Friday, 14 November 2014

Speech: Key elements in designing risk based regulation

After 50 years of regulation review we should be pretty close to wrapping things up and getting on with something more important.

The reality is that we probably have not even scratched the surface.

Why have we failed so badly at this?


Almost all legislation is reactive.  A problem arises, a champion rises to meet it, and the evil is publicly dispatched in parliament amidst great fanfare. Unfortunately, narrow legislation hardly ever benefits anyone.

Much legislation that is not reactive is reiterative. A good example is the Australian Trade Practices Act 1974. It is often said to have been revolutionary – but the reality was that there was nothing new, novel or adventurous in it. It was simply a concoction of provisions reorganised from earlier anti-trust legislation or the Common Law with provisions stolen from the US Commercial Code thrown in for good measure.

Truth is, the legal dialogue necessary to create approval for and passage of legislation is mundane. Lackluster political machines give preference to half measures that are either reactive or reiterative.

Almost all the legislation which finally emerges is next to useless, simply adding to confusion which already exists.

So, after 50 years of regulation review, we should have reduced the legislative burden to the point where the rules are crystal clear and simple.

Hasn’t happened. For every word we had ten years ago, we now have far more. The weight of legislation is increasing exponentially. This is not just a modern ailment. 

Corruptissima re publica plurimae leges. (When the republic is at its most corrupt the laws are most numerous.) Tacitus 


Let us take a step back from this and look at a couple of examples of how regulatory reform has been derailed.

1. Rule proliferation as a consequence of regulatory reform: The Market Ouvert and restraint of trade clauses

In the past, the Crown established markets.  Buyers purchased with a guarantee of safety within these markets protected by the doctrine of the market ouvert. The rule is blindingly simple. It can be expressed in one line:


"If you buy in a market ouvert, you get good title to the goods purchased."

Simply put, if you bought in good faith in a properly established open market, you got good title to the goods.  This rule, giving certainty to transactions, allowed buyers and sellers to transact with assurance – it kick-started modern market-based economies. 

So, if you wanted to buy a pig, you would do it with no risk as to title, with certainty, at the open market that ran, for example, from sunrise to sunset 45 days every year at Scarborough Fair. To be sure, the market would be crawling with market police, but if you bought something, there would be no doubt you then owned it fair and square. You would not transact in the back room at the local pub with folk of dubious morality. 

In the United Kingdom, this ancient protection came to a shuddering end twenty years ago. A couple of valuable paintings stolen from Lincoln’s Inn were sold for a bargain in a market ouvert in London. The original owners found that they could not reclaim the paintings from those who purchased in the market, as those purchasers had acted in good faith.  Their only recourse was against the thief.

As a result of this mischief, a charitable organisation called the Council for the Prevention of Art Theft promoted a private member's bill which was eventually introduced into the UK Parliament - the Sale of Goods (Amendment) Act 1994. The law was passed, abolishing the old rule. But, and here is the catch, the repeal was not just in relation to paintings stolen from Lincoln's Inn. Not just for paintings from any inn, motel, art gallery or private home. Not just for artwork or chairs from which artwork could be safely viewed from, or televisions, children's toys, novelty items, motor vehicles, small trains, hovercraft or rockets. The repeal applies to everything.

What consequences flow from this repeal of the market overt rule - a rule so old, that most people did not remember it? 

It is tempting to say that there haven’t been any consequences and this was a good example of getting rid of another of those silly old rules that no one understood and that some did not believe in anymore. 

But not everyone. Old police officers still walking the beat harboured an active dislike of the rule. For centuries they had to get up early on a weekend and wander around markets in the half-dark. Tired prosecutors trapped in dead-end careers in the petty courts disliked the rule because they occasionally lost a case to the rule. As they should have.

Still, it is hard to see on a superficial glance how any risk of a reduction in market confidence might occur because of the repeal. Two different schools of thought might be imagined to argue over the case.  

One school might assert that markets have had training wheels on for too long. They argue buyers are now more sophisticated and point to the emergence of virtual markets outside the control of governments in which risks are legion. 

