Constitutional Avoidance and Presidential Power

* Associate, Wachtell, Lipton, Rosen & Katz. The views expressed in this Essay are my own, and do not necessarily reflect the views of the firm or its clients.

Introduction

Recent developments have brought renewed attention to statutes designed to constrain and discipline the President. The federal anti-nepotism statute, the federal conflict of interest statute, and the Federal Advisory Committee Act all appear set to endure unusual stress in the coming years. Troublingly, these statutes have already been given limited constructions that weaken their power to restrain the President. Under the constitutional avoidance canon, courts construe statutes so as to avoid constitutional questions. Citing the avoidance canon and the President’s (sometimes merely arguable) constitutional prerogatives, courts have limited the scope of statutes meant to discipline the presidency. The application of constitutional avoidance in this context is uniquely troubling. The President is an active participant in the legislative process, and can use his veto power to protect his prerogatives for himself. As a result, judicial avoidance can greatly extend presidential power in a way that is difficult for Congress to reverse. The President’s unique powers also make the application of constitutional avoidance particularly problematic in this context.

Recent developments have brought renewed attention to statutes designed to constrain and discipline the President. The federal anti-nepotism statute, the federal conflict of interest statute, and the Federal Advisory Committee Act all appear set to endure unusual stress in the coming years. Troublingly, these statutes have already been given limited constructions that weaken their power to restrain the President. Under the constitutional avoidance canon, courts construe statutes so as to avoid constitutional questions. Citing the avoidance canon and the President’s (sometimes merely arguable) constitutional prerogatives, courts have limited the scope of statutes meant to discipline the presidency. The application of constitutional avoidance in this context is uniquely troubling. The President is an active participant in the legislative process, and can use his veto power to protect his prerogatives for himself. As a result, judicial avoidance can greatly extend presidential power in a way that is difficult for Congress to reverse. The President’s unique powers also make the application of constitutional avoidance particularly problematic in this context.

I. Constitutional Avoidance

News reports have suggested that various norms will be under unusual strain in the coming years. For example, while the text of the federal anti-nepotism statute, 5 U.S.C. § 3110, seems to prevent the President from appointing close relatives to any civilian role, the President’s son in law and daughter were recently appointed to White House positions.1

But even when statutory text cuts against such arrangements, courts seem willing to distort such texts to expand presidential discretion. For example, in Public Citizen v. United States Department of Justice2 the Supreme Court gave a limited interpretation to the Federal Advisory Committee Act (“FACA”). The FACA was enacted by Congress to bring order to the patchwork of committees, boards, and commissions created to advise executive branch officials.3 Where it applies, it imposes strict procedural requirements, including various disclosures.4 In Public Citizen, the Court considered whether FACA applied to executive consultations with the American Bar Association regarding judicial nominations.

The Supreme Court adopted a narrow reading of FACA that excluded the American Bar Association’s advice. While various considerations supported the decision, the Court was ultimately persuaded by the constitutional avoidance canon: “When the validity of an act of the Congress is drawn in question, and even if a serious doubt of constitutionality is raised, it is a cardinal principle that this Court will first ascertain whether a construction of the statute is fairly possible by which the question may be avoided.”5 Acknowledging the lower court’s concern that the statute “infringed unduly on the President’s Article II power to nominate federal judges and violated the doctrine of separation of powers,”6 the Supreme Court adopted a narrow FACA interpretation that avoided the constitutional question by excluding the consultations.7

Similarly, in Association of American Physicians and Surgeons v. Clinton, the District of Columbia Circuit held that the FACA did not apply to a presidential task force on health care, a group chaired by then-First Lady Hillary Rodham Clinton.8 The court was moved by constitutional concerns, stating that “Article II not only gives the President the ability to consult with his advisers confidentially, but also, as a corollary, it gives him the flexibility to organize his advisers and seek advice from them as he wishes.”9 Instead of deciding whether this principle would make it unconstitutional for Congress to regulate the task force, the court adopted a limited reading of the statute that excluded the task force.10

II. Presidential Involvement in the Legislative Process

The constitutional avoidance canon is well entrenched, though it has been heavily criticized.11 But the canon is particularly problematic in this context, given the President’s involvement in the legislative process. The President’s veto power over legislation allows him to defend his constitutional prerogatives for himself, and means that the constitutional avoidance canon can have an unusually distortive effect in this context.12

To illustrate, imagine that the extent of the President’s power is mapped on a single line.13 The point “P” refers to the President’s preferred level of power. The closer one gets to “P,” the more satisfied the President will be; the farther away, the less satisfied he will be. Similarly, “C” refers to Congress’s preferred level of presidential power, and “Cv” captures the preferences of the member of Congress whose vote will decide whether a presidential veto is sustained or overridden.14 Suppose that Congress passes a statute designed to change the situation from the status quo (“S”) to Congress’s preferred outcome (“C”):

1

The statute would be vulnerable to a veto. If the president vetoed the bill, the member of Congress whose vote will decide whether the veto is sustained will support the president — “S” is closer to “Cv” than “C” is, so the member would prefer the status quo to the bill.

Acting strategically, Congress might adopt a less aggressive measure, designed to bring about an intended outcome (“I”):15

2

If the President attempted to veto this legislation, his veto would be overridden: “I” is closer to “Cv” than “S,” meaning that the member of Congress whose vote will decide whether the presidential veto is sustained would prefer that the legislation remain intact.

This example demonstrates that, in the context of presidential power, the veto serves functions normally filled by the constitutional avoidance canon. It serves to resist intrusions on the relevant constitutional value, forcing Congress to back away from its preferred outcome “C” to a more moderate outcome “I,” and it demands an unusual degree of agreement within Congress before a more intrusive measure can be adopted.16 the burden of overcoming legislative inertia to those opposing the Court’s understanding of public values”); Trevor W. Morrison, Constitutional Avoidance in the Executive Branch, 106 Colum. L. Rev. 1189, 1212 (2006) (describing normative justifications for the avoidance canon as advanced by Professors Ernest Young and William Eskridge); Ernest A. Young, Constitutional Avoidance, Resistance Norms, and the Preservation of Judicial Review, 78 Tex. L. Rev. 1549, 1552 (2000) (rule enforces constitutional values by making it “harder—but still not impossible—for Congress to write statutes that intrude into areas of constitutional sensitivity”).] And this conclusion flows from the President’s formal powers alone. The President also has informal tools for shaping legislation, which amplify the effect.17 effective control into branches of government other than his own and he often may win, as a political leader, what he cannot command under the Constitution.”).]

The avoidance canon amplifies the effect even further. Suppose that a court, uncomfortable with the constitutional questions raised by the statute, adopts a judicial interpretation more favorable to the President (“J”):

3

Congress might seek to undo the interpretation with a new statute: 4

But this new statute would be vulnerable to a presidential veto.18 Since “J” is closer to “Cv” than “I,” the member of Congress whose vote will decide whether the presidential veto is sustained would back the President.

In sum, the judicial interpretation has the effect of making it impossible for Congress to achieve its desired outcome of “I.”19 Importantly, if the courts insist on this outcome because of “constitutional avoidance” instead of an actual violation of the Constitution, it is entirely possible that “I” — the outcome that the courts have prevented Congress from achieving — is a constitutional outcome that is within Congress’s legitimate power.

III. Unique Concerns with Presidential Power

Using the avoidance canon to give the President flexibility poses other problems. First, it emboldens the executive branch in potentially dangerous ways. The executive often interprets statutes, without any opportunity for judicial review.20 In these contexts, the executive can adopt a self-serving understanding of potential constitutional issues, and use that understanding to reshape statutes as it pleases without judicial discipline.21 Recent history suggests that this is not a purely theoretical concern.22 In an age when serious scholars remark that “the legally constrained executive is now a historical curiosity,”23 there is little need to further embolden the executive.

Second, the avoidance canon muddies the issues. The limits of presidential power cannot be identified in isolation — they emerge from the relationship between the President and Congress. Per the tripartite scheme articulated in Justice Jackson’s concurring opinion in Youngstown Sheet & Tube Co. v. Sawyer, the strength of the President’s authority depends on Congress’s position: “When the President acts pursuant to an express or implied authorization of Congress, his authority is at its maximum,” when he “acts in the absence of either a congressional grant or denial of authority” his authority is in a “zone of twilight,” and when he “takes measures incompatible with the expressed or implied will of Congress, his power is at its lowest ebb.”24 Avoidance blurs the categories: it treats presidential acts incompatible with statutory text as if they were consistent with a statute reinterpreted to avoid conflict.

Third, the canon distorts the balance of power between the branches. Institutionally, Congress must speak in generalities through universally applicable laws, while the President is able to make targeted decisions.25 That is particularly true in the context of statutes like FACA, which is intended to address extemporaneous groups instead of agencies established by statute. Congress cannot anticipate every group that the executive may be inspired to convene at some later time. By requiring Congress to speak with particularity, the constitutional avoidance canon places the burden of prediction on Congress, when it is often more reasonable to insist that the President anticipate problems and request an accommodation from Congress. Congress has proven willing to entertain such requests.26

Finally, presidential power often conflicts with other constitutional values, which Congress seeks to enforce through statutory law. When Congress adopted statutes prohibiting torture and limiting surveillance, it was defending values that find support in the First, Third, Fourth, Fifth, and Eight Amendments to the Constitution.27 Similarly, ethics statutes defend anti-corruption values that find support in the Emoluments Clauses.28 When avoidance is used to narrow these statutes, their underlying constitutional values are diminished in favor of the somewhat unclear29 constitutional provision vesting the “executive power” in the President.30

IV. Conclusion

The constitutional avoidance canon creates special problems when it is used to defend presidential prerogatives. In that context, its role is already filled by the presidential veto, and the presidential veto amplifies its distortive effect. The doctrine also interacts dangerously with the unique powers of the presidency. As statutes constraining the President are placed under stress, both courts and executive actors should hesitate to weaken them by deploying the canon of constitutional avoidance.

  1. See, e.g., Jackie Northam & Marilyn Geewax, Ivanka Trump’s Move to the White House Raises Questions About Ethics, NPR (Mar. 21, 2017), http://www.npr.org/sections/thetwo-way/2017/03/21/520965076/ivanka-trumps-move-to-the-white-house-raises-questions-about-ethics; Steve Holland & Emily Stephenson, Trump’s son-in-law Kushner to become senior White House adviser, Reuters (Jan 10, 2017), http://www.reuters.com/article/us-usa-trump-kushner-idUSKBN14T251. The Department of Justice’s Office of Legal Counsel blessed Kushner’s appointment in a memorandum alluding to avoidance principles. See Application of the Anti-Nepotism Statute to a Presidential Appointment in the White House Office, 41 Op. O.L.C. 1, 13 (2017).
  2. 491 U.S. 440 (1989).
  3. Id. at 445-46.
  4. Id. at 446.
  5. Id. at 465-66 (quoting Crowell v. Benson, 285 U.S. 22, 62 (1932)).
  6. Id. at 466.
  7. Id. at 467.
  8. 997 F.2d 898 (D.C. Cir. 1993).
  9. Id. at 909.
  10. Id. at 911. The court also briefly commented on the anti-nepotism statute. See id. at 905.
  11. See Caleb Nelson, Avoiding Constitutional Questions Versus Avoiding Unconstitutionality, 128 Harv. L. Rev. F. 331, 331 (2015) (noting that “critics include the most eminent circuit judge of the last generation, two of the most eminent circuit judges of the present generation, and a host of thoughtful scholars”).
  12. These issues do not apply when the canon is used to protect judicial instead of presidential prerogatives. See, e.g., Immigration & Naturalization Serv. v. St. Cyr, 533 U.S. 289, 300-01 (2001) (avoiding the constitutional issues that would be raised if Congress stripped courts of jurisdiction). Unlike the President, courts cannot affect statutory text. Avoidance in that context can also be an expression of judicial humility. Indeed, the Supreme Court’s greatest assertion of judicial power was based on the opposite approach – construing a statute so as to raise constitutional issues. See Akhil Reed Amar, Marbury, Section 13, and the Original Jurisdiction of the Supreme Court, 56 U. Chi. L. Rev. 443, 456 (1989) (arguing that the Court adopted a questionable statutory interpretation in Marbury v. Madison, 5 U.S. 137 (1803)).
  13. Figures like this one are used to capture legislative dynamics in Robert D. Cooter, The Strategic Constitution 215 (1999).
  14. In the event of a presidential veto, Congress could override by a two-thirds vote in both houses. See U.S. Const. Art. I, § 7. As a result, the person who would decide whether a veto is sustained or overridden would have preferences somewhere between those of the President (“P”) and a simple majority of Congress (“C”).
  15. As a possible example, the War Powers Resolution survived President Nixon’s veto, but incorporated compromises that actually expanded presidential power in significant ways. See Arthur M. Schlesinger, Jr., The Imperial Presidency 301-07 (3d ed. 2004).
  16. See, e.g., The Constitutional Separation of Powers Between the President and Cong., 20 Op. O.L.C. 124, 178 (1996) (stating that rule is intended in part to require unusual degree of agreement in Congress); Philip P. Frickey, Getting from Joe to Gene (McCarthy): The Avoidance Canon, Legal Process Theory, and Narrowing Statutory Interpretation in the Early Warren Court, 93 Cal. L. Rev. 397, 401 (2005) (avoidance can “shift[
  17. See Youngstown Sheet & Tube Co. v. Sawyer, 343 U.S. 579, 654 (1952) (Jackson, J., concurring) (“Party loyalties and interests, sometimes more binding than law, extend [the President’s
  18. See Neal Kumar Katyal & Thomas P. Schmidt, Active Avoidance: The Modern Supreme Court and Legal Change, 128 Harv. L. Rev. 2109, 2119-22 (2015); Morrison, supra note 16 at 1234.
  19. Applying the avoidance doctrine in this context can actually create more distortion than striking down the entire statute as a violation of the constitution. If the statute were struck down, the status quo “S” would be restored. There would thus be a broader range of legislation that would survive a presidential veto, since the member of Congress whose vote would decide whether a veto is overridden dislikes “S” more than she dislikes “J.” Congress would thus have a freer hand to legislate to the limits of its constitutional authority. While that limit would be to the right of “I,” it would be at or to the left of “J.”
  20. Morrison, supra note 16, at 1196-97.
  21. For this reason, some have urged that the executive branch should not apply the constitutional avoidance canon where presidential power is concerned. See H. Jefferson Powell, The Executive and the Avoidance Canon, 81 Ind. L.J. 1313, 1315 (2006); but see Morrison, supra note 16, at 1229-32 (urging that the executive use of the avoidance canon to weaken the statutory prohibition on torture was flawed on other grounds). But as shown above, the canon is problematic in the presidential power context even when courts apply it.
  22. See Katyal & Schmidt, supra note 18, at 2118 n.33 (listing recent aggressive executive interpretations of statutes).
  23. Eric A. Posner & Adrian Vermeule, The Executive Unbound 4 (2010).
  24. 343 U.S. 579, 635-37 (1952).
  25. See Aneil Kovvali, Power Games, 112 Mich. L. Rev. First Impressions 73, 75 (2014).
  26. See Josh Gerstein, Trump Owes Ethics Exemption to George H.W. Bush, Politico (Nov. 13, 2016), http://www.politico.com/story/2016/11/trump-bush-ethics-exemption-231773 (noting that Congress carved out an exception to the federal conflict of interest statute in response to executive request). Indeed, the executive has sometimes underestimated Congress’s willingness to cooperate. See Jack Goldsmith, The Terror Presidency 138-40, 207-08 (2009) (noting that Congress readily provided requested statutory authorities after courts had limited presidential power, but limiting decisions might have been prevented if the executive had simply requested authorities in advance).
  27. Constitutional avoidance was cited to diminish such statutes, despite their underpinnings. For a succinct treatment, see Trevor W. Morrison, The Canon of Constitutional Avoidance and Executive Branch Legal Interpretation in the War on Terror, 1 Advance 79, 85-94 (Spring 2007). Such application of constitutional avoidance is contrary to one of its strongest normative justifications — its effect of placing the burden of overcoming legislative inertia on the powerful when they seek changes that would harm the powerless. See Frickey, supra note 16, at 401; Einer Elhauge, Preference-Eliciting Statutory Default Rules, 102 Colum. L. Rev. 2162, 2210 (2002).
  28. U.S. Const. art. I, § 9, cl. 8; U.S. Const. art. II, § 1, cl. 7.
  29. See generally John F. Manning, Separation of Powers as Ordinary Interpretation, 124 Harv. L. Rev. 1939 (2011) (arguing that the concept of “separation of powers” does not have the precision often claimed for it).
  30. Indeed, any application of the constitutional avoidance canon to defend presidential power suffers from this problem, since it privileges the constitutional provisions that empower the President over provisions that empower Congress. This competition between constitutional principles suggests another drawback to application of the canon in the structural context. In other contexts, constitutional avoidance can help delay a constitutional decision as norms evolve. See Frickey, supra note 16, at 402-03. Norms around individual rights evolve rapidly. Compare Lawrence v. Texas, 539 U.S. 558 (2003) (invalidating sodomy laws); with Bowers v. Hardwick, 478 U.S. 186 (1986) (upholding sodomy laws); also compare W. Va. State Bd. of Educ. v. Barnette, 319 U.S. 624 (1943) (finding a constitutional right not to salute flag or recite pledge of allegiance); with Minersville School Dist. v. Gobitis, 310 U.S. 586 (1940) (holding that there is no such right). But there is no clear trend in structural norms that would routinely justify delay. See Schlesinger, supra note 15, at xxiv (describing cycles of expansion and contraction of executive power). Avoidance would only have value in a perceived emergency, where delay could prevent rash actions from being enshrined in constitutional law.

Give Gorsuch a 21st Century Litmus Test

* Mark Grabowski is a lawyer and associate professor of communications at Adelphi University in Long Island, where he teaches Internet law. He also is a nationally syndicated columnist for the Washington Examiner. Grabowski won the 2015 James Madison Prize for Outstanding Research in First Amendment Studies. For more information, visit markgrabowski.com.

Introduction

The United States Senate began confirmation hearings on March 20 to vet Neil Gorsuch, who was nominated to succeed the late Supreme Court Justice Antonin Scalia. Lawmakers are expected to apply litmus tests, probing him on issues such as abortion. They should also delve into his views on technology. As Wired’s political reporter Issie Lapowsky noted, “While liberals [focus] on such contentious issues as women’s reproductive rights and environmental protections, Gorsuch will also face cases that demand a solid command of the complex issues digital technology raises, from copyright and privacy to intellectual property rights and data storage.”1 Although Gorsuch has a decade’s experience serving as a judge on the U.S. Court of Appeals for the Tenth Circuit, he lacks an extensive record on tech-related cases and his decisions have been mixed, which should raise concerns about how he might decide such cases as a Supreme Court Justice. For example, Gorsuch is widely regarded as a strong supporter of free speech, including online speech, but he has not been as reliable an advocate for digital privacy. His support of network neutrality is far from certain. If confirmed, Gorsuch will likely rule on cases involving all of these issues and more. “The Supreme Court already has a list of digital civil liberties issues to consider in the near future, and that list is likely to grow,” predicted Kate Tummarello of the Electronic Frontier Foundation, a digital rights advocacy group. “If confirmed … Gorsuch … will be in a position to make crucial decisions affecting our basic rights to privacy, free expression, and innovation.”2 Indeed, he may be the deciding vote on important tech cases. During Scalia’s term, for example, the Supreme Court ruled 5-4 that the Child Online Protection Act violated the Free Speech clause of the First Amendment.3 “As we have seen with critical 5-4 decisions applying constitutional doctrine to changes in technology over the years . . . each and every Justice on the bench matters” – wrote Lisa Hayes, general counsel for the Center for Democracy & Technology, an internet rights group – “[w]e must take the time to thoroughly vet Judge Gorsuch and ensure we preserve an independent judiciary.”4

As it is, the High Court has “difficulty in handling the intersection of the [Constitution] with technology”5 and is often mocked for being “Hopelessly behind the times . . . out of touch . . . techno-fogeys.”6 For example, many of the Justices do not even use email.7 “The Justices are not necessarily the most technologically sophisticated people,” Justice Elena Kagan admitted.8 Without a tech savvy new Justice who appreciates how the average American uses computers, smart phones and social media, the Court risks taking a step backwards. That is because the new Justice’s predecessor had been the Court’s “standard-bearer” when it came to technology law.9 Despite his typically conservative views on social issues, Scalia was “shockingly forward-looking” on technology issues.10 In fact, he was considered a “hero”11 by tech and legal experts, who cite his “pro-technology” decisions on cases providing First Amendment rights for video games, privacy protections for smart phones, and regulations for network neutrality.12 Given that the Court will increasingly be called upon to make important judgments that relate to technology, experts say Scalia’s successor should demonstrate a genuine desire to keep up with the latest developments and provide guidance on how the Constitution should apply to the legal issues they raise—just as the late Justice did. Although President Donald Trump said he wants a Justice who is “‘very much in the mold of Justice Scalia’”13 and many court observers have dubbed Gorsuch “Scalia 2.0,”14 that may not be the case when it comes to technology law. An analysis of Scalia’s and Gorsuch’s decisions related to the First Amendment, Fourth Amendment and network neutrality indicate that the two jurists may be more different than similar. This should raise questions at the confirmation hearing by Democrat and Republican lawmakers alike.

I. Big Shoes to Fill

Scalia’s death leaves the Supreme Court with big shoes to fill when it comes to tech jurisprudence. He was widely regarded as a strong defender of technology. Even his biggest critics concede that he was progressive when it came to technology. “Scalia’s opinions were backwards in almost every possible arena,” observed Katharine Trendacosta, a staff writer at tech blog Gizmodo. “For all the harm he did sitting on the Court for nearly thirty years, Scalia was surprisingly adept at understanding technology.”15 Likewise, Jack Smith IV, who covers technology and inequality for millennial news site Mic, wrote: “Say what you want about Justice Antonin Scalia, he was great for technology.”16 Lisa Larrimore Oullette, a professor of technology law at Stanford Law School, called him “a pro-technology Justice.”17 Michael Bennett, a lawyer and associate research professor at Arizona State University’s School for the Future of Innovation in Society, labeled Scalia a “minor philosopher of technology.”18 Matthew Rozsa of Daily Dot, a blog covering Internet culture, added: “when it comes to Internet freedom, he may have been one of the great legal minds of our time.”19

In particular, video game enthusiasts owe a debt of gratitude to Scalia. He wrote the “historic majority opinion” in Brown v. Entertainment Merchants Association, which gave video games First Amendment protection.20 The Supreme Court’s ruling stopped California from regulating video games as products like cigarettes and alcohol instead of as a medium for expression like music, books, and movies.21 The Entertainment Software Association praised the decision: “It was a momentous day for our industry and those who love the entertainment we create and we are indebted to Justice Scalia for so eloquently defending the rights of creators and consumer everywhere.”22

Scalia also left an indelible mark on digital privacy laws.23 He made several key rulings, including requiring law enforcement to get a warrant before accessing the iPhone of a person they arrested,24 before using thermal imaging devices to search a home for marijuana,25 or before tracking a suspect using GPS.26 Scalia’s precedents continue to shape tech law and policy in other ways. For example, digital privacy advocates are now using the GPS precedent to challenge the constitutionality of Stingray-style devices.27 Smith, a tech journalist, said Scalia’s strong support of digital privacy rights has altered the way police conduct investigations: “[S]omewhere out there, there are police officers trying to use the most sophisticated technology of our time to peer into our lives in ways we never thought possible. And because of Antonin Scalia, someone is saying, ‘You’re going to need a warrant for that.’”28

Additionally, Scalia was “net neutrality’s unlikely hero,” according to Robinson Meyer, tech editor for The Atlantic.29 He went against the Court’s majority in a 2005 case, National Cable & Telecommunications v. Brand X Internet Services, arguing that Internet service was a telecommunications service, which made it subject to stricter government regulation.30 A decade later, the Federal Communications Commission reclassified Internet service as a telecommunication service in order to impose network neutrality—the principle that internet service providers should treat all data on the internet equally, not discriminating or charging differentially by user, content, or website.31 “It is certainly true that Justice Scalia’s dissent was pivotal to the FCC’s theories in the Open Internet Order,” said Peter Karanjia, co-chair of the appellate practice for law firm Davis Wright Tremaine. “The FCC in the order took pains to cite Justice Scalia’s opinion.”32

This is not to imply that Scalia was a computer whiz. During hearings, he sometimes asked embarrassing questions about technologies many Americans took for granted, such as cable television.33 He admitted to being “clueless” when it came to social media.34 And he staunchly opposed allowing cameras to broadcast Supreme Court hearings.35 But Scalia made great strides in understanding the latest technology. For example, at age 74, he boasted that he owned an iPod and an iPad and did so much work on his gadgets that he could “hardly write in longhand anymore.”36 Scalia also said that when he had to “take materials home for work, he use[d] a thumb drive, or accesse[d] the Court computer system remotely.”37 He even “joked that he played” the popular fighting game Mortal Kombat as part of his research in preparing for oral arguments in Brown.38

As a result, “he seemed to understand technology better than his peers,” according to Trendacosta.39 Likewise, Steve Vladeck, professor of law at University of Texas School of Law, said that “Justice Scalia was quick to grasp how particular technological innovations implicated constitutional protections in ways that might have taken his colleagues an additional step or two.”40 When reviewing Scalia’s body of work in technology cases, his legacy is nonpareil, according to experts. “[I]f there was any force in the forward-march of modern history that could consider Scalia a standard-bearer, it was technology . . . over and over again, he got it right,” Smith said.41 Stanford Law’s Oullette agreed: “[H]e deserves his reputation as a pro-technology Justice . . . . He supported legal rules that allow new technologies to flourish.”42

II. Gorsuch’s Mixed Record

Gorsuch has been dubbed “Scalia 2.0” by many court observers, including University of Michigan Law Professor Richard Primus, who wrote that Gorsuch is “not far from” being “Scalia reincarnated.”43 While that characterization may be accurate broadly speaking, it is less clear the two judges are identical when it comes to specific areas, especially technology law. Like Scalia, Gorsuch has a strong record defending free speech, including online speech. He also has some quirky preferences reminiscent of Scalia’s opposition to cameras in the courtroom. For example, while moonlighting as an adjunct law professor, Gorsuch “forbade students in his legal ethics class from using computers—an unusual move within law schools, where laptops are ubiquitous,” according to legal blog Above The Law.44 In contrast to Scalia, Gorsuch has been inconsistent in defending digital privacy rights. In addition, “Gorsuch, being the strict Constitutionalist that he is, may rule to strike down net neutrality regulations.”45 Given these disparities, Gorsuch’s record on technology deserves a closer look by the Senate.

