive communities, as well as conduct principles-based enforcement actions, poses significant challenges, making its implementation more difficult and its success less likely over time. A single securities regulator would be best able to provide the consistency and degree of focus required to properly steward principles-based securities regulation in Canada.

We believe that this regulatory approach could strengthen enforcement by expanding the capacity of enforcement authorities to act against those that did not violate a regulation or rule but did not act in the public interest. However, we are not of the view that it would dramatically improve enforcement in Canada. Enforcement is a complex and multifaceted area whose improvement relies on many jurisdictions and organizations.

Securities regulatory structure and enforcement are discussed more fully later in the report.

II. Proportionate-Based Securities Regulation

a) Overview¹⁰

Securities regulation is sometimes criticized for being applied in a manner that is insufficiently tailored to the economic characteristics of public companies.¹¹ Regulatory approaches may not always account for size, the diversity of sectors in which public companies operate, or the regulatory risk represented by public companies across sectors. As a result, small public companies might face undue compliance costs to meet regulations designed for large public companies. Securities regulators might impose too much regulatory scrutiny on large public companies. Disclosure might be insufficient to allow investors to make informed decisions. Securities regulators might devote too much time regulating entities that pose little risk to investors, and too few resources to higher risk companies.

Effective outcomes can be achieved if securities regulation is tailored to the economic characteristics of public companies. However, securities regulation that is overly tailored comes with its own set of inefficiencies. It could significantly increase administrative costs to the regulator, causing greater fees to be levied on market participants or taxpayers. Proportionate-based securities regulation could increase regulatory complexity and reduce the overall transparency of securities regulation to investors. The key challenge for securities regulators is to advance proportionate-based securities regulation in a manner that enhances economic efficiency and promotes investor protection.

Some elements of proportionate-based securities regulation already exist in Canada, predominately based on differentiating a public company by whether it is a venture issuer, listed on the TSX Venture Exchange (TSXV), or a non-venture issuer, listed on the Toronto Stock Exchange (TSX). Venture issuers, because of their smaller size and early-stage of development, are often subject to less onerous regulatory requirements, especially with respect to disclosure. Venture issuers are, however, subject to significant monitoring and oversight to guard against risks that are associated with early-stage companies that have less sophisticated compliance controls. In consultations, we heard that this approach has helped to support the development of venture issuers, while maintaining confidence in public capital markets.

Canada’s securities regulators have also adopted proportionate-based securities regulation to specifically address barriers to early-stage financing. For example, securities regulators have an agreement with the TSXV to allow capital pool companies to list on the TSXV subject to specific conditions.¹² This agreement provides nascent companies with the opportunity to access public capital markets to fund investments in growth-oriented activities. An additional example, albeit on a smaller scale, is the effort of the Government of Nova Scotia to simplify reporting requirements to encourage the establishment of investment funds that are aimed at providing early-stage financing to businesses located in Nova Scotia.¹³ The program provides streamlined regulatory requirements to facilitate the establishment of, and investment in, these investment funds, which in turn support economic development in the region.

According to our research study on proportionate-based securities regulation, provincial securities regulators have expressed varying degrees of interest in expanding the scope of proportionate-based securities regulation in Canada. The Alberta Securities Commission has noted some interest in developing a proportionate approach that would better regulate its mix of very large and very small public companies. The British Columbia Securities Commission is uncertain about its need for more proportionate-based securities regulation once it has fully implemented its outcomes-based approach, which would allow public companies to organize their own affairs to achieve the desired regulatory outcomes. Quebec’s regulator, the Autorité des marchés financiers (AMF), has not taken a public position on proportionate regulation. The Canadian Securities Administrators has indicated that they are considering opportunities to expand the scope of proportionate regulation.¹⁴ From this survey of regulators, it is unclear how quickly, at this point, proportionate-based securities regulation will be further advanced in Canada.

b) Consultations

During our consultations, we heard broad support for a more proportionate-based approach to securities regulation. Some proposals were relatively modest, including the streamlining of certain prospectus and financial reporting requirements, while others were more ambitious, calling for public companies to be regulated according to market capitalization or sector. Many stakeholders, however, suggested, in the context of a discussion of a single securities regulator, that its first priority should be to adopt a rigorous risk-based approach, to the extent that it can achieve an improvement over the status quo in Canada. This initiative itself, it was suggested, would likely better allocate regulatory resources and improve regulatory outcomes. Once complete, efforts should be expanded to examine areas that could benefit from more tailored regulation.

c) Opportunities

We believe there are opportunities to expand the use of proportionate-based securities regulation in Canada, in order to reduce regulatory burden and support the growth of Canada’s capital markets. Our research shows that Canada’s capital markets have a number of unique features that are well-positioned to benefit from a more tailored, innovative regulatory approach.¹⁵

Small public companies are an important contributor to the growth of the Canadian economy. Securities regulation must be particularly cost-effective for these companies, as their growth and overall success can be needlessly undermined by overzealous regulation. We believe that action must be taken to review current regulatory practices and examine opportunities to develop innovative regulatory approaches that streamline reporting requirements and, overall, reduce undue regulatory burden for small public companies in Canada.

