The Mandatory Repatriation Tax Is Unconstitutional

*J.D. Stanford Law School, 2016. The Author wishes to thank Joe Bankman, David Forst, Adam Halpern, and Mike Knobler for their incredibly helpful comments on drafts of this Essay, as well as his colleagues at Fenwick & West LLP for their support. He also wishes to thank the editorial team at the Yale Journal on Regulation Bulletin. All errors are his own.

In late 2017, Congress passed the first major tax reform in over three decades. This Essay considers the constitutional concerns raised by Section 965 (the “Mandatory Repatriation Tax”), a central provision of the new tax law that imposes a one-time tax on U.S.-based multinationals’ accumulated foreign earnings.

First, this Essay argues that Congress lacks the power to directly tax wealth without apportionment among the states. Congress’s power to tax is expressly granted, and constrained, by the Constitution. While the passage of the Sixteenth Amendment mooted many constitutional questions by expressly allowing Congress to tax income from whatever source derived, this Essay argues the Mandatory Repatriation Tax is a wealth tax, rather than an income tax, and is therefore unconstitutional.

Second, even if the Mandatory Repatriation Tax is found to be an income tax (or, alternatively, an excise tax), the tax is nevertheless unconstitutionally retroactive. While the Supreme Court has generally upheld retroactive taxes at both the state and federal level over the past few decades, the unprecedented retroactivity of the Mandatory Repatriation Tax—and its potential for taxing earnings nearly three decades after the fact—raises unprecedented Fifth Amendment due process concerns.

Introduction

In December 2017, President Trump signed H.R. 1, originally introduced as the Tax Cuts and Jobs Act of 2017 (the “TCJA”).1 The TCJA is the most wide-ranging change in federal tax law since the Tax Reform Act of 1986, a bipartisan rewrite of the Code signed into law by President Reagan.2 The TCJA’s many changes to the Code3 include: a reworking of the individual tax brackets,4 the near doubling of the standard deduction5 and the elimination of the personal exemption,6 the doubling of the estate tax exemption,7 the cutting of the corporate tax rate from thirty-five percent to twenty-one percent (along with the elimination of the corporate AMT8 and the imposition of a new excise tax on universities.9

Notably, the TCJA transforms the United States’ system of international taxation. In the corporate realm, the TCJA moves the United States away from something akin to a worldwide system of taxation, and into a quasi-territorial system of taxation.10 Under the U.S. international tax regime before the passage of the TCJA, many large U.S.-based multinationals11 accumulated considerable earnings overseas, deferring perhaps $2.5 trillion in earnings from U.S. taxation.12 While multinational entities’ overseas earnings have generally been subject to tax in the source jurisdiction—that is, taxed in the jurisdiction where the income is deemed to have been earned or attributable—accumulated overseas earnings have never been subject to tax in the United States.13 In the past, Congress has incentivized corporations to repatriate cash by providing a substantial deduction for such dividends, which lowered the effective U.S. rate on that overseas income.14

However, the TCJA goes beyond offering an optional deduction to incentivize repatriation. The TCJA imposes a tax on all post-1986 accumulated foreign earnings.15 Speaking generally, this “Mandatory Repatriation Tax”16 in the new Section 965 applies to certain United States shareholders of foreign corporations that have accumulated deferred foreign income.17

This tax is imposed on accumulated earnings whether or not such earnings are held in liquid or illiquid assets. There is a difference in rate between earnings held in liquid and in illiquid assets: all earnings held in cash or cash equivalents (as of late 2017) are to be taxed at a 15.5 percent rate, and earnings held in illiquid assets are to be taxed at an 8 percent rate.18 Corporations may elect to pay this tax in installments over the course of eight years.19

The imposition of this new, mandatory tax raises a constitutional question.20 The Mandatory Repatriation Tax appears to be a tax on wealth accumulated by a U.S. corporation’s foreign subsidiaries. Such a tax is not, at least on its face, a tax on income as permitted under the Sixteenth Amendment.21 Nor is it strictly a repatriation tax. Unlike past “repatriation holidays,” this tax is imposed on accumulated foreign earnings whether or not the entity repatriates any of its foreign assets.22

This Essay discusses, and challenges, the constitutionality of this tax on two independent grounds. First, I will argue that the Mandatory Repatriation Tax is an unconstitutional direct tax. Second, even if the tax is considered to be an income tax, it is a retroactive tax on income, and it is therefore vulnerable to a challenge under the Due Process Clause of the Fifth Amendment.

I. The Mandatory Repatriation Tax

This Part is intended to provide a nontechnical discussion concerning the basics of the U.S. international tax system and to discuss how past and current repatriation taxes have altered and fit into that system.

A. International Taxation of U.S. Multinationals

Domestic corporations in the United States are taxed on their worldwide income, including any income that the corporation earned from the direct conduct of a foreign business.23 This includes, for example, direct sales or the operation of a branch in a foreign jurisdiction.24 In general, income that a domestic corporation earned indirectly from the foreign operation of its foreign corporate subsidiaries was not taxed until the income was distributed to the domestic parent corporation.25 The U.S. tax on the earnings of foreign corporate subsidiaries can therefore be deferred until the multinational entity elects to repatriate the income by distributing it to its domestic parent corporation.26

A notable element of this tax system is the anti-deferral regime known as subpart F.27 Under Section 951(a), a U.S. shareholder of a “controlled foreign corporations” (a “CFC”), 28 is required to include in gross income for the current taxable year its pro rata share of certain items that are attributable to the CFC.29 These inclusions are commonly referred to as “subpart F income.”30

Congress enacted subpart F as part of the Revenue Act of 1962.31 Subpart F singles out a specific class of taxpayers—U.S. shareholders who have a substantial degree of control over a foreign corporation—and subjects them to immediate taxation on the grounds that they have the ability to treat the corporation’s undistributed earnings as they see fit.32 Thus, certain income of CFCs would be subject to immediate taxation.33

Subpart F income generally includes “passive income and other income that is readily movable from one taxing jurisdiction to another.”34 Subpart F income is comprised of: foreign base company income,35 insurance income,36 and certain other income relating to boycotts and other violations of public policy.37 Foreign base company income includes: certain types of passive income (including certain dividends, interest, rents, and royalties),38 certain foreign sales income,39 certain foreign services income,40 and—prior to the passage of H.R. 1—certain foreign oil-related income. 41 Subpart F operates as an anti-deferral regime, requiring the immediate inclusion of these limited types of income earned by controlled foreign corporations to major U.S. shareholders.

B. Past Attempts at Repatriation Taxes.

The most significant attempt to tax corporations’ accumulated overseas earnings occurred with the passage of Section 96542 in 2004 as part of the American Jobs Creation Act of 200443 (the “old Section 965”). The old Section 965 allowed CFCs to repatriate, at their election, accumulated foreign profits at a U.S. tax rate of 5.25 percent to the domestic corporate owners, rather than the standard 35 percent corporate rate.44 Various limitations existed on this “tax holiday,” including45: (1) a cap of $500 million in dividends applicable to most corporate taxpayers,46 (2) requirements that any dividends paid be extraordinary,47 and (3) a reduction in such benefit if the amount of indebtedness of the CFC to any related person increased as of the close of the taxable year for which the old Section 965 was in effect.48 This tax was markedly different than the TCJA’s Mandatory Repatriation Tax. Since the 2004 law offered an optional deduction, corporations could elect to benefit from the lower rate, but were not required to pay any tax if they chose to keep their profits permanently invested overseas.

Over the past decade, various individuals have suggested a tax holiday of some form as a way to generate revenue. In 2014, the Camp Plan—advanced by then Chairman of the House Ways and Means Committee Dave Camp—also proposed having a one-time tax on accumulated foreign earnings and profits (at an 8.75 percent rate).49 A repatriation holiday was potentially an integral part of bipartisan tax reform; even the Obama Administration suggested a one-time tax on overseas earnings as a potential revenue-raiser.50

The taxation of accumulated foreign profits would ultimately be a central component of the TCJA. The TCJA dramatically changed the tax treatment of foreign earnings with three new provisions: the foreign dividends received deduction, the deemed repatriation tax, and the tax on global intangible low-taxed income.

C. The TCJA and the New Quasi-Territorial Regime

The TCJA, the most substantial tax reform since the passage of the Tax Reform Act of 1986, transforms the world of international corporate tax. It drops the corporate rate from 35 percent to 21 percent51 and it imposes several new and extraordinarily complex and acronym-heavy taxes on multinational corporations, including: a tax on multinationals’ “global intangible low-taxed income” (their “GILTI”),52 a deduction for Foreign-Derived Intangible Income (“FDII”),53 and the base erosion and anti-abuse tax (the “BEAT tax”).54

But, in transitioning from a worldwide system to this new quasi-territorial regime, a key policy question for Congress was what it would do about already-deferred foreign-source earnings of U.S. multinationals. Many U.S.-based multinationals had accumulated billions in foreign-sourced earnings of its subsidiaries that had never been subject to U.S. taxation.55 Congress could have merely allowed for a full deduction on repatriation without any payment of tax, but given the need for revenues to fund the corporate tax rate cut, such an outcome seemed unlikely.56 The TCJA provides that these accumulated earnings and profits are subject to a one-time tax, payable over eight years.57

1. New Section 965: The Mandatory Repatriation Tax.

The TCJA provides that certain deferred foreign-source earnings and profits, accumulated by U.S.-owned foreign corporations between 1986 and 2017, are now deemed to be repatriated and are thus subject to immediate taxation, albeit at a reduced rate.58 Specifically, certain U.S. shareholders that own foreign corporations will now be taxed on such accumulated earnings at a rate of 15.5% for earnings held in cash or cash equivalents, and at a rate of 8% for all other earnings.59 It is not the foreign corporations themselves paying the tax, but rather the U.S. shareholders who own at least a 10% stake in the foreign corporations. Moreover, the shareholders will be responsible for this tax whether or not they are able to cause the foreign corporation to pay dividends.60

The mechanics of this tax are extraordinarily complicated.61 Put simply, all of a U.S.-parented multinational entity’s deferred foreign earnings—deferred profits which have never been subject to U.S. tax—are now subject to a 15.5 percent tax if they are cash or cash equivalents, or an 8 percent tax if they are not. This tax occurs as if the profits accumulated in late 2017,62 even though taxpayers may defer some of their payment of the tax to a later year.63 Importantly, the Mandatory Repatriation Tax is imposed on U.S. shareholders whether or not a multinational entity elects to repatriate the cash.

II. Constitutional Challenges to the Mandatory Repatriation Tax

This Essay raises two independent arguments that the Mandatory Repatriation Tax is unconstitutional. First, the Mandatory Repatriation Tax is not a tax on income, but is instead an unconstitutional direct tax, since it taxes wealth.64 Second, even if the tax is found to be an income tax, it should be considered to be a retroactive tax on income and is therefore unconstitutional under the Due Process Clause of the Fifth Amendment.

A. The Mandatory Repatriation Tax is an Unconstitutional Direct Tax on Accumulated Wealth.

1. The Mandatory Repatriation Tax is Not an Income Tax

Our starting point is to ask whether the tax is an income tax, and therefore is permissible under the Sixteenth Amendment (but still subject to due process limitations).65 If the tax is not an income tax, then the question turns to whether it is a “direct” tax (and therefore subject to apportionment66), or an “indirect” tax that is not subject to apportionment (e.g., an excise tax, or an automobile tax).

a. Defining Income Tax.

The Sixteenth Amendment allows for the taxation of income “from whatever source derived.”67 But an income tax must tax income, and the Mandatory Repatriation Tax—levied against a U.S. shareholder of a controlled foreign corporation—ultimately fails to do so.

Merriam-Webster defines “income” as “a coming in” and as “a gain or recurrent benefit usually measured in money that derives from capital or labor; also: the amount of such gain received in a period of time.”68 `
Any definition of income implies some type of transfer of property during a specific timeframe. To illustrate, Lucas v. Earl69—known to any tax student as the seminal case for the assignment of income doctrine—makes a theoretical distinction between the fruit of the tree (the income) and the tree itself (the income-producing entity).70

In Eisner v. Macomber, the Supreme Court carefully considered the definition of income, as it applied to a pro rata dividend of stock that did not impact an individual’s ownership of a corporation. In Macomber, the Court concluded that a pro rata stock dividend was not income. Rather, it was analogous to taxing the underlying earnings of the corporation rather than taxing a cash dividend. This analysis highlights how the Court conceptualized income. The Court held that “from every point of view, we are brought irresistibly to the conclusion that neither under the Sixteenth Amendment nor otherwise has Congress power to tax without apportionment a true stock dividend made lawfully and in good faith, or the accumulated profits behind it, as income of the stockholder.”71

It appears to follow from the holding of Macomber that, until actually distributed, accumulated foreign earnings and profits of a controlled foreign corporation are not income to a U.S. shareholder of such controlled foreign corporation. While later cases challenged the holding of Macomber in the context of subpart F,72 those cases all involved the current-year attribution of current earnings. They do not address the novel issue presented here, which is whether past, accumulated earnings are properly considered to be income to the 10-percent shareholders of a controlled foreign corporation without any dividend being paid.73

Some special cases need to be addressed. There are certain circumstances where a taxpayer could be taxed on “accumulated earnings” without the payment of a dividend to the U.S. parent corporation or to a U.S. shareholder. Under Section 956, an investment of current or accumulated earnings in certain U.S. property can trigger a subpart F inclusion.74 The Tax Court has held that such investment into U.S. property can be seen as “manifesting the shareholder’s exercise of control over the previous income of the corporation.”75 That is, even in the case of a subpart F inclusion triggered by investment in U.S. property, it is the investment in U.S. property that creates the event that is substantially equivalent to the payment of a dividend into the United States.76

In another case, a corporation may be subject to the “accumulated earnings tax,” imposed on the undistributed current earnings and profits of the corporation’s taxable year that are in excess of those retained by the corporation for its reasonable business needs.77 This tax is not self-assessed; it is imposed only when the IRS issues a notice of deficiency requiring the payment of such tax. Importantly, the base of the accumulated earnings tax is the corporation’s “accumulated taxable income.”78 A corporation’s accumulated taxable income is a modification of its taxable income, allowing for certain deductions (including taxes paid and charitable contributions), but disallowing certain others (including a deduction for net operating losses). Despite its name, the accumulated earnings tax is nevertheless a further tax on the income of the corporation.

b. Section 965 does not tax income, nor does it tax current-year inclusions of deferred income.

The Mandatory Repatriation Tax uses as its base the accumulated foreign earnings of certain controlled foreign corporations.79 The mechanism of the tax itself—as discussed above—is to include a taxpayer’s earnings as subpart F income in their last taxable year beginning before January 1, 2018, along with a deduction (that, in effect, lowers the rate of tax owed on such income). But such an inclusion is not necessarily for income earned during the taxable year under which the Mandatory Repatriation Tax is imposed.80 Calling something income does not make it so.

Importantly, there is no requirement under new Section 965 that cash or property be repatriated to a U.S. corporation in order for the U.S. shareholders to be liable for the taxes owed.81 Further, there is no transfer, no disposition, and no recognition event which must occur to create income. This is how this tax can be distinguished from, say, the estate tax, which requires an event (death) which causes a transfer of assets. The tax is treating accumulated wealth as income to the taxpayer in the current year. It matters not if the taxpayer actually transfers the income into the United States.

Further, the Mandatory Repatriation Tax does not take into account whether the taxpayer has the actual ability to, at their election, repatriate foreign earnings. In this light, it is worth considering the mark-to-market provisions of Sections 475 and 1256.82 In the 1993 case Murphy v. United States, the Ninth Circuit rejected a constitutional challenge to Section 1256.83 The Court found that the taxpayer was entitled to withdraw his profits at any time. Relying on the doctrine of constructive receipt, the Court found that a taxpayer who traded futures contracts received profits as a matter of right daily, and thus could be taxable on a mark-to-market basis due to “the unique accounting method governing futures contracts.”84

A taxpayer subject to the Mandatory Repatriation Tax, however, is not necessarily receiving profits as a matter of right daily, or annually. A ten-percent shareholder in a controlled foreign corporation is not in control of that corporation; such a shareholder cannot unilaterally access the profits of the foreign corporation by forcing a dividend.85 Thus, unlike the taxpayer in Murphy, the taxpayer subject to the Mandatory Repatriation Tax has not constructively received the profits of the controlled foreign corporation; the Ninth Circuit’s reasoning should not apply.

An additional argument against this position might assert that Section 965 goes no further than does subpart F, which taxes U.S. shareholders on certain earnings of controlled foreign corporations in the United States immediately—in the year that the income was earned—despite the fact that the income may not be brought into the United States. The rationale behind subpart F, and its requirement that U.S. shareholders immediately include certain forms of passive income as U.S. gross income, is that certain U.S. persons with some substantial degree of control over a foreign entity (a controlled foreign corporation must have at least 50 percent of its shareholders be 10 percent U.S. shareholders)86 should be required to include easily moveable passive income as their own income.87

As discussed above, a taxpayer may have a subpart F inclusion where a taxpayer invests accumulated earnings in U.S. property. The Tax Court found that the act of investing in U.S. property was an event that was substantially similar to the payment of a dividend. And the accumulated earnings tax under Sections 531 and 532 imposes a tax on the current earnings and profits of a corporation. And further, the accumulated earnings tax is levied at the level of the corporation, not at the level of the shareholder.

With the Mandatory Repatriation Tax, there is no such event that creates a rational basis for Congress to attribute income to a taxpayer.88 And unlike older repatriation holidays, there is no requirement that taxpayers elect to repatriate cash or other property. Absent such a clear recognition event (or the constructive receipt of income), there is no income to be taxed, and the constitutional basis for the tax is not established under the Sixteenth Amendment.

All that said, even if a court finds that the Mandatory Repatriation Tax is properly characterized as an income tax, there are still potential constitutional challenges to the tax on due process grounds, discussed below in Section II.B.

2. The Mandatory Repatriation Tax is Best Characterized as Direct Tax on Wealth

If the Sixteenth Amendment does not provide for the constitutionality of an income tax, we must turn to the taxation provisions of Article I. In particular, Section 9, Clause 4 of Article I of the Constitution provides that no “Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.”89 It is somewhat unclear what the Constitution and the framers meant when they used the term “direct tax.” To Justice Chase, writing in 1796, only capitation taxes and taxes on real property ought to be considered direct taxes. In Fernandez v. Wiener90 the Court held that a “tax imposed upon the exercise of some of the numerous rights of property is clearly distinguishable from a direct tax, which falls upon the owner merely because he is owner, regardless of his use or disposition of the property.”91

Scholars have also weighed in as to what it means for a tax to be properly considered a “direct tax.” For instance, Erik Jensen believes a “direct tax” is any tax that cannot be shifted, a definition that should encompass any tax on the economic attributes of persons—including a consumption tax.92 Joseph Dodge has taken what he calls a “middle of the road position”93 arguing that apportionment “should be required of taxes on real and personal tangible property only, excluding taxes on intangible property.”94 Dodge further asserts that personal wealth taxes are “unconstitutional at least to the extent that the value of real estate and tangible property is included in the tax base.”95

There has also been a notable scholarly challenge to the validity of the apportionment requirement itself. Bruce Ackerman argues that, after the Reconstruction Amendments were passed, the apportionment clauses were effectively repealed, since those clauses have a tainted history due to their invention during the Constitutional Convention as a compromise regarding slavery.96

Notwithstanding Ackerman’s objection, a scholarly consensus appears to be that the taxation of some forms of personal wealth is unconstitutional under the apportionment provisions of Article I.97 The Mandatory Repatriation Tax is best characterized as a direct tax on wealth because it is levied on the taxpayer not because some recognition event is occurring—like the repatriation of cash into the United States under the old Section 965, the investment in U.S. property under Section 956, or even the death of an individual with respect to the estate tax—but rather is levied solely because the U.S. shareholder is the owner of an asset that, as of an arbitrary date,98 has accumulated foreign earnings. That is, to apply the Court’s framing in Fernandez v. Weiner, the tax is being levied upon the owner of stock in a foreign CFC merely because of the fact that owner is the owner.99

Of course, the Mandatory Repatriation Tax is not apportioned among the states. This means that, if classified as a direct tax, it should be an unconstitutional exercise of Congress’s limited taxing powers.100 That said, even if the tax is characterized as an income tax, it presents unprecedented due process concerns, as discussed in the next Section.

B. If the Mandatory Repatriation Tax Is an Income Tax, it is Unconstitutionally Retroactive

Even if a court finds that the Mandatory Repatriation Tax is an income tax,101 it nevertheless should consider constitutional challenges to the tax on due process grounds under the Fifth Amendment. The Supreme Court has considered similar challenges to other, less problematic, tax laws. While courts have often found retroactivity constitutionally permissible, the reasoning that courts have provided suggests that the Mandatory Repatriation Tax raises unprecedented due process concerns.

