Electric Power Resilience: The Challenges for Utilities and Regulators

*Regulatory economist/consultant. Previously employed by the National Regulatory Research Institute, the Illinois Commerce Commission, the Argonne National Laboratory and Commonwealth Edison Company. I want to thank Robert Bradley, Devin Hartman, Ross Hemphill, and Peter Larsen for their comments on an early draft. I wish to express my deep appreciation to the editorial staff of the Yale Journal on Regulation, especially Blake Shultz and DJ Sandoval, for their thorough review and insights that enhanced the quality of this Essay.

Few people doubt that the United States will continue to experience long-lasting electric power outages affecting a large number of people and businesses (e.g., outages from Superstorm Sandy, Hurricane Maria in Puerto Rico, and severe hurricanes in Florida).1 Some industry observers believe that the resilience of the U.S. electric-power network is deficient, and if industry spends additional funds on improving its resilience, the benefits would outweigh the costs.2

Customers, the media, and the public have taken more interest in scrutinizing utilities’ responses to weather-related disasters and cyberattack threats.3 There is a full-court press at the federal, state, and local levels to bolster the resilience of electric power.4

The common perception is that the benefits are too large to ignore. This belief seems plausible on its surface. After all, the damages from a long power outage can be devastating to a locale, affecting almost everyone.5 Possible damages include economic and noneconomic components. An example of the latter is the inconvenience and discomfort caused by an outage. Imputing a dollar value on the noneconomic effects is difficult—not much more than a guess. Any event that causes prolonged power outages over a large area is extremely costly—both for restoration and to the economy, and in terms of citizens’ health, safety, and general welfare.

Studies have shown that electricity outages, on a kilowatt hour (kWh) basis, have far higher costs than both the price of electricity and the cost of producing and delivering electricity.6 Outage costs include spoiled food, lost productivity, lost business revenues, and inconveniences. On net, then, electric customers are worse off when they experience an outage, even when their electricity bills decline. This is no surprise for anyone that has experienced an outage, especially for a long duration.7

Both the utility provider and electricity consumers can mitigate the damages from extended power outages. Resilience should be an integral goal of utility planning to determine long-term investments and other measures. Through pricing, a utility can determine how much its customers are willing to pay for different levels of resilience. Customers can also self-insure and take other protective actions to mitigate the damage from long-term outages.

The widely recognized Coase Theorem favors the imposition of liability on those parties who are able to address a problem at the lowest cost.8
It may be true that customers can more cost effectively make investments and take other adaptive actions to mitigate the effects of long-term power interruptions. But solely maximizing efficiency avoids the question of who should bear the risk from an “equity” perspective.9 At the other extreme lies strict liability. Under strict liability, the utility alone is responsible for all long-term service interruptions, irrespective of the cause and cost. Imposing all liability on a utility might both be inefficient and unfair to the utility and its shareholders. It presumes that either (1) the utility could prevent and mitigate the damage at a lower cost than customers could (an efficiency argument), or (2) fairness demands that the utility absorb all costs, since the occurrence and the actual consequences of service interruptions are largely under the utility’s control. Each condition, or both, may fail to hold.

This Essay argues that, for an electric power system, achieving a socially optimal level of resilience poses more challenges to utilities and their regulators than achieving optimal reliability and thus requires a special form of regulatory analysis. A host of factors—flawed decision-making (e.g., probability neglect), ambiguity over the definition of resilience and the scope of activities to which it is relevant, the high uncertainty of the benefits from improving resilience, the difficulty of measuring resilience and establishing a benchmark, and the optimal institutional arrangement involving both utility planning and a consumer-driven approach—complicate the tasks of both utilities and regulators. This Essay discusses each factor in turn.

   I. Differentiating Resilience from Reliability

A fundamental problem in developing policies that guide utility-resilience investments is the lack of a consensus on the definition of resilience and deficiencies in measuring and assessing resilience on various scales. Experts and other observers disagree over the scope of resilience. Should it include only actions to restore power service? Or does it encompass avoiding service interruptions as well? What most differentiates resilience from reliability is the attention paid to utility activities once a service interruption begins, a presumed longer interruption period, and a wide selection of mitigating actions.

 A. Ambiguity Over the Definition of Resilience

Various definitions of resilience abound, differentiated by the nature and scope of actions directed at making a power system more resilient.10 Often the term resilience is used loosely and inconsistently.

One generally accepted definition of resilience is that it measures the performance of a system under threat or stress, for example, power grid performance under severe weather conditions or a cyberattack. 11 According to this definition, a resilient power system possesses the capability to absorb a disruptive event and still continue to operate. If service is interrupted, resilience turns to the ability to mitigate the damage or social cost. Sources of system disruption from a major event are both natural (e.g., severe storms) and human (e.g., cyber and terrorist) threats. A resilient power system has the ability to withstand and recover from both malicious and inadvertent cyber and physical attacks.

The above definition of resilience contains two components. The first is static, which is the ability of a power system to remain functional when shocked. The second is dynamic, which involves hastening the speed of recovery from a disruption.12 The first component relates to keeping the lights on. The second involves restoring service quickly when the lights go out and, considering the economics, at the minimum cost to consumers and society. Static resilience and dynamic resilience are substitutable. By spending more money to prevent service interruptions, the operator can reduce the money spent on managing an outage and restoring service.

Utilities commonly engage in four broad activities related to resilience: (1) sustaining operation of the power system; (2) restoring service; (3) planning and preparing for future extended interruptions; and (4) adapting to future events based on past experiences.13 The last activity, often overlooked, refers to the process in which, after a disruptive event happens, a utility learns from that experience. This can result in the utility modifying its future actions in response to a disaster, which will improve resilience and thereby reduce the duration of a service interruption.

The 2017 U.S. Department of Energy report on Electricity Markets and Reliability recapitulates the unique challenges associated with resilience:

Recent severe weather events have demonstrated the need to improve system resilience. The range of potential disruptive events is broad, and the system needs to be designed to handle high-impact, low probability events. This makes it very challenging to develop cost-effective programs to improve resilience at the regional, state, or utility levels. Planning, practice, and coordination on an all-hazards basis and having a mix of resources and fuels available when a major disturbance occurs are both essential to fast response.14

The Edison Electric Institute has compiled a listing of recent studies, programs, and policies on grid hardening and resilience for distribution systems in response to large storms. It notes that no single solution exists to make all systems more resilient; rather, “utilities and their regulators must look at the full menu of options and decide the most cost-effective measures to strengthening the grid and responding to storm damages and outages.”15

 B. A Two-Part Definition of Reliability

The North American Electric Reliability Corporation (NERC) disaggregates reliability into two parts. The first, operating reliability, is “the ability of the electric system to withstand sudden disturbances,” such as electric short circuits or unanticipated loss of system components.16 Operating reliability identifies short-term operational aspects of the system, which overlap with maintenance of system functionality when confronted with an extreme event like a hurricane. It relates to that element of resilience that prevents the system from going down and interrupting service to customers.

The second part, adequacy, is “the ability of the electric system to supply the aggregate electric power and energy requirements of the electricity consumers at all times, taking into account scheduled and reasonably expected unscheduled outages of system components.”17 Reliability is generally measured by interruption metrics.18 It is a binary concept of system performance: the lights are either on or they are not. Reliability, therefore, concentrates on a system’s general capability to provide power with as few service interruptions as possible.

 C.  The Uniqueness of Resilience

Resilience, as discussed supra, focuses more on one-time extreme events with the potential for widespread and long-lasting damage. A more resilient system can better withstand an extreme event. With a disruptive event, the damage is smaller and recovery is faster. Moreover, resilience extends beyond the duality that characterizes reliability by allowing for intermediary positions between service and no service.

First, consumers experience benefits of resilience and reliability investments differently. Resilience-improving actions attempt to mitigate the damage done by extreme (i.e., not routine) circumstances. Customers enjoy most of the benefits from investing in resilience only after an extreme event. Indeed, with luck, in a given year, they may realize no benefits other than a perceived reduction in risk due to these investments—for example, comfort in knowing that they would suffer less damage if a severe storm happens. In contrast, because investments in reliability enhance routine operations and conditions, customers should see their benefits within a few years.

Second, improving resilience requires a greater diversity of activities because of resilience’s broader scope. Resilience-improving conduct occurs over a broad time range. Some, like preparation and planning, occur before an event is on the horizon. Others, like the retention of service and service’s quick recovery, only occur after an event happens.19 Activities also vary in priority because of their greater benefits, lower costs, or both. For example, many observers consider two-way communication with customers during a long-term outage as critical and relatively low cost.20 Customers can better adapt if they know how long a service interruption will continue. Their behavior will likely differ if, say, the estimated time to restoration is eight hours versus thirty minutes. Other commonly cited resilience improvements include more redundancy (e.g., spare parts), hardening of distribution lines (e.g., upgrading poles and structures with stronger materials), distributed energy resources (DER) and microgrids, remote-controlled switches, system design accommodating recovery, mutual assistance programs, security measures, a diversified and integrated grid, training and workforce development, smarter operation of distribution component, and better communications with customers. 21

Finally, resilience improvements require more effort on the part of utility companies. To combat a major event, the utility may have to repair damaged overhead lines, transformers, and substations.22 It also may have to grapple with service interruptions throughout its system and for a large number of customers. These possibilities make resilience-based outages more challenging to confront and analyze than reliability-based (e.g., less than twenty-four hour) outages.23

Resilience is, however, not the sole purview of utility operators. A holistic perspective of resilience views how power operators, electric consumers, and the general economy respond to a disruption—even perhaps through utility-community joint efforts that require outside help from the government.24 Holism also involves how electric consumers react to an extended service outage and what precautions they took prior to the outage to lessen the actual harm they otherwise would suffer.25 These actions represent adaptive responses to a major threat.26 Any regulatory policy should recognize that a utility and its customers, along with the community assisted by the government, can jointly contribute to mitigating the damages from an extended service interruption. These entities possess complementary expertise and skills that can efficiently and equitably mitigate the damage done by extended outages to utility customers and the community.

 II. Flawed Decision-Making

 A. Probability Neglect

Evidence from different contexts has shown that “probability neglect,” namely the sole focus on outcome and disregard for its probability, helps to explain excessive reactions to low-probability, catastrophic events.27 That is, the responses to tragedies and other highly damaging events often occur right after outrageous incidents with high public exposure. The result is a failure to apply rigorous, analytical approaches to managing risks. Resilience of electric power is susceptible to this conundrum.

Because policymakers and system operators rightly fear extended service interruptions and blackouts—they would face the brunt of criticism—they may not think twice about burdening electric customers with the cost of avoiding them. They will tend to err on the side of excessive caution that translates into higher electricity prices for their customers.28 The problem is that they may view improved resilience to be beneficial from their perspective when it is not from society’s.

The mindset of many decision-makers and industry observers seems to be: we can’t let this happen again, no matter how slim the chances are and the economics.29 Moreover, their risk perceptions are exaggerated, derived from high-profile publicity given to such events. The policy discourse over electric power resilience exemplifies this flawed thinking.

Prudent decisions on resilience require consideration of the probability of events, whether calculated objectively with historical data or determined subjectively. Assessing the economics of improved resilience should account for the likelihood of the future frequency and duration of extended outages covering a large area. Otherwise, how can decision-makers conduct a valid cost-benefit review of costly investments and other actions?

 B. The Precautionary Principle

Analysts often refer to the precautionary principle in setting environmental, safety, and other public policies across different industries and contexts.30 The precautionary principle warns that society is gambling when it acts to prevent a potential harmful event only under stringent conditions (e.g., a highly certain future). It assigns a benefit to prevention even with inconclusive risk. The application of the precautionary principle to electric power resilience seems appropriate. The reason is that, even though it becomes difficult to assign a probability to a catastrophic event and measure, with reasonable accuracy, the benefits from actions to enhance resilience, the event could cause severe damage to electric consumers and the regional area.

1.  What Is the Precautionary Principle?

According to the precautionary principle, the optimal decision in a world of less-than-perfect certainty and large risk from the status quo calls for new action. Uncertainty exists where decisionmakers lack reasonably accurate estimates or forecasts for the benefits from enhanced resilience. The precautionary principle strategy mirrors a “min-max” approach—i.e., minimizing the maximum harm that can result from an adverse event31—which is most appropriate for situations where the outcomes can afflict substantial damage to property and human life, in addition to being highly uncertain.

Under the precautionary principle, even in the face of uncertainty, society should expend resources today to mitigate the chances of severe problems in the future.32 The implication for resilience is that society should spend some amount of money today to enhance resilience and avoid a worst-case scenario, notwithstanding the high uncertainty over the benefits.

To wit, the precautionary principle says that society takes an inordinate risk when it attempts to prevent a potential harmful event only under certainty. It supports society erring on the side of caution in protecting the general public from risk, adopting a “better safe than sorry” stance that insures against catastrophic events. For resilience, the precautionary principle would recognize both the possible extensive damage to society from threats to the electric power grid and the inconclusive nature of the costs from service disruptions.

A conservative interpretation of the precautionary approach aligns with the “real options theory.” According to this theory, decision-makers would “hedge” by deferring costly actions until they acquire more definitive information necessary to reduce the chances of making the wrong decision (e.g., overspending on resilience).33 This wait-and-see posture can help avoid uneconomic actions. Decision-makers would delay undertaking a major initiative until they know more about the risk level of threats. This cautious approach would result in some spending today on enhancing resilience as an insurance against the possibility of a catastrophic outcome.

2.     Critiques of the Precautionary Principle

The precautionary principle is not uncontroversial.34 Critics note its shortcomings compared to a cost-benefit analysis that accounts for uncertainty and the risk aversion of the decision-maker. How much money should society spend today to mitigate the consequences of major threats to the electric power system? Should a utility spend a hundred million dollars or two billion dollars for mitigation? Unlike a cost-benefit analysis, the precautionary approach provides little guidance.

When people purchase insurance, they at least implicitly compare the premiums with the expected cost of an adverse event.35 Should society not have an idea of the expected benefits from spending money today to reduce the damages from long-extended power outages? But the precautionary principle places the burden on those would devote little or no resources toward mitigating a hazard where reasonably accurate information about its consequences and the probability of its occurrence is nonexistent.36 The default option is that society should act to avoid a risk with potentially catastrophic consequences, irrespective of the likelihood of the event. That is why a prominent scholar harshly said that the precautionary principle “offers no guidance—not that it is wrong, but that it forbids all courses of action, including inaction.”37

Indeed, the precautionary principle may not represent an economically rational way to guide socially desirable policy, especially when it involves society spending large sums of money today. Assume that the utility spends substantial sums of money to improve its resilience. Although the investment would reduce the expected damages from a severe storm, that money might have been better spent on alternative utility activities designed to improve safety or reduce other risks. The benefits of the paths not taken constitute the opportunity cost of spending the money on resilience.38

So even if a course of action is tenable, rational behavior would limit spending for preventing the possibility of future harm from catastrophic events. In the face of uncertainty, the best policy may be to avoid the worst outcome irrespective of the probabilities for different scenarios. This rationale assumes a risk-averse society and severe damages from an event.

III.  Uncertainty as a Complicating Factor

Uncertainty differs from risk in that the probability of occurrence is not quantifiable, thereby requiring subjective judgment by decision-makers.39 Under uncertainty, a common approach is to describe various hazard scenarios or assign them a probability based on the decision-maker’s personal assessment.

Uncertainty can warrant action, but decision-makers should exercise caution when doing so. When deciding to perform a costly action with uncertain benefits, economic or noneconomic, people often hesitate, and they hesitate rationally. Decision-makers need to continuously acquire better information, whether from credible modeling or more informal sources, to increase the chance that they take socially desirable actions in the face of uncertainty. This seems to be true for electric power resilience.40

To make socially optimal—or even effective—decisions on resilience requires reasonably accurate information about the true cost of service interruptions for both utility customers and the local area. As of today, methods that estimate willingness to pay (WTP) are inadequate to inform the benefit-cost analysis of “resilience investments.”41

A. “Black Swans”

Analysts label power interruptions of long duration as a high impact, low probability (HILP) event, also known as a “Black Swan” event. A Black Swan event poses special challenges for decision-makers because of its (1) far-reaching impact; (2) poorly understood risk (“uncertainty”); (3) costly mitigation; and (4) the unclear role for industry, power customers, and government in sharing the responsibilities for mitigating the effects of a major event.42

HILP events can have macroeconomic and other societal impacts (e.g., nonmonetary inconvenience). The likelihood and magnitude of societal impact increases as an interruption endures for an extended period over a large area.43 As the extent of an outage and the dispersal of its effects increases, the benefits of any actions to improve resilience become harder to measure.

 B.  Addressing Uncertainty

Decision-makers44 face a high degree of uncertainty about the effects of major disruptions on an electric power system. Because of scant data to draw upon, predicting their frequency and the damage they might cause is pure speculation.45 Compared with natural threats to electric grid reliability, such as extreme weather, cyber threats are more difficult to anticipate and address.

One source of greater uncertainty that has proliferated recently is more extreme weather, which some experts predict to worsen in the future.46 Another relatively new source of uncertainty is cyberattacks; utilities have little clue when they will occur and with what likelihood.47
Uncertainty inevitably forces decision-makers to rely heavily on value judgment. These value judgments frequently are part of the evaluation of the benefit side of “resilience” investments.48 It also makes strict cost-benefit tests less feasible. 49 Analysis of resilience thus differs from evaluating reliability concerns, which are more accurately described as risks. The likelihood of inadequate capacity to meet demand is derivable from historical data for both system peak load50 and power-plant outage rates. Reliability is also more precisely measurable and is less ambiguous in its definition.51 An Electric Power Research Institute (EPRI) report summarizes the current state of cost-benefit analysis for electric power resilience, and demonstrates how much these analyses differ:

In conventional cost-benefit analysis, prospective investments can be evaluated by comparing the costs and benefits expressed in present-value currency terms, which make comparisons straightforward. Resiliency investments are considered to avert the consequences of events characterized by low probability, uncertain timing, and high severity (while the costs are certain and large). If costs or benefits are not known with certainty, then the analysis must account for this from an expected risk perspective. Risk is traditionally defined as a function of the hazard (i.e., probability) and the consequence. Consequence can be further described as a function of exposure and vulnerability . . . . [T]here is no unifying perspective or framework for cost-benefit analysis of resiliency efforts, though there is much interest in advancing the state of the art. 52

One way to handle uncertainty is to know the customer’s implicit WTP for enhanced resilience in order to justify investments or other actions. While decision-makers cannot expect to eliminate uncertainty, they can incorporate it (e.g., by using subjective probabilities) into WTP calculations and cost-benefit analyses. The decision-maker can then better understand how uncertainty affects the cost-effectiveness of investments and other resilience-improving measures under different scenarios.

One unavoidable question is: how much is society willing to pay for increased resilience? The answer depends on the avoidance of lost welfare that would otherwise occur. Lost welfare measures what analysts refer to as the “Value of Lost Load” (VOLL). VOLL estimates can help to set resilience targets and to allocate monies toward different measures to enhance resilience. A risk-averse society would be willing to spend more than the expected loss in welfare. The tough chore for decision-makers is to calculate the risk tolerance of different customers. For the utility-planning approach, discussed infra Section V.A, analysis requires aggregating the disparate risk preferences across utility customers into a single standard for society.

Knowing with reasonable accuracy how much customers and society would be willing to pay for avoiding long service interruptions, therefore, is critical for prudent decision-making. But presently, willingness-to-pay information is too imprecise to render much value.53 For example, VOLL estimates are highly uncertain and specific to local conditions, outage duration, and scope. Besides, almost all studies focus on outages of twenty-four hours or less.54 The benefits of investments in resilience to counter interruptions of long durations (e.g., multi-day service outages) are consequently dubious and much more uncertain than the benefits for investments in electric power reliability.

Uncertainty often causes suboptimal behavior. People sometimes act overconfidently by overstating the sureness of their decision, saying something like: “We just know that spending more money on resilience is cost-beneficial. We observe how damaging long-term power outages can be, so we can never throw too much money at trying to mitigate their effects.” Others may rationalize inaction because of the high degree of uncertainty, stating, “Since we have highly imprecise estimates of what the benefits will be, we shouldn’t throw any money at improving resilience until we get better estimates.” Both responses can lead to irrational behavior and a socially undesirable outcome.55 The arguments are akin to the policy issues facing climate change, with divergent positions taken.56

IV.  Metrics for Resilience

A major if not central purpose of regulation is to induce high-quality performance from public utilities.57 To achieve that objective, regulators should measure and evaluate utility actions. Performance depends on how well utility management uses available resources. Yet factors outside utility management’s control also affect performance.58

The challenge for regulators is to determine what constitutes a well-performing utility.

What do they consider acceptable performance? Regulators must address this question if they are to exploit fully the information contained in performance metrics to take appropriate action, including those metrics relating to resilience. Measuring performance trends in the absence of a standard, for example, greatly constrains what actions regulators should take. How can they rightly penalize a utility without a benchmark against which to evaluate a utility’s performance?59

     A.  Challenges to Developing Resilience Metrics

Developing metrics for resilience is inherently difficult but is critical for decision-making.60 It involves measuring how well system operators prepare for and deal with rare events without any history (therefore, with significant uncertainty).61 As amplified in one study:

Reliability metrics measure grid operations during expected outages that could occur under relatively normal conditions. However, reliability metrics typically do not include outage information when low-probability, high-consequence events such as storms, earthquakes, and cyber-attacks occur. As the hazard landscape continues to change, historical data used for reliability calculations may not be suitable for characterizing future potential outages because emerging threats can differ significantly from historical precedents.62

According to the National Academy of Sciences, “[w]hile reliability metrics are relatively well established and widely used in electricity system planning and operation, the development of agreed-upon metrics for resilience lags significantly behind.”63 Decision-makers have found it difficult to assign standards to each of the activities advancing resilience, let alone measure their effectiveness. From the perspective of utility customers, a number of metrics are relevant. They relate to the frequency of long interruptions; the duration of long interruptions; the affected population; survivability (the provision of essential service); and lost welfare, like inconvenience and economic losses.

 B.  Limitations of Resilience Metrics

1. A Cautionary Note

Appropriate use of performance metrics, even where they accurately measure the outcome of utility actions, depends on the regulator’s ability to separate the effects of external and internal factors on performance. For resilience, several factors are relevant, some internal to a utility’s control and others outside utility management control. The challenge for regulators is to distinguish between these internal and external factors when deciding on whether a utility’s actions are prudent. Without this separation, applying performance metrics for regulatory decision-making becomes more difficult, even counterproductive. One example is comparing two utilities’ time to restore service after an outage. It may well be that the utility taking the longer time faces more challenging physical and environmental conditions. It would be unfair to penalize or reprimand that utility without considering those conditions. Regulators should therefore exercise caution in using performance metrics mechanically or as the sole source of information for evaluating a utility’s performance.

Regulators should pay special attention, however, to those utilities exhibiting abnormal or “outlier” performance, which might lead to more detailed inquiry. A metric, therefore, can act as a guide to future regulatory scrutiny and remedial actions. Metrics function best as a gross indicator signaling a potential problem warranting further inquiry.

2. An Example of Metrics’ Limits: The Utility of Input Metrics

For example, a serious limitation of input metrics (e.g., money spent on vegetation management) is that they provide no indication of how well a power system will operate in the event of a disruption or of the effectiveness of specific actions to enhance resilience.64 The real indicators of a power system’s resilience are the consequences that befall the system during and after a disruptive event. The utility can either estimate the consequences,65 account for the inherent uncertainties, or measure consequences after an event.

Input metrics also fail to consider the tradeoffs between different processes or standards. Assume that a utility meets a mandated regulatory standard for hardening its infrastructure to mitigate damage from a severe storm. Perhaps the money invested in infrastructure could have been better spent on emergency and planning activities or on better communications with customers during an event. That is, the actual dollars spent by the utility could have been used for greater improvements of resilience; the opportunity cost of the infrastructure investments exceeded their benefits.

 V.  Alternative Institutional Arrangements

A “resilience” strategy should focus on the consumer. Later, this Part argues that focusing on the individual consumer is a more economically efficient and equitable approach than lumping all the customers together, such as under the utility planning approach, to make decisions on resilience.

The decision to spend money on improving resilience should hinge on the risk-adjusted expected value to consumers. In a market-based environment, the resiliency of electric service will depend more on the value that consumers place on different levels of resilience. Under this “bottom up” approach, pricing and market incentives become major factors. Overall, customer-oriented strategies incorporate flexible, market-based rules accommodating the demands of individual customers.

But with long-term and massive power service interruptions having spillover effects on the economy, there is a macroeconomic effect (and noneconomic effects like safety, health and inconvenience) with a sum cost greater than the aggregate costs suffered by utility customers. When an industrial firm has no electric service, the relevant cost to the firm is the loss of profits. In contemplating whether to purchase backup service, the firm compares the cost of that service to the benefits (which would be avoided profit losses). But this private benefit would fall short of the social benefit, which would include employees not losing work and wages and other economic and noneconomic benefits external to the firm. The total benefit to the local economy would exceed the benefits to the firm. Thus, the profit-maximizing firm would be underinvesting, since it would not internalize some of the benefits that would result from having backup service. In other words, society should be willing to pay more for avoiding a massive outage than what the sum of individual customers would be willing to pay. This gap would then call for some action to close it, action that should be taken by the government or by utilities.

     A. Utility Planning Approach

1. Causes of Suboptimal Outcomes

From a public-interest perspective, the ultimate question is whether a “resilience problem” exists; namely, either utilities are spending too much on the resilience that they presently have (however it is measured), spending too little for enhancing their resilience, or are overly resilient today.

On one hand, deficient resilience can exist because of the net-positive externalities—for example, the social benefits, which may include public health and safety—exceed the benefits to electricity customers and the utility itself. On the other hand, utilities may be overspending on resilience because of excessive caution and probability neglect.

Utilities can also spend too much on the resilience desired because of the absence of a sequence of actions based on cost-effectiveness. Some analysts have questioned the cost-effectiveness of underground lines; for example, these lines can cost three to four times more than overhead lines of equal distances. Although underground lines can reduce the frequency of service interruption, outage duration is typically longer than with overhead lines because of the greater difficulty in repairing underground lines. Other measures (e.g., investment in an outage management system) taken by one utility can be cost-effective while the same measures may not be for another utility. One example is underground distribution lines in areas like Florida, where long-term, weather-related outages are more frequent than in other areas, would tend to be more economical.

Under conventional ratemaking, utilities may have an incentive to inflate their rate base to improve resilience (assuming that the authorized rate of return exceeds a utility’s cost of capital66)—in regulatory jargon, gold-plating67—by spending excessively to boost their profits. They may approach their regulators with key actions and investments to improve resilience without explicitly considering their costs or effectiveness. The likely outcome is utility customers paying for resilience at an amount more than either the benefits they receive or the amount they should pay, because of utilities’ cost inefficiencies. For example, communicating better with customers during an outage may be less expensive than investing in new distribution hardware.

2.  Alternatives to Cost-Benefit Analysis

If a problem exists, what might utilities do? How do we know if improved resilience is net beneficial to society? These questions are tough to answer, especially when relying on conventional cost-benefit analysis. Other analytic approaches may provide a fuller picture.

One of these approaches, break-even analysis, asks the following question: if we know the costs of increasing resilience and the costs of electric outages to customers and society, how large does the probability of an event, combined with the effect of resilience investment on the costs of the event’s consequences, have to be to balance benefits and costs? Break-even analysis becomes more valid when there is a high degree of uncertainty over the probability distributions of relevant outcomes. With high uncertainty, even when examining different futures, policymakers have little clue of the probability for each future.68

Another strategy would be to expend resources today to mitigate the smallchance of a future disaster (i.e., the “fat tail” part of a probability distribution), even when the benefits are highly uncertain.69 This resembles the earlier-described “min-max” strategy that aims to minimize the maximum harm that can result from an adverse event. Even a “fat tail” approach, however, might lead to underinvestment in resilience. Long-term service interruptions could result in damages far greater than what is presently considered likely. One policy implication is that instead of viewing “resilience” actions as a cost-benefit question, decision-makers should consider them as a form of insurance against a catastrophe that might happen, but with an unknown likelihood.70 Yet this begs the question of how much utilities should spend in total and for each resilience-improving measure. These are the basic challenges facing both utilities and their regulators.

 B.  Customer-Driven Approach

A customer-driven approach involves utilities offering customers service-differentiated pricing.71 Such pricing has the potential to optimize the response to service interruptions by allowing utilities to charge a premium to customers who value uninterruptible service at the highest level. These customers, to the extent technically feasible, will have their service cut off only after the utility interrupted service to other customers.72 Service-differentiated pricing considers explicitly a customer’s WTP.73 Evidence shows that customers suffer widely varying costs from power interruptions.74

For example, some retail customers are very tolerant of variations in power quality and power interruptions, while other customers are less accepting of these conditions. Customers would therefore be willing to pay different amounts for protection against interruptions.75 One prime example is interruptible rates for customers who are willing to accept less reliable service in return for a lower rate.76 Critical peak pricing and peak-time rebates also illustrate where customers are willing to tolerate lower reliability for savings on their electricity bills.77

In comparison, the central planning, or top-down alternative previously mentioned—whereby a utility makes network-wide investments to increase resilience for all customers—can be extremely expensive. It would also raise a “fairness” issue: those customers who impute a relatively low value on increased resilience would subsidize other customers.

One widely acceptable practice is to minimize service interruptions of critical services. This may require the use of distributed generation and microgrids for essential load like police and gas stations, hospitals, and cell towers, and taking nonessential loads offline. Another action may be to ensure that essential services have backup systems. There are different ways to maintain essential services when power is out, and the most economical ones ought to be part of a “resilience” plan.78

Noncritical customers can mitigate the damage from extended outages, in other ways than purchasing insurance from a third party. Many industrial customers who find service interruptions extremely costly have a direct connection to the bulk power system and backup generation. Other customers can purchase a backup generator, solar photovoltaic systems with smart islanding inverters, or install Powerwall batteries.79 Residential customers can prepare for an outage by buying extra batteries, flashlights, and blankets, and mitigate losses by purchasing surge protectors. Enhancing resilience is therefore a split responsibility between utilities and their customers.80

VI.  Policy Implications

The overall goal of resilience should be to minimize the lost value to electric customers and society from service interruptions caused by external natural and human threats, net of costs. In other words, actions to improve resilience should minimize the social costs from a disruptive event, which requires accounting for both the benefits and costs.

To quantify the social costs with reasonable accuracy, utilities will need to develop new data and models. These additional analytical capabilities can identify areas of greatest risks and system vulnerabilities, allocate resources more efficiently, and help prioritize investments. Research and development for promising technologies and mechanisms, like improvements to control systems and distribution automation, holds the key to improving resilience in the long term.

Achieving socially optimal resilience poses more of a challenge for utilities and their regulators than reliability does. Resilience covers a wider array of diverse activities, and its benefits are more uncertain. Undertaking a cost-benefit analysis to evaluate different actions is more specious for resilience than for reliability. For example, reliability concerns are more accurately described as risks. The likelihood of inadequate capacity to meet demand is derivable from historical data. Reliability is also more precisely measurable and is less ambiguous in its definition.

To wit, a fundamental problem in developing policies that guide utility resilience investments is the lack of a consensus on the definition of resilience and deficiencies in measuring and assessing resilience on various scales. Experts and other observers disagree over the scope of resilience: should it include only actions to restore power service or does it encompass avoiding service interruptions as well? This Essay supports the latter definition.

A customer-driven approach with service-differentiated pricing is the most promising path to pursue if one wants to know how much customers are willing to pay for resilience. But because of the external benefits like macroeconomic effects, public health and safety from higher resilience, and the technical and political difficulty for a utility to differentiate services across individual customers, it would be ill-advised to rely on market forces alone to achieve a socially optimal outcome.

One important function of public utility regulators is to identify any undue barriers to enhancing resilience and those actions that can most cost-effectively eliminate or mitigate them. Such barriers exist when (1) they cause economically inefficient and socially harmful outcomes, and (2) their mitigation passes a cost-benefit test, making them amenable to public-policy intervention. One possible barrier derives from the perception that utilities could expend substantial money on enhancing resilience with the benefits only realized after a major event. Trying to quantify those benefits prior to investments is extremely difficult: what is the probability that customers will realize benefits, when will they realize them, what are the chances of a major event occurring, and how much do customers benefit when a major event occurs? It would seem hard for a utility to justify expenditures on resilience to a regulator, especially when trying to compare them with the expected benefits to its customers.

With utilities strongly motivated to enhance resilience—perhaps excessively—regulators face two tasks attuned with the public interest. The first is to make sure that utilities implement the most cost-effective actions. The second is to prevent utilities from “gold-plating” their rate base.

In closing, in an ideal world, utilities could justify proposed “resilience” actions by making demonstrated and verifiable benefits at the least cost. But since this is next to impossible, decisions affecting resilience require subjective judgment by utilities and their regulators—more so than for decisions relating to reliability. This implies that any action relies heavily on the decision-maker’s judgment devoid of precise or even reasonably accurate quantification. Utilities (and regulators) need to prioritize “resilience” actions despite the absence of useful estimates of benefits or cost effectiveness.