 

We were intrigued by the notion of differentiating the application of proportionate-based securities regulation to the size or to the sector of public companies. As suggested by a number of stakeholders, given the unique features of Canada’s capital markets, there might be value in tailoring regulation to the size of public companies (e.g., by market capitalization) or by sector, particularly in respect of financial services, oil and gas, diversified industries, and mining. However, these proposals might increase the cost of administering securities regulation and the complexity of the regulatory system, possibly reducing the transparency of the system to market participants, particularly investors. The merits of these proposals must be carefully studied to better understand the risks and opportunities.

d) Risk-based Securities Regulation

We believe that the resources of a securities regulator should be allocated to market participants, such as issuers and securities firms, and investment products that pose the greatest risk to the economy generally and the investor in particular. We understand that this risk-based approach to securities regulation is used by many securities regulators in Canada. For example, the Ontario Securities Commission and those of several other provinces use a risk-based approach to select prospectuses for more detailed review and to select reporting issuers for a continuous disclosure review. They also use this approach to determine the frequency of compliance reviews of advisors and fund managers as well as to determine which enforcement matters will be pursued through full investigations. The Ontario risk-based selective review system for prospectuses may result in a prospectus being subjected to a basic review, a full review, or an issue-oriented review. The risk factors used to determine the level of review have been published.¹⁶ They relate to the issuer’s corporate structure and underlying business, to its financial condition or results, to the nature of the offering, and to matters related to the issuer’s advisors or corporate governance.

Risk-based regulation is also employed by self-regulatory organizations (SROs). For instance, IIROC and the MFDA¹⁷ have each developed a sophisticated and well-conceived risk-based model to determine the frequency and depth of audits of its members. IIROC has also worked with the Canadian Investor Protection Fund to coordinate auditing activities with a view to eliminating duplication, targeting those members whose activities are more likely to give rise to problems, and ensuring that limited resources are effectively employed and that the regulatory burden is proportionate to the risk posed.

During our international consultations, we learned about the risk-based approach used by the FSA in the United Kingdom. The FSA prioritizes regulatory intensity based on risk, assessed in part through the use of a sophisticated model that calculates a risk score for all regulated entities. Risk is calculated as a function of the probability of failure and the impact of that failure. This risk calculation is then complemented by a qualitative analysis, conducted by experts in regulatory risk management. Risk scores and peer comparisons are shared by the FSA with all regulated entities. The FSA approach allocates resources to the most risky enterprises regardless of size, recognizing that it cannot prevent the failure of all companies. We believe that the FSA risk-based approach is a global best practice and should inform the further advancement of risk-based securities regulation in Canada.

e) Structure and Enforcement

We believe that the advancement of proportionate-based securities regulation is not well-served by the current securities regulatory structure. The degree of proportionate securities regulation in use, and the priority for its advancement, significantly varies across the provinces.¹⁸ We believe that the benefits of a proportionate approach should be consistently applied across Canada. Its potential benefits should not be limited to the market participants of a single province. There is no reason, for example, why the efforts of one jurisdiction to reduce the compliance burden for smaller public companies should not be provided to the rest of Canada. We believe that a single securities regulator would be better positioned to advance a comprehensive agenda of proportionate regulation for Canada.

The nature and design of proportionate-based securities regulation will determine its impact on enforcement in Canada. We note that risk-based regulation is well-positioned to strengthen enforcement. It allows resources to be focused on market participants that pose the greatest risks to investors. The impact, however, of other types of proportionate regulation, such as tailoring to size or sector, need to be carefully assessed within the context of compliance and enforcement. There is risk that a poorly conceived approach could reduce compliance burden while compromising disclosure. Proportionate regulation should not come at the expense of investor protection.

Endnotes

⁸ This section draws on a research study commissioned by the Expert Panel. See Ford, Cristie. “Principles-Based Securities Regulation.” Expert Panel on Securities Regulation (2009).

⁹ The establishment of an investor panel could provide a greater voice for investors in informing the securities regulatory policy development process. The investor panel is discussed in greater detail in the section entitled “Better Serving Investors.”

¹⁰ This section draws on a research study commissioned by the Expert Panel. See Sarra, Janis. “Proportionate Securities Regulation: The Potential for Scaled Treatment of Junior Issuers.” Expert Panel on Securities Regulation (2009).

¹¹ The discussion of proportionate-based securities regulation is limited to publicly-listed companies.

¹² Capital pool companies have no assets (other than cash) and have not commenced business activity.

¹³ This initiative is known as the “Community Economic Development Investment Funds” (CEDIF).

¹⁴ The Canadian Securities Administrators is a forum for the securities regulators of Canada to coordinate and harmonize the regulation of Canada’s capital markets.

¹⁵ Canada’s capital markets embody a number of unique features. Canada has a large number of very small public companies and a small number of very large public companies. Many of Canada’s largest companies are cross-listed on international stock exchanges, particularly in the United States. Canada’s market capitalization is concentrated in Ontario, Alberta, Quebec, and British Columbia. In each of these provinces, the market capitalization is heavily concentrated in one sector: financial services in Ontario, oil and gas in Alberta, diversified industries in Quebec
(e.g., forestry products, transportation), and mining in British Columbia.

¹⁶ Ontario Securities Commission Staff Notice 11-719–A Risk-based Approach for More Effective Regulation, effective December 20, 2002, 25 O.S.C.B. 8410.

¹⁷ IIROC is the Investment Industry Regulatory Organization of Canada, while the MFDA is the Mutual Fund Dealers Association of Canada.

¹⁸ Unless stated otherwise, “provinces” shall refer to “provinces and territorities.”