1. Carlton and Retroactive Taxes.

The Fifth Amendment provides that no person shall be “deprived of life, liberty, or property without due process of law.”102 In the tax caselaw that developed under the Fifth Amendment, two distinct bodies of law are relevant to the Mandatory Repatriation Tax: (1) the doctrine concerning the constitutionality of retroactive taxation, and (2) the doctrine concerning the lack of notice.

The last Supreme Court case to consider a due process challenge to a retroactive tax law was United States v. Carlton in 1994.103 In Carlton, the Supreme Court considered a provision of the federal estate tax statute that limited the availability of a recently added deduction for certain employee stock-ownership plans.104 Congress provided that this deduction would apply retroactively, taking effect roughly one year before it was passed.105 The Court considered “whether the retroactive application of the [amendment to the estate tax law] violates the Due Process Clause of the Fifth Amendment.”106

The Court concluded that the 1987 amendment’s retroactive application met “the requirements of due process.”107 The Court applied rational basis review in evaluating whether the law in issue violated substantive due process.108 More specifically, the Court applied the same standard that is generally applicable to retroactive economic legislation: a “legitimate legislative purpose furthered by rational means.”109

First, the Court noted that “Congress’ purpose in enacting the amendment was neither illegitimate nor arbitrary.”110 The law itself was “adopted as a curative measure,” as the Court found that Congress “did not contemplate” that the deduction—without amendment—would have such broad applicability.111 The Court saw the law as a technical correction, making the law work the way Congress had clearly intended for it to work. This justified Congress’s choice to make the amendment retroactive back to the date of the law’s original passage.

In addition, the Court concluded that “Congress acted promptly and established only a modest period of retroactivity.”112 In Carlton, the period of retroactivity was slightly longer than a year. The Court at least suggests that a much longer period of retroactivity should present greater constitutional concern. Noting all of these factors, the Court nevertheless held that the 1987 amendment’s limited retroactive application ultimately met the constitutional requirements of due process.113

The Supreme Court has recently had multiple opportunities to reconsider its holding in Carlton in the context of a retroactive state tax law, but has so far declined to do so.114 It is possible that the Supreme Court will expand the notion of what constitutes an acceptable retroactivity when it considers such a case. But no such case has been granted certiorari. Given the unprecedented retroactivity of the Mandatory Repatriation Tax, a court that considered it to be an income tax should still seriously grapple with the Fifth Amendment concerns the law raises.

2. The Mandatory Repatriation Tax has an Unconstitutionally Extended Period of Retroactivity.

In Carlton and in related cases, courts have held taxes constitutional where there has been a modest period of retroactivity (in Carlton, the period was slightly over a year).115 In Carlton, the curative nature of the law (it merely corrected what seemed a good faith oversight by Congress in the drafting of the bill) made retroactivity back to the main law’s date seem sensible.116 Congress quickly acted, and the error was resolved with new legislation (with retroactive effect).

However, quite unlike the law at issue in Carlton, The Mandatory Repatriation Tax has a period of retroactivity back to 1986—over three decades prior to the imposition of the tax. Almost certainly there exist multinationals who will be able to demonstrate that they are being effectively subject to a new income tax on their overseas earnings from over thirty years ago. Unlike the cases considered in Carlton, this is not a mere readjustment of an earlier law, or a minor change to an existing regime. Rather, this is the imposition of a new tax with a retroactive effect lasting over three decades.

A counterargument to this point—a position it seems likely the government will take if and when the retroactivity of Section 965 is litigated —is that Section 965 is not a retroactive tax, but merely an acceleration of an already imposed income tax. To put it another way, the government could argue that the realization event occurred when the income was earned, and the deferral of the tax was merely a timing issue. Thus, the government has the right to accelerate the timing—since that income was always to be subject to tax—and has done so through the imposition of Section 965. The tax is merely a lower rate on deferred incomes.

This argument has multiple flaws: its assumption that the earnings of CFCs would eventually have been subject to U.S. tax, and its characterization of all transactions in which a CFC earns income as realization events for U.S. tax purposes. Under the pre-TCJA U.S. tax regime, CFC income that was not subpart F income was generally not subject to U.S. tax as long as it was not repatriated.117 In general, U.S. multinationals took the position that it would never be repatriated, and by taking that position they were able to avoid accruing the U.S. tax as a deferred liability on their financial statements.118

Furthermore, the pre-TCJA system of international tax did not impose a tax on foreign income that fell outside the net of the subpart F anti-deferral regime. It imposed a tax on the act of repatriation. The act of bringing the dividend into the United States was the recognition event, except in the case of subpart F income (which Congress and the government asserted was stripped from domestic income), which was immediately recognized as U.S. gross income. This is not a timing issue. Rather, it is the imposing of a new income tax retroactively on income that was not subject to taxation in the past year.

Hence, Congress did not act to correct some technical failure in a tax law. There was no defect—unless the defect is the entire structure of the U.S. international tax regime. Congress is, in effect, attempting to raise the income tax rate on corporations over the past thirty years by retroactively subjecting their international earnings to an additional tax. This is not a mere timing issue, unless the very nature of the pre-TCJA system of international taxation is overlooked.

And considering the Court’s balancing of interests in Carlton, a court might consider whether the retroactivity of the Mandatory Repatriation Tax is a rational means to further a legitimate legislative purpose. The government could argue that as a matter of fairness, imposing some type of mandatory repatriation tax was necessary to avoid rewarding those who had never repatriated their overseas earnings. But this would ignore the fact that many companies had permanently reinvested overseas income, as reflected on their financial statements.

Ultimately, the Mandatory Repatriation Tax—if characterized as an income tax—should not stand up to a court’s rational basis review due to its retroactive imposition on taxpayers. Congress has violated the substantive due process of U.S. persons by subjecting them to a retroactive income tax in the form of Section 965.

3. The Mandatory Repatriation Tax Might Be Unconstitutional Because Taxpayers Lacked Notice.

Taxpayers could raise an additional procedural argument; they could argue that they lacked notice of the Mandatory Repatriation Tax. That said, when Congress changes the law, taxpayers don’t have any inherent right to rely on past provisions.119

The Revenue Act of 1924120 enacted a gift tax in June 1924, retroactive back to all gifts made after January 1, 1924. Two cases, Blodgett v. Holden121 and Untermyer v. Anderson,122 held that the retroactive application of the tax was unconstitutional.123 Congress had created a totally new tax and imposed it upon taxpayers who had no notice that their gifts could be subject to federal taxation.

In Carlton, the Supreme Court distinguished Blodgett and Untermyer. First, the Court noted that Blodgett and Untermyer “were decided during an era characterized by exacting review of economic legislation under an approach that ‘has long since been discarded.’”124 That caveat aside, the Court continued to discuss the merits of the case. The Court believed that Blodgett and Untermyer “do not control” when considering the retroactivity of a 1987 amendment to the 1986 tax law.125 The gift tax cases had involved the creation of a “wholly new tax,” not an amendment to an existing tax law—as was the case in Carlton.126

These cases suggest a limited possibility that a taxpayer may have its due process rights violated because it lacked notice of a wholly new tax.127 However, in 1937—roughly a decade after Blodgett and Untermyer—the Supreme Court held in United States v. Hudson128 that a totally new tax—a tax on silver passed as part of the Silver Purchase Act of 1934—was constitutional even though it was retroactive.129 The Court did not explicitly discuss notice as mandated by the Fifth Amendment, but the Court noted that “[f]or some months prior to this period there was strong pressure for legislation requiring increased acquisition and use of silver by the Government, and several bills providing therefor were presented in the Senate and House of Representatives.”130

With respect to the Mandatory Repatriation Tax, it is at least possible that a court might consider and apply the reasoning in Blodgett and consider that it is wholly unreasonable for a taxpayer to expect that her ten percent stake in a foreign corporation would subject her to a tax on that corporation’s accumulated earnings all the way back to 1986, regardless of whether the corporation had repatriated cash.131

To put it bluntly, the Mandatory Repatriation Tax is not an adjustment to a bill, a change in rate, or technical correction of the law. This is a dramatic altering of the U.S. system of international tax that fundamentally shifts the economics for individuals who hold investments in a foreign corporation in 2017. It is certainly reasonable for a taxpayer to plausibly argue that they should have had notice that their investments could be subject to further taxation.

Conclusion

This Essay has sketched out some arguments that could underlie a constitutional challenge to Section 965. Such a challenge will present the courts with a fundamental question that will forever define Congress’s power to tax, what Alexander Hamilton called one of the most fundamental powers interwoven into the framework of the federal government.132 Holding Section 965 constitutional would render the constitutional language on direct taxation all but meaningless. And a tax on, say, the earnings of an individual twenty years prior—payable in the year the bill passed—would appear constitutionally permissible if Section 965 is held to be a constitutional income tax.

These outcomes might seem extreme, but they highlight the importance of courts considering constitutional limitations carefully. Even amid the field of “invisible boomerangs”133 that is the federal tax code, Section 965 (whether a retroactive tax or a wealth tax) is inapposite to the defined constitutional powers granted to Congress. The Framers—including Hamilton himself—clearly intended some limitation on the federal government’s power to tax. Courts should not be afraid to consider these constitutional questions, and to enforce the limitations on the taxing power imposed by the text of the Constitution.

  1. An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018, Pub. L. No. 115–97, 131 Stat. 2054 (2017) [hereinafter “TCJA” ].
  2. Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085.
  3. All references to “Code” refer to the Internal Revenue Code of 1986, as amended. References to “old” Code sections refer to the Code prior to amendment by the TCJA, while “new” Code sections refer to those as amended by the TCJA.
  4. See TCJA § 11001 (to be codified at I.R.C. § 1).
  5. See TCJA § 11021 (to be codified at I.R.C. § 63).
  6. See TCJA § 11041.
  7. See TCJA § 11061.
  8. See TCJA § 13001–02 (to be codified at I.R.C. §§ 11, 243, 245) (lowering the corporate tax rate); TCJA §§ 12001-02 (to be codified at I.R.C. §§ 53, 55) (repealing the corporate AMT).
  9. TCJA § 13701 (to be codified at I.RC. § 4968).
  10. Generally speaking, a true territorial system of international corporate tax would tax only an entity’s profits sourced in that country. Likewise, a true worldwide system would tax an entity’s worldwide income, irrespective of where that income was paid.
  11. Throughout this Article, the term “multinational entity” refers to corporate entities with subsidiaries in multiple jurisdictions.
  12. Tatyana Shumsky, Tax Overhaul Could End Record Pileup of Offshore Cash, Wall St. J. (Nov. 20, 2017), https://blogs.wsj.com/cfo/2017/11/20/tax-overhaul-could-end-record-pileup-of-offshore-cash/ [https://perma.cc/NM84-2ZAN].
  13. See J. Clifton Fleming Jr. et al., Getting from Here to There: The Transition Tax Issue, 154 Tax Notes 69, 69 (2017). But see Edward D. Kleinbard, Stateless Income, 11 Fla. Tax Rev. 699, 701-06 (2011) (criticizing the generation of what Kleinbard describes as “stateless income,” income derived by a multinational group from “business activities in a country other than the domicile (however defined) of the group’s ultimate parent company, but which is subject to tax only in a jurisdiction that is not the location of the customers or the factors of production through which the income was derived, and is not the domicile of the group’s parent company”). See generally Paul R. McDaniel et al., Introduction to United States International Taxation 69-74 (2014) (discussing the system of U.S. international corporate taxation prior to the passage of H.R. 1).
  14. See TCJA § 14103 (to be codified at I.R.C. § 965).
  15. See TCJA § 14103 (to be codified at I.R.C. § 965).
  16. Throughout, I use the term “Mandatory Repatriation Tax” to refer to the tax imposed under the new Section 965.
  17. See I.R.C. § 965(a) (West 2018); id. § 965(e)(1).
  18. TCJA § 14103 (to be codified at I.R.C. § 965).
  19. See TCJA § 14103 (to be codified at I.R.C. § 965).
  20.  The constitutional question surrounding a transition tax has been suggested before. See J. Clifton Fleming Jr. et al.¸ supra note 13, at 70 n.6 (raising the possibility of a constitutional challenge to a tax on accumulated overseas profits of a U.S. multinational). Fleming Jr. et al. argue that the primary basis for such a challenge would be a retroactivity argument, and that “the Supreme Court will just as likely find a way to uphold Congress’s selection of a transition tax regime.” Id.
  21. U.S. Const. amend. xvi.
  22. See supra note 14 and accompanying text.
  23.  This is in line with how the United States taxes individuals—based on their citizenship, rather than their place of residence. See Ruth Mason, Citizenship Taxation, 89 S. Cal. L. Rev. 169, 170-77 (2016).
  24. See Joint Comm. on Taxation, JCX-96-15, Present Law and Selected Proposals Related to the Repatriation of Foreign Earnings 2 (2015) [hereinafter JCT Repatriation Report].
  25. See Dave Fischbein Mfg. Co. v. Comm’r, 59 T.C. 338, 353 (1972); see also JCT Repatriation Report, supra note 24, at 2 (discussing the deferral of foreign source income earned by controlled foreign corporations).
  26. See JCT Repatriation Report, supra note 24, at 2.
  27. See generally I.R.C. §§ 951-965 (West 2018).
  28.  A “controlled foreign corporation” is defined in the Code as “any foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned directly, indirectly, or constructively by U.S. shareholders on any day during the taxable year of such foreign corporation or more than 50% of the total value of the stock is owned directly, indirectly or constructively by U.S. shareholders on any day during the taxable year of the corporation.” IRS I.R.M. 4.61.7.3(2); see also I.R.C. § 957(a) (West 2018) (defining “controlled foreign corporation”).
  29. See I.R.C. § 951(b) (West 2018); id. § 957; id. § 958; SIH Partners LLLP v. Comm’r, 150 T.C. No. 3, slip op. at 12; see also JCT Repatriation Report, supra note 24, at 2.
  30. See, e.g., JCT Repatriation Report, supra note 24, at 2.
  31.  Revenue Act of 1962, Pub. L. No. 87-834, § 12, 76 Stat. 960, 1006.
  32. See Dougherty v. Comm’r, 60 T.C. 917, 928 (1973).
  33.  Subpart F has never been found unconstitutional, despite some challenges to its constitutionality being levied. See, e.g., Richard J. Horwich, The Constitutionality of Subpart F of the Internal Revenue Code, 19 U. Miami L. Rev. 400, 400-09 (1965).
  34.  JCT Repatriation Report, supra note 24, at 2.
  35. See I.R.C. § 954 (West 2018).
  36. See id. § 953.
  37. See id. § 952(a)(3)-(5); see also JCT Repatriation Report, supra note 24, at 3.
  38. See I.R.C. § 954(c) (West 2018) (defining “foreign personal holding company income”). The definition of foreign personal holding company income includes myriad exceptions, a full discussion of which lies outside the scope of this Article. See id. § 954(c)(2) (discussing exceptions to subpart F). For example, rents and royalties derived in the active conduct of a trade or business are excluded from treatment as subpart F. See id. § 954(c)(2)(A).
  39. See id. § 954(d) (defining foreign base company sales income).
  40. See id. § 954(e) (defining foreign base company services income).
  41. See id. § 954(g) (defining foreign base company oil related income), repealed by TCJA § 14211.
  42.  I.R.C. § 965 (West 2018).
  43.  American Jobs Creation Act, Pub. L. No. 108-357, 118 Stat. 1418.
  44. See I.R.C. § 965(a) (West 2018).
  45.  These are some of the key limitations. A full review of the technical mechanics of the old Section 965 is outside the scope of this Article; this list should thus not be read as complete.
  46. See id. § 965(b)(1).
  47. See id. § 965(b)(2).
  48. See id. § 965(b)(3); see also BMC Software, Inc. v. Comm’r, 780 F.3d 669 (5th Cir. 2015); Analog Devices, Inc. v. Comm’r, 147 T.C. No. 15 (2012).
  49. See Tax Reform Act of 2014 Discussion Draft (as prepared by Rep. Dave Camp, Feb. 26, 2014), https://waysandmeans.house.gov/UploadedFiles/Statutory_Text_Tax_Reform_Act_of_2014_Discussion_Draft__022614.pdf [https://perma.cc/7U99-EKN4]; see also Kyle Pomerleau & Andrew Lundeen, The Basics of Chairman Camp’s Tax Reform Plan, Tax Foundation (Feb. 26, 2014), https://taxfoundation.org/basics-chairman-camp-s-tax-reform-plan/ [https://perma.cc/63BG-BR3M].
  50. See Nick Timiraos & John D. McKinnon, Obama Proposes One-Time 14% Tax on Overseas Earnings, Wall St. J. (Feb. 2, 2015), http://www.wsj.com/articles/obama-proposes-one-time-14-tax-on-overseas-earnings-1422802103 [https://perma.cc/V5QN-2YB4].
  51.  TCJA § 13001 (to be codified at I.R.C. § 11).
  52.  TCJA § 14201 (to be codified at I.R.C. § 951A). The GILTI tax creates a new anti-deferral regime for CFCs, imposing a tax on the CFCs of a U.S.-parented multinational by looking to their overall foreign tax rate, and imposing an immediate U.S. tax on the income that isn’t found to be sufficiently taxed under the complex GILTI statutory framework. Id.
  53. TCJA § 14202 (to be codified at I.R.C. § 250).
  54. See TCJA § 14401(a) (to be codified at I.R.C. § 59A) (imposing a tax on what is called the “base erosion minimum tax amount”).
  55. See Timiraos & McKinnon, supra note 50.
  56. See Jim Tankersley et al., Republican Plan Delivers Permanent Corporate Tax Cut, N.Y. Times (Nov. 2, 2017), https://nyti.ms/2iV3TJI [https://perma.cc/U4T7-M5G2].
  57. See TCJA § 14103 (to be codified at § 965).
  58. See TCJA § 14103(a) (to be codified at § 965).
  59. See id.
  60. For instance, if a taxpayer is only a 10 percent shareholder of a CFC, it is quite plausible that they would not be able to cause such payment.
  61.  For a more technical overview of the Mandatory Repatriation Tax, see Patrick J. McCormick, Effects of the Deemed Repatriation Provisions of the Tax Cuts and Jobs Act, 89 Tax Notes Int’l 607 (Feb. 12, 2018).
  62. See I.R.C. § 965(a) (West 2018).
  63. The Mandatory Repatriation Tax will take effect for the foreign corporation’s last taxable year that begins before January 1, 2018. Id. § 965(a). Therefore, for a calendar-year taxpayer, the tax will occur in 2017. For other taxpayers, the tax liability will not arise until the calendar year of the taxpayer ends. Taxpayers may elect to pay the tax liability in installments over eight years. Id. § 965(h). Further, the taxpayer will have some ability to offset the tax with certain foreign tax credits. See id. § 965(g); see also Adam Halpern, A Concise Summary of the New Tax Law, Fenwick & West LLP (January 5, 2018), https://www.fenwick.com/publications/Pages/A-Concise-Summary-of-the-New-Tax-Law.aspx [https://perma.cc/RQB4-HTPU] (“Foreign tax credits can be used to reduce a corporate U.S. shareholder’s U.S. tax liability, but credits are only allowed for foreign taxes on the taxable portion of the deemed repatriated earnings, based on the reduced rates. Individual U.S. shareholders can elect to be taxed as corporations to obtain the benefit of foreign tax credits.”).
  64. Berg and Feingold have discussed the first possibility for levying a constitutional challenge—they assert that Section 965 is an unapportioned direct tax on incomes. Mark E. Berg & Fred Feingold, The Deemed Repatriation Tax – A Bridge Too Far, 158 Tax Notes 1345, at 1352-56 (2018). This Essay hopes to build upon their analysis as to whether Section 965 ought to be considered an income tax and presents new challenges as to the potential issues with the tax’s retroactivity.
  65. Some commentators—notably Berg and Feingold—have concluded that the Mandatory Repatriation Tax is an unconstitutional direct tax. See Berg & Feingold, supra note 64, at 1353.
  66.  U.S. Const. art. I, § 2, cl. 3 (“Representatives and direct taxes shall be apportioned among the several States which may be included within this Union, according to their respective numbers . . . .”); U.S. Const. art. I, § 9, cl. 4 (“[No] Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.”).
  67.  U.S. Const. amend. xvi.
  68. Income, Merriam Webster Online, https://www.merriam-webster.com/dictionary/income [https://perma.cc/N3LA-T2G3] (last visited June 6, 2018).
  69.  281 U.S. 111 (1930).
  70. Id.
  71. Id. at 219.
  72. See Garlock v. Comm’r, 58 T.C. 423, 438 (1972), aff’d 489 F.2d 197 (2d Cir. 1973); Estate of Whitlock v. Comm’r, 59 T.C. 490, 505-10 (1972), aff’d 494 F.2d 1297 (10th Cir. 1976); Dougherty v. Comm’r, 60 T.C. 917, 927-30 (1973); see also Berg & Feingold, supra note 64, at 1353-55 (discussing subpart F challenges). As Berg and Feingold note, Dougherty represents perhaps the “high water mark” in these cases, where the Tax Court found a rational basis for an inclusion of past earnings by looking to the combination of the CFC’s investment in U.S. property in the current year under Section 956 and the U.S. shareholders’ control over the CFC. Berg & Feingold, supra note 64, at 1353.
  73.  Berg and Feingold correctly point out that taxpayers might face an inclusion under Section 965 “even when the DFIC has neither current nor accumulated earnings” under certain circumstances. Berg & Feingold, supra note 64, at 1354.
  74. See I.R.C. § 956 (West 2018).
  75. Dougherty, 60 T.C. at 930.
  76. See id.
  77. See I.R.C. § 531 (West 2018); id. § 532. This tax is not applicable to certain corporations, including personal holding companies, certain corporations exempt from tax, and passive foreign investment companies. Id. § 532(b).
  78. See Id. § 531; id. § 532.
  79. See Id. § 965(a).
  80. I say “not necessarily” because this argument would not apply to a taxpayer’s earnings during the taxable year when the Section 965 tax is imposed. That would be income to the taxpayer and could be subject to taxation under the Sixteenth Amendment.
  81. This differentiates it from the old Section 965, which provided an 85% tax break for whatever income a taxpayer repatriated. See I.R.C. § 965 (2006).
  82. See I.R.C. § 475 (2012); id. § 1256.
  83. 992 F.2d 929, 931-32 (9th Cir. 1993).
  84. Id. at 931 (emphasis added).
  85. It is worth noting that a controlled foreign corporation is “controlled” insofar as more than 50 percent of the total combined voting power is owned by 10 percent U.S. shareholders.
  86. See I.R.C. § 954 (West 2018).
  87. See supra notes 34-41 and accompanying text.
  88. See Berg & Feingold, supra note 64, at 1355-56.
  89.  U.S. Const. Art. 1, § 9, cl. 4.
  90.  326 U.S. 340 (1945).
  91. Id. at 362 (emphasis added).
  92. Erik M. Jensen, The Taxing Power, the Sixteenth Amendment, and the Meaning of “Incomes,” 33 Ariz. St. L.J. 1057, 1091-1107 (2001).
  93.  Joseph M. Dodge, What Federal Taxes Are Subject to the Rule of Apportionment Under the Constitution, 11 U. Pa. J. Const. L. 839, 842 (2009).
  94. Id. at 932. He further notes that taxes on tangible personal property can easily be structured as excises, and therefore their characterization as direct taxes is inconsequential. Id.
  95. Id. at 933.
  96.  Bruce Ackerman, Taxation and the Constitution, 99 Colum. L. Rev. 1, 28, 58 (1999) (“Given the Reconstructionist Amendments, there is no longer a constitutional point in enforcing a lapsed bargain with the slave power.”).
  97. If Ackerman is correct, his conclusion effectively limits the reach of the apportionment provision so as to render any argument about direct taxation requiring apportionment to be invalid.
  98. Specifically, as of two arbitrary dates. See I.R.C. § 965(a) (West 2018).
  99. 326 U.S. 340 (1945). This conclusion aligns with the conclusion drawn by Berg and Feingold, that the Mandatory Repatriation Tax is a direct Tax under the Constitution. See Berg & Feingold, supra note 64, at 1352.
  100. See, e.g., Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519, 570 (2012).
  101.  As discussed in Section III.B, supra, this Article argues that treating the Mandatory Repatriation Tax as an income tax is incorrect.
  102.  U.S. Const. amend. v.
  103.  512 U.S. 26 (1994).
  104. Id at 27.
  105. Id.
  106. Id.
  107. Id. at 32.
  108. Id. at 30-31.
  109. Id. (quoting Pension Benefit Guaranty Corp. v. R.A. Gray & Co., 467 U.S. 717, 733 (1984)).
  110. Id.
  111. Id. at 31.
  112. Id.
  113. Id. at 32.
  114.  The cases denied for certiorari were: Sonoco Products Co. v. Mich. Dep’t of Treasury, 137 S. Ct. 2157 (2017); Skadden, Arps, Slate, Meager, & Flom LLP v. Mich. Dep’t of Treasury, 137 S. Ct. 2157 (2017); Gillette Comm. Operations v. Mich. Dep’t of Treasury, 137 S. Ct. 2157 (2017); IBM Corp. v. Mich. Dep’t of Treasury, 137 S. Ct. 2180 (2017); Goodyear, et al. v. Mich. Dep’t of Treasury, 137 S. Ct. 2157 (2017); DirecTV Grp. Hldgs. v. Mich. Dep’t of Treasury, 137 S. Ct. 2158 (2017).
  115. See United States v. Carlton, 512 U.S. 26, 32 (1994); United States v. Darusmont, 449 U.S. 292, 299-300 (1981).
  116. Carlton, 512 U.S. at 32.
  117.  However, certain types of income, including effectively connected income, fixed, determinable, annual or periodical income from sources within the U.S. that are not effectively connected with a trade or business, and FIRPTA income earned by a CFC, could all be subject to U.S. tax prior to repatriation.
  118. Accounting Principles Board, APB Opinion No. 23, Accounting for Income Taxes—Special Areas (1972). (allowing such treatment of so-called “permanently invested earnings” where “sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely”).
  119. Notice arguments are difficult in the tax context—and none have been successful at the Supreme Court since the 1920s. See Untermyer v. Anderson, 276 U.S. 440 (1928); Blodgett v. Holden, 275 U.S. 142 (1927).
  120. Revenue Act of 1924, Pub. L. No. 68-176, 43 Stat. 253.
  121.  275 U.S. 142 (1928).
  122.  276 U.S. 440 (1928).
  123. See Blodgett, 275 U.S. at 147; Untermyer, 276 U.S. at 445-46.
  124. Carlton, 512 U.S. at 34 (quoting Ferguson v. Skrupa, 372 U.S. 726, 730 (1963)).
  125. Id.
  126.  Id. (noting that the gift tax cases’ authority is “of limited value in assessing the constitutionality of subsequent amendments that bring about certain changes in operation of the tax laws” (quoting United States v. Hemme, 476 U.S. 558, 568 (1986)).
  127. See Erika Lunder et al., Cong. Research Serv., R42791, Constitutionality of Retroactive Tax Legislation 4 (2012).
  128.  299 U.S. 498 (1937).
  129. Id. at 501.
  130. Id.
  131.  Blodgett v. Holden, 275 U.S. 142, 147 (1927).
  132.  The Federalist No. 30 (Alexander Hamilton).
  133.  Arrowsmith v. Comm’r, 344 U.S. 6, 12 (1952) (Jackson, J. concurring).