  1. See Resilience Strategies for Power Outages, Ctr. for Climate & Energy Sols. (Aug. 2018), https://www.c2es.org/site/assets/uploads/2018/08/resilience-strategies-power-outages.pdf [https://perma.cc/NZD9-ZV68].
  2. See Enhancing the Resilience of the Nation’s Electricity System, Nat’l Acads. Sci., Engineering, & Med. 13 (2017), https://www.nap.edu/catalog/24836/enhancing-the-resilience-of-the-nations-electricity-system [https://perma.cc/5SD3-8MC6]. Extreme weather and distribution-level problems are the primary factors in the duration of electric power interruptions, with bulk generation shortfalls accounting for only a tiny number of customer outages, especially extended outages. Thus, the emphasis is on spending more money at the distribution level to enhance resilience. See Alison Silverstein et al., A Customer-focused Framework for Electric System Resilience, Grid Strategies, LLC 14-18 (May 2018), https://gridprogress.files.wordpress.com/2018/05/customer-focused-resilience-final-050118.pdf [https://perma.cc/V4JY-JE4P].
  3. See Cong. Research Serv., IN10895, Electric Reliability and Power System Resilience (2018), [https://perma.cc/R57Q-3G7G#93;; Before and After the Storm, Edison Electric Inst., at v. (Mar. 2014), http://www.eei.org/issuesandpolicy/electricreliability/mutualassistance/Documents/BeforeandAftertheStorm.pdf [https://perma.cc/KV3Y-ABMD#93;;  Hardening the Grid: How States Are Working to Establish a Resilient and Reliable Electric System, Nat’l Conf. State Legislatures (Apr. 2018), http://www.ncsl.org/Portals/1/Documents/energy/HardeningGrid_1_32298.pdf [https://perma.cc/EV45-CU7S].
  4. See Order Terminating Rulemaking Proceeding, Initiating New Proceeding, and Establishing Additional Procedures, Fed. Energy Regulatory Comm’n (Jan. 8, 2018), https://www.ferc.gov/CalendarFiles/20180108161614-RM18-1-000.pdf [https://perma.cc/6SQB-YCB2#93;. See also Before and After the Storm, supra note 3, for a listing of state activities addressing issues related to electric power resilience.
  5. According to estimates by the Lawrence Berkeley National Laboratory, sustained power outages cost the United States around fifty-nine billion dollars annually, with businesses and industrial firms incurring about ninety-seven percent of the costs. Joseph H. Eto, The National Cost of Power Interruptions to Electricity Customers—A Revised Update, Lawrence Berkeley Nat’l Lab. (Jan. 10, 2017), http://grouper.ieee.org/groups/td/dist/sd/doc/2017-01-10%20National%20Cost%20of%20Power%20Interruptions%20to%20Electricity%20Customers%20-%20Eto.pdf [https://perma.cc/AL9H-TKG9#93;. This supports the importance of electric utilities providing uninterruptible service and prompt service restoration when interruptions occur.
  6. Id.
  7. Assume a stylized model in which customers benefit from electricity usage at the amount U. Extended service interruptions occur at the probability p with an average damage of d (i.e., damage per unit of kWh interruption). Consistent with empirical research, d is much greater than the price of electricity. Michael J. Sullivan et al., Estimated Value of Service Reliability for Electric Utility Customers in the United States, Lawrence Berkeley Nat’l Lab., at xxvi, tbl.ES-5 (June 2009), https://emp.lbl.gov/sites/default/files/lbnl-2132e.pdf [https://perma.cc/2NBH-GM3L#93;. On net, the benefit to a customer from electricity service equals U – p·d. Because the average American customer relies heavily on electricity, service interruptions can impose a high cost on households and businesses. Overall, customers would be willing to pay up to this U – p·d for electricity. Customers should therefore be willing to pay a higher price for electricity that is more resilient, since they would suffer less damage from service interruptions. The ability to charge a higher price arguably should incentivize the utility to incur additional costs to improve its resilience. To the extent that customers place greater value on more resilient electricity than it costs the utility to provide it, they benefit (assuming cost-based rates), the utility stands to profit, and aggregate economic welfare improves.
  8. Ronald Coase, The Problem of Social Cost, 3 J.L. & Econ. 1 (1960).
  9. The Coase Theorem may also conflict with the legal determination of which party should bear the risk.
  10. For different definitions of resilience, see Miles Keogh & Christina Cody, Nat’l Ass’n Reg. Util. Comm’rs, Resilience in Regulated Utilities (2013); Karen Palmer et al., Economic Approaches to Understanding and Addressing Resilience in the Bulk Power System: A Workshop Summary, Resources for the Future (June 2018), https://media.rff.org/documents/RFF_workshop_summary_final_0.pdf [https://perma.cc/C5WV-LVQH#93;; and Toward a Practical Theory of Grid Resilience, GRID Modernization Laboratory Consortium, U.S. Dep’t Energy (Apr. 2018), https://gridmod.labworks.org/sites/default/files/resources/Theory of Grid Resilience final_GMLC_0.pdf [https://perma.cc/4XRW-FWZB].
  11. Henry H. Willis & Kathleen Loa, Measuring the Resilience of Energy Distribution Systems, RAND Corp. (2015), https://www.rand.org/pubs/research_reports/RR883.html [https://perma.cc/LS27-3KBW].
  12. Adam Rose, Economic Resilience to Natural and Man-Made Disasters: Multidisciplinary Origins and Contextual Dimensions, 7 Envtl. Hazards 383 (2007).
  13. Richard J. Campbell, Weather-Related Power Outages and Electric System Resiliency, Congressional Research Service (Aug. 28, 2012), https://fas.org/sgp/crs/misc/R42696.pdf [https://perma.cc/V4ZA-GVZV#93;; supra note 3.
  14. Staff Report to the Secretary on Electricity Markets and Reliability, U.S. Dep’t of Energy 12 (Aug. 2017), https://www.energy.gov/sites/prod/files/2017/08/f36/Staff Report on Electricity Markets and Reliability_0.pdf [https://perma.cc/4XLZ-XBPT].
  15. Before and After the Storm, supra note 3, at v.
  16. Letter from Gerry Cauley, President & Chief Exec. Officer, N. Am. Electric Reliability Corporation, to Rick Perry, Secretary U.S. Dep’t of Energy 2 (May 9, 2017), https://www.eenews.net/assets/2017/10/03/document_ew_01.pdf [https://perma.cc/JAQ7-RHCC#93;. For the role of NERC in assuring reliable electric service, see the Federal Energy Regulatory Commission’s document at https://www.ferc.gov/legal/staff-reports/2016/reliability-primer.pdf [https://perma.cc/FP3L-B92P].
  17. Letter from Gerry Cauley, supra note 16, at 2.
  18. The classic reliability metrics are the System Average Interruption Duration Index (SAIDI), System Average Interruption Frequency Index (SAIFI), Customer Average Interruption Duration Index (CAIDI) and Momentary Average Interruption Frequency Index (MAIFI). See Electric Reliability: Problems, Progress and Policy Solutions, Galvin Electricity Initiative (Feb. 2011) http://www.galvinpower.org/sites/default/files/Electricity_Reliability_031611.pdf [https://perma.cc/2UDD-PQFW].
  19. Supra notes 2 & 3 and accompanying text.
  20. See Enhancing Distribution Resiliency: Opportunities for Applying Innovative Technologies, Electric Power Res. Inst. (Jan. 2013); supra note 2.
  21. Campbell, supra note 13; supra note 2. Of course, just listing the options begs the question of which ones are most cost-effective in providing the most “bang for the buck.” Some analyses develop a long list of recommendations for improving resilience that, if all executed, would be cost-prohibitive. They rarely provide guidance or systematic ranking as to which ones are most effective and economical, and whether any of them would pass a cost-benefit test. Regulators should demand that utilities choose and pick the most effective and economical actions because of their constrained resources and their obligation to their customers to hold rates down.
  22. Phil Zahodiakin, Making Distribution Grids Stronger, More Resilient, 4 EPRI J., July/Aug.2016, at 4-8 http://eprijournal.com/making-distribution-grids-stronger-more-resilient [https://perma.cc/FWY3-GCHD].
  23. According to one survey, state utility commissions make no distinction between reliability and resilience in their investments—they lump them together when evaluating investment proposals. Kristina LaCommare et al., Evaluating Proposed Investments in Power System Reliability and Resilience: Preliminary Results from Interviews with Public Utility Commission Staff, Lawrence Berkeley Nat’l Laboratory (2017), https://emp.lbl.gov/publications/evaluating-proposed-investments-power [https://perma.cc/USY3-4ZW2].
  24. As a common practice, utilities rely on community and government assistance when an extensive power outage occurs. Utilities also generally update their customers on the status of the outage and how to best cope with it, for example not opening their refrigerators to prevent food spoilage and releasing the garage door. See supra note 2 and Before and After the Storm, supra note 3; M. Finster et al., Front-Line Resilience Perspectives: The Electric Grid, Argonne Nat’l Lab. (Nov. 2016), https://www.energy.gov/sites/prod/files/2017/01/f34/Front-Line Resilience Perspectives The Electric Grid.pdf [https://perma.cc/4SKL-GQQT#93;; Are You Prepared for a Power Outage? FEMA (Mar. 29, 2019), https://www.fema.gov/media-library/assets/images/161542 [https://perma.cc/L9YC-EUUQ#93;. For an example of one utility’s (New Jersey Central Power & Light) strategy in preparing its customers for a possible outage from severe weather, see JCP&L Preparing for Severe Weather Forecast; Critical Customers Notified, PR Newswire (Oct. 24, 2018), https://www.prnewswire.com/news-releases/jcpl-preparing-for-severe-weather-forecast-critical-customers-notified-300737418.html [https://perma.cc/GX57-778N].
  25. There is little discussion in the literature and in the regulatory arena of the role of electric consumers in taking responsibility for damages that they may suffer from an extended power outage. If utilities alone are responsible for the damages, this could create what analysts call a “moral hazard” problem,” with customers forgoing potentially cost-effective behavior. (Although the “moral hazard” problem is a theoretical possibility, its seriousness requires an empirical analysis. The author is unaware of any such analysis.) Customers can take various actions to avoid or mitigate damages from an outage. Although customers have no legal responsibility to mitigate damages, it seems both unfair and inefficient to compensate customers for damages that they could have reasonably avoided or mitigated at a low cost. Just as utilities should be accountable in their actions, an argument is that customers should also have a duty to take reasonable actions in mitigating the consequences of an outage.
  26. One measure of adaptation by businesses is the percentage decline in production relative to the percentage decline in electricity availability from the local utility. If a business suffers no decline in production, say, because it has a back-up generator, it has perfectly adapted, or its resilience is one hundred percent.
  27. See generally Cass R. Sunstein, Probability Neglect: Emotions, Worst Cases, and the Law, 112 Yale L.J. 61 (2002).
  28. This is a theoretical argument with the premise that long-term service interruptions would impose greater risks (e.g., public outcry) for decision-makers than slightly higher electricity prices. This tradeoff might differ from that of electricity customers and society.
  29. One example is the U.S. Secretary of Energy’s proposed rule to the Federal Energy Regulatory Commission in 2017 to promote electric power resilience as vital to national security. The Commission remarked that “the Proposed Rule would allow all eligible resources to receive a cost-of-service rate regardless of need or cost to the system. The record, however, does not demonstrate that such an outcome would be just and reasonable. It also has not been shown that the remedy in the Proposed Rule would not be unduly discriminatory or preferential.”  Order Terminating Rulemaking Proceeding, Initiating New Proceeding, and Establishing Additional Procedures, Federal Energy Regulatory Commission 9 (Jan. 8, 2018), https://www.ferc.gov/CalendarFiles/20180108161614-RM18-1-000.pdf [https://perma.cc/6SQB-YCB2].
  30. Christian Gollier & Nicolas Treich, Decision-Making Under Scientific Uncertainty: The Economics of the Precautionary Principle, 27 J. Risk Mgmt. 77 (2003).
  31. See Cass R. Sunstein, The Paralyzing Principle, Regulation, Winter 2002-2003, at 32. This is especially applicable to utility investments in resilience. The frequencies and magnitudes of severe weather events are highly uncertain and the worst-case outcome reflects catastrophic damages of the highest magnitude.
  32. Gollier & Treich, supra note 30.
  33. For a discussion of real options theory and its application, see generally Lenos Trigeorgis, Real Options: Managerial Flexibility and Strategy in Resource Allocation (1996); and Real Options: Developments and Applications, 38 Q. Rev. Econ. & Fin. 533 (1998).
  34. See Richard A. Posner, Catastrophe: Risk and Response (2004); Robert W. Hahn & Cass R. Sunstein, The Precautionary Principle as a Basis for Decision Making, 2 Economist’s Voice (2005); supra note 31.
  35. Gary S. Becker, Economic Theory 61-64 (1971).
  36. Daniel Kahneman, Thinking, Fast and Slow 351 (2011).
  37. Trigeorgis, supra note 33, at 33.
  38. The definition of opportunity cost is the alternative use of the money spent on resilience that has the highest social value.
  39. In the real world, risky and uncertain situations are insurable. But uncertainty precludes decision-makers from relying on historical data to calculate the objective probability of an adverse event. This makes uncertain events more expensive to insure.
  40. If decision-makers have better information on the benefits of enhanced resilience, they would then expect to deviate less from a decision where the marginal benefit differs from the marginal cost.
  41. WTP is an economic concept used to value nonmarket goods such as cleaner air, more wildlife, fewer power outages, and lower obesity. For an application of the latter, see John Cawley, Contingent Valuation Analysis of Willingness to Pay to Reduce Childhood Obesity, 6 Econ. & Human Biology 281 (July 2008), http://citeseerx.ist.psu.edu/viewdoc/download?doi= [https://perma.cc/7583-7V96].
  42. For a discussion of “Black Swan” events, see generally Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (2010).
  43. See Seth Guikema & Roshanak Nategchi, Modeling Power Outage Risk from Natural Hazards, Oxford Research Encyclopedia of Natural Hazard Science (June 2018) https://oxfordre.com/naturalhazardscience/view/10.1093/acrefore/9780199389407.001.0001/acrefore-9780199389407-e-52 [https://perma.cc/39RR-UP8X].
  44. “Decision-maker” refers to utilities who create and execute strategies and tactics, and the regulators who approve them.
  45. This fact is a rationale for using an analytical tool other than cost-benefit analysis, such as break-even analysis, see Section V.E.2, to evaluate investments in resilience. See Peter Fox-Penner & William P. Zarakas, Analysis of Benefits: PSE&G’s Energy Strong Program, prepared for PSE&G (Oct. 7, 2013), http://files.brattle.com/files/936_analysis_of_benefits_-_pse_g’s_energy_strong_program_fox-penner_zarakas_10_07_13.pdf [https://perma.cc/9VF6-SC85].
  46. See Resilience Strategies for Power Outages, supra note 1.
  47. Keogh & Cody, supra note 10; Electric Distribution System Cybersecurity Is Critical in Today’s Interconnected Society, Edison Electric Inst. (Apr. 2018), https://www.eei.org/issuesandpolicy/cybersecurity/Documents/EEI_Cybersecurity_Considerations_Distribution_Fin-April27-2018.pdf [https://perma.cc/PK7Q-Y8UN#93;; Lynne Holt & Mary Galligan, State Public Utility Commissions’ Role in Cybersecurity and Physical Security Issues: Trade-Offs and Challenges (Public Utility Research Center, Working Paper, Dec. 12, 2017), https://bear.warrington.ufl.edu/centers/purc/docs//papers/1707_STATE_PUC_ROLE_Cybersecurity_12_12_17.pdf [https://perma.cc/QL5R-RBB7].
  48. Any calculated benefits, for example, would have a wide band of uncertainty causing ambiguous results. Investments and other actions that improve resilience may have additional benefits, such as energy efficiency, reliability, and economy.
  49. Some state jurisdictions have required cost-benefit analysis prior to approving the inclusion of grid modernization expenditures in rates. These programs will likely include the development of performance metrics for reliability, and possibly for resilience, if these new capabilities are to provide the expected service improvements. For a review of state grid modernization programs, see 50 States of Grid Modernization 2018 Annual Review, N.C. Clean Energy Tech. Ctr. (Feb. 2019), https://nccleantech.ncsu.edu/wp-content/uploads/2019/02/Q42018-GridMod-Exec-Final2.pdf [https://perma.cc/53KS-KYA3].
  50. Peak load is the highest electrical power demand over a specified time period.
  51. For reliability, the margin of redundancy reflects three factors: historical experience, the value lost to customers from service interruptions, and the cost of power-supply reliability.
  52. Electric Power Research Inst., Electric Power System Resilience: Challenges and Opportunities 45 (Feb. 2016), https://www.naseo.org/Data/Sites/1/resiliency-white-paper.pdf [https://perma.cc/4ZH4-KJ2J].
  53. Utilities, government agencies, and others in the United States commonly use the Interruption Cost Estimate (ICE) Calculator as a tool for estimating interruption costs, or the benefits of reliability improvements. Interruption Cost Estimate Calculator, Lawrence Berkeley Nat’l Laboratory & Nexant, Inc., https://icecalculator.com/home [https://perma.cc/7FDM-9GW8#93;. The U.S. Department of Energy funds the ICE Calculator. Id. Utilities provide the ICE Calculator with cost estimates for power interruptions lasting at most 16 hours. See id. Although users can extrapolate the costs to longer interruptions, and use them as a guide, the estimates would be less accurate when a nonlinear relationship exists between kWhs of lost service and interruption costs. It is reasonable to assume that the costs per kWh of lost service during prolonged interruptions differ significantly from the costs of short interruptions. Long interruptions tend to inflict social costs by having a ripple or “multiplier” effect on the economy. See Economic Benefits of Increasing Electric Grid Resilience to Weather Outages, Exec. Office President (Aug. 2013), https://www.energy.gov/sites/prod/files/2013/08/f2/Grid Resiliency Report_FINAL.pdf [https://perma.cc/FT4J-PRYT#93;. This means that they would have a society-wide effect that extends beyond the costs to power customers. Applications of the the ICE Calculator generally consider only the direct costs to customers. See Peter H. Larson, Projecting Future Costs to U.S. Electric Utility Customers from Power Interruptions, Lawrence Berkeley Nat’l Lab. 9-10 (Jan. 2017), https://www.ourenergypolicy.org/wp-content/uploads/2017/02/lbnl-1007027_1.pdf [https://perma.cc/M67T-6F92#93;. Therefore, it excludes the costs suffered by businesses not directly affected by an interruption. Overall, scaling up the estimates of short interruption would likely lead to inaccurate results. For a critique of the ICE Calculator, see Electric Power System Resilience: Challenges and Opportunities, Elec. Power Res. Inst. 46 (Feb. 2016), https://www.naseo.org/Data/Sites/1/resiliency-white-paper.pdf [https://perma.cc/YQM8-7YWW].
  54. VOLL per kilowatt-hour for residential customers can be more than two orders of magnitude above the price of electricity; for commercial and industrial customers, the order of magnitude is far greater. Sullivan, supra note 3. VOLL reflects what economists call “compensating variation” or “equivalent variation.” See Hal R. Varian, Microeconomic Analysis Ch. 10 (1992). The former measures what customers would be willing to pay to avoid a service interruption, while the latter measures what customers would be willing to accept for having a service interruption. Surveys generally have shown the latter measure to be higher. See supra note 7, at 59. Customers feel they have an entitlement to continuous service, which is compatible with one of the tenets underlying behavioral economics and prospect theory. For a discussion of prospect theory, see generally Amos Tversky & Daniel Kahneman, Advances in Prospect Theory: Cumulative Representation of Uncertainty, 5 J. Risk & Uncertainty 4, 297 (1992). Applying prospect theory to customers, their utility should pay them a nontrivial sum for agreeing to have their service interrupted because that would violate their basic right to electric service.
  55. Behavioral economics can explain this irrationality. See Kahneman, supra note 36, at 55; Richard H. Thaler & Cass R. Sunstein, Nudge: Improving Decisions about Health, Wealth, and Happiness (2008).
  56. Examples of divergent (or as some people would say, extreme) positions are (a) climate change is a hoax that poses no problem, and (b) we need to take immediate aggressive action to reduce greenhouse gas emissions or else catastrophe is inevitable.
  57. The presumption is that when a utility performs well, for example, in controlling its costs and providing highly reliable and resilient service, it is advancing the interests of both its customers and society. If the generally agreed-upon goal of regulation is to serve the public interest, a better performing utility would then seem compatible with that goal.
  58. A chronic problem for regulators is that they observe only a utility’s performance, not the effect of management’s effort on cost, service quality, and other outcomes affecting customer welfare. Because of this reality, if given the chance, utilities have an incentive to engage in strategic behavior, resulting in a zero-sum game where they benefit from higher profits or other managerial goals at the expense of their customers. See Paul L. Joskow, Incentive Regulation in Theory and Practice: Electricity Distribution and Transmission Networks (Jan. 21, 2006) (manuscript prepared for the Nat’l Bureau of Economic Research Conf.), https://economics.mit.edu/files/1181 [https://perma.cc/83KU-CSSU#93;.
    In the context of this Essay, regulators lack the ability to determine the minimum costs compatible with a certain level of resilience (if measurable). Utilities inherently have better information that motivates them to overestimate the cost of resilience. This incentive is more acute when utilities receive zero or minimal benefits from better managing their costs or improving their resilience. That is, the higher the allowed costs, the less risk there would be that unanticipated additional expenditures (e.g., cost overruns on underground distribution lines) would result in the utility earning a return on capital below its allowed return.
  59. A benchmark allows the regulator to compare an individual utility’s performance with some predefined reference, either a peer group or the utility’s own past performance. It focuses on outcomes, for instance the services provided by a utility per unit of labor or capital, or the frequency and duration of service interruptions. As an alternative, a benchmark would center on a utility’s practices and uses of different technologies—i.e., has the utility adopted “best practices” in the form of state-of-the-art technologies and management processes? See Mehdi Farsi et al., Benchmarking and Regulation in the Electricity Distribution Sector (Ctr. for Energy Policy and Economics, Working Paper No. 54, 2007), http://citeseerx.ist.psu.edu/viewdoc/download?doi= [https://perma.cc/HCQ4-L2ET].
  60. In the absence of quantifiable metrics, it becomes difficult for decision-makers (e.g., utility management and regulators) to know if a utility’s “resilience” performance is falling short of, achieving, or surpassing predetermined objectives or targets. Metrics can empower regulators to grade utilities, mindful of limitations in their use for regulatory actions. Performance metrics can accompany special incentive mechanisms, management audits, and other detailed investigations to determine recovery of resilience-related costs for a utility. For examples of the different uses of performances metrics in the regulatory arena, see Ken Costello, How Performance Measures Can Improve Regulation, Nat’l Regulatory Res. Inst. (June 2010), http://nrri.org/download/2010-09-how-performance-measures-can-improve-regulation [https://perma.cc/KLE5-PQUD].
  61. Conventional reliability metrics like the System Average Interruption Duration Index (SAIDI, the total duration of interruption for the average customer during a predefined period) are misleading because often they exclude data on service interruptions originating from major events. There are also inconsistencies in the definition of a “major event.” U.S. Energy Information Admin., EIA Data Show Average Frequency and Duration of Electric Power Outages, Today in Energy (Sept. 12, 2016), https://www.eia.gov/todayinenergy/detail.php?id=27892 [https://perma.cc/QY3B-695G#93;. Problems also arise from measuring the benefits of resilience with metrics traditionally used for reliability planning. Reliability metrics like average service interruption indices are ill-suited for characterizing resilience.
  62. Eric Vugrin et al., Resilience Metrics for the Electric Power System: A Performance-Based Approach, Sandia Nat’l Labs. 7-8 (Feb. 2017), https://prod-ng.sandia.gov/techlib-noauth/access-control.cgi/2017/171493.pdf [https://perma.cc/Z92B-VEG4].
  63. Enhancing the Resilience of the Nation’s Electricity System, supra note 2, at 34.
  64. See id.
  65. The estimates can represent expected or maximum consequences, along with their subjective probabilities.
  66. Harvey Averch & Leland L. Johnson, Behavior of the Firm Under Regulatory Constraint, 52 Am. Econ. Rev. 1052 (1962).
  67. Edward E. Zajac, Note on ‘Gold Plating’ or ‘Rate Base Padding’, 3 Bell J. Econ. and Mgmt. Sci. 1, 311-15 (1972).
  68. The costs of interruptions itself, of course, would be subject to a high degree of uncertainty. The alternative question then becomes how much would the expected benefits have to be to justify the costs. While the break-even approach is superior to conceding ignorance, it involves much judgment. As an illustration, if the costs to improve resilience is fifty million dollars, the utility can justify the action if it sets a lower-bound estimate of the benefits at a level greater than fifty million dollars. On the other hand, if the utility sets the upper-bound estimate at less than fifty million dollars, the utility should not act, as the benefits could not justify the costs. See William P. Zarakas et al., Utility Investments in Resilience: Balancing Benefits with Cost in an Uncertain Environment, 27 Electricity J. 5, 31 (2014); supra note 45.
  69. See supra note 42 and accompanying text for a general discussion of “fat tails.”
  70. A similar conceptual issue has become part of the discussion over the optimal public policy for climate change. There is one notable difference: as of now, we have not experienced any catastrophic effect from climate change while we have encountered substantial welfare losses from long-term power outages. See Robert S. Pindyck, Fail Tails, Thin Tails, and Climate Change Policy (Nat’l Bureau of Econ. Research, Working Paper No. 16353, 2010), https://www.nber.org/papers/w16353.pdf [https://perma.cc/AD5R-F6RB].
  71. Individual electricity customers generally cannot choose their preferred level of resilience. This is because utilities rarely provide differentiated resilience; instead, they provide uniform resilience to their customers with some exceptions. One exception is interruptible service for customers who are willing to accept less reliable service for lower rates. For a discussion of interruptible rates, see Sanford V. Berg & John Tschirhart, Natural Monopoly Regulation: Principles and Practice 218 (1988). Another exception is critical customers, who receive preferential treatment during service restoration. See Public Utilities Commission of Ohio, Electric Power Outages: A PUCO Guide to Being Prepared, https://www.puco.ohio.gov/be-informed/consumer-topics/electric-power-outages-a-puco-guide-to-being-prepared/ [https://perma.cc/L7CH-TN69#93;; supra note 23.
  72. One obstacle is the high transaction costs for the utility from providing higher/lower quality service to customers willing to pay more/less. It seems that this would be much more difficult to implement than simple interruptible service—but probably more feasible in view of present and emerging technologies.
  73. See C.K. Woo et al., A Review of Electricity Product Differentiation, 114 Applied Energy 262 (2014).
  74. Michael Sullivan et al., Estimating Power System Interruption Costs: A Guidebook for Electric Utilities, Lawrence Berkeley Nat’l Lab. (July 2018), http://eta-publications.lbl.gov/sites/default/files/interruption_cost_estimate_guidebook_final2_9july2018.pdf [https://perma.cc/7SVE-K2EB].
  75. But for customers to make efficient decisions, they will need to have some idea of the likelihood of future events that will interrupt electricity service for an extended period. They could acquire an historical record of service interruptions from their utility or base their decisions on personal experiences.
  76. For examples of interruptible rates, see Is-4 Electric Interruptible Service, Madison Gas & Electric Co. (2019), https://www.mge.com/customer-service/for-businesses/electric-rates/is-4-electric-interruptible-service [https://perma.cc/QAC9-HVB5#93;; and Schedule No. 38; Noticed Interruptible Power Service, El Paso Electric Co. https://www.epelectric.com/files/html/Rates/TX_Tariff_Schedules/TX_Sch_No._38_Notice_Interruptible.pdf [https://perma.cc/4QC4-KMKP].
  77. For examples of critical peak pricing and peak-time rebates see, respectively, Get to Know Critical Peak Pricing (CPP), S. Cal. Edison (2019), https://www.sce.com/business/rates/cpp [https://perma.cc/B9L7-QJN8#93;; and Peak Time Rebates, Portland General Electric, https://www.portlandgeneral.com/residential/energy-savings/peak-time-rebates #91;https://perma.cc/75G5-KY8G#93;.
  78. National Research Council, Terrorism and the Electric Power Delivery System Ch. 8 (2012), https://www.nap.edu/read/12050/chapter/8 [https://perma.cc/8J8R-N73C].
  79. See Battery Backup Power, Revision Energy (2019) https://www.revisionenergy.com/solar-power-for-your-home/battery-backup [https://perma.cc/4VHY-NV22].
  80. See Be Prepared for a Power Outage, FEMA (May 2018), https://www.fema.gov/media-library-data/1527865875064-7a5a439a4714d4bb8d553294e0023d2b/PowerOutage_May2018.pdf [https://perma.cc/WGK7-YWKG].

Regulatory Takings Without Confiscatory Returns

*Department of Economics, Kansas State University. I am grateful to Glen Robinson for critical insights into the case law underlying regulatory takings and for constructive comments on previous drafts of this manuscript. I thank David Sappington for helpful comments and thought-provoking discussions on the topic of this Essay over the course of our many research collaborations. Finally, I wish to express my sincere gratitude to the editorial staff of this Journal, particularly Charlie Bullock and Brendan Costello, for their careful review and critical insights that greatly improved the Essay.

In regulated industries, including telecommunications, electric power, and natural gas, there has been a dramatic substitution of price cap regulation (PCR) for rate-of-return regulation (RRR). Despite this sea change in regulatory regimes, the Hope Standard, which protects the regulated firm from confiscatory rates so that it remains a financially viable enterprise, continues to serve as the litmus test for whether a regulatory taking has occurred. This creates some tension between the economics and the law. The incentive properties of PCR are superior to those of RRR precisely because PCR breaks the link between allowed revenues and costs. This is problematic because the Hope Standard employs an earnings test to assess takings claims which requires relinking revenues and costs to measure financial returns. This Essay contends that if the desirable incentive properties of PCR are to be preserved, the law must recognize that a taking can occur even when the regulated firm’s returns are not confiscatory. This new standard integrates the traditional Hope Standard with a Sustainable Price Standard to ensure that (i) the regulated firm remains financially viable and (ii) earnings above confiscatory levels would no longer be sufficient to reject a taking claim.

I. Introduction

A taking does not become a noncompensable exercise of police power simply because the government in its grace allows the owner to make some ‘reasonable’ use of his property.

Dissent of Chief Justice William Rehnquist in Penn Central v. City of New York

The past three decades have witnessed a dramatic substitution of price cap regulation (PCR) for rate-of-return regulation (RRR) in North America and throughout the world.1 This substitution has been most dramatic in the telecommunications industry,2 but other sectors including airports, electric power, and natural gas have also participated in this trend.3 The principal reason for the pervasive adoption of PCR is the opportunity it provides to improve outcomes for all primary interest groups.4

Regulators have policy instruments other than RRR and PCR available to them to influence the behavior of the regulated firm. Prominent among these instruments are accommodative competitive-entry (ACE) policies. ACE policies are regulatory initiatives that go beyond opening markets to competition to simulating that competition by placing the proverbial regulatory thumb on the scale in a manner that does not reflect competition on the merits.5 A seminal theme that underscores this discussion is that a regulator’s propensity to adopt ACE policies is not independent of the type of regulatory regime (i.e., RRR or PCR).6

This Essay is motivated by two observations about the transition from RRR to PCR. First, the theoretical literature concludes that PCR is superior to RRR in that it provides enhanced incentives for efficiency.7 Nonetheless, the empirical evidence is mixed as to whether PCR has resulted in significant efficiency gains.8 Second, the interplay between the Hope Standard, which constrains regulatory behavior with an earnings floor, and ACE policies permits the regulator to reestablish the linkage between the firm’s revenues and costs that PCR seeks to break and thereby appropriate the regulated firm’s efficiency gains. The incentives for regulators to enact ACE policies are particularly pronounced under pure PCR.9

The key policy conclusion that follows from this analysis is that various legal and regulatory policy mechanisms may intercede to prevent PCR from delivering on its promised efficiency gains. The problem is that under prevailing case law the legal standard for a taking turns on the regulated firm’s earnings even under price regulation. As a result, the regulator can act with impunity in employing ex post policy changes, including ACE policies, that promote competition artificially to unilaterally reduce the regulated firm’s earnings provided they do not fall below the minimum level established under Hope. The more efficient the regulated firm, the greater the regulator’s discretion to accommodate competition and appropriate the regulated firm’s excess earnings, ceteris paribus.

In order to preserve the desirable incentive properties of PCR, the law must recognize that a taking can occur even when the regulated firm’s returns are not confiscatory. This new standard for a taking integrates the traditional Hope Standard with a Sustainable Price Standard to ensure that (i) the regulated firm remains a financially viable enterprise and (ii) earnings above confiscatory levels would no longer be sufficient to reject a taking claim.

The remainder of this Essay is structured as follows. The fundamentals of price regulation are discussed in Part II. Part III illustrates the problem of regulatory moral hazard with examples drawn from the telecommunications industry. The applicable case law for determining the presence of a regulatory taking is reviewed in Part IV. Part V proposes an economic standard for a regulatory taking under price regulation. Part VI concludes.

II. Price Regulation Fundamentals

A. Economic Regulation Emulates Competition

The regulatory economics literature recognizes that a primary objective of economic regulation is to emulate a competitive market standard. To this end, Professor Alfred Kahn observes that “the single most widely accepted rule for the governance of the regulated industries is regulate them in such a way as to produce the same results as would be produced by effective competition, if it were feasible.”10 In similar fashion, Professor James Bonbright observes that “[r]egulation, then, as we conceive it, is indeed a substitute for competition; and it is even a partly imitative substitute.”11

RRR seeks to instill competitive discipline by capping the regulated firm’s financial returns.12 Pure PCR seeks to instill competitive discipline by capping the prices for regulated services.13 A central question in the economics of regulation literature is whether earnings-based regulatory regimes, price-based regulatory regimes, or regimes based on some combination of the two types of regulation are the best means to replicate the discipline of competitive markets and encourage the investment behavior that regulators wish to encourage.14

The early economics literature on PCR emphasizes two distinct yet related themes. First, the regulator is not all-knowing and the regulated firm possesses superior information about its costs and demands.15 Second, efficiency is the result of a discovery process and the regulated firm must be provided with incentives to invest in the (unobservable) effort required for such discovery.16

B. The Efficiency Properties of PCR

Under pure PCR the link between the regulated firm’s allowed revenues and costs is severed.17 The superior incentive properties of PCRderive in large measure from breaking this link between allowed revenues and costs so that the regulated firm is the residual claimant for its efficiency gains.18 This means that the regulated firm retains a full dollar for each additional dollar of cost savings (at least until rebasing occurs at the end of the PCR regime).19

Delinking allowed revenues and costs provides the regulated firm with incentives to: (1) operate with the least-cost technology; (2) operate with no waste; (3) diversify efficiently into new markets; (4) undertake efficient levels of cost-reducing innovation; (5) report its costs truthfully;20
and (6) eliminate abuse.21 Earnings sharing, which is essentially a tax on earnings, weakens the desirable efficiency properties of PCR because the regulated firm bears the full cost of its efforts to reduce costs but retains only a fraction of the corresponding benefits. Earnings sharing may even encourage regulators to disallow costs that have been prudently incurred so as to move financial returns from the non-sharing range (commonly referred to as the “deadband”) into the sharing range.22

Consumers benefit from prices that do not vary directly with the reported costs of the firm because they bear little or no risk for excessive price variability for the duration of the price cap regime. This invariance property of pure PCR explains why it is sometimes characterized as a fixed-price contract. Conversely, traditional RRR (and some forms of PCR with earnings sharing) operates in similar fashion to a cost-plus contract.23 This means that the prices that consumers pay under RRR vary more directly with the reported costs of the firm and therefore tend to exhibit greater volatility.

PCR is commonly referred to as “I X” regulation because the maximum annual increase in the regulated firm’s average prices is governed by a general inflation index (I) less a productivity offset (X).24 For example, if the rate of inflation is 4% and the X factor is 2%, the price cap formula would permit the regulated firm to raise average prices a maximum of 2% (4% – 2%) per year.

The “I – X” price adjustment formula follows from the idea that in a competitive market industry-average productivity gains are passed along to consumers in the form of lower prices after controlling for inflation. Specifically, because the regulated firm retains the entirety of its efficiency improvements beyond those guaranteed ex ante through the X factor, it has ideal incentives to strive for maximum efficiency. This explains why the regulated firm may be expected to enlist its informational advantage regarding costs and demand to improve efficiency.

As discussed in the following passage, because PCR breaks the link between allowed revenues and costs it must also break the link between higher than normal profits and excessive rates.

It is possible to conclude that under a properly articulated economic rationale, consumer protection against “excessive profits,” as traditionally applied under profit level regulation, could not be invoked to reestablish a necessary link between prices and profits . . . . In effect, therefore, the standard of constitutional protection for consumers under a price level regime would be modified. The focus would shift from protection against “excessive profits” per se, as defined under profit level regulation, to protection against prices viewed as “unconscionable” and “demonstrably irrelevant” to the purposes of the price level regime.25

C. Regulatory Commitment is Critical to the Superior Performance of PCR

The finding that PCR has superior incentive properties in comparison with RRR must be qualified. PCR closely approximates the incentives of a competitive market—but only when the regulator’s commitment to the basic tenets of PCR is a credible one.26 This means that the regulated firm must have confidence that changes in the level of the price cap are independent of its own performance so that it is the residual claimant for its efficiency gains.27

When changes in the X factor are conditional on the regulated firm’s performance, the regulatory regime is said to incorporate a “ratchet effect” and the firm’s incentives for superior performance are adversely affected.

To illustrate the incentive problem associated with a “ratchet effect,” suppose the X factor is initially set at 2% and the regulated firm works diligently to innovate and improve operating efficiency. Because of these efforts, the regulated firm realizes efficiency gains of 3% per year. Having observed that the firm is able to achieve efficiency gains that exceed the X factor, the regulator determines that the X factor can safely be ratcheted upward without jeopardizing the firm’s financial viability. Over time, the regulated firm learns that its “reward” for successful innovation is to have its efficiency gains appropriated by the regulator in the form of a higher X factor and, in turn, a slower rate of allowed price growth.28

Under pure PCR, therefore, the regulatory authority agrees not to adjust the prices of the regulated firm’s services based on its actual earnings or costs for the duration of the price cap regime.29 A strong regulatory commitment is therefore critical to the superior performance of PCR. The greater risk the firm bears under PCR must be coupled with the distinct possibility of greater reward. “Absent credible rewards for superior performance and/or credible penalties for poor performance, the regulated firm will have little incentive to incur the effort costs that increase the likelihood of good performance.” 30

A key premise underlying PCR is that the regulator and its constituency will view higher profits by the regulated firm as something other than a failure of regulation itself.31 If this premise is false and the regulated firm is uncertain as to whether regulatory commitments will be honored, there may be little difference between PCR and RRR in practice.

The discussion of the efficiency properties of PCR in this Section is standard in the economics literature. Nonetheless, the superior incentive properties attributed to PCR depend on two critical assumptions that may not align with institutional reality. The first assumption is that there are no ex post policy instruments that would enable the regulator to decrease the (sustainable) market price below the price cap without breaching the price cap commitment. The second assumption is that the Hope Standard, discussed in Part IV infra, would not be used strategically by the regulator to appropriate “excess earnings” under PCR.32 The next two parts respectively examine real-world examples of these assumptions being violated and the case law that purportedly enables such behavior.

III. Regulatory Moral Hazard

The economics of regulation literature focuses almost exclusively on how various regulatory regimes, including PCR and RRR, influence the behavior and incentives of the regulated firm. And yet, as Professor Ronald Braeutigam has observed, “Regulation is a political act . . . . from a political point of view, perhaps the most significant feature of regulation is that it redistributes income, creating winners and losers, thereby shaping interest groups and coalitions.” 33 It should therefore be anticipated that changes in the regulatory regime affect not only the behavior and incentives of the regulated firm but those of the regulator as well. In this light, it is important to understand the properties of a regulatory regime in terms of a mechanism that imposes discipline on both the regulator and the regulated firm.34

The primary objective of this Part is to examine the issue of “regulatory moral hazard.”35 Specifically, we explore how the regulator’s behavior changes when it is insulated from the adverse effects of its actions. The key observation that underscores this discussion is that the regulator is almost perfectly insured under PCR against earnings deficiencies on the part of the regulated firm that would have triggered increases in politically sensitive, basic service rates under RRR (or PCR with earnings sharing).

For example, pure PCR can be self-defeating for the regulated firm because the regulator bears no cost of competitive entry measured in terms of shared earnings foregone or required increases in basic service rates that may anger consumers, the regulator’s constituency.36 Conversely, under RRR or PCR with earnings sharing, a pronounced earnings deficiency by the regulated firm would require the regulator to raise basic service rates. As a result, regulators are almost “fully insured” under pure PCR against financial losses incurred by the regulated firm from increased competition.37 This provides the regulator with strong incentives to allow the maximum degree of entry-accommodation38 consistent with preserving the financial viability of the regulated firm.39

The phenomenon of regulatory moral hazard is illustrated with three examples drawn from the telecommunications industry.

A. Competition in the Long-Distance Market

The idea that the regulated firm can “strategically influence” the behavior of the regulator has a long history in the telecommunications industry. Crandall observes that AT&T did not object to increased subsidy flows from long-distance to local telephone service when competition first threatened in the long-distance market.40 Crandall contends that AT&T tolerated such price distortions to increase the cost to the regulator, measured in terms of subsidies foregone, of allowing competitive entry. “Perhaps it saw this distortion as its ultimate, political defense against competitive entry in long-distance services.” 41 Robinson observes that “no resistance to this subsidy was forthcoming from AT&T, since it was largely just an intercorporate transfer of revenues.”42 The original idea can be traced back to a pioneering article by Richard Posner:

A firm that engages in internal subsidization can argue forcefully to the regulatory agency that the agency should not permit, or at least should strictly limit the entry of competitors into those markets where the firm makes large profits, because those profits – which new entrants would erode – are necessary in order to cover the losses in subsidized markets. 43

B. Implementation of the 1996 Telecommunications Act

Under the provisions of the 1996 Telecommunications Act, the incumbent telecommunications providers were required to unbundle their networks and lease the component parts of these networks, referred to as unbundled network elements or UNEs, to rivals at “cost-based” rates determined by regulators.44 Hence, the Act empowers regulators to essentially control the rate at which competitive entry materializes through their ability to calibrate the input prices paid by the rivals of the regulated firm. This is significant because competition is no longer exogenous but is instead endogenous to the regulator’s actions.

Lehman and Weisman45and Onemli46 provide empirical evidence that in implementing the 1996 Telecommunications Act regulators in states with PCR set lower lease rates for UNEs than regulators in states operating under some form of earnings regulation.47 The propensity for regulators in price cap states to create lower barriers to entry relative to regulators in states that have some form of earnings-based regulation aligns with the theory that the regulator is “insured” against the adverse effects of pro-competitive entry policies under PCR because the regulated firm’s prices do not vary with its earnings.48 The regulator’s incentives to engage in such behavior may be expected to increase with the length of the PCR plan because a regulated firm subject to a longer PCR plan has no short-term remedy for deficient earnings through the process of rebasing (i.e., the realignment of rates with underlying costs).

C. Open Meeting of Texas Public Utility Commission

A noteworthy illustration of the phenomenon discussed in the previous subsection played out in an open meeting of the Texas Public Utility Commission.49 The public record indicates that the commissioners observed (i) a dearth of competition in local telephone service markets; (ii) that the inclusion of contribution and subsidies in the wholesale rates for network inputs might discourage competition due to high barriers to entry;50 and (iii) that since Southwestern Bell had “freely elected into” PCR, the company had limited recourse to the Commission if lower wholesale rates designed to spur retail competition should lead to an earnings deficiency. Notably, this occurred after the Texas Commission had extracted a sizable infrastructure commitment from Southwestern Bell that required it to deploy advanced digital technology in rural areas of the state as the quid pro quo for the right to operate under PCR rather than RRR.

The record appears to support the contention that the Texas Commission recognized that PCR provided “insurance” against increases in basic service rates that would have occurred under traditional RRR. It could therefore act with virtual impunity in reducing barriers to entry and thereby facilitate increased competition in local telecommunications markets. The Commission did not have full insurance, however, because the Hope Standard precluded it from setting network element prices so low as to undermine Southwestern Bell’s financial viability.

IV. Applicable Case Law

A. Hope Natural Gas

The foundation for a governmental (regulatory) taking follows from the Fifth Amendment (“nor shall private property be taken for public use, without just compensation”)51 and the Fourteenth Amendment (“nor shall any state deprive any person of life, liberty, or property, without due process of law”) to the U.S. Constitution.52 In practice, this is a double-edged sword. Regulated firms are protected against unduly low rates,53
but they are also exposed to various forms of regulatory opportunism that may result in the appropriation of excess returns.54

Under the Hope Standard, a regulated firm is entitled to a “return . . . sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and attract capital” and to “enable the company to operate successfully . . . and to compensate its investors for the risks assumed . . . .”55 The regulator is granted broad discretion under Hope to adopt the lowest rates for the regulated firm consistent with the above standard being met even though it may produce only a meager return.56 In this sense, Hope seeks to balance consumer and investor interests.57 A regulatory taking occurs when the regulatory regime (inclusive of rates and service obligations) fails to provide the regulated firm with a return sufficient to assure confidence in the financial integrity of the enterprise. 58

The Hope Standard poses potentially serious if not fatal problems for the performance of PCR. On the one hand, the regulator can appeal to Hope as justification for the appropriation of “excess returns” that the firm realizes under price regulation through its superior business acumen, thereby weakening incentives for efficiency. Specifically, the greater the regulated firm’s investment in cost-reducing innovation, the greater the regulator’s ability to accommodate competitive entry without violating the minimum earnings standard required by Hope. Under these conditions, the Hope Standard can devolve into both a floor and a ceiling on the earnings of the regulated firm.

On the other hand, a regulated firm subject to price regulation that exhibits inferior business acumen may potentially be able to invoke Hope as a safety net of sorts to protect against downside risk, thereby undermining the critical risk-return tradeoff that differentiates PCR from RRR. In a certain sense, the regulated firm cannot be allowed to fail as it would deprive consumers of an essential service. The problem is that even under price regulation the legal (Hope) standard for a taking turns on the regulated firm’s earnings.

The regulator’s role in accommodating competitive entry is the crux of the problem. As a direct result of ACE policies, pricing at the original price cap is no longer sustainable for the regulated firm because it would result in a loss of sales to rivals so substantial that a lower price would be more profitable.59 These ACE policies may not technically breach the price cap commitment, but their effect is to ratchet up the X factor so that the regulated firm is forced to set prices lower than would otherwise be required, thereby weakening the superior incentives that PCR was designed to put in place since the regulated firm is no longer the residual claimant for its efficiency gains. This was one of several concerns that precipitated the myriad legal challenges60 to the implementation of the 1996 Telecommunications Act.61

B. Duquesne

The key holding in Duquesne is that “a State’s decision to arbitrarily switch back and forth between methodologies in a way which required investors to bear the risk of bad investments at some times while denying them the benefit of good investments at others would raise serious constitutional questions.”62

Suppose that the regulated firm is subject to a price cap constraint of the form p ⋜ p in time-period 1, where p is the regulated firm’s average retail price and p is the price cap set by the regulator. In time-period 2, the regulator implements an ACE policy comparable to that employed by the Federal Communications Commission (FCC) to implement the 1996 Telecommunications Act. The regulator is empowered with a new policy instrument, entry-accommodation (a), where p(a) defines the market price that is decreasing in a (i.e., ∆p(a)/∆a < 0). Hence, there exists a level of entry accommodation â > 0 such that p ⋜ p(â) ⋜ p for all a ⋝ â. The regulator can use this new policy instrument to essentially “switch” the original price cap constraint (p ⋜ p) for a more stringent price cap constraint (p ⋜ p(â) ⋜ p). Because the regulated firm was promised one form of regulation, frequently in exchange for substantial concessions,63 but forced to operate under another, this amounts to a form of regulatory “bait and switch.”

C. Verizon

In Verizon, the FCC argued that its rate methodology for UNEs was not confiscatory because “the incumbents have continued to enjoy generous returns, on both their interstate and intrastate activities, in the years since they were required to lease network elements at rates based on forward-looking costs.”64 The FCC further observed that there was no attempt on the part of Verizon to demonstrate that its rate methodology resulted in a “constitutionally inadequate return.”65 What is noteworthy is that the FCC did not contest the claim that its actions reduced economic values along the lines of Market Street Railway,66 but rather focused on whether its rate methodology produced returns below some constitutionally determined floor.

The court in Verizon found that there was not sufficient evidence on the record to establish that the rate methodology in question was confiscatory in violation of Hope nor that it constituted an opportunistic switch in regulatory regimes prohibited under Duquesne.

First of all, there was no “switch” of methodologies, since the wholesale market for leasing network elements is something brand new under the 1996 Act. There was no replacement of any predecessor methods, much less an opportunistic switch “back and forth.” And to the extent that the incumbents argue that there was at least an expectation that some historically anchored cost-of-service method would set wholesale lease rates, no such promise was ever made.67

The court either did not recognize or failed to acknowledge that the “brand new” wholesale market put in place to enable rivals to compete with incumbent providers was a substitute for PCR in disciplining retail rates.68 The “switch” occurred in the methodology used to regulate the retail market, because the regulator’s control over wholesale prices conferred de facto control over retail prices.69 In deference to Duquesne, the court further observed in Verizon that “there may be a taking challenge distinct from a plain vanilla objection to arbitrary or capricious agency action if a ratemaking body were to make opportunistic changes in ratesetting methodologies just to minimize return on capital investment in a utility enterprise.”70 This passage is noteworthy for what the court does not say: that earnings must fall below the “floor” of the Hope Standard. This “omission” is significant if it signals the court’s willingness to accept that regulatory actions that endogenously reduce earnings under PCR may constitute a taking even if those earnings do not fall to confiscatory levels.

D.Market Street Railway

In Market Street Railway, the Supreme Court reaffirmed that while the Due Process Clause of the Fourteenth Amendment cannot be applied to “insure values or restore values that have been lost by the operation of economic forces,” it does protect utilities against “governmental destruction of existing economic values.”71 The key question concerns whether regulators have the discretion to artificially create the market forces (via ACE policies) that have the effect of reducing existing economic values for the regulated firm even if the resulting financial returns remain compensatory. To state this question somewhat differently, is the validity of a takings claim independent of the origins of the market forces (artificial or natural) that reduce the regulated firm’s earnings?72

Indeed, if regulators can use ACE policies as a fig leaf for the claim that market forces rather than economic regulation have reduced prices and earnings, then there is no protection against “governmental destruction of existing economic values.” This is precisely why we cannot reflexively rely upon the “competitive model” to determine just compensation because not all competitive roads lead to the same destination.73

In general, governmental action that merely reduces value is not sufficient to establish a taking.74 The important distinction here is that the regulator’s ability to appropriate excess earnings (reduce value) may exist only because the regulated firm was led to believe that it was the residual claimant for its efficiency gains under PCR when it was not. In this sense, the opportunity for the regulator to reduce value (appropriate excess returns) would not exist but for the successful deception of the regulated firm.75 The natural question is why a regulated firm that anticipated that its excess earnings would be appropriated under PCR would have (i) invested the substantial time and resources required to replace RRR with PCR;76 (ii) invested in the cost-reducing innovation required to improve performance and generate excess returns; and (iii) opted not to dissipate these earnings so that there would be no excess earnings to appropriate.77 It would defy rationality for these regulated firms to have knowingly “left money on the table.”

V. An Economic Standard for a Regulatory Taking

The existing case law notwithstanding, we contend that if PCR represents a superior regulatory regime relative to RRR, it must be the case that regulators cannot unilaterally reduce the price cap through the strategic use of ex post policy changes. Nonetheless, it is necessary to carefully distinguish between the regulator’s decision to allow competition and the artificial propagation of that competition. It is only the latter that is pertinent to the question of a governmental taking.

A. Elements of the Proposed Standard

The economic standard proposed for a governmental taking under price regulation combines the traditional Hope Standard and what I refer to as the Sustainable Price Standard. The Hope Standard is discussed in detail above. The Sustainable Price Standard inquires whether the regulator’s ex post policy change renders the regulated firm’s ex ante price (and concomitantly its earnings) unsustainable.

We commence the analysis by defining the following terms.

H= The minimum level of earnings per unit of time required to comply with the Hope Standard.

E = The level of earnings realized under PCR per unit of time with no ex post policy change.78

EA= The actual level of earnings realized under PCR per unit of time with the ex post policy change.

There is a two-part criterion for a taking. The first part inquires whether the traditional Hope Standard is violated. The second part inquires whether ACE policies (or other ex post policy changes that do not reflect competition on the merits) result in a level of earnings lower than that which the regulated firm would have realized otherwise. Specifically, do the regulator’s actions endogenously reduce the regulated firm’s earnings ex post by rendering the price that it would otherwise have been able to levy unsustainable?

Let T denote the monetary value of the governmental taking per unit of time where

T= max {0, H – EA, E– EA}.79

A value of T> 0 indicates that a taking has occurred. There is a taking under the Hope Standard when H – EA> 0 and a taking under the Sustainable Price Standard when E– EA> 0. There is no taking under either standard whenT = 0 ⇒ H – EA≤ 0 and E– EA≤ 0. Suppose that H – EA> 0 and E– EA> 0. Since both expressions have the EA term in common, T is based on the Hope Standard when H>E and the Sustainable Price Standard when H < E. The various taking permutations are illustrated in Table 1.


Table 1. Delineation of Taking Permutations


The following examples are instructive in understanding the mechanics of the proposed economic standard and how it could work in practice.


Example 1. Suppose that H= 100, E= 90 and EA= 80. The monetary value of the taking is given by T= max {0, 10080, 9080} = max {0, 20, 10} = 20. There is a taking under both standards since H – EA= 20 > 0 and E– EA= 10 > 0. In this example, the Hope Standard correctly identifies both the existence of a taking and the monetary value of the taking. The Sustainable Price Standard understates the monetary value of the taking. This case is illustrated graphically in Figure 1.


Figure 1. Regulatory Taking Under Both Standards

Example 2. Suppose that H= 80, E= 100 and EA= 90. The monetary value of the taking is given by T= max {0, 8090, 10090} = max {0, -10, 10} = 10. There is no taking under the Hope Standard since H – EA= -10 < 0. There is a taking under the Sustainable Price Standard since E – EA= 10 > 0. In this example, the Hope Standard correctly identifies neither the existence of a taking nor the monetary value of the taking and therefore corresponds most closely with the Verizon case discussed in Section IV.C. This case is illustrated graphically in Figure 2.


Figure 2. Regulatory Taking Under Sustainable Price Standard


Example 3. Suppose that H= 100, E= 80 and EA= 80. The monetary value of the taking is given by T= max {0, 100 80, 80 – 80} = max {0, 20, 0} = 20. There is a taking under the Hope Standard since H – EA= 20 > 0, but there is no taking under the Sustainable Price Standard since E – EA= 0. In this example, the Sustainable Price Standard correctly identifies neither the existence of a taking nor the monetary value of the taking. This case is illustrated graphically in Figure 3.


Figure 3. Regulatory Taking Under Hope Standard

Example 4. Suppose that H= 100, E= 110 and EA= 90. The monetary value of the taking is given by T= max {0, 10090, 11090} = max {0, 10, 20} = 20. There is taking under both standards since H – EA= 10 > 0 andE – EA= 20 > 0. In this example, the Hope Standard correctly identifies the existence of a taking, but understates the monetary value of that taking. This case is illustrated graphically in Figure 4.


Figure 4. Regulatory Taking Under Both Standards

B. Discussion and Analysis

Several observations follow from this analysis. First, under PCR the regulator would no longer be able to insulate itself against a taking claim solely on the basis that earnings are sufficient (i.e., EAH). Second, one regulated firm may have a credible taking claim even though its earnings are relatively strong, whereas another regulated firm may have no taking claim even though its earnings are relatively weak. Third, we can conceive of pure PCR as conferring a property right upon the regulated firm as the residual claimant for its efficiency gains. Hence, a “taking” is any regulatory action that infringes on that property right.80 Fourth, operating in isolation, the Hope Standard does not prohibit the regulator from “taking” from the regulated firm provided the amount that is taken does not undermine the ability of the enterprise to attract capital. Finally, under PCR the Hope Standard alone can be underinclusive in terms of identifying a regulatory taking and in determining the monetary amount of that taking.

It is natural to inquire why the traditional Hope Standard for a regulatory taking is necessarily problematic under price regulation. The simple answer is that the Hope Standard is not problematic if the objective is for PCR to perform similarly to RRR. To see this, suppose that we have two types of regulated firms, those with low potential for efficiency gains and those with high potential for efficiency gains. The former may be expected to perform similarly under RRR or PCR.81 The preponderance of the gains from PCR are likely to come from the high-potential firms. And yet, what incentive would these firms have to bear the high effort cost requisite to the realization of higher returns if the regulator can simply invoke the Hope Standard should these efforts prove successful to appropriate any realized efficiency gains ex post? In the final analysis, the low-potential firms are predestined for mediocrity while the high-potential firms exhibit mediocrity simply because they have limited incentives to do otherwise. It is in this manner that the traditional Hope Standard undermines the promise of PCR.

There are a multitude of challenges associated with the application of the proposed new standard for a regulatory taking that may not be easy to overcome. Prominent among these is the fact that it is difficult to precisely determine what the earnings of the regulated firm would have been absent the ex post regulatory policy change because the counterfactual is not observable.82 This is potentially problematic given the Supreme Court’s observations in Verizon regarding the historical importance of incontrovertible data to support a taking claim.

This want of any rate to be reviewed is significant, given that this Court has never considered a taking challenge on a ratesetting methodology without being presented with specific rate orders alleged to be confiscatory.83

Granted, the Court has never strictly held that a utility must have rates in hand before it can claim that the adoption of a new method of setting rates will necessarily produce an unconstitutional taking, but that has been the implication of much the Court has said.84

The regulated firm must carry the burden for credibly demonstrating what its earnings would have been but for the regulator’s ex post policy change, ceteris paribus. This is not a low bar. In addition, it may prove difficult to distinguish between the losses the regulated firm suffers from natural (organic) competition and those losses attributable to regulatory policies that artificially strengthen competition. There is also the matter of whether the taking calculation should run in perpetuity or for a finite time period and, if it is the latter, how should that time period be determined? Further complicating matters is the fact that from Duquesne through Verizon,85the Supreme Court has refused to bite on the concept of an ex ante taking.86

VI. Conclusion

The superior incentive properties of price regulation derive from the regulated firm being the residual claimant for its efficiency gains. This requires severing the link between allowed revenues and costs. The Hope Standard, which relies upon an earnings floor to constrain regulatory behavior, in combination with entry accommodation enables the regulator to reestablish the linkage between the regulated firm’s costs and revenues under PCR and thereby appropriate its efficiency gains.

This Essay contends that if PCR is to have a valid claim of being a superior regulatory regime relative to traditional RRR, the standard for a regulatory taking must change accordingly. Specifically, the traditional Hope Standard, which predates the pervasive adoption of PCR, must be supplemented in a manner that limits the regulator’s ability to recontract ex post with impunity so that the regulated firm remains the residual claimant for its efficiency gains.

To this end, this Essay proposes a two-part criterion for a taking. The first part inquires whether the traditional Hope Standard is violated. The second part, referred to as the Sustainable Price Standard, inquires whether ACE policies (or some other ex post regulatory policy actions that do not reflect competition on the merits) result in a level of earnings lower than that which the regulated firm would have realized otherwise. A taking may arise under the Sustainable Price Standard even when there is no taking under the Hope Standard. This implies that merely providing for “adequate revenues” would no longer be sufficient to reject a taking claim under price regulation.