On issues related to free speech, “it is readily apparent that” Gorsuch has a “long and informed commitment to the First Amendment,” according to Ronald Collins, a First Amendment professor at University of Washington School of Law.46 Gorsuch’s free speech advocacy includes defending the rights of online journalists. In a much-celebrated 2010 decision, Gorsuch joined Tenth Circuit in ruling that a college journalist had his constitutional rights violated when police searched his home and confiscated his computer after a professor complained of being libeled by the student’s online satirical newsletter. In his concurrence in Mink v. Knox, Gorsuch wrote that, “the First Amendment precludes defamation actions aimed at parody, even parody causing injury to individuals who are not public figures or involved in a public controversy.”47 The American Civil Liberties Union, Student Press Law Center and Foundation for Individual Rights in Education all lauded the court’s decision.48

On privacy matters, Gorsuch “has dealt with several Fourth Amendment cases that raised novel technology issues.”49 Based on his record on such cases, he does not appear to share Scalia’s “legacy as a defender of privacy rights”50 in technology. That said, as Orin S. Kerr, a George Washington University law professor who specializes in Fourth Amendment and technology issues observed, Gorsuch’s opinions suggest that he is “not a knee-jerk vote for the government.”51 Most recently, in August 2016, Gorsuch strengthened online privacy protections in United States v. Ackerman.52 That case—involving authorities searching emails for child pornography without a warrant—expanded the definition of what a search means, thereby expanding the types of situations that require a warrant to include instances where a person or organization is searching emails on behalf of the government.53 In a 2013 case, involving police officers erroneously stopping someone because of a faulty license plate database, then discovering evidence of a crime, Gorsuch ruled that the police’s use of the flawed technology made the search sufficiently unlawful to block prosecutors from using the drugs as evidence.54 In some cases, however, Gorsuch has sided with law enforcement. For example, in June 2016—despite Scalia’s and the Supreme Court’s 2012 ruling that police officers need warrants to monitor suspects’ movements by attaching GPS trackers to their cars—Gorsuch ruled that prosecutors could use GPS evidence without a warrant because the tracking occurred a year prior to the Supreme Court’s decision.55 In another blow to digital privacy, in the 2007 case United States v. Andrus, Gorsuch ruled that a 91-year-old man giving authorities permission to search his son’s computer files was sufficient consent under the Fourth Amendment.56 These inconsistent decisions indicate that Gorsuch could be a swing vote on digital privacy cases in the Supreme Court.

There is also doubt over whether Gorsuch will uphold network neutrality. Internet Service Providers have challenged the FCC’s policy in federal court and the case could eventually make its way to the Supreme Court by 2018 “by which point Gorsuch, of the Tenth Circuit, may be confirmed.”57 The FCC maintains that it has the authority to regulate the Internet based on the “Chevron doctrine,” named for a 1984 Supreme Court decision that expanded the regulatory power of the federal government, which Scalia “was often a defender of.”58 On the other hand, a “recent concurring opinion Gorsuch wrote from the appellate bench suggests that he could target just the sort of agency authority the FCC asserted in its net neutrality order.”59 In his August 2016 concurring opinion in Gutierrez-Brizuela v. Lynch, Gorsuch called Chevron, and a subsequent Supreme Court ruling that recognized the FCC’s authority to determine whether the Internet should be regulated as a telecommunications service, the “elephant in the room.”60 Gorsuch said the principles enshrined by Chevron “permit executive bureaucracies to swallow huge amounts of core judicial and legislative power and concentrate federal power in a way that seems more than a little difficult to square with the Constitution of the framers’ design.”61 According to Case Western Reserve University Law Professor Jonathan Adler, the issue of whether courts should defer to administrative agencies such as the FCC when a statute is ambiguous is “the greatest area of difference between Gorsuch and Scalia.”62

III. Tech Litmus Test

In addition to ruling on network neutrality, Gorsuch could make landmark rulings for technologies that have not even been imagined yet. Because Supreme Court Justices enjoy lifelong appointments, Gorsuch—who would be the youngest Justice on the current Supreme Court bench at 49 years old—could serve for three or four decades. Just within the next few years, several key issues involving technology are on the horizon. With Apple resisting the Federal Bureau of Investigation’s demand to help it hack a terrorist’s iPhone, Google’s data mining techniques leading to invasion of privacy lawsuits, and cyberbullying testing the limits of free speech, Ars Technica tech policy reporter Joe Silver predicts that “the Supreme Court is likely to be confronted with many . . . challenging technology cases, and it will play a central role in shaping the 21st century cyberlaw debate.”63

It is crucial that senators carefully vet Gorsuch to ensure he is the right jurist to decide such issues. Both his savvy and legal philosophy regarding technology should be examined. “Future nominees to the bench should be quizzed on their knowledge of technology at confirmation hearings,” suggested Trevor Timm, Executive Director of the Freedom of the Press Foundation.64 They do not need a million followers, or even a social media account. But, like Scalia, Court nominees should at least demonstrate a genuine desire to learn about \technology and attempt to properly balance innovation and expression with privacy and safety. “A justice typically isn’t confirmed or denied based on these kinds of issues,” said Shaun Bockert, an intellectual property attorney at Blank Rome.65 “There are hot button issues, and unfortunately whether software is copyrightable is not one of them.” But, as Wired’s Lapowsky notes, “that doesn’t mean these cases won’t have far-reaching implications for the tech industry and users of tech alike—which is to say pretty much everyone.”66 For everyone’s sake, the Senate must ensure Gorsuch is “very much in the mold of Justice Scalia” when it comes to technology.

  1. Issie Lapowsky, Trump’s SCOTUS Pick Needs to Get Tech—These Cases Show Why, Wired (Jan. 31, 2017), https://www.wired.com/2017/01/trumps-scotus-pick-needs-get-tech-cases-show/.
  2. Kate Tummarello, Digital Rights Issues on the Horizon at the Supreme Court, Elec. Frontier Found. (Feb. 6, 2017), https://www.eff.org/deeplinks/2017/02/digital-rights-issues-horizon-supreme-court.
  3. Ashcroft v. Am. Civil Liberties Union, 542 U.S. 656 (2004).
  4. Lisa A. Hayes, Justice Neil Gorsuch?, Ctr. for Democracy & Tech. (Jan. 31, 2017), https://cdt.org/blog/justice-neil-gorsuch/.
  5. Leading Cases, 144 Harv. L. Rev. 179, 184 (2010), http://cdn.harvardlawreview.org/wp-content/uploads/pdfs/vol_12401city_ontario_v_quon.pdf.
  6. Paul Fletcher, On Point: Don’t Know Much ‘Bout Technology …, Legal News (Jun. 13, 2014), http://www.legalnews.com/detroit/1390728.
  7. Will Oremus, Elena Kagan Admits Supreme Court Justices Haven’t Quite Figured Out Email Yet, Slate (Aug. 2, 2013), http://www.slate.com/blogs/future_tense/2013/08/20/elena_kagan_supreme_court_justices_haven_t_gotten_to_email_use_paper_memos.html.
  8. Id.
  9. Jack Smith IV, Say What You Want About Justice Antonin Scalia, He Was Great for Technology, Mic (Feb. 14, 2016), https://mic.com/articles/135263/say-what-you-want-about-justice-antonin-scalia-he-was-great-for-technology.
  10. Katharine Trendacosta, Antonin Scalia, The Supreme Court’s Unlikely Defender of Technology, Gizmodo (Feb. 14, 2016), http://gizmodo.com/antonin-scalia-the-supreme-court-s-unlikely-defender-o-1759075490.
  11. Robinson Meyer, Antonin Scalia Totally Gets Net Neutrality, The Atlantic (May 16, 2014), http://www.theatlantic.com/technology/archive/2014/05/net-neutralitys-little-known-hero-antonin-scalia/361315/.
  12. Ian Lopez, A ‘Pro-Technology’ Justice Scalia’s Relationship with Tech, Legaltech News (Feb. 23, 2016), http://www.legaltechnews.com/id=1202750446375/A-ProTechnology-Justice-Scalias-Relationship-with-Tech.
  13. Jonathan H. Adler, How Scalia-esque will Donald Trump’s Supreme Court Nominee Be?, Wash. Post: The Volokh Conspiracy (Jan. 26, 2016), https://www.washingtonpost.com/news/volokh-conspiracy/wp/2017/01/26/how-scalia-esque-will-donald-trumps-supreme-court-nominee-be/?utm_term=.78347d2cd777 (quoting Donald Trump).
  14. Richard Primus, Trump Picks Scalia 2.0, Politico Magazine (Jan. 31, 2017), http://www.politico.com/magazine/story/2017/01/trump-gorsuch-supreme-court-scalia-20-214718.
  15. Trendacosta, supra note 10.
  16. Smith IV, supra note 9.
  17. Lopez, supra note 12.
  18. Michael G. Bennett, Justice Scalia: Minor Philosopher Of Technology, Medium (Apr. 7, 2016), https://medium.com/imaginary-papers/justice-scalia-minor-philosopher-of-technology-72bbe664d5a.
  19. Matthew Rozsa, Supreme Court Justice Antonin Scalia’s Evolution on Internet Freedom, Daily Dot (Feb. 14, 2016), http://www.dailydot.com/via/supreme-court-justice-scalia-legacy-internet-freedom/.
  20. Owen S. Good, ESA Lauds the Late Antonin Scalia, Justice Who Enshrined Video Games as Protected Expression, Polygon (Feb. 14, 2016), http://www.polygon.com/2016/2/14/10988692/esa-lauds-the-late-antonin-scalia-justice-who-enshrined-video-games.
  21. Brown v. Ent. Merch. Ass’n, 131 S. Ct. 2729 at 2788 (2011).
  22. Good, supra note 20.
  23. Lawrence Rosenthal, The Court After Scalia: Fourth Amendment Jurisprudence at a Crossroads, ScotusBlog (Sept. 9, 2016), http://www.scotusblog.com/2016/09/the-court-after-scalia-fourth-amendment-jurisprudence-at-a-crossroads/.
  24. Riley v. California, 134 S. Ct. 2473, 2485 (2014).
  25. Kyllo v. United States, 533 U.S. 27, 40 (2001).
  26. United States v. Jones, 565 U.S. 400, 400 (2012).
  27. Adam Schwartz and Jennifer Lynch, EFF To Court: Accessing Cell Phone Location Records Without A Warrant Violates The Constitution, Elec. Frontier Found., Apr. 26, 2016, https://www.eff.org/press/releases/eff-aclu-court-accessing-cell-phone-location-records-without-warrant-violates.
  28. Smith IV, supra note 9.
  29. Meyer, supra note 11.
  30. Nat’l Cable & Telecomm. v. Brand X Internet Servs., 545 U.S. 967, 1006 (2005).
  31. Federal Communications Commission, in re Protecting and Promoting the Open Internet, FCC 15-24 (2015), https://apps.fcc.gov/edocs_public/attachmatch/FCC-15-24A1_Rcd.pdf.
  32. Jacob Fischler, Scalia’s Sharp Dissent Helped Shape Net Neutrality, Law360 (Feb. 17, 2016), https://www.law360.com/articles/759979/scalia-s-sharp-dissent-helped-shape-net-neutrality.
  33. Transcript of Oral Argument at 35, Am. Broad. Cos. v. Aereo, Inc., 134 S. Ct. 2498 (2014) (No. 13-461), https://www.supremecourt.gov/oral_arguments/argument_transcripts/2013/13-461_97l5.pdf (indicating Scalia did not understand that HBO was a cable network that was not available free over the airwaves).
  34. Jordan Fabian, Chairman to Justices: “Have Either of Y’all Ever Considered Tweeting or Twitting?,” The Hill: Hillicon Valley (May 21, 2010, 3:30PM), http://thehill.com/policy/technology/99209-chairman-to-justices-have-either-of-yall-ever-considering-tweeting-or-twitting- (quoting Scalia’s testimony at a House judiciary subcommittee hearing).
  35. Maria Bartiromo, Justice Scalia Says “Not a Chance” to Cameras, Today (Oct. 11, 2005), http://today.msnbc.msn.com/id/9649724/ns/today/t/justice-scalia-says-not-chance-cameras/ (quoting Scalia on whether cameras will be allowed in the Supreme Court as saying, “Not a chance, because we don’t want to become entertainment. I think there’s something sick about making entertainment out of real people’s legal problems.”)
  36. David Lat, Justice Scalia at the Federalist Society Fête, Above The Law (Nov. 20, 2010), http://abovethelaw.com/2010/11/justice-scalia-at-the-federalist-society-fete/.
  37. Id.
  38. Dean Takahashi, Supreme Court justices appear to favor video game industry in violence case, Venture Beat (Nov. 2, 2010), http://venturebeat.com/2010/11/02/supreme-court-justices-appear-to-favor-video-game-industry-in-violence-case/. See also Brown v. Ent. Merch. Ass’n, 564 U.S. 786 (2011) (Scalia writes, “Reading Dante is unquestionably more cultured and intellectually edifying than playing Mortal Kombat,”).
  39. Trendacosta, supra note 10.
  40. Lopez, supra note 12.
  41. Smith IV, supra note 9.
  42. Lopez, supra note 12.
  43. Primus, supra note 14.
  44. Kathryn Rubino, Judge Gorsuch and the Laptop Ban, Above The Law (Feb. 6, 2017), http://abovethelaw.com/2017/02/judge-gorsuch-and-the-laptop-ban/.
  45. Tara Seals, SCOTUS Pick Neil Gorsuch Will Have Important Voice on Data Privacy, Infosec. Magazine (Feb. 10, 2017), https://www.infosecurity-magazine.com/news/scotus-pick-neil-gorsuch-data/.
  46. Ronald Collins, Judge Neil Gorsuch—the Scholarly First Amendment Jurist, First Amendment News (Feb. 7, 2017), http://mtpress.mtsu.edu/firstamendment/judge-neil-gorsuch-the-scholarly-first-amendment-jurist/.
  47. Mink v. Knox, 613 F.3d 995, 1012 (10th Cir. 2010) (Gorsuch, J., concurring).
  48. Azhar Majeed, Prosecutor Coughs Up $425,000 for Violating Student’s First Amendment Rights, Found. for Individual Rights in Educ. (Dec. 13, 2011), https://www.thefire.org/prosecutor-coughs-up-425000-for-violating-students-first-amendment-rights/.
  49. Charlie Savage, Was That Search Illegal? Sometimes, Neil Gorsuch Ruled It Was, N.Y. Times (Feb. 2, 2017), https://www.nytimes.com/2017/02/02/us/politics/neil-gorsuch-supreme-court-fourth-amendment.html.
  50. Tom Risen, Garland Would Influence SCOTUS Encryption, Privacy Cases, U.S. News & World Report (March 16, 2016), https://www.usnews.com/news/articles/2016-03-16/garland-would-influence-scotus-encryption-privacy-cases.
  51. Savage, supra note 49.
  52. United States v. Ackerman, 831 F.3d 1292 (10th Cir. 2016).
  53. Id. at 4. See also Tummarello, supra note 2.
  54. United States v. Esquivel-Rios, 725 F.3d 1231 (10th Cir. 2013).
  55. United States v. Mitchell, 653 F. App’x 651 (10th Cir. 2016).
  56. United States v. Andrus, 483 F.3d 711 (10th Cir. 2007).
  57. Kyle Daly, GOP Lawmakers Leave Net Neutrality to FCC to Pressure Dems, Bloomberg BNA (Feb. 13, 2017), https://www.bna.com/gop-lawmakers-leave-n57982083721/.
  58. Fischler, supra note 32.
  59. Daly, supra note 58.
  60. Gutierrez-Brizuela v. Lynch, 834 F.3d 1142, 1149 (10th Cir. 2016).
  61. Id.
  62. Jonathan H. Adler, Gorsuch’s Judicial Philosophy is Like Scalia’s—With One Big Difference, Wash. Post (Feb. 1, 2016), http://wapo.st/2nD26WP.
  63. Joe Silver, Supreme Court Struggles with E-Mail But Will Shape Technology’s Future, Ars Technica (May 6, 2014), http://arstechnica.com/tech-policy/2014/05/supreme-court-struggles-with-e-mail-but-will-shape-technologys-future/.
  64. Trevor Timm, Technology Law Will Soon Be Reshaped By People Who Don’t Use Email, The Guardian (May 3, 2014), https://www.theguardian.com/commentisfree/2014/may/03/technology-law-us-supreme-court-internet-nsa.
  65. Lapowsky, supra note 1.
  66. Id.

No Country for Cybersecurity Arbitrage

* Partner, Yigal Arnon & Co., Jerusalem, Israel. J.D., Yale Law School; M.S., Columbia University.

Introduction

On October 28, 2016, regulations issued by the Copyright Office exempted a wide swath of cybersecurity research from the anti-circumvention provisions of the Digital Millennium Copyright Act (DMCA).1 These regulatory exemptions were motivated by assertions that the DMCA anti-circumvention prohibitions hinder cybersecurity research and practice. This article investigates the accuracy of these claims by examining the single developed market economy2 that does not prohibit (and is not obligated under treaty to prohibit) the use of anti-circumvention technology. More generally, this article examines the ability of firms to engage in international regulatory arbitrage – to exploit regulatory disparities across jurisdiction.3 The analysis demonstrates that opportunities to engage in regulatory arbitrage cannot be analyzed without attention to the identity and structure of industry players.

Broadly speaking, anti-circumvention prohibitions assist copyright holders in controlling their works. Copyright holders often use technology to prevent unauthorized use or distribution. Such technology may include, for example, measures that prevent the illicit distribution of music or e-books, software that prevents the use of mobile phones on competing networks,4 or mechanisms that prevent unauthorized tampering with software in automotive vehicles.5 Statutory anti-circumvention prohibitions (such as those in the DMCA) impose civil or criminal liability for bypassing such technological measures.

Over the last twenty years, international treaties have required most of the developed world to ban technology that circumvents technological protection measures. Israel is unique among the developed market economies in that it has not, and vociferously does not intend to, promulgate any anti-circumvention prohibitions. In superficial confirmation of the cybersecurity criticisms of anti-circumvention law, Israel boasts a booming industry in security technology, far out of proportion to its relatively small population. Nevertheless, as shown below, there is scant evidence to connect Israel’s success in cybersecurity to its lack of anti-circumvention prohibitions.

This article complements existing literature by providing insight into the actual effects of non-circumvention prohibitions, and the current wisdom of creating a regulatory exception for security research. In a broader sense, however, the paper adds to a “surprisingly thin”6 literature on international regulatory arbitrage. Existing research into regulatory arbitrage has mostly concentrated on how jurisdictions compete for business activity through regulatory innovation, with little attention paid to how actors and institutions actually take advantage of those differences or how arbitrage opportunities are mediated by technological, commercial and national institutions.7 This paper shows the importance of analyzing the character and organization of firms and institutions in determining the scope of actual arbitrage opportunities.

I. Anti-Circumvention and Security Research

Anti-circumvention restrictions have been imposed by many countries, and are cemented in international treaties. Article 11 of the WIPO Copyright Treaty (WCT), for example, provides that countries will protect “against the circumvention of effective technological measures . . . that restrict acts, in respect of their works, which are not authorized by the authors.”8

In 1998, Congress passed the DMCA, bringing the United States into compliance with the WCT. The DMCA prohibits circumvention of any “technological measure that effectively controls access” to a copyrighted work.9 In addition, the DMCA prohibits trafficking in technology that is designed or marketed for the purpose of circumventing protection measures that control access to or copying of copyrighted works.10 The European Union implemented the anti-circumvention provisions of the WCT treaty in EU Directive 2001/29/EC. The Directive requires member states to provide “adequate legal protection against the circumvention of any effective technological measures” as well as against the trafficking of circumvention technologies.11

A number of commentators have expressed strong concern that anti-circumvention prohibitions discourage research into security vulnerabilities.12 In the course of investigating any specific technology for vulnerabilities, security researchers are likely to probe and possibly disable any technical measures protecting such technology. Moreover, the subsequent dissemination and publication of such security research – which can include directions on how to circumvent the protection measure – could lead to charges of illegal “trafficking” in circumvention technology. Indeed, individuals conducting research into security vulnerabilities have been threatened with civil and criminal action under the anti-circumvention provisions of the DMCA.13

The DMCA does contain statutory exceptions permitting “encryption research”14 and “security testing”15 activities. These statutory exceptions, however, are limited by an array of conditions that narrow their practical significance.16 Exemptions for security and encryption research in the EU Directive are also limited. Recital 48 of the Directive does declare that the anti-circumvention prohibition “should not hinder cryptography research,” but this declaration was not translated into an operational provision of the Directive. Only a limited number of EU countries have in fact implemented any exceptions for encryption research or security activities in their national laws.17

The DMCA authorizes the Librarian of Congress to grant limited exemptions to the DMCA anti-circumvention prohibitions.18 Given the narrow applicability of the statutory exceptions, interested parties have over the years applied to the Librarian to obtain broader exceptions for security research activities. After overcoming its initial skepticism, the Librarian granted a number of relatively narrow exceptions for security testing.19 In the recent 2015 rulemaking, however, the Librarian granted the broadest exception to date for “good faith security research.”20 This last exception was granted pursuant to findings that the existing statutory exceptions were “inadequate to accommodate” security research activities “due to various limitations and conditions”, and that the anti-circumvention prohibitions of the DMCA had hindered “legitimate security research.”21 Even this relatively broad exemption, however, were circumscribed by a number of limitations and restrictions.22

II. A Regulatory Arbitrage Opportunity

Alone among the OECD countries, Israel has neither implemented any anti-circumvention prohibitions in its domestic law nor is it under any international treaty obligation to implement such prohibitions.23 Indeed, the legality of circumventing technological protection measures in Israel is unusually clear.24 In 2007 Israel adopted a new copyright law, which deliberately omitted any provisions concerning anti-circumvention technology. As described in more detail below, The Supreme Court of Israel subsequently confirmed that Israeli copyright law cannot be interpreted to infer a prohibition on anti-circumvention technology. Moreover, also as described below, Israel has defended its lack of legal anti-circumvention prohibitions on the international stage.

In 2013, the Supreme Court of Israel confirmed in Telran Communications (1986), Ltd. v. Charlton, Ltd. that Israeli copyright law, in the absence of any express provisions prohibiting the circumvention of technological measures, could not be interpreted to imply such a prohibition.25 The Telran defendants sold (unauthorized) cards that allowed for the decryption of foreign satellite communications. The plaintiff asserted that Telran’s sale of the cards interfered with plaintiff’s exclusive rights to broadcast the 2006 World Cup within Israel. The case raised a number of questions, including as to whether the circumvention of broadcast encryption was prohibited by Israeli law. The Court noted that the Knesset was aware of the WCT treaty, and yet did not include prohibitions on circumvention technology in domestic Israeli law. As such, the Court ruled that existing statutory provisions could not be interpreted to prohibit circumvention technologies.

Moreover, the government of Israel has publicly defended its failure to implement prohibitions against circumvention measures. Until 2014, Israel was included in the annual Special 301 Report of the United States Trade Representative (USTR).26 In each report, the USTR encouraged Israel to implement the WCT treaty (and, by extension, prohibitions on the circumvention of technological measures). Nevertheless, in a 2009 submission to the USTR, the Israeli government boldly refused to implement anti-circumvention prohibitions, noting that several large Israeli “authors’ groups” were “vehemently opposed” to such bans.27

The case of Israel provides an excellent test case for analyzing claims that legal anti-circumvention restrictions impede security research. If such assertions are correct then, all things being equal, jurisdictions that lack such circumvention prohibitions should see a boost to their cybersecurity research and development efforts.28 Academics in such jurisdictions would be able to conduct research that would be legally problematic elsewhere. Multinationals would be able to shift cybersecurity research to such countries, evading the legal problems that would dog those efforts in other jurisdictions. Local technologists would gain unique experience in circumvention technologies, and startups benefiting from the unique ecosystem would be able to develop inimitable products and services.

Indeed, Israel boasts a booming cybersecurity industry. Israel, with a population of just more than 8 million, exports more cybersecurity-related products and services than all other countries in the world combined, excluding the United States.29 Reports show the tiny country making 5% of all global sales in cyber security products and attracting 20% of global investment in the sector.30 Israel should be exceedingly well positioned to take advantage of any arbitrage opportunity presented by its lack of anti-circumvention prohibitions.

Even so, there is scant evidence to connect Israel’s cybersecurity prowess to its lack of legal prohibitions on circumvention technology. Instead, Israel’s unusual expertise in cybersecurity is variously attributed to government support of the industry, the country’s precarious geopolitical security position, public investments in education, or connections between the Israeli military and civilian technology firms.31 Scholarly accounts of Israel’s cybersecurity policies do not address Israel’s lack of anti-circumvention prohibitions.32 Multinationals with Israeli branches do not point to the lack of anti-circumvention prohibitions as a reason for establishing those offices.33 In sum, an objective outside observer of Israel’s cybersecurity industry would be justified in concluding that the country’s lack of anti-circumvention prohibitions is irrelevant to the success of its cybersecurity industry.

Exemptions to anti-circumvention prohibitions are not costless. Allowing circumvention activities can, aside from increasing the risk of intellectual property infringement, raise serious security34 and safety concerns.35 The case of Israel may show that the benefit to security research from permitting circumvention activities is minimal. As such, the new DMCA regulatory exemptions for security research may not be justified, in that they impose substantial risks for little profit.

III. Structural Barriers to Arbitrage

At first glance, the seemingly underwhelming effects of Israel’s regulatory regime suggest that non-circumvention controls have little impact on the cybersecurity industry. This section, however, considers a number of structural barriers that may prevent actors and institutions from exploiting the opportunity presented by Israel’s lack of anti-circumvention controls. In other words, the failure of industry and academic players to arbitrage Israel’s lack of anti-circumvention prohibitions may not mean that such prohibitions do not impact security research. Rather, the ability of actors to take advantage of international regulatory differences must be evaluated in light of constraints and incentives in the industry.

First, the internal organization of commercial cybersecurity firms may prevent those companies from engaging in cross-border legal arbitrage. Cybersecurity firms often boast international teams, providing such companies with the capability of providing around-the-clock services for malware analysis and software support.36 Such global firms are often structured to allow cross-border cooperation among international teams and, as such, they may resist arbitrage opportunities that require them to cage specific activities within a single jurisdiction. Smaller, local firms may also refrain from pursuing activities upon which the global economy looks askance, especially if the local firm is hoping to be acquired by an international cybersecurity concern.

