Notice & Comment

Agency Guidance and the Agency Costs of Compliance, by Sean J. Griffith

Inhabitants of the administrative state who are concerned about the rule of law may be comforted by the fact that there are rules about making rules.  The Administrative Procedure Act (“APA”) requires regulatory agencies to expose prospective rules to democratic processes, most notably the notice and comment period, before they become binding.  “Guidance” – regulatory pronouncements issued in the form of advisory manuals, policy statements, interpretative letters, FAQs, and so on – is exempted from these processes.  Yet guidance often has the same effect as rule-making.  Although technically non-binding, guidance is frequently viewed as binding by regulated entities.  The result is a massive loophole in the APA.  Agencies’ authority is unconstrained by democratic processes as long as they issue regulatory pronouncements as guidance rather than rules.

Professor Parrillo offers an insightful study of this problem, drawing upon interviews with 135 participants in the regulatory process.  He finds, first of all, that the phenomenon of regulation through guidance is a real one.  Regulated entities often fail to distinguish between rules and guidance, instead following guidance as though it were law.  Critically, however, Professor Parrillo locates the source of this problem not in devious officials plotting to achieve indirectly what they could not achieve directly, but rather in structural factors, including agency pre-approval powers, ongoing monitoring, in-house compliance departments, and costly enforcement.  To address these structural problems, Professor Parrillo calls for an institutional reform he calls “principled flexibility.”  Under a regime of principled flexibility, regulated entities may receive exemptions from agency guidance, but only if the agency provides a public statement of reasons which then becomes a precedent for future exemptions.

This is fascinating work, about which there is much to be said.  Because space is limited, however, I will confine my comments to the aspect of Professor Parrillo’s study that is most familiar to me.  That is, the interaction between regulatory guidance and corporate compliance.  In particular, I will argue that in industries with robust in-house compliance departments, principled flexibility may not succeed as a result of information asymmetries and incentive problems created or enhanced by compliance intermediaries.  Under these circumstances, guidance might continue to bind notwithstanding the potential to seek exemption.  These obstacles are not insurmountable, however, and I close by suggesting how in-house compliance departments might be redesigned to interact more successfully with regulators under a regime of principled flexibility.

Much of Professor Parrillo’s account of how principled flexibility would work focuses on the “producers” of guidance—the agencies themselves.  The articulation of reasons, it is hoped, will make agencies both more flexible and more principled in offering exemptions from regulatory rules.  But there remains a problem on the “consumer” side of guidance—that is, the regulated entities that must decide whether to seek an exemption or whether simply to follow existing guidance.  Firms would presumably prefer to seek an exemption any time complying with guidance is not cost-justified to the firm.  In order for principled flexibility to improve their lot, these entities must be fully informed on the distinction between (binding) rules and (non-binding) guidance, and they must perform a complex cost-benefit calculation, weighing the cost of compliance, the risk of enforcement, and the probable cost of being found not in compliance.  Yet regulated entities are just that—entities.  And entities, especially large corporations, are beset by information and incentive problems that impede efficient outcomes.

The critical intermediary on the consumer side of guidance is, of course, the chief compliance officer.  Unlike other corporate officers who serve shareholder interests, the chief compliance officer and the in-house compliance officers that report to her are not simply accountable to the interests of shareholders.  The compliance function owes its origin in large part to government enforcers—prosecutors in particular—who have insisted upon the implementation of a compliance function to carry out an enforcement agenda inside the firm. Federal enforcers not only tell regulated entities what to do (comply with the law) but how to do it (through robust in-house compliance departments).  Differences between the extent of the in-house compliance function—Professor Parrillo notes differences between banking and pharmaceutical companies, on the one hand, and construction firms, on the other—reflect the industry’s history of prosecutorial intervention.  In industries where compliance is robust, it is especially beholden to an external enforcement agenda.

Seeing compliance officers as agents with ambiguous mandates raises the question of their incentives with respect to guidance.  Insofar as compliance officers see their goal as maximizing compliance, it is unclear whether flexible guidance presents an obstacle or an opportunity.  Compliance officers may not fully inform their firms of the non-binding character of guidance or the potential to obtain an exemption if they fear that doing so might lead to less compliance.  Indeed, Professor Parrillo’s study suggests this when he finds that compliance officials at regulated firms typically fail to distinguish between rules and guidance.  Similarly, compliance officers may be slow to seek exemptions, due either to a desire to maintain an expansive base of authority within the firm or, alternatively, to a good faith belief that seeking exemptions may weaken compliance overall.  Complying with non-binding guidance might raise the corporation’s costs, but engaging with the firm’s overall cost-benefit function is not a principal concern of compliance departments and, were it to be so, it is unlikely that compliance officers would approach the problem with shareholders’ best interests as their sole or primary concern.

Nor are chief compliance officers the only relevant intermediary.  Compliance is often intermediated by outside “compliance consultants,” especially in industries with less intense enforcement and, therefore, less robust in-house compliance programs.  Compliance consultants have their own incentives to control information about compliance, emphasizing its complexity and variability, the kind of thing for which firms ought to hire outside expertise. On the basis of these incentives, compliance consultants might be expected to oversell costly compliance structures and to undersell the distinction between rules and guidance and the potential for exemption.

Intermediaries with their own interests may prevent firms from making optimal use of principled flexibility.  Compliance intermediaries, whether internal or external to the firm, may block firms from receiving the necessary information to distinguish between rules and guidance.  Furthermore, compliance intermediaries bring their own interests to bear in analyzing whether firms should comply with or seek exemption from regulatory guidance.  Because the interests of compliance intermediaries likely skews toward simple compliance, principled flexibility may prove inflexible in practice.

One way of addressing this situation might be to reunite compliance with the general counsel’s office, making the officer charged with compliance report to the officer charged with interpreting and applying the law.  The general counsel, unlike the chief compliance officer, has both the information and the incentives needed to operate within a regime of principled flexibility.  Lawyers understand the distinction between rules and guidance, and they are accustomed to complex risk-reward calculations.  More importantly, the general counsel’s authority flows from shareholders, not prosecutors or other external enforcement agents.  As a result, the general counsel is more likely to perform the cost-benefit calculation from the shareholders’ perspective, seeking exemption any time complying with guidance is not cost-justified to the firm.  The chief compliance officer, by contrast, may often arrive at a different answer.  Furthermore, putting the general counsel in charge of compliance increases the odds that compliance consultants will be used to find regulatory exemptions, rather than building costly compliance structures.

Unfortunately, the recent momentum in compliance has been toward the separation of compliance from legal and the further insulation of compliance from other departments of the firm.  This is a regrettable development, not least because it introduces an alien element into the governance of the firm, but also because it diminishes the prospect of reforms, like Professor Parrillo’s, to correct excesses of the administrative state.  Preventing the administrative state from exceeding the bounds of its authority requires attention not only to the producers of regulation and guidance but also to their consumers.  In this case, the consumers who have been conditioned, sometimes coerced, into following regulatory guidance as though it were a regulatory rule.  A necessary step in achieving principled flexibility might thus involve the redesign of corporate compliance departments.

Sean J. Griffith is the T.J. Maloney Chair and Professor of Law at Fordham Law School in New York City.

This post is part of a symposium on federal agency guidance. The rest of the posts in this symposium can be viewed here.

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