The proposed new standard would ensure that the case law reflects the distinction that the economics literature makes between price-based and earnings-based regulatory regimes. Specifically, it is necessary to recognize explicitly the property right conferred upon the regulated firm under price regulation as the residual claimant for its efficiency gains. Under this standard, a regulator would no longer be able to contend, as the FCC did in Verizon, that it retains the discretion under price regulation to “take,” provided that the amount that is taken does not jeopardize the financial viability of the enterprise. If regulators are permitted to invoke Hope in this manner, there may be no real hope for price cap regulation to constitute a meaningful departure from traditional rate-of-return regulation.

  1. Whereas RRR places a cap on the earnings of the regulated firm, PCR places a cap on the average prices that the regulated firm may charge for its services. See David E.M. Sappington & Dennis L. Weisman, Designing Incentive Regulation for the Telecommunications Industry (1996); Timothy J. Brennan, Regulating by Capping Prices, 1 J. Reg. Econ.133, 133 (1989). The terms price regulation and price cap regulation are used interchangeably throughout this analysis.
  2. See David E.M. Sappington & Dennis L. Weisman, Price Cap Regulation: What Have We Learned from Twenty-Five Years of Experience in the Telecommunications Industry?, 38 J. Reg. Econ.227 (2010).
  3. See David E.M. Sappington & Dennis L. Weisman, The Disparate Adoption of Price Cap Regulation in the U.S. Telecommunications and Electricity Sectors, 49 J. Reg. Econ. 250 (2016); Peter Navarro, The Simple Analytics of Performance-Based Ratemaking: A Guide for the PBR Regulator, 13 Yale J. on Reg.105, 111 (1996); Paul L. Joskow & Richard Schmalensee, Incentive Regulation for Electric Utilities, 4 Yale J. on Reg.1, 38-39 (1986).
  4. Consumers benefit from real price reductions or a slower rate of price growth. The regulated firm benefits from the greater pricing flexibility necessary to respond to competition and the prospect of higher profits if it can innovate and reduce costs. The regulator benefits from a streamlined regulated process. Competitors benefit from the regulated firm’s inability to offset competitive losses with higher rates for monopoly-supplied services.See Jaison R. Abel, The Performance of The State Telecommunications Industry Under Price-Cap Regulation: An Assessment of The Empirical Evidence (Nat’l Regulatory Research Inst. NRRI 00-14, 2000); Dale E. Lehman & Dennis L. Weisman, The Political Economy of Price Cap Regulation, 16 Rev. Indus. Org. 343 (2000).
  5. The term “competition on the merits” refers to the basic idea that the returns that a firm enjoys should reflect its superior efficiency and business acumen in the marketplace vis-à-vis its relatively less proficient rivals. See United States v. Aluminum Co. of Am., 148 F.2d 416, 430 (2d Cir. 1945) (“The successful competitor, having been urged to compete, must not be turned upon when he wins.”). For a modern exposition of the principle of competition on the merits in the context of U.S. antitrust law, see Antitrust Modernization Comm’n, Report and Recommendations 81–82, 90–98, 448 (2007), https://govinfo.library.unt.edu/amc/report_recommendation/amc_final_report.pdf [
  6. This is not to suggest that ACE policies did not exist under RRR, because they did. For example, in the FCC’s efforts to open long-distance markets to competition it regularly adopted competitive-handicapping policies that restrained AT&T in responding to the market inroads made by its long-distance rivals. See Gerald Brock, Telecommunications Policy for the Information Age (1994); Mark S. Fowler, Albert Halprin, & James D. Schlichting, “Back to the Future”: A Model for Telecommunications, 38 Fed. Comm. L. J. 145, 193-94 (1986); John Haring, The FCC, the OCCs and the Exploitation of Affection (Fed. Commc’ns Comm’n Office of Plans and Policy Working Paper No. 17, 1985); John Haring, Implications of Asymmetric Regulation for Competition Price Analysis(Fed. Commc’ns Comm’n Office of Plans and Policy, Working Paper No. 14, 1984).
  7. Ronald R. Braeutigam & John C. Panzar, Diversification Incentives Under “Price-Based” and “Cost-Based” Regulation, 20 Rand J. Econ. 373 (1989); Luis M.B. Cabral & Michael H. Riordan, Incentives for Cost Reduction Under Price Cap Regulation, 1 J. Reg. Econ. 93 (1989).
  8. See Marcelo Resende, Regulatory Regimes and Efficiency in US Local Telephony, 52 Oxford Econ. Papers 447 (2000); Chunrong Ai & David E.M. Sappington, The Impact of State Incentive Regulation on the U.S. Telecommunications Industry, 22 J. Reg. Econ. 133, 148–50 (2002); David E.M. Sappington, Price Regulation, in Handbook of Telecommunications Economics 225, 278-82 (Martin Cave, Sumit Majumdar, & Ingo Vogelsang eds., 2002); Sappington & Weisman, supra note 2.
  9. See Dennis L. Weisman, Why Less May Be More Under Price-Cap Regulation, 6 J. Reg. Econ.339, 341 (1994); Dennis L. Weisman, What Do Regulators Value?, 16 B.E. J. Econ. Analysis & Pol’y(2016). Pure PCR refers to a price cap regulation regime in which there is no ex post sharing of earnings. For a discussion of the evolution from RRR to PCR in the U.S telecommunications industry, see Sappington & Weisman, supra note 2.
  10. 1 Alfred E. Kahn, The Economics of Regulation: Principles and Institutions 17 (1970).
  11. James C. Bonbright, Principles of Public Utility Rates107 (1961). In Taxation by Regulation, Richard Posner challenged the prevailing orthodoxy that economic regulation emulates competition along the lines of the Public Interest Theory of regulation. Specifically, he argued that observed regulatory behavior, including various socially equitable pricing policies such as cross-subsidization and restrictions on market entry and exit, were not easily reconciled with the view that regulators seek to emulate competition. Posner argued that regulation is best understood as a branch of public finance in which the power of the state is leveraged to achieve market outcomes that are not sustainable under competition. Richard A. Posner, Taxation by Regulation, 2 Bell J. Econ.& Mgmt. Sci. 22 (1971). See also Sam Peltzman, Toward a More General Theory of Regulation, 19 J. L. & Econ. 211 (1976); David E.M. Sappington & Dennis L. Weisman, Regulating Regulators in Transitionally Competitive Markets, 41 J. Reg. Econ.19 (2012); George Stigler, The Theory of Economic Regulation, 2 Bell J. Econ.& Mgmt. Sci. 3 (1971).
  12. RRR can foster industry investment by ensuring a high likelihood of a reasonable return on investment. The same is not true if the regulator severely limits the firm’s return on all successful investments and forces the firm to bear the full financial consequences of all unsuccessful investments. See A. Lawrence Kolbe & William B. Tye, The Duquesne Opinion: How Much “Hope” Is There for Investors in Regulated Firms?, 8 Yale J. on Reg.113 (1991); Sean P. Madden, Takings Clause Analysis of Utility Ratemaking Decisions: Measuring Hope’sInvestor Interest Factor, 58 Fordham L. Rev. 427(1989).
  13. Professor Stephen Littlechild, who was the original proponent of price cap regulation in the United Kingdom and also presided over its implementation, observed that the focus of price cap regulation was not on the “prevention of excess profits,” but rather on improving efficiency and expanding the range of profitable opportunities through innovation and discovery. Stephen Littlechild, The Birth of RPI-X and Other Observations,in The UK Model of Utility Regulation 31 (Ian Bartle ed., 2003).
  14. Mark Armstrong & David E.M. Sappington, Recent Developments in the Theory of Regulation, in 3 The Handbook of Industrial Organization 1557 (Mark Armstrong & Robert H. Porter eds., 2007); Paul Joskow, Incentive Regulation in Theory and Practice: Electricity Distribution and Transmission Networks, in Economic Regulation and Its Reform: What Have We Learned? 291 (Nancy L. Rose ed., 2014).
  15. “The interest in price caps also reflects a growing understanding that governmental regulation is limited in what it can accomplish. The firms that are the object of regulation are almost always better informed than regulators about their costs and the consequences of adopting particular, detailed regulatory schemes for prices or conditions of service. Thus, rather than creating regulation based on the premise of an omniscient regulator being able to set optimal prices based on full knowledge of costs and demand, a more realistic regulatory goal is to design incentive mechanisms for the regulated firm that will lead it to maximize society’s objectives (whether these are efficiency, distributive, or other objectives) while pursuing its self-interest.” Jan Paul Acton & Ingo Vogelsang, Introduction Regulation, 20 Rand J. Econ.369, 369 (1989).
  16. “([PCR] does not assume costs and demands are given or known; indeed, the problem is to provide adequate incentives for the company to discover them. The aim is to stimulate alertness to lower cost techniques and hitherto unmet demands. The emphasis is on productive rather than allocative efficiency (and even the RPI – X price cap reflects distributional rather than allocative considerations).” M.E. Beesley & S.C. Littlechild, The Regulation of Privatized Monopolies in the United Kingdom, 20 Rand J. Econ. 454v, 467 (1989).
  17. In contrast, PCR with earnings sharing requires the regulated firm to share earnings when they exceed a stipulated level. The amount that is shared typically increases with the degree to which earnings exceed the stipulated level. In addition, some earnings sharing schemes stipulate that rates be increased if the regulated firm’s earnings fall below some predetermined floor.
  18. Pure PCR is considered a high-powered regulatory regime because the regulated firm is responsible for a large share of its actual costs. In contrast, RRR is a low-powered regulatory regime because the firm is typically able to pass through a high proportion of cost changes in the form of rate changes. See Jean-Jacques Laffont & Jean Tirole, A Theory of Incentives in Procurement and Regulation11 (1993).
  19. Rebasing refers to the process of realigning the regulated firm’s rates with its underlying costs. As PCR plans become longer in duration, rebasing is correspondingly less frequent and the risk borne by the regulatory firm increases concomitantly because the regulated firm may experience an earnings deficiency for a prolonged period of time.
  20. See Braeutigam & Panzar, supra note 7.
  21. In this context, abuse refers to resource expenditures by the regulated firm for which the realized costs exceed the benefits. Abuse therefore represents expenditures on resources that the regulated firm would not undertake if it had to bear their full cost. See Glenn Blackmon, Incentive Regulation and The Regulation of Incentives (1994).
  22. See Ronald R. Braeutigam & John C. Panzar, Effects of the Change from Rate-of-Return to Price-Cap Regulation, 83 Am. Econ. Rev. (Papers & Proc.) 191 (1993); Dennis L. Weisman, Superior Regulatory Regimes in Theory and Practice, 5 J. Reg. Econ. 355 (1993). A possible example of this phenomenon occurred in the aftermath of epic floods that plagued the Midwest in summer of 1993. After questioning how Southwestern Bell allocated its resources in responding to this natural disaster, the Missouri Public Service Commission ordered cost disallowances that had the effect of moving the company’s financial returns from the non-sharing range to the sharing range. These events prompted Southwestern Bell to move expeditiously across its five states with initiatives to eliminate earnings sharing from its price regulation plans. (Private conversations with Southwestern Bell Officials). The first non-experimental incentive regulation plan for Southwestern Bell in Missouri incorporated earnings sharing and the Commission order discusses myriad expense disallowances. See In the Matter of Proposals to Establish an Alternative Regulation Plan for Southwestern Bell Telephone Company, Case No. TO-93-192, Report and Order, Before the Public Service Commission of the State of Missouri, Effective Date January 1, 1994.
  23. Under RRR, a regulated firm is provided with a reasonable opportunity to recover its prudently incurred costs plus a return on its capital investment. The “cost-plus” nature of RRR explains why it is sometimes characterized as a cost-plus contract.
  24. In the United States, the X factor is typically set to reflect expected industry productivity growth. See Jeffrey I. Bernstein & David E.M. Sappington, Setting the X Factor in Price-Cap Regulation Plans, 16 J. Reg. Econ. 5(1999). In Europe, the Xfactor tends to be more of a negotiated value. See Littlechild, supra note13; Stephen Littlechild, Regulation of British Telecommunications’ Profitability: Report to the Secretary of State (1983); Michael Crew & Paul Kleindorfer, Incentive Regulation in the United Kingdom and the United States: Some Lessons, 9 J. Reg. Econ. 211, 218, 220 (1996).
  25. Jordan Jay Hillman & Ronald Braeutigam, Price Level Regulation For Diversified Public Utilities 80-81 (1989).
  26. See Jean-Jacques Laffont & Jean Tirole, Competition in Telecommunications (2000); Sappington & Weisman, supra note 1, at ch. 7.
  27. One difference of note is that the regulated firm’s prices are capped by the regulator, whereas the forces of supply and demand determine the market price that competitive firms treat as being exogenous to their behavior.
  28.    A rational, long-lived regulator would refrain from expropriation due to its long-term, adverse impact on industry productivity growth. However, short regulatory tenures, coupled with common political pressures for immediate gains for consumers, can render expropriation rational behavior. Glen O. Robinson & Dennis L. Weisman, Designing Competition Policy for Telecommunications, 7 Rev. Network Econ. 509, 535-40 (2008).
  29. To reinforce this commitment, at least one regulatory commission (Massachusetts), in a noteworthy example of self-restraint, determined that it did not even want the regulated firm (Verizon) to file earnings information with the commission. See Paul B. Vasington, Incentive Regulation in Practice: A Massachusetts Case Study, 2 Rev. Network Econ. 451 (2003).
  30.  David E. M. Sappington, Designing Incentive Regulation, 9 Rev. Indus. Org. 245, 262-63 (1994).
  31. See Braeutigam & Panzar, supra note 7, at 389; Weisman, supra note 22, at 364-65.
  32. The term “excess earnings” refers to earnings above the minimum level necessary to comply with the Hope Standard (i.e., to ensure that the regulated firm is a financially viable enterprise).
  33. Ronald R. Braeutigam, Optimal Policies for Natural Monopolies, in 2 Handbook of Industrial Organization 1289, 1299 (Richard Schmalensee & Robert Willig eds., 1989).
  34. See Sappington & Weisman, supra note 11.
  35. A moral hazard is a type of incentive problem that arises when the economic agent does not bear the full costs of a loss and, as a result, fails to put forth the efficient level of effort (which cannot be observed directly) to avoid that loss. The moral hazard problem explains why most insurance policies require co-payments or deductibles to ensure that the economic agent has some “skin in the game.”
  36. See Dennis L. Weisman, Bribing Regulators, 22 Applied Econ. Letters 581 (2015); Weisman, supra note 9.
  37. Jarrell posits that utilities sought economic regulation for protection from the rigors of competition. See Greg Jarrell, The Demand for State Regulation of the Electric Utility Industry, 21 J. L. & Econ. 269 (1978). Weiman and Levin discuss the specific case of a regulated telecommunications provider “bribing” public officials for the right to acquire rivals and thereby limit competition. See David F. Weiman & Richard C. Levin, Preying for Monopoly? The Case of Southern Bell Telephone Company, 1894-1912, 102 J. Pol. Econ 103 (1994).
  38. The combination of capping politically sensitive basic service rates and the absence of earnings sharing tends to weaken the power of the regulated firm relative to other interest groups. As a result, the expected outcome is precisely the opposite of the standard predictions of the economic theory of regulation that new entrants will encounter artificially high costs. See Roger G. Noll, Economic Perspectives on the Politics of Regulation, in 2 Handbook of Industrial Organization 1253, 1266-67 (Richard Schmalensee & Robert Willig eds., 1989). In this setting, political utility maximization is consistent with regulatory policies that favor new entrants and consumers over the regulated firm.
  39. Whereas regulatory policies that artificially increase competition may improve static efficiency (prices are more closely aligned with incremental cost), they impair dynamic efficiency (optimal investment in innovation and discovery over time). For example, suppose the government unilaterally declares all patents null and void. The short-run effect of this policy would be to reduce the prices of goods and services that formerly operated under patent protection. The long-run effect of this policy would be to discourage investment in product and process innovation. There is a general consensus that dynamic efficiency trumps static efficiency in terms of economic welfare. See Bonbright, supra note 11, at 107; Alfred E. Kahn, Whom the Gods Would Destroy, or How Not to Deregulate (2001); William F. Baxter, The Definition and Measurement of Market Power in Industries Characterized by Rapidly Developing and Changing Technologies, 53 Antitrust L.J. 717 (1984); Robinson & Weisman, supra note 28; New Antitrust Laws for the “New Economy”?: Hearing Before the Antitrust Modernization Comm’n (testimony of Richard Gilbert) (Nov. 8, 2005).
  40. Robert W. Crandall, The Role of the U.S. Local Operating Companies, in Changing the Rules: Technological Change, International Competition, and Regulation in Telecommunications 114, 122 (Robert W. Crandall & Kenneth Flamm eds., 1989).
  41. Id. The 1996 Telecommunications Act sought to counter the “anticompetitive” practices on the part of state regulators. Section 253(a) of the Act states that “No State or local statute or regulation, or other State or local legal requirement, may prohibit or have the effect of prohibiting the ability of any entity to provide any interstate or intrastate telecommunications service.” Congress had good reason to be concerned that regulators would not naturally be inclined to allow competition that might ultimately render economic regulation unnecessary. This observation notwithstanding, Congress itself has not always been a stalwart champion of competition in the telecommunications industry. See Brock, supra note 6, at ch. 11. See alsoHoward A. Shelanski, Adjusting Regulation to Competition: Toward a New Model for U.S. Telecommunications Policy, 24 Yale J. on Reg. 55(2007) (arguing that regulators have tended not only to impede competition, but also to be too slow in deregulating workably competitive markets to the detriment of consumers). For examples of asymmetric and anticompetitive regulation in the railroad and trucking industries, see Theodore E. Keeler, Railroads, Freight, and Public Policy (1983); William J. Baumol & Alfred G. Walton, Full Costing, Competition & Regulatory Practice, 82 Yale L.J. 639 (1973).
  42. Glen O. Robinson, The Titanic Remembered: AT&T and the Changing World of Telecommunications, 5 Yale J. on Reg. 517, 518-19 n.7 (1988). These subsidies proved to be anything but “an intercorporate transfer of revenues” after the 1984 AT&T divestiture when regulators continued these subsidies in the form of grossly inflated carrier access charges which AT&T had to pay the local exchange carriers for the origination and termination of its long-distance messages. This caused some industry observers to reexamine whether AT&T had really pulled off a major coup in jettisoning the local exchange business as part of the divestiture decree. See Paul W. MacAvoy & Kenneth W. Robinson, Winning by Losing: The AT&T Settlement and its Impact on Telecommunications, 1 Yale J. on Reg. 1(1983); Paul W. MacAvoy & Kenneth W. Robinson, Winning by Losing: The First Year of the AT&T Divestiture, 2 Yale J. on Reg. 225 (1985);Robinson, supra, at 530-31.
  43. Posner, supra note 11, at 28.
  44. See Glen O. Robinson & Thomas B. Nachbar, Communications Regulation 560-61 (2008); Jerry A. Hausman & Gregory Sidak, A Consumer-Welfare Approach to Mandatory Unbundling of Telecommunications Networks, 109 Yale L.J. 417(1999); Alfred E. Kahn et al., The 1996 Telecommunications Act at Three Years: An Economic Evaluation of Its Implementation by the FCC, 11 Info. Econ. & Pol’y 319(1999).
  45. Dale E. Lehman & Dennis L. Weisman,The Telecommunications Act of 1996: The “Costs” of Managed Competition (2000).
  46. Muharrem Burack Onemli, Three Essays on Regulatory Economics(2010) (unpublished Ph.D. dissertation, Kansas State University), http://krex.k-state.edu/dspace/bitstream/handle/2097/4258/MuharremBurakOnemli2010.pdf?sequence=1&isAllowed=y &91;https://perma.cc/644K-6EJP7&93;.
  47. This problem is further compounded by the fact that FCC employed a controversial costing methodology to set the rates for leasing the incumbent’s network infrastructure. This costing methodology is referred to as TELRIC (total element long run incremental cost) and is based on the cost that would be incurred by an ideally efficient incumbent provider. The controversy surrounding TELRIC derives from the hypothetical nature of the exercise and the fact that it typically produces extremely-low cost estimates and therefore rates that may not be compensatory. See Lehman & Weisman, supra note 45, at ch. 6; Hausman & Sidak, supra note 44; Jerry A. Hausman, Valuing the Effect of Regulation on New Services in Telecommunications, Brookings Papers on Econ. Activity: Microeconomics, 1997; Kahn et al., supra note 44. The TELRIC methodology also leads to the paradox of “predatory costing” in which an incumbent provider can be foreclosed by a rival that leases network infrastructure from that incumbent provider. See Dennis L. Weisman, The (In)Efficiency of the ‘Efficient-Firm’ Cost Standard, 45 Antitrust Bulletin 195. In Verizon Communications Inc. v. FCC, 535 U.S. 467 (2002), the Supreme Court characterized the FCC’s approach as “novel rate setting designed to give aspiring competitors every possible incentive to enter local retail telephone markets, short of confiscating the incumbents’ property.” 535 U.S. at 489. I am grateful to Timothy Tardiff for calling this passage to my attention.
  48. See Dennis L. Weisman, Regulatory Moral Hazard: Price Caps and Endogenous Entry Under the 1996 Telecommunications Act, in Expanding Competition in Regulated Industries 1 (Michael A. Crew ed., 2000).Weisman contends that earnings sharing may be more profitable for the regulated firm than pure PCR in an environment in which the regulator controls the terms of entry. The prospective loss of shared earnings imposes a cost on the regulator should it adopt liberal competitive entry policies. Earnings sharing may discipline the regulator to maintain high entry barriers and sustain the profit stream of the regulated firm to obviate the need to increase politically sensitive service rates. Weisman, supra note 9. Blank and Mayo demonstrate how earnings sharing can arise endogenously in a setting where consumers and regulated firms lobby for favorable treatment. See Larry Blank & John W. Mayo, Endogenous Regulatory Constraints and the Emergence of Hybrid Regulation, 35 Rev. Indus. Org. 233 (2009).
  49. Texas Public Utility Commission, Open Meeting, Agenda Item No. 1, Docket Nos. 16189, 16196, 16226, 16285, 16290, 16455, 17065, June 18, 1997.
  50. The term “contribution” refers to the residual between prices and incremental costs that may be available to contribute to the recovery of overhead costs.
  51. U.S.Const. amend. V.
  52. U.S. Const. amend. XIV, § 1.
  53. The protection takes the form of the regulator being required to increase rates so that the regulated firm’s earnings are above the confiscatory levels prohibited under Hope.
  54. See Dennis L. Weisman, Did the High Court Reach an Economic Low in Verizon v. FCC?, 1 Rev. Network Econ. 90 (2002) (hereinafter “High Court”); Dennis L. Weisman, Is There “Hope” For Price Cap Regulation? 14 Info. Econ. & Pol’y 349 (2002) (hereinafter “Hope for PCR”).
  55. See Fed. Power Comm’n v. Hope Nat. Gas Co., 320 U.S. 591, 603, 605 (1944). The Supreme Court reaffirmed the fundamental tenets of Hope inDuquesne Light Co.v. Barasch, 488 U.S. 299 (1989). See also Bluefield Waterworks & Imp. Co. v. Pub. Serv. Comm’n of W. Va., 262 U.S. 679 (1923).
  56. InFederal Power Commission v. Texaco Inc., 417 U.S. 380 (1944), the Court ruled that “All that is protected against, in a constitutional sense, is that the rates fixed by the Commission be higher than the confiscatory level.” 417 U.S. at 391-392.
  57. See Madden, supra note 12.
  58. J. Gregory Sidak & Daniel F. Spulber, Deregulatory Takings and the Regulatory Contract 4-6(1997).
  59. ACE policies can also take less overt forms. The incumbent providers may be required to serve as carriers of last resort. See 2 Alfred E. Kahn, The Economics of Regulation 236-41 (1988); Dennis L. Weisman, Default Capacity Tariffs: Smoothing the Transitional Regulatory Asymmetries in the Telecommunications Market, 5 Yale J. on Reg. 149 (1988). Or, the incumbent providers may be required to cross-subsidize selected service offerings, engage in broad-based rate averaging and satisfy artificially high price floors. See Weisman, supra note 48. These policies are part and parcel of the voluntary exchange between the regulator and the firms they regulate that comprise the regulatory compact. See Posner, supra note 11; George L. Priest, The Origins of Utility Regulation and the “Theories of Regulation” Debate, 36 J. L. & Econ. 289 (1992). All these policies confer a marketplace advantage on rivals in competing with the incumbent providers. See Weisman, Optimal Re-Contracting, Market Risk and the Regulated Firm in Competitive Transition, 12 Res. L. & Econ. (1989).
  60. See Robinson & Nachbar, supra note 44, at 501; Robinson & Weisman, supra note 28.
  61. For a debate as to whether such policies constitute deregulatory takings. See Sidak & Spulber,supra note 58; William J. Baumol & Thomas W. Merrill, Deregulatory Takings, Breach of the Regulatory Contract and the Telecommunications Act of 1996, 72 N.Y.U. L. Rev. 1037 (1997); Stephen F. Williams, Deregulatory Takings and Breach of the Regulatory Contract: A Comment, 71 N.Y.U. L. Rev. 1000 (1996); Oliver E.Williamson, Deregulatory Takings and Breach of the Regulatory Contract: Some Precautions, 71 N.Y.U. L. Rev. 1007 (1996).
  62. Duquesne Light Co. v. Barasch, 488 U.S. 299, 315 (1989).
  63. See supra Section III.C and infra note 76.
  64. Brief for Respondents Federal Communications Commission & The United States at 13, Verizon Communications Inc. v. FCC, 535 U.S. 467 (2002) (Nos. 00-511, 00-555, 00-586, 00-590, 00-602), 2001 WL 726772, at *13.
  65. Id. at 31.
  66. See infra Section IV.D.
  67. Verizon Communications Inc. v. FCC, 535 U.S. 467, 528 (2002).
  68. See High Court, supra note 54, at 101-02. To draw an analogy, the court essentially found that a rule in basketball that prohibits raising the height of the basket is not violated by lowering the floor.
  69. The financial markets confirmed what the court would not. The share prices of the incumbent telecommunications providers declined when the FCC announced its (pro-competitor) unbundling rules. See Thomas W. Hazlett & Arthur M. Havenner, The Arbitrage Mirage: Regulated Access Prices with Free Entry in Local Telecommunications Markets, 2 Rev. Network Econ. 440, 447-50 (2003). The necessary implication is that ACE policies exert downward pressure on prices with negative financial implications for the incumbent telecommunications providers.
  70.  Verizon, 535 U.S. at 527 (footnote omitted).
  71. Notably, current case law does not differentiate between exogenous and endogenous market forces. This means that there is no distinction between the natural play of market and technological forces and those forces created and strengthened artificially at the hand of the regulator through ACE policies. I am grateful to Glen Robinson for this important observation.
  72. See Hope for PCR, supra note 54. In United States v. Cress, 243 U.S. 384 (1917), the U.S. Supreme Court held that a taking had occurred because the reduced property values resulting from the rising height of the river had artificial (a system of locks and dams) as opposed to natural origins. Figuratively speaking, the court recognized the importance of distinguishing between the arsonist’s match and the strike of a lightning bolt.
  73. It is important to distinguish carefully here between competition and mere rivalry. See Robert H. Bork, The Antitrust Paradox 58(1978). For example, the regulator can set unduly low UNE rates to flood the market with rivals and suppress the market price. There should be no mistaking this artificially low market price for a “competitive price.” The concern is that the courts in adjudicating taking claims will fail to make this critical distinction.
  74. In Penn Central v. City of New York, the Court observed that “[t]he economic impact of the regulation on the claimant and, particularly, the extent to which the regulation has interfered with distinct investment-backed expectations are, of course, relevant considerations.” 438 U.S. 104 at 124 (1978). The Majority further observes that “this Court has dismissed ‘taking’ challenges on the ground that, while the challenged government action caused economic harm, it did not interfere with interests that were sufficiently bound up with the reasonable expectations of the claimant to constitute ‘property’ for Fifth Amendment purposes.” Id. at 124-25. In dissent, Chief Justice Rehnquist observed that“A taking does not become a noncompensable exercise of police power simply because the government in its grace allows the owner to make some “reasonable” use of his property. “[It] is the character of the invasion, not the amount of damage resulting from it, so long as the damage is substantial, that determines the question whether it is a taking.” Id. at 149-50.
  75. Professor Glen Robinson, a former FCC Commissioner (1974-76), questions why the incumbent providers should have been surprised by the regulatory policies designed to promote competition under PCR. Specifically, given that ACE policies were adopted when AT&T was subject to PCR (and RRR), would not the incumbent providers have rationally factored the likelihood of such policies into their investment-backed expectations? This question prompts two additional questions. First, if the financial markets anticipated the FCC’s unbundling rules (and the competitive advantage they conferred on the rivals of the incumbent providers) how do we explain the adverse financial market reaction to the implementation of these rules? Second, do the ACE policies attendant to implementation of the 1996 Telecommunications Act represent a difference of kind rather than degree relative to historical benchmarks? To wit, regulators have never previously required incumbent providers to lease the individual components of their networks to rivals at prices based not on what it costs to provision these components but on what regulators believe it should cost (i.e., the efficient-firm cost standard).
  76.    It was common in the telecommunications industry for regulators to extract upfront “entry fees” from the regulated firms under their purview for the right to operate under PCR rather than RRR. These entry fees took many different forms, including network infrastructure/modernization commitments, rate freezes, bill credits, and refunds. See Sappington & Weisman, supra note 1, at ch. 3.
  77. This dissipation of earnings may be accomplished through regulatory abuse. See supra note 21.
  78.    For example, this level of earnings may reflect the regulator’s decision to open the market to competition but not reflect regulatory actions designed to propagate competition artificially (i.e., limiting the regulated firm’s ability to respond to competition with lower prices). The litmus test is whether the regulator’s actions violate competitive neutrality.
  79. This notation simply states that the taking, T, is based on the maximum (largest) of the three values that appear inside the braces. Hence, when H – EA≤ 0 and E– EA≤ 0, there is no taking since T= max {0, H – EA, E– EA} = 0.
  80.    Any violation of competitive neutrality or residual regulatory obligations borne disproportionately by the incumbent provider would seemingly satisfy this condition. In practice, it may prove difficult to determine conclusively when the property right has been infringed upon unless it has a pronounced, adverse impact on the regulated firm’s earnings.
  81. In fact, under the menu approach to incentive regulation, efficiency may be increased by providing the regulated firms with options among incentive regulation plans. The low-potential firms would be expected to self-select RRR or a low-powered variant of PCR. In contrast, the high-potential firms would be expected to self-select a high-powered variant of PCR. See Sappington, supra note30, at 258-60; Sappington, supra note 8, at 234-36; Acton & Vogelsang, supra note 15.
  82.  In contrast, application of the Hope Standard would seem more straightforward quantitatively. The actual returns of the regulated firm are readily observed and the financial markets provide objective metrics as to the returns necessary to attract capital based on the risk profile of the enterprise.
  83.    Verizon Communications Inc. v. FCC, 535 U.S. 467, 524 (2002).
  84. Id.
  85. Verizon arguably involved a difference in kind because the rate structure in question was at the wholesale rather than the retail level. The plaintiffs no doubt recognized that an ex ante taking claim was a steep climb, but perhaps thought it was justified by recognition that this confluence of issues defied a straightforward ex post remedy. &91;It is noteworthy, however, that Baumol and Merrill explicitly raise the possibility of a Tucker Act remedy. See Baumol & Merrill, supra note 61, at 1052.&93; Specifically, there were significant irreversibilities at play in that new entrants would base their business plans and investment decisions on a regulatory policy that could be overturned.See High Court, supra note 54. In addition, the plaintiffs may have believed that the longer those policies remained in place, and the greater the reliance placed on those policies by competitors in making their respective investment decisions, the less likely those policies were to be reversed. See Baumol & Merrill, supra note 61, at 1039 (arguing that “the Takings Clause and the law of contracts are not thought to give rise to what amounts to injunctive remedy. Instead, they are thought to guarantee only a right to just compensation after a taking or breach occurs.”).
  86. See id. at 526 n.36.

The Quiet Undoing: How Regional Electricity Market Reforms Threaten State Clean Energy Goals

Danny Cullenward is Policy Director, Near Zero; Research Associate, Carnegie Institution for Science; and Lecturer in Law, Stanford Law School. Shelley Welton is Assistant Professor, University of South Carolina School of Law.

In a series of largely unnoticed but extremely consequential moves, two regional electricity market operators are pursuing reforms to make it more difficult for states to achieve their clean energy goals. The federal energy regulator, FERC, has already approved one such reform and ordered a second market operator to go farther in punishing state-supported clean energy resources than it had initially proposed. In this Essay, we bring to light the ways in which the intricate, technical reforms underway in regional electricity markets threaten state climate change objectives and the durability of FERC’s regional market constructs. If FERC allows private market operators to impose their policy preferences on participating states—or if FERC requires pro-fossil market designs—progress in decarbonizing the electricity sector will likely slow. At the same time, the potential for greater regional cooperation in electricity markets—a critical strategy for integrating a high penetration of renewable energy onto the electricity grid—will diminish.

I. Introduction1

In the past year alone, the Trump Administration has announced two brazen new strategies to prop up ailing coal and nuclear power plants.2
Each of these has been the subject of many headlines.3 Neither, however, has yet come to fruition—in large part because they have been opposed by the key federal agency in charge of wholesale electricity markets, the Federal Energy Regulatory Commission (FERC).4 FERC’s commissioners have all spoken out against any strategies that would undo the decades of progress that the agency has made in crafting robust, well-functioning regional energy markets.5 At the same time, in a series of lawsuits challenging state support for nuclear power, FERC has encouraged the federal courts to defer to FERC’s decisions about how best to manage the intersection of state clean energy goals and federally overseen electricity markets.6

FERC’s stance in these debates might seem to provide some comfort that the agency will refuse political efforts to stymie the clean energy transition by propping up fossil fuel resources. But in fact, in a pair of a deeply divided and technically dense decisions, the Commission has recently approved two extraordinary market reforms that threaten to undermine state clean energy goals.7 These decisions, we submit, present a “quiet undoing” of state progress in tackling climate change, and although they are less blatant than President Trump’s dramatic proposals, they are pernicious in their own right.

FERC’s reforms have gotten little attention due to their maddeningly technocratic veneer.8 In this Essay, we describe the Commission’s aggressive interventions to bring to light the ways in which its recent reforms present a serious threat to states’ autonomy over their energy mix—at the same time that state clean energy policies are shaping up to be the only progress forward on climate change under the Trump Administration.

II. The Battles in Eastern Markets

In this Part, we begin by describing the basic structure of regional energy markets. Next, we turn to the role that state financial support plays in determining market outcomes, which leads to tension between different kinds of generators. Finally, we describe the reforms undertaken by two East Coast market operators, which are pursuing market designs that aim to “correct” for state policy choices, and in so doing, frustrate state clean energy policy goals.

A. Energy and Capacity Market Basics

At the dawn of the U.S. electricity industry in the late nineteenth century, energy regulation was a matter left exclusively to the states. Over time, however, the creation and integration of federal authority has altered the regulatory landscape.9 The Federal Power Act of 1935 created the enduring divide between federal and state authority in the electricity sector that applies today: the federal government oversees interstate “wholesale” electricity sales, whereas states retain control over “retail” sales and “facilities used for the generation of electric energy.”10 States have long relied on the Federal Power Act’s reservation of state control over generation as an explicit sanction of states’ authority to control their own resource mix.11 And state control over generation has persisted, even as federal regulators have increasingly ushered market-based competition into the industry under their authority to ensure “just and reasonable” interstate wholesale rates.12

The modern FERC was created in 1977 and began in the late 1990s to encourage (but not require) federally regulated electricity markets, which now serve two-thirds of national electricity demand.13 These markets sought to replace the previous system of vertically integrated utilities and bilateral transactions with a more robust and transparent market mechanism for facilitating the exchange of power among utilities.14 Through a series of orders, FERC asked utilities to voluntarily join regional market constructs known as Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs), subject to the approval of their home states.15 (For convenience, we will refer only to RTOs in this essay, although our analysis applies equally to ISOs as well.16)

Unlike FERC and its state counterparts, these market operators are private, non-profit organizations charged with developing electricity markets that ensure open access to the transmission systems they operate. Market operators develop and reform market rules via complex stakeholder processes; some use weighted sector voting by RTO members (predominantly utilities and generators) to advance proposals.17 Although state governments and civil society can participate as stakeholders in these processes, market operators’ independent governing boards make the ultimate decisions about what gets filed with FERC.18

RTOs operate two broad categories of federally regulated electricity markets: energy and capacity markets.19 Energy markets are the more intuitive of the two. RTOs operate real-time and day-ahead energy markets for electricity, matching supply and demand based on customer load, power plant generators’ bids, and the physical constraints of the transmission network they operate. RTOs select the lowest-cost bids (expressed as dollars per megawatt-hour ($/MWh) of electrical energy) capable of serving customer loads; all generators whose bids are accepted receive the market-clearing price, which is set by the highest accepted bid necessary to meet demand.

Capacity markets address a different issue. Not only must electrical energy be available at the instant it is demanded, but regulators must also ensure that sufficient generation capacity will be available to meet future projected demand. Some foresight is needed because power plant construction and permitting take years, not seconds. Many areas of the country rely on state- or utility-level “resource adequacy” obligations that achieve this outcome by requiring utilities to own or contract for future electricity supply adequate to meet their anticipated customer demand.20 But in several of the RTOs—located predominantly in the eastern part of the country—market operators have instead decided to ensure adequate future electricity supply through running separate, centralized capacity markets.21

In centralized capacity markets, the regional market operator first determines the amount of future generation capacity the region needs throughout its footprint, typically three years in the future. Then, the RTO accepts bids from power plant owners that reflect the price at which they would commit to have future generation available when called upon.22 Just as with energy markets, the market-clearing price for capacity markets (typically expressed as dollar per megawatt ($/MW) of capacity) is based on the amount necessary to compensate a sufficient number of generators with the necessary capacity. However, the economics of capacity markets are significantly more complex, due to the variety of market designs, the bidding strategies of market participants, and the presence of state and federal subsidies.23

B. A Brief Overview of Prominent Subsidies

Like all energy markets, electric energy and capacity markets include market participants that receive a wide range of subsidies.24 Fossil fuel generators receive an implicit subsidy because most are not forced to internalize the costs of environmental pollution, including greenhouse gas emissions.25 Although significant, these externalized social costs are less visible than the explicit financial subsidies that many resources also receive. As one FERC commissioner has noted, “[s]ince 1950, the federal government has provided roughly a trillion dollars in energy subsidies, of which 65 percent has gone to fossil fuel technologies.”26 Clean energy has increasingly received explicit subsidies, in forms including federal tax credits for wind energy (provided on a $/MWh basis),27 state renewable portfolio standards (which require utilities to procure a certain share of their total resource mix from qualified renewables, often through the purchase of environmental attributes called RECs),28 and state support to keep nuclear power plants in operation.29

Each of these policies affects capacity market outcomes. To take just one example, consider the case of a wind farm that receives financial support from the state and federal governments. In this case, the wind farm will be able to bid less than its “true” costs because the power plant’s owner does not need to recover this full amount from the capacity market as a result of the subsidies she receives. This will have two effects. First, the wind farm is more likely to produce a winning bid, which would make it eligible to receive the capacity market’s clearing price. Second, by bidding in at a lower price, the wind farm may decrease the overall market-clearing price, reducing the compensation all successful bidders receive.

What should one make of these consequences? Given the breadth of subsidies that permeate energy markets, there is no obvious way to parse which subsidies should or should not be allowed to influence markets.30 Historically, RTOs have hesitated to make any value judgments in this regard, identifying themselves as neutral technocrats charged with developing efficient market designs within the policy confines imposed on them by state and federal policymakers—even when those policies work at competing ends from a theoretical economic perspective.31
Consequently, market operators that follow this philosophy have generally attempted to accommodate the heterogeneous policy preferences of their member states.

As the ambition of many states’ clean energy policies grows and diverges with respect to that of their neighbors, however—and as U.S. electricity markets find themselves with excess capacity—market operators are increasingly viewing heterogeneous state policies as a threat to economically efficient markets. From the perspective of a non-renewable power plant, the lower market prices to which state clean energy subsidies contribute translate into lower revenues. These price impacts become more relevant as renewable energy resources make up a growing share of capacity additions in federally regulated energy markets. Whereas most new generation capacity in the 2000s came from non-renewable resources, more than half of the nameplate capacity added since 2010 comes from renewable facilities.32 But there is no free lunch: the full costs of these facilities are paid by a combination of capacity market participants (with costs ultimately borne by utility customers) and taxpayers. Critically, renewables do not impose direct costs on legacy fossil generators, although they may capture market share and therefore reduce fossil generators’ revenues. Moreover, however they are financed, these additions to the grid help to satisfy the region’s needs for additional capacity.33

The substantial impact of these policies, then, is to redistribute power plant compensation levels through state support for certain resources—largely away from one set of resources (fossil fuel generators) and towards another (new renewable energy generation).34 One could view this result as a problem undermining theoretically ideal markets—or, as we prefer, simply as the inevitable consequence of hard-won state progress toward decarbonization in the absence of a federal price on carbon. Below, we describe the view taken by certain market operators and recently endorsed by FERC, before explaining why we think it is a blinkered approach to the long-term challenges confronting electricity markets and electricity federalism.

C. Case Studies

Two regional markets stand out for having gone the furthest in restructuring their capacity markets in response to state clean energy policies: New England (ISO-NE) and the mid-Atlantic (PJM). A divided FERC accepted New England’s reforms earlier this year. More recently, the Commission held that PJM’s proposals do not go far enough in insulating markets from state clean energy policies, leading FERC to demand even more stringent reforms from PJM. Here, we summarize these intricate reforms in plain English to help a broader set of readers understand why these changes portend a troubling turn for energy federalism and clean energy politics.

    1. ISO-NE

New England is the first region to have adopted a substantial re-design of its capacity market to respond to state renewable energy policies. In January 2018, ISO-NE responded to low capacity market prices and the expected surge in regional clean energy by proposing a novel two-stage capacity auction, which FERC approved two months later.35 In the first stage, resources receiving state “sponsorship”36 must bid in at an administratively determined “minimum offer price” (also called a “MOPR”)—thus eliminating the possibility that state-supported renewable resources might suppress capacity market prices by submitting lower bids that factor in their state support.37 In practice, this structure means that few state-sponsored resources will clear the first-stage capacity auction.38

A second stage then attempts to shift capacity commitments from near-end-of-life generation to state-sponsored (typically renewable) resources by allowing older resources to name a price at which they would be willing to transfer their capacity commitments to state-supported renewables and retire.39 In essence, this design means that state-sponsored renewables may only enter the market after ratepayers first buy out old fossil fuel or nuclear generators, which then receive a severance payment equal to the difference between the first (higher) and second (lower) capacity auction prices.40 Under this market design, renewable and other state-supported resources receive less revenue from the capacity market than their fossil-fuel counterparts. ISO-NE celebrates this design for “closely coordinating the entry (of sponsored) and exit (of retiring) capacity resources.”41

Although FERC approved this design in March 2018, three of five commissioners wrote separately to express reservations42 and a fourth subsequently expressed agreement with some of these concerns.43 It is thus unsurprising that several petitions for rehearing are pending.44 We turn below to our arguments as to why FERC should reconsider its approval of these reforms, after exploring the second regional capacity market transformation currently underway.

    2. PJM

PJM took a different tack than ISO-NE in its capacity market reforms, largely due to fierce infighting within the region as to their necessity and advisability. Unable to reach stakeholder agreement on a single path forward, PJM filed two alternative proposals with FERC in April 2018, expressing its preference for one but leaving the ultimate choice to the Commission.45 Each proposal suggests a different way to deal with what PJM calls “subsidized resources.”46

Under PJM’s preferred option, “Capacity Repricing,” the market operator would run the market one time with “subsidized resources” included at their self-determined bid price, to figure out which resources receive capacity obligations.47 Then, the market would be run a second time, with subsidized bids “repriced to a competitive level” in order to set higher compensation levels to be paid to all resources that cleared the first market.48 Alternatively, PJM proposed extending its “minimum offer price rule extension” (or MOPR-Ex)—which currently requires some resources to submit mandated minimum bids—to state-supported resources, with the possible exception of resources needed specifically to meet state renewable portfolio standards.49 In this model, covered renewables would only clear the capacity market if they were cost-competitive with other resource types after factoring out any state support.50

In a move that stunned many, FERC rejected both of these proposals in a 3-2 decision issued June 29, 2018—but not because it thought they intruded too deeply into states’ sovereignty over their own resource mix. Instead, the essence of FERC’s order was that neither went far enough in insulating markets from state policy choices.51 For this reason, the Commission decided to declare PJM’s existing capacity market rules “unjust and unreasonable,” and to initiate its own “paper hearing” to consider yet a third alternative capacity market reform.52

The Commission’s preferred approach would expand the MOPR to all resources that “receive out-of-market payments,” while allowing state-supported renewable resources to choose to remove themselves from the capacity market “along with a commensurate amount of load, for some period of time.”53 It analogized this structure to PJM’s existing “Fixed Resource Requirement” (FRR) option, which allows a utility to elect to secure its capacity obligations via bilateral contracts made outside the region’s centralized capacity market.54 The majority admitted in its order that this proposal leaves many questions unanswered about how the FRR construct should apply to renewable resources.55 For this reason, it requested interested parties to file comments on FERC’s proposal within 60 days.56

Two FERC commissioners—as it happens, the two Democratic Commissioners whose appointments are required by statute to maintain ideological balance on the five-member Commission57—offered vigorous dissents. One decried the majority’s procedural choices, arguing that the Commission’s decision to open a paper hearing focused on a modified FRR constituted a rush-job end-run around the region’s stakeholder processes and mechanisms of state engagement.58 The other focused on the substantive reasoning underpinning the majority’s FRR proposal, arguing that the Commission fundamentally misconstrues the relationship between federally overseen markets and state energy policies in deciding that the goal of market design is to “‘mitigate’ state efforts to shape the generation mix.”59 Below, we explain why we find this second critique particularly compelling, before turning to discuss the broader implications of FERC’s rulings on ISO-NE’s and PJM’s proposed reforms.