From this perspective, the very uniqueness of Israel’s legal position may prevent firms from effectively pursuing the arbitrage opportunity. A global firm that wishes to exploit Israel’s exceptional lack of anti-circumvention prohibitions must be careful to confine any potentially illegal circumvention activities to Israel. Employees and contractors located outside Israel must, regardless of how the firm ordinarily structures its international cooperation, shy away from those activities. The firm’s legal counsel may have difficulty drawing a precise line between permitted international interaction and proscribed assistance to the “rogue” Israeli researchers. In other words, a firm may determine that the cost of realizing the arbitrage possibility (and disregarding clear, firm-wide standards) exceeds the benefit to be had from the arbitrage itself.37

Second, the distinctive structure of anti-circumvention provisions may work to thwart the possibility of legal arbitrage. Many jurisdictions prohibit not only the act of circumvention, but also the act of trafficking in circumvention technologies.38 These trafficking prohibitions may not legally reach extraterritorial conduct, but in practice they hinder cybersecurity research worldwide. First, researchers may be concerned that scholarship disseminated in other jurisdictions could violate those countries’ bans on trafficking in circumvention technologies, even though the research was originally published in jurisdictions where those activities were legal.39 Second, trafficking prohibitions could limit the enthusiasm of multinationals to take advantage of the arbitrage opportunity, since any cross-border sharing of legally developed circumvention technology could violate the trafficking ban. In other words, the trafficking prohibition makes it more difficult to cage anti-circumvention activities in Israel, thus further limiting the ability of firms to engage in regulatory arbitrage.

A third possibility would view Israel’s legal arrangements as less unique than presented by a first reading of the statutory anti-circumvention prohibitions. Commentators have noted that much Israeli cybersecurity research and development occurs in the context of Israel’s military and national security organizations. These organizations also serve as training grounds for future technologists and entrepreneurs, many of whom join the commercial sector or establish startup companies when they conclude their military service.

Like Israel, many countries can conduct research into circumvention technologies through their military or other security organizations. Laws against circumvention technology often exempt law enforcement, militaries and security agencies from that prohibition. For example, the DMCA expressly exempts “lawfully authorized investigative, protective, information security, or intelligence activity” from its anti-circumvention prohibitions.40 This exemption also extends to contractors working on behalf of the government.41 Similarly, the EU Copyright Directive provides that the anti-circumvention prohibition shall be applied “without prejudice to … public security.”42 As such, Israel’s military institutions and actors do not benefit from a unique legal space for circumvention technologies. Rather, experience in circumvention technologies can be had in security agencies worldwide.

Conclusion

Israel’s resistance to controls on circumvention technology contrasts starkly with the legal picture in other developed countries, presenting a clear opportunity for international regulatory arbitrage. Industry players, however, seem to have declined the chance to exploit Israel’s distinctive legal position, and this article has suggested a number of explanations for their reluctance. The common denominator of these suggestions is that the possibility of regulatory arbitrage cannot be analyzed independently of the character and organization of the institutions that engage in the regulated activity. Commercial entities, and especially multinationals, may not be structured in a manner that facilitates recognition and exploitation of differences across jurisdictions. On the other hand, governments and militaries may not require the possibility of regulatory arbitrage in order to engage in the controlled activity. At base, the analysis of international regulatory arbitrage and competition demands not only the identification of appropriate legal differences, but also an analysis of the structures and incentives that facilitate or prevent the exploitation of those differences.

References

  1. Exemption to Prohibition on Circumvention of Copyright Protection Systems for Access Control Technologies, 80 Fed. Reg. 65,944 (Oct. 28, 2015) (to be codified at 37 C.F.R. pt. 201) [hereinafter 2015 Exemptions\. Most provisions of the 2015 Exemptions came into effect on October 28, 2015. The effectiveness of the security research exemption was delayed for one year in order to allow “other parts of the government sufficient opportunity” to opine on the “wisdom of granting an exemption” for the purpose of cybersecurity research. Id. at 65,956.
  2. This Article uses a country’s membership in the Organization of Economic Cooperation and Development (“OECD”) as a proxy for whether it constitutes a developed market economy.
  3. For a description of how intellectual property rules may enable international regulatory arbitrage, see Pamela Samuelson, Intellectual Property Arbitrage: How Foreign Rules Can Affect Domestic Protections, 71 U. Chi. L. Rev. 223 (2004).
  4. See, e.g., Tracfone Wireless Inc. v. Dixon, 475 F. Supp. 2d 1236 (M.D. Fla. 2007) (holding that unlocking cellular handsets violates the DMCA).
  5. See 2015 Exemption, supra note 1, at 65,954 (discussing anti-circumvention technology in motor vehicles).
  6. Annelise Riles, Managing Regulatory Arbitrage: A Conflict of Laws Approach, 47 Cornell Int’l L.J. 63, 68 (2014).
  7. Claudio M. Radaelli, The Puzzle of Regulatory Competition, 24 J. Pub. Pol’y 1, 13 (2004) (stating that “we do not know enough about how corporations … respond to international regulatory competition”).
  8. World Intellectual Property Organization Copyright Treaty art. 11, Dec. 20, 1996, 17 U.S.C. §§ 1201–1205. Article 18 of the World Intellectual Property Organization Performance and Phonograms Treaty contains a similar provision. See World Intellectual Property Organization Performances and Phonograms Treaty art. 18, December 20, 1996, 17 U.S.C. §§ 1201–1205.
  9. 17 U.S.C. § 1201(a)(1) (2016).
  10. 17 U.S.C. § 1201(a)(2) (2016) (prohibition on trafficking in technology that circumvents access controls); 17 U.S.C. § 1201(b)(1) (2016) (prohibition on trafficking in technology that circumvents the “protection afforded by a technological measure that effectively protects a right of a copyright owner”).
  11. EU Directive 2001/29, art. 6, 2001 O.J. (L 167) 17 (EC) [hereinafter EU Copyright Directive\. Council Directive 91/250, 1991 O.J. (L 122) (EC) also imposes anti-circumvention prohibitions on software works.
  12. See, e.g., Derek E. Bambauer and Oliver Day, The Hacker’s Aegis, 60 Emory L.J. 1051 (2011); Jennifer Stisa Granick, The Price of Restricting Vulnerability Publications, 9 Int’l J. Comm. L. & Pol’y 1, 9 (2005); Joseph P. Liu, The Law and Technology of Digital Rights Management: The DMCA and the Regulation of Scientific Research, 18 Berk. Tech. L.J. 501 (2003).
  13. Bamberger & Day, supra note 12, at 1080; Granick, supra note 12, at 10, 19. The Librarian of Congress expressed similar concerns when promulgating the 2015 Exemptions. See infra text accompanying note 21.
  14. 17 U.S.C. § 1201(g) (2016).
  15. 17 U.S.C. § 1201(j) (2016).
  16. Bambauer & Day, supra note 12, at 1083; Liu, supra note 12, at 509.
  17. Ian Brown, The Evolution of Anti-Circumvention Law, 20 Int’l Rev. L. & Computers 240 (2006).
  18. 17 U.S.C. §§ 1201(a)(1)(B)–(D) (2016).
  19. The first request for security testing exemptions was advanced during the 2003 rulemaking procedures, but the Librarian asserted that the request “failed to explain why the existing exemptions are insufficient.” Exemption to Prohibition on Circumvention of Copyright Protection Systems for Access Control Technologies, 68 Fed. Reg. 62,011, 62,018 (Oct. 31, 2003). During the 2006 rulemaking process, the Librarian granted a narrow exception for security research in CDs, finding the exception necessary “in light of . . . [the\ uncertainty” of the statutory exception “and the seriousness of the problem” of security vulnerabilities. Exemption to Prohibition on Circumvention of Copyright Protection Systems for Access Control Technologies, 71 Fed. Reg. 68,472, 68,477 (Nov. 27, 2006). The 2010 rules contained an exception for the circumvention of technical protection measures applicable to video game technology. Exemption to Prohibition on Circumvention of Copyright Protection Systems for Access Control Technologies, 75 Fed. Reg. 43,825, 43,839 (July 27, 2010).
  20. 2015 Exemptions, supra note 1, at 65,956.
  21. Id.
  22. Id.
  23. All OECD countries have acceded to the WCT treaty save Iceland, Israel, New Zealand and Norway. For a list of the contracting parties to the WCT, see WIPO Copyright Treaty Contracting Parties. World Intell. Prop. Org., http://www.wipo.int/treaties/en/ShowResults.jsp?lang=en&treaty_id=16 (last visited Jan. 21, 2017). Nevertheless, Iceland and Norway, as members of the European Economic Area, have implemented prohibitions on anti-circumvention technology in their domestic law. See Copyright Act, Article 50a–50d (Act No. 73/1972)(Ice.); Copyright Act, Sections 50a–50e (Act No. 2/1962)(Nor.). New Zealand has also implemented anti-circumvention provisions in its domestic law. See Copyright Act, Sections 226A–226E (Act No. 143/1994)(N.Z.). Chile has to date not implemented any anti-circumvention provisions under its domestic law, though it is obligated to do so under Article 11 of the WCT treaty and Article 17(5) of the United States-Chile Free Trade Agreement. See United States-Chile Free Trade Agreement, art. 17(5), June 6, 2003, 19 C.F.R. §§ 10.401–10.490; World Intellectual Property Organization Copyright Treaty art. 11, Dec. 20, 1996, 17 U.S.C. §§ 1201–1205.
  24. The ability to engage in international regulatory arbitrage depends to some extent on the clarity of the regulatory differences between jurisdictions. See Radaelli, supra note 7, at 7.
  25. CA 5097/11 Telran Communications (1986) Ltd. v. Charlton Ltd (Nevo, September 2, 2013) (Isr.).
  26. The Special 301 Report is an annual report produced by the USTR reviewing the “global state of intellectual property rights (IPR) protection and enforcement.” Office of the United States Trade Representative, Special 301, https://ustr.gov/issue-areas/intellectual-property/Special-301.
  27. Office of the United States Trade Representative, 2009 Submission of the Government of Israel to the United States Trade Representative with Respect to the 2009 “Special 301 Review”, at 8. See also Nate Anderson, Israel Rebukes US: Our Copyright Laws Are Fine, Thanks, Ars Technica (Mar. 18, 2008), http://arstechnica.com/uncategorized/2008/03/israel-rebukes-us-our-copyright-laws-are-fine-thanks/.
  28. See Samuelson, supra note 3, at 226 (discussing how lower-protection IP regimes can spur innovation in software).
  29. Barbara Opall-Rome, Israel Claims Surge in Cyber Sales, Investment, Defense News (Jan. 21 2016), http://www.defensenews.com/story/defense/2016/01/21/israel-claims-surge-cyber-sales-investment/79119378/.
  30. See, e.g., id.; John Reed, Israel Cyber-Security Expertise Lures Growing Share of Investment, Financial Times (Jan. 12, 2016), http://www.ft.com/cms/s/0/dfa5c916-b90e-11e5-b151-8e15c9a029fb.html#axzz4DP5aeWoU. For a wide-ranging discussion of Israeli advances in cybersecurity, see Michael Eisenstadt & David Pollock, Washington Institute for Near East Policy, Asset Test: How the United States Benefits from its Alliance with Israel 34-37 (2012).
  31. See, e.g., Lior Tabansky & Isaac Ben Israel, Cybersecurity in Israel 18 et seq. (2015) (attributing Israel’s high-technology success to elements of culture and human capital, including the role of the military in developing these, and government incentives for research and development); Peter Suciu, Why Israel Dominates in Cyber Security, Fortune (Sept. 1, 2015), http://fortune.com/2015/09/01/why-israel-dominates-in-cyber-security/ (attributing Israel’s success in cybersecurity to geopolitical pressures on the country).
  32. See, e.g., Daniel Benoliel, Towards a Cybersecurity Policy Model: Israel National Cyber Bureau Case Study, 16 N.C. J.L. & Tech. 435 (2015).
  33. See, e.g., Einat Paz-Frankel, Why the World’s Largest Tech Companies All Want a Piece of the Israeli Pie, NoCamels Israeli Innovation News (Sept. 30, 2015), http://nocamels.com/2015/09/multinational-high-tech-companies-presence-israel/.
  34. See, e.g., 2015 Exemptions, supra note 1, at 65,955 (noting concerns that information obtained from circumvention activities could be used to “hack into highly regulated machines and devices, including medical devices and vehicles”).
  35. See id. (expressing concern that “security researchers may not fully appreciate the potential ramifications of their acts of circumvention on automobile safety”).
  36. See, e.g., Kim Zetter, Countdown to Zero Day: Stuxnet and the Launch of the World’s First Digital Weapon 19, 58 (2015) (describing international cooperation among teams in the computer security industry).
  37. Cf. Jack L. Goldsmith & Alan O. Sykes, The Internet and the Dormant Commerce Clause, 110 Yale L.J. 785, 806 (2001) (discussing the difficulty of complying with inconsistent regulations across jurisdictions).
  38. See supra notes 10-11 (noting anti-trafficking provisions in the DMCA and European Union Directives).
  39. Foreign computer programmers have in fact been arrested in the United States under the DMCA for their part in creating circumvention technologies abroad. See Liu, supra note 12, at 514.
  40. 17 U.S.C. 1201(e) (2016).
  41. Id.
  42. EU Copyright Directive, supra note 11, at 14. See also id. at 18 (“This Directive shall be without prejudice to provisions concerning . . . security.”).

What Shareholder Proposals on Proxy Access Tell Us About its Value

* Bernard S. Sharfman is an associate fellow of the R Street Institute and a member of the Journal of Corporation Law’s editorial advisory board. Mr. Sharfman would like to thank Jonathan Cohn, Shane C. Goodwin, John G. Matsusaka, and Tara Bhandari for their helpful comments and suggestions. Mr. Sharfman is dedicating this article to his wife, Susan David, and his daughter, Amy Sharfman.

Introduction

Proxy access is the ability of certain privileged shareholders to have their own slate of director nominees included in the company’s proxy materials whether or not the board of directors (“Board”) approves. These materials include a proxy statement used to solicit shareholder votes and a voting card allowing shareholders to vote without having to attend the annual meeting.1 For many years, the default rules of corporate and securities law have provided the Board with exclusive authority to decide whether shareholder proposals seeking to implement proxy access are to be included in a public company’s proxy solicitation materials. Five years ago the Securities and Exchange Commission (SEC) amended its rules to require these proposals be included.2

Because of the difficulty of crafting a binding proxy access bylaw within the confines of the SEC’s 500 word limit on shareholder proposals,3 proposals are usually non-binding, requesting, not requiring, the Board to implement proxy access by amending the company’s governing documents. These proposals can be understood as the first step in the process of implementing proxy access on a company-by-company basis.

Roughly 200 companies received proxy-access proposals in 2016.4 The proposals usually limit the availability of proxy access to large shareholders who have held at least three percent of company shares, individually or as an aggregation of 20 to 25 investors, for at least three years.

When voting on a proxy access proposal, shareholders need to be informed about the expected effect of proxy access on the market value of their shares. Boards also need to be informed about this expected change in value when considering if it should amend its governing documents to include proxy access, either for purposes of preempting a shareholder vote or considering its implementation subsequent to such a vote at the annual meeting. The SEC needs to be informed about the expected change in value on a market-wide basis prior to making any changes to its proxy access rules, including putting back on its agenda the idea of universal proxy access for all public companies (“universal proxy access”).5

One way to understand the value of proxy access is through empirical analysis of the shareholder proposals on proxy access that have already been submitted for inclusion in the proxy materials of public companies. Unfortunately, the empirical research on these proposals is limited to one empirical study. This study, even though well executed, leads to more questions than answers and thus cannot be relied upon as authority on a standalone basis. This is a critical point that shareholders, board members, and the SEC need to understand when such empirical evidence is used in support of or against proxy access.

I. The Bhandari Report

The available empirical study is a report prepared by Tara Bhandari, Peter Ilievy, and Jonathan Kalodimos.6 The report was initiated when all three were employees of the SEC’s Division of Economic and Risk Analysis.7 This report took the form of an “event study.” An event study investigates the impact of new information upon the expected stock returns of a targeted cross-section of firms.8 In the report, the event was the Office of the Comptroller of New York City’s (“Comptroller”), the custodian and investment adviser to the New York City Pension Funds, unexpected announcement to the public that it had simultaneously submitted non-binding proxy access proposals to 75 public companies.9

An event study is used to determine “whether there is an abnormal stock price effect associated with an unanticipated event”10 (the Comptroller’s announcement) on a sample of firms that may have been uniquely affected by the event (the 75 firms to which the Comptroller simultaneously submitted proposals). The null hypothesis to be tested is whether the mean abnormal return (abnormal stock price effect on the targeted sample of firms) at the time of the event is equal to zero. That is, if there was no effect from the announcement, then the mean abnormal return at the time of the event will equal zero.11 The event date was November 6, 2014. The authors found that the Comptroller’s announcement led to a positive, statistically significant, 0.53% abnormal return for the 70 firms12 used in their sample. In terms of hypothesis testing, the results meant that the null hypothesis had been rejected.13 Moreover, they interestingly found a strong correlation between the returns generated on this event date and the returns of the sample on the date, approximately four years earlier,14 when the SEC announced it was going to stay the implementation of its universal proxy access rule.15

II. Selection Bias and a Lack of Randomness

Even though the Bhandari report indicates that proxy access has value, this is far from the end of the story. The small sample size makes it very difficult to make inferences about why the Comptroller’s announcement had such a significant impact on the target firms. The sample cannot be further broken up to see if certain sub-groups are responsible for moving the numbers.

Moreover, the sample lacks randomness as a result of selection bias. Randomness means that each element of a population has an equal chance of being part of the sample. A random sample is required in order to make generalized claims about how the entire population of U.S. public firms would be affected by shareholder proposals on proxy access (i.e. external validity). The Comptroller’s selection process violated the requirement of randomness and, therefore, the results lack external validity.

The 75 companies were targeted for multiple reasons unrelated to enhancing shareholder value. Thirty-three were targeted because they were in industries directly related to climate change; 24 for a lack of board diversity; and 25 were cited for having received “significant opposition to their 2014 advisory vote on executive compensation.”16 This resulted in 20 of the 75 target firms being from the gas and oil industry, nine from the utilities industry and another six from the coal industry.17 Such a weighting of companies either producing or consuming huge quantities of carbon-based fuels is not representative of the current universe of U.S. public companies.18

It is also reasonable to assume that the selection process was a function of how successful the Comptroller expected to be in either getting firms to implement proxy access prior to a shareholder vote or at least getting a substantial percentage of votes if a shareholder vote took place. The Comptroller would not have wasted its time selecting a firm where the expected probability of success was zero or close to it. According to Nell Minow, a leader in the shareholder empowerment movement, the Comptroller has “been very smart about picking companies where shareholders are looking to make a change.”19

However, the selection bias discussed so far does not entirely explain how the Comptroller whittled down the number of targeted firms to 75 out of the over 3,000 public firms that it could choose from. It is reasonable to assume that it also targeted firms that had not been historically responsive to its engagement or the engagement of other like-minded shareholder activists on issues including board diversity, executive compensation, climate change, disclosure of political contributions, employee wages, etc. According to the Comptroller, “to effect true change, you need the ability to hold entrenched and unresponsive boards accountable and that is what we are seeking to do.”20 Therefore, an additional targeting criterion may have been firms that had not adequately cooperated on one or more of these other issues. For those firms that had been cooperative, it would be counterproductive for the Comptroller to target them for proxy access. This additional criterion would have created more bias in the sample.

One counterargument is that the Comptroller’s sample was random with respect to the expected value of proxy access. Ironically, as described above, this may be true to some extent given that the Comptroller was not targeting firms based solely on the criterion of enhancing shareholder value. However, the abnormal returns found in the Bhandari report did not measure the value of proxy access per se, but the expected returns of proxy access as a function of both the market’s estimation of its value at a target firm (positive or negative) and the probability that proxy access could actually be achieved at the firm. Selection bias with respect to the second variable may have resulted in a lack of external validity.

As argued above, the Comptroller would have targeted firms where it believed it would have success, i.e. firms with dissatisfied investor bases, making the probability of success higher than it would be if the target firms were selected in a random fashion. Moreover, it is possible that the two variables are not independent, but are positively correlated. In other words, the greater the level of investor dissatisfaction means not only the higher probability of success but also the greater the likelihood the market will find the value of proxy access to be positive. If so, then the Comptroller’s selection process will yield more companies that the market feels will benefit from proxy access versus a randomly selected sample.

In sum, the Comptroller’s selection process excluded a vast sector of the universe of public companies. This adversely affected the ability of the analysis to accurately represent the expected benefits or costs of proxy access to all public companies, making the results biased, most likely in the upward direction. The study thus lacks external validity outside the boundaries of the Comptroller’s selection criteria.21 The results of the Bhandari report may be able to inform us about how proxy access may have affected the firms in the small sample under study, but there is great uncertainty if it can be generalized to the three thousand plus other firms that also make up the universe of public companies.

III. Omitted Variable Bias

Even if the Bhandari report lacks external validity, one result that is still extremely interesting is the finding that the Comptroller’s announcement had such a large impact on the value of the target sample, a 0.53% average abnormal return. This result is puzzling given the proposals were non-binding and uncertainty existed over whether they would win approval by shareholders or be implemented by the Board even after shareholder approval. Moreover, there was uncertainty whether shareholders had the wherewithal or even desire to ever use their right to nominate if implemented, and if they did use their right to nominate, if any of their nominees would actually win election.

There are several other reasons why the result is perplexing. First, the proposals effectively excluded activist hedge funds from participating in proxy access because of the required three-year holding period.22 Second, the Bhandari report found that the Comptroller was not specifically targeting poor performing firms that could benefit the most from proxy access.23 Third, the study controlled for abnormal returns generated by the industries where the target firms belonged.24 But most importantly, proxy access does not exist in isolation from the markets for corporate control (friendly and hostile takeovers through mergers and acquisitions)25 and influence (shareholder activism including hedge fund activism),26 the primary means by which board members are replaced outside of board nominating committees.

In the market for corporate control, Doidge, Karolyi, and Stulz report that from 1997 to 2012, 4,957 firms were delisted from U.S. stock exchanges as a result of merger activity.27 This activity must have resulted in thousands of Board members losing their seats. In the market for corporate influence, shareholders are already getting significant board representation through engagement with the Board. From 2006 to 2013, a total of 1,128 dissident seats were granted to shareholders either through a proxy contest or private negotiation, with 179 in 2013 alone.28 Moreover, of those 1,128 seats granted, 702 seats were gained through hedge fund activism.29

Given the more powerful means by which to change the composition of a Board, this should put a significant cap on the value of proxy access as a means to reduce agency costs caused by the separation of share ownership from board management. In sum, the 0.53% average abnormal return found in the Bhandari report is counter-intuitive.

A possible explanation is that one or more independent variables, not specified in the event study’s regression equation, may be causing the abnormal return. If so, then there may be omitted variables that are correlated with both a company receiving a proxy access proposal from the Comptroller and the abnormal returns generated by the shares of the target firms on the event date.

So, what could these omitted or missing independent variables be if they indeed exist? For one, such a variable would describe the level of dissatisfaction the company’s shareholder investor base currently has with the Board and/or executive management. The identification of a dissatisfied shareholder base is critical to the workings of those who participate in the market for corporate control (takeovers) and hedge fund activism.<30

If correct, then we should interpret the appearance of a proxy access proposal as a new or confirming signal to the market that there is a high level of shareholder dissatisfaction with the Board. Proxy access, unlike other shareholder proposals, makes a compelling statement that large activist institutional investors are extremely dissatisfied with the Board and would be happy to see a change.

Such a proposal is a clear signal to the market that the Board may be vulnerable to hedge fund activism or a takeover (friendly or hostile), especially when the stock price has been under pressure.31 In essence, the company has been put “in play.” This is valuable information for the market in its process of continually reevaluating the price of a company’s shares. We know from recent research on hedge fund activism that the up-front gains in a company’s stock price from such activism can be extremely rewarding to shareholders.32 Therefore, the increased potential for hedge fund activism or acquisition activity may be the true drivers of the abnormal returns found in the Bhandari report, not the market’s estimation of the value of proxy access as a stand-alone tool for enhancing corporate governance.

A counterargument is that the report’s finding of a strong correlation between the returns of the target firms on the date that the Comptroller announced its proxy access initiative and the returns that the target firms yielded on the date the SEC stayed its universal proxy access rule confirms the primary role of proxy access as being the cause in the change in value. Yet, this interesting finding does not negate the potential for omitted variables as an explanation for the counter-intuitive results. The potential for omitted variables still needs to be researched. If such a variable is found, then the strong correlation discussed above is just that: a correlation between two events, and only two events, that occurred four years apart, and no more.

In sum, the mean abnormal returns are much too high to be explained simply by the disclosure of the Comptroller’s proxy access proposals. Proxy access is just a very small part of the story of how Board composition is influenced by market forces. The potential for omitted variables is great and needs to be explored in future empirical studies.

IV. Non-Stationarity

The Bhandari report, which focused on one event at one point in time, must also be understood in the context of non-stationarity: the potential for the stock market to react differently to the same events at different points in time.33 If non-stationarity exists, then the stock market may provide “one result for a period and a diverse outcome for another period” as the perception of investors change over time.34 This is consistent with an efficient market where the market price is an unbiased estimate of the true value of the investment, but is not necessarily a correct one at any point in time.35

It is easy to see how non-stationarity may play a role in the results of future event studies on proxy access. At this time, the stock market has zero practical experience with proxy access. Investors have yet to use proxy access to nominate candidates for the Board. Therefore, there is no data to evaluate how the performances of those nominees who have been elected to the Board have affected shareholder value. As a result, it is possible that as the market becomes more informed about the real value of proxy access, future event studies, including studies on the value of shareholder proposals on proxy access, may provide different results based on changed perceptions.36

To overcome the perception that the Bhandari report may be tainted by the potential for non-stationarity, a number of event studies would need to be conducted on various event dates over a number of years. Hopefully, they will generate results that are consistent. Until then, the issue of non-stationarity will need to be acknowledged by those who utilize the Bhandari report.

V. Conclusion

The Bhandari report is an important first step in the process of trying to understand the value of proxy access based on shareholder proposals. However, even though the authors appear to have done the best job possible with a limited data set, it is not possible to use the report as support for the proposition that proxy access is an enhancement to the corporate governance of a public company, either generally or at a targeted company. More specifically, the results of the report lack external validity resulting from a sample that is not randomly generated; there is the strong possibility of omitted error bias; and the issue of non-stationarity limits the significance of the results.