The other school claims that we are now riding a tricycle on two wheels, placing new stresses on the rest of the economy. It would go on to point out to an increase in the amount of regulation which has arisen in the past twenty years to track good title in goods from inception to disposal. I have tried to estimate the amount of new legislation that has flowed into our law as a result of the repeal. In one federal jurisdictions, consisting of a mix of Commonwealth, State and local government acts, regulations and rules, I estimate that some 25,000 lines of legislation has been added to the statute books (whether in credit transaction registers, the motor vehicle spare parts industry or electronic cattle tagging).

The rule still applies in lots of places around the world. If you buy a Plasma Screen TV from one of our large distributors (in those jurisdictions still blessed with the rule) during business hours you will get good title - certainty working at its best  However, if you purchase the screen in Brisbane or London you might NOT get good title. The curse of uncertainty is suddenly in play and it cannot be exorcised from the transaction. Suddenly the consumer wears the risk. 

Regulatory reform has not just thrown away old rules with no apparent purpose. In some cases it has overseen the ghastly transfer of rules out of the public arena into the realm of private lawmaking.

Recently I have been studying a species of contractual clause that has appeared in commercial agreements following the repeal of a statutory provision which had formerly set out the law on a subject. 

I found that an industry standard had emerged in each of the commercial agreement I examined. However, unlike the old statutory provision, the new industry standard is drafted in the most obscure manner imaginable. No expense has been spared to remove any hint of certainty from this area of contract law, leaving every possible interpretation of the efficacy of the provision to future expensive litigation. 

Getting rid of legislative provisions dealing with restraint of trade have simply transferred the legal provisions out of the public arena of legislation into the murky world of private contracts.  Sometimes private rule-making is a good thing.  However, in many cases it is very bad. 


These examples can be repeated ad nauseum across every area of business regulatory reform, from core rules dealing with corrupt public and private behaviour through to new regulatory provisions rushed into existence under cover of patching the law about certainty of title.  

But today I am disinterested in whether any particular 'reform' was a proverbial 'pig in a poke'. My purpose in raising it was to draw attention to the perspective lawmakers brought to bear on this issue of certainty. Generally, when legislating, lawmakers seem to be concerned about a single type of risk: for example, the sort of loss that might occur in relation to the theft of a Lincoln Inn painting.  They do not direct their attention to the broader issue of market certainty and the downstream consequences.

Regulatory reforms tend to be very narrow rather than broad. At the end of each reform cycle, Ministers have loudly trumpeted success based on vague calls on the number of provisions amended or repealed. Industry groups have breathlessly pointed to repeals, to justify their own existence. And, usually, the rest of us go back to the real world in which little of a practical nature has changed

Often the legislative intervention has been of a technical nature, seldomly impacting on the real world. Sometimes, the intervention deals with a specific problem, but in its wake creates a whole new pressure for regulatory intervention in a hundred new industries. In these cases, we have changed the nature of markets without knowing.




2. Incoherence in legislative systems: Australian employment law

Having discussed one type of regulatory reform which is useless, let us discuss an area where regulatory reform is needed and would make a difference. That is, where it might be useful. Let us use a simple test: where a small business employer and employee say, at the end of the process, "that helped". Too simple a test?

Operational risks are legion in employment arrangements. Some arise from the circumstances faced by a particular employer and may be unique to that employer. Many others arise from a basic failure to deal with strategic risk issues and impact on all employers.  

The following example describes a strategic risk affecting one business sector. This time I will focus on how it arises and how the problem can be resolved, by simplifying the regulatory environment.  It demonstrates that if strategic risk is dealt with, there may be significant flow on advantages to an entire sector. Something that satisfies the "that helped" test.

One of the most significant issues any small business has to deal with is that of taking on a new employee.  A new employee may help business grow, give owners relief from long hours and may bring new skills and opportunities into a small business.  Balanced against these possible benefits are a number of risks.  Some of these risks, such as whether the new employee will work out, are also difficult to quantify.  However, many businesses move through the employment process without ever quantifying those costs and poor decision making here may ultimately lead to financial stress, litigation or collapse.  A common risk is that the business might stall part way through the process.

One significant type of risk arises through Government regulation of different employment sectors.  Narrow Government goals, to secure fair terms and conditions of employment, enjoy wide community support. In real terms, present modes of government intervention create uncertainty.  This type of risk, arising through faulty government intervention, creates strategic risk across the entire sector. 