III. A Dangerous Transformation in the Role of RTOs

For readers not steeped in energy market theory, it is tempting to view these capacity market reform debates as arcane and technocratic squabbles. But construing these changes as nothing more than inside baseball would be a major mistake. In this section, we describe how capacity market debates highlight a growing tension between state clean energy goals and federal electricity markets—one that threatens to undermine the delicate balance at the heart of U.S. energy law. In the next Part, we explain the larger federalism and clean energy implications of FERC’s and certain RTOs’ apparent disdain for state policy objectives.

A. The Contested Hierarchy of State Policies and Federal Market Prices

Although ISO-NE and PJM have responded with different capacity market modifications, their proposed reforms—and FERC’s responses—are driven by similar concerns. All paint these reforms as striking a balance that resolves the fundamental tension between “investor confidence” as the touchstone of capacity markets’ “integrity,” on the one hand, and concededly legitimate state policy goals, on the other.60 When allegedly impossible to reconcile, FERC and the market operators have “favored the preservation of competitively-based capacity pricing” over accommodation of state clean energy goals.61

This favoritism inverts the proper relationship between state public policy objectives and the oblique aim of “investor confidence” in capacity markets. The Federal Power Act explicitly reserves authority over generation resources to the states.62 As the Supreme Court recently reaffirmed,63 the Act allows states broad control over the type of resources they prefer, including the ability to “limit new construction to more expensive, environmentally-friendly units.”64 The policies that FERC is now targeting as “interferences” that threaten the “integrity” of its otherwise “perfect” markets are in fact perfectly legitimate state efforts to reward and promote different (and worthy) objectives: healthy citizens and a stable climate.65 What the Federal Power Act gives, FERC and the RTOs should not be allowed to take away through policies that subserviate state goals to investor earnings.66

Indeed, “investor confidence” and the ill-defined concept of “market integrity” are not—and should not be—end goals for capacity markets.67 Although these concepts are worthwhile in the abstract, they are not self-obvious, sacrosanct objectives that can justify a transfer of economic wealth made in retaliation against legitimate state policy decisions. For one thing, we see no reason to focus exclusively on the confidence of those who invested in legacy fossil resources, while destabilizing the investment environment for those who invest in new clean energy resources—we would assert that this hardly comprises a market with true “integrity.”

Nor is investor confidence itself an absolute virtue. As FERC explained in approving ISO-NE’s market redesign, the goal of these markets is “to ensure resource adequacy at just and reasonable rates”—in other words, to provide reliable electricity as affordably as possible over time.68 Investor confidence is a means to ensuring this end, but only under certain conditions. If a region is substantially over-supplied with generation capacity, the market should not give investors confidence that they will recover their investment costs—otherwise, the region will end up with more generation than it needs, paid for by customers, in contravention of FERC’s obligations to protect consumers.69

As it happens, electricity markets in both New England and the mid-Atlantic have substantially more generation than they need for reliability purposes.70 For this reason, these RTOs should be celebrating lower prices in their capacity markets, rather than resisting them.71 If and when resource adequacy again presents a challenge for these markets, prices in the markets should accordingly rise, even with the unfettered participation of state-sponsored renewables.72

Ignoring these dynamics, RTOs have decided that protection of investor interests—in other words, the assurance of certain levels of profit for fossil fuel generators that might have prevailed in the absence of state preferences for clean energy—trumps respect for democratically determined state requirements for clean air and climate safety. This posture is particularly galling given the strange institutional position that RTOs occupy as private entities, whose members are predominantly for-profit companies in the electricity industry and whose decision-making processes are generally not subject to the administrative law requirements that apply to state and federal regulators.73 No longer neutral grid facilitators, a majority of FERC commissioners and the RTOs in the examples discussed here appear to be taking the side of legacy corporations, working against the public health and welfare.

B. The Ongoing Duty to Ensure Just and Reasonable Rates

Although states control which power plants get built in their territories, RTOs are not without tools to manage the markets that affect the costs of competing choices. The Federal Power Act gives FERC authority over “rates and practices” that “directly affect” federal markets,74 allowing RTOs and the Commission to refine market rules to respond to state policy changes that render market rates unjust or unreasonable. But on this score, it is unclear that either ISO-NE’s approved reform, or the Commission’s new FRR proposal in PJM, is a just and reasonable solution.75

The ISO-NE capacity market reforms will raise rates by billions of dollars for consumers, as PJM’s proposed reforms also would have.76 The precise impacts of FERC’s PJM proposal are not yet known, but these reforms are also designed to raise capacity prices and thus the expense to customers in the region.77 In exchange for what? It remains unclear: neither FERC nor the RTOs have identified any problem that the proposals are designed to solve, beyond increasing capacity payments to non-clean energy resources.78 But since neither region’s market is currently having trouble attracting the investment it needs to ensure reliability, it is hard to understand how increasing these payments is just or reasonable.

As Commissioner Glick observed in his partial dissent to FERC’s approval of ISO-NE’s reforms: “the fact that state policies are affecting matters within the Commission’s jurisdiction is not necessarily a problem for the Commission to ‘solve,’ but rather the natural consequence of Congressional intent.”79 And as he further pointed out in dissenting from FERC’s curious PJM decision, the Commission continues to act upon nothing but a hunch that capacity markets could theoretically be harmed, sometime in the future, by an influx of state-supported resources.80 As of yet, however, no concrete evidence of actual challenges to the grid’s long-term reliability has been adduced.81 If FERC and its RTOs believe that state policies create concrete resource adequacy concerns that have not yet been voiced, then they should explicitly identify these challenges and look for targeted solutions. Otherwise, the reforms on the table appear to be an exceedingly complex and misguided effort to shield certain market players from the impacts of personally disfavored but utterly legitimate state policy goals.

IV. Beyond Capacity Markets: The Risks of FERC Accepting RTOs’ Expanded Role

The big-picture implications of accepting RTOs’ reforms have largely been sidelined in the tussles over critical market design details. In this final Part, we call attention to the ways in which these changes are likely to reduce the growth of clean energy and threaten the delicate cooperative balance that FERC has established with its state counterparts in the energy sector.

A. Slowing Down the Clean Energy Transition

In their reform proposals, both ISO-NE and PJM suggest that one of the primary consequences of capacity market reforms will be to raise prices for consumers forced to over-purchase capacity, because states are not likely to eliminate their clean energy goals.82 In the short-to-medium term, this assumption probably holds. PJM, though, nods to potential longer-term consequences, noting that some proponents of its minimum-offer-price reform “hope that it will work to dis-incent states from providing subsidies in the first instance.”83

We fear that PJM has the long-term diagnosis correct—and that all the proposals on the table are likely to push in the direction of undermining state clean energy policy preferences. Ultimately, to stabilize the global climate, the electricity sector will need to approach zero emissions.84 That’s a tall task for a sector that currently produces 63% of its power from fossil fuels.85 To date, residents of the more ambitious clean energy states have proven willing to accept some additional costs to meet these goals. But there may be a breaking point at which the pendulum of public sentiment swings the other way, should the costs of the transition rise too high—especially since some states are currently shouldering all the burden of greenhouse gas emissions cuts while their neighbors shirk. By raising the cost to ambitious states of meeting their energy goals by potentially hundreds of millions of dollars,86 the capacity market reforms under consideration could cause a backlash against ambitious state policies. At the same time, these reforms prop up fossil fuel resources at the expense of customers in many states whose democratically elected representatives chose a different path—clean energy.

We write this Essay at a time of significant uncertainty with respect to how PJM’s market reforms will play out, and therefore we must acknowledge that there is a scenario in which our concerns regarding the Commission’s proposed reforms might be overblown. Some commentators have suggested that the reforms could prove a surprising boon for clean energy by allowing states more flexibility in deciding which resources should supply capacity directly to in-state utilities, and which should participate in regional capacity markets.87 Others echo concerns similar to those expressed in this Essay, arguing for an outcome that respects state policy autonomy and more adequately compensates state-supported renewable and nuclear energy resources.88 Currently, a utility must be either “all out,” or “all in,” with respect to capacity market participation; in contrast, under the next phase of FERC’s PJM Order, the Commission might allow utilities to pursue clean energy capacity procurement outside the capacity market, turning to the capacity market only for whatever fraction of their capacity needs remain.89 But this result will obtain only if FERC allows states substantial flexibility in determining how to match renewable energy supply with load in ways that allow renewable resources to make up the payments lost from the capacity market, in addition to being compensated for their renewable attributes.

Given the Commission’s demonstrated antipathy to state clean energy policy and its aggressive timeline for reform, we are skeptical that the Commission will design a program that treats clean energy resources fairly in light of their full social benefits. But we strongly encourage the Commission to prove us wrong. For example, FERC might allow states to self-determine which resources to pull from capacity markets and might then devise a collaborative scheme in which these resources could be reasonably compensated for both their capacity provisioning and environmental attributes. This flexibility would go a long way towards easing the jurisdictional tension at the heart of this Essay—although largely by facilitating a de facto withdrawal from regional capacity markets.90 While this outcome might seem problematic to those who had hoped to see regional capacity markets support a robust approach to resource adequacy, in our view, shifting the responsibility of maintaining resource adequacy back to the states may be the only sensible path remaining in light of FERC’s unfortunate decision to punish state-supported resources in capacity markets.

B. Implications for RTOs Without Capacity Markets

It might be tempting to dismiss the East Coast policy debates as matters that only affect RTOs with mandatory capacity markets, in which utilities must participate to fulfill their regionally assigned resource adequacy obligations.91 (In other regions, including the Midwest and California, no such rigid construct exists; capacity markets are voluntary in the Midwest and non-existent in California, which manages resource adequacy via other mechanisms.92 But this response misses the mark. The capacity market reform debates currently underway are only the latest episode in a longer battle for policy-making control between private market operators, state regulators, and FERC. If RTOs are empowered by FERC to propose market designs that punish state clean energy policies in capacity markets, what is to stop them from taking a similar approach in energy markets? In our view, the question of RTO governance should be front and center, no matter the market. To paraphrase Sinclair Lewis, those who say “it can’t happen here” fail to acknowledge that, at least as far as the governance concerns discussed in this Essay go, “it has already happened there.”

Even if the impacts of the shift in governance illustrated by the ISO-NE and PJM reforms remain limited to RTOs with mandatory capacity markets—a containment we find implausible—this is little comfort. Capacity markets themselves are the result of market operators exerting increased control over state regulators: states whose markets now feature centralized capacity markets first joined energy-only regional markets, only gradually acceding to a construct in which the RTO also controlled resource adequacy after the decision to delegate their market governance to the RTO had been made. Previously, some PJM and ISO-NE states expressed serious reservations about the creation of mandatory capacity markets, which they worried would interfere with states’ historical right to choose their mix of power plants.93 But states’ objections didn’t stop FERC from eventually ordering the RTOs to construct new systems that went beyond bilateral resource adequacy requirements.94 Subsequently, FERC negotiated settlements between each RTO and its stakeholders that established centralized capacity markets in 2006.95

As the history of capacity market formation in ISO-NE and PJM indicates, states within RTOs—whether single- or multi-state—do not have unfettered control over whether FERC might eventually decide that a centralized capacity market is required to satisfy the Federal Power Act’s “just and reasonable” ratemaking standards.96 Because the decision of whether to require a capacity market “directly affects” wholesale rates, FERC maintains jurisdiction in this domain.97 Certainly state wishes matter, but as PJM and ISO-NE states’ recent experiences illustrate, a majority of today’s FERC Commissioners feels free to disregard them. Thus, even where state law might ostensibly preclude participation in a centralized capacity market, an RTO—or any private party, such as an out-of-state generator in the regional market—might nevertheless propose a centralized capacity market to FERC.

Should such a proposal be made, the identity of the proposing party is legally significant. When an outside party petitions FERC for a change in an RTO’s rules, FERC must find the current market structure “unjust” or “unreasonable” to force a change upon an RTO under Section 206 of the Federal Power Act.98 In contrast, when an RTO itself petitions for a change to its market structure under section 205 of the Act, FERC need only find that the RTO’s new proposal is one among potentially many “just and reasonable” alternatives.99 For this reason, RTO-sanctioned proposals are more likely to win FERC approval—making RTO composition and governance central to any analysis of the potential for a regional capacity market.

Already, private parties that have taken note of the capacity market reforms in the East are seeking to expand these markets’ footprint. A natural gas power plant recently petitioned FERC to declare California’s current resource adequacy regime “unjust and unreasonable” under Section 206 of the Federal Power Act and replace it with a centralized capacity market.100 Although the Commission may well refuse this outside request, the filing nevertheless indicates how the Commission, not the state, has the final word on capacity market formation.101

At its core, the history of capacity markets indicates that no state within an RTO can insulate itself from the possibility that its RTO may ultimately pursue—or be forced to accept—market changes that FERC deems just and reasonable. Critically, the RTO’s position on proposed changes determines the legal standard under which FERC reviews market proposals. Accordingly, states wary of the recent FERC decisions regarding ISO-NE and PJM capacity markets would be wise to focus on RTO governance as an important channel for preserving and accommodating state resource preferences—a topic to which we turn in our final subsection. Yet even a governance structure that precludes an RTO from proposing a capacity market to FERC cannot prevent FERC from declaring the RTO’s approach to resource adequacy unjust or unreasonable, and possibly even ordering a capacity market in its place.

C. Implications for California and the West

Thus far, we have only considered the ways in which capacity markets—present and potential—can stymie the clean energy goals of their participating states. But the precedents that FERC has established with respect to PJM and ISO-NE capacity markets are likely to have reverberations that extend far beyond the question of capacity market design. The broader trend of regional RTOs asserting their primacy over state policy preferences—as FERC has sanctioned in recent months—threatens the conditions under which states with divergent environmental policies can cooperate in regional electricity markets.

The most prominent example of expanded regional cooperation concerns California, which has a federally regulated wholesale electricity market, and the rest of the West, which does not. Currently, the California Independent System Operator (CAISO) operates an energy market that covers most of the state and a small portion of Southern Nevada.102 For several years, California policymakers have considered expanding CAISO’s footprint to include other states’ utilities, forming a regional energy market similar to those in place in PJM and ISO-NE.103 Advocates of regionalization argue that a broader market will facilitate increased and more efficient renewable energy deployment by integrating the broader region’s renewable resources and allowing renewables in California to sell their excess power to neighboring states.104 However, it is widely understood that other states would not join a regional CAISO without a significant change in CAISO’s governance structure.

Such a change would carry with it the risk of increasing regional and private-sector influence over California’s clean energy trajectory, as is occurring in the ISO-NE and PJM states. Currently, each of CAISO’s five Governors is appointed by the Governor of California and subject to confirmation by the California Senate—a unique arrangement that may not be possible to recreate under current FERC regulations.105 What would happen if this arrangement changed is an open and critical question. The integration of state policy priorities in the management of CAISO’s energy markets is among the most complex in the country, which makes the close alignment between the current CAISO governance structure and state political structure extremely relevant. CAISO also manages a voluntary regional energy market called the Energy Imbalance Market (EIM), which includes portions of Oregon, Washington, Idaho, Nevada, Arizona, Utah, and Wyoming106—a list that includes several interior states that explicitly prefer coal, in contrast to the low-carbon preferences of their coastal neighbors.

To date, CAISO has deftly managed the challenging politics of being a regional trailblazer on climate change. Most notably, CAISO secured the first FERC-approved carbon price, integrating California’s cap-and-trade program into the EIM market tariff such that the carbon price applies to electricity voluntarily exported from the EIM territory to serve CAISO load.107 After nearly two years of negotiations with the state climate regulator, CAISO has transmitted a greenhouse gas accounting mechanism for the regional EIM market to FERC, which is reviewing the petition as of this writing.108 CAISO has done all of this under its power to petition FERC for market changes the Commission finds to be “just and reasonable”109—a power that has worked to the good of California climate policy in a context where the RTO’s goals are aligned with those of state policymakers.

CAISO deserves enormous credit for the work that has gone into navigating the technical and legal issues that arise when trying to fully account for the net greenhouse gas emissions impacts of cross-border carbon pricing. However, it is critical to observe that this work has occurred in a context where CAISO’s entire Board of Governors is fundamentally accountable to the state political process. Would this work continue unperturbed if the control of CAISO governance shifted to appointees made by states or private parties without a longstanding commitment to clean energy and climate policy—or even a demonstrated antipathy towards climate policy?110 Would a new governance structure continue to support the application of California’s carbon price to imports from within the broader regional market? If not, what would prevent coal-fired generators in neighboring states from selling their power to California customers, thereby undercutting California’s climate goals? And even if a regional RTO were formed with a governance structure that preserves California’s interests alongside those of its neighbors, regionalization still might create greater practical risks of FERC’s meddling. Given the many market rules necessary to accommodate disparate state regulatory regimes, and the enlarged pool of players in a regional RTO, a regional market has more potentially dissatisfied market participants that might petition FERC to declare the RTO’s market design unjust or unreasonable.

In our view, California policymakers should acknowledge the mounting evidence that regional market operators are no longer required to be neutral “takers” of state policy preferences, as exemplified by the experiences in PJM and ISO-NE. The shift in power towards private market regulators increases the risks that a regional market operator could work to undermine the progress that CAISO and state regulators have achieved to date. Similarly, the hostility to state clean energy policies from FERC raises questions about what guarantees state law can offer in advance of FERC’s review of an expanded market design proposal. Given the inability of state law to constrain FERC’s review of RTO market designs—either on its own initiative, or at the petition of any market participant—many of our questions cannot be resolved through legal guarantees. Rather, their resolution would instead be contingent on the political economy of electricity markets and the policy perspectives FERC’s commissioners bring to future regulatory disputes.

In our view, the potential gains of an enlarged, regional RTO are significant and should be considered alongside the governance risks outlined above. We make no judgment here about whether regionalization is worth pursuing on balance, and if so, under what conditions and institutional forms. Our aim is simply to bring to the regionalization conversation an account of the increasing risks that confront states whose policy preferences are not respected by those who participate in or govern their electricity markets.

V. The Delicate Future of Energy Federalism

Energy federalism is in flux following a string of three recent Supreme Court cases that re-considered the state-federal relationship in energy law.111 In decades past, the Supreme Court interpreted the Federal Power Act to draw a “bright line, easily ascertained” between federal and state spheres of control.112 That understanding no longer holds in the modern world of energy markets. In Hughes, Justice Sotomayor described the Act as a “collaborative federalism statute[], [which] envisions a federal-state relationship marked by interdependence.”113 As this jurisprudential evolution suggests, states and FERC are still finding their way in regional energy markets. This challenge is unfolding in rapidly changing conditions, as states within RTOs also happen to be some of the most ambitious supporters of clean energy.

Regional energy markets hold the potential to play an important role in states’ clean energy transitions. We count ourselves among those who view well-designed regional markets as vital tools for integrating higher quantities of variable wind and solar resources on the grid. As a further testament to RTOs’ success, most of the states involved in the recent acrimony over capacity markets have professed their desire to preserve these regional constructs, even as they oppose onerous capacity market reforms114—although New Jersey’s utility regulator recently expressed willingness to contemplate leaving PJM.115

Nevertheless, East Coast states’ faith in RTO governance has clearly been shaken.116 Some are frustrated that ISO-NE ignored key components of the regional compromise reached in advance of its filing with FERC.117 PJM more brazenly put forward two proposals to FERC that each failed to earn stakeholder or state support: in fact, a majority of stakeholders and states preferred “no action” to either of PJM’s alternatives.118

FERC, for its part, approved the controversial ISO-NE proposal and called for even more substantial reform of the PJM market on a timeline that will leave little space for state engagement, leading some to predict that the reforms that FERC demands within PJM may portend an “unraveling” of the region’s capacity market.119 With this move, the Commission is signaling more strongly than ever that participation in its markets may well come at the expense of state policy priorities. That is a message that few states are likely to want to hear—and it may upset the fundamental balance of state-federal and public-private relations that sustains energy market constructs today.

To preserve the neutral, well-functioning markets FERC has created and nourished over the past two decades, the Commission should stop pretending that regional electricity markets are a pristine construct under siege from state clean energy goals. These markets are merely a tool in the larger project of ensuring “just and reasonable” electricity rates in the United States—subject to any constraints states and other actors impose on them through legitimate legal means. Climate change is an existential problem and mustering the political will to tackle it is no small feat. FERC must not allow nebulous appeals to preserving “investor confidence” or “market integrity”—which in reality mask certain generators’ attempt to use private energy markets to end-run state political processes—to stand in the way of states’ efforts. If FERC does, states would be wise to reevaluate who really controls their energy mix—and whether that’s an arrangement their citizens can afford to endure.

  1.  We are grateful for comments and feedback from Steve Weissman, Ari Peskoe, Justin Gundlach, Michael Panfil, Robbie Orvis, and Miles Farmer. Any errors and all opinions are ours alone.
  2.  Department of Energy Grid Resiliency Pricing Rule, 82 Fed. Reg. 46,940 (Oct. 10, 2017) (proposing a rule to FERC that would require ISOs and RTOs to compensate coal and nuclear power plants for their full costs, independent of market prices); White House, Statement from the Press Secretary on Fuel-Secure Power Facilities (June 1, 2018), https://www.whitehouse.gov/briefings-statements/statement-press-secretary-fuel-secure-power-facilities/ [https://perma.cc/M7TX-666A] (directing Secretary of Energy Rick Perry “to prepare immediate steps to stop the loss of” fuel-secure resources); Letter from FirstEnergy Solutions Corp. to Department of Energy Secretary James Richard Perry (Mar. 29, 2018), https://statepowerproject.files.wordpress.com/2018/03/fes-202c-application.pdf [https://perma.cc/D2GN-H89S] (requesting an emergency order to require cost recovery for FirstEnergy’s coal and nuclear power plants in PJM, pursuant to Section 202(c) of the Federal Power Act).
  3.  See, e.g., Steven Mufson, Trump Orders Energy Secretary Perry to Halt Shutdown of Coal and Nuclear Plants, Wash. Post (June 1, 2018), https://www.washingtonpost.com/business/economy/trump-officials-preparing-to-use-cold-war-emergency-powers-to-protect-coal-and-nuclear-plants/2018/06/01/230f0778-65a9-11e8-a69c-b944de66d9e7_story.html?utm_term=.cc80aaa8e373 [https://perma.cc/63QZ-W7PB]; Brad Plumer, Trump Orders a Lifeline for Struggling Coal and Nuclear Plants, N.Y. Times (June 1, 2018), https://www.nytimes.com/2018/06/01/climate/trump-coal-nuclear-power.html [https://perma.cc/LNY6-46VH]; Timothy Puko, Energy Department Urges Pricing Shift that Could Bolster Coal, Nuclear, Wall St. J. (Sept. 29, 2017), https://www.wsj.com/articles/energy-department-urges-pricing-shift-that-could-bolster-coal-nuclear-1506698449 [https://perma.cc/3WG3-TKR8].
  4.  FERC, Grid Reliability and Resilience Pricing, 162 FERC ¶ 61,012 (2018) (denying Sec. Perry’s proposed rule and opening a new proceeding to consider grid resiliency issues).
  5.  Id.; see also U.S. Senate Committee on Energy and Natural Resources, Full Committee Oversight Hearing of the Federal Energy Regulatory Commission (June 12, 2018), https://www.energy.senate.gov/public/index.cfm/2018/6/full-committee-oversight-hearing-of-the-federal-energy-regulatory-commission [https://perma.cc/6P3K-QMJH] (featuring testimony from all five FERC Commissioners).
  6.  Brief for the United States and the Federal Energy Regulatory Commission as Amici Curiae in Support of Defendants-Respondents and Affirmance at 10, Vill. of Old Mill Creek v. Star, Nos. 17-2433 & 17-2445 (consolidated) (7th Cir. May 29, 2018); see also Danny Cullenward & Shelley Welton, Will FERC Uphold State Support for Clean Energy?, Utility Dive (June 4, 2018), https://www.utilitydive.com/news/will-ferc-uphold-state-support-for-clean-energy/524819/ [https://perma.cc/4YLR-UUWY]. The Second and Seventh Circuits subsequently adopted FERC’s position, declining to preempt state subsidies for nuclear energy while also indicating that FERC retains the authority to impose punitive wholesale electricity market designs. Elec. Power Supply Ass’n v. Star, Nos. 17-2433 & 17-2445, slip op. at *7 (7th Cir. Sept. 13, 2018); Coal. Competitive Elec. v. Zibelman, No. 17-2654cv, slip op. at *6 (2d Cir. Sept. 27, 2018).
  7.  See infra Section II.C.
  8.  For two important exceptions, see Miles Farmer & Bruce Ho, Federal Power Rules Threaten New England Renewable Energy, Nat’l Res. Defense Council Blog (Apr. 10, 2018), https://www.nrdc.org/experts/bruce-ho/federal-power-rules-threaten-new-england-renewable-energy [https://perma.cc/6EPQ-2RE9]; and David Roberts, Trump’s Crude Bailout of Dirty Power Plants Failed, but A Subtler Bailout Is Underway, Vox (Mar. 23, 2018), https://www.vox.com/energy-and-environment/2018/3/23/17146028/ferc-coal-natural-gas-bailout-mopr [https://perma.cc/J5H7-HSKT].
  9.  For an overview, see Scott Hempling, Regulating Public Utility Performance: The Law of Market Structure, Pricing and Jurisdiction § 3.A.1 (2013). See generally Richard F. Hirsh, Power Loss: The Origins of Deregulation and Restructuring in the American Electricity Utility System (1999) (charting the course of electricity law in the twentieth century).
  10.  16 U.S.C. § 824(b) (2018).
  11.  See Hughes v. Talen Energy Marketing, LLC, 136 S. Ct. 1288, 1299 (2016) (holding that states act within their traditional domain by “encouraging production of new or clean generation” so long as they do not condition programs on federal wholesale market participation); Elec. Power Supply Ass’n v. Star, slip op. at *6 (affirming “state authority over power generation” in upholding state support for nuclear power against a federal preemption challenge).
  12.  See David Spence, Can Law Manage Competitive Energy Markets?, 93 Cornell L. Rev. 765, 772-75 (2008) (describing the U.S. transition to electricity markets).
  13.  FERC, Energy Primer: A Handbook of Energy Market Basics 1, 40 (2015).
  14.  See Spence, supra note 12, at 770-72.
  15.  Order No. 888, Promoting Wholesale Competition Through Open Access Non-discriminatory Transmission Services by Public Utilities, Recovery of Stranded Costs by Public Utilities and Transmitting Utilities, 75 FERC ¶ 61,080 (1996); Order No. 2000, Regional Transmission Organizations, 89 FERC ¶ 61,285 (1999). RTOs are very similar to ISOs; for the purposes of this Essay, we will refer to RTOs to mean either RTOs or ISOs, leaving aside the subtle differences in their legal and historical origins.
  16.  FERC first created ISOs with Order 888, which established open-access interstate transmission policy. FERC later refined these concepts with Order 2000, which created RTOs more specifically. Some market operators qualify as both an ISO and an RTO; the names currently in use typically reflect the initial origin of the operators’ formation (i.e., in response to Order 888 or Order 2000), rather than any particular legal or organizational function.
  17.  See generally Kyungjin Yoo & Seth Blumsack, Can Capacity Markets Be Designed by Democracy?, 53 J. Reg. Econ. 127 (2018) (breaking down PJM’s voting members into categories).
  18.  See, e.g., Stephanie Lenhart, Natalie Nelson-Marsh, Elizabeth J. Wilson & David Solan, Electricity Governance and the Western Energy Imbalance Market in the United States: The Necessity of Interorganizational Collaboration, 19 Energy Res. & Soc. Sci. 94 (2016); see also Benjamin A. Stafford & Elizabeth J. Wilson, Winds of Change in Energy Systems: Policy Implementation, Technology Deployment, and Regional Transmission Organizations, 21 Energy Res. & Soc. Sci. 222 (2016).
  19.  Astute readers might add a third category: ancillary services markets, which procure a highly technical set of resources that help ensure grid load balancing at the speed of light. Although critically important, ancillary services are not implicated in this Essay’s focus on jurisdictional tension.
  20.  For a more in-depth discussion, see James Bushnell, Michaela Flagg & Erin Mansur, Capacity Markets at a Crossroads § 2 (Energy Institute at Haas Working Paper No. 278, 2017).
  21.  Four of the nation’s seven wholesale electricity markets have a centralized capacity market: the Midcontinent Independent System Operator (MISO), the New York Independent System Operator (NYISO), PJM Interconnection (PJM), and the Independent System Operator of New England (ISO-NE). Three do not: the California Independent System Operator (CAISO), the Southwest Power Pool (SPP), and the Electricity Reliability Council of Texas (ERCOT). Most areas of the western and southeastern United States lack wholesale markets of any kind. Id.
  22.  Companies that reduce electricity demand may also bid in to provide “demand response” services and energy efficiency, in lieu of power plant generation capacity. For an overview, see generally Yingqi Liu, Demand Response and Energy Efficiency in the Capacity Resource Procurement: Case Studies of Forward Capacity Markets in ISO New England, PJM and Great Britain, 100 Energy Pol’y 271 (2017).
  23.  See generally Bushnell et al., supra note 20.
  24.  We use the term “subsidy” for convenience and not to express judgment as to the merits of a particular policy.
  25.  National Academies of Science, Hidden Costs of Energy: Unpriced Consequences of Energy Production and Use § 3 (2009).
  26.  Calpine Corp. v. PJM Interconnection, L.L.C., Order Rejecting Proposed Tariff Revisions, Granting in Part and Denying in Part Complaint, and Instituting Proceeding under Section 206 of the Federal Power Act, 163 FERC ¶ 61,236, at pp. 92-93 (2018) [hereinafter “PJM Order”] (Glick, Comm’r, dissenting) (citations omitted).
  27.  North Carolina Clean Energy Technology Center, DSIRE Database, Renewable Energy Production Tax Credit (PTC) (Feb. 28, 2018), http://programs.dsireusa.org/system/program/detail/734 [https://perma.cc/4EHF-EN99].
  28.  See generally Galen Barbose, U.S. Renewable Portfolio Standards, 2017 Annual Status Report, LBNL Report No. 2001031, 1, 8 (July 2017). Renewable Energy Certificates (RECs) are created by state law to represent the environmental attribute of pollution-free energy that may be “bundled” with renewable energy generation or sold separately as a tradable commodity. See generally WSPP Inc., Order Conditionally Accepting Service Schedule R, 139 FERC ¶ 61,061 (2012) (discussing the legal structure of RECs and disclaiming federal jurisdiction over unbundled RECs).
  29.  See, e.g., Joel B. Eisen, The New(Clear?) Electricity Federalism: Federal Preemption of States’ “Zero Emissions Credit” Programs, Ecology L. Currents 149 (2018) (arguing that states’ use of ZEC subsidies that reference wholesale prices are preempted); Ari Peskoe, State Clean Energy Policies at Risk: Courts Should Not Preempt Zero Emissions Credits for Nuclear Plants, Ecology L. Currents 172 (2018) (arguing that such policies should not be preempted).
  30.  See PJM Order, supra note 26, at pp. 92-95 (Glick, Comm’r, dissenting); N.Y. Pub. Serv. Comm’n v. N.Y. Indep. Sys. Operator, Inc., 158 FERC ¶ 61,137, at p. 19 (2017) (Bay, Comm’r, concurring) (“The fact of the matter is that all energy resources receive federal subsidies, and some resources have received subsidies for decades..” (citing U.S. Energy Info. Admin., Direct Federal Financial Interventions and Subsidies in Energy in Fiscal Year 2016 (Apr. 2018), https://www.eia.gov/analysis/requests/subsidy/pdf/subsidy.pdf [https://perma.cc/GAM7-L4DW[)).
  31.  See Stafford & Wilson, supra note 18, at 229 (quoting RTO staffer explaining: “We are a taker of policy not a maker of policy . . . . We don’t create policy. We attempt to interpret policy as handed to us.”); see also ISO New England Inc., 162 FERC ¶ 61,205, at P. 26 (2018) (FERC insisting that the agency remains resource neutral) [hereinafter “ISO-NE Order”].
  32.  Bushnell et al., supra note 20, at 42-43.
  33.  Renewable capacity presents additional technical grid integration challenges due to the fact that grid operators often cannot dispatch it at will and therefore individual facilities require backup resources to ensure system reliability. Id. at 42-46; see generally Joachim Seel, Andrew D. Mills & Ryan H. Wiser, Impacts of High Variable Renewable Energy Futures on Wholesale Electricity Prices, and on Electric-Sector Decision Making, LBNL Rep. No. 2001163 (May 2018). But RTOs are not currently asserting challenges with integrating renewables as a basis for their proposed reforms, and so we consider these challenges to be beyond the scope of this Essay.
  34.  Existing nuclear energy power plants are also affected by low capacity prices and the rise of state-subsidized renewables. In many cases, however, states with large nuclear fleets have created state policies to support these resources using compensation mechanisms called Zero Emission Credits (ZECs) that mirror the RECs awarded to renewable generators. See generally Eisen, supra note 29; Peskoe, supra note 29.
  35. See generally ISO-NE Order, supra note 31.
  36.  ISO-NE’s tariff defines a “Sponsored Policy Resource” as one that is renewable or clean and receives “an out-of-market” revenue source. Tariff § I.2.2 (quoted in ISO-NE Order, supra note 31, at P. 3 n.6).
  37.  See ISO New England, Transmittal Letter re: Revisions to ISO New England Transmission, Markets and Services Tariff Related to Competitive Auctions with Sponsored Policy Resources, Docket No. ER18-619-000, at 5-6 (Jan. 8, 2018) [hereinafter “ISO-NE Transmittal Letter”].
  38.  See Partial Protest and Comments of the Mass. Attorney General, ISO New England, FERC Docket No. ER-18-000, at 2 (Jan. 29, 2018).
  39.  The second stage is conducted through a sealed-bid auction, where near-end-of-life generators’ bids are matched with bids from renewable resources. ISO-NE Transmittal Letter, supra note 37, at 6.
  40.  Id. at 21 (calling these “severance payments”); ISO-NE Order, supra note 31, at 5.
  41.  ISO-NE Transmittal Letter, supra note 37, at 6.
  42.  See ISO-NE Order, supra note 31 at p. 57 (LaFleur, Comm’r, concurring in part); id. at p. 60 (Powelson, Comm’r, dissenting); id. at p. 65 (Glick, Comm’r, dissenting in part and concurring in part). However, much of the debate centered on one particular paragraph discussing FERC’s intended “standard solution.” See id. at P. 22. We note that these concerns were expressed by the Commission’s two Democratic members (LaFleur and Glick) as well as one Republican (Powelson), who subsequently retired from the Commission well ahead of the end of his term. Rod Kuckro & Sam Mintz, Powelson Upends FERC with His Departure. EnergyWire (June 29, 2018), https://www.eenews.net/stories/1060087361 [https://perma.cc/7ZTE-B666] (highlighting Commissioner Powelson’s previous experience as a state utility regulator and his opposition to the Trump Administration’s most aggressive attempts to bail out coal and nuclear power plants).
  43.  Gavin Bade, Chatterjee Opposes MOPR as ‘Standard Solution’ for State Policies, Utility Dive (Apr. 19, 2018), https://www.utilitydive.com/news/chatterjee-opposes-mopr-as-standard-solution-for-state-policies/521731/ [https://perma.cc/8R97-9ZHF] (reporting Commissioner Chatterjee’s reservations about a paragraph in the decision that suggested the MOPR reforms should be a standard response to state clean energy subsidies).
  44.  See FERC, Order Granting Rehearings for Further Consideration, ISO New England Docket No. ER18-619-001 (May 7, 2018).
  45.  See PJM Interconnection, L.L.C., Transmittal Letter re: Capacity Repricing or in the Alternative MOPR-Ex Proposal: Tariff Revisions to Address Impacts of State Public Policies on the PJM Capacity Market, FERC Docket No. ER18-1314-000, at 17 (Apr. 9, 2018) (hereinafter “PJM Transmittal Letter”) (“After a lengthy PJM stakeholder process on this challenging issue, two alternatives emerged, but neither could gain the two-thirds affirmative sector vote needed for endorsement.”).
  46.  See id., Attachment A: Revisions to the PJM Open Access Transmission Tariff, Option A, § 5.14(j); id., Attachment C: Revisions to the PJM Open Access Transmission Tariff, Option B, § 5.14(h) (setting forth PJM’s complex proposed definitions for “actionable subsidy”).
  47.  Id. at p. 42.
  48.  Id. at pp. 42-43, 51.
  49.  Id. at p. 1; see also id. at p. 15 (describing how its proposals create certain “non-actionable” subsidies).
  50.  Id. at 43.
  51.  FERC found “Capacity Repricing” to be too generous to renewable resources, since this approach would have awarded renewable resources a higher capacity price in addition to their state support. PJM Order, supra note 26, at ¶¶ 63-68. Regarding the “MOPR-Ex” proposal, FERC found PJM’s proposed exception for resources necessary to meet state renewable portfolio standards to be unsupportable. Id. at ¶¶ 100-06.
  52.  The Commission instituted this paper hearing under the authority provided to it in Section 206 of the Federal Power Act, which allows it to void utility rates found to be unjust and unreasonable. See 16 U.S.C. § 824e (2018); PJM Order, supra note 26, at ¶ 149.
  53.  PJM Order, supra note 26, at ¶¶ 8, 160.
  54.  Id.
  55.  Id. at ¶¶ 164-71.
  56.  Id. at ¶ 172.
  57.  42 U.S.C. § 7171(b)(1) (2018).
  58.  PJM Order, supra note 26, at pp. 82-84 (LaFleur, Comm’r, dissenting).
  59.  Id. at p. 87 (Glick, Comm’r, dissenting).
  60.  ISO-NE Order, supra note 31, at ¶ 29; PJM Order, supra note 26, at ¶¶ 1, 150. But see id. at p. 90 (Glick, Comm’r, dissenting) (criticizing FERC for focusing on “investor confidence” as the critical issue in the ISO-NE Order and then shifting, without explanation or serious mention of “investor confidence,” to a new market “integrity” standard in the PJM Order).
  61.  ISO-NE Transmittal Letter, supra note 37, at 5; ISO-NE Order, supra note 31, at ¶ 72 (endorsing this decision); PJM Order, supra note 26, at ¶¶ 150-56.
  62.  See 16 U.S.C. § 824(b)(1) (2018) (providing that the Commission “shall not have jurisdiction . . . over facilities used for the generation of electric energy”).
  63.  See Hughes v. Talen Energy Marketing, LLC, 136 S. Ct. 1288, 1299 (2016).
  64.  See Connecticut Dep’t of Pub. Util. Control v. FERC, 569 F.3d 477, 481 (D.C. Cir. 2009).
  65.  See PJM Order, supra note 26, at p. 91 (Glick, Comm’r, dissenting).
  66.  On the impacts that capacity market reforms are likely to have on state clean energy policies, see infra Part IV.
  67.  See ISO-NE Order, supra note 31, at p. 68 (Glick, Comm’r, dissenting in part and concurring in part) (questioning the aim of “investor confidence”); PJM Order, supra note 26, at p. 92 (Glick, Comm’r, dissenting) (observing that the majority order never defines market “integrity”).
  68.  Id. at ¶ 9.
  69.  FERC has previously explained the goal of market design reform as “ensur[ing] that capacity prices will reflect the price needed to elicit new entry when new capacity is needed.” PJM Interconnection, L.L.C., 119 FERC ¶ 61,318 at P. 165 (2007) (quoting Devon Power LLC, 115 FERC ¶ 61,340, at P. 113 (2006)) (emphasis added) (internal quotation marks omitted); see also Order on Rehearing, 158 FERC ¶ 61,138, at P. 11 (2017) (describing the ideal capacity price as one that “provide[s] an incentive to develop and retain a sufficient level of capacity to ensure reliability” while “protecting customers from overpaying for that capacity” (emphasis added)).
  70.  See North American Electricity Reliability Corporation, 2018 Summer Reliability Assessment (May 30, 2018) at 20 (finding that ISO-NE has more than sufficient capacity reserve margins that protect against reliability concerns), https://www.nerc.com/pa/RAPA/ra/Pages/default.aspx [https://perma.cc/46A4-JQNU]; ISO-NE Transmittal Letter, supra note 37, at 11 (“[T]he region now has significant excess capacity . . . “); PJM Transmittal Letter, supra note 45, at 36 (“[C]apacity commitments in PJM are well above the installed reserve margin . . . “); id. at 24 (reporting PJM’s reserve margin at 32.8%, more than double the reference margin of 16.1%). Reserve margins represent the extra generation capacity available above and beyond the forecasted peak capacity demand in a given year and reference margins are the levels needed to ensure resource adequacy. U.S. Energy Information Administration, NERC’s Summer Reliability Assessment Highlights Seasonal Electric Reliability Issues (June 29, 2018), https://www.eia.gov/todayinenergy/detail.php?id=36592 [https://perma.cc/3PNJ-T8LL].
  71.  See Comments of the Organization of PJM States, Inc., FERC Docket No. ER18-1314-000, at 6 (May 7, 2018) (urging FERC to reject both options) (“Rather than rising, there is significant data that shows capacity prices should be falling.”).
  72.  See Sylwia Bialek & Burcin Unel, Capacity Markets and Externalities: Avoiding Unnecessary and Problematic Reforms, Institute for Pol’y Integrity 18 (2018) [hereinafter IPI Report] (arguing that capacity markets that include state-supported resources will still “self-correct” in the event of an actual resource adequacy challenge). In fact, PJM’s capacity market prices did rise substantially in the region’s most recent auction, without their proposed reforms in place. See PJM, 2021/2022 RPM Base Residual Auction Results, at 6 (May 2018), http://www.pjm.com/-/media/markets-ops/rpm/rpm-auction-info/2021-2022/2021-2022-base-residual-auction-report.ashx [https://perma.cc/4X5Y-MCGN].
  73.  See Christina Simeone, Kleinman Ctr. For Energy Pol’y, PJM Governance: Can Reforms Improve Outcomes? 1, 22 (2017); Michael H. Dworkin & Rachel Aslin Goldwasser, Ensuring Consideration of the Public Interest in the Governance and Accountability of Regional Transmission Organizations, 28 Energy L.J. 543, 553 (2007); Shelley Welton, Electricity Markets & the Social Project of Decarbonization, 118 Colum. L. Rev. ­­1067 (2018).
  74.  Fed. Energy Regulatory Comm’n v. Electric Power Supply Ass’n, 136 S. Ct. 760, 774 (2016); see also Order on Rehearing, 158 FERC ¶ 61,138, at P. 7 (2017) (“The Commission has acknowledged the right of states to pursue their own policy interests but must be mindful of state regulatory actions that impinge on FERC-jurisdictional market mechanisms to set price.”).
  75.  See NRG Power Mktg., LLC v. Fed. Energy Regulatory Comm’n, 862 F.3d 108, 113 (D.C. Cir. 2017) (interpreting the roles of RTOs and FERC under FPA Section 205 filings); see also 16 U.S.C. § 824d (2018) (establishing the Commission’s “just and reasonable” standard).
  76.  One expert estimates that PJM’s proposals will cost somewhere between $9.1 billion and $24.6 billion annually. See Protest of Clean Energy Advocates, FERC Docket No. ER18-1314, at 7 (May 7, 2018).
  77.  See PJM Order, supra note 26, at ¶ 2 (describing one key impetus for its reforms as “lower auction clearing prices,” thus implying that the goal is to raise auction clearing prices).
  78.  Id. at p. 92 (Glick, Comm’r, dissenting) (arguing that FERC’s order inappropriately stymies state climate change policies, illegally “deploy[ing] the FPA to make it ever more difficult for states to address this existential threat); see also IPI Report, supra note 72, at i (finding “no conclusive evidence that capacity markets are under threat”). To the extent that FERC has previously endorsed generalized balancing efforts absent showing a particular market challenge, see, for example, New England States Committee on Electricity v. ISO New England Inc., 142 FERC ¶ 61,108, at P. 35 (2013), reh’g denied, 151 FERC ¶ 61,056 (2015), we would urge the Commission to reconsider this precedent in light of the growing tension it creates for states within regional markets.
  79.  See ISO-NE Order, supra note 31, at p. 66 (Glick, Comm’r, dissenting in part and concurring in part).
  80.  See PJM Order, supra note 26, at pp. 95-96 (Glick, Comm’r, dissenting).
  81.  Id. (“Today’s order is all the more troubling because there is not substantial evidence in the record to support a finding that there is a resource adequacy problem in PJM or that the capacity market is otherwise unjust and unreasonable or unduly discriminatory or preferential.”).
  82.  See id. at 49; PJM Transmittal Letter, supra note 45, at 56; see also Request for Rehearing of Clean Energy Advocates, FERC Docket No. ER18-619-000, at 1 (Apr. 9, 2018) (arguing that “the predictable result” of ISO-NE’s re-design is that “thousands of megawatts of clean energy will be barred from accessing the ISO-NE capacity market, and the region’s customers will be forced to spend vast sums to buy an equivalent amount of redundant capacity.”).
  83.  PJM Transmittal Letter, supra note 45, at 56 n.138.
  84.  Intergovt’l Panel on Climate Change, Summary for Policymakers, in Climate Change 2014: Mitigation of Climate Change, Contribution of Working Group III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change 1, 20 (O. Edenhofer et al. eds., 2014) (“In the majority of low-stabilization scenarios, the share of low-carbon electricity supply . . . increases from the current share of approximately 30 percent to more than 80 percent by 2050, and fossil fuel power generation without [carbon capture and storage] is phased out almost entirely by 2100.”).
  85.  Frequently Asked Questions, Energy Info. Admin., https://www.eia.gov/tools/faqs/faq.php?id=427&t=3 [https://perma.cc/9ME4-QDPP].
  86.  See Protest of Clean Energy Advocates, supra note 76.
  87.  Gavin Bade, How FERC’s ‘Unprecedented’ PJM Order Could Unravel Capacity Markets, Utility Dive (July 3, 2018) (quoting analysts’ suggestions that an opt-out “Fixed Resource Requirement” (FRR) rule could enable state-supported clean energy resources to bypass the punitive capacity market entirely), https://www.utilitydive.com/news/how-fercs-unprecedented-pjm-order-could-unravel-capacity-markets/527053/ [https://perma.cc/UH5J-CXDG]; see also PJM Order, supra note 26, at ¶¶ 160-62 (describing how a “resource-specific FRR alternative” might operate).
  88.  Ann McCabe and Miles Farmer, How FERC Can Protect Customers and Respect State Energy Policy Authority in its PJM Capacity Market Proceeding, Utility Dive (Sept. 25, 2018), available at https://www.utilitydive.com/news/how-ferc-can-protect-customers-and-respect-state-energy-policy-authority-in/533095/ [https://perma.cc/B9VD-NKU9].
  89.  See PJM Order, supra note 26, at ¶ 70 (explaining that utilities may currently enter and exit the capacity market only on a “utility-wide basis,” but that under the new proposal, a utility could “remove a specific resource”).
  90.  See ISO-NE Order, supra note 31, at pp. 58-59 (LaFleur, Comm’r, concurring) (expressing concern that overly blunt capacity market reforms may lead to utilities exiting RTOs and states re-regulating markets); PJM Order, supra note 26, at p. 86 (LaFleur, Comm’r, dissenting) (same).
  91.  Some regions with ostensibly “mandatory” markets do offer exit options under stringent conditions, usually requiring a utility to exit the capacity market entirely for a multi-year period. See PJM, Fixed Resource Requirement Alternative—Overview (Sept. 17, 2017), https://www.pjm.com/-/media/committees-groups/task-forces/ccppstf/20170817/20170817-fixed-resource-requirement-overview.ashx [https://perma.cc/CZ4A-44GB]; see also Bushnell et al., supra note 20, at 26-27 (describing the mandatory capacity market construct and exceptions to it).
  92.  California currently sets its own “resource adequacy” requirements that utilities can meet through self-supply or bilateral contracting. The Midcontinental ISO runs a non-mandatory capacity market, which utilities can use as a backstop to self-supply or bilateral contracting. See id. at 25-26 (describing California’s and the Midwest’s capacity schemes); see also Midwest Indep. Transmission Sys. Operator, Inc., 153 FERC ¶ 61,229, at P. 46 (2015) (refusing to make MISO’s capacity market mandatory in response to a petition under Section 206 of the Federal Power Act).
  93.  Harvard Electricity Law Initiative, Comment of the Harvard Electricity Law Initiative to FERC re: PJM Interconnection, Revisions to Address Impacts of State Policies, FERC Docket No. ER18-1314 (May 7, 2018).
  94.  Conn. Dept. of Pub. Util. Control v. FERC, 569 F.3d 477, 480 (D.C. Cir. 2009) (dismissing state challenge to ISO-NE’s authority to determine an installed capacity requirement to drive a regional forward capacity market); PJM Interconnection LLC, 115 FERC ¶ 61,079, at P. 1 (2006) (concluding, in response to a filing under Section 206 of the Federal Power Act, that PJM’s previous system of bilateral resource adequacy requirements was no longer “just and reasonable”); Devon Power LLC, et al., 103 FERC ¶ 61,082, at P. 29 (2003) (ordering ISO-NE to create a “market-type mechanism” as a superior method of managing regional resource adequacy).
  95.  PJM Interconnection LLC, 117 FERC ¶ 61,331, at P. 6 (2007); Devon Power LLC, 115 FERC ¶ 61,340, at P. 2 (2006)
  96.  16 U.S.C. §§ 824d(a), 824e(a) (2018).
  97.  See, e.g., PJM Interconnection LLC, 119 FERC ¶ 61,318, at P. 42 (2007) (finding that resource adequacy and resource requirements in PJM “directly affect” wholesale rates subject to the Commission’s jurisdiction); see also supra note 74 and accompanying text (explaining “directly affecting” jurisdiction).
  98.  16 U.S.C. § 824e(a) (2018).
  99.  Id. at § 824d(a).
  100.  CXA La Paloma, LLC v. California Indep. Sys. Operator, Inc., FERC Docket No. EL18-177 (June 20, 2018).
  101.  To help resolve this uncertainty, we would encourage FERC to articulate a clear principle for whether and under what conditions the Commission might consider imposing a capacity market under Section 206 of the Federal Power Act. Ultimately, however, so long as the Commission asserts jurisdiction to review resource adequacy requirements under Section 206—as it has done in previous capacity market decisions for ISO-NE, PJM, and MISO—any such principle would be a Commission policy, not a jurisdictional limitation, and therefore subject to change.
  102.  Technically, CAISO is not a single-state market, although it is governed like one. Not all of California is in CAISO territory; CAISO territory also includes a small portion of southern Nevada.
  103.  Cal. Pub. Util. Code § 359.5 (as added by Senate Bill 350, Stats. 2015, Ch. 547, § 13).
  104.  See, e.g., Frequently Asked Questions, Fix the Grid, https://www.fixthegridcalifornia.org/frequently-asked-questions/ [https://perma.cc/J6ZA-2D2Y].
  105.  Cal. Pub. Util. Code § 337 (defining the appointment process for CAISO Governors). FERC originally disapproved of this governance structure, ordering California to replace its state-appointed Governors with representatives determined by a private governance structure. See Order Concerning Governance of the California Independent System Operator, 100 FERC ¶ 61,059 (2002). CAISO successfully challenged this order, which the D.C. Circuit Court of Appeals vacated two years later. See Calif. Ind. System Operator v. FERC, 372 F.3d 395 (D.C. Cir. 2004). Although the court left open the possibility that FERC could de-certify the current CAISO governance structure under FERC’s Order 888, FERC never took any such action and CAISO continues to operate under the formerly disputed governance structure. Although the status quo approach seems workable given CAISO’s track record of performance, it is an open question whether any future ISO or RTO could be structured with state-appointed governance—at least not without a change in FERC policy.
  106.  Governance of the CAISO EIM is shared with participating states. See Lenhart et al., supra note 18. But CAISO maintains exclusive control over California’s core energy markets.
  107.  Generators located in California automatically include carbon prices in their CAISO bids because they are subject to California’s cap-and-trade program. Generators outside the state decide whether to bid to supply electricity to CAISO on a voluntary basis; they are only dispatched to serve CAISO load if they affirmatively elect to do so and submit a winning bid that includes a supplemental greenhouse gas bid adder reflecting California’s carbon price. For an overview, see Andy Coghlan & Danny Cullenward, State Constitutional Limitations on the Future of California’s Carbon Market, 37 Energy L.J. 219 (2016); see also CAISO Tariff § 29.32 (Feb. 15, 2018), http://www.caiso.com/rules/Pages/Regulatory/Default.aspx [https://perma.cc/FC6X-HJCN]; CAISO, Regional Integration California Greenhouse Gas Compliance Issue Paper (Aug. 29, 2016), http://www.caiso.com/Documents/IssuePaper-RegionalIntegrationCaliforniaGreenHouseGasCompliance.pdf [https://perma.cc/QWN3-XCHQ]; see also generally California Independent System Operator, Order on Rehearing, Clarification, and Compliance, 149 FERC ¶ 61,058, at PP. 56-59 (2014) (describing the voluntary nature of the “GHG Bid Adder” that out-of-state generators must include in their bids in order to be dispatched to serve CAISO load).
  108.  As of this writing, CAISO has submitted a concept to FERC for approval in the EIM. See CAISO, Transmittal letter re: California Independent System Operator Corporation Energy Imbalance Market, Docket No. ER18-2341-000, at 5-6 (Aug. 29, 2018), http://www.caiso.com/Documents/Aug29_2018_TariffAmendment-RegionalIntegration_EIMGHGCompliance-EIMBidAdder_ER18-2341.pdf [https://perma.cc/QWN3-XCHQ]. However, questions remain about the efficacy of the EIM design. See, e.g., William W. Hogan, An Efficient Energy Imbalance Market with Conflicting Carbon Policies, 30(10) Electricity J. 8 (2017). Professor Hogan’s analysis concerned an earlier version of the proposed greenhouse gas accounting mechanism, but it raises several conceptual issues that remain in CAISO’s subsequent proposal and California’s treatment of imported electricity in its cap-and-trade program for greenhouse gases.
  109.  See 16 U.S.C. § 824d (2018).
  110.  Tom Lutey, Coal States Montana and Wyoming Push Back on Washington State Proposed Carbon Tax, Billings Gazette (Feb. 21, 2018) (reporting that the Attorneys General of Montana and Wyoming sent a letter to Washington Governor Jay Inslee asserting that Washington’s proposed carbon tax raises constitutional concerns); Brian Maffly, Lawmakers Considering Spending Millions to Sue California and Fight the ‘War on Utah Coal’, Salt Lake Trib. (Feb. 18, 2018), https://www.sltrib.com/news/environment/2018/02/16/lawmakers-considering-spending-millions-to-sue-california-and-fight-the-war-on-utah-coal/ [https://perma.cc/LW8C-BWVJ] (reporting that the Utah Legislature was considering a $2M appropriation to fund a lawsuit against California’s climate policies, including its application of the carbon price in the CAISO EIM); Letter from Tim Fox, Montana Attorney General, and Peter K. Michael, Wyoming Attorney General, to Governor Jay Inslee (Feb. 20, 2018), https://media.dojmt.gov/wp-content/uploads/Letter-Re-Washington-SSB-6203-002.pdf [https://perma.cc/ZT9S-QDGM].
  111.  FERC v. Elec. Power Supply Ass’n, 136 S. Ct. 760 (2016); Hughes v. Talen Energy Marketing, LLC, 136 S. Ct. 1288 (2016); OneOK, Inc. v. Learjet, Inc., 135 S. Ct. 1591 (2015).
  112.  Fed. Power Comm’n v. So. Cal. Edison Co., 376 U.S. 205, 215 (1964).
  113.  Hughes, 136 S. Ct. at 1299 (Sotomayor, J., concurring); see also Matthew R. Christiansen, FERC v. EPSA: Functionalism and the Electricity Industry of the Future, 68 Stan. L. Rev. Online 100 (2016) (arguing that the Court’s opinion in FERC v. EPSA shifts the “bright line” from a formalist to a functionalist interpretation); Robert R. Nordhaus, The Hazy “Bright Line”: Defining Federal and State Regulation of Today’s Electric Grid, 36 Energy L.J. 203 (2014) (discussing the increasingly complex division between state and federal authority under the Federal Power Act prior cases like Hughes and EPSA).
  114.  See FERC Technical Conference, State Policies and Wholesale Markets Operated by ISO New England Inc., New York Independent System Operator Inc., and PJM Interconnection L.L.C., Docket No. AD17-11-000, Panel I, Remarks of State Regulators (May 1-2, 2017), http://www.ferc.gov/EventCalendar/EventDetails.aspx?ID=8663&CalType=%20&CalendarID=116&Date=&View=Listview [https://perma.cc/N95K-NEWS].
  115.  Rory D. Sweeney, NJ Regulator Threatens to Exit PJM Amid States’ Complaints, RTO Insider (July 2, 2018), https://www.rtoinsider.com/pjm-joe-fiordaliso-95702/ [https://perma.cc/EE9H-E3P2].
  116.  Some independent experts have called for RTO governance reforms in PJM and across FERC-regulated markets. See, e.g., Simeone, supra note 73.
  117.  See Protest by the Conn. Pub. Util. Reg. Auth. et al., FERC Docket No. ER18-619, at 14-15 (Jan. 29, 2018).
  118.  See Protest of Clean Energy Advocates, supra note 76, at 62.
  119.  Id.