  1. For a legal history of proxy access, see Bernard S. Sharfman, What Theory and the Empirical Evidence Tell Us about Proxy Access, 12 J.L. Econ. & Pol’y (forthcoming 2016). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2757761.
  2. 17 C.F.R. §240.14a-8(i)(8) (2011).
  3. 17 C.F.R. §240.14a-8(d) (2011).
  4. Sidley Austin LLP, Proxy Access Update – Momentum Continues to Build in 2016 4 (2016), http://www.sidley.com/~/media/update-pdfs/2016/09/proxy-access-momentum-in-2016–september-22-2016.pdf.
  5. Universal proxy access would automatically allow certain privileged shareholders to place their Board nominees into the proxy solicitation materials of almost all public companies without the need for a charter amendment or bylaw. The SEC adopted a universal proxy access rule that was to become effective on November 15, 2010. Prior to it being implemented, the D.C. Circuit Court of Appeals unanimously decided to vacate the rule after determining that the SEC had promulgated the rule in violation of the Administrative Procedure Act’s “arbitrary and capricious” standard of review. See Sharfman, supra note 1, at 18.
  6. Tara Bhandari, et al., Public versus Private Provision of Governance: The Case of Proxy Access, (SEC Staff Working Paper, 2015), http://www.sec.gov/dera/staff-papers/working-papers/public-vs-private-provision-of-governance.pdf. For a review of empirical studies on universal proxy access, see Sharfman, supra note 1.
  7. Illievy and Kalodimos are no longer with the SEC.
  8. Roberta Romano, Less is More: Making Shareholder Activism a Valuable Mechanism of Corporate Governance, 18 Yale J. on Reg. 174, 187 n.37 (2001).
  9. Press Release, Office of the New York City Comptroller, Comptroller Stringer, NYC Pension Funds Launch National Campaign to Give Shareowners a True Voice in How Corporate Boards Are Elected (Nov. 6, 2014), http://comptroller.nyc.gov/newsroom/comptroller-stringer-nyc-pension-funds-launch-national-campaign-to-give-shareowners-a-true-voice-in-how-corporate-boards-are-elected/.
  10. S.V.D. Nageswara Rao and Sreejith U, Event Study Methodology: A Critical Review, 3(1)A The Macrotheme Rev. 40, 44 (Spring 2014).
  11. S. P Khotari & Jerold B. Warner, Chapter 1 – Econometrics of Event Studies, in Handbook of Empirical Corporate Finance 3 (B. Espen Eckbo ed., 2007).
  12. Five firms were removed from the sample because they had made earnings announcements on that day.
  13. The Bhandari report was not exclusively focused on the Comptroller’s announcement. In total, it evaluated 158 proxy access proposals, including the Comptroller’s 75 proposals, at 133 firms over four proxy seasons. Bhandari, supra note 6, at 14.
  14. The stay date was October 4, 2010. See Bhandari, supra note 6, at 11.
  15. Bhandari, supra note 6, at 19.
  16. Sumberg, supra note 9.
  17. Bhandari, supra note 6, at 43, tbl. 3.
  18. Sharfman, supra note 1, at 15.
  19. Jena McGregor, ExxonMobil Shareholders Just Approved a Powerful New Measure That Could Reshape investors’ Influence on Company Boards, Wash. Post, May 25, 2016, https://www.washingtonpost.com/news/on-leadership/wp/2016/05/25/big-investors-are-getting-a-powerful-new-right-in-record-numbers-if-they-ever-use-it/.
  20. Sumberg, supra note 9.
  21. Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset 121 (3d ed. 2012) (When a sample is “random, this does limited damage to the results of the study. If the choice is biased, it can provide results which are not true in the larger universe.”).
  22. Bernard S. Sharfman, Activist Hedge Funds in a World of Board Independence: Creators or Destroyers of Long-Term Value?, 2015 Colum. Bus. L. Rev. 813, 825 (2015).
  23. Bhandari, supra note 6, at 28.
  24. Id. at 15 (“We control for industry in all of our tests.”).
  25. Henry G. Manne, Mergers and the Market for Corporate Control, 73 J. Pol. Econ. 110 (1965).
  26. See generally Brian R. Cheffins & John Armour, The Past, Present, and Future of Shareholder Activism by Hedge Funds, 37 J. Corp. L. 51, 58 (2011); Paul Rose & Bernard S. Sharfman, Shareholder Activism as a Corrective Mechanism in Corporate Governance, 2014 BYU L. Rev. 1014 (2015).
  27. Craig Doidge et al., The U.S. Listing Gap 5 (Nat’l Bureau of Econ. Research, Working Paper No. 21181, 2015).
  28. Shane Goodwin, Myopic Investor Myth Debunked: The Long-Term Efficacy of Shareholder Advocacy in the Boardroom 51, tbl. 1 (Harvard Bus. Sch., Working Paper, 2014), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2450214.
  29. Id. at 52.
  30. See Damien Park, How Activist Investors Identify Their Targets, Director Notes (Conference Bd., N.Y.), June 2016, at 3, fig. 3.
  31. See generally Bernard S. Sharfman, A Theory of Shareholder Activism and its Place in Corporate Law, 82 Tenn. L. Rev. 791 (2015); Bernard S. Sharfman, The Tension Between Hedge Fund Activism and Corporate Law, J.L. Econ. & Pol’y (forthcoming 2016), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2722124 (exploring the connections between proxy access proposals and market perception).
  32. See, e.g., Lucian A. Bebchuk et al., The Long-Term Effects of Hedge Fund Activism, 115 Colum. L. Rev. 1085 (2015); Nicole M. Boyson & Robert M. Mooradian, Corporate Governance and Hedge Fund Activism, 14 Rev. Derivatives Res. 169, 175–78, 201 (2011); Alon Brav et al., Hedge Fund Activism, Corporate Governance, and Firm Performance, 63 J. Fin. 1729, 1731 (2008); Christopher P. Clifford, Value Creation or Destruction? Hedge Funds as Shareholder Activists, 14 J. Corp. Fin. 323, 324 (2008); Robin M. Greenwood & Michael Schor, Investor Activism and Takeovers, 92 J. Fin. Econ. 362, 374 (2009); April Klein & Emanuel Zur, Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors, 64 J. Fin. 187, 217–18 (2009).
  33. See Rao & Sreejith U, supra note 10.
  34. Id.
  35. See Damodaran, supra note 21, at 112.
  36. See Yaniv Konchitchki & Daniel E. O’Leary, Event Study Methodologies in Information Systems Research, 12 Int’l J. of Acct. Info. Systems 99, 108 (2011).

Navigating Conflicting Roles: The Ethical Obligations of an Organization’s Lawyers Post-Wells Fargo

* J.D. Yale Law School (2016); J.D. candidate, Yale Law School (2017 expected); J.D. candidate, Yale Law School (2017 expected), respectively. The authors are student members of the Ethics Bureau at Yale, a legal clinic at Yale Law School supervised by Professor Lawrence J. Fox, the George W. and Sadella D. Crawford Visiting Lecturer in Law at Yale Law School. For their time, insight, and meticulous guidance, we are indebted to Professor Larry Fox, Christine Michelle Duffy, Irwin Warren, and the student members of The Ethics Bureau at Yale. All errors are our own.

Introduction

Government-initiated enforcement actions aimed at exposing white-collar crime have proliferated considerably following the recent financial crisis. To get ahead of these investigations, many organizations hire in-house or external counsel to conduct their own preliminary investigations. These internal investigations create significant issues for lawyers who must provide to employees they interview an “Upjohn warning”—a disclosure that the lawyer represents only the organization and its interests. Lawyers must caution employees that while their communications are protected by the attorney-client privilege, the privilege belongs to the organization, and the corporation may elect to waive the privilege and disclose otherwise protected information to third parties.1 To date, lawyers have largely confined Upjohn warnings to the context of internal investigations. But a recent case, decided by the District Court for the Southern District of New York, raises the possibility that the ethical lawyer should give Upjohn-like warnings in a wider variety of day-to-day conversations and consultations.

In United States v. Wells Fargo Bank, N.A.,2 the court held that an employee could not disclose the privileged information necessary to raise an advice-of-counsel defense because the corporation owned the privilege.3 As a result, Wells Fargo poses a corollary question to the one addressed in Upjohn. Under Upjohn, organizational lawyers must warn employees that the organization may disclose privileged information over an employee’s objection. After Wells Fargo, the question becomes whether organizational lawyers warn employees that the organization may refuse to disclose privileged information in response to an employee’s legitimate request to do so. This white paper explores the professional ethical repercussions of the Wells Fargo decision and proposes several steps that organizations and their lawyers can take to reckon with the case’s implications.

I. Wells Fargo, Upjohn, and the Obligation to Warn

In Wells Fargo, the government brought fraud charges against both Wells Fargo Bank and Kurt Lofrano, one of the bank’s vice presidents. Lofrano stated that he relied on the advice of company counsel, but Wells Fargo objected to the disclosure of privileged attorney-client communications.4 The court issued two important holdings. First, it held that an employee otherwise lacking authority to waive the attorney-client privilege on the corporation’s behalf could not do so for the purpose of raising a personal advice-of-counsel defense, stating that “the privilege is not waived by the employee’s mere invocation of an advice-of-counsel defense during discovery.”5 Having refused to find an implied waiver, the court then had to decide whether “Lofrano’s right to present an advice-of-counsel defense . . . override[s] Wells Fargo’s privilege.”6 The court concluded that it did not, explaining that “to hold that Lofrano can pursue his defense over the Bank’s objection would ‘render[ ] the privilege intolerably uncertain.’”7

Wells Fargo holding affirms the longstanding principle that only the party who holds the privilege may waive it through either an explicit or implied waiver.8 Indeed, this principle appears to hold true despite the tremendous costs it may place on employees’ abilities to put forth their best defense.9 As such, an employee who receives and acts on the advice of organizational counsel would likely be barred from raising an advice-of-counsel defense if the organization refuses to waive attorney-client privilege, even when that defense is the backbone of the employee’s case.

Wells Fargo belongs to a long line of cases wherein organizations and their employees diverge on the issue of waiving attorney-client privilege.10 The most important of these cases is Upjohn Co. v. United States. In Upjohn, the Court held that organizational counsel’s conversations with employees fell under the attorney-client privilege, but the privilege belonged solely to the corporation, and not the employee. There, “[m]anagers were instructed to treat the investigation as ‘highly confidential’ and not to discuss it with anyone other than Upjohn employees who might be helpful in providing the requested information.”11 The Court found this disclaimer to constitute sufficient notice to inform the employees that their communications with counsel were privileged and that the employees did not control that privilege. In reaching its decision, the Court explained: “[T]he privilege exists to protect not only the giving of professional advice to those who can act on it but also the giving of information to the lawyer to enable him to give sound and informed advice.”12

The purpose of the Upjohn warning is to inform employees that the advice they receive is for the organization and not themselves. The warnings have no statutory basis, and so companies may formulate them in multiple ways. Standard Upjohn warnings inform the employee of the following: (a) the lawyer represents the employer; (b) any advice given during the conversation is for the organization and not the employee; (c) the communication is protected by the attorney-client privilege, but that privilege belongs to the organization and not the employee; (d) the organization may choose to waive the privilege and disclose the employee’s statements to a third party, including government authorities; and (e) the employee has an obligation to keep the contents of the communication confidential.13 However, even seemingly watered-down Upjohn warnings have been held acceptable so long as employees do not reasonably believe that they have an attorney-client relationship with the organizational counsel. For example, the Ninth Circuit found a warning that the employee was being interviewed “on behalf of” a company sufficient, at least where subsequent conduct by the employees indicated that they were aware that the privilege belonged to the company.14

In addition to allowing less formal versions of the Upjohn warning in the internal investigation context, Wells Fargo and other federal court opinions suggest that Upjohn warnings may also be required outside the context of internal investigations. For example, in In re Kellogg, Brown & Root, Inc., the court held that the distinction between talking with counsel for the sake of gaining legal advice and for purposes of complying with a routine regulatory or company policy rested on a “false dichotomy.”15 The court also noted that “a variety of other federal laws require similar internal controls or compliance programs.”16 Indeed, courts may hesitate to draw lines between investigative and non-investigative communications because, as a practical matter, the potential for conflicts of interest will exist in both situations.

II. The Dual Nature of Lawyers’ Ethical Obligations

Wells Fargo made clear that employees who act in reliance on the advice of organizational counsel may be prevented from raising an advice-of-counsel defense in litigation. Lawyers now have notice that courts may honor an organization’s refusal to waive privilege, meaning that reliance on the lawyer’s advice might put the employee in legal peril. This raises a series of Upjohn­-like questions: After Wells Fargo, when does an organizational lawyer have an ethical duty to warn? Must organizational lawyers always inform employees that they do not represent them and that all succeeding conversations are protected by organizational privilege, or do lawyers have flexibility to decide when such warnings are necessary? What information should the warning contain, and should lawyers advise employees to retain their own counsel?

The organizational lawyers’ obligation to warn can be gleaned from the Model Rules of Professional Conduct (Model Rules), which imposes duties on lawyers with respect to both their organizational clients and the individual employees within the organization. The Model Rules set the following standard: An organization’s lawyer must warn employees that they are not the lawyer’s clients, and that the organization owns the privilege for any succeeding conversations, in situations wherein the lawyer reasonably believes that the employee’s interests may be or become adverse to the organization’s interests. This standard derives from a combined reading of Model Rules 1.13, 4.3, and 1.7.17

First, Model Rule 1.13 sets out lawyers’ ethical obligations when representing an organizational client. Because an organization cannot act except through its directors, officers, and other employees, counsel’s client is “the organization acting through its duly authorized constituents.”18 Lawyers do not, however, represent individual employees in their personal capacity.19 Thus, “[i]n dealing with an organization’s directors, officers, employees, members, shareholders or other constituents, a lawyer shall explain the identity of the client when the lawyer knows or reasonably should know that the organization’s interests are adverse to those of the constituents with whom the lawyer is dealing.”20 The comment to Rule 1.13(f) further explains that this warning should include reminders that “lawyer[s] cannot represent such constituent,” “that such person may wish to obtain independent representation,” and that lawyers’ discussions with “the individual may not be privileged.”21

The Wells Fargo decision sheds light on when organizational lawyers should perceive potential adversity between the organization and employees’ interests. Because lawyers must maintain confidentiality of client information, employees may become adverse to the organization whenever employees face personal liability for which they would like to raise an advice-of-counsel defense. In such a situation, the organization may refuse to waive the attorney-client privilege. When lawyers reasonably foresee that such a conflict may arise, they have a duty to remind the employee of the identity of their organizational client and their client’s right to prohibit the employee from disclosing any legal advice the organization’s lawyers provide.

This interpretation is further bolstered by Model Rule 4.3, which governs lawyers’ interactions with unrepresented persons. It states:

In dealing on behalf of a client with a person who is not represented by counsel, a lawyer shall not state or imply that the lawyer is disinterested. When the lawyer knows or reasonably should know that the unrepresented person misunderstands the lawyer’s role in the matter, the lawyer shall make reasonable efforts to correct the misunderstanding. The lawyer shall not give legal advice to an unrepresented person, other than the advice to secure counsel, if the lawyer knows or reasonably should know that the interests of such a person are or have a reasonable possibility of being in conflict with the interests of the client.22

This rule clearly requires that, in situations wherein the interests of the organization and an individual employee may potentially conflict, organizational counsel must refrain from giving any indication that would lead such employees to believe that they are represented by counsel. The burden is on lawyers to unambiguously communicate that they represent the interests of the organization and not the employees. This communication should include a reminder that, in any correspondence between the lawyer and the employee, the organization owns the privilege and is the sole entity that may waive it.

Failure to clarify the identity of an organizational counsel’s client not only violates a lawyer’s duties to unrepresented employees, but also may violate a lawyer’s obligations to their organizational clients. Of course, employees’ interests will not always clash with organizational interests; oftentimes, interests will align.23 However, when organizational counsel can reasonably foresee a potential conflict, they must adequately dispel an employee’s perception that a lawyer-client relationship has been formed. Otherwise, they risk unwittingly creating an “accidental client” based on the employee’s detrimental reliance.24 Taking on an accidental client can violate a lawyer’s ethical obligations to their organizational clients if the new employee-client’s interests are adverse to the interests of the organization. Indeed, the Model Rules prohibit a lawyer from taking on a representation that involves a concurrent conflict of interest—a situation in which “the representation of one client will be directly adverse to another client” or “there is a significant risk that the representation of one or more clients will be materially limited by the lawyer’s responsibilities to another client.”25

In sum, the discussed Model Rules converge to impose an obligation on organizational lawyers to warn employees that the lawyers represent the organization, not the employee, whenever lawyers reasonably believe the employee’s interests may be or become adverse to the organization’s. This adversity arises because the organization may refuse to waive attorney-client privilege despite the employee wishing to waive it for the purpose of raising an advice-of-counsel defense.

III. Recommendations for Organizations and their Lawyers

The failure to give an adequate warning could have serious consequences for both lawyers and her organizational clients. Lawyers may face state bar disciplinary proceedings and/or malpractice liability, and employers may suffer the attendant reputational (and potentially financial) costs of their lawyers’ professional misconduct. Importantly, disciplinary and civil malpractice proceedings would progress separately from the original litigation, and the failure to warn does not necessarily affect the organization’s ability to control disclosure of the privileged communication.26 However, if the failure to warn creates an accidental client, then the employee can assert her own attorney-client privilege. Furthermore, if corporate counsel accidentally forms a lawyer-client relationship with the un-warned employee, then counsel would need to withdraw from both representations in order to avoid concurrent representation of adverse clients.27

That said, identifying the existence of an ethical obligation to warn in theory leaves many questions open in practice. Organizational lawyers provide advice to employees in a variety of contexts, and it would not be practical or advisable for lawyers to begin each and every interaction with a warning. At least in certain contexts, requiring a warning before every consultation might deter employees from sharing information with organizational counsel. As the Supreme Court has recognized, these consultations are essential because they allow “the advocate and counselor to know all that relates to the client’s reasons for seeking representation [so that] the professional mission [can] be carried out.28 Furthermore, “full and frank communication between attorneys and their clients . . . promote[s] broader public interests in the observance of law and administration of justice.”29 Thus, Wells Fargo exposes a central irony that plagues the attorney-client privilege in the organizational context—the very privilege that is supposed to encourage employees to talk with counsel also threatens to chill such interactions.

The need to balance counsel’s obligations to both the organization and individual employees prevents the mechanical application of cookie-cutter rules. Rather, the proper approach is structural, involving effort along two dimensions. First, by drawing on institutional memory and building organizational capacity, counsel should proactively identify situations that require warnings and clearly communicate those warnings when appropriate. Second, to protect both the organization and its employees in situations where the need for a specific warning was not anticipated, organizational lawyers must foster a culture of notice through the organization’s daily business practices and employee training.

A. Giving Specific Warnings to Employees

The organizational lawyer’s first task is to determine when a warning is appropriate. On one hand, lawyers understand that there is an ethical obligation to clarify the existence and scope of representation unambiguously. On the other hand, lawyers should also be aware that excessive warnings could damage rapport and have a chilling effect on employees, making them less willing to seek or accept counsel’s advice. As the analysis above has indicated, ethical rules require that lawyers clearly warn an employee when they reasonably believe that the interests of the employee and the organization may be or become adverse to one another in the matter consulted upon. However, consultations with organizational counsel may lead to both organizational and individual liability in many situations. As such, the important task is to determine when the interests of the organization and the individual would not align in cases wherein both are sued for an alleged wrongdoing. To make this complex determination reliably, companies must engage in capacity-building efforts involving dialogue among employees, information gathering, and extensive record keeping.

Based on their professional experiences, lawyers have a general sense of the types of issues that are more likely to result in adversity between the organization and the individual employees. Some examples of these issues include individual acts of corruption or managerial employment discrimination against specific groups of employees. By collecting this information from practicing lawyers, looking into the organization’s specific history and institutional practice, and examining relevant case law and government investigation histories, organizations and their lawyers should work together to build a repertoire of potentially risky scenarios that are more likely to lead to conflicts. Furthermore, lawyers should dutifully record this information to aid institutional memory and serve as a reference for other organizational lawyers faced with similar dilemmas.

Once an organizational lawyer determines that a warning is necessary, she must clearly issue the warning before the employee reveals any information or receives any advice. The warning should include the following components:

  1. Counsel represents the organization and not the employee.
  2. The employee’s communications with the lawyer are protected by the attorney-client privilege.
  3. The privilege belongs solely to the organization and not to the employee.
  4. Only the organization may waive the privilege in order to disclose the contents of the communication to third parties in any subsequent proceeding.
  5. The employee will not be notified if the privilege is waived.
  6. The employee must keep confidential the information discussed, even if the employee later wants to say it relied on counsel’s advice.
  7. The employee should consider securing separate, individual representation.

Organizational lawyers should memorialize the giving of the warning, for example, by requiring the employee being interviewed to date and sign a form before proceeding with the communication.30 This memorialization serves two purposes. First, it provides the organization and employee with written evidence of notice, which is useful in future investigations and hearings. Second, the formality of the approach gives employees the opportunity to read the warning carefully and weigh the benefits and risks of continuing the communication.

B. Developing an Organizational Culture of Notice

Legal discretion is, of course, imperfect. Situations will inevitably arise, especially in the capacity-building stage, wherein lawyers reasonably believe that an organization and its employees will not develop interests adverse to one another but unexpected events later create an unforeseen conflict. It is very hard for lawyers to remedy this type of situation satisfactorily after-the-fact. As such, it is critical that lawyers cooperate with organizations to prospectively equip employees with knowledge of Wells Fargo’s implications through educational structural and policy adjustments. Giving employees a degree of control over how they choose to communicate with lawyers is the best safeguard to maintaining the delicate balance between their interests and the organization’s.

The first step towards establishing an ethical culture of notice is to provide information and training to every employee as part of the onboarding process. This is especially necessary for key employees who will be heavily involved in organizational decision-making. First, employees must be made aware of a relevant section on legal representation in their employee handbook and should also be provided with a memorandum on the scope of legal representation in their onboarding packets. Furthermore, employees could be required to attend introductory training sessions that mirror routine orientation lectures already provided by many organizations. These sessions should emphasize the implications of Wells Fargo and may employ a variety of learning tools such as simulations, lectures, videos, and hands-on exercises. Of course, current employees hired before the onboarding program’s launch should retroactively receive the same training and resources so that information is freely, fully, and continuously disseminated.

The efforts should not end, of course, at the beginning of an employee’s tenure at the organization. Organizations and their lawyers should collaborate to periodically remind employees of the nature and scope of organizational counsel’s representation. Such a reminder can be accomplished through the circulation of internal memoranda or company-wide e-mails. Organizational counsel may also arrange short seminars and workshops wherein employees are allowed to speak candidly with the organization’s lawyers about representational issues in a variety of legal scenarios. The benefits of such seminars would be two-fold. First, they would foster more open discussions about organizational lawyers’ roles and relationship with individual employees. Second, the seminars would also serve as a forum for lawyers to build rapport and trust with the organization’s employees.

It is imperative that the aforementioned seminars, trainings, and informational materials be tailored to specific employees’ functions, seniority levels, and decision-making roles within the organization. Indeed, the legal issues facing a manager are far more numerous than and fundamentally different from the issues facing entry-level employees. As such, managers would likely need additional and extended sessions. Similarly, training should increase in the wake of major changes in the law, such as Wells Fargo and Upjohn, as well as major events in the organization, such as a government investigation or enforcement action. Finally, employees, especially managers and officers, should be constantly alerted to the option of seeking individual representation in areas of high legal complexity and risk.

To be sure, creating an organizational culture of notice will require an investment of institutional resources—but the benefit is worth the cost. Most importantly, all lawyers have an obligation to comply with applicable rules of professional conduct, even when compliance costs time and money. Second, and more directly relevant to an organization’s bottom line, building a culture of notice will help prevent the creation of accidental clients and insulate the organization against litigation concerning a former employee’s putative advice-of-counsel defense. Lastly, clearly communicating the organizational counsel’s role will help build trust between employees and an organization’s lawyers, ensuring that both groups can more effectively and efficiently support each other’s work.

IV. Conclusion

Wells Fargo clearly exposes the challenges facing lawyers in the context of organizational representation. Specifically, lawyers must serve as effective and zealous advocates for their organization while simultaneously honoring their ethical duties to unrepresented employees. As this white paper has discussed, lawyers must craft creative solutions to prevent the negative consequences of a Wells Fargo dilemma. Specifically, they should strive to institute small structural changes that (1) aid in the prediction of potential adversity between organizational and individual interests and (2) foster a culture of notice and information regarding the scope of legal representation.

  1. See Upjohn Co. v. United States, 449 U.S. 383 (1981).
  2. 132 F. Supp. 3d. 558 (S.D.N.Y. 2015) [hereinafter Wells Fargo I]. In fact, the court issued two opinions on the advice-of-counsel issue. See also United States v. Wells Fargo Bank N.A., No. 12-CV-7527 (JMF), 2015 WL 3999074, at *1 (S.D.N.Y. June 30, 2015) ]hereinafter Wells Fargo II]. In the body text, this paper will collectively refer to both opinions as the Wells Fargo case.
  3. Wells Fargo I, 132 F. Supp. 3d at 563.
  4. Wells Fargo I, 132 F. Supp. 3d at 560.
  5. Wells Fargo II, No. 12-CV-7527 (JMF), 2015 WL 3999074, at *2.
  6. Wells Fargo I, 132 F. Supp. 3d at 563.
  7. Id. at 564 (quoting Ross v. City of Memphis, 423 F.3d 596, 604 (6th Cir. 2005) (alteration in original)).
  8. Note, however, that because managers are fiduciaries acting on behalf of stockholders, courts may in some cases permit shareholders to discover attorney-client communications between corporate counsel and corporate managers. See Garner v. Wolfinbarger, 430 F.2d 1093, 1103–04 (5th Cir. 1970) (“The corporation is not barred from asserting [attorney-client privilege] merely because those demanding information enjoy the status of stockholders. But where the corporation is in suit against its stockholders on charges of acting inimically to stockholder interests, protection of those interests as well as those of the corporation and of the public require that the availability of the privilege be subject to the right of the stockholders to show cause why it should not be invoked in the particular instance.”); see also 1 John K. Villa, Corporate Counsel Guidelines § 1:27 (2015) (stating that “Garner has become the accepted law” and collecting cases).
  9. Acknowledging that “the Supreme Court did leave open the possibility that ‘exceptional circumstances implicating a criminal defendant’s constitutional rights might warrant breaching the privilege,’” the Wells Fargo Court emphasized that “this case is civil, not criminal, and therefore would not fall within such an exception even if it did exist.” Wells Fargo I, 132 F. Supp. 3d at 562.
  10. Furthermore, although Wells Fargo imagines a for-profit context, its implications extend to non-profit organizations as well.
  11. Upjohn Co. v. United States, 449 U.S. 383, 387 (1981).
  12. Id. at 390.
  13. See Robert R. Calo et al., Upjohn Warnings: Recommended Best Practices When Corporate Counsel Interacts with Corporate Individuals, Am. B. Ass’n (2009), https://www.crowell.com/PDF/ABAUpjohnTaskForceReport.pdf.
  14. United States v. Ruehle, 583 F.3d 600, 609 (9th Cir. 2009).
  15. 756 F.3d 754, 758 (D.C. Cir. 2014).
  16. Id. at 762.
  17. The New York Rules of Professional Conduct have an even more expansive conflict of interest standard that bars lawyers from representing clients with “differing,” and not necessarily adverse, interests. N.Y. Rules of Prof’l Conduct r. 1.7(a)(1).
  18. Id. r. 1.13.
  19. Id. r. 1.13 cmt. 2.
  20. Id. r. 1.13(f).
  21. Id. r. 1.13 cmt. 10.
  22. Id. r. 4.3.
  23. See Susan R. Martyn, Accidental Clients, 33 Hofstra L. Rev. 913, 939 (2005).
  24. See id. at 938.
  25. N.Y. Rules of Prof’l Conduct r. 1.7.
  26. United States v. Ruehle, 583 F.3d 600, 612-13 (9th Cir. 2009).
  27. See Brandon L. Garrett, Corporate Confessions, 30 Cardozo L. Rev. 917, 944-45 (2008).
  28. Trammel v. United States, 445 U.S. 40, 51 (1980).
  29. Upjohn Co. v. United States, 449 U.S. 383, 389 (1981).
  30. See, e.g., United States v. Nicholas, 606 F. Supp. 2d 1109 (C.D. Cal. 2009).

