Regulatory action: Shock and awe

Rather than surprising investors with their final decisions, disclosing findings on an ongoing basis would better prepare the market for eventual outcomes

We often see regulatory actions against various financial entities after the regulator has “inspected their books”. Recent regulatory action includes restrictions on accepting deposits, opening new accounts through online banking channels, issuing co-branded cards, launching new mobile products, and managing debt public issues. These actions reflect the regulators’ commitment to maintaining financial stability, fair markets, and ensuring compliance with regulations. However, investors view such action with shock and awe, as they impact them directly.

Another sector that periodically sees inspections — and regulatory action — is pharmaceutical firms exporting to the US. Here, inspections are conducted by the US Food and Drug Administration (FDA) to assess a regulated facilities’ compliance with applicable laws and regulations, such as the Food, Drug, and Cosmetic Act, and various other related Acts, to ensure the safety and quality of medicines.

Unlike the financial sector reviews and audits, which are an “all-year” affair, US FDA inspections are conducted every few years with an element of surprise regarding their timing. The FDA investigators arrive at the premises and present a “notice of inspection”, or form 482. They then examine the production process, look at relevant records and collect samples. At the conclusion of the inspection, the observations, referred to as Form 483, are submitted, serving as a guide for corrective action. This gives the facility an opportunity to take voluntary remedial steps and prevent their recurrence. In extreme cases, the FDA might recommend recalling a drug or preventing its export to the US.

Similar to financial inspections, the Form 483 remains confidential between the regulator and the reviewed entity. But there are two variations that I am aware of. As with the financial sector regulator, FDA inspections are confidential initially. But the FDA does review the findings, the company’s response, and other data, and usually classifies its finding within 90 days into three buckets— (i) no action indicated, when there are no significant issues; (ii) voluntary action indicated, when minor issues that need correction are identified; and (iii) official action indicated, where serious violations are identified that require enforcement action. The classification is publicly disclosed.  

Two, under the Freedom of Information Act, individuals can request the FDA 483 for a fee. The FDA redacts commercially sensitive information before releasing the document. Unfortunately, there is no time commitment to this, and people have been known to wait for up to two years to access this information. This redacted file is then uploaded on the FDA website and can be freely accessed by all stakeholders, including its investors. I have simplified things, but this is the broad protocol.

The regulators work with the objective of ensuring patient safety, fair treatment of borrowers, and adherence to rules. Their actions, even if viewed as somewhat extreme, helps them preserve the integrity of the industry they regulate. But there is no getting away from the fact that severe regulatory decisions impact various stakeholders and may have unintended consequences. To give just one example, admonishing a bank that its systems are vulnerable might lead to an uptick in cyberattacks. This is not to argue that regulators should overlook shortcomings, but there needs to be a way to involve investors and other affected stakeholders into this exchange. 

At present, once an entity hears from the regulator, it discloses the summary to the stock exchange. If the action is punitive, it leaves investors feeling bruised, who then argue that such action is knee-jerk, even if the discussion has been ongoing.

Should the FDA then first give a cure period when serious violations are observed? It is hard to argue given that lives and limbs are involved, so I will focus on the financial sector, where change may be relatively easy.  Given that the inspections are often ongoing, making a public disclosure only after the “final” letter is received is what causes severe market disruptions, particularly if the action is also severe. Disclosures and updates regarding the intervening communication should be encouraged. While it may be argued that whenever such information is first disclosed, it may lead to market volatility, timely and meaningful disclosures in some form would better prepare the market.

Further, financial regulators should explore classifying their regulatory communication based on the nature and seriousness of the findings. They can publish the summary findings and eventually the entire inspection report or encourage the regulated entities to do so. An annual or semi-annual summary of their inspection findings, without naming specific entities, will also go a long way in articulating regulatory expectations. They should also highlight the best practices that they have observed. This will give stakeholders the information that they crave for and all regulated entities clear metrics for improvement.

The writer is with Institutional Investor Advisory Services India Ltd. The views are  personal. X: AmitTandon_In