A typical example is employment in any of our large service industries: for example, motor repair shops, electricians or hairdressers.  These service industries engage a lot of young people entering the workplace, yet educators and industry observers say that many of these arrangements fail to the cost of both employer and employee. 

The problem is simple.  The rules dealing with employment in these industries are a mess.  There is significant confusion of Commonwealth legislation and awards that govern the area.  For a small business, with limited time to decide whether to engage an apprentice and the cost impacts, and for a young apprentice, just out of school, this is a serious problem.   More than any other single issue, this strategic risk is one of the most serious regulatory problem facing small business. It acts as a significant disincentive to employment. Yet the problem has not been addressed. Regulatory reform in the area has simply muddied the waters. Promises to get in and clean the system up have failed, time after time.

One possibility is to simply repeal the rules and let the parties make up their own rules.  No doubt this could work where the parties are reasonable people and are able to come to a fair deal.  However, even if the agreement was fair, the parties still need to cover all the bases, the agreement still must be capable of dealing with a whole range of contingencies, some likely and others unusual.  Some of the unusual cases can expose either or both parties to considerable, and perhaps unreasonable, loss if the wrong option is chosen.

A reasonable employer can sometimes do unreasonable things.  Sometimes this is not from thrift or short-sightedness.  Sometimes it can be forced by the unreasonable actions of a third party, or because the business or personal interests of the employer come under pressure.  In Australia at this time, some small businesses operate out of large shopping malls that are open until late each night and employers operating in the malls are required to trade for quite long hours.  The requirement to keep open, even when trade is slight, can result in an employer seeking to get employees, particularly low paid employees, to work exceptionally long hours.

How can the strategic risk (uncertain State and Commonwealth rules) be addressed?  

The market risk described above can be removed by designing a simple system that allows an employer to test fair options before employing an apprentice.  Today, a simple graphic interface could be built that allowed the employer to quickly work out when the employee could work and the fair cost of engagement across those times.  The interface could demonstrate all aspects of the employment, from taxation, superannuation, long leave, leave and termination. It can be done in a single screen able to be taken in, in a minute or so, with a minimum of text and no legal language.  Prospective employees could be shown the page and test alternatives, with the confidence that they are negotiating within a fair framework that will deliver a contract that deals with all of the outcomes.

Here our perspective has been constrained to the view from the floor – employees and employers, rather than top down.  We have focused on providing a simple answer to the key issue facing small business: what is the actual cost of that new employee. 

Sounds easy.  It is easy.  So why doesn’t it happen? 

Instead of a simple business-friendly framework, we have a cumbersome rules based system which forces both parties to learn a lot of irrelevant and confusing guff, and gives no assistance as to core issues such cost impacts.  Worse, because some of the rules span different rule makers, some of the rules are directly inconsistent.  A detailed examination of the rules will take someone already familiar with the structure and scope of work-place rules about four hours to get across the rules in any of these sectors.  There are gaps and inconsistencies everywhere. 

Small businesses have been asked whether they thought they understood the system.  Most said they tried, but gave up because the rules didn’t make sense.  Employees have been asked whether they thought they understood the system.  All said they did not.  Testing the actual working arrangements in one sector, in relation to apprentice hairdresser, suggest that they are being systemically underpaid, asked to work outside reasonable times and denied basic conditions of service.  In some cases, employers and employees had adopted unfair practices after discussions with government agencies.  Testing the advice of the agencies showed them to be consistent wrong.

The existing system fails business and employees.

While the individual risk faced by an employee or employer can be ameliorated by one-on-one advice, the real problem here is that the systemic risk caused by a basic failure by States and the Commonwealth to ensure consistent and understandable rules.  

It is time to change the rules to make them consistent and to work on a way of delivering a simple employment solution to the parties. 

Again, the problems here can be repeated ad nauseum across every area of business regulatory activity. It is not just present in employment law, or consumer law or business and security law. It exists in a lot of places where it should not. It is evident in lots of places where people have been laboring for years to try and eliminate problems, without any notable success. It has been a long time since any regulator has heard a heartfelt and deserved "that helped" as a result of regulatory reform.

So how do we design risk based regulation?