Reforming the True-Sale Doctrine

*Professor of Law, American University, Washington College of Law. I thank Mark Yurich, JD ‘18, for excellent research assistance.

The true-sale doctrine is central to the multi-trillion dollar asset-backed securities (ABS) market. The assets backing ABS are only bankruptcy-remote if they were assigned in a true sale, rather than as collateral for a loan, and it is the true-sale doctrine that distinguishes sales from loans. Despite its importance, the doctrine is inconsistent, lacks normative direction, and is under-theorized. Negotiations regarding the status of securitized assets in bankruptcy—affecting creditors such as employees, retirees, and tort claimants—happen in the shadow of the law. This Essay argues that state lawmakers should formulate true-sale rules that codify the relevance of price in true-sale analyses. The price that a company receives in exchange for securitized assets represents value with which to distinguish between problematic judgment-proofing on the one hand, and, on the other hand, assignments that isolate assets from bankruptcy in a way that is fair and produces efficiencies. Reforming the true-sale doctrine to ensure economic substance-based determinations that consider price terms could fortify unsecured creditors’ positions. In addition, such reform would reinforce appropriate boundaries between state commercial laws and federal bankruptcy policy.

Introduction

The true-sale doctrine determines the status of securitized assets: it is the state-law doctrine that distinguishes sales from loans. When companies assign large pools of receivables to a special-purpose entity in order to raise capital, the true-sale doctrine governs characterization of the assignment, and therefore whether creditors can reach such assets in bankruptcy. Despite the fact that the true-sale doctrine governs transactions that are central to the multi-trillion-dollar securitization market, the doctrine is inconsistent, lacks normative direction, and is under-theorized.1 This Essay argues that lawmakers should formulate state, statutory true-sale rules and that such rules should establish the relevance of price in true-sale analyses.2

This Essay builds directly upon my recent work, Property and the True-Sale Doctrine.3 That article maps arguments about the efficiency and desirability of securitization4 to varying formulations of the true-sale doctrine.5 While discussion of securitization’s efficiency is plentiful, scholars and policy-makers have not sufficiently related positions on securitization to formulations of the true-sale doctrine. Different views on securitization would suggest different normative positions on true-sale rules. Property and the True-Sale Doctrine does the work of mapping descriptions of securitization’s efficiency to varying normative positions on the true-sale doctrine.6 This Essay will not repeat that exercise. Property and the True-Sale Doctrine fills a gap in the literature by (i) explicitly linking true-sale rules to views on securitization’s efficiency and by (ii) elucidating how we might better ground true-sale rules in property law principles. In doing so, it demonstrates the importance of the doctrine and its current lack of normative direction or consistency.7 However, it is agnostic on the question of what approach to the true-sale doctrine is the right or the best approach.

This Essay takes the next step of proposing an approach to true sales of receivables that confers rights of exclusion from securitized assets in a way that is better justified and clearer than the current law. It argues that states should consider statutory provisions to codify the relevance of price as a factor in true-sale analyses. Enacting an approach to true sales that is rooted in an economic substance analysis that considers price would ground true-sale rules and the legal underpinnings of receivables securitization in well-established property law strategies for determining the scope of a conveyance and the rights of exclusion it creates.8 Price terms are relevant and important,9 and their relevance in true-sale determinations should therefore be codified. The price that a company receives in exchange for securitized assets represents value with which to distinguish problematic judgment proofing10 from assignments that are more likely to be efficient and more likely to be fair to non-adjusting creditors.11

Some commercial law scholars entertain creating a model act or revising the uniform commercial code only in the context of industry demand for change or clarification.12 There is at present no such industry demand for true-sale doctrine reform. This Essay contends that maintaining the rule of law in capital markets and protecting the positions of creditors in weak bargaining positions, warrants the custodial work of improving the true-sale doctrine regardless of the financial industry’s lack of urgency or concern. Currently, negotiations regarding the status of securitized assets in bankruptcy—affecting creditors such as employees, retirees, and tort claimants—happen in the shadow of the law. A true-sale doctrine that ensures economic substance-based determinations could fortify such creditors’ positions and would ground the legal infrastructure of securitization in well-established commercial law principles.

In addition, true-sale rules operate within an allocation of institutional authority that distinguishes states’ authority over commercial law and private-law rights from federal authority under the bankruptcy code. True-sale rules that contravene established property or commercial law principles to direct bankruptcy outcomes may face federal preemption.13 Statutory provisions codifying an approach to true sales that is economic substance-based would ground the doctrine within the scope of states’ commercial law rulemaking authority.14

This Essay advances a type of rule-of-law project. True-sale rules are property law—they determine the scope of interest that an assignment of receivables creates in any given transaction. Yet the property-based nature of the true-sale doctrine is obscured by statutes and confusing factors-based approaches that suggest that a contract’s form—rather than the economic substance of the transaction the contract reflects—controls characterization of receivables assignments15 The doctrine is meant to align property rights and risk. Characterizing a deal according to its actual economic content prevents regulatory arbitrage. If the doctrine is well-administered, parties cannot avoid bankruptcy rules or UCC Article 9 rules for disposition of collateral by calling their transaction a “sale” when it reflects intent to create a loan.

By arguing for property-based true-sale rules in which the relevance of price is codified, this Essay adds to a larger project on the under-explored potential of property-law doctrines for market governance.16 This larger project seeks to fortify the legal infrastructure of capital markets by (i) asserting that property-law concepts have untapped potential for market governance,17 (ii) explicating the relationship between one private-law doctrine (the law of true sales of receivables) and the extensive financial market to which it is integral (securitization),18 and now (iii) proposing an approach to the true-sale doctrine that is rooted in property-law strategies for characterizing the scope of a conveyance and that improves the doctrine’s coherence while contemplating its potential externalities.

Part I summarizes the true-sale doctrine and the inadequacy of current formulations and academic recommendations. It then contends that uniform state statutory provisions are appropriate to reform the doctrine. It argues in favor of state laws that codify an economic substance-based approach to true-sale determinations, and it discusses the relationship between commercial law and bankruptcy law. Part II argues for codifying the relevance of price as a factor in distinguishing sales of receivables from loans collateralized by receivables. Part III calls for a Uniform Law Commission19 drafting committee to create a model act, or to revisit relevant provisions of the Uniform Commercial Code (UCC), to engage in the task of formulating better true-sale rules.

The Case for Uniform True-Sale Rules

The true-sale doctrine distinguishes assignments to secure loans from true sales, after which assets are the property of a special-purpose entity,20 reachable exclusively by investors. Given that the doctrine governs receivables securitizations,21 bankruptcy and, in some instances, accounting outcomes22 hinge on this doctrine’s correct administration.

The importance of the true-sale doctrine may not be obvious given that, regardless of how true-sale disputes are resolved, investors in securitized receivables prevail over competing claimants. But focusing on investor priority regardless of deal characterization underestimates the consequences of true-sale rules. Assets reachable in bankruptcy, even if subject to a first-priority security interest, may be used to service obligations during bankruptcy proceedings and may be assigned to obtain continuation financing.23 Bankruptcy-remote assets, on the other hand, cannot be used in these ways. Also, whether a company can reach assets in bankruptcy affects the efficiency of continuation and liquidation decisions.24 In short, the fact that investors can assert the priority of their interests regardless of whether they obtained them in a true sale does not mean that the true-sale doctrine is inconsequential for unsecured creditors.

At present, the true-sale doctrine lacks consistency and normative direction. Factors-based common law approaches do not cohere around an established list of factors, though price and recourse often emerge as important.25 Statutory true-sale rules enacted in a minority of states override economic substance-based true-sale determinations and disregard the interests of unsecured creditors, creating uncertainty regarding the application of such rules in bankruptcy proceedings.26

Commercial law scholars Steven Harris and Charles Mooney have proposed a “property-based methodology” for making true-sale determinations that disregards both recourse and price and asks only whether a company retains an interest in securitized assets that secure an obligation.27 Their proposal does not sufficiently explicate the property interest a company retains, and it relies on an analogy to the true-lease context that does not fully consider important distinctions between receivables securitizations and leasing transactions.28 In short, each existing approach or proposal is problematic.

The UCC leaves the task of determining true sales of rights to payment to the courts. Given the fact-specific nature of characterizing assignments of receivables, it may seem infeasible to codify true-sale rules that root characterization in economic substance.29 Uniform true-sale provisions, however, do not need to determine characterization in all contexts. Provisions that create a safe harbor, or that codify the relevance of specific factors, could provide clarity and coherence without requiring statutory language that disposes of fact-specific, true-sale analyses. In fact, in 2001 Uniform Law Commissioner Edwin Smith suggested that the Commission consider a uniform law to create a safe harbor as to what will qualify as a true sale of rights to payment and to determine which state’s law applies when determining whether there is a true sale.30 Commissioner Smith issued a discussion draft outlining reasons for codifying true-sale rules,31 but his proposal did not ultimately result in draft provisions.32

The reasons cited in 2001 for proposing the possibility of uniform true-sale rules included: (i) that lawyers’ true-sale opinion letters create “considerable transaction costs”33 because the result is not clear, (ii) that “quirky statutes and decisions”34 exist, (iii) that “some states are passing legislation that ignores creditors’ rights issues,”35 and (iv) that the federal government was considering the issue in the bankruptcy law context.36 Today, some of Smith’s reasons for proposing uniform true-sale rules are still salient, while others are less so. True-sale opinions still involve considerable cost. However, the “quirky” decision in Octagon Gas Systems, Inc.37 to which Smith presumably refers, has been widely criticized, including by the Permanent Editorial Board of the Uniform Commercial Code.38 On the other hand, the “quirky” interim order issued in In re LTV Steel Company to which Smith presumably refers continues to shape discussion of securitization and true sales despite the fact that it is not a true-sale doctrine precedent.39 On the legislative front, a number of states do enact asset-backed securities facilitation acts (“ABS statutes”)—legislation that ignores creditors’ rights issues.40 However, the proposed federal bankruptcy law provisions regarding true sales of receivables in Section 912,41 to which Smith presumably refers, were withdrawn in 2002.42

The Uniform Law Commission responded to Smith’s suggestion by declining to move forward with a drafting effort,43 citing the difficulties that arise from the fact-intensive true-sale determinations, and the absence of a need for such effort given the lack of industry demand for revised rules.44

Again, this Essay rejects the notion that reforming true-sale rules should only happen in response to industry demand. Lack of industry demand may be a function of the fact that the financial industry potentially benefits from approaches that fortify investors’ positions at the expense of unsecured creditors. In theory, bringing clarity to the legal foundations of asset-backed securities is in the interest of investors as well as companies securitizing assets. But in practice creditors in weak bargaining positions have more to gain from the type of approach articulated here than investors, and it is investors who would articulate industry demand to which uniform law commissioners would respond.

The true-sale doctrine is integral to capital markets and can affect the positions of non-adjusting and non-consenting creditors.45 When a company is in financial distress, the state of the law informs negotiations and proceedings regarding the status of securitized assets. Rules that codify an economic substance-based approach to true sales could fortify the positions of such creditors. In addition, proposing uniform, statutory true-sale rules is a type of rule-of-law project; it is custodial. In addition to clarifying the law, codifying an economic substance-based approach that establishes the relevance of price terms reinforces appropriate boundaries between state commercial laws and federal bankruptcy policy.

Ronald Mann discusses the federalism concerns that securitization presents when state true-sale rules are formulated to direct bankruptcy outcomes, calling out the ABS statutes as problematic.46 The bankruptcy code generally leaves to state law the determination of property rights in a bankruptcy estate.47 Therefore, the rules governing commercial transactions affect bankruptcy outcomes. The bankruptcy code attempts to maintain a boundary between state rulemaking authority (which includes elucidating contract and property rights) and federal rulemaking authority (to administer the kinds of relief and asset disposition that bankruptcy contemplates). Mann observes that states challenge this boundary, however, when they “cheat” by issuing “rules that formally operate as ordinary rules of commercial law but in fact are directed at situations of business failure, i.e., state-promulgated bankruptcy-directed legislation.48

The ABS statutes present an example of such legislation. As Mann states:

[T]hose statutes allow the parties to have their transaction treated as a sale for bankruptcy purposes without obligating the purchaser to take on the risks that would be inherent in a complete transfer of the assets from the purported seller. Again, because the principal purpose of those statutes is to affect bankruptcy outcomes, they afford a prime example of bankruptcy-directed legislation.49

Mann undertakes the tricky task of distinguishing legitimate state laws from problematic, boundary-violating laws by focusing on a statute’s effects. He asserts that the concern lies with laws that have no notable effect outside of bankruptcy.50

Mann’s approach raises complex questions. For example, one might ask what effects any true-sale rules, or UCC Article 9 priority rules for that matter, have outside of bankruptcy. The point here is to identify that true-sale rules are state commercial laws that operate within an allocation of institutional authority that distinguishes states’ authority over private-law rights from federal authority under the bankruptcy code. If state true-sale rules depart from established property or commercial law concepts, they may be preempted by federal bankruptcy law.51 Uniform, statutory provisions codifying an approach to true sales based on economic substance would ground the doctrine within the purview of states’ commercial law rulemaking authority.

Uniform, state statutory provisions face the challenge that state legislatures may decline to enact them. States that already enact an ABS statute, for example, may not consider replacing that legislation with a proposed alternative along the lines discussed here. Given the risk that an ABS statute could be preempted in bankruptcy,52 and given the current state of the true-sale doctrine, Congress could consider adding provisions to the bankruptcy code to effectuate state statutory true-sale rules devised by a Uniform Law Commission drafting committee regardless of how widely states adopt them. The Uniform Law Commission and federal statute drafters have contemplated this approach when a federal law would require UCC reform to achieve its objectives, but not all states will necessarily enact the reform provisions.

