When it comes to corporate law and governance, substantially similar rules can be implemented and enforced by a wide range of entities. For example, regulatory agencies, legislatures, stock exchanges, and private bodies have all issued rules on climate-related risk disclosure,^[1] board gender-diversity,^[2] and director independence.^[3] While most policymakers and scholars would intuit that the source of a rule matters, they might be harder pressed to concisely explain how.

In a forthcoming article, we develop an analytical framework that critically examines the core features of rule-making and implementation bodies (RMIBs), explaining how it matters who makes corporate rules. Our framework, described below, explains how a) incentives, (b) regulatory competition, (c) available and relative resources, (d) rule-making speed and certainty, and (e) legitimacy all influence the effectiveness of rule-making in the corporate law and governance context.

Framework

(a) Incentives for making and implementing the rules

To begin, we compare established arguments on legislatures’ incentives to make politically salient rules, stock exchanges’ commercial interests to create investor protecting rules and respond to market participants’ needs (though facing stronger conflicts of interest to enforce these rules), and private self-regulatory bodies’ incentives to make and enforce rules in ways that benefit their members, constrained primarily by the threat of government intervention.

(b) Regulatory competition

We avoid well-worn debates surrounding U.S. interstate competition for corporate charters and instead present evidence in the UK of the strong influence of regulatory competition on public rulemaking in the context of the 2021 Lord Hill listing rules review and recently enacted Financial Services and Markets Act 2023 (FSMA 2023). We explain how regulatory competition can both positively and negatively influence rule-making for legislatures, public regulatory agencies, and also for private bodies, suggesting for the latter that high competition can result in multiple regulatory standards which lack consistency, struggle to influence the market, and undermine widespread adoption and network benefits.

(c) Available and relative resources

Here we outline how regulatory resources including human capital (with the right expertise), financial capital, and other crucial assets such as data contribute to more effective rule-making. We review some of the empirical studies suggesting that resource constraints can significantly undermine firm compliance and enforcement, particularly at the SEC. We also point out that RMIBs possessing fewer resources must implicitly rely more on gatekeepers or regulatory intermediaries to make up for the shortfall (e.g., an RMIB with minimal accounting expertise must rely heavily on assessments from third party accountants).

(d) How quickly an RMIB makes and implements the rules, and the certainty of its decisions

Rule-making speed or adaptability refers to how long an RMIB takes to create or revise new rules. Rulemaking certainty refers to the clarity and predictability of a rule’s content and enforcement, which is influenced by the nature of the rule-maker and how susceptible a rule is to challenge that could result in the content or application of the rule being changed.

We explain the “internal” and “external” determinants of speed: internally, speed is affected by regulatory resources such as budget size and employee headcount, and externally speed is affected by statutory requirements to provide notice, consultation, or mandatory cost-benefit analysis, which lengthen rulemaking timelines.

Certainty can be undermined by external factors such as judicial review of the constitutionality of rulemaking, leading to rules being struck down. We argue that rulemaking certainty is higher for public RMIBs in the UK than in the U.S., given the paucity of judicial-review precedent for rulemaking by the Financial Conduct Authority (FCA) or Prudential Regulation Authority (PRA).

(e) Legitimacy in the eyes of regulated parties, market participants, and relevant stakeholders

Here legitimacy refers to “the belief that one ought to obey the law,” regardless of personal benefit, because the legal authority “has the right to dictate behavior,”[4] Legitimacy is important because it is positively associated with voluntary compliance, suggesting that an RMIB’s legitimacy is relevant to its effectiveness.

We argue that legislatures and regulatory agencies derive democratic-based legitimacy from procedural fairness and public accountability, whereas stock exchanges and private bodies derive market-based legitimacy from the rule-makers’ reputational capital, technocratic expertise, and market participants’ voluntary consent to the economic regime. We also suggest that democratic-based legitimacy could be seen as providing a more compelling justification for corporate rulemaking that is important to the general public because of the significant economic externalities or social consequences imposed (e.g., climate-related risks disclosure), as compared with less inclusive market-based legitimacy. 

Case Studies

We then use climate-related risks disclosure as our first case study to apply the framework and analyze which RMIB should make which type of rules. Given problems of a lack of consistent and comparable disclosure standards, the need to comprehensively analyze the costs and benefits of these rules, the need to quickly and flexibly make and amend the rules in light of changing scientific developments and market conditions, and objections based on democratic legitimacy, we suggest that climate-related risks disclosure rules would be best implemented by the legislature, in conjunction with another body such as a stock exchange or regulatory agency (as occurred in the UK).

Our second case study involves the UK’s recently enacted Financial Services and Markets Act 2023 (FSMA 2023), a “once-in-a-generation” regulatory overhaul that will move the bulk of financial rulemaking from the Parliament to the FCA and PRA. We suggest that the legislative debate — focused on regulatory competition and justifying the sweeping changes based on parliamentary resource limitations and rulemaking speed and adaptability constraints — devoted insufficient attention to the potential for misaligned incentives at the FCA and PRA  that stem from Parliament’s delegation of rulemaking authority, as well as the risk of eroding legitimacy if the regulators are not held sufficiently accountable to the public.

Our objectives

Our hope is to provide a set of factors for rule-makers and appraisers to reflect upon in order to arrive at more considered views of which RMIB should make or implement a particular rule within their jurisdiction, or how rules could be better tailored to the strengths and limitations of the existing RMIB. Our categorization is not the only way to break down analytically the larger issues; rather, our aim is to generate clarity by bringing together the myriad issues discussed in the existing but often disparate strands of literature, and to do so by categorizing salient RMIB features in a manner that preserves necessary detail and avoids unnecessary overlap.

ENDNOTES

[1] e.g., in the UK, rules on climate-related risk disclosure were first enacted by a regulatory agency (Financial Conduct Authority), followed by the legislature; in Hong Kong, a stock exchange (Hong Kong Stock Exchange) implemented the relevant rules; and transnationally, regulators (e.g., Singapore, Japan, Brazil, France, etc.) have significantly aligned with rules made by a private body (Task Force on Climate-related Financial Disclosures).

[2] e.g., in California and India, the legislature has enacted rules on board gender-diversity; in the UK, a regulatory agency (Financial Conduct Authority) has enacted board diversity rules; and in the U.S., a stock exchange (NASDAQ) has issued rules on board diversity.

[3] e.g. in India, the rules requiring independent directors come from the legislature (India Companies Act 2013); in the UK, a quasi-governmental private body promulgates these rules for listed companies (Financial Reporting Council); and in the U.S., stock exchanges (NYSE and NASDAQ) establish the rules on director independence for listed companies.

[4] Tom Tyler, Why People Obey the Law (Princeton University Press, 2006), pp. 4, 27, 161.

This post comes to us from Jonathan Chan at University College London (UCL) and Ernest Lim at National University of Singapore’s Faculty of Law. It is based on their recent article, “How It Matters Who Makes Corporate Rules,” available here.