Reforming the True-Sale Doctrine

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

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


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

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

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

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

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

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

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

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

The Case for Uniform True-Sale Rules

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

II. The Relevance of Price Terms

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

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

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

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

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

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

III. Directive for a Drafting Committee

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

A. Practical Challenges to the Deregulation Inside the Agency

1. Ossification

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

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

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

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

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

2. Burrowing

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

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

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

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

3. Prosecutorial Discretion

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

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

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

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

B. The Evolving Nature of Regulation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

B. Internal Forces of Regulatory Inertia

1. Agency Costs

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

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

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

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

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

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

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

2. Manager-Specific Investments

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

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

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

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

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

3. Specific Knowledge, Centralization, and Switching Costs

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

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

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

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

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

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

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

4. Professionalization, Advocacy, and Culture

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

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

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

5. Repositioning the Regulatory Agenda

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

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

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

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

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

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

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

6. Regulatory Persistence as a Barrier to Entry

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

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

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

C. External Forces of Regulatory Inertia

1. Board Risk Taking and Caremark Duties

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

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

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

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

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

2. Reputation and External Reporting Pressures

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

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

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

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

3. The Revolving Door and the Human Capital Hypothesis

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

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

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

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

Future Regulatory Uncertainty

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

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

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

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

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


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

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

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


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

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

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

The Modigliani-Miller Theorem at 60: The Long-Overlooked Legal Applications of Finance’s Foundational Theorem

*Theodore Warner Professor, University of Pennsylvania Law School; Professor of Real Estate, The Wharton School; Co-director, Center for Tax Law and Policy, University of Pennsylvania. Thanks to Alvin Dong for assistance with the research, to my colleagues for their comments and suggestions, and to my students for their willingness to grapple with many of these issues. Copyright 2018 by Michael S. Knoll. All rights reserved.

2018 marks the sixtieth anniversary of the publication of Franco Modigliani and Merton Miller’s The Cost of Capital, Corporation Finance, and the Theory of Investment, which purports to demonstrate that a firm’s value is independent of its capital structure. Widely hailed as the foundation of modern finance, their article is little known by lawyers and legal academics even though it led to many major economic advances, such as agency costs and asymmetric information, recognized and used throughout the law today. The legal profession’s lack of familiarity with these Nobel Prize-winning authors and their work is not merely an oversight; it is a missed opportunity. When inverted, the Modigliani-Miller theorem describes the mechanisms through which capital structure can affect value. This “reverse” Modigliani-Miller theorem provides a powerful framework that can be extremely useful to legal academics, practicing attorneys, and judges.


In June 1958, two young economists, Franco Modigliani and Merton Miller, published an article, The Cost of Capital, Corporation Finance, and The Theory of Investment in the American Economic Review.1 That article, which directly challenged then-conventional financial orthodoxy, is today widely acknowledged as the foundation of the modern academic discipline of finance.2 Yet, the article, which is still read by nearly all economics and finance graduate students, is little known among lawyers and legal academics, many of whom have never heard of or have only a passing acquaintance with the authors’ names and their work. Nonetheless, MM (as the pair of authors, their joint articles, and the theorems they contain are all colloquially referred to by economists)3
has long been implicitly used throughout the legal profession, although the debt has only been occasionally acknowledged and their work is rarely directly and knowingly applied by legal academics.4 That oversight is unfortunate because the first MM theorem, when reversed, provides a powerful framework with broad applications throughout the law. As the sixtieth anniversary of the publication of MM’s first article approaches, it is time for the legal profession to add the reverse MM theorem to the lawyer’s toolkit,5 alongside other well-known economic ideas, such as the Coase theorem.6

The rest of this Essay is organized as follows. After describing MM and its development, I introduce the reverse MM theorem—the idea that if capital structure matters it must work through one of the original MM theorem’s assumptions. The three following sections then describe how the reverse MM theorem can be used by legal academics, practicing lawyers, and judges in their work. In each section, I provide one or more examples to illustrate how the reverse MM theorem can serve as a framework to address a broad range of recurring, but challenging legal issues. I then speculate as to why the reverse MM theorem is not already widely known and used by lawyers before offering a conclusion.

I. History

Modern business school finance departments are stocked with Ph.D.s whose scholarship tends to focus on abstract questions with real-world applications. Sixty years ago, the situation was different.7 Finance departments were much smaller and something of a backwater. The field lacked mathematical precision and conceptual rigor, relying heavily on accounting conventions, rules of thumb, and anecdotes.8 The prevailing view at the time was that the impact of leverage on the value of a firm was “complex and convoluted.”9 Debt was generally considered preferable to equity because it was cheaper (the stated return on debt was less than the implied return on equity10 and because interest could be deducted, whereas dividends could not; however, there was thought to be some unspecified upper limit on value-increasing debt because the risk of corporate bankruptcy and the interest rate increased with leverage. However, none of these intuitions had been formalized.11

With their 1958 article, MM directly challenged the prevailing thinking that debt was cheaper than equity and that each firm had an optimal capital structure. They argued that under certain idealized assumptions the amount of debt had no impact on firm value.12 Expressed more confrontationally, MM averred that their finance colleagues were wasting their time and their clients’ money trying to ascertain what a firm’s optimal capital structure was because one capital structure was as good as any other.13 That idea, which is also MM’s principal substantive result and is today known as the capital structure irrelevancy proposition, or more succinctly, as MMI,14 has been called “the bombshell assertion.”15 As with many bold ideas, the underlying intuition is extremely simple. In an interview after Modigliani won the Nobel Prize in Economics, Miller (who subsequently won the prize, too) analogized their irrelevancy proposition to slicing a pizza. A pizza can be cut into as many slices as desired but doing so does not change the pizza’s size.16
Similarly, MM argued that the firm’s capital structure divides the firm’s cash flows, but because it does not change those cash flows, it does not affect the overall value of the firm, which is just the present value of all of the firm’s cash flows.

Although MM’s main result is most intuitively expressed by analogy, they presented their argument formally. MM began their formal argument with a series of idealized assumptions. Although there are different ways to state the MM assumptions, from a lawyer’s perspective, the most intuitive and helpful listing of the MM assumptions is probably as follows:

Efficient capital markets – All investors have access to the same information, which they process in the same way. As a result, all investors agree on the market value of all cash flow streams.

Frictionless markets – There are no transaction costs. Contracts can be costlessly written to cover all contingencies and can be costlessly enforced.

No taxes (or other regulations) – There are no taxes at the firm or the individual investor level. There are also no government regulations, or at least no regulations that relate to or are affected by capital structure.

Only cash flows matter – Investors care only about the cash flow generated by an investment. Alternatively, no investments generate nonpecuniary benefits, such as shelter (owner-occupied housing) or aesthetic appreciation (art).

Using only the above four assumptions, MM showed that a firm could not change its value by adjusting its leverage. MM proved their central claim by assuming the contrary result (that the firm could change its value by adjusting its leverage) and then showing that the result could not persist in a market with rational investors.

Because MM’s capital structure irrelevancy theorem was so out-of-step with conventional thinking and practice, it was initially met with deep skepticism.17 Many thought the theorem was simply wrong: that the conclusion did not follow from the assumptions. However, after some back-and-forth and various technical corrections, economists concluded that the argument was correct as a matter of theoretical economics. Given the initial assumptions (efficient and frictionless markets, no taxes, and only cash flows matter) the result (a firm’s value was independent of its capital structure) held.18 Next, skeptics questioned whether the assumptions were so inaccurate as to render the theorem true as a matter of internal logic, but not very useful. Most practicing finance professionals reached that conclusion and they largely ignored MM’s work. Academic economists, however, took a different approach. For a time, many accepted the theorem as fairly accurate and turned their attention to other issues, but they did not ignore MM.19 Instead, they built modern finance upon it.20

The economists, whether or not they accepted the MM capital structure irrelevancy result, mined MM’s formal argument. By appealing directly to the economic principle of one price—the notion that two perfect substitutes will sell for the same price—the MM proof introduced the idea of arbitrage into financial economics.21 Since its introduction by MM, financial economists have been employing arbitrage arguments in order to develop new insights.22 Consider two major examples from the 1960’s and 1970’s. The first example is the capital asset pricing model (CAPM), which holds that investments are priced according to their market risk (typically measured by beta – β), which cannot be diversified away, not their unique risk, which can be eliminated through diversification.23 The second example is the Black-Scholes option pricing model, which recognizes that a call option is equivalent to holding a share of the underlying stock and borrowing against that share.24Today, arbitrage is the cornerstone of financial economics. Indeed, the MM proof has been called the “watershed between old and new finance.”25

Economists, however, were not finished with capital structure. After a roughly twenty-year hiatus, economists began to return to studying capital structure.26 And when they did, they recognized that the MM capital structure irrelevancy proposition provided the key to understanding capital structure.

By that time, financial economists had recognized that the MM irrelevancy proposition had wide application. Given the original MM assumptions, it follows that a broad array of corporate actions, not just leverage, have no impact on firm value. Indeed, the MM assumptions imply that the value of a firm is determined solely by the firm’s investments or assets (the left side of the balance sheet), not how those investments are financed (the right side of the balance sheet). Thus, for example, the MM assumptions also imply that hedging activities, leasing versus owning, the form of legal organization, the compensation structure, the state of incorporation and the legal rules that follow, and so much more have no impact on firm value either. That suggests a tension, if not an outright conflict, between the MM capital structure irrelevancy theorem and the goal of understanding capital structure.

The key to reconciling this tension was to reverse or invert the MM irrelevancy theorem. As Miller wrote in 1988, as part of a symposium on the thirtieth anniversary of the publication of the first MM article, MM wrote their original article in order to dispel much thinking about how capital structure can affect firm value.27 However, by showing which aspects of capital structure do not affect value, MM also showed how capital structure can affect value.28 Thus, the power of MM is through the MM assumptions, which describe how capital structure can impact firm value This idea is called the reverse MM theorem, and it holds that capital structure can affect the overall value of the firm only by releasing or withholding information, by decreasing or increasing transactions costs, by decreasing or increasing taxes (or the costs of other regulations), or through the allocation of assets with consumption elements. According to MM, the above is an exhaustive list of how capital structure decisions can affect firm value.

The reverse MM theorem, thus, takes the original MM theorem and turns it on its head. It replaces the idea that under certain assumptions capital structure does not affect the value of the firm with the idea that capital structure affects firm value only to the extent that it operates through the MM assumptions.29

Starting in the 1970s, economists began to mine the MM assumptions for insights into how capital structure affects the total value of the firm. Consider the following two examples from that decade. Michael Jensen and William Meckling argued that the conflicting interests of the managers and the owners of a business generate agency costs, which the owners seek to reduce by monitoring and writing contracts that bond their employees with contingent payments.30 Thus, Jensen and Meckling developed a theory of capital structure that exploits the notion that the second MM assumption, frictionless markets, is false.

Around the same time, Stephen Ross recognized that managers are usually better informed about a firm’s prospects than are its shareholders. Ross argued that mangers could signal to shareholders that a firm’s prospects have improved by raising the firm’s debt-to-equity ratio or declined by reducing that ratio. Ross argued that investors can easily read these signals, which are credible because they are costly for managers to send.31 Ross’s article, which was the first application of signaling theory to finance, assumes that the first MM assumption, informationally perfect markets, is wrong.

The above are only two examples—albeit two very important and highly influential examples—of how capital structure can impact value. Over the last forty years, economists have developed many ideas in addition to the two above that illustrate how capital structure can affect value in situations where the original MM assumptions do not hold (Miller himself developed many of the ideas about taxes and value.32). And some of these ideas, including agency costs and signaling, have made their way into the lawyer’s toolkit. However, the work of MM, which gave birth to these ideas, and which in the form of the reverse MM theorem serves as a framework that organizes these and many other ideas, has not been incorporated. That is unfortunate because the reverse MM theorem is a powerful analytical tool with a wide range of legal applications.

II. Ivy Halls: Use by Legal Academics and Policy Makers

Scholars can use the reverse MM theorem for both positive and prescriptive analyses. Positively, academics can use the theorem to understand why a particular structure is used and how it has developed and changed over time. Implicit in the exercise is the assumption that the observed structure is the structure that maximizes value. The theorem is then being used to explain why the observed practice is optimal. Scholars can also use the reverse MM theorem prescriptively to criticize existing structures and to develop recommendations for improved structures.

A. Positive Analysis

Use of the reverse MM theorem for positive analysis is sometimes explicit in finance scholarship,33 but it is rarely explicit in legal scholarship.34
Nonetheless, sophisticated legal academics frequently make arguments in the vein of the reverse MM theorem. Such arguments often take the form that some capital structure is optimal because it solves a particular informational, incentive, or tax problem, which is to say it solves a problem relating to a failure of one of the MM assumptions. Contained within that argument is usually a nod to the notion that the structure does not create or amplify other problems—that it does not increase costs relating to a failure to meet the other assumptions.

The practice of aircraft leasing, for example, can be readily understood through the reverse MM theorem. Airlines have three alternatives to fund new aircraft: equity, debt, or capital (long-term) leases.35 Among the three alternatives, airlines rarely purchase new aircraft by issuing equity or using retained earnings. That is largely because equity financing is subject to two levels of taxation—first at the corporate level and then at the investor level—whereas borrowing and lease-financing incur only one level of taxation.36 Thus, airlines rarely finance aircraft through equity because the tax cost, which relates to the third MM assumption, is prohibitive.

If the airline were to borrow to purchase the aircraft, the airline could depreciate the aircraft because the owner of tangible personal property is entitled to the depreciation deductions on that property. Depreciation reduces income, and thus provides the owner of the depreciable property with a tax benefit. Moreover, aircraft are eligible for accelerated depreciation.37 These favorable depreciation rules make commercial aircraft a tax-advantaged asset. Such assets are worth most to high-bracket taxpayers confident that they will have the income to take full advantage of the deductions.38 Airlines, however, are not such taxpayers. The airline industry is capital-intensive (aircraft are expensive), volatile, and low-profit. Accordingly, if the airlines took all of the depreciation deductions from the aircraft they operated, they would frequently realize little or no value from doing so. Thus, the aircraft lease and its close cousin, the leveraged aircraft lease, were created in order to transfer the depreciation deductions from the airlines to other taxpayers that value them more.

In an aircraft lease, a third party takes title and leases the aircraft to the airline. The lessor as the aircraft’s owner uses the depreciation deductions to offset other income. The airline benefits through a lower operating cost because the lessor accepts a reduced lease rate. In effect, the airline transfers the depreciation tax benefits to the lessor in exchange for a lower lease rate. In a simple lease, the lessor would purchase the aircraft for cash, tying up capital. Because it is the lessor’s tax attributes—and only those tax attributes—that make it the preferred owner, most aircraft leases are leveraged leases. In a leveraged lease, a lender provides most of the capital required to purchase the aircraft.

For a brief period during the early 1980’s, there was a practice called safe harbor leasing under which any transaction called a lease would be respected as such, even if it closely resembled a sale.39 In that environment, lessors would transfer the full risk of ownership to lessees. Because lessors had no residual risk from the aircraft (which was insured during the lease), they passed nearly all of the tax benefits to lessees through lower lease rates. Later in the 1980’s, the safe harbor leasing provisions were eliminated.40 The Internal Revenue Service (Service) would then challenge parties’ characterization of transactions as leases if the purported lessors had too little residual risk (under the tax law, ownership is not determined by who holds title, but rather by who has the benefits and burdens of ownership.). If the Service’s challenge succeeded, it would treat the nominal lessee as owner (and hence the lessee, not the lessor, would be entitled to the depreciation deductions). Accordingly, aircraft leasing changed. Leasing remained, but lessors took on more residual risk, which created agency problems because lessees controlled the aircraft during the lease. The lease documentation became longer, and the parties and their lawyers carefully negotiated and executed the leases so as to ensure that the lessors retained the requisite amount of risk and that the resulting agency costs were controlled. Lease payments also increased in order to compensate lessors for their increased risk and their increased contracting and monitoring costs.41 Thus, the elimination of safe harbor leasing led to changes in the optimal capital structure because it changed the trade-offs across the four MM assumptions.

Although aircraft leasing can be understood without reference to the reverse MM theorem, the theorem focuses on the relevant issues—taxes and incentives—the optimal balance among which changed as the legal regime changed. Used in this way, the reverse MM theorem operates as a template to understand alternative transactional structures and their development over time.

B. Prescriptive Analysis

The reverse MM theorem can also be used to criticize inefficient capital structures and to suggest how those structures might be improved. The reverse MM theorem can be used prescriptively because it asks the right question from an economic efficiency perspective—what structure maximizes the total value of the firm—and provides a roadmap to answer that question. In corporate law, the central issue of debate has long been the allocation of control rights among corporate managers, directors, and shareholders. Because directors are typically seen as passive, the corporate governance debate is usually binary: one side argues that shareholders should have greater control rights and, concomitantly, that managers should have less. The other side makes the opposite argument: Managers should have greater control rights and shareholders should have less. The arguments are often anecdotal, but they are increasingly econometric. These competing views of the proper allocation of power between managers and shareholders play out across such issues as staggered boards, waiting periods, and takeover defenses.

The first view, the shareholder primacy position, is often described as the agency model, and it emphasizes the agency costs from having managers make decisions on behalf of shareholders. As such, the agency model is a straightforward example of a violation of the second MM assumption of frictionless markets. The latter view, the management primacy position, is sometimes described as the commitment view. Under that view, activist investors deter firms from making long-term, positive-net-present-value investments that cannot be valued by the market. Thus, the commitment view is an example of a violation of the first MM assumption of informationally perfect markets. The debate usually takes the form of which approach is better—favoring managers or shareholders—which is to say whether the agency costs from manager control are greater than the costs resulting from imperfect information with shareholder control.

The reverse MM theorem suggests a different approach, one emphasizing the need for a governance structure that maximizes the total value of the firm. A third alternative that mediates between the above two polar positions is to appoint stronger, more independent directors who can identify and value investments that cannot be publicly disclosed (without losing value). Such directors would allow the firm to capture the benefits from making long-term investments not accurately valued by the market without the costs of managerial entrenchment. Hiring and empowering such directors has the potential to increase firm value above that from either polar position because it takes seriously the concerns expressed by both sides and looks to alleviate each side’s concerns without exacerbating the other side’s concerns. This suggestion, in essence, is Ira Millstein’s proposal for activist directors who partner with management, but who also take responsibility for the corporation’s strategy.42 As Millstein writes, he favors

a board-centric approach to corporate governance by placing more activist directors in the boardroom – people who will ask the tough questions, challenge management practices, and resist those who put their own agendas ahead of those of the corporation and investors like you. Choosing directors will require new diligence and care.43

Millstein developed his proposal for more activist directors without appeal to the reverse MM theorem, but by drawing upon his lengthy and highly successful legal career. For those who lack the in-depth knowledge and experience that comes from decades of working at the pinnacle of the legal profession, the reverse MM theorem provides a framework that should make it easier to develop and defend efficient new forms of corporate governance and capital structure, because the theorem focuses inquiry on the relevant issues and provides a lens through which those issues can be examined and weighed.

Moreover, the observation or recommendation that directors should have more power is only the beginning of the analysis. A more thorough and detailed response would describe the additional duties directors take on, the powers they should have, and the limitations there should be on their powers. In addition, a more thorough analysis would describe how directors should be compensated and how much effort they should apply to each firm. Although I do not know the value-maximizing answers to those questions, the path to finding them runs through the reverse MM theorem, because the theorem directs those using it to look for the structure that strikes the value-maximizing balance across the MM assumptions.

C. Summary

The reverse MM theorem categorizes and partitions the various ways that capital structure, which includes governance, can affect the total value of the firm. The reverse MM theorem takes a large collection of seemingly unrelated concepts and organizes them into categories of closely-related ideas. Once so organized, these concepts can be used and applied more easily and systematically to understand and evaluate existing financial practices and in the search for efficiency enhancing innovations. This organizational framework is of particular use to scholars because it leads them to examine the structure that maximizes value across the MM assumptions, which MM have shown is the value-maximizing structure (because everything outside of its assumptions has no effect on value). The reverse MM framework can be used both to understand capital structures and how they change over time, as with aircraft leasing, and to criticize current practice and develop new ideas, as with governance. The above examples only scratch the surface where academics can use the reverse MM theorem to understand capital structure.44

III. Wall Street: Use by Practitioners

Lawyers who have taken a class in corporate finance would have seen the MM theorem, and if they remember it, they probably consider it irrelevant to their work. That is unfortunate because in its reverse form, the theorem can be very useful to transactional lawyers (as I show in this section) and litigators (as I show in the next section).

A. Training Lawyers

For nearly a century, transactional lawyers have been trained through the Cravath method, named for Paul Cravath, of the New York law firm Cravath, Swaine and Moore. Under the Cravath method, a junior associate would start by working on a small piece of a transaction under the supervision of a more senior associate. As the lawyer gained experience, he (and more recently, she) would move up the pyramid, taking responsibility for successively larger portions of the transaction and seeing closely at each stage how a more senior lawyer handled the next stage. The rationale for such a method of training was that good transactional lawyering was more art than science, that almost everything there was to learn (beyond the directly applicable law) had to be learned through experience, by working with other lawyers, and that this craft could not be taught in the traditional fashion of most academic subjects.45

Slightly more than thirty years ago, Ronald Gilson suggested that important aspects of the professional education of transactional lawyers did not have to be learned through an apprenticeship, but instead could be taught in the classroom.46 Gilson asked the following questions: Why do smart, sophisticated business people hire business lawyers, and what is it that business lawyers do that makes them valuable to clients? Gilson described transactional lawyers as business or transactional engineers.47

Moreover, those lawyers face the same types of fundamentally economic problems–dealing with incentives and imperfect information—over and over again. Although those problems arise in different situations and present themselves in different forms, ultimately there are only a small number of basic economic concepts that underlie the core work of transactional lawyers. Gilson further believed that lawyers would benefit from studying these basic economic concepts. In Gilson’s view, such an economically trained lawyer would be better able to recognize one of these issues and would have a deeper understanding.48 Also, by identifying and understanding the issue, such a lawyer could more quickly and easily draw upon prior transactions to find an appropriate solution, modify that solution to fit the situation, and even develop new solutions when the situation demands it. Gilson then put that thought into practice by teaming with two Columbia colleagues, Victor Goldberg and Daniel Raff, and offering the first Deals course at the Columbia law and business schools.

Deals courses typically begin by introducing the students to the relevant economic concepts through the use of highly stylized examples. The course then progresses through increasingly less stylized case studies that illustrate how these issues present themselves in different legal contexts as well as some standard techniques that address those challenges. The course typically concludes with presentations by professionals of actual transactions, which are then analyzed by the students. The students’ task is to explain why the transaction was structured as it was, using the concepts covered in class. The professionals’ presentations (and the students’ analyses) are intended to reinforce the theoretical concepts covered in class by challenging the students to find and identify those issues in actual transactions, underscoring the importance and ubiquity of such issues in practice, and giving the students an opportunity to see how those issues were addressed by professionals. The practitioners’ presentations, however, are less successful pedagogically when the structure is driven by one or more concepts not specifically covered in class. In that case, there is an uncomfortable disconnect between the classroom pedagogy and the final presentations. Accordingly, Raff and I, after Raff left Columbia for Penn and recruited me to teach Deals with him, began using the reverse MM theorem to organize the ideas presented in the course. Because the MM assumptions span the ways transactional structures affect the value of a firm (and partition those ways into silos), the reverse MM theorem ensures that the full range of ways in which structure can affect value are at least introduced (and covered at a high level of generality) even though not all variations can be explored at length. Thus, even if a structure is largely driven by a particular issue not explicitly covered in class, the driver can be placed in one of the four MM silos and its similarities to other ideas can be drawn upon to understand the issue and its resolution.49

Raff and I have found that there are additional pedagogical advantages from using the reverse MM theorem to organize a Deals course. Lawyers (and other transaction professionals) structure and execute transactions. Each step of the way there are choices to be made that involve trade-offs within and across the MM assumptions. The reverse MM theorem makes those trade-offs explicit. Because it provides a framework that organizes the full range of ways in which structure can affect value, the reverse MM theorem lies at the heart of transactional lawyering. A lawyer who knows the reverse MM theorem and is familiar with the main ideas in each silo is better able to understand the issues driving a transaction. In addition, the same lawyer can more quickly acquire knowledge because she is building out a framework (using the reverse MM theorem as a skeleton), and she is better able to retain knowledge because she can store it systematically, not just as a series of one-off examples. Such a lawyer can also more readily recall and employ her knowledge when a new situation arises because once she has identified and categorized the problem she can focus her search for a solution among solutions to structurally similar problems across various practice areas, rather than gravitating towards what has been done before in the same practice area.50

The teaching of the reverse MM theorem is, thus, an example of the kind of reform for which the 2007 Carnegie Report on Legal Education called. The Carnegie Report criticized law schools for relying too heavily on post-graduation apprenticeships in order to train lawyers and recommended that law school faculty seek to identify powerful analytical frameworks that lawyers can use to accelerate their transition from law students to successful practitioners.51 The reverse MM theorem is precisely such a framework because it captures much of what transactional lawyers do in practice, albeit at a high level of generality.52

B. Practice

The applicability of the reverse MM theorem can be illustrated through some common examples from mergers and acquisitions. There are what might seem to be (especially to a new associate) a bewildering array of methods whereby one corporation (Purchaser) can acquire another corporation (Target). The basic possibilities include:53 Purchaser acquires Target’s assets; Purchaser acquires Target’s stock; Target merges into Purchaser (forward direct merger); Purchaser merges into Target (reverse direct merger); Target merges into Purchaser’s subsidiary (forward triangular merger); or Purchaser’s subsidiary merges into Target (reverse triangular merger). The main result of all of these transactions is the same – Purchaser ends up owning Target’s assets – but there can be very different legal and economic consequences depending upon the method chosen. The reverse MM theorem can help attorneys (especially beginning attorneys) by giving them a better and deeper understanding of the issues that drive the choice of merger-and-acquisition structure, which come down to the MM assumptions. By recognizing the trade-offs across incentives, informational asymmetries and taxes that arise with the different structuring choices, the reverse MM theorem can also help lawyers to choose an acquisition method. Indeed, as one reads sophisticated treatments by practitioners of the various options and their advantages and disadvantages, their reasons regularly relate back to and can be catalogued under the MM assumptions.54 A young lawyer who has internalized the reverse MM theorem should find it easier to acquire, store, retrieve and apply the relevant skills and knowledge required to progress.

As another example where the reverse MM theorem can be useful, consider an example Gilson emphasized in his original article, the negotiation of representations and warranties.55 Representations and warranties are statements of fact to which a party to a contract is attesting. Many of Target’s typical representations and warranties concern Target’s assets and liabilities. For example, Target usually represents to Purchaser that Target owns or has the rights to the assets that it uses in its business and shows on its financial statements. Also, Target commonly represents to Purchaser that Target does not have liabilities beyond those it has disclosed. James Freund, a retired Skadden Arps mergers and acquisition partner and the author of a classic book on mergers and acquisitions, describes the process of negotiating representations and warranties as competitive, with each attorney trying to capture more value for her client.56 In contrast, Gilson describes the process as cooperative (or argues that it should be cooperative) because the less well-informed party (typically, Purchaser with the above representations and warranties) wants assurances that it is receiving what it is paying for and sellers have the incentive to provide this information in order to encourage buyers to pay more.57 Thus, Gilson’s view of representations and warranties fits nicely within the reverse MM theorem framework. The representations and warranties respond to a violation of the first MM assumption, perfect information, by providing Purchaser with useful information about Target and assurances as to the accuracy of that information.

What about Freund’s competitive view of negotiating representations and warranties? Recall that the reverse MM theorem holds that capital structure can affect the value of the firm only through the MM assumptions, and hence the capital structure that maximizes the overall value of the firm minimizes the total cost from falling short of the assumptions. However, the lawyers negotiating a merger or acquisition (and their clients) are not only interested in maximizing the value of the deal; each side also has an interest in receiving as much value as it can. Familiarity with the reverse MM theorem can help to explain the disagreement between Freund and Gilson. The reverse MM theorem is a statement about value creation, and the total value of a transaction can be increased by providing information and assurance. The reverse MM theorem says nothing about how that value is distributed. My conjecture is that among experienced mergers and acquisitions lawyers, such as Freund, little time and energy is spent negotiating the representations and warranties that cover what the parties understand each needs. That, however, leaves more time and energy to spend fighting over the division of (expected) surplus that characterizes the rest of the negotiation.58

Thus, a scholar reading the final document could conclude it is mostly cooperative, but the lawyer who negotiated it would say more of the time was spent in competitive negotiations. For the new associate, however, the challenge is often figuring out what is going on in the negotiations. Understanding both the value creation and value distribution exercises taking place and the role the reverse MM theorem plays with the former as well as the conflict that often arises between value creation and value distribution can help the young associate to become a more effective advocate and negotiator.

C. Summary

For most practicing transactional lawyers, the suggestion that much of their work is an application of the reverse MM theorem is likely to be met with either a shrug or resistance. Immersed in the details of a transaction while focused on the competitive aspects of the negotiations, it is easy to lose sight of the big picture and the scaffolding on which it stands. The reverse MM theorem is that scaffolding, and the lawyer who has internalized that theorem has a powerful framework that can be used to help to identify problems and tailor solutions for her client even in complex and novel situations. Also, because of its breadth, compactness and utility, the reverse MM theorem is a powerful pedagogical tool that can accelerate young lawyers’ learning.

IV. The Court Room: Use by Judges and Litigants

Finally, one area where, to the best of my knowledge, the reverse MM theorem has yet to be explicitly applied is in litigation. In this section, I describe how the reverse MM theorem can assist judges in drafting common law rules and litigators in seeking to persuade them.

Consider, for example, the calculation of prejudgment interest. Prejudgment interest is interest that the defendant pays to the plaintiff on a judgment. Prejudgment interest accrues from the date of injury until the date of judgment.59 Federal law does not provide for a particular fixed or floating prejudgment interest rate, nor does it explicitly call for a specific method of calculation. Instead, the federal courts have sought to award prejudgment interest at a rate that will compensate the successful plaintiff for delay. According to the economics-based coerced loan theory, a successful plaintiff should receive prejudgment interest at the defendant’s unsecured borrowing rate. The rationale is that the defendant, through its wrongful action, has forced the plaintiff to make a loan to the defendant, which debt would be treated as an unsecured debt in the event of defendant’s bankruptcy. Accordingly, in order to compensate the successful plaintiff for the risk of not being able to collect its judgment, the defendant should pay the plaintiff interest at the defendant’s unsecured borrowing rate taking the duration of the loan into account.60

However, recognizing that the court should award the plaintiff prejudgment interest at defendant’s cost of unsecured borrowing from the date of injury to the date of judgment does not provide the court with all of the direction it needs to determine a unique and unambiguous interest rate. In principle, the defendant could have borrowed unsecured from plaintiff at a fixed interest rate or at an array of floating interest rates. The coerced loan theory cannot resolve this matter as there can be multiple market-based interest rates that can compensate the plaintiff. In such circumstances, the reverse MM theorem suggests that the court should adopt a rule that will minimize the combined cost to the parties from failures of the MM assumptions. Litigants have some control over the pace of litigation. Accordingly, because it is easier to delay litigation than to accelerate it, and because a non-market interest rate gives one party an incentive to delay (and the other to accelerate), a fixed rate obligation is likely to lead to delay (which, in violation of the assumption of frictionless markets, is costly for the parties and the court together). If interest rates have gone up (so the original fixed interest rate is below market), the defendant will have incentive to delay; alternatively, if interest rates have gone down (so the original rate is above market), the plaintiff will have incentive to delay. In contrast, with a floating market interest rate, because the plaintiff is not receiving an above-market interest rate and the defendant is not paying a below-market rate neither party has an incentive to delay.

More generally, there is a broad class of cases that involve choosing among multiple remedies that could in principle compensate a successful plaintiff. Many of these examples involve whether to make an ex-ante or an ex-post calculation of damages.61 The choice of a fixed or floating prejudgment interest rate is such an example as the fixed rate (the market interest rate at the date of injury) is an ex-ante calculation whereas the floating rate (say, a series of yearly interest rates from the date of injury to the date of the award) is an ex-post calculation. From an expected value perspective, both ex-ante and ex-post calculations will compensate the successful plaintiff. The reverse MM theorem provides a framework for the court to use to allow it to resolve these issues efficiently because it will focus the court’s attention on the informational, incentive and tax differences across the alternative rules and their impact on the parties.62

V.  Why the Oversight?

The question, “if you’re so smart, why aren’t you rich?” has been a cliché since at least the time of Aristotle.63 The variant here is if the reverse MM theorem is such a useful framework for the law, why hasn’t it already been adopted? One answer is that it has in that so many of the ideas economists have developed using the reverse MM theorem, such as asymmetric information and agency costs, have been incorporated into the law. However, the reverse MM theorem itself has not been generally and widely adopted as an ordering principle, which is its incremental value after six decades of scholars building out its main insight. Of course, as an intellectual framework or ordering principle, its exclusion does not withhold any specific idea or preclude any specific analysis. What is lost is a more effective way of ordering and drawing upon knowledge, which still leaves the question.

As for the failure of transactional lawyers to adopt the reverse MM theorem a possible partial explanation is that the theorem would often apply in an environment where both value creation and value distribution are taking place simultaneously. As described above, mergers and acquisition negotiations, including negotiations of representations and warranties and choosing a particular acquisition or merger structure, are simultaneously both cooperative and competitive.64 In such circumstances, the competitive aspects frequently overshadow the cooperative aspects.65 The reverse MM theorem addresses only the cooperative aspects, and so it does not address all aspects of the negotiations, let alone the most confrontational, which could make it easy to overlook. Nonetheless, as negotiation experts regularly emphasize, understanding the relevant issues and the potential value they have to all parties is a sure way to make one a better negotiator.66

Another possible reason for the oversight is suggested by an important recent working paper by Professors Lee Anne Fennell and Richard H. McAdams, entitled Inverted Theories.67 Fennell and McAdams argue that some of the most well-known ideas in law, including the Coase theorem, the Tiebout hypothesis, and Kaplow and Shavell’s theory of tax superiority, are commonly understood in their original form, in which they yield negative or impossibility results.68 Fennell and McAdams further argue that the heavy emphasis on the original form of the theorem and the near-total absence of its inverse or reverse form is a major error that calls for correction.69 According to Fennell and McAdams, the above theorems are better understood in their inverted form, which takes the focus off of the negative or impossibility result and puts the focus on the assumptions.70 Moreover, Fennell and McAdams attribute the emphasis on the original form of the theorem as connected with the conservative political valence of such negative or impossibility result, as opposed to the inverse, which invites an inquiry into situations where the theorem’s assumptions do not hold, which they argue is more appealing to liberals.71

Thus, as applied to the reverse MM theorem, Fennell and McAdams’ analysis suggests several reasons why the reverse MM theorem might not have caught on. First, that reverse theorems or inverted theorems are uncommon if not completely unknown in the law. The reverse MM theorem is, of course, such an inverted theorem. Moreover, the reverse MM theorem in its original forms says little about law—or at least little that is likely to appeal to lawyers—since it implies that transactional lawyers are wasting their time and their clients’ money. If the MM theorem is accurate, then lawyers are just transaction costs and add no value for their clients. That is not a theorem that lawyers (or legal academics) are likely to embrace. Finally, the MM theorem (as well as the reverse MM theorem) would seem to have little political valance, which would eliminate the ideological motivations that Fennell and McAdams credit for raising the profiles of their original, uninverted examples.