The Federal Reserve Bank of New York has been drafting a “National Mortgage Note Repository Act” for possible enactment by Congress.53 The act would create a national note registry to clarify questions such as who is a holder of a note with enforcement capacity, thereby addressing issues that can destabilize foreclosure proceedings. The Uniform Law Commission has convened a committee to draft revisions to UCC Articles 1, 3, 8, and 9, to harmonize the UCC with the proposed federal law. The UCC drafting committee has created draft choice-of-law provisions for the Repository Act that direct a court to look to state law to resolve a commercial law matter. However, the provisions direct the court to “apply the law of that State if the UCC Amendments are in force in that State . . . . If the UCC Amendments are not in force in that State, the court would resolve the commercial-law matter by applying the law of that State as if the UCC Amendments are in force in that State.”54

The Repository Act has a very different purpose from the bankruptcy code, and a different relationship to state commercial laws given its objectives. Drafters are still formulating the Repository Act. The related UCC amendments are under construction as well. While lawmakers may ultimately reject the Repository Act’s approach, the concept that a federal law could generate the effect of uniform enactment of Uniform Law Commission statutory provisions with this type of federal statutory provision raises an interesting possibility for reforming the true-sale doctrine.

II. The Relevance of Price Terms

Literature on the efficiency of securitization impliedly assumes that companies receive an adequate price for assets assigned for purposes of securitization.55 For example, Steven Schwarcz distinguishes “legitimate securitization transactions from judgment proofing”56 by explaining that in a securitization, originators receive value in exchange for assets securitized. Schwarcz responds to critics who contend that securitization is an inefficient and unfair form of judgment proofing against claims of unsecured creditors.57 These critics point out that securitization artificially depresses costs of capital for originators by shifting those costs to non-adjusting creditors.58 Some critics find both securitization and first-priority secured lending to be an unfair form of judgment proofing in that it permits companies and investors to contract away the claims of non-adjusting third parties. Critics also find securitization, and secured lending, to be inefficient in the sense that these transactions externalize costs onto non-adjusting creditors.

The responses to these criticisms vary and include the observation that many forms of established commercial activity could be called “judgment proofing.” Consider the “judgment proofing” effects, for example, of limited liability entities or of property conveyances creating rights of exclusion generally. Commentators respond on the efficiency point as well, arguing that the wealth generated by securitization is greater than the costs externalized to unsecured creditors.

This Essay takes the view that we do not know, as an empirical matter, whether securitization is in fact efficient. As such, this Essay works from the premises that securitization can present the possibility of inefficient externalization of costs onto non-adjusting creditors, and that the isolation of assets from company bankruptcy proceedings should correspond to added value contributed to the company in order to mitigate the risks of unfairness and inefficiency. The distinction between problematic judgment proofing and legitimate securitization implies that originators are exchanging assets for cash of equivalent value. If the true-sale doctrine does not assess price provisions, then companies are free to securitize assets on terms that extract an unfair and inefficient subsidy from non-adjusting creditors.

While many courts consider the purchase price as a factor in true-sale analyses, they are not obligated to do so, as there is no codified list of factors.59 In states that enact an ABS statute, price is explicitly irrelevant.60 While some commentators disagree on the relevance and importance of price terms in characterizing assignments of receivables,61 this Essay argues that the relevance of price terms should be codified to ensure that true-sale determinations take price into account.

Price terms may be challenging to evaluate given the complexity of receivables securitization and the intricate combinations of recourse, servicing obligations, and discounting that receivables assignments involve.62 Yet despite this complexity, scholars have argued before that true-sale analyses should tackle the question of adequate price.63 For example, Thomas Plank has stated that “[t]he first and most significant element of economic substance is the price paid for the loans,”64 along with the parties’ ostensible characterization in the deal documents. In addition to price and the parties’ characterization, Plank argues that courts should determine how a transaction allocates the burdens and benefits of ownership. Determining which party has the preponderance of burdens and benefits of ownership, according to Plank, should be undertaken as a legal analysis, not an economic one.65 The economic value of the burdens and benefits of ownership is relevant to assess whether the purchase price is of fair-market value for the receivables.66 Aicher and Fellerhoff also direct courts to assess the adequacy of price when they characterize receivables assignments, despite the complexity of such assessment. They state that if the price paid by the purchaser—taking into account recourse provisions—is significantly less than what an informed buyer would pay a willing seller, then the transaction should be treated as a secured loan.67

This Essay builds on these earlier calls for the consideration of price in true-sale determinations by focusing on the significance of price in establishing the fairness and efficiency of the rights of exclusion from securitized assets that sale characterization creates. If investors have property rights in receivables sufficient to exclude non-adjusting creditors in bankruptcy, they should have completed a fair-market-value exchange for those receivables.

III. Directive for a Drafting Committee

This Part discusses the possibility of creating a model act or revising relevant UCC provisions to codify an economic substance-based approach to true sales that considers price terms.68 A model act would be a stand-alone, state statute that enacts true-sale rules. Alternatively, there are a number of UCC sections that could be appropriate sites for provisions addressing true sales of receivables, such as Article 9’s section 9-109, or Article 1’s definitional provisions.

In order to formulate true-sale rules grounded in economic substance that establish the relevance of price, the Uniform Law Commission would need to convene a drafting committee. Drafting committees typically assume responsibilities in response to industry directives to facilitate certain types of transactions, to lower transaction costs, to allocate burdens of due diligence, and to complete other such goals. However, as discussed above, this Essay contends that industry demand is not a pre-requisite for engaging in the process of lawmaking to improve the rules governing a market-dominant transaction.69 Taking seriously the custodial work of maintaining clear commercial law doctrines, grounded in private-law principles, supports Uniform Law Commission engagement with statutory true-sale rules.

The UCC maintains that although the question of deal characterization is left to the courts; it is economic substance that determines the status of a deal.70 The UCC generally governs receivables securitizations (as defined in this project)71 because the scope of Article 9 extends to “a sale of accounts, chattel paper, payment intangibles, or promissory notes.”72 In other words, Article 9 covers both secured loans and true sales of these assets. Section 9-318 confirms that a “debtor that has sold an account, chattel paper, payment intangible, or promissory note does not retain a legal or equitable interest in the collateral sold.”73

This Essay concerns the integrity of state commercial laws and the expression of property principles to fortify the legal bases of securitization within the proper scope of states’ rulemaking authority.74 The federal bankruptcy code could be a viable site for true-sale reform as well.75 The bankruptcy code could enact substantive true-sale rules along the lines of a model state act, or it could enact provisions designating certain state law provisions to be in effect for purposes of true-sale characterizations in bankruptcy.76

Model act. A number of states enact free-standing ABS statutes.77 A drafting committee could undertake the task of formulating an alternative model of asset-backed securities act.

The ABS statutes call for broad construction of the term “securitization transaction.”78 An alternative model act could follow this same approach or could undertake a definition that specifies the category of deals to which the rules apply, providing a substantive formulation of “receivables securitization.” As noted above and discussed elsewhere, the term securitization often lacks definition.79 A model true-sale act could add definitional clarity.

To the extent lawmakers want simply to clarify the doctrine and fortify the legal infrastructure of securitization in a way that comports with states’ commercial law rulemaking authority, a model act that references securitization generally and that construes the term broadly may be desirable. To the extent lawmakers agree with the contention of this Essay that true-sale rules should confer rights of exclusion against unsecured creditors in a way that is more likely to be fair and efficient, it may make sense to define “securitization” to limit the rules to contexts in which the transaction could, possibly, extract a subsidy from non-adjusting creditors.80

A model act could provide that in determining the legal characterization of an assignment of receivables, courts (i) may consider various factors, and (ii) shall consider price terms. Factors courts have considered, and could consider under a true-sale statute, include recourse to the seller, retention of servicing and commingling of proceeds, investigation of account debtors’ credit, seller rights to excess collections, seller repurchase options, rights to unilaterally adjust pricing terms, rights to unilaterally alter other terms of transferred assets, the language of the documents, and the conduct of the parties.81 The model act could authorize consideration of such factors, along with any other factor a court finds relevant to determining the economic substance of the transaction at issue.

The model could then include provisions stating that courts shall consider the adequacy of the price that the purchaser paid to the seller for the receivables, taking into account any relevant terms of the transaction. After such consideration, if the price the purchaser paid is inconsistent with what an informed buyer would pay an informed seller for the risks and benefits transferred,82 then the court shall find that the assignment constitutes security for a loan and not a true sale.

This type of approach would leave the heavy lifting of true-sale determinations to the courts. A model act could merely establish that true-sale determinations, to the extent the state’s laws apply, are based on economic substance and sensitive to the relationship between price and intent to convey an ownership interest.

A drafting committee could consider any number of formulations, of course. A model act could delineate factors more precisely and it could create presumptions or allocate burdens of proof. The concept expressed here is a broadly conceived alternative to the existing ABS statutes. If those statutes codify an approach that elevates form over substance, an alternative model could codify the authority of economic substance while requiring consideration of price terms.83

UCC Article 1. Article 1 contains provisions that apply throughout the UCC, including important definitions. A drafting committee could revise Article 1 to contain: (i) a definition of true sale of receivables that creates a safe harbor for conforming transactions84 (ii) a definition of value, specific to the securitization context, that establishes a connection between the value given for receivables, and the scope of the interest a receivables assignment creates.

UCC Article 1 enacts a provision for distinguishing a true lease from a secured loan.85 In the context of equipment finance, companies frequently acquire equipment in transactions that take the form of a lease, even though the transaction’s objective is for the company to purchase the equipment. If the financing party is a lessor, then it owns the equipment and does not have to enforce its interest as a lien in the event the company files for bankruptcy. The true-lease doctrine distinguishes transactions that have the economic substance of a lease from those that are secured financings, taking the form of a lease solely for the purpose of avoiding UCC Article 9 and bankruptcy rules that protect debtors.

Equipment leasing presents a market context quite different from receivables securitization in which transacting parties enter into deals that may require re-characterization in the event of bankruptcy. In the true-sale context, a safe harbor that establishes when a sale of receivables occurs, but then directs courts to do a case-by-case characterization analysis in any context involving ambiguity may also make sense.86 Harris and Mooney argue that the residual interest test in Section 1-203 provides a useful analogy for the true-sale context.87 Whereas Section 1-203 looks to the existence of a residual interest in determining true-lease status, Harris and Mooney state that the law should ask whether or not an originator retains an economic interest in receivables it assigned to an SPE that secures an obligation.88

There are significant differences between the equipment leasing and the receivables securitization contexts that call into question the desirability of treating true sales as analogous to true leases for purposes of determining when assets will be bankruptcy remote.89 However, a version of Harris and Mooney’s proposal—one that more substantively defines “economic interest”—could lead to welcome true-sale doctrine reform. Determining whether an originator retains an economic interest in securitized receivables could involve, for example, consideration of whether investors paid a full, fair market value for the loans. A drafting committee could explore the validity of creating a safe harbor for true sales, drawing on Section 1-203 as a model.

For example, the beginnings of a draft provision could read:

[Section 1-__] Sale of Receivables Distinguished from Security Interest.

(a) Whether a transaction in the form of a sale of receivables creates a sale or security interest is determined by the facts of each case.

(b) “Receivables” for purposes of this section shall mean [accounts, chattel paper, payment intangibles, or promissory notes].

(c) A transaction in the form of a sale of receivables creates a security interest if the consideration that the purchaser is to pay the seller for the assignment of receivables [reflects an amount that is significantly less than what an informed buyer would pay a willing seller, taking into consideration all terms of the transaction].

The definition of “receivables” here tracks Section 9-109(a)(3).90 A broader (or narrower) definition could be appropriate. The language in subsection (c) tracks Aicher and Fellerhoff,91 but a more formulaic approach could be better.

UCC Article 1 contains a general definition of “value.”92 “Value” for a sale of receivables contemplated by Section 9-109(a)(3), as opposed to an assignment of collateral within the scope of Section 9-109(a)(1), could be defined to mean a price that “an informed and willing buyer would pay a willing seller for the risks and benefits transferred.”93 (UCC Article 9 requires that value be given in order to create an enforceable security interest.)94

A drafting committee may have a more precise method of expressing adequacy of price or may prefer a broad formulation. The purpose here is to identify a concept: model provisions to establish the relevance of price in a true-sale determination based on economic substance could take the form of a definition of “value” which distinguishes Section 9-109(a)(3) transactions from those that fall under 9-109(a)(1).

UCC Section 9-109. Texas and Louisiana enacted a non-uniform provision 9-109(e) that overrides the common-law true-sale doctrine,95 with content and effect similar to the ABS statutes enacted elsewhere. A drafting committee could explore the possibility of an alternative form of Section 9-109(e), taking the approach described above for a free-standing model true-sales act. It could authorize courts to consider various factors to determine economic substance and require them to consider price.96

Other possibilities. A committee of experts, empaneled to draft model provisions, and receiving advice from a range of interested participants, may identify approaches to codification not contemplated here. Such a committee could take up related questions, such as governing law for true-sale analyses. This Essay calls for the Uniform Law Commission to convene a drafting committee to undertake the task of expressing the relevance of price in codifying an economic substance-based approach to true sales.

Conclusion

A better approach to true-sale rules—one that would create rights of exclusion from securitized assets in a way that is better justified and more coherent than the current law—is overdue. By arguing for such an approach, this Essay tends to the legal infrastructure of the multi-trillion dollar securitization market. The relevance of price terms in true-sale determinations should be codified. The price that a company receives in exchange for securitized assets represents value with which to distinguish between problematic judgment proofing on the one hand, and assignments that isolate assets from bankruptcy in a way that is fair and produces efficiencies on the other hand.

Industry demand is not a pre-requisite for convening a uniform law commission drafting committee to undertake true-sale doctrine reform. Negotiations about the status of securitized assets, affecting creditors in weak bargaining positions, are happening in the context of current true sale rules—rules that are inconsistent and lack normative direction, or, alternatively, are codified to eliminate creditors’ positions and that raise federalism concerns. Maintaining the rule of law in capital markets demands the custodial work of clarifying the true-sale doctrine, regardless of the financial industry’s lack of concern.

