Monday, July 02, 2007

How Should Federations Regulate?

When the Canadian Western Bank decision came out earlier this year, Andy and I disagreed on its merits. The power to regulate banks is given to the federal government by s. 91(15) of the BNA Act, while the power to regulate insurance was found to be provincial in one of the earliest Canadian constitutional cases. The issue that the SCC finally dealt with this year was what regulation applies to a bank selling insurance? The SCC and the Pithlord both think that banks that do this should have to follow provincial insurance regulation, except to the extent the federal government specifically immunizes them. Andy thinks this duplicates already-burdensome regulation unfairly and inefficiently.

There is clearly a bit of tension between two "conservative" biases here. Wariness of excessive centralisation battles with wariness of duplicative regulation. This issue comes up again and again in federations and free trade areas. The classic example is the regulation of publicly-offered securities and corporate governance respectively in the US. Securities regulation is federal with a broad interpretation of "pre-emption" limiting the state role. Corporate governance is governed by state law -- in practice, for national companies principally by Delaware's state law, since most corporate lawyers prefer it. Most people to the right of Ted Kennedy think Delaware corporate law functions better than federal securities law. In Canada, companies can choose between federal and provincial corporate governance regimes -- securities law is provincial. The same kind of people who complain about the incredible complicance costs of Sarbanes-Oxley tend to want a national securities regulator. Similar issues come up in all kinds of regulation. Is a national market best served by a single set of food safety regulations, rules about class actions or pension regulations? The general trend of federations is for an increasing number of these issues to be decided centrally, although Canada is a partial exception (and it is an open question how much further centralisation can go in Europe, given the almost total lack of public support for it). I thought I might use the blog to put together my ill-formed thoughts on first principles.

So what would the ideal federation look like?

I think it is critical at the outset to draw a distnction between voluntary interactions (insurance, purchase of shares, licensing of professionals etc.) and involuntary ones (car accidents, pollution, etc.). Regulating voluntary interactions is necessary to prevent fraud and abuse of asymmetrical information, but such interactions are presumptively beneficial to both sides. Overregulation and protectionism are particular concerns. Given modern technology, voluntary interactions tend to be easily accomplished in different jurisdictions, and regulatory cost is going to be one of the considerations. Inter-jurisdictional competition is generally going to be a good thing when it comes to voluntary interactions.

Involuntary interactions are more likely to be local -- both the victim and doer of the harm are probably in the same place when it happens. When this is true, it should always be the state or province that regulates. However, sometimes (river pollution being the classic example), it is possible to cause the harm in one jurisdiction and feel it in another. Here there is a real danger of externalizing ones's harms through under-regulation.

If everyone substantially affected by a transaction is within the boundaries of the state or province, then by the subsidiarity principle, the province or state should exclusively regulate. The trouble is that this condition almost never applies. At minimum, local regulation creates a barrier to outsiders entering and competing, since they have to learn about the regulation and possibly obtain licensing.

If the regulation is of involuntary transactions, Ottawa would have to authority to change provincial conflict-of-law rules. With genuinely interprovincial or international common pools (the Columbia, the St. Lawrence, persistent pollutants in the atmosphere or oceans), Ottawa would have the power to directly regulate and its regulation should pre-empt provincial regulation (particularly of the receiving province -- the originating province would have no incentive to overregulate, so its rules can apply concurrently). Physical flows of harms across borders should be substantial before a federal role is recognized. Doctrinally, interprovincial and international externalities should be analyzed under the "peace, order and good government" clause, where the caselaw is mostly sensible.

If the regulation is of voluntary transactions, the best solution is to let the parties choose the jurisdiction that regulates them. American corporations do this by deciding where to incorporate. Canada should adopt the same principle as widely as possible -- generalizing the proposals for a "passport" system made in relation to securities legislation.

Here is how it would work. If you want to sell insurance or practice dentistry in Nova Scotia, you could either (a) abide by Nova Scotia's regulatory-licensing regime or (b) abide by some other province's regulatory/licensing regime and disclose which province it was to your customers. Federal authority would extend to providing minimum standards provincial regimes would have to meet to operate inter-provincially. Only other provinces would have standing to challenge whether they met these standards, and the expectation would be that the federal requirements would be loose. Each province could charge the regulated industry what it wanted in fees and could make its own arrangements for extra-provincial enforcement. Compliance with the provincial regime of choice would be a full answer to tort liability, at least if the provincial regime covered the issue. Federal legislation under the Trade and Commerce power would guarantee that anyone who registered and complied with the regime in any province could trade in all the others.

The result would be beneficial regulatory competition. I think even critics would have to concede that every province would have an incentive to keep compliance costs down to attract business (and this would reduce the ultimate cost to the consumer.) Would this cause them to cheat on protection? I doubt it, because it would be relatively easy to keep track of an unusual number of scandals arising out of (say) Manitoba's dentistry rules or PEI's insurance regulation. Such scandals would hurt the reputation of everyone regulated under that jurisdiction. In any event, if things got unusually bad, there would be the possibility of federal minimums intervening.

Undoubtedly, most industries would end up following the rules of a single regulator, as most large corporations in the US follow the governance rules of Delaware. But this would not be the grey uniformity of the centre, but the success of a nimble competitor.

Note: I've rewritten this post somewhat.

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