Iterative Energy Policy: Resisting An Apology (Book Review)

* Associate Dean for Public Engagement and Professor of Law, the George Washington University Law School. The author thanks Joel Eisen, Rob Glicksman, and Dick Pierce for their helpful comments.

Book Review

Steve Isser, Electricity Restructuring in the United States: Markets and Policy from the 1978 Energy Act to the Present (Cambridge Univ. Press 2015)

Most energy law scholars have a general sense of the piecemeal fashion in which energy law and policy have unfolded in the past several decades. Notwithstanding the lack of a unifying policy, markets have opened, for both natural gas and electricity; environmental policy has become increasingly intertwined with the energy sector; and natural gas prices matter.1 The laws and policies ushering in these developments can be lined up against presidential administrations, economic crises, and major domestic and world events. Indeed, that context aids tremendously in understanding contemporary energy law, and it has become part standard fare, part lore for energy law aficionados.2

In Steve Isser’s Electricity Restructuring in the United States,3 readers will find a rich resource that delves deeply into the story of energy law’s evolution. The book covers the particulars of nearly every development in U.S. energy law and policy related to electricity restructuring from 1978 until about 2014. It documents the kinds of details that are lost over time: names,4 squabbles,5 and strange bedfellows6 that contributed to energy law as we know it. For researchers, such details provide texture and an ample array of sources for further exploration. Indeed, I begin this review with an overview of the book’s descriptive project and offer a few pragmatic thoughts on the book’s utility for legal scholars in the field. Second, I briefly engage a particular issue the book raises: translating complicated scientific, technical, and economic theory into on-the-ground regulatory policy. Third, I suggest that the book’s preference for an iterative approach to electricity policy can be analogized to adaptive management, perhaps offering a way of reconciling the traditional tensions between regulatory and market-based policy approaches to electricity. I conclude with a cautionary note of my own.

I. The Details of Muddling Through

The book’s general approach is to provide a deeply descriptive account of the transition from traditional regulation to wholesale electricity markets. For the most part, Isser does not take strong normative positions, which may be unsettling for readers accustomed to such an approach. As Isser explains in the book’s Introduction, “This work is an unapologetic economic policy history that is more focused on description than theory.”7 And indeed, the monograph unfolds largely as advertised. After providing some background on the origins of the Federal Power Act (FPA) and the regulated electric industry today, the book takes the reader headlong through a tour of everything from the Clean Air Act to industry restructuring to the California energy crisis. These “main events” of energy law are accented with tidbits—like which corporation lobbied for the qualifying facility (QF) provisions in the Public Utility Regulatory Policy Act (PURPA), and which law firm provided representation.8

Isser consistently applies this exacting attention to detail throughout the book. He carefully attends to the rise of environmental regulation,9 investor responses to PURPA,10 the policy transition to economic modeling for electricity,11 and even the particulars of how electricity dispatch software works.12 As he lays out the transition to wholesale electricity markets,13 Isser makes sure to describe the politics,14 the players,15 and the phenomenal shifts in both the electricity industry’s organization and the regulatory structures that accompanied the transition.16

At the book’s conclusion, Isser does not attempt to reconcile these rich details into any overarching theory. Rather, he frames the book’s journey as an apology for “muddling through.”17 To be sure, Isser shares his opinions at the end of the book. He concludes that muddling through is superior to radical restructuring; that promises of dramatic cost savings through restructuring proved to be “so much hype and hot air”; that stronger regulation of transmission is necessary to reap the gains of restructuring; and that retail competition “has been grossly overrated.”18 Yet the book as a whole seems more detached than these strong concluding opinions suggest. Isser offers only glimpses of his own views in most of the chapters, making these concluding observations seem more an afterthought than a set of overarching themes on which a reader might engage.

This descriptive approach, however, has the benefit of inviting the reader to draw her own conclusions. Scholars wishing to support public choice theory in energy policy development, for example, will find mountains of examples permeating the book.19 Environmental law as a driving force in energy policy is also amply demonstrated.20 The interplay between natural gas prices and the electricity fuel mix is likewise shown to be a perennial issue for energy policy.21 The book’s factual richness prompts many sparks of ideas and supplies information that is otherwise difficult to find.

II. Iterative Regulation and the Fallacy of Models

An issue that Isser engages more thematically, albeit somewhat tacitly, is that of translating complex scientific, economic, and technological concepts to working regulatory models. This is perhaps best demonstrated in the chapter entitled “The Economists are Coming, The Economists are Coming.” As the title suggests, this is one topic regarding which Isser cannot really hide his own perspective. Here he explains how it was that economic theory infiltrated the public policy of electricity regulation.22 First, he notes the role of economic concepts as political “rhetoric,” stating that some of the terms are used “promiscuously,” suggesting more than can be delivered.23 “Efficient market,” for example, suggests a sort of perfection that cannot be obtained in the real world.24 Efficiency is an ideal, while a market is a “mechanism for organizing economic activity” rather than an end in and of itself.25 Nevertheless, competing economists—many of whom Isser calls biased and self-interested—engaged in a “battle of the experts” in which the winners were proposing deregulation with little supporting evidence.26 As competing academics disseminated arguments to consultants, who translated the information to lobbyists, who once again translated information to politicians, complex issues became grossly oversimplified.27

These observations dovetail with others’ criticisms of how scientific and technical information is managed by, and incorporated into, the U.S. legal system. From concerns about “hired-gun” expert witnesses at trials28 to the politicization of science in federal agencies,29 there is intuitive appeal to the view that, in order for the law to be fair, legal institutions must get the science “right.”30 From a pragmatic perspective, this is not a controversial goal; however, it is extremely limited in operation because science is neither static nor certain.31 Instead, most science is accompanied by varying types and degrees of uncertainty, making it a fallacy to state that science can provide answers.32 The decision what to do in light of science and uncertainty—and other relevant factors—is inherently a decision of policy.33

Isser’s emphasis on the weaknesses of economic models resonates with these principles. As he succinctly puts it, “It is our models that are simple, not the real world.”34 This is no condemnation of modeling; rather, it is a plea for policymakers to resist the urge to blindly rely on theory and models without explicitly confronting their accompanying uncertainties. By itself, this is a problem of transparency. Rhetorical appeals to superficially objective models often obscure the real rationales for decisionmaking, undermining participatory values at the heart of democratic processes.35 But consider also this passage from the Economists chapter:

Economists and consultants were both guilty of understating the difficulties and oversimplifying the complexity of building real-world electricity markets. This in turn encouraged politicians to support overly ambitious timelines for restructuring markets, resulting in software and market structures that contained serious design flaws. At best, this meant numerous software iterations, as market flaws were identified and desired functionality was added to stakeholder and regulator wish lists. The worst case scenario was the California market meltdown, where poor market design, rushed implementation, and a “perfect storm” of events lead to an economic disaster.36

Isser’s critique is not so much one involving democratic norms and the fallacy of models as a warning against haste. His competing-expert and uncertainty-based critiques are not borne of concerns about decisionmaking as a process so much as decisionmaking outcomes.

These observations offer a provocative lens for evaluating the recently released Clean Power Plan.37 Opponents and supporters alike have emphasized the significant changes that the Plan heralds for electricity policy.38 A fundamental building block of the Plan—replacing coal-fired power with natural-gas fired power—is sure to bring changes in the electricity fuel mix.39 Another building block anticipates further fuel-switching to low-carbon fuels.40 EPA has expressly disavowed any intention to interfere with electricity dispatch, but it has also emphasized that the fungible nature of electricity enables “shifting dispatch from steam generators” to lower-carbon units.41 Critics of the Plan argue that it will severely reduce grid reliability,42 while EPA downplays any such impacts.43 The point here is not to resolve these competing views. Rather, the point is the acute relevance of what Isser has identified: over-generalizing incredibly complex policy efforts risks significant flaws in the implementation phase.44

Adaptive Management and Iterative Policy

This note of caution brings us full circle to Isser’s framing device: the apology for muddling through. Isser suggests that the antidote to this problem of incorporating economic principles into regulatory policy is incremental change. He recognizes that such an approach is “out of fashion” given “the illusion in economics and management decision science that large complex problems can be modeled and solved.”45 But he argues the fallacy of this illusion, and supports gradual changes and incremental policy implementation.46

This view calls to mind the concept of adaptive management, which has received considerable attention in the environmental law literature. The goal of adaptive management, as described by Professors Craig and Ruhl, is to “reduce uncertainty through integrative learning fostered in a structured, iterative decisionmaking process.”47 It is an oversimplification to call this approach “learning by doing,” but its point is to permit agencies to revise their policies as new information emerges, rather than requiring an irreversible commitment to a particular course of action.48 Professors Craig and Ruh provide the example of an agency managing a river system that includes numerous impoundments and other ecological resources.49 Although there may be significant uncertainty regarding the impact of releasing particular amounts of water from the impoundments, the agency can easily control that impact by altering the releases.50 An adaptive management approach would use monitoring to provide feedback on the ecological impact of the releases and to adjust the releases before serious ecological problems arose.51

Of interest for this Review is that adaptive management is viewed as belonging on the opposite end of the spectrum from market-based regulatory solutions because the former relies on regulatory discretion while the latter seeks to minimize regulatory decisionmaking in favor of market-driven outcomes.52 The picture painted by Isser in favor of iterative decisionmaking, however, invites speculation whether adaptive management and actual (as opposed to theoretical) regulated markets are really in such opposition. The story of electricity restructuring, at least, reveals not a true open market but a collection of market-type principles being constantly tinkered with by federal and state regulators and legislatures, and other quasi-governmental actors like Regional Transmission Operators (RTOs) and Independent System Operators (ISOs).

Admittedly, a closer look suggests some mismatches. Adaptive management theory suggests that the most favorable conditions for that approach involve high uncertainty, high controllability, and low risk.53 The river system example above, for instance, meets these criteria.54 By contrast, the wholesale markets—at least those Isser describes as representing incremental change—do not fit these criteria so neatly. Although the markets in practice do involve high uncertainty, Isser contends that decisionmakers’ overreliance on economic models led to the false assumption that there was low uncertainty. In other words, it is important that a decisionmaker accurately understand the degree of uncertainty inherent in a regulatory approach.

Moreover, unlike the gates of a reservoir, the markets are not particularly controllable, as evidenced by the history of consumer worries about widely fluctuating rates and regulators’ insistence on price caps.55 Further, market design risks can be quite high—as demonstrated by blackouts costing millions of dollars.56 At the same time, the failures to which Isser points took place within regulatory contexts that were certainly not adaptive; his whole point is that state restructuring especially was undertaken too quickly.

Still, reconciling Isser’s argument for incremental change with adaptive management theory may be a worthwhile exercise57. Perhaps there is a kernel possibility for aligning the theory of regulated markets with traditional regulation in hopes of developing a more accurate model of modern regulatory theory generally. And, perhaps, there are lessons inherent in that exercise for making progress on the best way to incorporate uncertain science, economics, and technology into regulatory decisionmaking. Isser identifies the problem; adaptive management aims at least in some circumstances to account for evolving scientific knowledge rather than freezing the state of knowledge in time.58

V. Conclusion

I conclude with one additional thought, drawing from the philosophy of science. Consider Thomas Kuhn’s view: that science is normally a cumulative exercise of evolving consensus, punctuated by occasional paradigm shifts.59 A loose analogy can be made to law: there are periods of incremental, iterative policymaking, punctuated by major shifts like the New Deal and the environmental, health, and safety statutes of the late 1960s and early 1970s. The starting place for Electricity Restructuring fits neatly within the latter period and may be best viewed as such a punctuating shift. Isser’s apology for muddling through involves the long process of learning and implementing since that time. History, however, suggests that another paradigm shift may be due. Climate change may well be the motivating force; the urgency of mitigation and adaptation are only increasing. Even if incremental change is at times the best path for regulatory decisionmaking, one hopes that in the next several decades, we are not apologizing to our children and grandchildren for our inability to do more than muddle through.

  1. See Joel B. Eisen et al., Energy, Economics and the Environment 6-8 (4th ed. 2015) (briefly describing eras of energy law).
  2. See, e.g., id. at 8 (“[S]everal distinct themes recur throughout the history of energy law. . . . history often repeats itself.”); William Boyd, Public Utility and the Lowe-Carbon Future, 61 UCLA L. Rev. 1614, 1635-36 (2014) (describing changing conceptions of the public utility); Emily Hammond & David B. Spence, The Regulatory Contract in the Marketplace, – Vand. L. Rev. – (forthcoming 2016), http://ssrn.com/abstract=2584619 (providing overview of changes in markets and environmental policy since late-1970s); Alexandra B. Klass & Elizabeth J. Wilson, Interstate Transmission Challenges for Renewable Energy: A Federalism Mismatch, 65 Vand. L. Rev. 1801, 1814-21 (2012) (describing history of federal authority over transmission); Richard J. Pierce, The Past, Present, and Future of Energy Regulation, 31 Utah Envtl. L. Rev. 291 (2011) (describing major developments in energy law and critiquing policy options for the future); Jim Rossi, The Political Economy of Energy and Its Implications for Climate Change Legislation, 84 Tulane L. Rev. 379 (2009) (describing how public choice theory and federalism policy in energy sphere relate to political economy of climate change legislation).
  3. Steve Isser, Electricity Restructuring in the United States: Markets and Policy from the 1978 Energy Act to the Present (2015).
  4. Often, if Isser cites a study, he will also tell you who sponsored it. See, e.g., id. at 440 n.23 (noting sponsors of reliability study); id. at 443 n.1 (describing studies and listing “self-interested” sponsors).
  5. E.g., id. at 292 (describing unwillingness of North American Electric Reliability Corporation (NERC) to real-time generation and transmission data with FERC, because NERC members “did not want FERC staff to have the data”).
  6. E.g., id. at 53 (referencing the combination of environmental idealists and industry groups that supported the Clean Air Act Amendments of 1977).
  7. Id. at 2.
  8. It was Wheelabrator-Frye Corporation, a waste-to-energy facility developer, represented by Van Ness, Feldman, and Sutcliffe. Id. at 82.
  9. Id. Ch. 2.
  10. Id. Ch. 4.
  11. Id. Ch. 5.
  12. Id. Ch. 7.
  13. Id. Chs. 8-12.
  14. Id. Ch. 11.
  15. Id. Ch. 10.
  16. Id. Chs. 13-25.
  17. Id. at 460.
  18. Id. at 461.
  19. See, e.g., id. Ch. 2 (describing environmental regulation of electricity generation), Ch. 6 (describing events leading to Energy Policy Act of 1992).
  20. See, e.g., id. Ch. 2 (describing environmental regulation of electricity generation), Ch. 25 (describing recent Clean Air Act initiatives).
  21. See, e.g., id. at 87 (“The decline in the price and the increased availability of natural gas due to deregulation made natural gas a more attractive fuel for electricity generation during a period when there were significant advances made in turbine and power plant design.”).
  22. Id. at 102.
  23. Id. at 97.
  24. Id.
  25. Id. at 102.
  26. Id. at 101.
  27. Id. at 102.
  28. See generally Peter W. Huber, Galileo’s Revenge: Junk Science in the Courtroom (1991); Edward K. Cheng & Albert H. Yoon, Does Daubert or Frye Matter? A Study of Scientific Admissibility Standards, 91 Va. L. Rev. 471 (2005) (studying admissibility outcomes under two most prominent admissibility regimes).
  29. See Emily Hammond Meazell, Super Deference, the Science Obsession, and Judicial Review as Translation of Agency Science, 109 Mich. L. Rev. 733, 744-56 (2011) [hereinafter Hammond, Super Deference] (discussing this issue).
  30. See Emily Hammond Meazell, Scientific Avoidance: Toward More Principled Judicial Review of Legislative Science, 84 Ind. L.J. 239, 242 (2009) [hereinafter Hammond, Scientific Avoidance] (“With society’s faith in science comes an inherent belief that scientific “truth” is inextricably linked to fairness.”).
  31. See Nat’l Academies Press, Responsible Science Volume I: Ensuring the Integrity of the Research Process 38 (1992) (“Although [science’s] goal is to approach true explanations as closely as possible, its investigators claim no final or permanent explanatory truths. Science changes. It evolves. Verifiable facts always take precedence.”). It is in fact difficult to find examples of courts or agencies getting scientific facts wrong (as opposed to “best science” or state-of-the-art). A possible, if disputed, example, is Wells v. Ortho Pharmacy, 788 F.2d 741, 742 (11th Cir. 1986) (upholding district court’s credibility-based determination that spermicidal jelly caused birth defects, even though scientific consensus was otherwise). See also Wendy E. Wagner, The Bad Science Fiction: Reclaiming the Debate over the Role of Science in Public Health and Environmental Regulation, Law & Contemp. Probs., Autumn 2003, at 72-87 (exhaustively demonstrating that there are very few examples of agencies getting positive science wrong).
  32. Hammond, Super Deference, supra note 29, at 744-48.
  33. Hammond, Scientific Avoidance, supra note 30, at 250-51.
  34. Isser, supra note 3, at 99; see also Robert L. Glicksman, Bridging Data Gaps Through Modeling and Evaluation of Surrogates: Use of the Best Available Science to Protect Biological Diversity Under the National Forest Management Act, 83 Ind. L.J. 465, 479 (2008) (“[Models] are capable neither of providing a completely accurate representation of reality nor of eliminating the scientific uncertainty that induces the decision maker to resort to modeling in the first place.”).
  35. See Hammond, Super Deference, supra note29, at 736 nn. 9-10 (collecting sources).
  36. Isser, supra note 3, at 109.
  37. Carbon Pollution Emission Guidelines for Existing Stationary Sources: Electric Utility Generating Units, 40 C.F.R. § 60 (2015) [hereinafter Clean Power Plan].
  38. Barack Obama, Remarks by the President in Announcing the Clean Power Plan (Aug. 3, 2015) (calling CPP “single most important step America has ever taken in the fight against global climate change”); cf. Scott Segal, Lots of Pain with Questionable Benefits, U.S. News Debate Club, Aug. 13, 2015 (“We can expect significant potential threat to the electric reliability upon which our modern way of life depends.”).
  39. Clean Power Plan, supra note 37, at 7 (listing building block 2 as “[s]ubstituting increased generation from lower-emitting existing natural gas combined cycle units for reduced generation from higher-emitting affected steam generating units”).
  40. Id.
  41. Id. at 593.
  42. E.g., Segal, supra note 38.
  43. Clean Power Plan, supra note 37, at 51.
  44. These potential flaws are the subject of a current project with co-author Richard J. Pierce.
  45. Isser, supra note 3, at 460.
  46. Id.
  47. Robin Kundis Craig & J.B. Ruhl, Designing Administrative Law for Adaptive Management, 67 Vand L. Rev. 1, 20 (2014); see generally id. (providing comprehensive review of literature and theoretical underpinnings).
  48. Id. at 16-17.
  49. Id. at 20.
  50. Id.
  51. Id.
  52. Id. at 3-11.
  53. Id. at 19-21. Some regulatory decisions, by contrast, are binary, that is, yes/no actions such as whether to grant a license or approve a tariff. Id. at 19. These are not amenable to adaptive management because they require a single decision meant to minimize uncertainty and control risk, though subsequent monitoring may be amenable to an adaptive approach. Id. at 21.
  54. Id. at 20.
  55. Cf. Richard J. Pierce, Jr., Completing the Process of Restructuring the Electricity Market, 40 Wake Forest L. Rev. 451, 482 (2005) (describing how price ceiling have negative effects on market efficacy).
  56. Isser, supra note 3, at 407.
  57. Regrettably, a full analysis here is beyond the scope of this Review. It promises instead a rich area of exploration for future work.
  58. See Robert L. Glicksman & Sidney A. Shapiro, Improving Regulation Through Incremental Adjustment, 52 U. Kan. L. Rev. 1179, 1185-87 (2004) (describing benefits of “back-end” regulatory adjustments).
  59. Thomas S. Kuhn, The Structure of Scientific Revolutions 36-42, 52 (3d ed. 1996).

How King v. Burwell Creates Tax Problems for Consumers and What The Treasury Can Do About It

* Associate Professor of Law, University of Iowa. Comments, corrections, and criticisms are welcome at agrewal@iowa.uiowa.edu.

After the Supreme Court agreed to hear King v. Burwell,1 a case addressing whether taxpayers can receive Section 36B premium tax credits for health insurance policies purchased on federally established exchanges (“federal policies”), commentators have expressed concerns about a potential death spiral in the health insurance market. Under the worst case scenario, the absence of credits for federal policies will deter consumers from future enrollment. With this smaller enrollment pool, premiums will spike sharply during the 2015-2016 Affordable Care Act enrollment season, the first following the Court’s anticipated June 2015 ruling. Those price increases will further deter enrollment, and the Act will eventually collapse.2

This focus on future enrollment seasons masks the potentially harsh tax consequences for consumers who purchase federal policies during the 2014-2015 enrollment season. Many such consumers cannot pay the sticker price for federal policies and receive tax credits to assist with their monthly insurance payments. However, an adverse decision in King v. Burwell would generally require that they pay back those credits.

This conclusion might seem surprising to 2014-2015 purchasers of federal policies. Under the ACA’s advance payment mechanisms, consumers seemingly take the premium tax credit immediately upon the purchase of a federal policy.3 Unsophisticated consumers—or even sophisticated ones—can easily assume that advanced payments do not have to be paid back.4 After all, those payments go straight to insurers and never appear on consumers’ bank accounts.

But advance payments are like loans in the sense that consumers have to repay them if those payments exceed their properly allowable tax credits. The government tentatively makes an advance payment because a consumer’s premium tax credit ultimately depends on various factors, including the consumer’s annual household income, which cannot be accurately determined until the end of the taxable year.5 Consequently, anyone who receives advance payments must file a tax return to demonstrate her entitlement to the premium tax credit.6 If the advance payments exceed the allowable tax credit, Section 36B(f) requires that the consumer pay back the excess.7

Excessive advance payments commonly arise when a consumer estimates her credit using a household income lower than the actual income for the year.8 Under Section 36B, the allowable credit shrinks as income increases, so underestimation of income generally causes a consumer to overstate her anticipated credit.9 Excessive payments will also arise if the government loses King v. Burwell because any advance payment on a federal policy would necessarily exceed the proper credit of $0.

Although it might seem harsh, this result follows from the Tax Code’s annual accounting rule.10 Under the Code, transactions generally do not independently establish tax credits or liabilities. That is, a consumer does not earn a credit simply by purchasing a health policy, whether on a federal exchange or a state exchange, and a consumer does not face a tax liability simply because, for example, he sold property for a big gain.11 The year as a whole requires examination.12 And if the Court decides King v. Burwell against the government, that end-of-year examination will show that purchasers of federal policies were entitled to no premium tax credits.

However, Section 7805(b)(8) may provide some relief to consumers.13 Under that statute, the Treasury can deny retroactive effect to judicial rulings, even ones made by the Supreme Court. But any action by the Treasury will fully protect only those who purchased federal policies during the 2013-2014 enrollment season. Purchasers of federal policies during the current enrollment season will not definitively establish their right to tax credits until after December 31, 2015, approximately six months after a potentially adverse decision in King v. Burwell.14 These taxpayers would need the Treasury to deny prospective effect to the Court’s ruling, a power not contemplated by Section 7805(b)(8).

Arguably, Section 36B reflects a departure from the annual accounting concept, and the Treasury can use Section 7805(b)(8) to protect any advance payments processed before King v. Burwell takes effect. Under Section 36B, the eligibility for a premium tax credit turns on a month-by-month analysis even though a consumer’s actual tax credit or liability depends on annual household income and other factors established at the end of the year.15 Consequently, the Treasury might treat consumers as having established their right to tax credits at the close of each month and might establish some type of pro-ration regime for computing allowable credits.16

But even under this scenario, consumers face potential problems. In the months after King v. Burwell takes effect, no credit related to a federal policy would be allowable, and taxpayers would have to repay any advance payments made for those months. Alternatively, the government might stop making advance payments on federal policies in July 2015, such that taxpayers would effectively see an unaffordable spike in their monthly premium payments. Either way, trouble awaits.

Also, although Section 7805(b)(8) may provide relief for pre-King v. Burwell months, there’s no guarantee that the Treasury will exercise its authority under that statute, given the potential blowback it might face.17 If the Treasury flatly rules that King v. Burwell does not apply for the months preceding the Court’s decision, penalties on individuals and employers would follow. That is, the individual penalty for failure to obtain coverage and the employer penalty for a failure to provide coverage depend, in part, on whether Section 36B extends to consumers who purchase federal policies.18 If the Treasury broadly denies retroactive effect to King v. Burwell, then some individuals and employers will find themselves paying penalties even though they prevailed in the Supreme Court. Although it is doubtful that Section 7805(b)(8) was intended to let the Treasury rob taxpayers of judicial victories, the statute’s plain text does not force the Treasury to exercise its authority in a purely taxpayer-favorable manner.19

Arguably, the Treasury can turn off King v. Burwell only for consumers who purchase federal policies and allow it to take full effect for other individuals and for employers. Section 7805(b)(8) allows the Treasury to “prescribe the extent, if any, to which any ruling” operates without retroactive effect. The Treasury might thus deny retroactive effect to King v. Burwell only to the “extent” that it protects a consumer’s tax credits for federal policies, but no further.

However, it is not obvious that Section 7805(b)(8) allows the Treasury to slice and dice a judicial decision that way. Instead, Section 7805(b)(8) might refer solely to temporal elements, not substantive ones. That is, the Treasury can choose only the “extent” of King v. Burwell‘s retroactivity period and may prescribe, for example, that it takes effect as of June 1, 2015, or as of May 1, 2015, or as of some other date. Under this reading, the Treasury could not chop up the Court’s holding; it would have to accept the decision in toto, subject to whatever period of retroactivity it chooses.