  1. See Heather Hughes, Property and the True-Sale Doctrine, 19 U. Pa. J. Bus. L. 870 (2017) [hereinafter Hughes, Property]; Robert D. Aicher & William J. Fellerhoff, Characterization of a Transfer of Receivables as a Sale or a Secured Loan Upon Bankruptcy of the Transferor, 65 Am. Bankr. L.J. 181, 186-98 (1991); Steven L. Harris & Charles W. Mooney, Jr., When Is a Dog’s Tail Not a Leg?: A Property-Based Methodology for Distinguishing Sales of Receivables from Security Interests That Secure an Obligation, 82 U. Cin. L. Rev. 1029 (2014); Peter V. Pantaleo et al., Rethinking the Role of Recourse in the Sale of Financial Assets, 52 Bus. Law. 159, 161 (1996).
  2. This Essay is not the first call to clarify and codify the true-sale doctrine. Edwin E. Smith proposed a drafting committee to formulate true-sale rules in 2001. See Edwin E. Smith, Proposal for a Uniform State Law on What Constitutes a True Sale of a Right to Payment (Confidential Discussion Draft in Process, 2002) (on file with author). Steven L. Harris and Charles W. Mooney, Jr. published an article in 2014 calling for true-sale rules that mirror the uniform commercial code true-lease provisions. See Harris & Mooney, supra note 1. These existing proposals have not yielded model provisions or other codified reform. This Essay, along with Property and the True-Sale Doctrine, builds upon and departs from these prior proposals. It joins them in calling for coherent true-sale rules. It builds upon the notion that true-sale rules should look to economic substance of a transaction and should be explicitly property-based. It departs from prior efforts in that it (i) overtly links the doctrine to the literature on the efficiency and fairness of securitization, and (ii) focuses on the relevance of price terms and the property concept of rights of exclusion, considering when and why companies should exclude unsecured creditors from securitized assets. (The minority of states that enact asset-backed securities facilitation acts, of course, do have statutory true-sale rules, albeit very different ones from what this Essay, or Smith, or Harris and Mooney would propose. See infra text accompanying notes 27, 35; Hughes, supra note 1, at 905-910.)
  3.  Hughes, Property, supra note 1. This piece is the third in a series about the under-explored potential of state private laws for market governance and financial regulation. The first such article explores the emerging relevance of property concepts for financial product regulation. See Heather Hughes, Financial Product Complexity, Moral Hazard, and the Private Law, 20 Stan. J. L. Bus. & Fin. 179 (2015) [hereinafter Hughes, Financial Product Complexity] The second, Property and the True-Sale Doctrine, considers a particular doctrine integral to the creation of financial products—the true-sale doctrine—and its relationship to arguments about securitization’s efficiency and to property law.
  4.  The term “securitization” often lacks definition in secondary sources and in laws that reference the term. See Jonathan C. Lipson, (Re)Defining Securitization, 85 S. Cal. L. Rev. 1229, 1232-33 (2012) (arguing for a coherent definition of “securitization”). Lipson finds “over two dozen regulatory and statutory definitions of the word ‘securitization,’” compounded by various definitions used by market actors and commentators. Id. at 1257. This Essay refers specifically to receivables securitizations: transactions in which a company (the originator) assigns receivables to a bankruptcy-remote special purpose entity (SPE) that issues securities that are backed by the pool of receivables. In order to successfully isolate the assets from bankruptcy risk of the originator, the SPE must be a separate entity not subject to consolidation, and the assignment of receivables must be a true sale (not a secured loan). For a more extensive definition of “receivables securitization,” see Hughes, Property, supra note 1, at 881.
  5. See Hughes, Property, supra note 1.
  6. Id.
  7. Id. at 875.
  8. See Hughes, Property, supra note 1, at 914-19.
  9. See infra text accompanying note 55.
  10. For discussion of “judgment proofing” and its relevance here, see infra text accompanying notes 56-59.
  11. Non-adjusting creditors are parties (like employees or suppliers) who extend credit to the company but cannot adjust their rate of return in response to the increased risk that a change in capital structure may present. For citations and discussion of non-adjusting creditors, Franco Modigliani’s and Merton Miller’s irrelevance theorem, and “the puzzle of secured credit,” see Hughes, Property, supra note 1, at 884.
  12. See Ronald J. Mann, The Rise of State Bankruptcy-Directed Legislation, 25 Cardozo L. Rev. 1805, 1819 (2004); Tara L. Carrier, Unsafe Harbors: Why State Securitization Statutes Won’t Protect Against Recharacterization in Bankruptcy (March 19, 2018) (unpublished manuscript) (on file with author); infra text accompanying note 51.
  13. See Ronald J. Mann, The Rise of State Bankruptcy-Directed Legislation, 25 Cardozo L. Rev. 1805, 1819 (2004); Tara L. Carrier, Unsafe Harbors: Why State Securitization Statutes Won’t Protect Against Recharacterization in Bankruptcy (March 19, 2018) (unpublished manuscript) (on file with author); infra text accompanying note 51.
  14. Mann, surpa note 13.
  15. See Hughes, Property, supra note 1, at 914.
  16. See supra note 3.
  17. See Hughes, Financial Product Complexity, supra note 3.
  18. See Hughes, Property, supra note 1.
  19. The Uniform Law Commission, in conjunction with the American Law Institute (ALI), creates model laws. The Commission convenes drafting committees to craft model acts or provisions that then may be enacted by state legislatures.
  20. This entity isolates assets from bankruptcy risk. See infra text accompanying note 21. In some instances, the entity is also off-balance sheet. See Thomas E. Plank, Securitization of Aberrant Contract Receivables, 89 Chi.-Kent L. Rev. 171, 187 n.56 (2013).
  21.  Again, these are transactions in which a company assigns receivables to a bankruptcy-remote special purpose entity (SPE) that issues securities backed by the receivables. The SPE is a distinct legal entity not subject to consolidation with the originator in bankruptcy; the assignment of receivables is a true sale, not a secured loan. The true-sale doctrine determines whether the assignment from the originator to the SPE is actually a sale as opposed to an assignment of collateral. See Hughes, Property, supra note 1, at 871.
  22. See Fin. Accounting Standards Bd. [hereinafter FASB], Accounting Standards Codification, Topic 860, Transfers and Servicing (2009) (replacing FASB, Statement of Financial Accounting Standards [hereinafter FAS] No. 166, which replaced FAS No. 140); Summary of Statement of No. 140: Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – A Replacement of FASB Statement No. 125, FASB (Sept. 2000), http://www.fasb.org/summary/stsum140 [http://perma.cc/EK5M-R4NE].
  23. See Hughes, Property, supra note 1, at 872.
  24. See Kenneth Ayotte & Stav Gaon, Asset-Backed Securities: Costs and Benefits of Bankruptcy Remoteness, 24 Rev. Fin. Stud. 1299; Hughes, Property, supra note 1, at 872.
  25. See Hughes, Property, supra note 1, at 901.
  26. Id. at 905.
  27. See Steven L. Harris & Charles W. Mooney, Jr., When Is a Dog’s Tail Not a Leg?: A Property-Based Methodology for Distinguishing Sales of Receivables from Security Interests That Secure an Obligation, 82 U. Cin. L. Rev. 1029 (2014).
  28. See Hughes, Property, supra note 1, at 877.
  29. See, e.g., National Conference of Commissioners of State Laws, Committee on Scope and Program, Minutes of January 11, 2002, meeting, Baltimore, Maryland, http://www.uniformlaws.org/Shared/meetings/Sp011102mn.pdf [http://perma.cc/V5QW-BU5P] (discussing Commissioner Smith’s report on whether there should be a uniform law on what constitutes a true sale of a right to payment and noting concern about “whether such an act could be effective in a fact-specific area”).
  30. See National Conference of Commissioners of State Laws, Committee on Scope and Program, Minutes of August 11, 2001, meeting, White Sulphur Springs, West Virginia, http://www.uniformlaws.org/shared/minutes/scope_081101mn.pdf [http://perma.cc/7VH5-UN56].
  31. See Smith, supra note 2.
  32. See National Conference of Commissioners of State Laws, Committee on Scope and Program, Minutes of January 11, 2002, meeting, Baltimore, Maryland, http://www.uniformlaws.org/Shared/meetings/Sp011102mn.pdf [https://perma.cc/V3VR-URMK]; see also Kenneth C. Kettering, True Sale of Receivables: A Purpose Analysis, 16 Am. Bankr. Inst. L. Rev. 511, 524-25, 560 (2008) (mentioning Smith’s proposal and that it did not result in model provisions).
  33. See National Conference of Commissioners of State Laws, Committee on Scope and Program, Minutes of January 11, 2002, meeting, Baltimore, Maryland, supra note 30, at 8.
  34. See id. at 8.
  35. See id. at 8. Smith is referring to the ABS statutes, presumably. See Hughes, Property, supra note 1, at 905-09.
  36.  National Conference of Commissioners of State Laws, Committee on Scope and Program, Minutes of August 11, 2001, meeting, White Sulphur Springs, West Virginia, http://www.uniformlaws.org/shared/minutes/scope_081101mn.pdf [http://perma.cc/H7K2-XFB2].
  37.  Octagon Gas Systems, Inc. v. Rimmer, 995 F.2d 948 (10th Cir. 1993), cert. denied, 114 S. Ct. 554 (1993).
  38. See PEB Commentary No. 14, June 10, 1994.
  39. See Hughes, Property, supra note 1, at 899.
  40.  These statutes deem all assignments of receivables for purposes of securitization to be sales, regardless of economic substance. They confer “sale” status on transactions the economic substance of which would not otherwise warrant that status. See Ala. Code § 35-10A-2(a)(1) (2016); Del. Code Ann. tit. 6, §§ 2701A-2703A (West 2016); La. Stat. Ann. § 109-109(e) (2016); Nev. Rev. Stat. §§ 100.200-100.230 (West 2017); Ohio Rev. Code Ann. § 1109.75 (West 2016); N.C. Gen. Stat. Ann. §§ 53-425, 53-426 (West 2015); S.D. Codified Laws § 54-1-10 (2016); Tex. Bus. & Com. Code Ann. § 9-109(e) (West 2015); Va. Code Ann. § 6.1-473 (West 2008); see also Hughes, Property, supra note 1, at 876.
  41. See Bankruptcy Reform Act of 2001, S. 220, 107th Cong.; H.R. 333, 107th Cong. § 912(i) (2001).
  42. See Hughes, Property, supra note 1, at 924.
  43. See National Conference of Commissioners of State Laws, Committee on Scope and Program, Minutes of January 11, 2002, meeting, Baltimore, Maryland, at 2, http://www.uniformlaws.org/Shared/meetings/Sp011102mn.pdf [http://perma.cc/2CJL-S8HM].
  44. Id.
  45.  Non-consenting creditors (like tort judgment holders) are not only non-adjusting, they did not consent to extend credit to the company in the first place. See infra text accompanying note 58.
  46. See Mann, supra note 13.
  47. Butner v. United States, 440 U.S. 48, 54-55 (1979); Mann, supra note 13, at 1808.
  48. Mann, supra note 13, at 1810.
  49. Id. at 1818.
  50. Id. at 1819.
  51. Id.
  52. See Carrier, supra note 13; Hughes, Property, supra note 1, at 908.
  53. See Draft of the National Mortgage Note Act of 2018 (January 28, 2018), http://www.uniformlaws.org/shared/docs/UCC%201,%203,%209/2017AM_UCC139_NatlMortRepAct_PublicDraft.pdf [http://perma.cc/MGN5-YAHQ].
  54.  Steven L. Harris, Reporter, Memorandum re: Choice of Law in the National Mortgage Note Repository Act of 2018 (February 22, 2018), http://www.uniformlaws.org/shared/docs/UCC%201,%203,%209/2018mar_UCC1389_Memo%20re%20Choice%20of%20Law_Harris_2018feb22.pdf [http://perma.cc/7L3U-2QSW].
  55. See Hughes, Property, supra note 1, at 886-87.
  56.  Steven L. Schwarcz, Ring-Fencing, 87 S. Cal. L. Rev. 69, 83 n.94 (2013); Steven L. Schwarcz, The Conundrum of Covered Bonds, 66 Bus. Law. 561, 583-84 (2011).
  57. See Lynn M. LoPucki, The Irrefutable Logic of Judgment Proofing, 52 Stan. L. Rev. 55, 59-67 (1999) (analyzing Steven L. Schwarcz’s response to LoPucki’s The Death of Liability to refute the argument that the costs of judgement-proofing outweigh the benefits); Lynn M. LoPucki, The Death of Liability, 106 Yale L. J. 1 (1996). But see Steven L. Schwarcz, The Inherent Irrationality of Judgment Proofing, 52 Stan. L. Rev. 1 (1999) (arguing, through an economic analysis, that judgment-proofing techniques, such as LoPucki’s, may not be standard practice); James J. White, Corporate Judgment Proofing: A Response to Lynn LoPucki’s The Death of Liability, 107 Yale L.J. 1363 (1998) (arguing that American businesses are making themselves increasingly judgment-proof).
  58. See Richard Squire, The Case for Symmetry in Creditors’ Rights, 118 Yale L.J. 806, 838-42 (2009) (stating that debtor opportunism in shifting costs to non-adjusting creditors is the most likely explanation for the persistence of asymmetrical asset partitioning). Cf. Yair Listokin, Is Secured Debt Used to Redistribute Value from Tort Claimants in Bankruptcy? An Empirical Analysis, 57 Duke L.J. 1037, 1076 (2008) (finding that firms with high uninsured tort risk do not issue more secured debt than other firms, negating the redistribution theory of secured credit).
  59. See Harris & Mooney, supra note 27, at 1040; see also Robert D. Aicher & William J. Fellerhoff, Characterization of a Transfer of Receivables as a Sale or a Secured Loan Upon Bankruptcy of the Transferor, 65 Am. Bankr. L.J. 181, 186-98 (1991) (detailing the various factors courts use in examining sale and loan determinations for purposes of the true-sale doctrine); Hughes, Property, supra note 1, at 901.
  60. See Hughes, Property, supra note 1, at 905-910.
  61. See Hughes, Property, supra note 1, at 910.
  62. See id. at 902-903; Aicher & Fellerhoff, supra note 59, at 209.
  63. See Hughes, Property, supra note 1, at 876-877.
  64. Plank, supra note 20, at 334.
  65. Id. at 337-39.
  66. Id. Plank notes that although courts have not always considered price in true-sale determinations, “using an analysis of the price paid for the loans would not have significantly changed the results of many court decisions.” Id. at 334-335.
  67. Aicher & Fellerhoff, supra note 59, at 207.
  68.  A drafting might also take up the issue of governing law. See Smith, supra note 2.
  69. See supra text accompanying notes 44-45.
  70. The UCC as enacted in Louisiana and Texas depart from this baseline for receivables assignments, as discussed above, by enacting non-uniform section 9-109(e). See infra text accompanying notes 95-96.
  71. See supra note 4; Hughes, Property, supra note 1, at 880-881 n.54.
  72. See U.C.C. § 9-109(a)(3). Article 9 generally applies to secured transactions—meaning assignments of personalty to secure obligations. See U.C.C. § 9-109(a)(1). However, it extends its reach to commercial consignments and to sales of certain assets for policy reasons that are not at issue here. See U.C.C. § 9-109(a)(3) and (4).
  73. See U.C.C. § 9-318(a).
  74. See supra text accompanying notes 51-52; Mann supra note 13.
  75. See Hughes, supra note 1, at 921-924.
  76. See supra text accompanying note 54.
  77. See Ala. Code § 35-10A-2(a)(1) (2016); Del. Code Ann. tit. 6, §§ 2701A-2703A (West 2016); Nev. Rev. Stat. §§ 100.200-100.230 (West 2017); N.C. Gen. Stat. Ann. §§ 53-425, 53-426 (West 2015); Ohio Rev. Code Ann. § 1109.75 (West 2016); S.D. Codified Laws § 54-1-10 (2016); VA. Code Ann. § 6.1-473 (West 2008).
  78.  Del. Code Ann. tit. 6 § 2702A (“It is intended by the General Assembly that the term ‘securitization transaction’ shall be construed broadly.”).
  79. See supra note 4; Hughes, Property, supra note 1; Lipson, supra note 4.
  80. See supra text accompanying notes 56-58.
  81. See Aicher & Fellerhoff, supra note 59, at 186-94; Hughes, Property, supra note 1, at 901.
  82.  This formulation tracks Aicher and Fellerhoff’s approach to true-sale determinations. See Aicher & Fellerhoff, supra note 59, at 207.
  83. See supra text accompanying notes 55-67.
  84. Cf. Harris & Mooney, supra note 27, at 1049-1053.
  85. See U.C.C § 1-203.
  86.  For example, in bankruptcy, a true lease finding may permit the bankrupt lessee to continue to use the equipment as long as it makes lease payments. In contrast, a true sale finding for a receivables assignment means that the bankrupt company has no further access to an important cash flow. For discussion of distinctions between the equipment leasing and receivables securitization contexts, see Hughes, Property, supra note 1, at 910-914.
  87. See Hughes, Property, supra note 1, at 911-913.
  88. See Harris & Mooney, supra note 27, at 1031.
  89. See Hughes, Property, supra note 1, at 877.
  90.  U.C.C. § 9-109(a)(3).
  91. See Aicher & Fellerhoff, supra note 59, at 207.
  92. The definition reads: “Value. Except as otherwise provided in Articles 3, 4, [and] 5, [and 6], a person gives value for rights if the person acquires them: (1) in return for a binding commitment to extend credit or for the extension of immediately available credit, whether or not drawn upon and whether or not a charge-back is provided for in the event of difficulties in collection; (2) as security for, or in total or partial satisfaction of, a preexisting claim; (3) by accepting delivery under a preexisting contract for purchase; or (4) in return for any consideration sufficient to support a simple contract.” U.C.C. § 1-204.
  93. Aicher and Fellerhoff, supra note 59, at 207.
  94. See U.C.C. § 9-203(b)(1).
  95. See La. Stat. Ann. § 10:9-109(e) (2016); Tex. Bus. & Com. Code Ann. § 9-109(e) (West 2015).
  96. See supra text accompanying note 81.

In-House Regulators: Documenting the Impact of Regulation on Internal Firm Structure

*J.D. 2017, The University of Chicago Law School. Thanks to Christina Bell, Anthony Casey, Brian Feinstein, Annie Gowen, Matt Ladew, Jennifer Nou, and Jonathan Masur for thoughtful comments on earlier drafts. Thanks also to the editors of the Yale Journal on Regulation for their hard work on this piece. All errors and views are, of course, my own.

In a deregulatory environment, what do regulated firms do? The standard assumption is simple: firms revert to their pre-regulatory form. This Essay challenges that basic assumption. Increasingly, regulation is conducted through broad standards foisted on firms to implement internally. Congress articulates a policy goal; agencies enact specific standards for regulated entities; and firms are left to sort out how to comply with such standards. Recent mandates in financial, privacy, and medical regulation exemplify this approach. Despite these changes, scholars have not turned their attention to how this new form of regulation changes the structure of the regulated entity. Using case studies and theoretical insights, this Essay hypothesizes that the structures firms create in a regulated environment will not immediately disappear in a deregulatory world. Rather, they will persist. Modern regulation causes firms to make department-specific investments and centralize information gathering. Firms accomplish this, in part, by increasing the presence of regulatory-related staff. And, once these investments are completed, they will insulate regulatory-related staff from immediate removal in a deregulatory environment. That is, in-house regulators will be sticky. This Essay aims to provide an array of theories to support this phenomenon.

Introduction

Deregulation is an integral part of President Trump’s agenda.1 Scholars have been quick to point out that there are multiple headwinds to his deregulatory agenda. The Senate stymied efforts to repeal and replace the Affordable Care Act, for instance.2

Congressional repeal is not Trump’s only option—regulatory changes have focused on agency process. But scholars are also quick to point out that deregulation faces both legal and practical hurdles. In the legal realm, the repeal of rulemaking must go through the standard notice-and-comment process,3 and can be challenged as arbitrary and capricious.4 On the more practical side, deregulation requires the cooperation of a vast bureaucracy consisting of agency employees with their own incentives.5

These hurdles are significant, and I do not dispute them here. However, this Essay’s aim is to recognize regulation’s impact on how firms are organized and suggest that regulation changes firm structure and that this change may persist, albeit mildly, in a deregulatory state. This Essay’s hypothesis is simple: regulation creates extragovernmental hurdles to deregulation by changing how firms are organized.

New regulation brings about observable changes to firms. In areas such as finance, privacy, and medicine, regulation is now accomplished through broad standards that firms must implement themselves. 6 This regulation through delegation requires regulated firms to gain regulatory expertise. To do this, firms hire experts—they invest in processes that will allow them to comply with inherently opaque regulatory pronouncements.

The increased hordes of in-house regulators will “not go gentl[y] into that good night.” 7 That is, they will attempt to fortify their influence within the firm regardless of deregulation. Within the administrative state, this fortification is not surprising, and administrative law scholars have studied it extensively.8 But their focus has generally been inward, looking at administrative agencies and their agents.9 This Essay looks outward, at the agents within regulated entities tasked with regulatory implementation. These in-house regulators have their own incentives and want to keep their jobs even in a deregulatory environment. How they go about accomplishing that has not been systematically documented or studied.

The aim of this Essay, then, is both positive and theoretical. Administrative law is inwardly focused, with scholars turning their lens toward either controls on the administrative state or the structure of the administrative state.10 Often overlooked in this literature is the impact of regulation on the regulated entities.11 Even the scholarly debate surrounding cost-benefit analysis tends to be about its impact on agency discretion.12 Lacking so far in the literature is an account of how regulations impact the structure of regulated entities. To supplement the literature, this Essay first provides a brief overview of the modern regulatory state, documenting two phenomena: the tendency of the administrative state to reject deregulation or, at least, slow a deregulatory tide, and an increasingly standards-based or delegatory administrative state. After briefly highlighting the impact of regulation’s shift on firms, this Essay explores how changes in firm structure may insulate firm regulatory staff in a deregulatory environment.

I. Deregulation Inside the Administrative State: The Impediments Posed by Administrative Agencies

As others have observed, deregulation is not easy. Practical and legal impediments hinder deregulation’s speed13 Before taking up deregulation’s effect on regulated entities, it is important to survey these hurdles. In part, these hurdles may explain this Essay’s hypothesis—if deregulation inside the administrative state proceeds at a lethargic pace, firms may respond accordingly.

Regardless, understanding regulatory effects on firms requires a basic understanding of two key features of the modern administrative state. First, the evolving nature of regulation—the shift from command-and-control regulatory schemes to more deregulatory schemes—changes how firms implement and respond to regulatory pressures.14 Second, in part due to this shift, the significance of practical hurdles to deregulation—such as ossification and burrowing—increases. And more complex, standards-based regulation necessarily places more discretion in bureaucrats whose policy preference may not align with the administration’s.

Bureaucracies can resist outside pressure (or political pressure from the top). To deregulate, agencies must show, via studies, fact-finding, and comments received, that the proposed rule (or proposed removal of a rule) is not a “clear error of judgment.”15 And “[t]he high costs associated with rule change lead[s] to ‘ossification’—a powerful status quo bias.”16 Burrowing serves to increase the costs of deregulation. By placing members of a former president’s staff in career positions within agencies, the view of agency staff aligns with the former, not the current, political order.17 But agency heads must rely on these staffers to conduct the laborious and methodical work required for deregulation to pass judicial muster. The problem for deregulation is obvious—the burrowed staffers will drag their feet on policies they dislike.

These theoretical insights, of course, are currently bumping up against a messy reality. Data suggest that “civil servants are bailing,” contrary to the burrowing hypothesis.18 Political appointees’ requests for budget cuts may exacerbate this exodus.19 Nevertheless, an understanding of the current state of play in how the administrative state regulates and operates has implications for how firms respond. And an outline of current agency process will serve as a backdrop for an understanding of why regulated entities respond the way they do to regulation and deregulation. To that end, this Part first highlights the practical realities of agency administration in a deregulatory environment before documenting the evolving nature of regulation and discussing how the theoretical hurdles to deregulation work in a standards-based regulatory system.

A. Practical Challenges to the Deregulation Inside the Agency

1. Ossification

Changes to regulations must be “based on a consideration of the relevant factors,” and courts will want to see the agencies “examin[ing] the relevant data and articulat[ing] a satisfactory explanation for its action including a rational connection between the facts found and the choice made.”20 In practice, this standard increases the time and cost it takes to repeal or change regulation—it “requir[es] that agencies provide detailed explanations of their behavior, consider viable alternatives, explain departures from past practices, and make policy choices that are reasonable on the merits.”21 Currently, Trump has directed the heads of executive agencies to investigate deregulatory avenues.22 But, even where regulation can be identified and modified, the process of actually doing so will require executive agencies to show, via studies, fact-findings, and comments received, that the proposed rule is not a “clear error of judgment.”23 The high costs associated with rule changes make the status quo sticky.24

Besides the issues raised by State Farm and arbitrary-and-capriciousness review, the cost of notice-and-comment rulemaking remains. “Rule making” as defined by the Administrative Procedure Act,25 includes “repealing a rule,” 26 and even informal rulemaking requires notice and comment.27 Rulemaking is not a painless process. For example, in April 2009, the GAO found that even simple rulemakings can take six months to complete, and that was on the lower end of estimates for agencies. Some agencies, like the FDA, estimated “that a straightforward rulemaking may take up to 3½ to nearly 4 years from initiation to final publication.”28 Despite increasing presidential control of the administrative process, these figures have not changed.29 For instance, in 1992 Professor Thomas O. McGarity reported that rulemaking by the FTC took, on average, five years and three months. 30

And if history is any indicator, the lethargic pace of agency rulemaking is unlikely to change in the future. Ossification, then, has the effect of keeping regulation in place despite expressed deregulatory pressures.

Agency staff exacerbates this ossification because they will be required to carry out Trump’s deregulatory policies. 31 And while agency staff has become, over the past few administrations, “more [of] an extension of the President’s own policy and political agenda . . . no President . . . c[an] . . . supervise so broad a swath of regulatory activity.” 32 At a technical level, staff is required to carry out the studies necessary to survive arbitrary and capriciousness review. If they are antagonistic towards Trump’s deregulatory agenda, they can stall the process. Moreover, while the actual requirements of regulation can be changed, agency staff can protest the deregulatory action by increasing the number of audits or internal investigations at individual financial firms—changing their oversight policy from one of capital requirements to one of more extensive auditing.

Finally, at the end of a presidential administration, agencies may finalize a tremendous amount of rules in order to stay the hand of the new president.33 This can create hurdles for the new president for the reasons discussed above—changing a rule requires costly and time-consuming rulemaking. And ossified rules present a challenge for regulated entities in that political rhetoric does not immediately translate into laxer regulatory schemes. For regulations that require large capital investments, this can be seen as a positive—ensuring regulated parties that the regulatory scheme will not be upended before the return on their investments are realized.34 But for structural regulation—such as bank capital requirements or privacy concerns—ossification imposes costs and limitations on firms far after the administration has deemed those costs unwarranted.