Sixty years ago, Professors Modigliani and Miller unveiled their capital structure irrelevancy theorem and revolutionized financial economics with their “bombshell assertion” that under certain idealized assumptions the total value of a firm was independent of its capital structure. Although their theorem has made little inroad into law, many ideas that have developed out of their fundamental insight—that capital structure can affect firm value only through the original MM theorem’s assumptions—are today part of the canon of foundational legal ideas, such as informational asymmetries and agency costs. However, the failure to recognize the many legal settings where the reverse MM theorem can be applied and the numerous issues it can illuminate has deprived legions of lawyers of a powerful analytical framework. Explicitly incorporating the reverse MM theorem into legal analysis and giving it a prominent place in the legal canon will help legal academics, practicing lawyers, and judges all perform their work better. That is because much legal work involves designing and executing value-enhancing capital structures, and the reverse MM theorem provides a roadmap for doing so.

  1. Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporate Finance and the Theory of Investment, 48 Am. Econ. Rev. 261 (1958) [hereinafter Modigliani & Miller, Capital
  2. Schools Brief: Unlocking Corporate Finance, Economist, Dec. 8, 1990, at 81 [hereinafter Schools Brief; J. Fred Weston, What MM Have Wrought, 18 Fin. Mgmt. 29, 29 (1989) [hereinafter Weston, Wrought ]
  3. Peter L. Bernstein, Capital Ideas: The Improbable Origins of Modern Wall Street 174 (1992) [hereinafter Bernstein, Capital Ideas]. Modigliani and Miller jointly authored two more classic articles on the irrelevancy of capital structure. Franco Modigliani & Merton H. Miller, Dividend Policy, Growth and the Valuation of Shares, 34 J. Business 411 (1961) [hereinafter Modigliani & Miller, Dividends](arguing under certain idealized conditions that dividend policy had no impact on firm value); Franco Modigliani & Merton H. Miller, Corporate Income Taxes and the Cost of Capital: A Correction, 53 Am. Econ. Rev. 433 (1963) [hereinafter Modigliani & Miller, Correction](correcting calculations of value of tax shield provided by corporate debt when there is a corporate income tax).
  4. The few explicit references in the legal literature that I am aware of are William W. Bratton & Simone M. Sepe, Shareholder Power in Incomplete Markets 15-17 (Inst. Adv. Studies in Toulouse, Working Paper, Nov. 1, 2017), https://www.iast.fr/sites/default/files/IAST/conf/law/bratton.pdf; Claire Hill, Securitization: A Low-Cost Sweetener for Lemons, 74 Wash. U. L.Q. 1061, 1084-1106 (1996); Peter H. Huang & Michael S. Knoll, Corporate Finance, Corporate Law, and Finance Theory, 74 S. Cal. L. Rev. 175 (2000); Michael Knoll, Taxing Prometheus: How the Corporate Interest Deduction Discourages Innovation and Risk Taking, 38 Vill. L. Rev. 1461, 1467 n.24 (1993); Michael S. Knoll & Daniel M.G. Raff, A Comprehensive Theory of Deal Structure: Understanding How Transactional Structure Creates Value, 69 Tex. L. Rev. 35 (2010) [ hereinafter Knoll & Raff, Comprehensive]; Kimberly D. Krawiec, Derivatives, Corporate Hedging, and Shareholder Wealth: Modigliani-Miller Forty Years Later, 1998 U. Ill. L. Rev. 1039, 1058-78 (1998).
  5. See, e.g., Ward Farnsworth, The Legal Analyst: A Toolkit for Thinking about the Law (2007) (listing and explaining more than thirty standard legal moves across economics, philosophy, psychology and other fields, but not including MM).
  6. Ronald H. Coase, The Problem of Social Cost, 3 J. L. & Econ. 1 (1960).
  7. The development of the MM theorems in the context of contemporary practice and academic understanding is colorfully described by Bernstein, Capital Ideas, supra note 3, at 163-80.
  8.  Schools Brief, supra note 2, at 82.
  9. Stephen Ross, Randolph Westerfield, Jeffrey Jaffe & Bradford Jordan, Corporate Finance 497 (11th ed. 2016) [hereinafter Ross et al., Corporate Finance].
  10. The implied return on equity is the inverse of the price-earnings ratio or the earnings-price ratio. According to Miller, at the time they were working on their first article, interest rates on corporate debt were around three to five percent, whereas the cost of equity capital ran from fifteen to twenty percent. Merton H. Miller, The Modigliani-Miller Propositions After Thirty Years, 2 J. Econ. Persp. 99, 100 (1988) [hereinafter Miller, Thirty].
  11. Bernstein, Capital Ideas, supra note 3, at 167.
  12. Modigliani & Miller, Capital, supra note 1.
  13. Five years later, MM made a similar claim about dividend policy. Modigliani & Miller, Dividends, supra note 3.
  14.    MM derived two more theorems from MMI. MMII describes the relationship between leverage and the required return on equity. MMIII holds that the weighted average cost of capital to the firm is independent of capital structure.
  15. James R. Vertin, Editorial Board Commentary, 20 CFA Dig. 56, 57 (1990) (appended to abstract of Weston, Wrought and recommending that article to subscribers because of Weston’s “comprehensive review of the research that flowed from [MM’s] bombshell assertions”).
  16. Ross et al., Corporate Finance, supra note 9, at 505. In their original article, MM drew an analogy to milk. Although cream sells for more than whole milk, which in turn sells for more than skim milk, a dairy farmer cannot increase the value of the milk by separating whole milk into cream and skim milk. Modigliani & Miller, Capital, supra note 1, at 279-80.
  17. The journal that published MM’s original article, the American Economic Review, published five critiques and a brief sur-reply that Miller credited with publicizing MM’s methods and results. Bernstein, Capital Ideas, supra note 3, at 175.
  18. Id. at 174-77.
  19.  See id. at 177-80.
  20. See id. at 181-269.
  21. Arbitrage is the simultaneous purchase and sale of the same asset (or cash flow stream) in two different markets to take advantage of price differences. Profit-seeking arbitrageurs tend to eliminate arbitrage opportunities forcing prices in separate markets to equalize. Economists use arbitrage arguments to price an asset (the price of which is unknown) in terms of a second asset (the price of which is known).
  22.  E.g., Hal R. Varian, The Arbitrage Principle in Financial Economics, 1 J. Econ. Persp. 55 (1987).
  23.  Much of that work was done by Jack L. Traynor, William F. Sharpe, John Lintner and Jas Mossin.
  24. Fischer Black & Myron Scholes, The Pricing of Options and Corporate Liabilities, 81 J. Pol. Econ. 637 (1973).
  25.    Schools Brief, supra note 2, at 82 (quoting Robert Merton).
  26.    Miller, who continued to work on capital structure during the 1960’s and 1970’s, was a notable exception to this trend. See, e.g., Merton H. Miller, The Corporate Income Tax and Corporate Financial Policies, in Stabilization Policies 381 (1963).
  27.    Miller, Thirty, supra note 10, at 100.
  28.    Id.; see also Bernstein, Capital Ideas, supra note 3, at 176-80; Clifford W. Smith, Jr., The Theory of Corporate Finance: A Historical Overview, in The Modern Theory of Corporate Finance 3, 4 (Clifford W. Smith ed., 2d ed. 1990).
  29.    The reverse MM theorem is the contrapositive of the MM theorem. The contrapositive of a theorem “if A, then B,” is “if not B, then not A.” If a theorem is true, its contrapositive must be true. The reverse MM theorem adds economic content because capital structure must affect value through the MM assumptions (not merely because some assumptions do not hold).
  30.    Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, 3 J. Fin. Econ. 305 (1976) [ hereinafter Jensen & Meckling, Agency].
  31. Stephen Ross, The Determination of Financial Structure: The Incentive Signaling Approach, 8 Bell J. Econ. 23 (1977).
  32. The most well-known of Miller’s solo work on taxation and capital structures is Miller’s presidential address to the American Finance Association, which was published as Merton H. Miller, Debt and Taxes, 32 J. Fin. 261 (1977).
  33. E.g., Clifford Smith, Charles Smithson, & D. Sykes Wilford, Financial Engineering: Why Hedge?, in Handbook of Financial Engineering 126 (Clifford Smith & Charles Smithson eds., 1990).
  34. For examples in the legal literature where the reverse MM theorem is explicitly drawn upon, see sources cited in supra note 4.
  35. The present value of the payments on a capital lease cover the cost of the equipment less the equipment’s expected residual value plus the lessor’s return. A capital lease, which is a financing technique, stands in contrast to a short-term or operating lease, such as renting a car while on vacation, which is typically for convenience. Operating leases can be understood through the reverse MM theorem as they avoid the transaction costs in buying and selling the leased item.
  36. The tax analysis below is for the tax law before it was amended by the Tax Cuts and Jobs Act, Pub. L. No. 115-97, 131 Stat. 2054 (2017). Although some details, such as tax rates, change, the preference for long-term leases remains.
  37. The aircraft frame has an economically useful life of twelve years but is depreciated over seven years using the declining balance method. See IRS, How to Depreciate Property (IRS Publication 946), at 106 (2016).
  38. However, if an airline (or any U.S. taxpayer) has a net operating loss for the year, the government does not typically provide a tax refund. Instead, the taxpayer receives a net operating loss (NOL) carryforward. NOLs are not worth as much as current deductions because they can be used only if the taxpayer has positive income. See I.R.C. § 172(b)(1)(A) (2012).
  39. The safe harbor was found in I.R.C. § 168(f)(8) and was enacted in title II, § 2(a) of the Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, 95 Stat. 172, 203. For a critical, contemporary discussion of safe harbor leasing, see Alvin C. Warren & Alan J. Auerbach, Transferability of Tax Incentives and the Fiction of Safe Harbor Leasing, 95 Harv. L. Rev. 1752 (1982).
  40. Safe harbor leasing was repealed in 1982 as part of the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97–248, 96 Stat. 324.
  41. Accordingly, lease rates today also reflect airlines’ reputations for maintenance, and the agreed upon use of the aircraft because how the aircraft is used—length of flight, altitude, etc.—impacts the aircraft’s and its engines’ residual values.
  42.  See Ira M. Millstein, The Activist Director (2017) [hereinafter Millstein, Director].
  43.   Id. at ix (italics in original).
  44. When a structure is adopted for non-efficiency reasons, the reverse MM theorem can be used to estimate the efficiency cost of not choosing the most efficient solution.
  45. For a description of the Cravath model and a discussion of its economic rationale, see William D. Henderson, The “Cravath” System: Excerpts from the Legal Profession Blog, Teaching Legal Ethics (2008), www.teachinglegalethics.org/sites/default/files/Henderson-CravathSystem.pdf [ https://perma.cc/3QZN-X3TQ].
  46. See Ronald J. Gilson, Value Creation by Business Lawyers: Legal Skills and Asset Pricing, 94 Yale L.J. 239 (1984) [hereinafter Gilson, Value].
  47.  Id. at 253-56.
  48.  Id. at 303-06.
  49.  Knoll & Raff, Comprehensive, supra note 4.
  50.  Id. at 48. Such a lawyer would also be less likely to fall into the trap of selecting a solution that resolves a particular problem within one silo, but inadvertently causes a larger problem within another silo. Because the reverse MM theorem explicitly invites tradeoffs across silos, practitioners are encouraged to examine the impact of a structure across all four silos.
  51.  William M. Sullivan et al., Educating Lawyers: Preparation for the Profession of Law 126-61 (2007) [hereinafter Carnegie Report]
  52. Knoll & Raff, Comprehensive, supra note 4, at 48.
  53.  There are more complex methods as well.
  54.  See generally James Freund, Anatomy of a Merger: Strategies and Techniques for Negotiating Corporate Acquisitions (1975) [hereinafter Freund, Anatomy]; Christopher S. Harrison, Make the Deal: Negotiating Mergers and Acquisitions (2016).
  55.  Gilson, Value, supra note 46, at 267-94.
  56.  Freund, Anatomy, supra note 54, at 229 (“I’m willing to bet my briefcase that lawyers spend more time negotiating “Representations and Warranties of the Seller” than any other single article in the typical acquisition agreement.”).
  57.    Gilson, Value, supra note 46, at 271-73.
  58. The competitive aspect of negotiating representations and warranties is exacerbated by the usual practice of negotiating only after the price and acquisition method are set.
  59.  Interest that accrues from the date of judgment until payment is post-judgment interest. Jurisdictions often have different rules for prejudgment and post-judgment interest and it is common to have a fixed statutory rate or formula for post-judgment interest even if there is not a similar rule for prejudgment interest.
  60.  Gorenstein Enterprises v. Quality Care, 874 F.2d 431 (7th Cir. 1989) (awarding prejudgment interest at defendant’s cost of unsecured borrowing); Jeffrey Colon & Michael S. Knoll, Prejudgment Interest, in Litigation Services Handbook: The Role of the Financial Expert 16.1-14 (Roman L. Weil, Daniel G. Lentz & Elizabeth A. Evans eds., 6th ed. 2017) [hereinafter Colon & Knoll, Prejudgment]; Michael S. Knoll, A Primer on Prejudgment Interest, 75 Tex. L. Rev. 293 (1996) [hereinafter Knoll, Primer]; James M. Patel, Roman L. Weil, & Mark A. Wolfson, Accumulating Damages in Litigation: The Roles of Uncertainty and Interest Rates, 11 J. L. Stud. 341 (1982) [hereinafter, Patel et al., Accumulating]. Proponents of the coerced loan theory recognize that defendant’s unsecured borrowing rate will not fully compensate plaintiff if plaintiff is an individual and the debt constitutes a large portion of plaintiff’s wealth. If plaintiff cannot readily insure against or sell the claim, then the risk of nonpayment will likely impact plaintiff’s consumption. In such cases, defendant’s borrowing rate will not fully compensate plaintiff for having funds tied up with defendant. Conversely, when plaintiff is a public corporation, or the claim is small relative to wealth, defendant’s unsecured borrowing rate is sufficient to compensate the plaintiff. Colon & Knoll, Prejudgment, at 16-17; Knoll, Primer, at 345-47; Patel et al., Accumulating, at 354-62. The above can be understood as applications of the reverse MM theorem. When informationally imperfect markets and market frictions make it impractical for plaintiff to sell a claim for its expected value, a plaintiff might require extra compensation to compensate for delay.
  61.  See generally Elizabeth A. Evans & Roman L. Weil, Ex Ante Versus Ex Post Damages Calculations, in Litigation Services Handbook: The Role of the Financial Expert 5.2-23 (Roman L. Weil, Daniel G. Lentz & Elizabeth A. Evans eds., 6th ed. 2017).
  62.  Of course, the reverse MM theorem is about economic value or efficiency; it says nothing about non-economic values, such as distributional fairness. Accordingly, if an award is made not to maximize efficiency, but with a nod towards other values, such as distributional fairness, the reverse MM theorem provides a framework through which to examine the efficiency costs of pursuing other values.
  63.  Aristotle, Politics, bk. I, ch. 11, reprinted in The Complete Works of Aristotle 1990 (Jonathan Barnes ed., 1984) (describing how the philosopher Thales, when reproached for his poverty, used his knowledge of meteorology to predict a bumper olive crop; Thales then rented all of the olive presses at a reduced rate months before the harvest; when the harvest came in as Thales anticipated, Thales rented out those presses at a substantial profit).
  64. Freund, Anatomy, supra note 54, 229-84 (representations and warranties); Martin D. Ginsburg & Jack S. Levin, Mergers, Acquisitions and Buyouts ¶104 (2001) (deal structuring).
  65.  See Roger Fisher, William L. Ury, & Bruce Patton, Getting to Yes: Negotiating Agreement Without Giving In (2011). Although some other authors view the Getting to Yes authors as having gone too far in the cooperative direction, the authors of Getting to Yes were early writers on negotiation to recognize the importance of the cooperative aspect.
  66.  E.g., James C. Freund, Smart Negotiating: How to Make Good Deals in the Real World (1992); G. Richard Shell, Bargaining for Advantage (2006).
  67.  Lee Anne Fennell & Richard H. McAdams, Inverted Theories (University of Chicago Coase-Sandor Institute for Law & Economics, Working Paper No. 648, 2017), https://ssrn.com/abstract=3017437 [https://perma.cc/5CCX-2VDG]. If a theorem is of the form “if A, then B,” the inverse of the theorem holds “if not A, then not B.” In contrast with the contrapositive, which is true if the theorem is true, the inverse is not true simply because the original theorem is true.
  68.  Id. at 4-5.
  69.  Id. at 5-7.
  70.  Id. at 1-2.
  71.  Id. at 30.

Political Control Over Public Communications by Government Scientists

* Lisa Randall is the Frank B. Baird, Jr. Professor of Science at Harvard University. Cass R. Sunstein is the Robert Walmsley University Professor at Harvard University.

Recent years have seen a great deal of controversy over political control of communications by government scientists. Legitimate interests can be found on both sides of the equation. Clearly there is a strong public interest in the free flow of scientific information. On the other hand, political leaders in any administration might need advance notice of what government scientists plan to say, and they might also seek to control the timing of their presentations and announcements. Although many important questions remain to be addressed, this essay offers a first step towards a framework that is meant to accommodate these interests and that answers a series of concrete questions about when, and what kind of, political control is appropriate. The framework allows advance notice to political officials, including the White House, and also allows control over timing, without allowing censorship of the substantive content of scientific information.

I. The Problem

In a free society, scientists—even those working for the government—should have the right to communicate with the public. But government employees have long been subject to restrictions on what they can say and when they can say it, even when simply presenting scientific results.1 In recent years, both Democratic and Republican administrations have failed to develop clear principles governing political control of communications from government scientists, with potentially detrimental consequences to our nation. Our goal here is to suggest initial steps to fill this gap and answer most questions in a brief space. We emphasize that our framework is preliminary and that it leaves many open questions and a few gray areas. But in the absence of some kind of framework, we risk ad hoc judgments, inconsistency, excessive political control, and loss of the benefits that ready access to scientific information can provide.

During the Obama Administration, the effort to develop such principles produced intense internal and external controversy.2 As Administrator of the White House Office of Information and Regulatory Affairs, one of the present authors (Sunstein) was directly involved in the internal debates. The defining moment came in December 2010, when Science Advisor John Holdren tried to synthesize the consensus within the White House with four defining principles.

  1. In response to media requests on scientific or technological issues, agencies should offer an “objective and nonpartisan” spokesperson.
  2. Federal scientists may speak to the media and the public about scientific and technological matters based on their official work, with appropriate coordination with their immediate supervisor and their public affairs office.
  3. In no circumstance may public affairs officers ask or direct Federal scientists to alter scientific findings.
  4. Mechanisms should be devised to resolve disputes about whether or not to proceed with public information-related activities.3

Each of these principles deserves support, but they leave many unanswered questions. Who, exactly, is an objective and nonpartisan spokesperson? What counts as “appropriate coordination” with a public affairs office? What kinds of “disputes about whether or not to proceed” are even legitimate, and what would “mechanisms” look like?  Even if public affairs officers may not “alter” scientific findings. do the four principles allow such officers to forbid disclosure of such findings? How does an agency treat data not originating within its organization? And how do we guarantee that set policies are actually implemented?

In response to this guidance, a number of government agencies developed implementation policies, some of which tried to address these issues through formal, publicly available documents or through other informal practices.4 Even so, critical gaps remain in understanding policy and practice. Under President Donald Trump, the White House has yet to announce its own principles, and many people are concerned by what they see as a precipitous trend toward severe restrictions on communications from government scientists.5 We think that a few important distinctions, not yet part of the debate, can cut through the fog – and show how to accommodate legitimate concerns of both government scientists and political officials.

II. The Concerns

Communications offices and other public officials—in, say, the White House or the office of a cabinet head—are often concerned about the potentially negative consequences of communications between government scientists and the public. This concern is sometimes legitimate. Issues range from those with obvious political valence to those that are more abstract; they may involve avian flu, particulate matter, asteroid collisions, artificial intelligence, distracted driving, the origins of life, or nuclear material, for example. Government officials who oversee federal agencies might ask for one of four things from government scientists.

A notation before we begin: we deliberately phrase the concerns in abstract terms, without reference to particular cases. Claims about any such cases will be contestable. But for identifiable reasons, the concerns are manifested in numerous real-world controversies.6

  1. Public officials might insist on advance notice of public communications from government scientists. They might fear surprises. They might not want to have to address questions from the press or the public without having time to prepare. They might need to work with scientists to learn what to say and how to say it.
  2. Public officials might want to control the timing of those communications. A disclosure of a scientific finding might disrupt a policy announcement scheduled for that same day. Perhaps the disclosure would distract attention from the announcement or be in some tension with it. For reasons that are not self-evidently illegitimate, political officials, including the White House communications team or even the president personally, might want the announcement to occur only after some kind of specified delay.
  3. They might want to control the content of those communications, in extreme circumstances by forbidding their disclosure altogether (a “gag rule”). Such restrictions might range from political officials who insist that government scientists describe their findings in a particular way, perhaps to ensure clarity and to avoid confusion or to more troublesome cases in which officials think that the disclosure of the findings, even if valid, risk jeopardizing some identifiable political position or goal. For that reason, they might tell government scientists that they may not speak publicly at all.

To be more concrete: Political officials might believe that a new finding—for example, involving the carcinogenic properties of some commonly used product, or other health risks associated with using it—might create public alarm. They might judge that the finding is too preliminary, or in conflict with other findings. They might believe that even if the finding is neither preliminary nor contested, it might produce a kind of panic, unjustified by the science at such.7 Alternatively, they might believe that some finding has an obvious or potential policy implication—say, that greenhouse gases should be regulated, that some chemical should be banned, or that the argument for some proposed law, opposed by the President, is actually quite strong. Political officials might want to prevent the public announcement of findings with such unwelcome implications, which may disrupt ongoing debates, and give fuel to political adversaries.

  1. They might want to control what agency employees say, even when not speaking on the agency’s behalf. It is true that some high-level public officials believe that whenever government employees speak in public, they speak for government; they never speak in their private capacity. And that is undoubtedly true for some officials (such as the Secretary of State and the Secretary of Defense). But by tradition, government scientists have sometimes had the authority to say that they do not speak on behalf of their agency.8 Even so, the White House, or offices of Cabinet heads, might want to limit what they say in public.

For its part, science that comes from the government can be categorized in three ways:

  1. Policy relevance. Some scientific findings are tightly connected with high-level policy debates. For example, a government scientist might conclude that the climate change problem is likely to be far more (or less) serious than existing research suggests, in the sense that anticipated warming, by 2100, will be higher (or lower) than previously projected.9 Or a government scientist might conclude that some chemical, now in widespread use, poses serious health risks for children; public disclosure of that finding will predictably produce a market reaction, with economic consequences, and trigger a demand (and perhaps a legal requirement) for regulatory action.
  2. No policy relevance. Some scientific findings have no evident connection with high-level policy debates. For example, a government scientist might make some new finding about black holes, or might offer fresh information about a new species of dinosaur or bird. In such cases, let us simply stipulate that public disclosure of the relevant findings will not raise issues or produce concerns that could possibly be of interest to policymakers.
  3. Potential policy relevance. Some scientific findings might seem to government scientists and to most people to have no connection with high-level policy debates, even when those who work in the White House or an office of an official in the Cabinet might not find that entirely clear. In fact, this kind of disconnect—between political leadership and scientists—is quite common. For example, some findings with respect to dwindling fish populations, ocean acidification, or the spread of influenza might seem technical, but they might be invoked in debates about policy issues.

III. Ten Cases

With these distinctions in mind, we can identify ten kinds of cases, five of which seem straightforward.

A. Straightforward Cases

  1. There is no reasonable objection when political officials merely seek advance notice of a scientific finding that has policy relevance. Both communications offices and policy officials can legitimately contend that in order to do their jobs, they need to have a clear sense of scientific announcements that bear on policy. The issue here is only how far in advance the notice should be.
  2. Political officials may appropriately control the timing of release of a scientific finding with manifest policy relevance. Officials can legitimately argue that they are entitled to control the policy agenda and that it is appropriate to ensure that scientific announcements from government employees do not compromise that agenda. Outside of the most unusual circumstances, there is an important qualification: There should be a fixed limit to the delay.
  3. If a scientific finding has potential policy relevance, political officials can appropriately seek advance notice of its disclosure. Officials should be entitled to have a clear sense of scientific announcements that might bear on policy discussions, even if we emphasize the word “might.”
  4. If a scientific finding has even potential policy relevance, it remains legitimate for political officials to control the timing of its disclosure. The considerations in point 2 above apply here as well.
  5. No democratic government should seek to control the content of disclosure of scientific findings that lack policy relevance. Such findings might be intriguing, controversial, or disturbing, but policy officials, not versed in science, have no business altering them in any way.

B. Difficult Cases

Five cases might be viewed as more controversial, and so we approach them with questions, to which we offer our preferred answers:

1. Is it appropriate for public officials to seek advance notice of disclosure of scientific findings without policy relevance?

At first glance, the answer would seem to be no. Why should officials receive advance notice of findings that lack policy relevance? But there are two complications, which make a negative answer too simple. The first is that officials might not trust the scientists’ judgment about policy relevance; they might want advance notice of a very broad set of disclosures in order to test that judgment and to ensure that it is reasonable or right. The second complication is that some such findings might attract public attention, which means that communications offices and policy officials might want advance notice. For some and perhaps many agencies, it would be simplest to have no clearance process for scientific findings that fall in this category. But a more general clearance process might be justified, so long as it is defended and administered with the single goal of preventing surprises and allowing preparation for questions from the public.

2. Is it appropriate for public officials to seek to control the timing of disclosure of scientific findings without policy relevance?

At first glance, the answer again would seem to be no. By hypothesis, the disclosure will not produce real concerns from the standpoint of officials themselves. But if the findings are potentially newsworthy and might attract public attention, it would not necessarily be inappropriate for public officials to say: tomorrow, not today. Again, the debate would center on what the timing should be.

3. Is it ever appropriate for public officials to forbid the announcement of scientific findings, or to prohibit government scientists from presenting their work in public?

At first glance, the answer to this question is also no. Recall, however, that the principles announced during the Obama Administration do not seem to offer an answer. They forbid political interference with the substance of the science, with the ban on alteration of scientific findings. But they do not clearly forbid political officials from saying: you may not appear in public, or you may not say that in public.10

In some cases, such prohibitions might be legitimate. Suppose, for example, that political officials want scientists to do science—and not to travel to various places, to appear on panels, or to become public figures. Within any administration, the public appearances of high-level officials are policed (it is to be hoped for legitimate reasons). If controls on public appearances are based on a neutral principle (“do your job”), they are unexceptionable.

The most challenging cases arise when a ban on a public announcement grows out of some kind of political uneasiness with its content. If a scientist will say something in tension with a political commitment of the administration—for example, that genetically modified foods are dangerous, that secondhand smoking is not so dangerous, that depletion of the ozone layer is not such a problem—political officials might say: we will not alter what you say, but we do not want you to say it. It is not entirely implausible to suggest that while there should be a flat rule against political interference with content, there should be no such flat rule against political interference with public appearances or announcements.

We think that in a free society, such interference is clearly legitimate only when it is based on a neutral principle, and that it should be presumed to be illegitimate if it is based on political uneasiness with its content. In such cases, a prohibition on public appearances or announcements should be treated as analogous to interference with content, and should be governed by similar principles—to which we now turn.

4. Is it appropriate for public officials to control the content of disclosure of scientific findings with policy relevance?

This may well be the most important and challenging question. We think that the answer depends on the meaning of “control the content.”

(a) It would never be appropriate for policymakers to direct government scientists to misreport or misrepresent the science. Policymakers have no business distorting the evidence and the facts. This conclusion is consistent with that offered during the Obama Administration.11

(b) It can be appropriate for policymakers to direct government scientists not to venture into policymaking domains that do not involve the science, strictly speaking. If policymakers want to restrict government scientists to science, and to direct scientists not to offer judgments about regulation or legislation, they are entitled to do that so long as there is no conflict with their scientific integrity.

(c) So long as there is no violation of (a), it would be appropriate for communications offices and policy officials to consult with scientists to ensure clarity and intelligibility, and to work to prevent public misunderstandings of what the science shows. This might be justified (for example) to ensure against excessive or unjustified public fear. It is important, however, that a consultation is just that, and not an order to government scientists with respect to science itself. If the question is how to present the science accurately, scientists should have the final say, so long as the question is genuinely limited to science, broadly applied.

(d) Apart from (b) and (c), there should be a very strong presumption against political interference with the content of scientific communication by government scientists, or of scientists’ decisions about how to present their results. We recognize that some circumstances can test the strength of this presumption and that reasonable people might disagree on when, if ever, it might well deserve special treatment. More difficult examples would arise when a finding might have an adverse effect on some portion of the economy, or might conflict, in some sense, with the administration’s policy positions and goals. Policymakers might not welcome disclosure of new evidence that some widely used product might be carcinogenic, not because they distrust the science, but because they believe that the evidence might create an excessive public reaction that will have serious adverse consequences on millions of people. In imaginable circumstances, a desire to avoid an excessive public reaction could justify a stronger role for policymaking officials.

It would of course be entirely acceptable for policymakers to present their own interpretation of how to construe results, or of how they believe those results should inform policy. So too, policymakers might legitimately disapprove of a presentation because they think it has not been suitably qualified. It is also critical that agencies dealing with scientific topics include scientists with expertise, and do not exclude them on the basis of prior association with the agency under previous administrations.

5. Is it appropriate for public officials to control the content of disclosure of scientific findings with potential policy relevance?

The answer is the same as for (9). To be sure, we are speaking here of merely potential, rather than clear, policy relevance, but the relevant considerations are not different.

III. Conclusions

The following matrix summarizes our conclusions:

Table 1

  Policy Relevance Potential Policy Relevance No Policy Relevance
Advance Notice Yes Yes A qualified no
Control Timing Yes (with deadline) Yes (with deadline) A qualified no
Suggest (but not require) Content Changes Yes, but with limitations, e.g., for clarity and with the understanding that scientists can reject changes that they believe incorrectly alter or suppress scientific content Yes, but with limitations, e.g., for clarity and with the understanding that scientists can reject changes that they believe incorrectly alter or suppress scientific content No

Important questions remain, such as how to guarantee information flows in accordance with the foregoing guidelines. Our hope is that at a minimum, a clear set of principles can provide a framework under which any disputes can be settled or at least addressed in a systematic and well-defined fashion. Another question is whether and when government employees are entitled to speak in their individual capacity, even when disagreeing with the policy of the agency to which they belong. This is not our central concern here, and it is too complex to resolve in this brief Essay, but agencies should work to develop clear guidelines so that their employees can have clear expectations.

Free societies are deeply skeptical, and properly so, about any efforts to control the flow of scientific information, even when that information comes from government employees. We have attempted to vindicate that skepticism here, while also identifying the most legitimate bases for political coordination and intervention. Gray areas remain, but we are hopeful that the foregoing categories and distinctions provide a promising start toward achieving the ideal of maintaining the most transparent and robust uses of science in an open and democratic society.

  1. For the most elaborate public statement, see Memorandum from John P. Holdren, Dir. of the Off. of Sci. and Tech. Pol’y, to the Heads of Exec. Dep’ts & Agencies (Dec. 17, 2010), http://obamawhitehouse.archives.gov/sites/default/files/microsites/ostp/scientific-integrity-memo-12172010.pdf [http://perma.cc/H6VA-TU59].
  2. For one view, see The White House’s Scientific Integrity Directive, Union Concerned Scientists, http://www.ucsusa.org/our-work/center-science-and-democracy/promoting-scientific-integrity/SI-directive.html [http://perma.cc/K9UU-FD7Z]. Additionally, consider some of the statements from agencies. E.g., Communications Policy Language: Samples from a Variety of Agencies and Departments, Off. Sci. & Tech. Pol’y, http://obamawhitehouse.archives.gov/sites/default/files/microsites/ostp/SI-workshop-communications-guidance.pdf [http://perma.cc/4N6C-AAXN].
  3. See Holdren, supra note 1, at 2-3.
  4. The public documents may be found online. Scientific Integrity, Off. Sci. & Tech. Pol’y, http://obamawhitehouse.archives.gov/administration/eop/ostp/library/scientificintegrity [http://‌perma.cc‌‌/R29Q-WVBE].
  5. See, e.g., Dina Fine Maron, Trump Administration Restricts News from Federal Scientists at USDA, EPA, Sci. Am. (Jan. 24, 2017), http://www.scientificamerican.com/article/trump-administration-restricts-news-from-federal-scientists-at-usda-epa/ [http://perma.cc/L6UU-84FD]; Juliet Eliperin & Brady Dennis, Federal Agencies Ordered to Restrict their Communications, Wash. Post (Jan. 24, 2017), http://www.washingtonpost.com/politics/federal-agencies-ordered-to-restrict-their-communications/2017/01/24/9daa6aa4-e26f-11e6-ba11-63c4b4fb5a63_story.html [http://perma.cc/MAD3-STF9‌?type‌‌=image]; Angela Chen, Trump Silences Government Scientists with Gag Orders, Verge (Jan. 24, 2017, 3:58 PM), http://www.theverge.com/2017/1/24/14372940/trump-gag-order-epa-environmental-protection-agency-health-agriculture [http://perma.cc/U9ME-W8QZ].
  6. See, e.g., Kenneth R. Foster et al., Phantom Risk (1993) (exploring the public concerns and tort litigation that results from preliminary, inadequate, or inconclusive evidence of risks); Kenneth L. Mossman, Radiation Risks in Perspective (2007) (exploring the public overestimation of radiation risks); Timur Kuran & Cass R. Sunstein, Availability Cascades and Risk Regulation, 51 Stan. L. Rev. 683 (1999) (tracing the cases of excessive public fear in response to scientific findings).
  7. On why this might be so, see Cass R. Sunstein, Probability Neglect: Emotions, Worst Cases, and Law, 112 Yale L.J. 61 (2002) (arguing that people tend to focus on the adverse outcome, not on its likelihood).
  8. The National Science Foundation has made this explicit in the context of NSF scientists and recipients of federal funds. See NSF Public Communications & Media Policy, Nat’l Sci. Found, http://www.nsf.gov/news/policies_for_media.jsp [http://perma.cc/LNS3-W2F5] (“NSF-funded scientists and NSF staff have the fundamental right to express their personal views, provided they specify that they are not speaking on behalf of, or as a representative of, the agency but rather in their private capacity.”).
  9. On public reactions to such findings, see Cass R. Sunstein et al., How People Update Beliefs about Climate Change: Good News and Bad News, 102 Cornell L. Rev 1431 (2017) (arguing that people who are not sure human-made climate change is occurring and oppose an international climate agreement update their beliefs in response to unexpected good news but not unexpected bad news, and people who strongly believe human-made climate change is occurring and favor an international climate agreement update their beliefs far more in response to unexpected bad news than in response to unexpected good news).
  10. See Holdren, supra note 1.
  11. Id.

An “Unusual Jurisdictional Argument”: The Codifier’s Canon in Ayestas v. Davis

* Student, Yale Law School 2019. I would like to thank Professor Jerry Mashaw for his insights on an early draft; Charlie Seidell for alerting me to this oral argument; and the editors of the Yale Journal on Regulation, especially Rachel Cheong and John Brinkerhoff, for their help developing this piece.

Not every one of a judge’s actions is judicial. Judges also engage in administrative tasks, such as hiring personnel. In Ayestas v. Davis, the Court has been asked to decide a jurisdictional question that rests on whether a particular authority was conferred on judges in their administrative or judicial capacities. This Essay offers a resolution to the jurisdictional issue by looking at the underlying statutory provision. By examining the provision’s codification in the United States Code, interpreted in light of the codifier’s canon, it can be seen that the relevant authority is judicial in nature.


It is the nature of the law that sometimes life or death determinations can hinge on technicalities. Such is the case in Ayestas v. Davis, which was argued before the Court earlier this Term. The question in that case is whether the Fifth Circuit erred in the standard it set for withholding resources to investigate and develop an ineffective-assistance-of-counsel claim in the capital habeas corpus context. Arguing that the Court lacked jurisdiction to decide this issue, the Texas Solicitor General, counsel for the respondent, claimed that the authority conferred by the relevant provision, 18 U.S.C. §3599(f), was conferred to the judge in her administrative capacity, and not her judicial capacity.1 Expressing skepticism toward this argument, Justice Breyer suggested that the placement of the provision among other provisions establishing judicial duties implied that § 3599(f) is also conferred upon the judge in her judicial capacity.2

Is such an argument from placement in the Code legitimate? The Court seems to think so. For example, in Yates v. United States, the Court narrowed the meaning of the word “tangible object” in 18 U.S.C. § 1519, in part by citing the fact that the provisions surrounding it in the Code only dealt with documents and records.3 But the decision in Yates was not uncontroversial. Soon after the decision was handed down, Tobias Dorsey, a former attorney for the House Office of Legislative Counsel, noted that a little-known provision appearing in Title 18—along with a number of other titles—seems to say that courts may not invoke a statutory provision’s placement or caption in the Code as indicative of legislative intent.4 The provision Dorsey pointed to is a legislated canon, a congressional instruction to the courts regarding how they should interpret statutes. That Justice Breyer seems prepared to flout its direction raises deep questions about the relationship between the legislative and judicial branches, including whether Congress can restrict to which tools a judge can reach when seeking to resolve ambiguities in the law.

Given this potential conflict between the Court and Congress, it would be ideal if such invocations of placement in the Code could be reconciled to Congress’s enacted interpretive instruction. In a recent Comment in the Yale Law Journal, I argued that, in fact, they can be.5 I contend that this interpretive rule—which I call the codifier’s canon—is consistent with certain invocations of a provision’s placement. Specifically, the codifier’s canon allows judges to draw interpretive inferences from codifications decisions made by Congress, but blocks off from consideration any editorial changes introduced by the non-legislative codifiers—that is, the Office of the Law Revision Counsel.

Yates, for example, exhibits such a reconcilable invocation—relying upon organizational features in the Code that were deliberated upon by Congress.

In this Essay, I explain how Justice Breyer’s suggested consideration of placement is also legitimate given a proper interpretation of the codifier’s canon. This Essay proceeds in two Parts. Part I briefly explains the codifier’s canon and the potential role of codification in statutory interpretation. Part II then provides an overview of the relevant issues in Ayestas v. Davis, including the context of Justice Breyer’s remarks. It then examines the statutory history, with particular attention to codification, for evidence of legislative intent. As the analysis of Justice Breyer’s comments reveals, by understanding the function of the codifier’s canon—and the role of codification more generally—one can more accurately and legitimately engage in statutory interpretation.

I. The Codifier’s Canon: Learning from Codification

The Court has often struggled with the impact of codification on substantive questions of law. Maine v. Thiboutot6 is one remarkable example. There the dissent and majority sparred over the relevance of a statutory phrase that was modified during an early attempt at codifying the federal laws. As the dissent pointed out, the majority relied on a change introduced by the codifiers to vastly expand the set of rights for which Section 1983 provides a cause of action.7 The change was introduced despite significant effort “to expunge all substantive alterations” resulting from the codification process.8 The fact that such efforts were ultimately unable to prevent the Court from finding the meaning of the statute changes helps to illustrate why Congress saw the need to legislate particular instructions for how the Court should treat elements added by the codifiers. As elaborated below, the codifier’s canon is such an interpretive direction, intended to help courts avoid being misled by editorial decisions that cannot rightfully thought to be expressions of legislative intent.9

The codifier’s canon has been enacted into at least fourteen titles of the United States Code, its language nearly identical in each instance.10 The version in the title at issue in Ayestas is typical: “No inference of a legislative construction is to be drawn by reason of the chapter in Title 18 . . . in which any particular section is placed, nor by reason of the catchlines [captions] used in such title.”11 On its face, the rule construction appears to prohibit entirely the invocation of the captions or placement of a section in the Code, throwing into doubt the argument alluded to by Justice Breyer. While this is the interpretation assumed by some scholars, a careful reading of the provision’s text and its history reveals a much narrower meaning.

The codifier’s canon only appears in positive law titles of the Code.12 These are titles that have been significantly edited and restructured by the codifier’s office and then enacted into law. The process of positive law codification repeals and replaces the law that the positive law title is intended to codify.13 This is in contrast to non-positive law titles, which are mere editorial compilations of enacted law, but not enacted into law themselves.14 Ideally, positive law codification should be done in such a manner so as not to change the meaning of the underlying law in a substantive manner. But that is a herculean task. When deciding where to place a provision in the Code, the codifiers must determine the intentions of Congress when the provisions were enacted—an event that may have occurred decades before. There is a risk that they will make a mistake, resulting in an organizational decision that implies some incorrect meaning. The case of Maine v. Thiboutot,15 discussed above, is a one illustration of these sort of concerns.16

The Members of Congress, when enacting the first titles into positive law, were highly cognizant of this risk.17 For this reason, they added the codifier’s canon to the title in order to direct interpreters not to rely on organizational decisions made by the codifiers during the positive law codification process. But note that this same concern does not apply to amendments to the positive law title. Once a positive law title is enacted, it becomes a statute. Any subsequent change must be in the form of a congressional amendment. Thus, every subsequent amendment to a positive law title includes instructions within the statute itself as to how the amendments should be codified. Enacted into law like any other part of the statutory text, these organizational decisions—including where in the Code the statute should be placed—can legitimately be relied upon as evidence of congressional intent.

This gives rise to a simple rule of thumb: “it is legitimate to cite the placement of a provision in a positive law title so long as the provision was enacted after the title itself was passed into positive law.”18 This rule is reflected in the text of the codifier’s canon. For example, the version of the canon that appears in Title 18 directs that “[n]o inference of a legislative construction is to be drawn by reason of the chapter in Title 18 . . . as set out in section 1 of this Act, in which any particular section is placed, nor by reason of the catchlines used in such title.”19 This rule was enacted as part of a statute that included the full text of Title 18, as prepared by the codifier’s office. The text of Title 18 appeared in section 1 of the enacting statute.

Thus, by pointing to the title “as set out in section 1 of this Act,” rather than using the language “this Title,” the legislated canon references only the version of the title included in the Act itself. Reading the text literally and narrowly, the prohibition on referencing placement and captions thus applies only to invoking these features of the title as first enacted into positive law.20

In other words, the codifier’s canon only prohibits invoking placement or caption decisions made in the context of the positive law codification process. No reference is made to future statutes that direct how amendments to Title 18 should be organized. In the next Part, I apply the codifier’s canon to the law relevant to Ayestas. As I explain, the proper interpretation of the codifier’s canon supports the legitimacy of Justice Breyer’s argument and suggests that Texas’s jurisdictional argument should not prevail.

II. The Judge as Administrator? An “Unusual” Jurisdictional Argument

In this Part, I turn to apply the codifier’s canon to the facts and law of Ayestas. The central question is whether the judge’s authority to grant funds to habeas petitioners for experts and investigators is conferred to her in her judicial or administrative capacity. While seemingly a mere semantic distinction, the consequences are severe for petitioners, as a judge’s decisions to deny funding would be effectively unreviewable if such decisions are determined to be administrative in nature. In the first Section, I outline the relevant law and explain why the question is ultimately one of congressional intent. In the second section, I invoke codification to gain insight into Congress’s understanding the relevant provision. Through the lens of the codifier’s canon, it is clear that Justice Breyer was right to be skeptical of Texas’s jurisdictional argument.

A. A Jurisdictional Boundary: The Administrative and Judicial Capacities of the Court

In 18 U.S.C. § 3599(f), Congress provided that federal courts in post-conviction capital cases involving indigent defendants should fund “investigative, expert, or other services [that] are reasonably necessary for the representation of the defendant, whether in connection with issues relating to guilt or the sentence.” The Fifth Circuit has interpreted the requirement of being “reasonably necessary” as meaning that a petitioner is only entitled to such funding if he or she can demonstrate a “substantial need” for the services, requiring a “substantiated argument, not speculation, about what the prior counsel did or omitted doing.”21 By setting this high bar, the Fifth Circuit broke with the Sixth Circuit, setting a standard that makes it much more difficult for indigent death-row inmates to challenge the effectiveness of their trial lawyers through federal habeas petitions.22

In Ayestas v. Davis, the Court granted certiorari to address whether the Fifth Circuit erred in its demanding interpretation of what “reasonably necessary” means in the context of § 3599(f); but when the case came up for oral argument another issue occupied much of the courtroom discussion. In particular, at least some of the Justices seemed interested in what Justice Breyer referred to as an “unusual jurisdictional argument” raised by the Texas Solicitor General, representing the respondent, Lorie Davis, the Director of the Texas Department of Criminal Justice.23 In the respondent’s brief, Texas argued that the denial of funding under § 3599(f) could not be reviewed by the Court because it was a nonjudicial “administrative” order.24

The jurisdictional argument was not argued in the court below, and no other circuit court has addressed this precise question. However, at least seven circuits have addressed a similar argument, ruling in such a manner as to give credence to Texas’s claim. When jurisdictional issues are raised, these circuits have held that a district court’s determination with regard to Criminal Justice Act (CJA) fee compensation, under 18 U.S.C. § 3006A, is not appealable.25 That conclusion is based on a judgment that such a decision is a mere “administrative act,” not a “judicial decision.”26 In distinguishing the decision as administrative, the courts pointed to two key indicia: (1) the decision is made by the district court through a “non-adversarial” process;27 and (2) the CJA provided for a particular appeals process, namely a form of “minimal review by the chief judge of the circuit.”28 In this way, the setting of compensation under the CJA does seem to mirror many other, more clearly administrative decisions made by district judges and subject to the approval of the chief circuit judge, such as the assignment of temporary bankruptcy referees29 and the hiring of law clerks.30

The circuit courts’ decisions were based on an interpretation of 28 U.S.C. § 1291 as granting jurisdiction only for judicial—as opposed to administrative—decisions.31 The Supreme Court has ruled similarly with regard to its own jurisdiction on Article III grounds, namely that “[w]hen judges perform administrative functions, their decisions are not subject to [the Supreme Court’s] review.”32 The Supreme Court had weighed similar indicia as the lower courts in judging whether a particular decision is made in a judicial or administrative capacity. Specifically, the Court has looked to whether a decision is: (1) made through an ex parte decision process;33 and (2) subject to an appeal process other than the traditional judicial hierarchy, such as review by the Secretary of Treasury34 or the Secretary of War.35

Both of these indicia have constitutional valences. The Court has indicated that a decision cannot validly be an exercise of “judicial power” if not acting on issues “presented in an adversary context.”36 Similarly, with regard to non-traditional appeals processes, the Court has suggested that there would be “constitutional questions” raised by an “arrangement” in which “an entity not wielding judicial power might review the decision of an Article III court.”37 But while these issues have driven the Court to invoke constitutional avoidance in determining whether a particular duty is administrative or judicial,38 the Court is fairly clear that the question is ultimately a statutory one: did Congress intend to confer the authority to the judge in her judicial or her administrative capacity?39 Ultimately, what the Court is looking for is evidence of congressional intent.