The case law provides little guidance on the Treasury’s authority under Section 7805(b)(8) to deny retroactive effect to judicial decisions. Although the Tax Code has long provided the Treasury the authority to deny retroactive effect to its own rules, the extension of the Treasury’s authority to judicial rulings came relatively recently, via a 1996 statutory amendment. And it is not clear that the Treasury’s authority under Section 7805(b)(8) applies to judicial rulings in the same way that it applies to agency rulings. It makes sense for the Treasury to determine the retroactive effect of its own rulings (whether along substantive or temporal lines), but slicing and dicing the substance of a Supreme Court ruling appears to intrude on judicial power.20

Given the complications of the annual accounting rule and the ambiguity over Section 7805(b)(8), the Court itself might take steps to protect consumers who purchase federal policies. Although the Court seems to have adopted a “firm rule of retroactivity” for civil cases,21 commentators argue that some issues remain unsettled.22 If the Court has the power to stay or delay the effect of its decision in a statutory case,23 policy concerns may support the exercise of that power. However, issuing a decision that applies only prospectively stands in tension with the judiciary’s proper role.24

Congress, of course, could adopt a commonsense statute that protects purchasers of federal policies during the current enrollment season. But a legislative fix seems unlikely given the strained relationship between the President and Congress. It is unfortunate that the people who can most easily protect purchasers of federal policies probably will not reach a sensible compromise.

Going forward, Congress should act cautiously before it houses a public assistance program in the Tax Code. Had Congress provided direct payments to assist with the purchase of policies, rather than tax credits, consumers, employers, and the Obama Administration could have avoided the complications discussed above. But when Congress uses the Tax Code, it incorporates all of its machinery, including the annual accounting rule. That rule may jeopardize the availability of credits for federal policies purchased during the current ACA enrollment season and may discourage signups.25

  1. King v. Burwell, 759 F.3d 358 (4th Cir.), cert. granted 135 S. Ct. 475 (2014).
  2. See, e.g., Jonathan Cohn, Here’s What the Supreme Court Could Do to Insurance Premiums in Your State, New Republic (Nov. 11, 2014).
  3. See 42 U.S.C. § 18082(a)(3) (2012) (establishing the advance payment regime). For a discussion of the rules relating to the computation of the advance payment amount, see Lawrence Zelenak, Choosing Between Tax and Nontax Delivery Mechanisms for Health Insurance Subsidies, 65 Tax L. Rev. 723, 726-28 (2012).
  4. See Robert Pear, White House Seeks to Limit Health Law’s Tax Troubles, N.Y. Times (Jan. 31, 2015), (noting that many consumers did not realize that advance payments may need to be paid back).
  5. Regulations provide detailed rules related to the computation of the premium tax credit. See Treas. Reg. §§ 1.36B-1 to -4 (2012).
  6. See Treas. Reg. § 1.36B-4(a)(1)(i) (2012) (“A taxpayer must reconcile the amount of credit allowed under [S]ection 36B with advance credit payments on the taxpayer’s income tax return for a taxable year.”).
  7. Technically speaking, the statute increases the taxpayer’s tax liability for the taxable year on account of the excess credits. See id. When a taxpayer’s household income is below 400% of the poverty line, Section 36B(f) limits this increase. In these circumstances, the increased tax liability will be limited to between $600 to $2,500, depending on income. See 26 U.S.C. § 36B(f)(2)(B)(i) (2012).
  8. See, e.g., Treas. Reg. § 1.36B-4(a)(4) (2012). The Department of Health and Human Services (HHS) has issued guidance under 42 U.S.C. § 18082(b)(1) (2012) regarding income estimates.
  9. See 26 U.S.C. § 36B(b)(2)(B)(ii)-(b)(3)(A) (2012).
  10. See 26 U.S.C. §§ 441(g), 446(a) (2012) (codifying the Tax Code’s annual accounting rule, which provides that taxable income shall be computed on the basis of the taxpayer’s taxable year, which is usually the calendar year for individuals); see also 26 U.S.C. § 36B (2012) (noting that Section 36B and related provisions “apply to taxable years ending after December 31, 2013,” not to coverage months (emphasis added)).
  11. Spring City Foundry v. Comm’r, 292 U.S. 182 (1934) (holding that gains from the sale of goods early in the year accrued as gross income even though later events in the same year established doubts about full collectability).
  12. See Burnet v. Sanford & Brooks Co., 282 U.S. 359, 365 (1931) (“The computation of income annually as the net result of all transactions within the year was a familiar practice, and taxes upon income so arrived at were not unknown, before the Sixteenth Amendment.”).
  13. In full, 26 U.S.C. § 7805(b)(8) provides, “The Secretary may prescribe the extent, if any, to which any ruling (including any judicial decision or any administrative determination other than by regulation) relating to the internal revenue laws shall be applied without retroactive effect.” 26 U.S.C. § 7805(b)(8) (2012).
  14. Absent a rehearing or other unusual development, the Court will issue its decision in King v. Burwell by the end of June 2015.
  15. See 26 U.S.C. § 36B(b)(1) (2012) (calculating the annual healthcare credit by reference to “coverage months”); see also Treas. Reg. § 1.36B-2(a) (2012) (allocating “premium assistant amount[s]” by month).
  16. See Cent. Laborers’ Pension Fund v. Heinz, 541 U.S. 739, 748 n.4 (2004) (holding that the IRS can invoke authority under Section 7805(b)(8) to protect plans that, under the Court’s ruling, failed Section 411(d)(6)’s requirements); see also Rev. Proc. 2005-23, 2005-1 C.B. 991, as modified by Rev. Proc. 2005-76, 2005-2 C.B. 1139 (stating that a plan will not lose tax-exempt status under Heinz where plan terms are retroactively changed to the date of and reflect the holding of that case). The Heinz case dealt with a statutory regime that does not translate well to the Section 36B premium tax credit regime—Section 411(d)(6) contemplates continuous compliance with a restriction, not a computation of an allowable credit based on factors known only at year-end. Still, Heinz provides some support for the Treasury to allow tax credits for a taxpayer’s coverage months preceding any adverse decision in King v. Burwell.
  17. The government has refused to share its planned response to any adverse decision in King v. Burwell and has made no promises regarding Section 7805(b)(8). See Sarah Ferris, Defiant Health Chief Says ObamaCare Will Win Day at Supreme Court, The Hill (Dec. 23, 2014) (noting that HHS Secretary Burwell “declined to say whether the administration had a contingency plan for the potential loss of $64 billion in subsidies, adding: ‘I’m going to stick with where I am’”).
  18. See 26 U.S.C. § 4980H(a)(2)-(b)(1)(B) (2012) (imposing penalties on an employer when a tax credit is allowed with respect to an employee’s purchase of a qualified health plan); King v. Burwell, 759 F.3d 358, 365 (4th Cir. 2014) (explaining how availability of credits partly determines whether an individual can satisfy the unaffordability exception to the individual mandate, such that she can escape penalties for failing to obtain health insurance).
  19. Of course, other statutes could impose limitations on the Treasury’s taxpayer-adverse exercise of authority under Section 7805(b)(8). See, e.g., Administrative Procedure Act, 5 U.S.C. § 706(2)(A) (2012) (providing that courts shall set aside agency action when discretion has been abused).
  20. The Court of Appeals for the Second Circuit has reserved its judgment on whether the Supreme Court’s “retroactivity rule or other legal principles might constrain the IRS’s authority to limit the retroactive effect on the rights of parties of judicial decisions” under Section 7805(b)(8). Swede v. Rochester Carpenters Pension Fund, 467 F.3d 216, 221 n.9 (2d Cir. 2006). The Treasury has applied Section 7805(b)(8) to a judicial decision only once, when the Court itself directed the Treasury to consider exercising its statutory authority. See Rev. Proc. 2005-23, 2005-1 C.B. 991, as modified by Rev. Proc. 2005-76, 2005-2 C.B. 1139 (following the Court’s suggestion in Cent. Laborers’ Pension Fund v. Heinz, 541 U.S. 739, 748 n.4 (2004)).
  21. Landgraf v. USI Film Prods., 511 U.S. 244, 278 n.32 (1994) (citing Harper v. Virginia Dept. of Taxation, 509 U.S. 86 (1993) (Harper)).
  22. See Laurence H. Tribe, American Constitutional Law § 3-3, at 226 (3d ed. 2000) (“[The] Court [in Harper] did not hold that all decisions of federal law must necessarily be applied retroactively. . . . [T]he Court has not renounced the power to make its decisions entirely prospective, so that they do not apply even to the parties before it.” (emphasis removed)); see also Nunez-Reyes v. Holder, 646 F.3d 684, 698 (9th Cir. 2011) (en banc) (concluding that the Court has not expressly overruled Chevron Oil Co. v. Huson, 404 U.S. 97 (1971), and that courts can limit the retroactive effect of their decisions in narrow circumstances).
  23. In a pre-Harper case, the Court stayed its judgment to allow Congress time to amend a statute to cure its constitutional defects. See N. Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982).
  24. See Am. Trucking Ass’ns, Inc. v. Smith, 496 U.S. 167, 201 (1990) (Scalia, J., concurring) (“[P]rospective decisionmaking is incompatible with the judicial role, which is to say what the law is, not to prescribe what it shall be.”). See generally Bradley Scott Shannon, The Retroactive and Prospective Application of Judicial Decisions, 26 Harv. J.L. & Pub. Pol’y 811, 874 (2003) (arguing that prospectivity’s costs outweigh prospectivity’s benefits).
  25. Cf. Lawrence Zelenak, Choosing Between Tax and Nontax Delivery Mechanisms for Health Insurance Subsidies, 65 Tax L. Rev. 723, 731 (2012) (“A person who is eligible for advance payments based on predicted income, and whose actual subsidy-year income is also in the targeted range, may decide not to participate because of the threat [of Section 36B(f)].”).

The Problem with “Coercion Aversion”: Novel Questions and the Avoidance Canon

* Assistant Professor, University of San Diego School of Law. Many thanks to Larry Alexander, Nick Bagley, Will Baude, Chris Egleson, Dick Fallon, Abbe Gluck, Anton Metlitsky, Abby Moncrieff, Hashim Mooppan, Anne Joseph O’Connell, Dave Owen, Mike Ramsey, David Shapiro, and Kate Shaw for helpful comments and conversations. I am grateful to Taylor Holmes and Ben Schwefel for capable research assistance and to the editors of the Yale Journal on Regulation for thoughtful editorial suggestions.

General Verrilli: I think that it would be – certainly be a novel constitutional question, and I think that I’m not prepared to say to the Court today that it is unconstitutional. … But I don’t think there’s any doubt that it’s a novel question … .

Justice Kennedy: Is it a—I was going to say, does novel mean difficult?

(Laughter.)1

Justice Kennedy may be the swing vote in King v. Burwell. Because of that, the post-oral-argument hubbub has focused on Justice Kennedy’s questions to counsel, which suggested that he was considering resolving the case in the government’s favor using the canon of constitutional avoidance. The King challengers assert that an IRS regulation, which permits federal tax credits to subsidize the purchase of health insurance plans on the federal health insurance exchange, contravenes the Affordable Care Act (“ACA”), which authorizes federal tax credits for purchases of health insurance plans on “an Exchange established by a State.”2 If the challengers’ reading of the ACA were correct, Justice Kennedy posited, the statute would amount to a Congressional threat to withdraw tax credits and impose a destructive subset of federal regulations on states that did not establish exchanges. That threat, he hinted, would be a forbidden attempt by Congress to “coerce” the states: “if your argument is accepted, the states are being told either create your own exchange, or we’ll send your insurance market into a death spiral.”3 His evident inclination was to apply the canon to avoid this reading of the statute and sustain the IRS’s rule.

Justice Kennedy’s unexpected embrace of this idea—let us call it the “coercion aversion” argument—was a curveball. Neither party raised it, presumably because neither had any incentive to raise it: the challengers because the argument would cut against them in this case, and the Solicitor General because it would cut against the federal government in future cases. Only one amicus brief devoted significant space to coercion aversion,4 out of the thirty-one amicus briefs filed on the government’s side.5 The challengers didn’t respond to the argument in their reply.6

From the moment Justice Kennedy floated it, however, it was clear that coercion aversion could point the way to five votes for the government. The Solicitor General grasped its import instantly. Though circumspectly noting his office’s continuing obligation to defend the ACA’s constitutionality,7 he nonetheless did not bat away the helping hand that Kennedy was extending. “[C]onstitutional avoidance becomes another very powerful reason to read the statutory text our way,” said General Verrilli.8

But there’s a problem with coercion aversion, and it arises from the novelty of the asserted Tenth Amendment problem here. This is the choice that the challengers’ reading of the ACA poses to states: “Set up an exchange, or else the federal government will deprive your citizens of tax credits and eliminate the mandate in your state and thereby cause the health insurance markets in your state to collapse.9 Whether this choice is an unconstitutionally coercive “regulatory threat” is clearly a question of first impression, and a consequential one.10 The Court has never invalidated an act of Congress as coercive of the states because of the regulatory burdens it placed on state residents, as opposed to the regulatory burdens it placed directly on states themselves. Nor has the Court ever invalidated an act of Congress as coercive of the states because of the conditions it placed on the money it offered to state residents. To date, the Court has only found unconstitutional coercion where Congress placed conditions on the money it offered to states themselves. Adopting the theory of coercion by regulatory threat would add a new arrow to the quiver of constitutional federalism.

So Justice Kennedy’s question was exactly the right one: is this novel question of constitutional law automatically difficult in a way that means that the King Court should read the statute to avoid it?11 The answer is no. Modern avoidance has two justifications:12 honoring Congress’s presumed intent not to legislate unintentionally close to a constitutional line and preventing courts from unnecessarily issuing constitutional opinions. The logic of these justifications disintegrates when the putative constitutional problem is a novel question of first impression that crystallized only after Congress legislated.13 Congress can’t be presumed to have legislated in light of new constitutional problems that were not evident at the time of lawmaking, and the Court can’t claim to be leaving constitutional law undisturbed when its avoidance holding itself manufactures new constitutional doubts. As a result, the Court should apply the canon to avoid truly novel constitutional problems only if it has exhausted other available tools of statutory interpretation, and even then only in preference to actual constitutional invalidation.

For King, this principle boils down to a simple syllogism. Because (1) the constitutional problem of coercion by regulatory threat is novel; and because (2) the justifications for the modern avoidance canon disintegrate where the problem being avoided is novel; therefore (3) the Court should use coercion aversion to resolve King only as a last resort. In King, an alternative avenue for resolving the case is necessarily available to a justice who would otherwise use the avoidance canon to circumvent this novel problem. To avoid the ostensibly coercive reading of the statute, a justice must conclude that an alternative, non-coercive construction of the statute is “fairly possible” or “reasonable.”14 But if there’s a “reasonable” reading of the ACA whereby tax credits are not linked to the creation of state exchanges, then a fortiori the ACA must fail to state unambiguously the conditions on the availability of tax credits—which would run afoul of the federalism clear-statement cases that require Congress to impose such conditions in unmistakable terms.15 Consequently, a justice inclined towards coercion aversion need not and should not rely on it to resolve the case—even if that justice would rule that a clearly worded regulatory threat of this kind was unconstitutional if she were unavoidably confronted with that novel question on the merits.

The essay proceeds as follows. Part I explains the novelty of the constitutional problem that the justices are considering avoiding. Part II describes the serious difficulties with equating “novel” questions with “difficult” ones for purposes of the avoidance canon. Part III applies this analysis to King. A short conclusion follows.

I. A New Version of Coercion

Imagine that the government loses King, and the Court holds that the ACA provides tax credits only on state exchanges. Now imagine the lawsuit in which a state contends that the ACA, so construed, contravenes the Tenth Amendment. That suit would be a successor to King, so let us call it Prince. The Prince lawsuit would claim that it was unconstitutional to force states to make the choice mentioned above: “Set up an exchange, or else the federal government will deprive your citizens of tax credits and eliminate the mandate in your state and thereby cause the health insurance markets in your state to collapse.”

Prince would pose not merely a run-of-the-mill question of first impression, but a truly novel constitutional claim. The Court has never before held that Congress had coerced the states by harming their citizens. As explained below, the offer in Prince is not barred by either the “commandeering” or the “coercive-conditions” lines of precedent. So, to strike down the offer in Prince as unconstitutional, the Court would have to create a meaningfully new rule of constitutional law.

As an initial matter, Prince is not a case of commandeering of the kind that was at issue in Printz v. United States.16 That case involved the Brady Handgun Violence Prevention Act, which directed state and local law enforcement officers to conduct background checks on prospective handgun purchasers.17 This, the Court held, was impermissible: the federal government may not “command the States’ officers” to “administer or enforce a federal regulatory program.”18 The choice in Prince, in contrast, does not contain any direct compulsion of or “command” to state officers. The tax credits at issue in Prince would act “directly upon individuals, without employing the States as intermediaries.19 A statute of this sort “is thus entirely consistent with the Constitution’s design,”20 because the Constitution gives Congress “the power to regulate individuals, not States.”21

Nor does the line of cases forbidding coercion suggest that a state might be unconstitutionally coerced by a federal statute that regulates not the state, but its citizens; the case law points in the opposite direction. Consider the statute at issue in New York v. United States,22 the Low-Level Radioactive Waste Policy Act (“LLRWPA”). This federal law included various “incentives” designed to encourage the states to provide for the disposal of low-level radioactive waste.23 One set of incentives encouraged states to adopt federal standards for radioactive waste disposal.24 If the state did not adopt the federal standards, it risked having its citizens be “den[ied] access to … disposal sites.”25 The Court was untroubled, reasoning that “[t]he affected States are not compelled by Congress to regulate,” because the “burden caused by a State’s refusal to regulate will fall on those who generate waste and find no outlet for its disposal, rather than on the State as a sovereign.”26 The Court did not contemplate that the additional federal regulatory burdens on these residents might force the state to provide offsetting relief out of the state’s own pocket.27

New York did, of course, strike a part of LLRWPA under the Tenth Amendment28—the “take title” provision—but the Prince offer noticeably differs from that portion of the statute. This provision offered states a choice between two direct Congressional commands to state legislators: either states could “tak[e] title to and possession of” all low-level radioactive waste generated in the state, or else states could regulate that waste in the manner Congress directed.29 Because both halves of the choice were beyond Congress’s power under the Tenth Amendment, forcing a state to choose between the two was also unconstitutional.30

Contrast this choice with the choice in Prince. Article I authorizes Congress, and Congress alone, to decide who should bear the costs of federal law and whether those costs will be subsidized by the public fisc.31 Outside the limited context of takings, the Constitution has never been held to require Congress to “pay as it goes” when it enacts federal laws. Thus, Congress can enact a statute that either (1) subjects insurers to federal guaranteed-issue and community-ratings requirements without offsetting federal subsidies to citizens, or (2) subjects insurers to federal guaranteed-issue and community-ratings requirements with offsetting federal subsidies to citizens. Both regimes are within Congress’s power to enact. The only question, then, is whether Congress has the further power to tether its grant of those subsidies to whether the state chooses to establish an exchange.

Of course, a conditional offer of federal money that leaves a state with no genuine choice but to accept is unconstitutionally coercive.32
But despite the ubiquity of federal conditional-spending schemes, the Court never invalidated such a law as coercive until NFIB,33
and the reasoning of NFIB itself stops well short of condemning a Prince-style offer. What so troubled the justices in NFIB was that the Medicaid expansion offer threatened to upend the terms of a long-standing federal-state bargain upon which the states had relied.34 The NFIB plurality was careful to note the manifold ways in which the federal flow of funds to the states had generated serious reliance interests.35 But Congress has made no analogous bargain with the states around the non-regulation of insurance. There are no elaborate state schemes to regulate or administer the federal tax credits supplied by the ACA. States have no cognizable reliance interest in the continued absence of federal regulation of insurance companies36—or even in the absence of “unwise” or dysfunctional federal regulation of insurance companies.37

Prince also differs from NFIB in another key respect: NFIB, like South Dakota v. Dole,38 involved a federal offer of conditional spending made to the state as sovereign; both cases were riddled with references to the fact that the federal offer threatened to pull money directly out of the state’s budget.39 But in Prince, the threatened loss will come not from the state’s purse, but rather from private individuals. The loss of tax credits will harm state residents, but it will only indirectly and probabilistically harm state budgets. Unlike the “gun to the head” of the state that NFIB deplored,40 Prince holds a gun to the head of the state’s citizens—and it’s a gun that (apparently) not all states perceive to be loaded.41

In Steward Machine Company v. Davis42 the Court considered and rejected the contention that an analogous offer to state citizens was coercive of the states. Steward Machine involved a provision of the Social Security Act that offered employers a tax credit for up to 90% of their federal unemployment tax as long as the businesses paid those funds into a state unemployment plan that met federally specified conditions.43 The challengers argued that this scheme forced “state Legislatures under the whip of economic pressure into the enactment of unemployment compensation laws at the bidding of the central government.”44 The Court grudgingly acknowledged that conditioning federal tax credits to state residents on state legislative action might result in “undue influence” on the states—“if we assume that such a concept can ever be applied with fitness to the relations between state and nation”45—but ultimately concluded the federal offer was proper. Why? Because, the Court reasoned, the federal offer furthered the legitimate end of “safeguard[ing]” the federal treasury from spending additional money on unemployment (itself a proper federal goal) and—“as an incident to that protection”—also promoted state autonomy.46

The Prince offer at least arguably satisfies these criteria. It promotes a legitimate federal goal—subsidizing access to health insurance—while also encouraging states to exercise local control over state insurance marketplaces. To receive billions in tax credits for health insurance purchases by their residents, all the states must do is create state exchanges on which citizens can spend those credits. Steward Machine searched in vain for a constitutional proscription of such an arrangement:

“Alabama is seeking and obtaining a credit of many millions in favor of her citizens out of the Treasury of the nation. Nowhere in our scheme of government—in the limitations express or implied of our Federal Constitution—do we find that she is prohibited from assenting to conditions that will assure a fair and just requital for benefits received.”47

In words that might ring in the ears of the judge who could some day decide Prince, the Court concluded “[a]n unreal prohibition directed to an unreal agreement will not vitiate an act of Congress, and cause it to collapse in ruin.”48

To say that a battle is uphill is not to say that it’s futile. The Tenth Amendment cases discussed above don’t preclude the theory of coercion by regulatory threat, and there’s considerable force to the claim that the Prince offer is worse for the states than any offer that the Court has thus far ratified. The Prince challengers may eventually—and deservedly—win the day.

The crucial question here, however, is not whether the Prince challenge will succeed or fail—it is whether the Prince challenge is novel. That it undoubtedly is. Today, even now that NFIB has broken the glass on invalidating conditional spending offers, the case that holds that Congress has unconstitutionally coerced a state by refusing tax credits to its citizens and regulating private corporations would be a blockbuster, one with large repercussions for federal power. Five years ago, when Congress was enacting the ACA—during an era when, it’s worth remembering, the conditional-spending test of Dole was widely regarded as a dead letter49—it could not have anticipated that this extension of the doctrine of constitutional federalism might lurk beyond the horizon.

II. Versions of Aversion

Both General Verrilli50 and the challengers51 seemed to agree on the threshold matter of the novelty of the theory of coercive regulatory threat, and the justices did not indicate that they felt differently. The real issue, then, is whether this new constitutional problem offers an appropriate occasion to apply the avoidance canon—or, as Justice Kennedy put it, “does novel mean difficult?”

At first blush, it may seem that the answer must be yes—which is why Justice Kennedy’s question was received as a bon mot instead of something that merited a serious answer. To a given justice, a novel constitutional theory may have considerable appeal. A justice may hold beliefs about the Constitution that are quixotic, that are out of the mainstream, or that are simply ahead of their time. To that justice, a novel constitutional problem might feel like a serious constitutional problem, or at least a problem that deserves to be taken seriously. From the point of view of that justice, the formal criteria for using avoidance will appear to be met.

The problem with this logic, though, is that using the avoidance canon to avoid novel constitutional doubts unmoors the canon from its justifications. A chief rationale for the modern avoidance canon is an interpretive presumption—an interpretive presumption that Congress does not want to legislate close to a constitutional line.52 Some have called this regime unfair, but at least it is clear: Congress is on notice that it must speak with special lucidity if it wishes to enact a statute in a constitutional danger zone.53 The more out-of-the-mainstream a constitutional theory is, though, the less defensible this rule is. Congress can’t be expected to legislate clearly to override avoidance of the penumbra of a constitutional right where Congress cannot know that right exists by inspecting settled constitutional doctrine. Imputing to Congress the capacity to divine new constitutional rules is just one tick short of imputing to it the intent to avoid a problem precluded by existing doctrine54—a move that the Court has called “unsound.”55

Put another way, modern avoidance carries an inherent qualification on its appropriate use. The constitutional problem that is being avoided must be the sort of problem that was recognizable as such by the Congress that enacted the law at issue. Treating a constitutional issue as a problem that merits avoidance means treating it as something that Congress might plausibly have legislated with knowledge of. But it’s implausible to require Congress to anticipate the existence of truly new questions of first impression. By using the canon to avoid such questions, the Court doesn’t just move the goal posts for Congressional clarity; it carries them off the field.

The second rationale for the modern avoidance canon—avoiding unnecessary constitutional decision-making—also disintegrates where the constitutional problem is novel.56 To see why, think back to the “classical” version of avoidance, under which the Court supplies a saving construction of a statute only upon finding that the alternative reading is unconstitutional.57 If a statute runs afoul of settled constitutional rules, the Court makes no new constitutional law when it recognizes that fact and construes the statute to save it. Conversely, in a classical avoidance holding predicated on a novel constitutional problem, the Court is by definition making novel constitutional law.

The same dynamic applies to modern avoidance, even though the Court is not formally making new constitutional law when it applies modern avoidance. Constitutional avoidance opinions matter; they influence later Courts,58 and they therefore influence lower courts and Congress.59 Modern avoidance gives “penumbras” to constitutional rights—shadows that have “much the same prohibitory effect as . . . the Constitution itself.”60 If the penumbra is not novel, then the Court does not alter constitutional law when it skirts the penumbra. If the penumbra is novel, however—which it will be when the doubt being avoided is a new one—the Court’s recognition of that new penumbra will make new penumbral constitutional law with new prohibitory effects. Applying the canon to novel constitutional questions is, in essence, self-defeating; as a practical matter, the Court creates new constitutional law simply by applying the canon.

These issues with avoiding novel doubts flow from the inherent nature of the modern avoidance canon: regardless of the case or of judicial proclivity, they will inexorably emerge whenever the constitutional issue being avoided is a truly novel one. Apart from these intrinsic problems, two other pitfalls might or might not arise depending on the case and on the various justices involved.

The first pitfall is that avoiding novel questions enhances the canon’s (already considerable) susceptibility to judicial manipulation.61 Limiting the canon to avoiding only known constitutional problems imposes some quantum of external constraint on its usage. Conversely, the latitude afforded by the canon becomes broader as the canon comes to be invoked to avoid novel or out-of-the-mainstream constitutional concerns. One need only imagine the sheer range of statutory cases in which one could assert a novel constitutional claim on one or both sides of the question presented. The Court’s federalism, separation of powers, substantive due process, and equal protection jurisprudence are fecund ground for the constitutional daydreamer—and everyone who has ever been a 1L knows that just about anything can be made out to be a First Amendment violation if you squint hard enough. A conscientious justice need not and might not abuse these additional degrees of freedom; still, there they are.