2. Burrowing

Just as new rules are promulgated at the end of a presidential administration, so too do abrupt staffing changes occur. At the end of President Clinton’s administration, over “one hundred political appointees moved to civil service positions35 Furthermore, “[o]utgoing political appointees may also hire significant numbers of civil servants or promote individuals to key supervisory positions inside the agency, [] with an eye to ensuring that the outgoing administration’s viewpoints and priorities remain represented within the agency.”36

Junking up an agency with those sympathetic to an outgoing president’s point of view imposes costs on the new administration. Antagonistic staff can hamper agency heads from engaging in a cohesive policy strategy. Moreover, agency staff is usually tasked with identifying the agency’s agenda or the pathways through which the political agenda can be accomplished.37 This subversive behavior can be “passive,” by letting deadlines slip, dragging out assignments, or overloading political appointees with needless information to stall agency activity.38 Of course, this subversion can also take an active form through leaks and other signs of disagreement. Like the legal hurdles to deregulation, these too can be overcome by a presidential administration bent on deregulating. But it is important to note that they increase the costs and time to deregulate in ways that may harm the effort globally.

Agency burrowing can also take the form of enforcement shifting whereby agency staff antagonistic towards the political views of the president increases other forms of regulatory burdens (e.g., audits or inspections) due to a perceived decline in top-down regulation. This is not merely a theoretical exercise. Scholars have observed that the rank-and-file agency staff responds to what they perceive as negative changes in policy.39 For instance, in response to President Ronald Reagan’s “outright assault . . . on environmental programs” and a decline in the agency’s budget, the Environmental Protection Agency’s monitoring and abatement activity surprisingly increased during the early part of the Reagan administration.40 The EPA was able to successfully circumvent parts of Reagan’s assault on environmental regulations because the “bureaucratic interest in shaping policy outputs” is sometimes strong enough to overcome presidential control.41 Ultimately, presidential administrations can impact policy, but agencies themselves are “responsible for much of the . . . public policy” implementation.42

This too has obvious deleterious effects on regulated entities. While official regulation is being slowly repealed, firms may be exposed to increased regulatory action through audits and other informal regulatory processes. This mismatch creates uncertainty that makes it difficult for firms to plan ahead. Although they can see formal deregulation occurring and plan investment changes accordingly, they simultaneously see an increased need to spend more time working with regulators. Firms may be accustomed to such bipolar regulatory responses, but they nonetheless force internal regulatory processes to persist within firms.

3. Prosecutorial Discretion

Finally, agencies—and their staff—possess extraordinary discretion when bringing enforcement actions. As SEC v. Chenery Corporation 43 tells us, agencies may choose between rules and adjudication in creating policy positions. But that does not end the story. After Heckler v. Chaney, 44 an agency’s decision to not bring enforcement action—as well as its decision to bring enforcement action—is effectively unreviewable. Except for the fact that the agency personnel bringing the enforcement action must be separated from those adjudicating the action45 agency personnel have complete discretion to bring enforcement actions.

Traditionally, enforcement was an after-thought in terms of agency policy—the focus on rulemaking either through notice and comment or adjudication. But increasingly, agencies have used enforcement—or the threat of enforcement—to regulate entities in ways that may expand the regulator’s purview or the agency’s policy portfolio46 The lengthy procedural processes that the APA and the courts have foisted on agency rulemaking makes regulation via enforcement attractive—the courts have limited review of these decisions, and settlement agreements allow for tailored enforcement of individual firms.

Regulation through enforcement and settlement also has ripple effects on other firms in the industry. The potential for enforcement threats, especially after enforcement against a similar firm has been observed, may change how firms behave. If firms in an industry observe an agency threatening enforcement against a competitor for a practice that might be prohibited by current regulation, they may change their policies in anticipation47 The cost of litigating against the agency is high and generally unrecoverable. So a firm must balance the cost of litigating (and the probability-adjusted cost of losing that litigation) against the cost of compliance. In that sense, it is easy to see why firms settle and other firms comply with the thrust of the settlement ex post.

Especially as regulation has become more standards-based48 the potential to expand the scope of regulation through the threat of enforcement increases. Of course, given the relative newness of enforcement through settlement, the persistence of this approach has not been studied. It may cut both ways. Appointed enforcement chiefs can stop bringing enforcement actions and can allow firms to stop complying with previously signed DPAs or stop ongoing litigation and investigation.49 On the other hand, burrowing may allow for ongoing minor enforcements and the continued enforcement of settlements. And even for deregulatory administrations, high-level enforcements may be politically attractive.

B. The Evolving Nature of Regulation

“[P]rivate firms increasingly exercise regulatory discretion of the type delegated to agencies.” 50 regulation’s goals have become more complex, regulators have shifted their focus from command-and-control directives to more performance-based models51 This is not a recent phenomenon. President Clinton required that agencies, “to the extent feasible, specify performance objectives, rather than specifying the behavior or manner of compliance that regulated entities must adopt.”52

Historically, regulators employed “technology-based” regulation that “intervene[d] in the acting stage, specifying technologies to be used or steps to be followed53 But increasingly, regulators are employing “performance-based” and “management-based” regulatory schemes. “Performance-based approaches intervene at the output stage, specifying social outputs that must (or must not) be attained. In contrast, management-based approaches intervene at the planning stage, compelling regulated organizations to improve their internal management so as to increase the achievement of public goals.”54

For example, the Nuclear Regulatory Commission’s Reactor Oversight Process does not mandate particular technologies or processes. Rather, it relies on a bevy of performance indicators to “assess the safety and security performance of operating commercial nuclear power plants.”55 Mandating specific technologies risks becoming outdated or depresses innovation, so the agency allows plants to conduct their operations organically. Inspections are conducted annually to observe the plant’s conditions and understand any trends or emerging risks, but the design and implementation of a safety and soundness program is left to the individual plants.56

Another “prominent example is the No Child Left Behind Act,” which “requires schools to achieve specified academic results as measured by a variety of indicators.”57 No Child Left Behind gave discretion to individual schools districts—they could choose what strategy, technologies, and processes worked best to accomplish the Act’s broad goals.

These are not isolated examples. Financial regulation, environmental regulation, and food safety regulation, to name a few, allocate some regulatory authority to the regulated entities.58 A full review of the regulatory shift is outside the scope of this Essay, but the examples help change the general perspective of what regulation is, especially as it relates to regulated entities. Typically, regulation is thought of as a binary—build X to decrease carbon emissions, add Y to cars to make them safer—but in more complex industries, the regulation is more prudential—implement changes to make the financial system safer, ensure that users’ data is protected and private, consider the efficacy of medical procedures on a hospital’s treatment policies. This shift is a necessary part of this Essay’s thesis.

Take, for example, the canonical case of Motor Vehicles Manufacturers Association v. State Farm Mutual Automobile Insurance Company.59 The fight in that case was over whether seatbelts or airbags would be installed in cars (and when)—a binary outcome. Either car manufacturers would have to invest capital to change their production process or they wouldn’t. But once they changed the process, there would be no thought about it—the capital invested, the regulation was effectively implemented. Modern regulatory schemes have changed this binary outcome. To use a highly politicized example, the Patient Protection and Affordable Care Act,60 requires the development of a National Quality Strategy to promote efficiency and efficacy of healthcare delivery.61 That is not a binary outcome for insurers and healthcare providers—it requires these firms to build internal units that can collect data, analyze the data, and propose recommendations (in addition to thinking about what data is valuable). These changes in regulatory strategy affect how firms structure their responses to regulation and, ultimately, may have persistent effects on firms’ structure even in a deregulatory environment.

II. Firm Responses to Regulation: Theories of Institutional Change in Response to Deregulatory Pressures

Firms respond to regulatory pressures. But missing from recent analysis is an understanding of how more complex, bottom-up regulation affects firm structure. Structure matters. Investment in a plant can be abandoned if deregulation makes its operation inefficient or unnecessary. But structure dictates how decisions are made. Responding to traditional, top-down regulation is easy: firms purchase the required equipment or invest in the necessary preventative apparatus. In essence, it is binary and likely does not require much change to current processes or procedures. For instance, when the FDA mandates that warnings be in a certain sized font,62 pharmaceutical manufactures change the label, but they do not change their research processes. But adhering to more complex regulation, such as the Federal Reserve requiring systemically important financial institutions conduct stress tests on their assets, requires increased staff, centralization of information, and coordination inside the firm. Responding to regulation by structurally changing organizational processes may fundamentally alert the organization and allow these changes to persist in the absence of regulation. To make that point clear, this Essay first proceeds by highlighting financial firms’ responses to Dodd-Frank through related antidotes. This Essay then turns to the heart of the matter—providing several theories of institutional change that will keep internal firm structures changed in the absence of regulation.

A. Firm Responses to Increased Regulation Through the Lens of Dodd-Frank

After the passage of Dodd-Frank, the rise of the regulatory, risk, and compliance staffs at financial institutions has been stunning. Or, as Bloomberg put it, the last few years have witnessed “the [r]ise of the [c]ompliance [g]uru.”63 For instance, JPMorgan Chase, the largest US bank by assets,64 increased the number of in-house regulators by over seventy-five percent from 2011 to 2015.65 JPMorgan is not an isolated example—other financial institutions have seen a similar rise in the number of staff devoted to regulation, risk, and compliance. At Goldman Sachs, in just one year, “[t]otal staff increased 8% . . . primarily due to . . . continued investment in regulatory compliance.”66 Perhaps more tellingly, it is becoming more difficult to staff these types of jobs, with senior compliance officers complaining of “staffing challenges.”67 Even non-US banks are increasing the size of their internal regulatory staff—by 2014, one-in-ten HSBC employees was an in-house regulator.68 Moreover, based on a 2016 survey of bank chief risk officers and other senior in-house regulators, “the upward [hiring] trend will likely continue overall, as the majority of firms expect to add more professionals to headcount in the next year.”69

Regulatory demands have driven most of the increases in in-house regulator headcount. But this unprecedented growth has been coupled with increased institutionalization of these functions. For instance, prior to 2008, the Chief Risk Officer at Morgan Stanley reported solely to the Chief Executive Officer.70 But now the Chief Risk Officer reports directly to both the Board of Directors and the CEO.71 A similar transition has occurred at Citigroup, where the Chief Risk Officer now “has regular and unrestricted access to the Risk Management Committee of the Board.”72 In perhaps a greater transformation, the Chief Risk Officer of Goldman Sachs previously reported to senior management (including the CEO, President, and CFO).73 Now Goldman’s Chief Risk Officer reports to both the CEO and the Board of Directors.74

Banks responded to Dodd-Frank in predictable ways—regulated entities generally seek to comply with new rules. But most scholars assume that firms will respond to deregulation in the same predictable way, by deconstructing the regulatory apparatus they created internally. The basic understanding of firms as profit-maximizing machines—and managers as agents for shareholders focused on earnings—highlights why this understanding is persuasive. This view of firms is present in both administrative law and corporate law literatures.75

Most of the current literature on firm regulatory response is focused on mandates—forced firm behavior.76 It does not seek to explain how complex, standards-based regulatory frameworks change regulated entities and cannot explain their response to deregulation. It suggests that sunk costs and switching costs may make singular investments or choices stable in a deregulatory environment77 That theory has some purchase in this context—the specter of regulations’ return poses switching costs—but is not robust in the presence of most modern regulatory schemes. Dodd-Frank required financial firms to hire an enormous amount of regulatory staff and was enormously costly,78 but the switching costs seem limited—laying off the regulatory staff may have psychic costs, but is otherwise a profitable move.

Cutting against that logic, I suggest that forces inside and outside the firm moderate the tendency to “deregulate” inside the firm. Indeed, Judge Richard Posner has noticed, “[d]eregulation does not bring about automatic changes in firm behavior. It changes the incentives facing management, and managers differ in their ability to respond intelligently to changes in incentives.”79 Below, I suggest several theories that may explain why firms will not respond to deregulation as expected. These theories are not mutually exclusive and some are more likely to be present in certain types of industries. Although some empirical evidence “suggests that older firms, firms that were profitable before deregulation, and family firms are apt to be more sluggish in responding to the challenges of deregulation than firms having the opposite attributes80 limited work has been done to construct theoretical arguments explaining that sluggishness.

The point is not to draw absolute conclusions about how firms will react; rather, the aim is positive and theoretical—to present a series of theories that punch against prevailing wisdom. Certainly more study of individual firms and industries will be necessary to test these theories, but they suggest prevailing wisdom may be incomplete.

B. Internal Forces of Regulatory Inertia

1. Agency Costs

Jensen and Meckling revolutionized corporate governance by conceptualizing firms as a nexus of contracts. A firm—in their view—“is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals . . . are brought into equilibrium with a framework of contractual relations.”81 The result of these contracts—between a principal, owner and agent, manager—is agency costs. Agency costs arise from the divergent interests of the principal and the agent. An owner has delegated responsibility of the firm to the manager. The owner wants the manager to maximize profits, but the manager is striving to maximize her compensation, potentially to the detriment of the owner. And, as the gap between principal and agent grows, so does this relationship’s agency costs.82

Agency costs exist not just at the owner–manager level, but also between senior and junior managers.83 As such, agency costs may stymie managers attempting to trim the size of their firm’s regulatory staff in a deregulatory environment. Regulatory staff has great autonomy and, within the firm, is expert on its processes and regulatory developments. In a deregulatory environment, they can use this expertise to their advantage. Ossification, burrowing, and prosecutorial discretion slows deregulatory rhetoric from directly translating to reduced regulatory burdens.84 While senior managers may want to reduce regulatory staff, the regulatory staff wants to maintain its size, stature, and salary. But because senior managers have less expertise in the guts of regulation, in-house regulators can use their expertise—coupled with the technicalities around ossification and the like—to encourage managers to reassess their initial inclinations.

Highlighting recent regulatory actions that occur in a deregulatory environment could be one technique regulatory staff employs to mitigate management’s view on deregulation. Even though presidential rhetoric is favorable, burrowing and prosecutorial discretion create enforcement opportunities that in-house regulators can seize. Take, for example, the Federal Reserve’s recent treatment of Wells Fargo. Because of regulatory lapses in the past, in February of 2018, the Federal Reserve fined Wells Fargo and prevented them from expanding until the issues are fixed.85

Bank compliance staff can employ this example should their managers seek to trim staff because of deregulatory presidential rhetoric. All else equal, compliance staff prefer to preserve their jobs than increase bank profits, so they can use the Wells Fargo example to argue that their positions are valuable—the staff may still be able to regulate despite top-down guidance. Moreover, because their knowledge of the regulatory landscape is greater than senior management’s, the regulatory staff can use burrowing and prosecutorial discretion to their advantage. They can assert that the Wells Fargo example is not an anomaly, but the result of regulatory resistance that will persist even as deregulation makes its way through the ossified process.

And despite agency costs theory’s prescription to centralize decision-making,86 management theory and practice increasingly push firms to decentralize decision-making.87 Decentralization has a pernicious downside—divisions will seek rents. This rent-seeking behavior can manifest itself in increased salaries or, more likely, larger budgets.88 Scharfstein and Stein develop a two-tier model of agency costs—agency costs between investor and manager, and manager and division heads.89 To maintain the division heads of weaker divisions, they predict that the manager will “pay” them with increased budgets, rather than increased salary. Weaker divisions will always rent seek while stronger divisions will not, and to retain the division head, the manager will “tilt the capital budget in his direction.”90 That is optimal for both the manager—who prefers to pay in capital investment rather than salary—and the division head.

The theory applies to in-house regulators. The division head—the Chief Risk Officer, the Chief Privacy Officer—will rent-seek in a deregulatory environment because their divisions will be “weaker” all else equal. The manager cannot do away with the division head, but will prefer to expand his budget rather than pay cash wages. In theory, cash wages reduce the manager’s flexibility to pay himself and others, but the “successful” units can subsidize the capital investment in the weaker division without harming the manager’s cash flexibility.

Theory aside, Scharfstein and Stein suggest that the agency costs that afflict managers and division units manifest themselves in greater budgets for the weaker units. For in-house regulators, this creates a type of one-way ratchet.91 In times of increasing regulation, firms spend capital to comply. But in deregulatory environments, rent seeking causes firms to undercompensate in-house regulators in real terms, but overinvest in in-house regulators (that is, in-house regulator’s may see their budgets grow while their wages stagnate). Agency costs theory, then, supports the notion that deregulation does not swiftly flow through firms—the internal dynamics of firms belie an immediate reduction in the size and sophistication of the firm’s regulatory staff.

2. Manager-Specific Investments

Managers are subject to pressures that align their interest with that of shareholders. The board and other senior leaders monitor managers for compliance with their profit-maximizing strategy. Moreover, the active labor market also reigns in a manager’s tendency to shirk, that is act in a way that is beneficial to her but to the shareholders’ detriment.

But these mechanisms are imperfect. Managers often act in self-interested ways. One theory for this is managerial entrenchment—the idea that managers make specific investments that subsequently make them “valuable to shareholders and costly to replace.”92 entrenchment may occur at any level of the organization. “A secretary, for example, has an incentive to design ways of keeping records or computer files that are very costly for anyone else to figure out.”93

In the mine-run case of entrenchment, boards (or anyone with oversight authority) allow managers to make entrenching investments because they are “insufficiently well informed to evaluate the investment, or because board members approve of the manager’s basic corporate strategy.”94 This may prove especially troublesome in the regulatory context, as boards cannot protect themselves from such investments. New regulation forces firms to invest in new, specific functions, and out of necessity, those implementing the regulation within the firm will be best positioned to determine how to invest. This creates an incentive for in-house regulators to invest inefficiently, that is invest to entrench.

Recent examples from financial regulation are apt. As financial regulators have placed increased demand on firms to oversee the risks being taken and develop comprehensive systems to analyze and monitor these risks, the in-house regulators tasked with this project have seen their staff and budgets balloon. Off-the-cuff risk management techniques traditionally done on trading desks moved to sophisticated risk tracking systems done by in-house regulators. The models and data that these systems spit-out is opaque—knowledge of risk metrics and other ideas is a necessary prerequisite to understanding what is going on. In the presence of regulation, the in-house regulators have made themselves valuable because they have built systems that they have a comparative advantage at understanding and decoding. Moreover, the centralization has meant that those on the trading desks that historically were called upon to do the quick-and-dirty risk management tasks of yore, no longer exist or have the expertise to do so. Therefore, investment in specific technology has increased the value of in-house regulators and made them more difficult to get rid of even in a deregulatory universe.

Of course, if the regulatory function is no longer valuable in a deregulatory universe, these investments will not lead to entrenchment—managers may eliminate the investments.95 But modern regulation’s scope has pervasive effects on firm operations. As the example above illustrates, the investments that in-house regulators make change how the firm itself is organized and operates. In line with the manager-specific investment thesis, in-house regulators will overinvest in systems that provide them with control over information or other inputs into firm operations. Normally, Boards would curtail overinvestment, but because of regulation’s complexity, they may not have the tools to properly account for what is needed, and the risk of undercompliance is high (and Boards may well be risk averse when it comes to compliance). The traditional check on manager-specific investments is muted in the regulatory landscape because the person with the most information about costs—the in-house regulator—has an incentive to inflate the costs to entrench herself and her staff.

3. Specific Knowledge, Centralization, and Switching Costs

“[M]anagement-based regulation will typically require information collection.”96 This is not surprising; modern regulation emphasizes monitoring and modeling—approaches that require centralized information collection. But this centralization may make in-house regulators sticky.

Another theory of the firm posits that it is an institutional arrangement to integrate the individuals’ knowledge.97 Knowledge is not held by the firm, but rather by individuals employed by the firm. Some of that knowledge is easily transferable (e.g., the number of employees in Human Resources or the price of a necessary input per a contract with the supplier). But most valuable knowledge is not easily communicated or transferable—“[t]acit knowledge is revealed through its application.”98

Much of the knowledge housed in the minds of in-house regulators is this less transferable knowledge. The ability to monitor, analyze, and synthesize data is not easily transferred, even if the data itself is easily communicated. Moreover, decision making housed in firm regulatory departments is a classic form of tacit knowledge—the combinations of data that each situation requires taking into account is not routine and can only be developed through use.99

Firm production requires the integration of multiple people’s knowledge. As in-house regulators emerge or grow, they are likely to centralize tasks—and thus knowledge—in themselves. This makes them essential components of firm production. Once “production requires the integration of many people’s specialist knowledge, the key of efficiency is to achieve effective integration while minimizing knowledge transfer through cross-learning by organizational members.”100 Dependence on in-house regulators’ knowledge makes them a valuable component of production. Deregulation should, thus, not have as great an impact as previously imagined because, although regulatory responsibilities are one component of their tasks and their origin, the integration of their knowledge into firm production means that they are now a more essential component of firm production. The firm’s ability to aggregate knowledge towards a productive means is what makes it competitive and profitable. Once in-house regulators are part of the knowledge aggregation process, removing them may change the firm’s production function and impact profitability.