You may be familiar with risk matrices, where possible adverse consequences are mapped against the probability of occurrence. While this can be a useful tool for filtering and weighing risks, it has a couple of serious problems. Matrices are often cost driven and can be hostage to inefficient structures.  Matrices do not address vulnerabilities or the strategies required to meet those vulnerabilities.


 NOTE: Vulnerability (as opposed to risk).  In simple terms, a vulnerability is a weakness which, in particular circumstances, might become a risk.  For example, a soldier without adequate training is a vulnerability.  In a combat situation, the untrained soldier is a risk.  Before the soldier moves into the combat situation, the vulnerability can be protected (eg, by training or replacement) - forestalling the risk emerging. When people try to deal with risks, they may be already trying to cope with a situation which has drifted beyond real control.  It is critical to deal with vulnerabilities early - before risk emerges. Regulation is a key method of protecting vulnerabilities - but more often than not, it just creates new problems.



I would like to draw a couple of key vulnerabilities from the examples given from a risk policy perspective.

Firstly, an obvious warning.  Blind enthusiasm is a vulnerability. Legislative reaction or repeal might feel good, but it is simply a false economy. The goal is not to shift rules* from one place to another: from legislation to industry specific legislation OR from public legislation to private contract.  If legislative action engenders more regulatory intervention, the action fails.

Secondly, focussing on legislative reiteration is a vulnerability.  Sure, it has its place, but should be avoided as an alternative to really addressing systemic risks within industry.  Rule churn is a fail.

Thirdly, regulative perspective should always be industry wide, recognising that information resides in inter-connected networks. Complex systems mandate the need for new ways of addressing problems from a whole-system perspective designed to identify and protect vulnerabilities before they become risks. (I have descended to jargon at this point in the hope of persuading Federal bureaucrats to take note.) Federal systems place particular strains on the need for a broad perspective.  Local, state and national bodies should operate within clear areas of responsibility and commit to work together to ensure an industry wide perspective. If the rules do not work together, they fail.

Fourthly, rules based systems are cumbersome. Government action should be designed in conjunction with tools that provide a simple view from the floor. If the rules cannot be understood, they fail.

Regulatory reform has a long way to go in this country. 





*NOTE  Rule shifting (in business situation)   This is one of the most difficult concepts to get across to students.  

A legal relationship exists only because of the rules that define and govern it.  Some of these rules are explicit, and within this group are found acts, regulations, orders, awards and the common law and the rules of equity binding on the parties. Within the group are also rules that the parties themselves have adopted, by contract, ex-contractual agreement, or unilateral undertaking.  The group may also contain rules that apply to both parties by agreements formed outside the relationship.  In addition to explicit rules, there are implicit rules, that arise through the conduct of the parties or the market itself.

For any relationship each rule can be described formally using deontogogical logic - and can be compared sequentially or globally to discover inconsistent rules or gaps in the rules. Finally, against the combined deontogogical product we can assess the actions of the relevant participants and determine whether their actions are rules compliant. - See Designing risk-based legislation

Assume that an actor is exposed to such a specified number of rules. To each actor, it really does not matter how the rule comes into existence - together they express the relationship.

If, through reform, a rule is added or removed from the realm of act, regulations, orders or awards - the relationship itself is changed. In such a case, the addition of a rule in that space may cut across rules sitting in the contractual sphere.  The removal of such a rule may create a gap in the relationship, giving rise to uncertainty or the need for a replacement contractual rule. Both of these are forms of rule shifting.

Rule shifting might be contrasted with the process of reducing the burden of rules (rule simplification).  Here, despite the reduction in the number of rules, the relationship remains the same.

Rule simplification, when harnessed with user interfaces - particularly graphical interfaces - can lead to powerful user-friendly tools for employers and employees.

Deregulation has tended to focus on (negative) rule shifting.  The vulnerability of rule shifting is that it changes relationships and tends to push the rules about that part of the relationship into contractual provisions. Deregulation is a more powerful and useful tool when it focuses on simplification. It become powerful when it is harnessed with an effective user interface.



This speech is based on one I first gave to the Australasian Regulation Review Conference in November 2014.  I update this version as I deliver it to other audiences.  


Peter Quinton
Palerang
November 2014
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