The second risk is that avoiding novel constitutional questions will exacerbate the unfortunate tendency of avoidance opinions to display “slopp[y]” constitutional decision-making.62 When a novel constitutional theory is first invented, a theory that is interesting and new and not at all straightforwardly required by existing jurisprudence, the theory is unlikely to have been much litigated, precisely because it is one that is out of the mainstream of regular constitutional argument. But that is no obstacle to the theory reaching the justices’ ears. Ours is the age of the Supreme Court “practice group,” 63 and (not coincidentally) the heyday of the Supreme Court amicus brief;64 each Term, an unstinting stream of green booklets urges the Court to avoid constitutional doubts old and new, slight and serious. Consequently, when the justices encounter a new constitutional doubt, they often do so in the environment least conducive to disciplined constitutional decision-making—bereft of adversarial argument, shorn of factual development, and far afield from the useful outposts of lower court opinions. In these circumstances, a diligent justice recognizing a novel constitutional problem might do the hard work of carefully developing and appraising the competing arguments on both sides. But there’s always the risk that won’t occur, and that instead of avoiding genuine constitutional problems, the justice will effectively be avoiding constitutional jitters or hunches.65 The after-effects of such a holding will be felt not just in casebooks, but also in Congress. At best, a poorly reasoned avoidance opinion may force Congress to revisit a statute to clarify its language, a waste of Congress’s time if the avoided problem isn’t substantial; at worst, a poorly reasoned avoidance opinion may deter Congress from exercising lawmaking powers that it can lawfully wield.66

Does all this mean that the Court should never avoid novel constitutional problems? Not quite. But it does mean that avoiding novel constitutional doubts should be a highly disfavored way of resolving a case,67 a method of last resort, to be used only once one has exhausted other techniques of statutory interpretation, and if one is prepared to hold that the novel constitutional problem is an actual barrier to the statute. At that extreme—where the novel constitutional issue poses an obstacle, not just a “doubt”—modern avoidance and its twin justifications become irrelevant; what remains, for good or ill, is classical avoidance’s raw imperative to save as much law as possible from actual nullification, whether by old law or new.68 Adopting this approach to novel doubts will discipline and curb the Court’s use of the avoidance canon by ensuring that when the justices first confront truly new constitutional questions, they will address them with the caution and carefulness of a court creating law, not dictum.

III. Coercion Aversion

The quartet of concerns just discussed applies with full force to King. First, and most salient, is the problem of confounding Congressional expectations. The government has contended, with considerable gusto, that it never occurred to anyone that the ACA was threatening to withdraw tax credits from states that failed to establish exchanges.69 For argument’s sake, stipulate the opposite—that Congress did consciously intend the threat. Even in that scenario, it never occurred to anyone that such a threat would violate the Tenth Amendment. The theory of coercive regulatory threat was fully aired for the first time in 2015,70 and it relies to a significant degree on NFIB, which was only decided in 2012.71 How could Congress have known in March 2010 that it had to legislate with especial clarity if it wished to make such a threat? In Donald Rumsfeld’s famous rubric, the regulatory threat theory was an “unknown unknown” at the time of the ACA’s passage.72 It is true that, to Justice Kennedy at least, the unconstitutionality of regulatory threats seems to have appeared straightforward. But his view only became evident to the world (and Congress) at oral argument. It stretches the interpretive presumption too far to imagine that Congress has the capacity to forecast the privately harbored constitutional commitments of a single justice—no matter how consequential his vote may be.

Second, a coercion aversion opinion will elicit shadow constitutional law that may have not-so-shadowy effects on future challenges to federal statutes. Consider the ACA’s “maintenance of effort” provision,73 which requires states to freeze into place their 2010 Medicaid enrolment and eligibility policies for adults until “the date on which [HHS] determines that an Exchange established by the State … is fully operational.”74 In other words, the ACA says to the states: “Set up your own exchange, or the federal government will subject your Medicaid program to the maintenance-of-effort rule.” As a limitation on state legislative autonomy, that is not such a far cry from the threat ostensibly being made in King. Opinions from “swing votes” on the Court reflecting that key justices regard such conditional offers as impermissible may induce a state that didn’t establish an exchange to bring a Tenth Amendment attack on this provision.75

Environmental law may also become caught up in the wake of a coercion aversion opinion. Peabody Energy Corporation is an intervenor in a pending challenge to the EPA’s forthcoming regulations on coal-fired power plants.76 Peabody’s brief to the D.C. Circuit, which was filed before oral argument in King, devoted a few sentences to asserting that the EPA was “commandeering” (not “coercing” or “threatening”) states into submitting state implementation plans; it made no mention of King.77 After Justice Kennedy’s questions at the King argument, Professor Laurence Tribe, who is counsel for Peabody, shifted gears. A Tenth Amendment argument leveraging the regulatory threat concept spanned a dozen pages of his subsequent Congressional testimony about the regulations at issue in that case78—regulations now portrayed as having coercive effects “strikingly similar” to the IRS rule in King79—and will surely feature prominently in the ongoing litigation over these new regulations.80

This partial snapshot captures the two most obvious examples of areas of the law that might be affected by an avoidance holding in King. If the justices were to endorse broad or loose language indicating that any kind of regulatory bargaining with the states is per se impermissible,81 the legal uncertainty for other cooperative federalism schemes would concomitantly increase. A King opinion that creates shadow constitutional law about coercion by regulatory threat could have important repercussions.

The two other pitfalls with avoiding novel constitutional questions also happen to be present in King. First, the case illustrates how the license to avoid novel constitutional claims may facilitate the judicial manipulation of case outcomes. Although the avoidance argument that caught the justices’ eye was made by an amicus brief in support of the IRS’s rule, state amici who oppose the IRS’s rule also made a rather novel Tenth Amendment argument: that the IRS’s reading of the statute mandates the states to provide health insurance to state employees and impermissibly subjugates the states to federal taxation.82 So the Scylla of regulatory threat is paired with the Charybdis of a direct mandate to and tax on the states. Is this new constitutional problem less worthy of avoidance than the regulatory threat problem? Who knows? If a justice avoids one of these problems and ignores the other, it is safe to assume that the real work of deciding the case has been done elsewhere.

Second, a non-negligible risk exists that the shadow constitutional law produced in King won’t be well-crafted shadow constitutional law. The theory of coercive regulatory threat received its first public airing at Supreme Court amicus briefing.83 Venturing forth to describe the contours of the regulatory threat concept without a single pair of adversarial briefs on the subject, let alone a set of lower-court opinions or a district-court record, would be a highly risky endeavor for a Court that, quite sensibly, tends not to proceed a voce solo when elaborating constitutional rules.

For all these reasons, the Court should not rely on coercion aversion to resolve King. Some might worry (or hope) that the upshot of this argument will be a defeat for the government, and death spirals in 34 states. But this overlooks an odd but important aspect of King. If a justice is convinced that the ACA can be “reasonably” read not to convey a coercive regulatory threat, then that justice believes that the ACA can be “reasonably” read not to condition tax credits on the creation of state exchanges. That, in turn, entails that the ACA fails to unambiguously specify the terms of a conditional spending offer to the states.84 In other words, the ambiguity that a justice would rely on to avoid this novel constitutional problem is necessarily sufficient to sustain the IRS’s rule on Pennhurst clear-statement grounds.85

Rather than writing a coercion aversion opinion, a justice inclined to avoid this novel constitutional problem ought to seize this alternative. This would be the best outcome: better than writing a coercion aversion opinion in the government’s favor, and (to a justice worried about regulatory threats) much better than holding against the government. Whatever such an opinion might lack in complete candor—if indeed it can be said to lack anything at all86—it would make up for in protecting sound constitutional decision-making in the long term.

Conclusion

If one or more of the justices use coercion aversion to decide King, it will be clear that the considerations urged here will have been overlooked or disregarded by those justices. But if no justice does so, the silence will be ambiguous. The opinions would say nothing about coercive death spirals, would eschew any mention of regulatory threats, and would refrain from speculating on possible Tenth Amendment obstacles. That end result, if a bit of an anticlimax, would be the right one. Even if coercion aversion lurks in the backs of their minds, the justices can—and therefore should—resolve King without using the avoidance canon to inaugurate a new branch of federalism jurisprudence.

  1. See Transcript of Oral Argument at 49, King v. Burwell, 135 S. Ct. 475 (argued March 4, 2015) (No. 14-114) [hereinafter “Transcript”] (alteration in original).
  2. See Patient Protection and Affordable Care Act § 1311, 42 U.S.C. § 18031 (2010) [hereinafter “ACA”]; King v. Burwell, 759 F.3d 358, 364-65 (4th Cir. 2014).
  3. See Transcript, supra note 1, at 16, 49.
  4. See Brief for Jewish Alliance for Law & Social Action (JALSA) et al. as Amici Curiae Supporting Respondents, King v. Burwell, 135 S. Ct. 475 (filed Jan. 16, 2015) (No. 14-114), 2015 WL 350366 [hereinafter “JALSA Brief”]. Another amicus brief spent its final four paragraphs on the argument that the challengers’ interpretation would raise “a serious Tenth Amendment question.” See Brief for the Commonwealth of Virginia et al. as Amici Curiae Supporting Respondents at 42-43, King v. Burwell, 135 S. Ct. 475 (filed Jan. 28, 2015) (No. 14-114), 2015 WL 412333 [hereinafter “Virginia Brief”].
  5. Docket, King v. Burwell, 135 S. Ct. 475 (No. 14-114).
  6. See Reply Brief, King v. Burwell, 135 S. Ct. 475 (filed Feb. 18, 2015) (No. 14-114), 2015 WL 737959.
  7. See Transcript, supra note 1, at 49-50.
  8. Id.
  9. See JALSA Brief, supra note 4, at 31 (“Establish an exchange, or the federal government will destroy your individual health insurance market.”).
  10. See id. at 7 (“Never before has this Court confronted a cooperative federalism scheme that threatens states with regulatory, rather than fiscal, harm if they refuse to implement federal policy.”); Virginia Brief, supra note 4, at 44 (“[I]t is a novel kind of pressure to threaten to injure a State’s citizens and to destroy its insurance markets in order to force State-government officials to implement a federal program.”).
  11. Other scholars have discussed the special problems that flow from using the canon to avoid novel constitutional doubts. See Lisa A. Kloppenberg, Avoiding Serious Constitutional Doubts: The Supreme Court’s Construction of Statutes Raising Free Speech Concerns, 30 U.C. Davis L. Rev. 1, 23-24 (1996); Lawrence C. Marshall, Divesting the Courts: Breaking the Judicial Monopoly on Constitutional Interpretation, 66 Chi.-Kent L. Rev. 481, 488-89 (1990); Robert W. Scheef, Temporal Dynamics in Statutory Interpretation: Courts, Congress, and the Canon of Constitutional Avoidance, 64 U. Pitt. L. Rev. 529, 558-60 (2003); Brian G. Slocum, Overlooked Temporal Issues in Statutory Interpretation, 81 Temp. L. Rev. 635, 670 n.175 (2008).
  12. See Adrian Vermeule, Saving Constructions, 85 Geo. L.J. 1945, 1949 (1997) (“The basic difference between classical and modern avoidance is that the former requires the court to determine that one possible interpretation of the statute would be unconstitutional, while the latter requires only a determination that one reading might be unconstitutional.”); Trevor W. Morrison, Constitutional Avoidance in the Executive Branch, 106 Colum. L. Rev. 1189, 1206-07 (2006) (describing justifications for modern avoidance). This essay adopts an “internal” point of view, in the sense that it accepts the canon as a settled feature of constitutional adjudication and takes its justifications at face value. The articles cited throughout will lead the interested reader to the rich debate over the legitimacy of the canon and the soundness of its rationales.
  13. Novelty is a distinct concept from ambiguity. Constitutional issues are often ambiguous or “unsettled,” and the Court may properly use the canon of constitutional avoidance to avoid addressing unsettled issues or resolving ambiguities. More rarely, though, constitutional questions arise that are not merely ambiguous in light of existing doctrine, but also novel, in the sense that they are unanticipated questions of first impression whose resolution will meaningfully change settled doctrine. As I explain in the text, the mischief begins when the Court uses the canon to avoid this distinct class of constitutional doubts.
  14. Almendarez-Torres v. United States, 523 U.S. 224, 270 (1998) (Scalia, J., dissenting) (“[T]he doctrine of constitutional doubt comes into play when the statute is ‘susceptible of’ the problem-avoiding interpretation—when that interpretation is reasonable, though not necessarily the best.”) (citation omitted); Crowell v. Benson, 285 U.S. 22, 62 (1932) (“fairly possible”).
  15. Pennhurst State Sch. & Hosp. v. Halderman, 451 U.S. 1, 12-13 (1981); see Brief for the Respondents at 39-40, King v. Burwell, 135 S. Ct. 475 (filed Jan. 21, 2015) (No. 14-114), 2015 WL 349885 [hereinafter “Gov’t Br.”]; Brief for Professors Thomas W. Merrill et al. as Amici Curiae Supporting Respondents at 7-9, King v. Burwell, 135 S. Ct. 475 (filed Jan. 28, 2015) (No. 14-114), 2015 WL 456257.
  16. United States v. Printz, 521 U.S. 898 (1997).
  17. Id. at 902.
  18. Id. at 935 (“The Federal Government may neither issue directives requiring the States to address particular problems, nor command the States’ officers . . . to administer or enforce a federal regulatory program. . . . [S]uch commands are fundamentally incompatible with our constitutional system . . . .”).
  19. New York v. United States, 505 U.S. 144, 164 (1992).
  20. Nat’l Fed’n of Indep. Bus. v. Sebelius, 132 S. Ct. 2566, 2626-27 (2012) (Ginsburg, J., dissenting) [hereinafter “NFIB“].
  21. Id. (quoting Printz, 521 U.S. at 920) (internal quotation marks omitted).
  22. New York, 505 U.S. 144.
  23. Id. at 152-54.
  24. Id. at 173.
  25. Id. at 174 (“States may either regulate the disposal of radioactive waste according to federal standards by attaining local or regional self-sufficiency, or their residents who produce radioactive waste will be subject to federal regulation authorizing sited States and regions to deny access to their disposal sites.”).
  26. Id.
  27. See id.
  28. Id. at 175.
  29. Id. at 174-75.
  30. Id. at 176.
  31. Helvering v. Davis, 301 U.S. 619, 645 (1937) (“When money is spent to promote the general welfare, the concept of welfare or the opposite is shaped by Congress, not the states.”).
  32. NFIB, 132 S. Ct. at 2603-05.
  33. NFIB, 132 S. Ct. at 2630 (Ginsburg, J., dissenting) (“The Chief Justice therefore—for the first time ever—finds an exercise of Congress’s spending power unconstitutionally coercive.”).
  34. NFIB, 132 S. Ct. at 2605-06 (Roberts, C.J., joined in part by Breyer & Kagan, JJ.) (“The Medicaid expansion . . . accomplishes a shift in kind, not merely degree. . . . A State could hardly anticipate that Congress’s reservation of the right to ‘alter’ or ‘amend’ the Medicaid program included the power to transform it so dramatically.”).
  35. NFIB, 132 S. Ct. at 2604 (Roberts, C.J., joined in part by Breyer & Kagan, JJ.) (“[T]he States have developed intricate statutory and administrative regimes over the course of many decades to implement their objectives under existing Medicaid.”).
  36. See U.S. Const. art. VI, cl. 2.
  37. Cf. Williamson v. Lee Optical of Oklahoma, Inc., 348 U.S. 483, 488 (1955) (applying the rational basis test to economic regulation).
  38. South Dakota v. Dole, 483 U.S. 203 (1987).
  39. See id. at 208-12; NFIB, 132 S. Ct. at 2601-04 (Roberts, C.J.).
  40. NFIB, 132 S. Ct. at 2604 (Roberts, C.J.).
  41. See Brief for Oklahoma et al. as Amici Curiae Supporting Petitioners, King v. Burwell, 135 S. Ct. 475 (filed Sep. 3, 2014) (No. 14-114), 2014 WL 7463546.
  42. Charles C. Steward Mach. v. Davis, 301 U.S. 548 (1937).
  43. Id. at 574.
  44. Id. at 587.
  45. Id. at 590.
  46. Id. at 591.
  47. Id. at 597-98.
  48. Id. at 598; see also Massachusetts v. Mellon, 262 U.S. 447, 482 (1923) (“But what burden is imposed upon the states, unequally or otherwise? Certainly there is none, unless it be the burden of taxation, and that falls upon their inhabitants, who are within the taxing power of Congress as well as that of the states where they reside.”).
  49. Lynn A. Baker & Mitchell N. Berman, Getting Off the Dole: Why the Court Should Abandon Its Spending Doctrine, and How A Too-Clever Congress Could Provoke It to Do So, 78 Ind. L.J. 459, 464-69 (2003) (describing the Dole test as “toothless”).
  50. See Transcript, supra note 1, at 49; see also supra note 10 (noting acknowledgements of the theory’s novelty by its proponents).
  51. See Transcript, supra note 1, at 15-16.
  52. See Morrison, supra note 12, at 1206-1207.
  53. William K. Kelley, Avoiding Constitutional Questions as a Three-Branch Problem, 86 Cornell L. Rev. 831, 865 (2001) (noting argument that “once it is established as the default rule that Congress must be clear to force the Court to decide a serious constitutional question, there is far less basis for objecting when the Court refuses to act on a constitutional question in the absence of legislative clarity”).
  54. Both of these (mis)applications of the canon are distinguishable from (and worse than) cases where the Court avoids a potential (but not novel) constitutional problem that it thereafter holds not to be a problem when confronted with the question on the merits. This latter type of error is an inevitable cost of a canon that applies to constitutional “doubts,” not constitutional “barriers.”
  55. See Harris v. United States, 536 U.S. 545, 556 (2002), abrogated on other grounds by Alleyne v. United States, 133 S. Ct. 2151 (2013) (rejecting as “unsound” the argument that the canon be used to avoid overruling one of this Court’s own precedents because “[t]he statute at issue . . . was passed when McMillan provided the controlling instruction, and Congress would have had no reason to believe that it was approaching the constitutional line by following that instruction”).
  56. See Morrison, supra note 12.
  57. Blodgett v. Holden, 275 U.S. 142, 147 (1927) (Holmes, J., concurring); Vermeule, supra note 12, at 1959.
  58. See Richard L. Hasen, Shelby County and the Illusion of Minimalism, 22 Wm. & Mary Bill Rts J. 713, 722-23 (2014); compare, e.g., Northwest Austin Mun. Utility Dist. No. One v. Holder, 557 U.S. 193, 204-16 (2009) with Shelby County v. Holder, 133 S. Ct. 2612 (2013).
  59. See Ernest A. Young, Constitutional Avoidance, Resistance Norms, and the Preservation of Judicial Review, 78 Tex. L. Rev. 1549, 1581 (2000).
  60. Richard A. Posner, Statutory Interpretation—in the Classroom and in the Courtroom, 50 U. Chi. L. Rev. 800, 816 (1983).
  61. See Morrison, supra note 12, at 1208 (summarizing criticisms of “the courts’ abuse of the avoidance canon” in service of “the courts’ own policy preferences”).
  62. Young, supra note 59, at 1583 (noting that a court engaging in avoidance “can do a much sloppier job of constitutional decision-making than it would do if it faced the constitutional issue directly”); see also Morrison, supra note 12, at 1208 (noting the argument that “courts tend . . . to overuse avoidance (by invoking it in the absence of genuine statutory ambiguity or in the service of an implausible constitutional concern) . . . ”).
  63. See Brandon D. Harper, The Effectiveness of State-Filed Amicus Briefs at the United States Supreme Court, 16 U. Pa. J. Const. L. 1503, 1522 (2014) (noting that state attorneys general have “created their own Supreme Court practice organization” that is “tasked with preparing parties and amicus briefs before the Court”); William E. Nelson et al., The Liberal Tradition of the Supreme Court Clerkship: Its Rise, Fall, and Reincarnation?, 62 Vand. L. Rev. 1749, 1782-89 (2009) (describing the emergence of Supreme Court practice groups in major national firms).
  64. Richard H. Fallon, Jr., Scholars’ Briefs and the Vocation of a Law Professor, 4 J. Legal Analysis 223, 225-26 (2012) (describing the increase in “law professor amici briefs” in recent years and how these briefs are sought after by Supreme Court practitioners); Michael E. Solimine, The Solicitor General Unbound: Amicus Curiae Activism and Deference in the Supreme Court, 45 Ariz. St. L.J. 1183, 1189-90 (2013) (describing reasons for the recent proliferation of Supreme Court amicus briefs).
  65. This risk persists even if you take the (favorable) view of the avoidance canon advanced by Professor Young, supra note 59. He argues that the avoidance canon is a “perfectly legitimate and even advantageous way to enforce the Constitution,” id. at 1614, but this claim obviously hinges on the existence of some prior account of what enforcing the Constitution entails. The more novel the constitutional question, the harder it will be for a justice to correctly formulate that account.
  66. Frederick Schauer, Ashwander Revisited, 1995 Sup. Ct. Rev. 71, 89 (1995) (“[T]he identification of a constitutional problem is sufficiently probative of the nontentative views of the identifiers that the act of identifying a problem will be treated by rational legislative actors as conclusive, and they will act accordingly.”).
  67. What might one lose by disfavoring avoidance of novel problems? As noted above, the main payoff of modern avoidance—braking the creation of new constitutional law—is basically a wash when issuing the avoidance opinion itself results in the identification of new constitutional penumbras. Another foregone benefit may be the loss of the higher-quality constitutional law that (let us suppose) the Justices would ultimately craft, if they used avoidance to grapple with novel constitutional issues in an incremental fashion. But publicly airing nonbinding drafts of constitutional doctrine in the pages of the U.S. Reports is a costly and unattractive way for the Justices to ruminate on constitutional questions. Many alternative and preferable methods exist for the Justices to improve the quality of their constitutional decision-making, e.g., usage of the discretionary certiorari power to select appropriate vehicles for resolving novel questions and permitting lower federal courts and state courts to “percolate” novel questions.
  68. This principle supplies a post hoc rationalization for Chief Justice Roberts’s otherwise “puzzling” “Commerce Clause essay,” NFIB, 132 S. Ct. at 2629 (Ginsburg, J., dissenting), in NFIB. Chief Justice Roberts’s notable failure to use modern avoidance makes sense if one supposes that the novelty of the Commerce Clause problem made it unjustifiable for Roberts to apply the modern avoidance canon. What was left on the table was the tool of classical avoidance, using which he decided the novel question on the merits and then adopted a saving construction of the act. See NFIB, 132 S. Ct. at 2600-01 (Roberts, C.J.).
  69. See Gov’t Br., supra note 15, at 18-19.
  70. See JALSA Brief, supra note 4, at ii.
  71. See id. at v (citing NFIBpassim”).
  72. Donald Rumsfeld, Sec’y, Dep’t of Def., Dep’t of Def. News Briefing (Feb. 12, 2002), http://www.defense.gov/transcripts/transcript.aspx?transcriptid=2636 (“[A]s we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know.”). Thanks to Dave Owen for this point.
  73. ACA § 2001(b).
  74. 42 U.S.C. § 1396a(gg)(1).
  75. Of course, a government victory in King might make this challenge moot by deeming the establishment of the federal exchange to have satisfied this condition. See Gov’t Br., supra note 15, at 29-30.
  76. See Petition for Extraordinary Writ, In re Murray Energy Corp., No. 14-1112 (D.C. Cir. June 18, 2014).
  77. Brief for Intervenor Peabody Energy Corp. at 12-13, In re Murray Energy Corp., No. 14-1112 (D.C. Cir. June 18, 2014), 2014 WL 7405848; id. at i (reflecting brief was filed December 30, 2014).
  78. See EPA’s Proposed 111(d) Rule for Existing Power Plants: Legal and Cost Issues: Hearing before the Subcomm. On Energy & Power of the H. Comm. on Energy & Commerce, 114th Cong. (2015) 2-4, 16-27 (testimony of Laurence H. Tribe, Professor, Harvard Law School).
  79. Id. at 3-4; id. at 26 (“[T]he gun consists of subjecting non-complying States to a kind of Russian roulette in which they run the risk of being hit with a centrally planned and administered federal scheme, a plan whose details are as yet unknown, but one that threatens significant disadvantage to them and their citizens, both in absolute terms and vis-à-vis other States, if they decline to submit their own plans to EPA.”).
  80. See Mario Loyola, Federal Coercion and the EPA’s Clean Power Plan, The Atlantic, May 17, 2015.
  81. Cf. JALSA Brief, supra note 4, at 29 (“Given the doctrinal difficulties that arise from regulatory incentives—and the constitutional doubts associated with any regulatory differentiation—it might make sense to hold that regulatory threats are unconstitutionally coercive no matter how trivial they might appear.”).
  82. See Brief for State of Indiana et al. as Amici Curiae Supporting Petitioners at 18-30, King v. Burwell, 135 S. Ct. 475 (filed Dec. 19, 2014) (No. 14-114), 2014 WL 7463545.
  83. See sources cited supra note 4.
  84. See Spector v. Norwegian Cruise Line, 545 U.S. 119, 141 (2005) (plurality opinion) (Kennedy, J.) (noting that the avoidance canon is “a canon for choosing among plausible meanings of an ambiguous statute”); Clark v. Martinez, 543 U.S. 371, 385 (2005) (asserting that the avoidance canon “comes into play only when . . . the statute is found to be susceptible of more than one construction . . . .”).
  85. See sources cited supra note 15.
  86. See David L. Shapiro, In Defense of Judicial Candor, 100 Harv. L. Rev. 731, 736 (1987) (“[T]he prevailing view of the judicial function (and one I fully accept) would support the judge who, as an individual, does not go as far as he might be willing to go if the case before him does not require it. The problem of candor, once again, arises only when the individual judge writes or supports a statement he does not believe to be so.”).

Abstinence in the Face of the Mutual Fund Debt Elixir: In Response to Professor John Morley

* A.B., College of the Holy Cross, 1994; J.D., New York University School of Law, 1997; M.B.A., Columbia Business School, 2001. This article is a private publication of the author, expresses only the author’s views and does not represent the views of any firm or any client or former client. The author would like to thank Paul Connell and the editors at the Yale Journal on Regulation for their first-rate assistance.

In recent years, a combination of bruising market losses, increased correlation among asset classes, unexpected illiquidity and high-profile scandals has left the investment management industry reeling.1 In the wake of the Great Recession,2 asset managers find themselves scrambling to respond to significant shifts in investor behavior and an evolving regulatory landscape.3 Two of the most observable trends have been (i) the investing class’s increasing appetite for alternative streams of return and (ii) a noticeable desire for more regulated investment vehicles.4

As an investment professional involved in today’s “liquid alternatives” mutual fund movement,5 I was quite pleased to come across Professor John Morley’s “The Regulation of Mutual Fund Debt” in the Yale Journal on Regulation.6 The article grapples—albeit from an academic point of view—with many of the issues that fund structurers encounter, on a more practical level, as we imagine, structure and develop innovative products for investors. Morley’s article represents a significant contribution to the discussion of mutual fund regulation, providing—in the professor’s own words—“the first general examination of mutual fund capital structure regulation under the Investment Company Act of 1940.”7 More basically, Morley’s article succeeds in establishing a firm foundation for additional examination and discovery and highlights the importance of imagining what might be instead of settling for what already is.