In her brief, the respondent argued that both of the aforementioned indicia augur in favor of finding a funding decision under § 3599(f) to be administrative in nature. But the argument is not particularly strong. First, Texas pointed to the fact that the § 3599(f) motions can be submitted ex parte to the district judge.40 But that is not dispositive, since, for example, the determination of whether one is entitled to a mental-health expert is made through a similarly ex parte proceeding, and yet such determinations are appealable judicial decisions.41 Second, Texas pointed to the fact that the statute establishes a process by which the amount of funding awarded under § 3599(f) is reviewed by the chief judge of the circuit if it is in excess of $7,500.42 This argument, while similarly inconclusive, at least has precedent in its favor.

As with regard to CJA compensation decisions, this review structure has been interpreted by the Tenth Circuit as implying that appellate courts do not have jurisdiction to review decisions regarding the amount of funding awarded in response to a § 3599(f) request.43 Of course, a lower court’s interpretation may not persuade the Court. But even if it did, the decision would not determine the jurisdictional question in Ayestas. While deciding the amount of funding might be administrative, it may very well be a judicial determination as to whether § 3599(f) services are “reasonably necessary” within the meaning of the statute. In fact, such a distinction was made with regard to CJA fees by the Tenth Circuit, which allows appeals of decisions not to compensate counsel at all.44 Thus, there is not an unambiguous case in favor of construing a decision on a § 3599(f) motion to be administrative in nature.

At oral arguments, Justice Breyer expressed skepticism towards Texas’s argument, pointing toward evidence in § 3599(f) that the Congress intended to confer authority to the judge in her judicial capacity. First, he pointed to the plain meaning of the text—which says, “the court may authorize”—as suggesting that a judicial capacity was understood. Then, after a brief exchange with the respondent, he said that the provision in question is “in with other statutes that talk about [the judge’s] judicial duties.”45 In context, it appears that Justice Breyer was referencing the codification of the statutory provision enacting the provision of funds for investigators and experts—that is, § 3599—alongside other statues that, in the Justice’s mind, unambiguously describe judicial duties.

To which other provisions in the Code Justice Breyer was referring is not altogether clear. For example, he might have been thinking of the other provisions appearing in the same chapter of the Code as § 3599, which all relate to the death penalty. Alternatively, he may have been referring specifically to the other subsections of § 3599, which concern the appointing of counsel to defendants charged with crime punishable by death—a decision that has been held to be reviewable by the Court.46

Regardless of which particular part of the Code Justice Breyer had in mind, it is reasonably clear that he was considering an argument based on the placement of § 3599(f) in the United States Code. As such, the argument must be reconciled with the codifier’s canon to be legitimate. The next Section explores the statutory history of § 3599(f), which confirms the legitimacy of Justice Breyer’s argument from codification and strongly suggests that Texas’s jurisdictional argument should not prevail.

B. The Codifier’s Canon Applied: An Argument from Codification

As reflected in Justice Breyer’s comments during oral arguments, a provision’s codification is frequently looked at as evidence of congressional intent. A key lesson for applying the codifier’s canon, however, is that an argument from codification must look to statutory history. Here, statutory history not only confirms the legitimacy of the argument from placement, but also provide further evidence to refute Texas’s argument that decisions to deny funding are made in an administrative capacity.

The codifier’s canon allows the statutory provision at issue in Ayestas—18 U.S.C. § 3599(f)—to be relied upon by interpreters. As outlined in Part I, the relevant question is whether the provision was added after the positive law codification of the title. Title 18 was enacted as a positive law title in 1948.47 The USA Patriot Improvement and Reauthorization Act, which first added § 3599(f) to Title 18, was enacted in 2006.48 Thus, the codifier’s canon permits arguments based on the provision’s placement in the Code. Justice Breyer’s line of argument can go forward. But the fact that the provision’s placement can be legitimately invoked without running afoul of the codifier’s canon does not imply that it is necessarily persuasive.

The strongest argument from placement—and the one that Justice Breyer likely had in mind—is that § 3599(f) appears in a section of Title 18 authorizing judges to appoint counsel in habeas cases, a role that has already been implicitly held to be judicial. As alluded to above, in addition to authorizing funds for investigators and experts, § 3599 directs district judges to appoint counsel to indigent defendants for habeas proceedings and provides that the appointed counsel may be “replaced . . . upon motion of the defendant.”49 While no standard is provided in the statute for evaluating those motions, the Court, in Martel v. Clair,50 held that it should be decided “in the interests of justice,” adopting the same standard utilized by such motions in non-capital cases under 18 U.S.C. § 3006A. By taking the appeal in Clair and judging the district court for abuse of discretion, the Court implied that decisions regarding the appointing of counsel are undertaken in the judge’s judicial capacity. Such a determination is highly reasonable, since a judgement about the propriety of replacing counsel, for example, requires making judgements based on many of the same facts and laws that appear before the judge as part of the core case.

The subsection of interest in Ayestas, § 3599(f), was added to Title 18 by the same statute and as part of the same section of the Code as § 3599(e), the provision at issue in Martel and, more recently, Christeson.51 Nothing on the face of the statute seems to suggest that Congress intended for a judge to exercise her authority under § 3955(f) in a capacity different from the capacity in which she is authorized under § 3955(e). In fact, the only plausible distinguishing factor is the somewhat unusual review process for fees and expenses under § 3955(f). In contrast, nothing is specified with regard to appeals for motions under § 3955(e). But it seems farfetched to rely upon that as evidence the Congress intended determinations of whether to award fees and expenses to be administrative in nature.

This is particularly true given § 3955’s statutory history. Although first added to Title 18 in 2006, the statutory scheme had been in force since 1988, when it was enacted as part of the Anti-Drug Abuse Act of 1988.52 The statute, which directed the section be added to 21 U.S.C. § 848, enacted a section essentially identical to the modern 18 U.S.C. § 3599, but with one major difference—no special review procedure is described. Thus, there is nothing in the original version of the provision to suggest that Congress intended for § 3599(f) to define an administrative duty. Unless one were to concede to an argument from constitutional avoidance, the statutory argument for finding no jurisdiction to review § 3599(f) claims is weak.

Nor is the weight of the constitutional questions particularly significant. Review of fees and expenses above $7,500 by the chief judge is not review by “an entity not wielding judicial power.” A chief judge can wield judicial power even when acting alone, much as the Justices do, for example, in the context of their circuit assignments.53 Congress is free to “ordain and establish” the lower courts in any manner that it wishes, making a single judge appellate panel prima facie unproblematic.54 Further, there is nothing inherently nonjudicial about a limited ex parte proceeding. A temporary restraining order, for example, is issued in a judge’s judicial capacity55 and yet is often done in an ex parte manner.56 While the Court has held that parties to a case must be adversarial to satisfy Article III,57 this requirement is met even if one of the parties does not participate in some particular part of the proceeding.58 Since the State, in this case through the director of Texas’s criminal justice system, regularly contests funding decisions, there are clearly adversarial parties for the purposes of Article III. Since neither of the potential routes toward constitutional avoidance are plausible, there is little justification for viewing a determination of whether a defendant is entitled to fees and expenses to cover investigators and experts to be anything other than a judicial duty. Thus, congressional intent, as expressed through the codification history, ought to be adhered to and Texas’s jurisdictional argument should not succeed.


The codifier’s canon, enacted into law and appearing in Title 18, directs judges to draw interpretive inferences only from placement and captioning decisions that originate with Congress and not the office of the codifiers. Since the decision to place § 3599(f) in a section of the Code authorizing other judicial duties was made by Congress, Justice Breyer was right to turn to that provision’s organizational context as evidence of legislative intent. In fact, considering the provision’s placement, in light of the statutory history, Texas’s jurisdictional argument is not persuasive.

  1. See Ayestas v. Stephens, 817 F.3d 888 (5th Cir. 2016), cert. granted in part sub nom. Ayestas v. Davis, 137 S. Ct. 1433 (2017).
  2. Transcript of Oral Argument at 42-43, Ayestas v. Davis, No. 16-6795 (Oct. 30, 2017).
  3. 135 S. Ct. 1074, 1083-84 (2015).
  4. Tobias A. Dorsey, Some Reflections on Yates and the Statutes We Threw Away, 18 Green Bag 2d 377 (2015).
  5. Daniel B. Listwa, Comment, Uncovering the Codifier’s Canon: How Codification Informs Interpretation, 127 Yale L.J. 464 (2017).
  6. 448 U.S. 1 (1980).
  7. Id. at 16-17.
  8. Id. at 19.
  9. Elsewhere I have drawn a distinction between the generic codifier’s canon and the legislated codifier’s canon. See Listwa, supra note 5, at 468 n.21. The generic codifier’s canon is simply the general principle that interpreters should distinguish between editorial decisions in the Code that reflect Congress’s intent and those that instead were introduced by the codifiers. The legislated codifier’s canon is the specific statutory text directing that interpreters ought not, in certain instances, draw inferences from a provision’s caption or placement in the Code. In this Essay, I only discuss that legislated codifier’s canon and thus refer to it merely as the “codifier’s canon.”
  10. Act of Sept. 6, 1966, Pub. L. No. 89-554, § 7(e), 80 Stat. 378, 631 (codified at 5 U.S.C. Front Matter at 10 (2012)); Act of Aug. 10, 1956, Pub. L. No. 84-1028, § 49(e), 70A Stat. 1, 640 (codified at 10 U.S.C. Front Matter at 12 (2012)); Act of Aug. 31, 1954, Pub. L. No. 83-740, § 5, 68 Stat. 1012, 1025 (codified at 13 U.S.C. Front Matter at 1 (2012)); Act of Aug. 4, 1949, Pub. L. No. 81-207, § 3, 63 Stat. 495, 557 (codified at 14 U.S.C. Front Matter at 2-3 (2012)); Act of June 25, 1948, Pub. L. No. 80-772, § 19, 62 Stat. 683, 862 (codified at 18 U.S.C. Front Matter at 5 (2012)); Act of June 25, 1948, Pub. L. No. 80-773, § 33, 62 Stat. 869, 991 (28 U.S.C. Front Matter at 5 (2012)); Act of Sept. 13, 1982, Pub. L. No. 97-258, § 4(e), 96 Stat. 877, 1067 (codified at 31 U.S.C. Front Matter at 6 (2012)); Act of Nov. 3, 1998, Pub. L. No. 105-354, §4(e), 112 Stat. 3238, 3245 (codified at 36 U.S.C. Front Matter at 11 (2012)); Act of Aug. 12, 1970, Pub. L. No. 91-375, § 11(b), 84 Stat. 719, 785 (codified at 39 U.S.C. Front Matter at 7 (2012)); Act of Aug. 21, 2002, Pub. L. No. 107-217, § 5(f), 116 Stat. 1062, 1304 (codified at 40 U.S.C. Front Matter at 7 (2012)); Act of Oct. 22, 1968, Pub L. No. 90-620, § 2(e), 82 Stat. 1238, 1306 (codified at 44 U.S.C. Front Matter at 3 (2012)); Act of Aug. 26, 1983, Pub. L. No. 98-89, § 2(e), 97 Stat. 500, 598 (codified at 46 U.S.C. Front Matter at 10 (2012), applying to subtitle II); Act of Nov. 23, 1988, Pub. L. No. 100-710, § 105(d), 102 Stat. 4735, 4751 (codified at 46 U.S.C. Front Matter at 10 (2012), applying to subtitle III); Act of Oct. 17, 1978, Pub. L. No. 95-473, § 3(e), 92 Stat. 1337, 1466 (codified at 49 U.S.C. Front Matter at 14 (2012)).
  11. Act of June 25, 1948, Pub. L. No. 80-772, § 19, 62 Stat. 683, 862 (codified at 18 U.S.C. Front Matter at 5 (2012)).
  12. Positive Law Codification, Off. L. Revision Couns., http://uscode.house.gov/codification/legislation.shtml [http://perma.cc/8RAZ-XX6Q].
  13. Id.
  14. Id.
  15. 448 U.S. 1 (1980).
  16. See supra notes 6-8 and accompanying text.
  17. See Listwa, supra note 5, at 476-78 (discussing congressional concerns that codification would introduce inadvertent substantive changes in the law).
  18. Id. at 489.
  19. Act of June 25, 1948, Pub. L. No. 80-772, ch. 645, § 5037, 62 Stat. 683, 862 (codified at 18 U.S.C. Front Matter at 5 (2012)).
  20. Listwa, supra note 5, at 484.
  21. Ayestas v. Stephens, 817 F.3d 888, at 896 (5th Cir. 2016), cert. granted in part sub nom. Ayestas v. Davis, 137 S. Ct. 1433 (2017).
  22. See Matthews v. White, 87 F.3d 756, 760 n.2 (6th Cir. 2015) (rejecting the “substantial necessity” standard); Wright v. Angelone, 151 F.3d 151 (4th Cir. 1998) (same).
  23. Transcript of Oral Argument at 41, Ayestas v. Davis, No. 16-6795 (Oct. 30, 2017).
  24. Brief for the Respondent at 18-28, Ayestas v. Davis, No. 16-6795 (Aug. 1, 2017).
  25. See United States v. French, 556 F.3d 1091, 1093 (10th Cir. 2009); United States v. Stone, 53 F.3d 141, 143 (6th Cir. 1995); Shearin v. United States, 992 F.2d 1195, 1196 (Fed. Cir. 1993); Landano v. Rafferty, 859 F.2d 301, 302 (3rd Cir. 1988); United States v. Rodriguez, 833 F.2d 1536,1537-38 (11th Cir. 1987); United States v. Walton (In re Baker), 693 F.2d 925, 927 (9th Cir. 1982); United States v. Smith, 633 F.2d 739, 742 (7th Cir. 1980). But see United States v. Turner, 584 F.2d 1389 (8th Cir. 1978) (allowing appeal where jurisdictional argument not raised); United States v. Ketchem, 420 F.2d 901 (4th Cir. 1969) (reversing denial of expenses for court appointed defense counsel where jurisdictional argument not raised).
  26. French, 556 F.3d at 1093.
  27. Id.
  28. Id.
  29. Act of Sept. 19, 1950, Pub. L. No. 81-790, 64 Stat. 866, 866 (codified at 11 U.S.C. § 71(c) (2012)).
  30. Act of July 5, 1935, Pub. L. No. 74-449, 49 Stat. 1140, 1140. That judges’ hiring decisions are not made within their judicial capacity is confirmed by the fact that absolute immunity does not apply in those contexts. See Forrester v. White, 484 U.S. 219, 220 (1988).
  31. See, e.g., Matter of Baker, 693 F.2d 925, 927 (9th Cir. 1982).
  32. Hohn v. United States, 524 U.S. 236, 245 (1998) (citing United States v. Ferreira, 54 U.S. (13 How.) 40, 51-52 (1851)). There is no reason to believe this jurisdictional bar could not be removed, but Congress has yet to do so. Congress has provided no general cause of action to appeal administrative decisions made by individuals within the judicial branch—there is no equivalent to § 702 of the Administrative Procedure Act, which only applies to executive agencies. See 5 U.S.C. § 7019(b)(1)(B) (2012) (defining “agency” to exclude “the courts of the United States”); Id. § 702 (providing a general cause of action for review of “agency action”). One caveat, however, derives from Marbury v. Madison, 5 U.S. (1 Cranch) 137, 174-176 (1803). In Marbury, Chief Justice Marshall made clear that the Court cannot exercise “appellate Jurisdiction” under Article III directly from an executive officer. Thus, any attempt to directly review an agency action would need to fall within the Court’s original jurisdiction to be valid. However, the original jurisdiction of the Supreme Court cannot be expanded. Id. at 174-176. Thus, the Court can only review an executive agency action by way of review of an appeal from a court. The question of what constitutes a “court” for the purposes of defining the Supreme Court’s appellate jurisdiction is an open question that may be resolved this Term. See Brief for Professor Aditya Bamzai as Amicus Curiae in Support of Neither Party, Dalmazzi v. United States, No. 16-961 (U.S. Nov. 14, 2017). However, it is likely the case that a judge acting in her administrative capacity is not a “court” within the relevant meaning. For this reason, Congress could only provide for Supreme Court review of judicial administrative actions by way of a cause of action that first places that claim in some other court, such as a federal district or circuit court.
  33. Ferreria, 54 U.S. (13 How.) at 46.
  34. Id. at 45.
  35. Hayburn’s Case, 2 U.S. (2 Dall.) 409, 409-10 & n.* (1792).
  36. Franks v. Bowman Transp. Co., 424 U.S. 747, 754-55 (1976) (discussing mootness as deriving from the Article III requirement that there be an adversarial controversy).
  37. Hohn, 524 U.S. at 245-46.
  38. See id.
  39. See United States v. Ferreira, 54 U.S. (13 How.) 40, 47 (1851).
  40. Brief for the Respondent at 22, Ayestas v. Davis, No. 16-6795 (Aug. 1, 2017).
  41. See Ake v. Oklahoma, 470 U.S. 83, 95 (1968).
  42. Brief for the Respondent at 24, Ayestas v. Davis, No. 16-6795 (Aug. 1, 2017) (discussing 18 U.S.C. § 3599(g)(2) (2012)).
  43. See Rojem v. Workman, 655 F.3d 1199, 1202 (10th Cir. 2011).
  44. See Hooper v. Jones, 536 F. App’x 796, 798-99 (10th Cir. 2013).
  45. Transcript of Oral Argument at 43, Ayestas v. Davis, No. 16-6795 (Oct. 30, 2017).
  46. See, e.g., Martel v. Clair, 565 U.S. 648, 652 (2012) (reviewing what standard courts should apply when determining whether appointed counsel should be replaced under § 3599(e)).
  47. Act of June 25, 1948, Pub. L. No. 80-772, § 20, 62 Stat. 683, 862 (codified at 18 U.S.C. (2012)).
  48. USA Patriot Improvement and Reauthorization Act, Pub. L. No. 109-177, § 222, 120 Stat. 192, 232 (2006) (codified at 18 U.S.C. § 3599(f)).
  49. 18 U.S.C. § 3599(e).
  50. 565 U.S. 648, 652 (2012); see also Christeson v. Roper, 135 S. Ct. 891 (2017) (reviewing a district court’s decision made pursuant to 18 U.S.C. § 3599(e)).
  51. 135 S. Ct. 891 (2017).
  52. Pub. L. No. 100-690, § 7001, 102 Stat. 4181, 4393-94 (1988).
  53. See Sandra Day O’Connor, Foreword: The Changing Role of the Circuit Justice, 17 U. Tol. L. Rev. 521, 523-24 (1985).
  54. U.S. Const. art. III, § 1.
  55. See, e.g., Ellakkany v. Common Pleas Court of Montgomery Cty., 658 F. App’x 25, 28 (3d Cir. 2016) (holding that absolute immunity applies to a decision not to issue a temporary restraining order, since such decisions fall within a judge’s judicial capacity).
  56. Fed. R. Civ. P. 65(b)(1).
  57. See, e.g., Franks v. Bowman Transp. Co., 424 U.S. 747, 754-55 (1976).
  58. Courts regularly utilize “judicial power,” id., in contexts in which only one of the parties to a controversy participate, either because one of the parties are excluded, like in an ex parte proceeding, or because one of the parties fails to appear.

Regulatory Reform in the Trump Era—The First 100 Days

* Roncevert Almond: Partner and Vice-President, The Wicks Group, Washington, D.C., J.D. (with honors) and M.A., Political Science, Duke University.

Marina O’Brien: Associate, The Wicks Group, J.D., Georgetown University.

Andy Orr: Associate, The Wicks Group, J.D., George Washington University.


Within the first 100 days of his administration, President Donald J. Trump initiated a bold regulatory reform agenda intended to downsize the imprint and reduce the influence of the federal government. Through a series of executive orders, supported by guidance from the Office of Management and Budget (OMB), and his proposed budget to Congress, the President has attempted to change the calculus and methodology underlying the federal regulatory process. To enforce his far-reaching agenda, the President is establishing a new administrative framework that challenges conventions on government oversight and rulemaking within the Executive Branch.

Even as other actions and controversies monopolize public attention, the President’s governing legacy may hinge on the scope and effectiveness of his effort to radically change the federal regulatory system. This Essay reviews this nascent program of administrative regime change. Part I analyzes the foundational tools underlying President Trump’s regulatory reform agenda; Part II explains how the President’s plans to enforce his deregulatory policies within the federal bureaucracy; Part III examines and compares the results of regulatory reform during President Trump’s first 100 days; and Part IV concludes by identifying implications and questions arising from the administration’s plan.

I. Establishing Regulatory Reform: The 2-for-1 Rule

A. Executive Order 13,771

Similar to preceding administrations, on the day of President Trump’s inauguration, the new White House initiated a review of all pending rulemaking at the federal agencies.1 Almost immediately following this “regulatory freeze,” the Trump administration embarked on a novel reform effort aimed at the federal rulemaking process writ large. On January 30, 2017, President Trump issued Executive Order 13,771, which required that “for every one new regulation issued, at least two prior regulations be identified for elimination,” and that the costs of the new regulation be, “prudently managed and controlled through a budgeting process.”2 Under the so-called “2-for-1 Rule,” the incremental costs of all new regulations for Fiscal Year 2017 must be no greater than zero, unless the regulation is required by law or consistent with advice provided in writing by the Director of the OMB.3 Agencies are expected to meet this new requirement by offsetting any incremental costs from new regulations with the supposed savings gained from eliminating two existing regulations.4

EO 13,771 applies to any “regulation” that serves as “an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy or to describe the procedure or practice requirements of an agency.”5 Excluded are regulations with a military, national security, or foreign affairs function, and regulations related to an agency’s organization, management, or personnel.6

The OMB plays an important role under the 2-for-1 Rule. For instance, the Director of the OMB can exempt any category of regulations from the rule.7 Executive Order 13,771 also modifies the requirements for the Annual Regulatory Cost Submissions that agencies must submit to OMB. Beginning in FY 2018 and in each fiscal year thereafter, agencies must identify offsetting regulations for each new regulation that increases incremental costs and provide the best approximation of the total cost savings for each new or repealed regulations.8 Regulations approved by the Director of the OMB will be included in the Unified Regulatory Agenda and, unless otherwise required by law, no regulation will be issued unless it was included on the most recent version of the Unified Regulatory Agenda.9

Executive Order 13,771 also makes the OMB Director responsible for “identify[ing] to agencies a total amount of incremental costs that will be allowed for each agency in issuing new regulations and repealing regulations for the next fiscal year.”10 Any new or repealed regulation that exceeds this cost limit set by OMB will not be allowed, unless required by law or approved in writing by the Director.11

Additionally, the OMB Director is directed to provide federal agencies with guidance on how to measure and estimate the incremental costs of new regulations, determine what constitutes new or offsetting regulations, and how to calculate the savings gained from the elimination of existing regulations.12 Within the OMB, responsibility for issuing guidance on such matters falls to the Office of Information and Regulatory Affairs (OIRA), a federal office that Congress established in the 1980 Paperwork Reduction Act.13

B. OIRA’s Interim Guidance

Consistent with Executive Order 13,771, OIRA issued its Interim Guidance Implementing Section 2 of the Executive Order of January 30, 2017, Titled “Reducing Regulation and Controlling Regulatory Costs” (the Interim Guidance).14 Through this guidance, OIRA clarified the scope of the 2-for-1 Rule and expanded on methods for its implementation.

1. Defining the Applicability of Executive Order 13,771

Under the Interim Guidance, Executive Order 13,771 only applies to “significant regulatory action,” as defined by Executive Order 12,866,15 and only to those agencies that are required to submit their significant regulatory actions to OIRA for review under Executive Order 12,866.16

Executive Order 12,866, signed by President Bill Clinton, is the primary governing executive order regarding regulatory planning and review.17 Under Executive Order 12,866, significant regulatory actions are defined as those actions that:

(1) have an annual effect on the economy of $100 million or more or adversely affect in a material way the economy, a sector of the economy, productivity, competition, jobs, the environment, public health or safety, or State, local, or tribal governments or communities;

(2) create a serious inconsistency or otherwise interfere with an action taken or planned by another agency;

(3) materially alter the budgetary impact of entitlements, grants, user fees, or loan programs or the rights and obligations of recipients thereof; or

(4) raise novel legal or policy issues arising out of legal mandates, the President’s priorities, or the principles set forth in Executive Order 12,866.18

OIRA’s also notes that new “significant guidance” or “interpretive documents” may also be covered by the 2-for-1 Rule. The Interim Guidance cites the OMB’s 2007 Bulletin for Good Guidance Practices.19 According to the OMB’s 2007 bulletin, the definition of “significant guidance” must have a “substantial impact on regulated entities, the public or other federal agencies,” which is similar to the language used to refer to “significant regulatory action.”20 The Interim Guidance instructs agencies to consult their OIRA desk officer, on a case-by-case basis, concerning whether agency actions constitute “significant guidance,” as may be the case with interpretive documents like letters of interpretation.21

2. Estimating Incremental Cost

OIRA’s Interim Guidance provides instruction on the proper method for agencies to estimate the incremental costs of new regulations and the savings that can be obtained by eliminating regulations. All costs are measured as an “opportunity cost to society,” as defined in OMB Circular A-4.22 Opportunity cost is determined through a “willingness-to-pay” model, which considers what an individual would be willing to pay to forgo to enjoy a particular benefit, or the “willingness-to-accept” model, which considers whether an individual would be willing to accept compensation for not receiving an improvement.23 Pursuant to this calculation, agencies are required to consider market prices, costs of forgone benefits, and any cost savings.

Agencies are further expected to annualize the costs in accordance with OMB Circular A-4, and ensure that the start and end point for the annualization allow for the cost of new regulation to be easily compared to that of the repealed regulation. In calculating cost savings, agencies are expected to consider all cost savings after the effective date of repeal. This would not include sunk costs, for example. Additionally, agencies may not consider future energy cost savings gained from requiring energy efficient technologies as an offset against the compliance costs.

3. Waivers and Implementing Measures

Executive Order 13,771 allows for individual waivers, for example, in the event of emergencies.24 In the Interim Guidance, OIRA noted that the circumstances supporting waivers include emergencies addressing critical health, safety, or financial matters, or other compelling reasons.25 Agencies are directed to facilitate the requests through their respective OIRA desk officer.

OIRA also provided guidance on methods for implementing the 2-for-1 Rule. For instance, agencies can bundle their new regulatory actions and their deregulatory actions in the same package, as long as the agency clearly identifies which provisions contain new regulations and which provisions eliminate old rules, and demonstrates how the bundled rules are logically connected.26 OIRA recommended that agencies identify the regulation to be eliminated and do so no later than by the date the new regulations are issued.

One of the more novel aspects of the 2-for-1 Rule is that cost savings may be transferred both within an agency and from one agency to another.27 According to OIRA, regulatory savings by a component in one agency can be used to offset a regulatory burden by a different component in that same agency. Moreover, if agencies are not able to generate sufficient savings to account for new regulatory actions under Executive Order 13,771, then they must submit a written request to the OMB Director to transfer savings from another agency before they submit a regulatory action for review that does not contain the needed offset. However, if the Director does not concur with this request, the agency must identify adequate offsets absent a waiver.

C. OIRA’s Memorandum

On April 5, 2017, OIRA issued a Memorandum titled Guidance Implementing Executive Order 13,771, Titled “Reducing Regulation and Controlling Regulatory Costs” (the OIRA Memorandum).28 The OIRA Memorandum builds upon the Interim Guidance, particularly in relation to the definitional scope of the 2-for-1 Rule.29

For instance, the OIRA Memorandum more clearly defines the regulatory and deregulatory actions subject to the offsetting regime of Executive Order 13,771. An “EO 13771 regulatory action” means a “significant regulatory action” as defined in Section 3(f) of Executive Order 12,866 that has been finalized and that imposes total costs greater than zero; or a “significant guidance document” reviewed by OIRA under the procedures of Executive Order 12,866 that has been finalized and that imposes total costs greater than zero.”30

In comparison, “EO 13,771 deregulatory action” is defined as an action that has been finalized and has total costs less than zero.31 An Executive Order 13,771 deregulatory action qualifies as both (1) one of the actions used to satisfy the provision to repeal or revise at least two existing regulations for each regulation issued and (2) a cost savings for purposes of the total incremental cost allowance. These deregulatory actions can be used as offsets and involve a wide variety of actions from rulemaking to official interpretations to information collection activities.32

With regard to the category of “significant guidance documents,” these do not include legal advisory opinions, briefs, and other positions taken by agencies in investigations, pre-litigation, and other enforcement proceedings, as well as speeches, editorials, media reviews, press materials, congressional correspondence, grant solicitations, warning letters, and case investigatory letters responding to complaints involving fact-specific determinations.33 Likewise, purely “internal” agency policies pertaining to facility operations and guidance materials directed solely to other federal agencies are not included in the definition.34

However, Executive Order 13,771 does apply to “internal” policies and guidance documents that “materially affect an agency’s interactions with non-federal entities, even if nominally directed only to agency personnel.”35 For example, an internal directive to field staff on how to implement a regulatory requirement (e.g., an agency enforcement manual) could be a “significant guidance document” subject to the 2-for-1 Rule.36 Likewise, modifications to existing guidance and interpretive documents would be considered “significant guidance documents” if they satisfy the definition provided in Executive Order 12,866 and the OMB’s 2007 bulletin on good guidance practices.37

Furthermore, OIRA notes that regulatory activities associated with regulatory cooperation with foreign governments and international bodies are also affected by Executive Order 13,771. Thus, if the regulatory activities involving international harmonization reduce costs to entities or individuals within the United States, or otherwise lower the regulatory costs to the U.S. economy, such activities may qualify as Executive Order 13,771 deregulatory actions. However, international harmonization actions that increase costs to U.S. entities or individuals may need to be offset.

If, by the end of a fiscal year, an agency does not finalize at least twice as many deregulatory actions as regulatory actions issued during the same fiscal year, or it has not met its total incremental cost allowance for that fiscal year, the agency must submit a plan for coming into full compliance with Executive Order 13,771 for the OMB Director’s approval within 30 days of the end of the fiscal year that addresses each of the following: (1) the reasons for, and magnitude of, non-compliance; (2) how and when the agency will come into full compliance; and; (3) other relevant information requested by the Director.38

When considering which federal requirements to repeal or revise, in order to serve as Executive Order 13,771 deregulatory actions, the OIRA Memorandum directs agencies to follow the priorities set forth in Executive Order 13,777 Enforcing the Regulatory Reform Agenda.39 As explained below, Executive Order 13,777 also establishes a new set of positions and administrative oversight bodies within the Executive Branch for enforcing the President’ regulatory reform agenda.

II. Enforcing the Regulatory Reform Agenda: A New Administrative Framework

A. Executive Order 13,777

Through Executive Order 13,777, President Trump has established a new administrative framework to ensure implementation of his regulatory reform agenda within the federal agencies.

First, Executive Order 13,777 creates the new position of “Regulatory Reform Officer” (RRO).40 RROs are empowered to oversee the implementation of regulatory reform initiatives and policies to ensure that agencies carry out regulatory reforms. RROs are specifically authorized to oversee: (1) Executive Order 13,771; (2) Executive Order 12,866; (3) Section 6 of Executive Order 13,563 of January 18, 2011 (Improving Regulation and Regulatory Review), regarding retrospective review; and (4) terminating programs and activities that derive from or implement executive orders, guidance, and interpretations that have been rescinded. Agency heads, except those whose agencies that receive a waiver from the OMB Director, are expected to designate an RRO within sixty days of the Executive Order 13,777’s issuance.

Second, President Trump mandated that agencies establish a new internal watchdog, the “Regulatory Reform Task Force” (RRTF), consisting of the agency’s RRO, the Regulatory Policy Officer (as designated pursuant to Executive Order 12,866), a representative of the agency’s central policy office, and for agencies listed in 31 U.S.C. § 901(b)(1), three additional senior agency officials.41 Executive Order 13,777 empowers the RRTF to evaluate existing regulations and make recommendations to the agency head to identify regulations that need to be repealed, replaced, or modified. The RRTF is also expected to target regulations that eliminate or inhibit jobs, are ineffective or outdated, impose costs that exceed benefits, create inconsistencies or otherwise interfere with regulatory reform initiatives, are inconsistent with the requirements of § 515 of the Treasury and General Government Appropriations Act,42 or are derived from subsequently rescinded executive orders or Presidential directives. Demonstrating the new authority of the RRTF, agency heads are expected to take instruction from the RRTF by prioritizing the elimination of regulations identified by the RRTF.43

B. Executive Order 13,781

To further enforce his regulatory reform agenda, President Trump issued Executive Order 13,781, Comprehensive Plan for Reorganizing the Executive Branch. The purpose of Executive Order 13,781 is to improve the “efficiency, effectiveness, and accountability” of the Executive Branch by ordering the OMB Director to propose a plan to reorganize governmental functions and eliminate unnecessary agencies.44

The OMB Director will create the government reorganization plan based on the submission from each agency head of a proposed plan to reorganize their own agencies to improve efficiency and effectiveness. In turn, the agencies must submit their respective plans with 180 days of the date of Executive Order 13,781. In addition, the public can provide recommendations for government reorganization to the OMB through a mandatory notice and comment period in the Federal Register.

Within 180 days of the closing date for public submissions, the OMB Director must submit his plan to President Trump, which will include plans to reorganize, eliminate, or merge agencies or their functions, and provide the legislative or administrative steps necessary to implement each part of the plan. In developing the plan, the OMB Director must consider factors designed to downsize or even eliminate federal agencies. These factors include: (1) transfer of “all of the functions of any agency” to state or local governments or to “free enterprise” via the private sector; (2) reduction of inter-agency functional and administrative redundancies at the agency, component, and program level; (3) the costs or benefits of the continuing operation of an agency; and (4) the costs of shutting down or merging agencies, components, or programs, including the costs of addressing the equities of affected agency staff.45

C. President Trump’s Budget

In addition to executive orders targeting regulatory reform, President Trump is seeking to reduce the federal government through his proposed budget to Congress, America First: A Budget Blueprint to Make America Great Again.46 For example, if enacted, President Trump’s budget will impact the U.S. Department of Transportation (DOT). The White House is asking for a thirteen percent reduction in funding for DOT as a whole.47 More broadly, the President’s budget calls for the complete elimination of nineteen federal agencies. Terminating these agencies will result in about $3 billion in savings, offsetting about six percent of President Trump’s proposed increase of $54 billion in military spending.48

III. Measuring Regulatory Reform in President Trump’s First 100 Days

Following the first 100 days of President Trump’s term, it is possible to measure initial implementation of his regulatory reform agenda. According to our analysis of rulemaking in the Federal Register during this period, only nineteen rules and sixteen proposed rules have referenced Executive Order 13,771 (which includes the 2-for-1 Rule) as part of the regulatory impact analysis.

As Table 1 below indicates, approximately sixty-eight percent of both the rules and proposed rules were issued solely by the U.S. Coast Guard under the U.S. Department of Homeland Security. The purpose of these rules and proposed rules was to secure water ways for sporting or cultural events (e.g. a water race). Because the U.S. Coast Guard determined that there was not a “significant regulatory action” under Executive Order 12,866, the 2-for-1 Rule was inapplicable.49 Other agencies offered the same justification for some of the remaining rules and proposed rules.50

Even when the regulatory actions were considered to be “significant” (mainly because their impact was determined to be greater than $100 million), there were two other justifications for why the requirements of Executive Order 13,771 were inapplicable. For instance, the U.S. Army Corps of Engineers explained that the 2-for-1 Rule did not apply to their rulemaking because the regulatory action involved exempted military and national security functions.51 In contrast, in five other significant regulatory actions, the acting agency determined that the rules and proposed rules do “not impose costs” that trigger the requirements of Executive Order 13,771 due to the “net impact of zero”52 or the “cost savings.”53

Only a single proposed rule even acknowledged that Executive Order 13,771 may apply, stating that the, “implications of this rule’s costs and costs savings will be further considered in the context of our compliance with Executive Order 13,771.”54 In this instance, the U.S. Department of Health and Human Services (HHS) interpreted the rulemaking to involve Medicare spending—a so-called “transfer rule” that is not covered by Executive Order 13,771, according to the OIRA Memorandum.55 Nonetheless, HHS determined that the rulemaking could involve requirements apart from transfers and that those regulatory actions would need to be offset to the extent that they impose more than de minimis costs. Notably, however, within the first 100 days of the Trump administration, no federal agency had actually applied the offset required by the 2-for-1 Rule.


Referral to Executive Order 13,77156





Total Number: 19 16
Agency, Department: 13 or 68.4%
Coast Guard/DHS
11 or 68.75%
Coast Guard/DHS
Justification: Not a significant regulatory action under Executive Order 12,866, thus Executive Order 13,771 is not applicable. 16 13
Justification: Even if significant regulatory action, the rule does not impose costs that trigger requirements of Executive Order 13,771. 2 2
Justification: Military or defense function and, therefore, Executive Order 13,771 is not applicable. 1 0
Potential application: Implications of the rule’s costs and cost savings will be further considered in the context of compliance with Executive Order 13,771. 0 1

On their face, these results suggest that the 2-for-1 Rule has yet to have a large impact on federal rulemaking. Based on our experience and interactions with federal regulators, agencies have reacted cautiously with respect to implementation of Executive Order 13,771. The Trump Administration’s need to issue interim guidance from OMB and then supplemental guidance from OIRA demonstrates a tacit recognition that a transition period is required for interpretation and implementation of the 2-for-1 Rule. To assist agencies, the OMB has even recommended that agencies request ideas from the public on deregulatory actions to pursue under Executive Order 13,771.57 For instance, the DOT has solicited similar public input in identifying existing regulations that are “unnecessary obstacles to transportation infrastructure projects” and acknowledged the related role of Executive Order 13,771.58 On an informal level, we are aware of outreach efforts by Trump’s political appointees at the agencies to identify potential deregulatory actions—to the extent such appointments have been made. In the first 100 days, the Trump Administration lagged far behind its predecessors, particularly Democratic Presidents Obama and Clinton, in terms of nominations and Senate confirmation of key officials responsible for setting agency policies, such as adherence to executive orders.59

In addition, the record in the Federal Register supports the conclusion that agencies have yet to determine a consistent approach for applying Executive Order 13,771. For example, as noted in Table 2, there are variations in agency identifications of rulemaking that involves “significant regulatory action” (generally, an annual effect on the economy of $100 million or more) with respect to Executive Order 13,771 versus Executive Order 12,866. A review of the Federal Register in Trump’s first 100 days indicates that only 383 rules (of the total 682) and 191 proposed rules (of the total 349) reference Executive Order 12,866—suggesting that an agency determination was made as to whether the rulemaking involved “significant regulatory action.” In comparison, the total rulemaking that referenced Executive Order 13,771—nineteen rules and sixteen proposed rules—is less than five percent of the rules and ten percent of the proposed rules that reference Executive Order 12,866. This disparity exists even though Executive Order 13,771 applies the same “significant regulatory action” threshold as set forth in Executive Order 12,866. Put differently, if agencies are invoking Executive Order 12,866, then they should also be considering Executive Order 13,771.

Further evidence of inconsistency in federal agency application of Executive Order 13,771 is found in the different number of rules identified in the Federal Register as being “significant regulatory actions.” Specifically, the Federal Register provides an advanced search filter for “Significant Regulatory Actions” that are “Deemed Significant Under Executive Order 12,866.” Under this advanced search, within the first 100 days of the Trump administration, the Federal Register only identifies seventy-one out of 1,031 total rulemaking actions—rules and proposed rules—as being “Deemed Significant Under Executive Order 12,866.” Moreover, of those seventy-one results, only eleven reference Executive Order 12,866 in comparison to only three references to Executive Order 13,771. There is not a clear explanation as to why agencies would undertake rulemaking deemed a “significant regulatory action” in the Federal Register database without referencing the presidential orders mandating this type of regulatory review—Executive Order 12,866 and Executive Order 13,771.


Continued Disparity in References to Executive Order 12,866 versus Executive Order 13,771

Rules Proposed Rules Rules and Proposed Rules “Deemed Significant

Under Executive Order 12,866”

Rules Referencing E.O. 12,86660 383 191 11
Rules Referencing E.O. 13,77161 19 16 3
Total62 682 349 71

In the end, the small number of references to Executive Order 13,771 within the first 100 days does not mean that President Trump’s regulatory reform agenda has not materially changed regulatory activity within the federal bureaucracy. The “regulatory freeze” at the start of the Trump-era resulted in the delay of dozens of regulations by one count.63 There have also been numerous federal regulations that have been revoked or delayed or subject to suspended enforcement.64 When compared to President Obama’s first 100 days, President Trump’s administration has engaged in twenty-five percent less rulemaking, as noted in Table 3 below. At least by this measure, covering a brief 100-day timeframe, President Trump has made progress toward reducing the government’s regulatory activity.

Comparing Presidents Obama to Trump
# of Rules Issued 900 732 19%
# of Proposed Rules Issued 473 370 22%
Rulemaking Total 1,373 1,102 20%

More generally, Executive Order 13,771 may be understood as presenting a set of deregulatory principles based on nine elements: (1) content; (2) objective; (3) scope; (4) cost measurement; (5) exceptions; (6) concentration of authority; (7) interagency transfer; (8) agency oversight; and (9) enforcement.68

We can use these elements to compare Trump’s attempts to substantially reform the federal regulatory process against those of prior presidents, such as President Ronald Reagan’s Executive Order 1229169 and President Clinton’s Executive Order 12,866.70 In relation to content and objective, the 2-for-1 Rule of Executive Order 13,771 provides a new formula for federal rulemaking. This prescription may also be interpreted as furthering Reagan’s offsetting principle established under Executive Order 12291 where regulatory action will not be undertaken unless the regulation’s potential benefits to society outweigh the potential costs to society.71 In turn, Clinton’s Executive Order 12,866 provided a more permissive cost-benefit and cost-effectiveness approach where an agency’s reasoned determination can support the conclusion that the benefits of the intended regulation justify its costs.72

In terms of scope, Executive Order 13,771 carries forward the “significant regulatory action” definition of Executive Order 12,866 with a threshold of “$100 million or more” for applicability.73 Executive Order 12,866 built upon the “major rule” definition of Executive Order 12291, which applied to regulations with “an annual effect on the economy of $100 million or more.”74 Executive Order 13,771 also retains the standard regulatory impact analysis set forth in Executive Order 12,866 for measuring costs.75 Similarly, Executive Order 12291, Executive Order 12,866, and Executive Order 13,771 all excluded rules issued by independent regulatory agencies even as these agencies—like the Federal Trade Commission, Securities and Exchange Commission, and Federal Communications Commission—have a significant impact on the U.S. economy.76 Executive Order 13,771, like Executive Order 12,866 and Executive Order 12291, exempt rules that pertain to a military or foreign affairs function, or that involve agency organization, management, or personnel matters.77

A key characteristic of Executive Order 13,771 is the centralization of rulemaking authority at the cost of the agencies’ discretion. Through Executive Order 12291, President Reagan concentrated authority in OIRA for overseeing rulemaking over “major” regulations (an annual effect on the economy of $100 million or more);78 President Clinton, via Executive Order 12,866, reversed this course and reaffirmed the “primacy” of agencies in the regulatory decision-making process;79 and, now, through Executive Order 13,771, the pendulum has swung again as President Trump has concentrated on enhancing regulatory power with OIRA.80 In addition, the President has delegated new power to the Director of the OMB to determine each agency’s total amount of incremental costs associated with rulemaking for each fiscal year and approve interagency transfers of savings in the event that an agency cannot identify the needed offset.81

President Trump has established a new oversight and enforcement framework. Executive Order 13,777 establishes the position of RRO and the RRTF, the individual and task force embedded at the agencies to enforce Executive Order 13,771.82 Notably, this agency oversight structure differs from President Reagan’s “Presidential Task Force on Regulatory Relief” under Executive Order 12291, which played more of an oversight role with respect to the Director of the OMB. In the event of non-compliance with the off-setting rule of Executive Order 13,771, offending agencies must submit to the Director of the OMB, within thirty days of the end of the fiscal year, a plan detailing how the agency will come into full compliance with Executive Order 13,771.83

Elements of Executive Order 13,771
Content For each regulatory action there must be two deregulatory actions
Objective The incremental costs associated with regulatory actions must be fully offset by the savings of deregulatory action
Scope Regulatory actions must be “significant” ($100M or more) but extend beyond rulemaking to include regulatory activities such as agency guidance material and interpretive documents
Cost Measurement Standard regulatory impact analysis (under Executive Order 12,866 and OMB Circular A-4)
Exceptions Independent regulatory agencies; statutory and judicial mandates; military, national security, and foreign policy functions; related to agency organization, management, or personnel; emergencies; de minimis actions; otherwise approved exemption (e.g., transfer rules)
Concentration of Authority Interpretation, approval and total incremental cost allowance determinations centralized with OMB and OIRA
Interagency Transfer Ability to transfer deregulatory action credits, subject to approval by Director of OMB
Agency Oversight Agency Regulatory Reform Task Force and Regulatory Reform Officer
Enforcement Within 30 days of the end of the fiscal year, submit compliance plan to Director of OMB for approval

Implications and Questions

Although further analysis is required to determine the long-term impact and effectiveness of President Trump’s regulatory reform agenda, we can identify key implications and questions arising from the President’s plan to reform the administrative state.84

First, President Trump’s actions—executive orders, implementing measures and proposed budget—demonstrate a clear policy to radically reduce the size and impact of the federal government. The 2-for-1 Rule provides a broad, but basic baseline for controlling regulatory actions by agencies. The Interim Guidance and the OIRA Memorandum create wide latitude and ample means for the White House to strike down proposed regulatory actions that are inconsistent with the policy priorities of President Trump. For instance, under Executive Order 13,771, any new or repealed regulation that exceeds the agency’s “total incremental cost allowance” set by OMB will not be allowed, unless required by law or approved in writing by the Director of the OMB.85 Through this measure, the administration is in effect an attempt to institutionalize a “regulatory budget” for agencies as a means of controlling the size of the administrative state, an approach that has been promoted by reform advocates in Washington and adopted by other countries.86

In addition, the fact that agency heads will need to provide reorganization plans justifying their respective agency’s continued existence may also dictate what if any agency rulemaking priorities move forward. Indeed, a number of recently appointed agency heads have been vocally hostile to the agencies they now control.87 The President’s budget calls for wholesale elimination of certain programs.88 Aside from the chilling effect on new regulatory actions, the culmination of these factors could create tension between longstanding career civil servants and new political appointees. In other words, beyond a quantitative analysis, we must also discern how measures like the 2-for-1 Rule and Trump’s new political controls impact the role, authority, and mission of federal agencies, which have traditionally been afforded a degree of autonomy and deference based on their technical expertise, meritocratic norms, and professional standards. As the President’s regulatory reform agenda unfurls, we may see internal agency appeals to Congress, particular relevant committees of jurisdiction, for support. One key question to be answered is whether President Trump has the political capital to effect the bold change he seeks.