After Dodd-Frank, financial firms were required to stress test their entire portfolios annually for the Federal Reserve. As discussed above, this herculean effort required centralizing data—and the ability to understand, manipulate, and synthesize that data—in risk departments. But this knowledge is valuable for everyday production. The profitability of a trade depends on whether it will offset overall risk, and now risk departments are central to understanding the complexity of a firm’s portfolio.

Moreover, the most efficient way to organize knowledge in a hierarchical organization is through bureaucracy.101 “In the knowledge-based firm, rules and directives exist to facilitate knowledge integration; their source is specialist expertise which is distributed throughout the organization.”102 Generally, in-house regulators are viewed as setting up procedures and protocols that facilitate compliance. But these same procedures are used to integrate knowledge across the firm—they exist not just to satisfy compliance but to structure knowledge integration to coordinate production.

The neoclassical retort to this line of reasoning is simple: if these processes and groups were valuable before regulation, they would have existed. Perhaps, but internal efficiency must be balanced against the high switching cost of knowledge transfer. Of course, it may be the case that the structure of firms ex ante was efficient, but once forced to restructure by regulation, the unraveling of the structure in a deregulatory universe imposes switching costs that may mitigate any efficiency gains that materialized in the previous organizational form.

4. Professionalization, Advocacy, and Culture

Regulating a firm requires expertise, and in-house regulators have become increasingly professionalized. The oft-maligned revolving door is one manifestation of professionalization—in-house regulators’ expertise is difficult to acquire and ex-regulators may be best positioned to understand in-house regulators’ roles. Regulation may also drive professionalization.103 Isolating or signaling out specific expertise may lead individuals across firms to associate. For example, privacy officers became increasingly professionalized after regulation encouraged firms to hire more of them.104

But increased professionalization has a downside for organization: it creates individual tension between professional norms and organizational priorities.105 Because most in-house regulators are, necessarily, somewhat separated from the other operations of the firm, they may develop a professional ethos or culture focused on attaining their perceived goal rather than focusing on optimizing firm goals. Given the headwinds to downsizing in-house regulators, the establishment of a culture of compliance not only leaves the in-house regulators in place but also leaves traces of the regulatory mandate in place.106

This is not to say that in-house regulators won’t change their culture or focus in a deregulatory environment—over time, they will respond to the incentive scheme that exists. And environmental factors may contribute. For example, financial risk managers and compliance professionals may be more likely to develop a culture of compliance because they co-located—most of these professionals live in the same few metropolitan areas. But there may be less cross-industry cultural development in privacy professionals or hospital administrators because of their geographic diversity. In any event, change may be slow, and given deregulation in fact already lags deregulatory rhetoric, the shadow of regulation in a deregulatory universe may be longer than previously anticipated. Indeed, it may outlast the administration proposing the deregulation, at which point the future fear of regulation may become another force that creates persistence among in-house regulators (see below).

5. Repositioning the Regulatory Agenda

What’s more, regulatory staff may entrench themselves by repositioning their role. What starts out as a regulatory mandate becomes a competitive advantage.

Take, for example, State Street’s “Fearless Girl,” the bronze statue of a young woman placed in front of the notorious Wall Street Bull.107 By building the statue, State Street signaled its commitment to employing its power to increase diversity on corporate boards. State Street may have legitimate business reasons for doing so,108 but it also bolstered State Street’s progressive reputation and likely aided its quest to manage pension and endowment assets.109

Regulation, in part, led to this approach. In its 2003 rule on Proxy Voting by Investment Advisors,110 the SEC issued regulations that required Investment Advisors, like State Street, to vote in the best interest of their shareholders. Most large investment managers, including State Street, created dedicated corporate governance groups to consider how to vote the shares State Street controlled.111

The policy goal behind the regulation is simple. If Investment Advisors consider only the interest of shareholders when voting, they will use their considerable power to increase the value of the firms that their shareholders are invested in. But, at State Street at least, this regulatory function was able to use its newfound expertise and power to reposition the regulatory function. Because of the nebulous nature of what is in the best interest of the shareholders, the corporate governance group was able to reposition itself as part of the sales force—using its votes to signal State Street’s values to current and future clients.

Although there is currently no proposal to remove the regulation that started this chain reaction, the group at State Street would likely persist even if that regulation were withdrawn. This reposition of the regulatory enterprise represents another way that in-house regulators attempt to entrench themselves. And in the State Street example, the corporate governance group gains more resources and maintains most of the group’s mission—voting in the interest of shareholders—while ensuring their future even in a deregulatory environment.

Empirical evidence suggests that board diversity has positive shareholder returns.112 But even if those empirical results are not robust, State Street’s governance team may be avoiding the regulatory mission with regard to some corporate governance decisions—for example, supporting directors on the basis of their gender—while accumulating resources and credibility with respect to its original mission. In this sense, if in-house regulators can reposition some of their tools to the firm’s benefit, it may allow them to continue to exercise most of the regulatory discretion they were initially given despite deregulatory pressures.

State Street’s “Fearless Girl” is not an isolated example. Energy firms have advertised how environmentally friendly they are.113 Similarly, the internal group driving this started because of regulatory pressure, but the group was able to reposition itself as a selling point to some clients—it turned regulatory compliance into a competitive advantage. This creates a feedback loop that furthers entrenchment. It may be that sales teams are expropriating the in-house regulators’ work for sales, but that does not undercut the point. If revenue-generating units perceive in-house regulators as valuable, they will continue to support internal regulatory efforts. Indeed, the more symbiotic the relationship becomes, the more sales goals may change how the in-house regulators operate and shift the sales teams dialogue with clients around how in-house regulators are a value-driver for clients. In part related to external reporting requirements discussed above, once clients are focused on this attribute, the firm will be loath to disband the group—it makes the group a profit center.

6. Regulatory Persistence as a Barrier to Entry

Finally, regulated industries may act strategically in keeping regulation to deter new entrants into the field. High compliance costs raise the cost of new entry and reduce the number of potential entrants. A reduction in potential entrants allows an industry to operate at higher profits than they would otherwise achieve, and thwarts threats to their business model.114

Even in deregulatory environments, firms may use the professionalization of in-house regulators to increase barriers to entry. This insight combines two forces of in-house regulatory persistence: repositioning and professionalization. For instance, privacy protections can be seen not just as a compliance function but as a source of value—customers are more comfortable transacting with a company that has robust privacy protections. In the technology space, this may allow incumbents to increase the costs for new entrants. “Don’t give your data to New Company because they do not have robust protections,” can be a persuasive way to transfer industry professionalization into a barrier to entry, increasing profitability for incumbents.115

This isn’t hypothetical. For example, industry experts expect Google and Facebook to benefit from Europe’s new privacy regulation, at the expense of smaller online advertising firms.116 Likewise, the Affordable Care Act gave hospitals and other healthcare organization an incentive to merge—larger organization can amortize regulatory costs over a larger sales base.117

C. External Forces of Regulatory Inertia

1. Board Risk Taking and Caremark Duties

Under Delaware law, boards have a duty to monitor the firm. That is, the board must “exercise a good faith judgment that the corporation’s information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations, so that it may satisfy its responsibility.”118 In-house regulators further this mission, and increased regulation gives them greater access to the board. Chief Risk Officers of financial firms now report directly, and regularly, to the board, as do privacy leaders.119

In 2006, the Delaware Supreme Court affirmed the Board’s duty to monitor under Caremark stating that:

Caremark articulates the necessary conditions predicate for director oversight liability: (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. In either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.120

While Caremark appears to be a robust doctrine when spelled out on its terms, it is severely limited. For instance, in 2009, Chancellor Chandler dismissed a claim against the Citigroup Board for failure to monitor. The plaintiffs alleged a violation of the Board’s Caremark duty for failure to monitor risk in Citigroup’s subprime mortgage portfolio.121 The court saw these claims as attempting to hold the directors liable for business decisions, and quickly dismissed the claim.122

Given the limited nature of the doctrine, Caremark may not create enough incentive for the board to retain in-house regulators in a deregulatory environment. However, to overcome a Caremark claim, directors “must make sure their risk oversight duties are met.”123 And directors familiar with only the presence of a duty to monitor, but not the fine gradations of the doctrine, will likely err on the side of additional monitoring and reporting to ensure compliance. As such, once a monitoring system is put into place, it may act as a one-way ratchet—the Board will be unlikely to remove the system because it fears that it may subject it to Caremark liability under the first doctrinal hook (failure to establish an adequate monitoring system). While these incentives may not be especially powerful, they present another avenue through which the board may encourage the maintenance of in-house regulators.

2. Reputation and External Reporting Pressures

Caremark’s oversight duty is not the only external pressure on boards and management to perpetuate regulatory staffs’ existence in a deregulatory environment. Just as internal actors rely on information produced by in-house regulators, external actors also rely on it. Privacy officers are responsible for producing and refining a firm’s privacy policy—a key document that the media and watchdog groups use to inform consumers.124 Similarly, hospitals are now able to provide more precise information to ratings organizations and potential donors.

Some legal regimes—like securities law—mandate disclosure. But there are non-legal explanations for revealing information. Reducing information asymmetry between management and the market reduces a firm’s cost of capital and enhances the liquidity of the firm’s securities.125 The release of information by one firm has two immediate effects. First, it pressures other firms to release similar information, else those interested will assume the worse. Second, it puts pressure on the firm to continue to disclose the information, else interested parties will assume nondisclosure reflects negatively on the firm.

Therefore, external reliance on information produced by in-house regulators can occur even absent a firm’s affirmative disclosure. Once one firm within an industry discloses, pressure on others will grow to disclose similar information.126 And if the information is dynamic—that is, it changes overtime—reliance interests will pressure the firm for continued reliance else a negative inference is drawn about the firm.

For example, bank equity analysts have started to drill down on capital and risk numbers in recent years. Because firms rely on the in-house regulators to supply these numbers, their value to management increases as external parties become more-and-more reliant on this information. Several financial firms have started to release forward guidance on their risk plans, and firms that did not have been chided by equity analysts.127 Irrespective of the regulatory environment, equity analysts strive to collect a full picture of the firm, which requires the information supplied by in-house regulators. Moreover, firms may have an incentive to disclose information to equity analysts, as those firms that disclose more tend to have higher returns, likely because investors’ expectations were appropriately calibrated.128 Reliance by third parties on information supplied by in-house regulators can bolster the credibility, importance, and, ultimately, resilience of in-house regulators in a deregulatory environment.

3. The Revolving Door and the Human Capital Hypothesis

The revolving door may also connect prosecutorial discretion with firm regulatory staff entrenchment. The human capital hypothesis posits that future job prospects will motivate regulators to regulate aggressively to show off their expertise and talents. In a deregulatory administration, regulators may foresee their future job prospects thinning. The alternative revolving door hypothesis—the rent seeking hypothesis in which regulators attempt to curry favor with regulated firms by going easy on them—is no longer attractive to regulators. Lax enforcement will not translate into a job if deregulation occurs—the regulator’s expertise won’t be needed. As a result, deregulatory rhetoric may, at least in the short-run, lead to more aggressive enforcement. Although generally thought to be explained by resistance, the EPA’s increased enforcement of environmental regulations after Reagan became president may reveal that deregulatory rhetoric hones regulators to focus on their future prospects.129

This goes back to the earlier point that agency costs allow in-house regulators to overstate their value in a deregulatory environment through examples of ongoing regulation. But these examples, then, are not flukes—they are likely systematic in a deregulatory environment. In many ways, the rent-seeking is recursive. As regulation increases, the regulators may have mixed incentives and pursue either more aggressive regulation (the human capital thesis) or less aggressive regulation (the revolving door hypothesis). In any event, in-house regulators have an incentive to communicate that harshness of regulation (regardless of the regulator’s actions).130 Therefore, in times of regulatory formation, the size and stature of in-house regulatory departments increases.

But then in deregulatory periods, regulators’ incentives change, and they are more likely to pursue aggressive regulation. The Wells Fargo example above might be an expected repercussion of deregulatory rhetoric, not an insolated, idiosyncratic example. In that case, in-house regulators have ready experiences to bring to bear on keeping their size (if not their stature). Although managers may observe deregulatory rhetoric, their inability to monitor in-house regulators (and the changed incentives of regulators) means that they may be more likely to defer.131

Again, this is not to say the persistence is infinite. Eventually, deregulation will become a reality and regulators will no longer be equipped with the tools to be aggressive (even if they are incentivized to be so). So, over time, in-house regulators will have less ammunition to fight off impending decreases in size and stature. The point, again, is not to posit infinite persistence but to show the time lag between rhetoric and on-the-ground change is burdened not just by administrative barriers but also by how those barriers can encourage and aid in-house regulators.

Future Regulatory Uncertainty

Regulated firms also face the possible return of regulation. Agencies need a commitment mechanism to regulate effectively into the future.132 The same impulse may exist with deregulation. In the regulatory context, regulated entities use administrative processes, like notice and comment, and political pressure, through lobbying, to mitigate regulation’s impact.133 In anticipation of the regulation, firms have rewired their operations to conform ex ante.

This same dynamic may hedge against deregulation’s immediacy within firm. In the event regulation returns, firms want the ability to shape regulation. They can do this by maintaining some in-house regulators. New regulation generally looks to the private sector for models,134 so when regulation reappears, regulated firms lobby to have the regulatory scheme fit their existing program. For this to work, they need some level of compliance—without any compliance, they will lack credibility in the face of regulatory pressures. As such, maintaining in-house regulators can be thought of as an affirmative future defense to the return of regulatory pressures.

Just as the revolving door may increase regulatory aggressiveness immediately following deregulatory rhetoric, future regulatory uncertainty may encourage firms to maintain regulatory staffs. Although presently in a deregulatory environment, firms know that they are just one election, appointment, or scandal away from regulation’s return. Swiftly returning to a regulatory environment requires experts, and firms may well want to maintain regulatory staff to hedge against the return of regulation. Their in-house regulators will be best positioned to take up the mantle of regulation, ensuring that the regulation isn’t too onerous, and they will understand the challenges firms actually face. Gutting in-house regulators in a deregulatory, but uncertain, environment depletes the firm’s regulatory expertise. In the event that expertise becomes valuable again, the underinvested firm will have to spend time and resources reacquiring this knowledge.

Moreover, uncertainty is, unexpectedly, stabilizing. Often, commentators talk about uncertainty as a drag on future investment—firms are loath to invest in the future if they cannot accurately anticipate future constraints or pressures on their operations. But the same force is at work in divesting. In an uncertain environment, removing regulatory staff is just as risky as hiring more regulatory staff.

Finally, in light of potential regulatory return, firm managers may fall into the sunk cost fallacy—the time and money spent on developing in-house regulators may make them averse to gutting the program at the hint of deregulation. Moreover, the cost of decreasing the program—severance, loss of knowledge, etc.—may future exacerbate this thinking. That is not to say it cannot be overcome; just that it creates a behavioral barrier that, in conjunction with other barriers, may exacerbate the tendency to retain in-house regulators.

***

Economic and sociological theory suggest that the response of regulated entities to deregulation will not be swift. If anything, it will be slow, plodding, and constrained by a host of internal and external forces. The effect on various companies and industries will depend on a variety of factors—firm size, the remaining regulatory burden, and the length of previous regulation, to name a few.

This evaluation does suggest regulation that causes firms to centralize and create internal and external dependencies on in-house regulators will be more persistent. Of course, deregulation may change the motivation and force of in-house regulations. For instance, as financial deregulation continues, risk managers will have less of a bludgeon to push back on risky trades—no longer will the regulatory mandate be a fait accompli to stop risky activity. But those same risk managers will continue to be present in the firm. Their participation in decision-making persists, and the new tools and processes developed to monitor and manage risk continue. Financial firms may get riskier in a deregulatory environment, but their internal structure may be less risky than in the pre-regulatory environment. In that way, regulation persists because of its impact on firm structure.

These theories may not operate simultaneously in all firms in all industries. But, from these theories, hypotheses can be formed and tested. Empirical analysis and case-study methods can help determine which pathways are most likely to make in-house regulators stick, and how those forces operate in different firms and industries. And these insights may impact how agencies conduct cost-benefit analysis, or suggest changes in regulatory design at both the congressional and agency level. Nevertheless, thinking about deregulatory inertia outside the administrative state paints a more realistic and multifaceted picture of how organization respond to the ebbs and flows of regulatory change.

Conclusion

Some may view this Essay’s predictions as positive—the persistence of regulation ensures ongoing safety and soundness in a deregulatory environment. Others may see the prediction as another argument against the administrative state. In any event, this Essay aims to be an opening salvo in thinking about regulatory persistence outside of the administrative state. As regulation increasingly becomes standards-based, the firms implementing the regulation become a key feature of the regulation, and must be a key feature of study to understand the effectiveness and persistence of regulatory arrangements.

Future research is, of course, needed to prove out the hypothesis that in-house regulators are “sticky.” Case studies of particular firms and industries will help expose which theories of persistence are more robust, and may highlight how firms have overcome the forces described by this Essay. But as we march through a period of deregulation, scholars should keep firms in their peripheral vision. Whether the parade of horribles some predict will result when deregulation manifests itself completely will be predicated, in part, on how firms respond. And if scholars and advocates can understand how firms adapt to deregulation, as well as regulation, they will be bettered positioned to craft regulation that is persistent regardless of administrative change.