This short Response (the “Response”) attempts to buttress the still nascent discussion surrounding mutual fund capital structure. Moreover, the Response encourages Professor Morley and the broader academic community to advance the examination of investment vehicles and their limitations in light of the evolving needs of today’s investing public. The seriousness and complexity of the subject matter, and its tangible ramifications for investors, necessitate a more thorough examination. And it is hoped that this Response plays some role in promoting that discussion.

This Response proceeds in three parts. Part I represents the heart of the Response, reintroducing the basic framework through which the article’s author analyzes the features unique to the mutual fund capital structure. This Part suggests that the strictures imposed on mutual fund capital structure represent a small part of the patchwork that forms the Investment Company Act of 1940 (“the Act”). The individual sections of the Act are not easily decoupled. Instead, the overall application of the entire Act exceeds the sum of its parts. As importantly, structuring choices and regulatory limitations have tangible effects on investors. Part II challenges the regime proposed by the article, arguing briefly that a regulatory accommodation allowing mutual funds to issue debt would not fulfill enough of an investor need to justify the change and, at the same time, might not be as harmless as the Article suggests. Finally, Part III concludes the Response by cautioning that any change to the regulation of mutual funds requires further consideration and deliberation.

Part I

As we approach the three-quarter century mark since the adoption of the Investment Company Act and the accompanying Investment Advisers Act of 1940, it is important to remember that, whatever its shortcomings, the regulation of mutual funds has served investors quite well.8 As Professor Morley acknowledges, the current regulatory regime deserves credit for an “almost complete absence of bankruptcies among mutual funds in the last 70 years.”9 Against such a backdrop, any changes similar to those suggested in the article face an uphill battle.

Nonetheless, the article makes a significant contribution by (i) examining the possible explanations for the blanket prohibition on the issuance of mutual fund debt securities and (ii) daring to ask whether mutual funds should be freed from the restriction, to “be allowed to issue debt securities to the public.”10

There are, however, shortcomings in the approach offered by Professor Morley. First, by focusing almost exclusively on the provisions of the Investment Company Act that directly address capital structure, the article glosses over some of the other protections mutual fund regulations typically afford investors.11 Second, the article’s proposal—allowing mutual fund debt issuance regulated as to form and amount—is likely to be met with all of the subjectivity of the current “senior security” regime without the benefit of seventy years of industry practice and regulatory interpretation.12

The provisions of the Act directly addressing capital structure cannot be understood in isolation. To the contrary, they represent a single part of a more robust regime. In describing the scope of the Act, a former SEC Commissioner once observed:

It places substantive restrictions on virtually every aspect of the operations of investment companies; their governance and structure, their issuance of debt and other senior securities, their investments, sales and redemptions of their shares, and, perhaps most importantly, their dealings with service providers and other affiliates.13

In addition to the provisions directly addressing capital structure,14 specific portions of the Act protect investors in terms of diversification,15 disclosure,16 liquidity17 and price transparency.18

Also, the unique tax status of mutual funds adds an additional layer of protection by requiring a reasonable amount of diversification. The taxation of mutual funds is governed by subchapter M of the Internal Revenue Code.19 Unlike most corporations, mutual funds are not subject to entity-level taxation on their income or capital gains, provided that they meet certain gross income, asset, and distribution requirements.20 In addition, at the close of each quarter, a fund must hold a mix of assets that qualify it as a “regulated investment company” and provide a reasonable level of diversification.21

After summarizing the capital structures available to mutual funds and examining several possible legislative motives informing the decision to prohibit mutual funds from issuing debt securities, Professor Morley concludes that the regulation of mutual funds’ capital structure is “incoherent.”22 Any such incoherence, however, might be in the eye of the beholder. And, while no structure can insulate an investor from market losses, the mutual fund regulatory framework has been remarkable for the breadth and depth of its regulation and the lack of mutual fund bankruptcies or scandals that have occurred during its time in place.23

Morley’s main proposal is to lift the ban on debt issuance in favor of a regime that manages some allowable level of debt.24 In many ways, this proposal sets out to solve a problem that does not exist. There seems scant evidence of an investing public clamoring for something that the mutual fund debt elixir will cure. In fact, investors have been inundated with innovative new products in recent years.25 Perhaps the current prohibition on senior securities would be more palatable to Professor Morley if it was recharacterized as a very conservative (and easier to administer) version of the regime he desires—with fund borrowings highly regulated as to form, amount and counterparty.26 Besides, in many contexts, abstinence often proves as easy as temperance might be difficult.27

Part II

Professor Morley cites the lack of available fixed rate products in support of allowing mutual funds to issue debt securities.28 Such a justification seems both curious and inexact. The article asserts that the lack of debt issuance by mutual funds has “profound consequences for the retirement portfolios of household investors” because it means that “most Americans’ retirement portfolios consist almost entirely of common stock, rather than debt.”29 The fact that the mutual fund investment itself represents an equity position in an investment company should be of little concern. More importantly, the mutual fund’s underlying portfolio might be comprised of all types of securities, fixed income and otherwise.30 A mutual fund holding a bond portfolio, for example, undoubtedly offers investors a return stream best characterized as fixed-income-like. Moreover, the risk of holding the equity of a mutual fund is mitigated by the fact that the fund’s capital structure is barred from including any debt or additional class of equity. As the residual claimholder, the mutual fund shareholder is only advantaged versus a typical equity investor in a corporation. Accordingly, she should find comfort from the embargo of any claimant who could assert priority in the capital structure.

In fact, the certainty that inures to the shareholder, free from any claim with priority in the capital structure, is at the heart of the current senior securities regulatory regime. Mutual fund investors enjoy the position as owners of a pro rata share of an underlying pool of investments. Such an understanding would be strained if the mutual fund were permitted to issue debt. The introduction of the accompanying leverage would require investors to perform an additional layer of analysis to understand the distortion to their pro rata status resulting from such debt.

The Investment Company Act of 1940 was, in large measure, a response to hearings that “revealed that the capital structures of many investment companies were highly complex, often consisting of many classes of securities with different dividend, liquidation, and voting rights.”31 Read in conjunction with other sections of the Act prohibiting transactions with fund affiliates, the limitations on capital structure were aimed at mollifying investor confusion and minimizing the risky leverage that characterized investment funds prior to the Act’s adoption.32

As one commentator observed shortly after the passage of the Investment Company Act,

Almost all agreed that it was unsound to have outstanding an issue of bonds or preferred stock, where the common stock was subject to redemption at the will of the stockholder, for the equity could thus be taken away completely from behind the senior security.33

Such words still ring true today. And, the legislative intent of the prohibition on debt coupled with (i) an absence of mutual fund failures, (ii) the wide and increasing variety of available investment products and (iii) the tremendous amount invested in today’s existing mutual funds counteract the notion that a pivot to a debt issuance regime is either necessary or worth the risks.

Part III

Professor Morley has done a real service in providing the opening framework for academicians, practitioners, investors, and firms to explore further the capital structure of mutual funds. While somewhat sympathetic to the incoherent nature of the capital structure regulations, I must confess skepticism toward the view that attributes significant investor benefits to any regulatory change allowing mutual funds to issue debt. Instead, it appears that the article largely aims to solve a problem that does not exist. In the process, it might reveal too trusting a view that any such change might be managed smartly and without unintended consequences. At the very least, a more thorough and holistic examination of the likely effects on the mutual fund’s overall regulatory framework is required before such an alteration can be responsibly suggested. Cognizant too that recent innovations in the alternative investment landscape have significantly expanded the products available to investors—perhaps beyond what Professor Morley and his colleagues in the academy might yet fully appreciate—one cannot help but recall Victor Hugo’s observation that sometimes “caution is the eldest child of wisdom.”

  1. See generally Exotic to Mainstream: Growth of Alternative Mutual Funds in the U.S. and Europe 2, SEI Investments Co. (May 4, 2010).
  2. For a discussion of the Great Recession and its causes, see Steven A. Ramirez, Lawless Capitalism: The Subprime Crisis and the Case for an Economic Rule of Law at xi-xvii (2012); Michael C. Macchiarola, Beware of Risk Everywhere: An Important Lesson From the Current Credit Crisis, 5 Hastings Bus. L.J. 267, 269-273 (2009).
  3. See, e.g. Exploring Strategies in Response to a Shifting Landscape, J.P. Morgan Investor Services (2013) (noting that today’s asset managers are confronting “numerous challenges, including capturing new capital from investors, escalating competition, increased regulatory requirements, operational complexity and profit margins that are still below pre-crisis levels.”).
  4. See generally The Rise of Liquid Alternatives & The Changing Dynamics of Alternative Product Manufacturing and Distribution, Citi Prime Services (May 2013) at 4 (observing a “growing need for alternative strategies” and a “flattening of the differences between publicly offered and privately offered funds.”).
  5. According to one study, “[a]ssets in U.S. alternative mutual funds and Exchange Traded Funds (ETFs) have more than doubled since 2008, and now represent 883 portfolios with more than $550 billion in assets.” The Retail Alternatives Phenomenon: What Enterprising Private Fund Managers Need To Know 2, SEC Investments Co. (June 12, 2013).
  6. John Morley, The Regulation of Mutual Fund Debt, 30 Yale J. on Reg. 343 (2013).
  7. Id. at Abstract. All statutory references to the Investment Company Act of 1940 (ICA) are to 15 U.S.C. § 80(a) (2006), and, unless otherwise stated, all references to the rules under the Investment Company Act of 1940 are to 17 C.F.R. 270 (2013).
  8. See, e.g., Paul Roye, Division Director of Div. of Inv. Mgmt., U.S., Sec. & Exch. Comm’n, Keynote Address at the EEESI General Membership Meeting 2000: Regulation of Mutual Funds in the United States: A Successful Regulatory Regime (Sept. 22, 2000) (noting that the Investment Company Act “has proved to be remarkably resilient”).
  9. Morley, supra note 6, at 346.
  10. Id. at 347.
  11. For a summary of some of those protections, see Dianne M. Sulzbach & Philip T. Masterson, Offering Alternative Investment Strategies in a Mutual Fund Structure: Practical Considerations, The Investment Lawyer (Oct. 2008).
  12. For a summary of some of the SEC’s interpretations of the “senior security” provisions of Section 18 of the Investment Company Act, see Registered Investment Company Use of Senior Securities——Select Bibliography, U.S. Sec. & Exch. Comm’n, http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.
  13. Roye, supra note 8.
  14. For example, Section 18(f)(1) prohibits a mutual fund from issuing any class of senior security, or selling any class of senior security of which it is the issuer. Funds are generally permitted to borrow from a bank provided that immediately after any such borrowing there is asset coverage, as defined in section 18(h), of at least 300%. The Commission and the staff have indicated, however, that they will not object to funds engaging in certain types of transactions without complying with the asset coverage and other requirements of section 18(f)(1), provided that the funds segregate assets, or otherwise “cover” their obligations under the instruments, consistent with Commission and staff guidance. See 15 U.S.C. § 80a-18 (2012).
  15. Section 5(b) of the Investment Company Act categorizes a fund as a “diversified company” or “non-diversified company” based on the quality and diversity of its total assets. Absent a shareholder vote, Section 13(a) prohibits a funds from (i) changing from diversified to non-diversified and (ii) deviating from the investment policy or concentration policy stated in its registration statement. See id. §§ 5(b) & 13(a).
  16. In pertinent part, Section 30(b)(1) of the Investment Company Act requires that every registered investment company file with the Commission “such information documents and reports (other than financial statements) as the Commission may require to keep reasonably current the information and documents contained in the registration statement of such company.” ICA § 30(b)(1). A Fund’s quarterly filing of portfolio holdings is accomplished on Form N-CSR or Form N-Q and, depending on circumstances and timing, need not be audited. See generally Final Rule: Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management Investment Companies Securities and Exchange Commission 17 CFR Parts 210, 239, 249, 270, and 274 [Release Nos. 33-8393; 34-49333; IC-26372; File No. S7-51-02], https://www.sec.gov/rules/final/33-8393.htm.
  17. SEC guidelines require a mutual fund to have at least eighty-five percent of its assets in liquid securities. A security is generally deemed to be liquid if it can be sold or disposed of in the ordinary course of business within seven days at approximately the price at which the mutual fund has valued it. See Revisions of Guidelines to Form N-1A, SEC Release No. IC-18612 (Mar. 12, 1992) (noting that the eighty-five percent standard was “designed to ensure that mutual funds will be ready at all times to meet even remote contingencies”). Although the Commission has rescinded the Guidelines to Form N-1A, most of the positions taken in the Guidance, including those relating to liquidity, continue to represent the SEC staff’s position.
  18. Nearly all funds offer shareholders liquidity and market-based valuation of their investments at least daily. Mutual fund shares are redeemable on a daily basis at a price reflecting the current market value of the fund’s portfolio, calculated according to pricing methodologies established by the fund’s board of directors. See generally ICA § 2(a)(41); 17 C.F.R. 270.22c-1.
  19. See I.R.C. § 851-855.
  20. The “Qualifying Income” test provides that to qualify as a regulated investment company at least ninety percent of a mutual fund’s gross income must be derived from certain sources, including dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stock, securities, or foreign currencies. I.R.C. § 851(b)(2).
  21. The “Diversification” test provides that at least fifty percent of the value of the fund’s total assets must consist of cash, cash items, government securities, securities of other regulated investment companies, and investments in other securities which, with respect to any one issuer, represent neither more than five percent of the assets of the fund nor more than ten percent of the voting securities of the issuer. In addition, no more than twenty-five percent of the fund’s assets may be invested in the securities of any one issuer (other than government securities or the securities of other funds). I.R.C. § 851(b)(3).
  22. Morley, supra note 6, at 347.
  23. See, e.g., Inv. Co. Inst., Investment Company Fact Book at App. A (53d ed. 2013) (noting that “[f]unds are subject to more extensive disclosure requirements than any other comparable financial product, such as separately managed accounts, collective investment trusts, and private pools”).
  24. Morley, supra note 6, at 348.
  25. See generally Retail Liquid Alternatives: The Next Frontier 3, Goldman Sachs Global Investment Research (Dec. 6, 2013) (describing the retail liquid alternative market as having nearly 400 products, with 1/3 of those products launched over the past two years).
  26. It should be noted that investors in funds with embedded derivatives facing certain counterparties are also provided an additional protection beyond the scope of this Response. In general, Section 12(d)(3) of the Investment Company Act of 1940 prohibits registered investment companies from purchasing or otherwise acquiring any security issued by a broker, dealer or underwriter. In effect, this prohibition significantly curtails the counterparty risk a mutual fund might incur contra a so-called “securities related issuer.” See 15 U.S.C. § 80a-12(d)(3) (2012). For a general discussion of Section 12(d)(3) and the accompanying Rule 12d3-1, see Lawrence P. Stadulis & Timothy W. Levin, SEC Regulation of Investment Company Investments in Securities Related Business Under the Investment Company Act of 1940, 2 Villanova J. L. & Inv. Mgmt. 9 (2000). For a general discussion of the ramifications of mutual funds employing derivatives, see SEC Concept Release, Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Release No. IC-29776; File No. S7-33-11 (Aug. 31, 2011).
  27. See, e.g., Gretchen Rubin, Happier at Home (2012) at 122 (discussing this philosophy, albeit in a far different context, and attributing it to Samuel Johnson).
  28. Morley, supra note 6, at 354.
  29. Id.
  30. The PIMCO Total Return Fund, for example, with over $230 billion in assets, seeks to achieve its investment objective by investing primarily in a diversified portfolio of fixed income instruments. See Prospectus for PIMCO Total Return Fund, PIMCO (July 31, 2013).
  31. Roye, supra note 8. See also Alfred Jaretzki, Jr., The Investment Company Act of 1940, 26 Wash. U. L. Qrtly. 303, 307 (1941) (asserting that open-end mutual funds first came to prominence after abuses were uncovered in the structure of investment companies, their affiliations and their high pressure sales practices).
  32. See generally Roye, supra note 8 (noting that “[t]he U.S. Congress enacted the Investment Company Act to address these abuses in the investment company industry, assure investor protection, and preserve the important role investment companies’ play in capital formation”).
  33. Jaretzki, supra note 31, at 335.

The Need for New Federal Anti-Spam Legislation

The CAN-SPAM Act of 2003 was passed in an attempt to stop “the extremely rapid growth in the volume of unsolicited commercial electronic mail” and thereby reduce the costs to recipients and internet service providers of transmitting, accessing, and discarding unwanted email.1 The Act obligates the senders of commercial email to utilize accurate header information, to “clear[ly] and conspicuous[ly]” identify their emails as “advertisement or solicitation,” and to notify recipients of the opportunity to opt-out of receiving future emails.2 Once an individual has opted out, that sender is then prohibited from emailing them further.3 Despite high hopes, the Act has largely been considered a failure for four reasons: 1. It eliminates many pre-existing private causes of action against senders,4 2. it does not require senders to receive permission before initiating contact,5 3. it relies upon a system of opt-out links that are both distrusted and frequently abused,6 and 4. it has been under-enforced.7

In the absence of comprehensive federal legislation, alternative solutions to the spam problem have proliferated, including state-by-state statutory regimes, decentralized private regulation, and restraints on the acquisition of email addresses itself. This paper examines some of the shortcomings of these alternative approaches, advocating instead for a new, more complete federal statutory regime.

I. State Solutions: Low Compliance, Low Enforcement

Some states have tried statutory approaches to curtailing spam.8 These regimes vary widely, ranging from completely prohibiting all “unsolicited commercial email,”9 to permitting unsolicited commercial emails but requiring that they contain certain keywords in the subject line,10 to merely requiring truthfulness in the sender and subject lines,11 to seemingly no regulation whatsoever.12 These broad categories have further differentiation—some states’ laws only apply to email sent to more than a certain number of recipients,13 for example—so that the result is a substantially heterogeneous patchwork of regulation across the country.

Since email addresses, unlike physical addresses, offer no indication of the location of the recipient, complying with each state’s particular laws becomes all but impossible for senders of commercial email. The result is low voluntary compliance, with weak enforcement mechanisms—low-incentive private causes of action14 and underfunded state investigators15—unable to pick up the slack. Uniform federal legislation against spam that preempts these state regimes, includes greater incentives for bringing private action, and allocates funding for investigations would increase compliance and improve enforcement across the country.16

II. Decentralized Private Regulation: Anticompetitive Concerns

Private internet service providers (ISPs) have also stepped in, generating lists of websites that they believe “send or support the sending of spam,” and “blocking transmission” between those websites and the addresses in its own system.17 This decentralized process of private regulation may be more flexible and adaptive to changing technology,18 but it creates significant anticompetitive concerns.19

The criteria for blacklisting can be quite elastic—despite dedicating significant resources to fighting spam and policing relay use, MIT ran afoul of one such blacklist for simply having “bad email practices”20—and could easily allow ISPs to engage in selective enforcement, disproportionately blocking the websites and communications of competitors. Since ISPs are already natural monopolies, with customers in a given location typically having few, if any, alternatives, market forces would do little to restrain capricious blocking activity. Furthermore, ISPs that operate as part of much larger corporations have added potential for abuse by leveraging their blocking power in other markets; AT&T, for example, might use its position as an ISP to block the website and commercial messages of a competing cell phone carrier while allowing its own to go through. In this way, allowing ISPs to maintain blacklists enables them to magnify their already significant market power. Federal legislation against spam can obviate the need for private blacklists, stopping spam without generating anticompetitive forces.

III. Restraints on Email Address Acquisition: No Protection in Many Cases

The Computer Fraud and Abuse Act (CFAA)21 as well as the common law of contract and trespass have been used to curtail spam indirectly by policing the illegitimate acquisition of email addresses.22 However, these solutions are incomplete at best. Focusing on the acquisition of email addresses does nothing for individuals whose email addresses are already in the hands of spammers. Additionally, these restraints miss a wide variety of email address acquisition techniques. Lists of email addresses can still be bought, sold, or posted for free by companies that acquired them. Users may unwittingly leave their contact information searchable on social media sites. Many email addresses can even be guessed.23 Federal legislation addressing the act of spamming directly is needed to close these gaps, and provide recourse once an email address has been acquired.

IV. Conclusion: Crafting Better Federal Spam Regulation

A new federal statutory regime regulating spam is needed to replace CAN-SPAM. State regulations are prohibitively difficult to comply with, and lack proper enforcement mechanisms. Private regulation raises too many anticompetitive concerns. Restrictions on email address acquisition, while beneficial, are an inadequate solution on their own. New federal regulation that directly targets spamming activity, requires opting in rather than opting out, provides sufficient incentives for private parties to file complaints or bring suit, and dedicates resources for investigations would go far in reducing spam below its current level.

  1. 15 U.S.C. § 7701(a)(2)-(3), (6) (2012).
  2. Id. § 7704(a)(1)-(2), (5).
  3. Id. § 7704(a)(4)(A).
  4. See Amit Asaravala, With This Law, You Can Spam, Wired (Jan. 23, 2004), http://www.wired.com/techbiz/media/news/2004/01/62020 (quoting Lawrence Lessig as saying the Act “is an abomination . . . . It’s ineffective and it’s affirmatively harmful because it preempts” other causes of action).
  5. See Statement on CAN SPAM, Coal. Against Unsolicited Commercial Email (Dec. 16, 2004), http://www.cauce.org/2004/12/cauce-statement-on-can-spam-act.html (noting that by adopting an opt-out system, “[CAN-SPAM] gives each marketer in the United States one free shot at each consumer’s e-mail inbox . . . .”).
  6. See Daniel Solove, What Exactly Is a “Spammer”?, Concurring Opinions (Jan. 7, 2007), http://www.concurringopinions.com/archives/2007/01/what_exactly_is.html (“It is common knowledge that you shouldn’t click the opt out link on an unsolicited email because many spammers use that trick as a way to verify that people have read the spam and will then send people even more spam.”).
  7. See Jonathan K. Stock, A New Weapon in the Fight Against Spam, Mondaq (Oct. 8, 2004), http://www.mondaq.com/article.asp?article_id=28901 (“The [CAN-SPAM] Act has largely gone unenforced.”).
  8. See, e.g., Washington v. Heckel, 24 P.3d 404 (Wash. 2001) (finding Heckel liable for sending unsolicited commercial email by applying Washington’s Commercial Electronic Mail Act, codified at Wash. Rev. Code § 19.190 (2012)).
  9. Cal. Bus. & Prof. Code § 17529.2(a)-(b) (West 2013).
  10. See, e.g., 815 Ill. Comp. Stat. 511/10(a)(a-15) (2012) (mandating use of “ADV” and “ADV:ADLT” in “unsolicited electronic mail advertisement’s subject line[s]”); Alaska Stat. § 45.50.479 (2012) (mandating the use of subject line keywords only for sexually explicit content); Wis. Stat. § 944.25 (2012) (same).
  11. See, e.g., Nev. Rev. Stat. §§ 205.492, 205.511 (2012); N.D. Cent. Code § 51-27-01 (2012); Wash. Rev. Code §§ 19.190.010 to .110 (2012).
  12. Hawaii, for example, “has no statutes addressed specifically to commercial email and spam.” Legal Information Institute, Hawaii, Cornell L. Sch., http://www.law.cornell.edu/wex/inbox/hawaii (last accessed Nov. 17, 2013).
  13. See, e.g., La. Rev. Stat. Ann. §§ 14:73.1, 14:73.6 (only applying to “electronic message[s] . . . sent in the same or substantially similar form to more than one thousand recipients”).
  14. Many states, for example, only allow plaintiffs to recover actual damages or a predetermined maximum amount; these are likely insufficient to incentivize the costly and time-consuming process of obtaining a lawyer, filing suit, and litigating. See, e.g., ,s>R.I. Gen. Laws § 6-47-2(h) (2012) (capping what plaintiffs may receive at $100, plus legal fees); Pa. Stat. Ann. § 2250.7(a)(1) (West 2013) (same); Me. Rev. Stat. tit. 10 § 224.1497(7)(B) (2012) (allowing for recovery of actual damages or $250, whichever is greater); Mo. Rev. Stat. § 407.1129 (2012) (allowing for recovery of actual damages or $500, whichever is greater).
  15. See Electronic Crime Needs Assessment for State and Local Law Enforcement, Nat’l Inst. of Justice (Mar. 2001), https://www.justnet.org/pdf/186276.pdf, at iv (voicing “serious concerns about the capability of [state] law enforcement resources to keep pace” with a wide variety of computer crimes).
  16. One might argue that senders of unsolicited commercial email ought to simply identify the strongest state law, obey it, and then they will be safe in every state. The result of this, however—uniform anti-spam law across the country—is more legitimately achieved through federal legislation than a single state’s unilateral action. Some states, for one reason or another, may not want stronger anti-spam laws. The federal legislative process would balance these interests, and take different states’ desires into account.
  17. Media3 Technologies v. Mail Abuse Prevention System, No. 00–CV–12524–MEL., 2001 WL 92389, at *2 (D. Mass. Jan. 2, 2001).
  18. See David G. Post, Of Black Holes and Decentralized Law-Making in Cyberspace, 2 Vand. J. Ent. L. & Prac. 70 (2000).
  19. Decentralized private regulation also raises the same compliance concerns outlined above. There are many different possible definitions of spam, let alone what constitutes “supporting” the sending of spam. Since ISPs may cover residents of multiple states, and states may have multiple ISPs, the result is a patchwork of private policies overlaid onto a patchwork of state regulations, further hampering compliance.
  20. See Lawrence Lessig, The Spam Wars, The Indus. Standard (Dec. 31, 1998).
  21. 18 U.S.C. § 1030 (2012).
  22. See, e.g., Register.com v. Verio, 356 F.3d 393 (2d Cir. 2004) (determining that querying Register’s servers to obtain their customers’ email information for spamming purposes constituted a breach of contract on the part of Verio, as well as trespass to chattels); America Online v. LCGM, 46 F. Supp. 2d 444, 450 (E.D. Va. 1998) (determining that by using an AOL membership to harvest the email addresses of AOL users, LCGM was in violation of AOL’s Terms of Service, and as a result both “exceeded authorized access” and “accessed without authorization” for the purposes of the CFAA).
  23. Combinations of common first and last names with popular domains such as @gmail.com or @aol.com generate numerous positive results as of this writing (search conducted via web applets such as Linksy’s Find-Email (http://linksy.me/find-email). There are even programs designed to help automate such guessing, such as the Gmail extension Rapportive (http://rapportive.com).