  1. See Reducing Regulation and Controlling Regulatory Costs, Exec. Order No. 13,771, 82 Fed. Reg. 9,339 (Feb. 3, 2017); Core Principles for Regulating the United States Financial System, Exec. Order No. 13,772, 82 Fed. Reg. 9,965 (Feb. 8, 2017).
  2. Erica Werner & Alan Fram, GOP Dealt Stiff Blow in Senate’s Bid to Repeal ‘Obamacare,’ Associated Press (July 28, 2017), http://apnews.com/a3286ef6fca74cac93fac360ad76f3d4 [ https://perma.cc/SHR5-QZBG].
  3. 5 U.S.C. §§ 551(5), 553 (2012).
  4. See, e.g., Motor Vehicles Mfrs. Ass’n of United States v. State Farm Mut. Auto. Ins., 463 U.S. 29 (1983); see also Jonathan S. Masur & Eric Posner, Cost-Benefit Analysis and the Judicial Role, 85 U. Chi. L. Rev. (forthcoming 2018) (discussing the “arbitrary and capricious” standard applied by courts); Daniel Hemel, Jonathan Masur & Eric Posner, How Antonin Scalia’s Ghost Could Block Donald Trump’s Wall, N.Y. Times (Jan. 25, 2017), http://www.nytimes.com/2017/01/25/opinion/how-antonin-scalias-ghost-could-block-donald-trumps-wall.html [ https://perma.cc/3UMN-DTF3].
  5. See Jennifer Nou, Taming the Shallow State, 36 Yale J. on Reg.: Notice & Comment (Feb. 28, 2017), http://yalejreg.com/nc/taming-the-shallow-state-by-jennifer-nou [https://perma.cc/PT9C-JSYY].
  6. “With the passage of HIPAA, Congress set in motion the development of specific security and privacy guidelines for the healthcare domain through standards-based regulation.” Paul N. Otto, Reasonableness Meets Requirements: Regulating Security and Privacy in Software, 59 Duke L.J. 309, 324 n.74, 325, (2009) (“There are several examples of other recent laws and regulations that adopt a standards-based approach to regulating security and privacy in software.”).
  7. The Collected Poems of Dylan Thomas, 1934–1952, at 128 (New Directions 1971). In fact, they may “[ r] age, rage against the dying of the light.” Id.
  8. See generally Nina A. Mendelson, Agency Burrowing: Entrenching Policies and Personnel Before a New President Arrives, 78 N.Y.U. L. Rev. 557 (2003).
  9. Kenneth A. Bamberger, Regulation as Delegation: Private Firms, Decisionmaking, and Accountability in the Administrative State, 56 Duke L.J. 377, 381 (2006) (“In general, however, administrative law’s sophisticated vision of organizational decisionmaking ends at the doors of the regulated firm.”).
  10. Similarly, business law scholars have, for the most part, presumed that deregulation causes firms to revert back to their pre-regulatory form. See Timothy F. Malloy, Regulating by Incentives: Myths, Models, and Micromarkets, 80 Tex. L. Rev. 531, 533 (2002) (“[ A]ssum[ ing] that the organization is a monolithic entity that essentially makes decisions as a natural individual would . . . [mean] the collective nature of the firm and its internal features are largely ignored.”).
  11. While recent scholarship has started to think about regulated entities, its focus remains on how administrative law or process changes incentives for firms, but does not address how those incentives work to actually change the structure and operations of the regulated entities. See, e.g., James W. Coleman, Policymaking by Proposal: How Agencies Are Transforming Industry Investment Long Before Rules Can Be Tested in Court, 24 Geo. Mason L. Rev 497 (2017) (documenting how, in regulated-rate industries such as power generation, regulators write excessively burdensome proposed rules that incentivize investment by increasing the certainty of regulation, even if the final rule is less burdensome than originally proposed); Aaron Nielson, Sticky Regulations, 85 U. Chi. L. Rev 85 (2018) (asserting that ossification creates incentives for firms to invest because it provides certainty that the rule will remain on the books for a prolonged period of time).
  12. See, e.g., John C. Coates IV, Cost-Benefit Analysis of Financial Regulation: Case Studies and Implications, 124 Yale L.J. 882, 882, 887 (2015) (arguing that cost-benefit analysis of financial regulation would result in a “guesstimation” and proposing that expert judgment is central to financial regulation); Masur & Posner, supra note 4 (celebrating judicial review of cost-benefit analysis and noting that such a review constitutes a “decision procedure” that agencies are then required to comply with).
  13. See Daniel Hemel, President Trump vs. the Bureaucratic State, Yale J. on Reg.: Notice & Comment (Feb. 18, 2016), http://yalejreg.com/nc/president-trump-vs-the-bureaucratic-state-by-daniel-hemel [https://perma.cc/BE56-R5DU] (observing that President Trump “might not have the bureaucratic buy-in necessary to carry those [deregulatory] policies through”).
  14. See generally Bamberger, supra note 9 (documenting the change in regulatory form from top-down to bottom-up regulation that relies on private actors to accomplish administrative goals).
  15. Motor Vehicle Mfrs. Ass’n of United States, Inc. v. State Farm Mut. Auto. Ins., 463 U.S. 29, 43 (1983) (citation and internal quotation marks omitted).
  16. Note, Judicial Review of Agency Change, 127 Harv. L. Rev. 2070, 2085 (2014).
  17. See generally Mendelson, supra note 8.
  18. Jennifer Nou, Bureaucratic Exit and Loyalty Under Trump, Yale J. on Reg.: Notice & Comment (Jan. 9, 2018), http://yalejreg.com/nc/bureaucratic-exit-and-loyalty-under-trump [https://perma.cc/X3CV-6XKA].
  19. See, e.g., Zeeshan Aleem, Trump Wants to Gut the State Department by 25 Percent. You Read That Right., Vox Media (Feb. 12, 2018, 6:50 PM EST), https://www.vox.com/policy-and-politics/2018/2/12/17004372/trump-budget-state-department-defense-cuts [https://perma.cc/T4U4-W6JJ].
  20. State Farm, 463 U.S. at 42–43 (citation and internal quotation marks omitted).
  21. Note, Rationalizing Hard Look Review After the Fact, 122 Harv. L. Rev. 1909, 1914 (2009).
  22. Core Principles for Regulating the United States Financial System, Exec. Order No. 13,772, 82 Fed. Reg. 9965 (Feb. 8, 2017).
  23. State Farm, 463 U.S. at 43.
  24. Note, Judicial Review of Agency Change, supra note 16, at 2085.
  25. 5 U.S.C. § 500 et seq. (2012).
  26. 5 U.S.C. § 551(5) (2012).
  27. See 5 U.S.C. § 553 (2012).
  28. Federal Rulemaking: Improvements Needed to Monitoring and Evaluation of Rules Development as well as to the Transparency of OMB Regulatory Reviews, Gov’t Accountability Off. 17 (Apr. 2009), http://www.gao.gov/assets/290/288538.pdf [https://perma.cc/A5N3-5DDH].
  29. For instance, OMB and OIRA review has been embraced and enhanced by presidents since President Ronald Reagan “creat[ed] a mechanism by which the Office of Management and Budget . . . would review all majority regulations of executive branch agencies.” Elena Kagan, Presidential Administration, 114 Harv. L. Rev. 2245, 2247 (2001).
  30. Thomas O. McGarity, Thoughts on “Deossifying” the Rulemaking Process, 41 Duke L.J. 1385, 1389 n.22 (1992).
  31. Throughout this Essay, I refer to the current administration as a pertinent example. The impediments to deregulation in the face of a pro-deregulation presidential administration are not limited to the current administration.
  32. Kagan, supra note 29, at 2248, 2250.
  33. See Mendelson, supra note 8, at 561–64.
  34. See Nielson, supra note 11.
  35. Mendelson, supra note 8, at 563 n.27.
  36. Id. at 563–64.
  37. Cf. id. at 610–16.
  38. See id. at 612–13.
  39. See, e.g., Dan Wood, Principals, Bureaucrats, and Responsiveness in Clean Air Enforcements, 82 Am. Pol. Sci. Rev. 213, 213 (1988) (finding “that the influence of elected institutions is limited when an agency has substantial bureaucratic resources and a zeal for their use”); see also Hemel, supra note 13 (briefly summarizing the literature and noting that Trump “might not have the bureaucratic buy-in necessary to carry those policies through”).
  40.  Wood, supra note 39, at 217–27.
  41. Id. at 229.
  42. Id.
  43. 332 U.S. 194 (1947).
  44.  470 U.S. 821 (1985).
  45. See 5 U.S.C. § 554(d) (2006).
  46. See Matthew C. Turk, Regulation by Settlement, 66 Kansas L. Rev 259 (2017).
  47. See Id.
  48. See infra Part I.B.
  49. See, e.g., Patrick Rucker, Exclusive: Trump Official Quietly Drops Payday Loan Case, Mulls Others – Sources, Reuters (Mar. 23, 2018, 3:04 AM), https://www.reuters.com/article/us-usa-cfpb-payday-exclusive/exclusive-trump-official-quietly-drops-payday-loan-case-mulls-others-sources-idUSKBN1GZ1A9 [https://perma.cc/7WJ3-S82Z].
  50. Bamberger, supra note 9, at 383.
  51. See id. at 385–89.
  52. Regulatory Planning and Review, Exec. Order No. 12,866, § 1(b)(8), 3 C.F.R. 638 (1994); see also Improving Regulation and Regulatory Review, Exec. Order 13,563, § 1(b)(4), 3 C.F.R. 13,563 (2012) (continuing the mandate).
  53.  Cary Coglianese & David Lazer, Management-Based Regulation: Prescribing Private Management to Achieve Public Goals, 37 Law & Soc’y Rev. 691, 694 (2003).
  54. Id.
  55. See NRC: Reactor Oversight Process (ROP), U.S. Nuclear Reg. Comm’n (Apr. 20, 2018), https://www.nrc.gov/reactors/operating/oversight.html [ https://perma.cc/DC9D-WPCF].
  56. See NRC Inspection Manual, U.S. Nuclear Reg. Comm’n (Oct. 3, 2017), https://www.nrc.gov/docs/ML1726/ML17264A782.pdf [https://perma.cc/BX7U-ER6L].
  57. Galit A. Sarfaty, Regulating Through Numbers: A Case Study of Corporate Sustainability Reporting, 53 Va. J. Int’l L. 575, 583 (2013).
  58.  “Dissatisfaction . . . with traditional regulatory strategies has prompted interest in alternatives to traditional command and control regulation” including “a wide range of ‘rule at a distance’ methods in which various forms of standard-setting and self-regulation are used instead of more command-and-control based forms.” Scott Burris, Michael Kempa & Clifford Shearing, Changes in Governance: A Cross-Disciplinary Review of Current Scholarship, 41 Akron L. Rev. 1, 38 (2008). For instance, in the context of financial regulation scholars have noted that “[t]he administrative state, through regulatory law, uses internal corporate structures to effectuate public policy, which effectively transforms the large corporation into a quasi-governmental actor that functions as a kind of self-regulatory organization.” Mercer Bullard, Caremark’s Irrelevance, 10 Berkeley Bus. L. J. 15, 22 (2013). In food safety regulation, the Federal Food, Drug, and Cosmetic Act “requires owners and operators of food facilities to evaluate the hazards that could affect food, and implement and monitor preventative controls.” Diana R. H. Winters, Not Sick Yet: Food-Safety-Impact Litigation and Barriers to Justiciability, 77 Brook. L. Rev. 905, 911–12 (2012).
  59. 463 U.S. 29 (1983).
  60. 42 U.S.C. § 18,001 (2012).
  61. Id. at §§ 3011–15.
  62. See, e.g., 21 C.F.R. § 1143.5(a) (2018) (requiring cigar manufacturers to place warning on their products “in at least 12-point font” that is “printed in conspicuous and legible Helvetica bold or Arial bold type”).
  63. Anthony Effinger, The Rise of the Compliance Guru—and Banker Ire, Bloomberg, (June 25, 2015, 3:00 AM PDT), http://www.bloomberg.com/news/features/2015-06-25/compliance-is-now-calling-the-shots-and-bankers-are-bristling [https://perma.cc/CQ5C-4XH8].
  64. Large Commercial Banks, Fed. Res. (Sept. 30, 2017), https://www.federalreserve.gov/releases/lbr/current [[https://perma.cc/AK3X-SAKR].
  65. Annual Report 2015, JPMorgan Chase & Co. 15 (2016), http://www.jpmorganchase.com/corporate/investor-relations/document/2015-annualreport.pdf [https://perma.cc/AHM8-247W] (“Since 2011, our total headcount directly associated with Controls has gone from 24,000 people to 43,000 people, and our total annual Controls spend has gone from $6 billion to approximately $9 billion annually over that same time period.”).
  66. Annual Report 2016, The Goldman Sachs Group, Inc. 57 (2017), http://www.goldmansachs.com/investor-relations/financials/current/annual-reports/2016-annual-report/annual-report-2016.pdf [https://perma.cc/XZT8-X68P].
  67. Thomson Reuters Annual Cost of Compliance Survey Shows Regulatory Fatigue, Resource Challenges and Personal Liability to Increase Throughout 2015, Thomson Reuters (May 13, 2015), https://www.thomsonreuters.com/en/press-releases/2015/may/cost-of-compliance-survey-shows-regulatory-fatigue-resource-challenges-personal-liability-to-increase.html. [https://perma.cc/G72B-VN4E]
  68. Margot Patrick, HSBC Third-Quarter Earnings: Key Takeaways, Wall St. J. (Nov. 3, 2014, 6:05 AM ET), http://blogs.wsj.com/moneybeat/2014/11/03/hsbc-third-quarter-earnings-key-takeaways [https://perma.cc/YDA2-XHDV].
  69. A Set of Blueprints for Success, EY & Institute of International Finance 13 (2016), http://www.ey.com/Publication/vwLUAssets/ey-a-working-set-of-blueprints-to-deliver-sustainable-returns/$FILE/ey-a-working-set-of-blueprints-to-deliver-sustainable-returns.pdf [https://perma.cc/WF4A-YC5W].
  70. See Form 10-K: Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Year Ended December 31, 2010, Morgan Stanley 97, https://www.sec.gov/Archives/edgar/data/895421/000119312511050049/d10k.htm [https://perma.cc/EQB3-HNW3].
  71. See Form 10-K, Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Year Ended December 31, 2016, Morgan Stanley, 75–76, https://www.sec.gov/Archives/edgar/data/895421/000119312517059212/d328282d10k.htm [https://perma.cc/R5GQ-S5T7].
  72. Form 10-K: Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Year Ended December 31, 2016, Citigroup, Inc. 65, https://www.sec.gov/Archives/edgar/data/831001/000083100117000038/c-12312016x10k.htm [https://perma.cc/B5BA-4RR7].
  73. See Form 10-K: Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Year Ended December 31, 2011, Goldman Sachs Group, Inc. 84, http://www.sec.gov/Archives/edgar/data/886982/000119312512085822/d276319d10k.htm [ https://perma.cc/B2L2-75K4].
  74. See Form 10-K: Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Year Ended December 31, 2016, Goldman Sachs Group, Inc. 84, https://www.sec.gov/Archives/edgar/data/886982/000119312517056804/d308759d10k.htm [https://perma.cc/6NYA-E4P5].
  75. See Timothy F. Malloy, Regulation, Compliance and the Firm, 76 Temp. L. Rev. 451, 453–55 (2003); Robert A. Prentice, The Inevitability of a Strong SEC, 91 Cornell L. Rev. 775, 780 (2006) (“In the deregulation worldview, investors, securities professionals, and ancillary actors such as auditors and attorneys are rational.”). See also supra note 10.
  76. See, e.g., Tom Ginsburg et al., Libertarian Paternalism, Path Dependence, and Temporary Law, 81 U. Chi. L. Rev. 291 (2014) (discussing the stickiness of a smoking moratorium in bars).
  77. See Nielson, supra note 12, at 133.
  78. For instance, Dodd-Frank alone costs banks an estimated $36 billion. Dodd-Frank Costs Reach $36 billion in Sixth Year, Bloomberg Brief (July 22, 2016), https://www.bloomberg.com/professional/blog/dodd-frank-costs-reach-36-billion-sixth-year-2 [ https://perma.cc/NRR5-RT2S].
  79.  Richard A. Posner, The Effects of Deregulation on Competition: The Experience of the United States, 23 Fordham Int’l L. J. S7, S17 (2000).
  80. Id.
  81. Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305, 311 (1976).
  82. See id. at 334–37.
  83. See, e.g., Sungbin Cho, Specialization, Agency Cost and Firm Size, Econometric Soc’y 2004 Far Eastern Meetings 705 (2004).
  84. See supra Part I.A.
  85. Emily Flitter et al., Federal Reserve Shackles Wells Fargo After Fraud Scandal N.Y. Times (Feb. 2, 2018), https://www.nytimes.com/2018/02/02/business/wells-fargo-federal-reserve.html [https://perma.cc/YQ7X-FGFF].
  86. See Fletcher Cyclopedia of the Law of Private Corporations, § 1037 (2017).
  87. See generally Thomas W. Malone, Decentralization is the New Center of Command (Harvard 2010).
  88. See generally David S. Scharfstein & Jeremy C. Stein, The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment, 6 J. Fin. 2537 (2000).
  89. Id.
  90. Id. at 2551.
  91. Id.
  92. Andrei Shleifer & Robert W. Vishny, Management Entrenchment: The Case of Manager Specific Investments, 25 J. Fin. Econ. 123, 123 (1989).
  93. Id. at 124.
  94. Id. at 126.
  95. But see infra Part II.A.3 (The value may come from transferability of knowledge that occurs.).
  96. Coglianese & Lazer, supra note 53, at 695.
  97. See generally Robert M. Grant, Toward a Knowledge-Based Theory of the Firm, 17 Strategic Mgmt. J. 109 (1996).
  98. Id.
  99. See generally Michael C. Jensen & William H. Meckling, Specific and General Knowledge and Organizational Structure, 8 J. Applied Corp. Fin. 251 (1995).
  100. Grant, supra note 97, at 114 (emphasis added).
  101. See id. at 118 (Once firms are viewed as institutions for integrating knowledge, a major part of which is tacit and can be exercised only by those who possess it, then hierarchical coordination fails . . . . Only one of the integration mechanism . . . is compatible with hierarchy: integration through rules and directives.”).
  102. Id.
  103. See generally David B. Clarke et al., No Alternative? The Regulation and Professionalization of Complementary and Alternative Medicine in the United Kingdom, 10 Health & Place 329 (2004) (discussing the increased professionalization of alternative medicine after Parliamentary Inquiry).
  104.  Kenneth A. Bamberger, Privacy on the Books and on the Ground, 63 Stan. L. Rev. 247, 277 (2010) (noting the importance of “the increasingly professionalized privacy-officer community”).
  105. See Margali S. Larson, The Rise of Professionalism: A Sociological Analysis 190–91 (Transaction Publishers 1977).
  106. See William A. Birdthistle & M. Todd Henderson, Becoming a Fifth Branch, 99 Cornell L. Rev. 1, 46 (2013) (noting that financial compliance staffs may build a “culture of compliance” that is difficult for the rest of the firm to overcome).
  107.  Sapna Maheshwari, Statue of Girl Confronts Bull, Captivating Manhattanites and Social Media, N.Y. Times (Mar. 8, 2017), https://www.nytimes.com/2017/03/08/business/media/fearless-girl-statue-wall-street-womens-day.html [https://perma.cc/64CF-YSXF].
  108. See George Tepe, Boards Should Use Diversity as a Defense Against Activists, CLS Blue Sky Blog (Sept. 21, 2017), http://clsbluesky.law.columbia.edu/2017/09/21/boards-should-use-diversity-as-a-defense-against-activists [https://perma.cc/5YQC-D6P2].
  109. See Maheshwari, supra note 107.
  110. See Final Rule: Proxy Voting by Investment Advisors, 17 C.F.R. § 275.206(4)-6, § 275.204-2 (2012), https://www.sec.gov/rules/final/ia-2106.htm [https://perma.cc/9HGF-PWQT].
  111. See Dorothy S. Lund, The Case Against Passive Shareholder Voting, 43 J. Corp. L. 493, 515-20 (2018).
  112.  See Tepe, supra note 108.
  113. See Miriam A. Cherry & Judd F. Sneirson, Chevron, Greenwashing, and the Myth of “Green Oil Companies,” 3 Wash & Lee Energy, Climate & Env’t 133 (2012).
  114. See Leora Klapper et al., Entry Regulation as a Barrier to Entrepreneurship, 82 J. Fin. Econ. 591 (2006).
  115. See Birdthistle and Henderson, supra note 106, at 44.
  116.  Sam Schechner & Nick Kostov, Google and Facebook Likely to Benefit From Europe’s Privacy Crackdown, Wall St. J. (April 23, 2018, 10:18 PM ET), https://www.wsj.com/articles/how-europes-new-privacy-rules-favor-google-and-facebook-1524536324 [https://perma.cc/998P-JA3K].
  117. See Jeffrey A. Singer, Obamacare’s Catch 22, U.S. News (Aug. 11, 2016, 3:15 PM), https://www.usnews.com/opinion/articles/2016-08-11/obamacare-gave-rise-to-the-health-care-mergers-its-advocates-oppose [https://perma.cc/8FT6-UEVS].
  118.  In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959, 970 (Del. Ch. 1996).
  119. See Kenneth A. Bamberger & Deirdre K. Mulligan, New Governance, Chief Privacy Officers, and the Corporate Management of Information Privacy in the United States: An Initial Inquiry, 33 L. & Pol’y. 477 (2011).
  120. Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006).
  121. See In re Citigroup Inc. Shareholder Derivative Litig., 964 A.2d 106, 123–24 (Del. Ch. 2009).
  122. Id. at 124 (“When one looks past the lofty allegations of duties of oversight and red flags used to dress up these claims, what is left appears to be plaintiff shareholders attempting to hold the director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company.”).
  123.  Brian J. McCarthy and Janisha Sabnani, Risk Governance Will Be the Talk in Corporate Boardrooms in 2010, S.F. Daily J. (Dec. 28, 2009).
  124. See Bamberger & Mulligan, supra note 119.
  125. See generally Douglas W. Diamond & Robert E. Verrecchia, Disclosure, Liquidity, and the Cost of Capital, 46 J. Fin. 1325 (1991) (suggesting that decreasing the information asymmetry between investors and the firm can reduce the firm’s cost of capital).
  126. Prentice, supra note 75, at 780–81 (discussing how rational issuers will self-regulate disclosures because of reputational constraints).
  127. See, e.g., Analysts Grill Goldman CFO Over Lack of Leverage Ratio Detail, Reuters (July, 16, 2013, 8:15 AM), http://www.reuters.com/article/goldman-results-call-idUSL1N0FM0U920130716 [https://perma.cc/AG5D-CPCP].
  128. See Alexandra Niessen-Runzi, Jerry Parwarda & Stefan Rueniz, Information Effects of the Basel Bank Capital and Risk Pillar 3 Disclosures on Equity Analyst Research—An Exploratory Examination, CIFR Working Paper Series (Aug. 2015), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2670418 [https://perma.cc/8PU7-QJV3].
  129. See Wood, supra note 39, at 217–27.
  130. See Donald C. Langevoort, Monitoring: The Behavioral Economics of Corporate Compliance With Law, 2002 Colum. Bus. L. Rev. 71, 83–90 (noting the difficulties managers have in monitoring compliance professionals).
  131. See id.
  132. See Jonathan Masur, Judicial Deference and the Credibility of Agency Commitments, 60 Vand. L. Rev. 1021, 1041–42 (2007).
  133. See Nielson, supra note 11.
  134. See David Zaring, Best Practices, 81 N.Y.U. L. Rev. 294, 304–05 (2006) (noting that scholars suggest agencies “look to the private sector for assistance with rule generation”).