Second, in order to achieve his goal, it is obvious that President Trump intends to consolidate regulatory and rulemaking power within the Executive Branch. The OMB and OIRA sit near the top of his program to reform regulations and reduce the footprint of the federal government. The OMB Director has broad discretion to set the incremental costs allowed for each agency under the 2-for-1 Rule. The Director is also charged with overseeing a new governmental deregulatory transfer scheme. Agencies with mandates or functions that are in disfavor with the President for policy or political reasons may be subject to stricter control by the OMB, particularly in relation to any reorganization efforts or new regulatory activity.

Within OMB, OIRA will also play a prominent role in weighing the impact of almost all new regulatory actions. For instance, OIRA desk offices, assigned to each agency, will review, on a case-by-case basis, any significant guidance or interpretive documents as well as proposed deregulatory actions that save costs but do not outright eliminate a regulation.89 OIRA has discretion over measuring the timing or annualization of costs, whether costs are duplicated in other regulatory actions, and whether certain costs are even quantifiable. Agencies have a clear incentive to establish a line of communication with their respective OIRA desk officer in order to avoid confusion or confrontation on potential regulatory actions subject to President Trump’s reform agenda.

President Trump nominated Neomi Rao, a conservative lawyer and law professor to head OIRA.90 Professor Rao’s views regarding the power of the presidency and independent agencies have been controversial. She has articulated the belief that federal agencies should have less independence and be subject to stricter White House control.91 Given her strong political views and the President’s stated deregulatory goals, Professor Rao may alter OIRA’s traditional role of serving as an analytic counterweight to agencies and regulatory arbiter during the regulatory process.

At the agencies, the new RROs will serve as deregulatory watchdogs, working in tandem with OIRA and OMB to control any new regulatory actions.92 The RRTF provides an additional layer and forum to ensure that the agencies are actually following President Trump’s regulatory reform agenda.93 Whether the RRO and task force serve to enhance or inhibit the authority of the agency remains to be seen and may vary on a case-by-case basis depending on the policy priorities of the agency leadership. The new RROs and RRTFs spreading across the federal government could have a chilling effect on agency actions, from rulemaking to interpretations to enforcement. This may be the intention of increased administration over the administrative state.

Recent press reports suggest that political appointees embedded at cabinet agencies as policy advisors are there to ensure agency officials are maintaining loyalty to President Trump.94 These aides reportedly will answer to the Office of Cabinet Affairs at the White House, not to their respective department secretaries.95 The centralization of regulatory authority within the Executive Branch will likely create uncertainty in terms of what discretion is left at the agency-level for carrying out typical regulatory and administrative functions. The effect of this ambiguity will extend beyond governmental turf battles to impact industry, which relies on a predictable framework for government regulation and oversight. A fundamental question arising from this reform process is how industry will respond to what could become an extremely static or unpredictably fluid regulatory environment.

Third, a review of rulemaking in the first 100 days indicates an extremely limited and inconsistent approach to implementation of Executive Order 13,771 and its deregulatory principles. In this period, no federal agency actually implemented the 2-for-1 Rule by eliminating two existing federal regulations in order to initiate a new significant regulatory action, generally a rule with an annual effect on the economy of $100 million or more.96 Moreover, the rulemaking within the first 100 days of the new White House demonstrates significant variations on how agencies are applying Executive Order 12,866 as compared to Executive Order 13,771 even though these two presidential orders are interrelated and share the same threshold for application. The fact that agencies are more likely to invoke the Clinton-era Executive Order 12,866 as part of the regulatory impact analysis, without necessarily referencing Trump’s Executive Order 13,771, may evidence a cautious approach by the federal bureaucracy to implementing Executive Order 13,771. Indeed, within the first 100 days, the Trump administration has incrementally rolled out interpretative documents from OMB and OIRA concerning Executive Order 13,771, implicitly demonstrating that a transition period for clarification is required.97 Even at the stroke of a pen, presidential orders cannot simply change the course of the administrative state.

Fourth, President Trump’s executive orders should be understood within a tradition of presidential initiatives that have attempted to reform the federal regulatory process. Executive Order 13,771 may be analyzed according to deregulatory principles that derive from predecessor Republican administrations and respond to changes made under Democratic ones. These presidential regulatory review procedures follow an established structure and terminology, even if they diverge within this framework. What is unique about President Trump’s addition to this tradition is the use of a strict offset rulemaking formula, the layering of new political and bureaucratic controls, and the employment of ungarnished rhetoric, all of which seek to disempower the agencies’ regulatory authority.

It should be noted that President Trump’s regulatory reform agenda has not gone without legal challenge. On February 8, 2017, Public Citizen, Natural Resources Defense Council, and Communications Workers of America, filed a lawsuit in federal court claiming that Executive Order 13,771 and the accompanying Interim Guidance implementing the 2-for-1 Rule are unconstitutional because these actions direct federal agencies to engage in unlawful actions that will harm Americans, including plaintiff’s members, in violation of the Take Care Clause.98

According to plaintiffs’ claim, Executive Order 13,771 would make federal agencies violate governing statutes like the Administrative Procedure Act, which establishes the process and methodology for agencies’ regulatory action.99 By forcing federal agencies to focus on costs rather than benefits, these groups argue that Executive Order 13,771 harms the public by forcing agencies to repeal beneficial regulations and arbitrarily preventing new regulations from being passed. As a result, the lawsuit contends that the President’s executive order endangers public health, safety, and the environment and compels federal agencies to violate current governing statutes by ignoring the non-financial public benefits of current and potential regulations. The federal government filed a motion to dismiss citing the lack of standing and ripeness in the case.100 However, following plaintiffs’ amendment of its complaint to address the standing allegations, the court subsequently dismissed the government’s request as moot.101 At this moment, there are two pending motions before the court: the government’s motion to dismiss plaintiffs’ first amended complaint,102 which the plaintiff opposed, and plaintiffs’ motion for summary judgment.103 After a motion hearing on August 10, 2017, the court took these matters under advisement before issuing a ruling.104

The final outcome of this lawsuit, like the consequence of President Trump’s agenda, remains to be seen. What we can clearly conclude at this time is that the President is attempting to deliver on his promise to change the status quo in Washington. Within the first 100 days, the new administration has taken a number of concrete steps towards achieving fundamental regulatory reform. Whether President Trump is able to deliver on his ambitious government reorganization plan will determine the weight of his White House legacy.

  1. Office of Mgmt. & Budget, Exec. Office of the President, Regulatory Freeze Pending Review, 82 Fed. Reg. 8346 (Jan. 20, 2017) [hereinafter Priebus Memo]; see also Trump Administration Delayed Rules, N.Y. Times (Mar. 3, 2017), http://www.documentcloud.org/documents/‌3480502-Trump-Administration-Delayed-Rules.html [http://perma.cc/L7VD-KNDN] (providing copies of similar memoranda from the administrations of President Barack Obama and President George W. Bush).
  2. Exec. Order No. 13,771, 82 Fed. Reg. 9339 (Jan. 30, 2017).
  3. Id.
  4. ”Agencies” do not include “independent regulatory agencies,” as defined in 44 U.S.C. § 3502(5) (2012), such as the National Transportation Safety Board.
  5. 82 Fed. Reg. 9339.
  6. Id.
  7. Id.
  8. Id.
  9. Id.
  10. Id.
  11. Id.
  12. Id.
  13. See Pub. L. No. 96-511, 94 Stat. 2812 (Dec. 11, 1980) (codified as amended in scattered sections of 44 U.S.C.).
  14. Office of Mgmt. & Budget, Interim Guidance Implementing Section 2 of the Executive Order of January 30, 2017, Titled “Reducing Regulation and Controlling Regulatory Costs,” Exec. Off. President (Feb. 2, 2017), http://www.whitehouse.gov/sites/whitehouse.gov/files/‌briefing-room/‌presidential-actions/related-omb-material/EO_iterim_guidance_reducing_regulations_‌controlling_regulatory_costs.pdf [http://perma.cc/Z6EG-GM72] [hereinafter OIRA Interim Guidance].
  15. 3 C.F.R. 638 (1993).
  16. OIRA Interim Guidance, supra note 14.
  17. See Anthony Vitarelli, Happiness Metrics in Federal Rulemaking, 27 Yale J. on Reg. 115, 120 (2010) (noting that Executive Order 12,866 is “the primary vehicle of regulatory approval through the current day”).
  18. 3 C.F.R. 638.
  19. OIRA Interim Guidance, supra note 14.
  20. Office of Mgmt. & Budget, Exec Office of the President, OMB Bull. No. 07-02, Agency Good Guidance Practices (2017).
  21. OIRA Interim Guidance, supra note 14.
  22. OMB Circular A-4, Regulatory Analysis, 68 Fed. Reg. 58,366 (Oct. 9, 2003).
  23. Id.
  24. Exec. Order No. 13,771, 82 Fed. Reg. 9339 (Jan. 30, 2017).
  25. See OIRA Interim Guidance, supra note 14.
  26. Id.
  27. Id.
  28. Office of Mgmt. & Budget, Exec. Office of the President, Guidance Implementing Executive Order 13371, Titled “Reducing Regulation and Controlling Regulatory Costs” (Apr. 5, 2017), http://www.whitehouse.gov/sites/whitehouse.gov/files/omb/memoranda/2017/M-17-21-OMB.pdf [http://perma.cc/9JQN-RUTU] [hereinafter OIRA Memorandum].
  29. Id.
  30. Id.
  31. Id.
  32. According to OIRA, Executive Order 13,771 deregulatory actions are not limited to those defined as significant under Executive Order 12,866 or OMB’s 2007 bulletin on good guidance practices. Id.
  33. Id.
  34. Id.
  35. Id.
  36. Id.
  37. Id.
  38. Id.
  39. Exec. Order 13,777, 82 Fed. Reg. 12,285 (Feb. 24, 2017).
  40. Id.
  41. Id.
  42. See Pub. L. No. 106-554, 114 Stat. 2763 (Dec. 21, 2000).
  43. Id.
  44. Exec. Order 13,781, 82 Fed. Reg. 13,959 (Mar. 13, 2017).
  45. Id.
  46. Office of Mgmt. & Budget, Exec. Office of the President, America First: A Budget Blueprint to Make America Great Again, Fiscal Year 2018 (2017).
  47. Id.
  48. Aaron Blake, The 19 Agencies that Trump’s Budget Would Kill, Explained, Wash. Post: The Fix (Mar. 16, 2017), http://www.washingtonpost.com/news/the-fix/wp/2017/03/16/the-19-agencies-that-trumps-budget-would-kill-explained/?utm_term=.b712c79751f8 [http://perma.cc/XYM6-4T5R].
  49. See, e.g., Ohio River MM 598-602.7, Louisville, KY, 82 Fed. Reg. 18,393 (Apr. 19, 2017) (to be codified at 33 C.F.R. pt. 100).
  50. Adjustment of Civil Monetary Penalties for Inflation, 82 Fed. Reg. 18,559 (Apr. 20, 2017) (to be codified at 34 C.F.R. pt. 36); Clarification of When Products Made or Derived from Tobacco are Regulated as Drugs, Devices, or Combination Products, 82 Fed. Reg. 14,319 (Mar. 20, 2017) (to be codified at 21 C.F.R. pts. 1100, 201, 801).
  51. Restricted Areas, 82 Fed. Reg. 15,637 (Mar. 27, 2017) (to be codified at 33 C.F.R. pt. 334).
  52. Market Stabilization, 82 Fed. Reg. 18,346 (Apr. 18, 2017) (to be codified at 45 C.F.R. pts. 147, 155, 156); Telephone interview with the Centers for Medicare & Medicaid Services (CMS), U.S. Department of Health and Human Services (Apr. 27, 2017).
  53. See, e.g., Class Exemption for Principal Transactions in Certain Assets Between Investment Advice Fiduciaries and Employee Benefit Plans and IRAs (Prohibited Transaction Exemption 2016-02), 82 Fed. Reg. 16,902 (April 10, 2017) (to be codified at 29 C.F.R. pt. 2510).
  54. Agreement Termination Notices, 82 Fed. Reg. 19,796, 20,228 (Apr. 28, 2017).
  55. In general, federal spending regulatory actions that cause only income transfers between taxpayers and program beneficiaries (e.g., regulations associated with Pell grants and Medicare spending) are considered “transfer rules” and are not covered by Executive Order 13,771. See OIRA Memorandum, supra note 28.
  56. These search results were obtained on July 7, 2017 by using the advanced search function on the Federal Register website. The search term was “13,771”, and the results were filtered for a publication date range starting on January 30, 2017 and ending on April 29, 2017.
  57. OIRA Memorandum, supra note 28.
  58. Notice of Review of Policy, Guidance, and Regulation, 82 Fed. Reg. 26,734 (June 8, 2017).
  59. Joe Davidson, Trump Drags Feet on Political Appointees, Lags Behind Predecessors, Wash. Post: PowerPost (Apr. 26, 2017), http://www.washingtonpost.com/news/‌powerpost/wp/2017/04/26/trump-drags-feet-on-political-appointees-and-lags-far-behind-predecessors/?‌utm_‌term=.‌8734490952e8 [http://perma.cc/2Q3K-NBU4].
  60. These results are based on the use of the advanced search function on the Federal Register website, http://www.federalregister.gov/documents/search. The search term was “12,866”, and the results were filtered for a publication date range starting on January 30, 2017 and ending on April 29, 2017.  Please note that the front end of the search range begins on the publication date of Executive Order 13,771, ten days following the first day of the Trump administration.
  61. These search results are based on the use of the advanced search function on the Federal Register website, http://www.federalregister.gov/documents/search. The search term was “13,771”, and the results were filtered for a publication date range starting on January 30, 2017 and ending on April 29, 2017.  Please note that the front end of the search range begins on the publication date of Executive Order 13,771, ten days following the first day of the Trump administration.
  62. These search results are based on the use of the advanced search function on the Federal Register website, http://www.federalregister.gov/documents/search. The search field was left blank and the results were filtered for a publication date range starting on January 30, 2017 and ending on April 29, 2017.  Please note that the front end of the search range begins on the publication date of Executive Order 13,771, ten days following the first day of the Trump administration.
  63. Eric Lipton & Binyamin Applebaum, Leashes Come Off Wall Street, Gun Sellers, Polluters and More, N.Y. Times (Mar. 5, 2017), http://www.nytimes.com/2017/03/05/us/politics/trump-deregulation-guns-wall-st-climate.html [http://perma.cc/UXG5-3K4E].
  64. Id.
  65. These search results are based on the use of the advanced search function on the Federal Register website, http://www.federalregister.gov/documents/search. The search field was left blank and the results were filtered for a publication date range starting on January 20, 2009 and ending on April 29, 2009.
  66. These search results are based on the use of the advanced search function on the Federal Register website, http://www.federalregister.gov/documents/search. The search field was left blank and the results were filtered for a publication date range starting on January 20, 2017 and ending on April 29, 2017.
  67. The “Percent Difference” is calculated as the percent decrease in regulatory action between the Obama and Trump administrations rounded to the nearest whole number.
  68. These elements are borrowed from Professor Nicholas R. Parillo.
  69. Exec. Order No. 12,291, 46 Fed. Reg. 13,193 (Feb. 17, 1981).
  70. Exec. Order No. 12,866, 3 C.F.R. 638 (1993).
  71. Exec. Order No. 12,291, at § 2(b).
  72. Exec. Order No. 12,866, at § 1(b)(6).
  73. Id. § 3(f).
  74. Exec. Order No. 12,291 § 1(b).
  75. Exec. Order No. 12,866 § 6(a)(C)(ii).
  76. Exec. Order No. 12,291 § 1(d); Exec. Order 12,866 § 3(b); Exec. Order 13,771 § 2(a), 82 Fed. Reg. 12,285 (Feb. 24, 2017).
  77. Exec. Order No. 13,771, § 4(a).
  78. Exec. Order No. 12,291 § 1(b).
  79. Exec. Order No. 12,866.
  80. Exec. Order No. 13,771 § 3.
  81. Exec. Order No. 13,771 § 2(d).
  82. Exec. Order No. 13,777.
  83. OIRA Memorandum, supra note 28.
  84. See Roncevert Almond et al., Administering the Administrative State: Regulatory Reform in the Trump Era, J. Hazmat Transp., Mar./Apr. 2017.
  85. Exec. Order 13,771 § 3(d).
  86. C. Jarrett Dieterle, Lessons from the Godfather of Regulatory Budgeting, Hill (Feb. 23, 2017, 11:00 AM), http://thehill.com/blogs/pundits-blog/economy-budget/320800-lessons-from-the-godfather-of-regulatory-budgeting [http://perma.cc/SKE3-UZSJ]; Jim Tizzo, The Coming of the Regulatory Budget, Reg. Rev. (Jan. 8, 2016), http://www.theregreview.org/2016/01/08/tozzi-regulatory-budget [http://perma.cc/X3H3-CH5V].
  87. Meg Jacobs, Trump is Appointing People Who Hate the Agencies They Will Lead, CNN, (Dec. 12, 2016, 10:40 AM), http://www.cnn.com/2016/12/10/opinions/government-is-the-problem-jacobs/index.html [http://perma.cc/DQK2-Q8GV].
  88. Niv Elis, Here Are the 66 Programs Eliminated in Trump’s Budget, Hill (May 23, 2017, 2:03 PM), http://www.thehill.com/policy/finance/334768-here-are-the-66-programs-eliminated-in-trumps-budget [http://perma.cc/8WG8-SACV].
  89. See OIRA Interim Guidance, supra note 14.
  90. Steve Mufson, Trump’s Pick for Rules Czar Would Hand More Power to Trump, Wash. Post (Apr. 20, 2017), http://www.washingtonpost.com/business/economy/trumps-pick-for-rules-czar-is-expected-to-hand-over-more-power-to-trump/2017/04/19/8b33b176-206f-11e7-a0a7-8b2a45e3dc84_story.html [http://perma.cc/H9PM-ES9Q].
  91. Id.
  92. Exec. Order 13,777 § 2.
  93. Exec. Order 13,777 § 3.
  94. Lisa Rein & Juliet Eilperin, White House Installs Political Aides at Cabinet Agencies To Be Trump’s Eyes and Ears, Wash. Post (Mar. 19, 2017), http://www.washingtonpost.com/powerpost/white-house-installs-political-aides-at-cabinet-agencies-to-be-trumps-eyes-and-ears/2017/03/19/68419f0e-08da-11e7-93dc-00f9bdd74ed1_story.html [http://perma.cc/JF53-G97M].
  95. Id.
  96. The authors found no rules or proposed rules containing references to Executive Order 12,866 or Executive Order 13,771, published on the Federal Register during Trump’s first 100 days, which indicated an agency was implementing the 2-for 1 rule by elimination of two existing federal regulations. These search results are based on the use of the advanced search function on the Federal Register website, http://www.federalregister.gov/documents/search. The search terms were “12,866” and “13,771”, and the results were filtered for a publication date range starting on January 20, 2009 and ending on April 29, 2009.
  97. See OIRA Memorandum, supra note 28; OIRA Interim Guidance, supra note 14.
  98. Complaint, Pub. Citizen, Inc. v. Trump, No. 1:17-cv-00253 (D.D.C. Feb. 8, 2017).
  99. See Administrative Procedure Act, Pub. L. No. 79-404, 60 Stat. 237 (June 11, 1946) (codified as amended in scattered sections of 5 U.S.C.).
  100. Memorandum of Points & Authorities in Support of Defendants’ Motion to Dismiss, Pub. Citizen, Inc., No. 1:17-cv-00253.
  101. Order, Pub. Citizen, Inc., No. 1:17-cv-00253.
  102. Motion to Dismiss First Amended Complaint, Pub. Citizen, Inc., No. 1:17-cv-00253.
  103. Motion for Summary Judgement, Pub. Citizen, Inc., No. 1:17-cv-00253.
  104. Motion Hearing Minute Entry, Pub. Citizen, Inc., No. 1:17-cv-00253.

Why the Bank Examination Privilege Doesn’t Work as Intended

* Mr. Epstein is a partner in the New York Office of Dorsey & Whitney LLP. He is the lead author of a new legal treatise, The Bank Examination Privilege, which was published in January by the American Bar Association. He also is a lecturer in law at Columbia Law School.


Bank examinations are one of the key tools used by federal regulators to supervise the banking and financial services industry. A bank examination is a dialogue between a regulator and a bank about the bank’s policies and practices. Confidentiality is crucial to making this dialogue work. As such, publicizing examination records could inhibit candid communication between banks and regulators, and, in some cases, harm the subject institution.1 But preserving secrecy is difficult when a bank is involved in a lawsuit against a nongovernmental party. In many cases, a bank’s adversary will attempt to obtain the bank’s examination records in order to use them as evidence against the bank. Surprisingly, however, no federal statute or regulation fully addresses this problem.

To plug this gap, federal courts developed a common law rule: the bank examination privilege. The modern incarnation of the privilege originated in a series of cases in the 1990s. Each of these cases involved examinations conducted by federal regulators, including the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board, and the Federal Deposit Insurance Corporation (FDIC).2 Courts wanted to give these regulators, and banks, a reasonable assurance of confidentiality while acknowledging litigants’ legitimate need for examination records. The privilege strikes a balance: it shields examiners’ opinions, recommendations and deliberations, unless a party has a sufficiently strong need, known as good cause, to obtain that information.3

Today, the bank examination privilege is recognized in every federal circuit.4 Within the landscape of federal law, the privilege is the primary rule for resolving privilege disputes related to bank examinations. But rifts are growing between how one would expect the privilege to work and how the privilege actually works in practice.

I. The Nature of the Problem

The problem revolves around the interplay between the bank examination privilege and state privilege law. State privilege law does not uniformly mirror the bank examination privilege. Instead, the state law on this issue reflects a spectrum of approaches. Some state laws track the federal approach, while others depart from it significantly.

For example, the rule in the state of Washington functions similarly to the bank examination privilege. A Washington statute provides that bank examination reports are generally, but not always, off-limits: “The court may permit discovery and introduction of only those portions of the report which are relevant and otherwise unobtainable by the requesting party.”5 The question of whether information is “relevant” and “otherwise unobtainable” is essentially a variation on the good cause exception to the bank examination privilege.

But some other states do not treat bank examination records as privileged, or have not adopted a clear rule on point. For instance, the Supreme Court of Michigan has held that a Michigan law “requiring information obtained by examiners to be kept secret is not intended to prevent testimony of State officers in the courts of the State under oath and upon due process.”6 At the opposite end of the spectrum, some states go even further than the bank examination privilege by strictly shielding examination records. Notably, Delaware has codified a “&$#91;f]inancial institution supervisory privilege,” which provides, in relevant part: “All confidential supervisory information shall be the property of the [State Banking] Commissioner and shall be privileged and protected from disclosure to any other person and shall not be discoverable or admissible into evidence in any civil action.”7

Thus, state privilege law in this area can differ on a state-to-state basis, and often clashes with the federal approach. Based on this author’s review of all published judicial decisions regarding the bank examination privilege, there do not appear to by any published judicial decisions finding that bank examination privilege preempts these state laws.8 Thus, in each state, the bank examination privilege coexists with the state law on protecting examination records. As a result, when the two differ, a choice of law question can arise. That is, in order to determine whether bank examination records are privileged, a court first has to decide whether to apply federal or state privilege law.

This choice of law question is the crux of a major problem. One would expect that, in determining the applicable law, courts would simply distinguish between federal and state regulators. As previously mentioned, the privilege is a federal rule. It sprung from cases involving bank examinations conducted by federal regulators, such as the OCC. As such, one would expect courts to look to the privilege whenever a litigant seeks to probe a federal bank examination, but would not expect the privilege to govern bank examinations conducted by state agencies. One would expect that those examinations would be subject to the privilege law of the state that conducted the examination.

To date, however, the federal courts that have grappled with this choice of law question have arrived at a very different solution. Instead of focusing on the nature of the regulator, federal courts have focused on the nature of the lawsuit. Specifically, federal courts have held that the relevant distinction is between federal-question cases (i.e., cases that involve federal law claims or defenses) and diversity-jurisdiction cases (i.e., cases that involve state law claims and defenses). In federal-question cases, the bank examination privilege governs, even if the records being sought belong to a state regulator.9 However, in diversity-jurisdiction cases, federal courts have held that it is appropriate to look to state privilege law, even if the examination records being sought belong to a federal regulator.10

Generally, in diversity-jurisdiction cases, that entails looking to the privilege law of the state in which the federal court is situated. For example, a Michigan federal court would apply Michigan state privilege law. If the examination at issue was conducted or otherwise centered in a different state, such as Washington, the Michigan federal court would follow Michigan’s choice of law rules in deciding which state’s privilege law to apply.11

II. Why It Matters

This nuance of the bank examination privilege has significant, real-world impact. As a practical matter, federal regulators and banks cannot rely on the privilege as a predictable or dependable rule, eroding confidence in the confidentiality of bank examinations. Despite the existence of the privilege, federal examination records are often at the mercy of the policies of individual states, some of which favor disclosure. In addition, in states that strictly protect examination records, the privilege can be a source of frustration for state regulators and financial institutions. In these states, when an institution is involved in a federal-question case, the privilege can potentially replace the state’s strict confidentiality rule, thereby lowering the bar for obtaining information about state-level examinations.

Two recent decisions help to illustrate this problem. SBAV v. Porter Bancorp was a diversity-jurisdiction case litigated in the U.S. District Court for the Western District of Kentucky.12 During discovery, the plaintiff sought records of bank examinations conducted by the FDIC and Federal Reserve. The Court held that because the case involved diversity jurisdiction, the bank examination privilege was inapplicable, notwithstanding the fact that the FDIC and Federal Reserve are federal regulators. Instead, the Court looked to the privilege law of the state, Kentucky, in which the Court was situated. The Court found that Kentucky does not consider bank examination records to be privileged.13 Therefore, the Court concluded, the FDIC and Federal Reserve’s bank examination records were unprotected.14

By contrast, United States ex. rel. Fisher v. Ocwen Loan Servicing was a federal-question False Claims Act (“FCA”) case litigated in the U.S. District Court for the Eastern District of Texas.15 During discovery, the plaintiff sought records of bank examinations conducted by the West Virginia Department of Financial Institutions (“WVDFI”). The Court found that, under West Virginia law, the documents would be non-discoverable. As the Court noted: “Clearly, these communications originated with an understanding that they would not be disclosed under state law.”16 But, the Court held, “there is no reason for WVDFI to assume that these documents would be protected in an FCA action based on a federal question, especially given the broad range of permissible discovery.”17 Thus, the Court applied the bank examination privilege instead of West Virginia privilege law. The Court further held that the records were discoverable based on the good cause exception to the bank examination privilege.

In the SBAV case, the bank examination privilege failed to protect examination records belonging to federal regulators. In the Fisher case, the bank examination privilege governed, but it only served to undermine state privilege law. In both cases, the outcome arguably was a far cry from the original intent of the bank examination privilege, which was to protect sensitive, confidential federal examination records.

Why does the privilege work this way? To answer that question, it is helpful to bear in mind five points about the nature and history of the privilege.

III. Five Points about the Privilege

1. The Impact of Federal Rule of Evidence 501

The primary reason the bank examination privilege does not work as expected is because although the privilege is important to banks and federal regulators, Congress has not codified it as a statute. Thus, it is considered to be a common law rule. The fact that it is uncodified is not just a technicality: under Federal Rule of Evidence 501, the common law nature of the privilege changes the way that the privilege functions.

Federal Rule of Evidence 501 governs how federal courts choose between federal privilege law and state privilege law. Rule 501 begins by distinguishing between, on the one hand, federal common law privileges, and, on the other hand, federal privileges that stem from the U.S. Constitution, federal statutory law or rules prescribed by the U.S. Supreme Court.18 Federal common law privileges apply in federal-question cases. But federal common law privileges do not apply in diversity-jurisdiction cases. In diversity-jurisdiction cases, state privilege law supersedes federal common law privileges.19

However, when a privilege stems from the U.S. Constitution, federal statutory law or U.S. Supreme Court rules, the equation changes. Rule 501 does not bar federal courts from applying such privileges in diversity-jurisdiction cases.20

In the field of banking law, an example of a federal statutory privilege is the privilege that shields Suspicious Activity Reports (SARs). The SAR privilege is derived from the Federal Bank Secrecy Act (BSA).21 When a financial institution submits a SAR, the BSA prohibits the institution from notifying “any person involved in the transaction that the transaction has been reported.”22 Federal regulations broaden that prohibition: Federal regulations categorically provide that “[a] SAR, and any information that would reveal the existence of a SAR, are confidential,” and in general “shall not be disclosed.”23

These rules create “an unqualified discovery and evidentiary privilege” with respect to SARs.24 Because the SAR privilege is grounded in a statute, Rule 501 does not restrict it to federal-question cases. Federal courts apply the SAR privilege in diversity-jurisdiction cases as well.25 State courts similarly defer to the SAR privilege.26

By contrast, there is no such statute underpinning the bank examination privilege. If such a statute existed, the bank examination privilege and SAR privilege likely would work in a similar fashion. But because there is no such statute, courts channel the bank examination privilege through Rule 501. Rule 501 shuts the privilege down in diversity-jurisdiction cases, even when federal examination records are at issue. Conversely, Rule 501 activates the privilege in federal-question cases, even when state examination reports are at issue.

2. Relationship to 12 U.S.C. § 1828(x)

There are occasional misconceptions that a federal statutory provision, 12 U.S.C. § 1828(x), codifies the bank examination privilege. As explained below, Section 1828(x) does not codify the privilege. Thus, courts treat the bank examination privilege as a common law rule. That is why Federal Rule of Evidence 501 skews the effects of the privilege.

Section 1828(x) is entitled “Privileges not affected by disclosure to banking agency or supervisor.” Section 1828(x) and the bank examination privilege share a similar purpose: to build a barrier between bank examinations and private litigation. But Section 1828(x) and the privilege address different aspects of this issue.

Section 1828(x) allows banks to share privileged information with bank examiners without waiving any applicable privileges.27 For example, perhaps a bank receives privileged legal advice from outside counsel in the form of an email. During a subsequent bank examination, perhaps the bank shares the email with the examiner. Under Section 1828(x), sharing the email with the examiner does not waive the attorney-client privilege. In a future lawsuit, if the bank’s adversary asks for the email, the bank can withhold it.

The difference between the bank examination privilege and Section 1828(x) is that the former is a privilege, while the latter is an anti-waiver rule. The bank examination privilege attaches a privilege to the opinions, recommendations and deliberations of bank examiners. Section 1828(x) cannot do that. It can protect an already-privileged document. But the privilege itself has to come from somewhere outside Section 1828(x).

In short, Section 1828(x) and the privilege are separate and distinct rules. They serve a similar policy goal, but they do so in different ways.

3. The Role of Regulatory Policy

Many federal regulators take the position that bank examination records are privileged. Some of these regulators have even issued formal regulations to that effect.28 These regulatory policies play a vital role when the bank examination privilege is litigated. Only regulators have the standing to assert the privilege. As such, a bank cannot defend the privilege without a regulator’s support.29 If federal regulators did not consider examination records to be privileged, the privilege likely would be a dead letter.

But these regulations are not the legal authority for the bank examination privilege. That is, the privilege is not an application of these regulations. The privilege is a common-law rule. Nor do these regulations carry the force of a privilege.30

Why? No federal statute empowers federal financial regulators to declare bank examination records to be privileged in federal litigation.31 In that sense, these regulations are unlike the SAR regulation. The SAR regulation is a valid privilege because it is grounded in a statute, but these regulations are not. Without an anchor in a statute, they do not transform the bank examination privilege into a statutory or regulatory privilege. As a result, they do not exempt the privilege from Rule 501.

4. Proposed Federal Rule of Evidence 509

Congress has considered several legislative proposals to shield bank examination reports from private litigants. However, Congress has not enacted any of these proposals. As a result, the bank examination privilege remains a common law rule.

One notable attempt to codify the privilege came about during the development of the Federal Rules of Evidence in the early 1970s. In 1972, the U.S. Supreme Court submitted draft rules of evidence to Congress. Among other things, these rules would have codified nine specific evidentiary privileges.32 These rules also would have prohibited courts from recognizing any other privileges under federal common law.33

One of these privilege rules, Proposed Federal Rule of Evidence 509, was entitled “Secrets of State and Other Official Information.”34 Proposed Rule 509 would have given the government “a privilege to refuse to give evidence and to prevent any person from giving evidence upon a showing of reasonable likelihood of danger that the evidence will disclose a secret of state or official information as defined in this rule.”35

Under Proposed Rule 509, the definition of “Official Information” would have included governmental information that is unavailable to the public under the Freedom of Information Act, or FOIA.36 FOIA is the federal statute that allows journalists and other members of the public to seek records from federal agencies outside of the litigation context. FOIA contains a variety of exemptions. Each exemption allows agencies to withhold a particular category of sensitive information when responding to FOIA requests.

One of these exemptions, FOIA Exemption 8, specifically concerns federal bank examinations. FOIA Exemption 8 shields information “contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions.”37

In effect, Proposed Rule 509 would have imported FOIA Exemption 8 into private civil litigation. By doing so, Proposed Rule 509 would have indirectly codified a bank examination privilege. In fact, in two ways, this rule would have been stricter than the common law privilege that exists today. First, Exemption 8 does not contain a good cause exception. Second, Exemption 8 is not limited to bank examiners’ opinions, recommendations and deliberations. It encompasses the entire bank examination process.

Proposed Rule 509, by incorporating FOIA Exemption 8, likely would have also reshaped how the privilege applies to federal and state examinations. In particular, it likely would have protected federal examination records in both diversity-jurisdiction and federal-question cases. At the same time, in federal-question cases, it likely would not have undercut state laws that strictly shield examination records.

However, ultimately, Congress chose not to codify any specific evidentiary privileges in the Federal Rules of Evidence. As such, Congress did not pass Proposed Rule 509 into law. The rejection of these privilege rules was not a disapproval of any common law privilege.38 Rather, Congress did not want to “freeze the law governing the privileges of witnesses in federal trials at a particular point in our history[.]”39 Congress intended courts to continue developing the law of privilege “in the light of reason and experience.”40

5. The Bank Examination Report Protection Act

In the late 1990s, Congress considered another proposal to legislatively protect bank examination reports: a bill entitled the Bank Examination Report Protection Act (BERPA).41 BERPA would have added a “Bank Supervisory Privilege” to federal statutory law. In particular, BERPA would have provided: “All confidential supervisory information shall be the property of the Federal banking agency that created or requested the information and shall be privileged from disclosure to any other person.”42 BERPA would have protected state examinations to the same extent in federal litigation.43

Procedurally, BERPA also would have prohibited litigants from requesting bank examination reports from banks. Instead, BERPA would have required litigants to seek such documents from the regulator that conducted the examination. If the regulator declined to produce the requested documents, BERPA would have allowed the litigant to ask the court to override the regulator’s decision. However, in most cases, the court’s role likely would have been limited to simply confirming that the documents being withheld were, in fact, confidential supervisory information, and therefore privileged.44

BERPA had support from federal45 and state46 regulators. Like Proposed Federal Rule of Evidence 509, BERPA would have fixed two of the anomalies in the common-law bank examination privilege. First, BERPA would have extended the privilege to diversity-jurisdiction cases. Second, by strengthening the privilege, BERPA would have prevented it from diluting state privilege laws. However, for reasons that are unclear from available legislative history, the bill stalled, and was never made into law.

IV. Potential Solutions

As noted earlier, the main purpose of the bank examination privilege is to create clear expectations regarding the confidentiality of federal bank examinations. However, currently, the privilege does not fully achieve that goal. With respect to federal bank examinations, the privilege is not a reliable rule. With respect to state bank examinations, it interferes with state laws that give bank examinations broader and more rigorous protection.

There are two ways to solve this problem. The first would involve legislative change. Congress could pass a bank examination privilege statute. It would have to apply consistently across all types of civil cases, whenever litigants seek federal bank examination records. It also would have to specify the role, if any, of state privilege law when litigants seek information about examinations conducted by state regulators.

The second solution would be to rethink how the existing, common-law bank examination privilege should work. In general, federal common law rules do not supersede state law. But federal common law rules can supersede state law “where there are uniquely federal interests at stake.”47 For example, “[o]ne such exception applies to litigation that implicates the nation’s foreign relations.”48 In such cases, “[b]ecause our foreign relations could be impaired by the application of state laws, which do not necessarily reflect national interests, federal law applies . . . even where the court has diversity jurisdiction.”49

Arguably, the bank examination privilege implicates another uniquely federal interest: specifically, the interest in effective federal regulation of the banking industry. Like foreign relations, this uniquely federal interest could be impaired if “left to divergent and perhaps parochial state interpretations.”50 Therefore, when litigants seek to uncover confidential federal examination records, the privilege arguably should supersede state law, even if a literal reading of Rule 501 might suggest that state privilege law should apply.

In addition, in federal-question cases, when litigants seek state examination records, federal courts could give greater weight to state statutes that strictly protect those records. Technically, federal privilege law governs in federal-question cases. But federal privilege law has the flexibility to import state statutory privileges. To determine whether federal privilege law should import a state statutory privilege, a federal court will “balanc[e] the policies behind the privilege against the policies favoring disclosure.”51 The court will explore:

(1) whether the fact that the . . . [state] would recognize the privilege itself creates good reason for respecting the privilege in federal court, regardless of our independent judgment of its intrinsic desirability; and (2) whether the privilege is intrinsically meritorious in our independent judgment.52

Thus far, only one decision—Fisher, which was touched upon earlier—has applied this test to bank examinations. In Fisher, the Eastern District of Texas concluded that this standard for the application of state privilege law was not met. The court reached this conclusion because “[t]here is a strong federal interest in FCA cases for seeking the truth, and in this case, federal law plays a predominant role in the litigation.”53 However, this precedent has not yet been analyzed by other federal district courts, or by any federal appellate court.

In sum, there are several potential pathways for fixing the bank examination privilege. For the time being, however, banks should be aware that the privilege does not offer ironclad protection, or even a predictable level of protection, with respect to bank examination records. As a result, during a bank examination, it can be difficult for a bank to know with certainty if the examination results will be revealed in future litigation.

Currently, the best way for a bank to reduce this uncertainty is to be mindful of both federal and state privilege law. During a bank examination, a bank should consider the federal rule: the bank examination privilege. But a bank also should consider the relevant state laws that may apply in a future case. In particular, a bank should consider the privilege laws of the states in which the bank is subject to regulatory oversight, as well as the privilege laws of the states in which the bank tends to face civil litigation. By creating a blended picture of these federal and state rules, a bank can assess the risk that its confidential communications with federal and state bank examiners may be exploited by an adversary in a lawsuit.

  1. In re Subpoena Served Upon Comptroller of the Currency, 967 F.2d 630, 633-34 (D.C. Cir. 1992).
  2. In re Bankers Trust Co., 61 F.3d 465 (6th Cir. 1995); In re Subpoena Served Upon Comptroller of the Currency, 967 F.2d 630; Principe v. Crossland Sav., FSB, 149 F.R.D. 444 (E.D.N.Y. 1993).
  3. In re Subpoena Served Upon Comptroller of the Currency, 967 F.2d 630, 634.
  4. Martinez v. Rocky Mountain Bank, 540 Fed. Appx. 846, 854 (10th Cir. 2013); In re Bankers Trust Co., 61 F.3d at 471-2; Rockwood Bank v. Gaia, 170 F.3d 833, 839 n.4 (8th Cir. 1999); In re Subpoena Served Upon Comptroller of the Currency, 967 F.2d at 633-35; Redland Soccer Club, Inc. v. Dep’t of Army of U.S., 55 F.3d 827, 853 n.18 (3d Cir. 1995); Overby v. U.S. Fidelity & Guar. Co., 224 F.2d 158, 163 (5th Cir. 1955); FDIC v. Jones, No. 2:13–cv–00168, 2015 WL 4275961, at *1 (D. Nev. Jul. 14, 2015); Gradeless v. Am. Mut. Share Ins. Corp., No. 1:10-CV-00086, 2011 WL 221895, at *6 (S.D. Ind., Jan. 19, 2011); In re JPMorgan Chase Mortg. Modification Litig., No. 11-MD-02290, 2012 WL 5947757, at *2 (D. Mass. Nov. 27, 2012); Raffa v. Wachovia Corp., 242 F. Supp.2d 1223, 1225 (M.D. Fla. 2002); Fed. Hous. Fin. Agency v. JPMorgan Chase & Co., 978 F. Supp.2d, 267, 273 (S.D.N.Y. 2013); Marriott Emps.’ Fed. Credit Union v. Nat’l Credit Union Admin., No. CIV.A. 96-478-A, 1996 WL 33497625, at *6 (E.D. Va. Dec. 24, 1996).
  5. See, e.g., Wash. Rev. Code § 32.04.220 (2016).
  6. In re Culhane’s Estate, 269 Mich. 68 (1934) (discussing Michigan state law).
  7. See, e.g., Del. Code Ann. tit. 5, § 145 (2017).
  8. U.S. Const. art. VI, § 2.
  9. Fisher v. Ocwen Loan Servicing, LLC, No. 4:12-CV-543, 2016 U.S. Dist. LEXIS 73759 (E.D. Tex. Jun. 7, 2015) (applying the privilege to examination records belonging to the New York State Department of Financial Services in a False Claims Act case); Rouson ex rel. Estate of Rouson v. Eicoff, No. 04-CV-2734, 2006 WL 2927161 (E.D.N.Y. Oct. 11, 2006) (applying the privilege to examination records belonging to the New York State Banking Department in a Racketeer Influenced and Corrupt Organizations case).
  10. See Mich. First Credit Union v. Cumis Ins. Soc’y, No. 05-CV-74423, 2007 U.S. Dist. LEXIS 17582 (E.D. Mich. Mar. 14, 2017) (applying Michigan privilege law to Michigan Office of Financial and Insurance Services examination records in diversity-jurisdiction case); SBAV LP v. Porter Bancorp, Inc., No. 3:13-CV-00710-TBR, 2015 WL 1471020 (E.D. Ky. Mar. 31, 2015) (applying Kentucky privilege law to FDIC and Federal Reserve examination records in diversity-jurisdiction case), vacated as moot, 3:13-CV-00710, 2015 WL 8004502 (W.D. Ky. Dec. 1, 2015); In re Powell, 227 B.R. 61 (Bankr. D. Vt. 1998) (applying Vermont privilege law to FDIC examination records in diversity-jurisdiction case).
  11. Klaxon Co. v. Stentor Elec. Mfg. Co., 313 U.S. 487, 496-97 (“Subject only to review by this Court on any federal question that may arise, Delaware is free to determine whether a given matter is to be governed by the law of the forum or some other law.”).
  12. SBAV LP, 2015 WL 1471020, at *1.
  13. Id. at *5.
  14. The FDIC and Federal Reserve subsequently moved for reconsideration of this decision. Shortly thereafter, the case was settled. Thus, the Court did not decide the motion for reconsideration.
  15. No. 4:12-CV-543, 2015 WL 3942900, at *2 (E.D. Tex. June 26, 2015).
  16. Id. at *5.
  17. Id.
  18. See Fed. R. Evid. 501.
  19. Id.
  20. See 23 Charles Alan Wright & Kenneth W. Graham, Federal Practice and Procedure § 5436 (1980); see also Pierce Cty. v. Guillen, 537 U.S. 129, 147-48 (2003) (holding that Congress had the authority under the Commerce Clause to pass a statute restricting the discovery and admissibility of evidence in state and federal court).
  21. 31 U.S.C. § 5318(g)(2) (2012).
  22. Id.
  23. 12 C.F.R. § 21.11(k) (2017).
  24. Whitney Nat’l Bank v. Karam, 306 F. Supp.2d 678, 682 (S.D. Tex. 2004).
  25. See, e.g., Lee v. Bankers Trust Co., 166 F.3d 540, 543-45 (2d Cir. 1999) (applying SAR privilege in diversity-jurisdiction case).
  26. See Union Bank v. Super. Ct., 29 Cal. Rptr. 3d 894 (2005) (applying SAR privilege).
  27. 12 U.S.C. § 1828(x) (2012).
  28. See, e.g., 12 C.F.R. § 4.36(b) (2016) (“It is the OCC’s policy regarding non-public OCC information that such information is confidential and privileged. Accordingly, the OCC will not normally disclose this information to third parties.”).
  29. Merchants Bank v. Vescio, 205 B.R. 37, 42 (D. Vt. 1997).
  30. See, e.g., In re Bankers Trust Co., 61 F.3d 465, 470 (6th Cir. 1995.
  31. Id.
  32. Jaffe v. Redmond, 518 U.S. 1, 8 n.7 (1996).
  33. See Fed. R. Evid. 501 (unenacted), http://www.law.harvard.edu/publications/evidenceiii/rules/501_proposed.htm.
  34. See Fed. R. Evid. 509 (unenacted), http://www.law.harvard.edu/publications/evidenceiii/rules/509_proposed.htm.
  35. Id.
  36. Id.
  37. 5 U.S.C. § 552(b)(8) (2012).
  38. See S. Rep. No. 93-1277, at 7059 (1974) (noting that “the action of Congress should not be understood as disapproving any recognition of a psychiatrist-patient, or husband-wife, or any other of the enumerated privileges contained in the Supreme Court rules.”).
  39. Jaffee v. Redmond, 518 U.S. 1, 9 (1996).
  40. See S. Rep. No. 93-1227.
  41. See H.R. 174, 106th Cong. (1999).
  42. Id. at § 45(b)(1)(A).
  43. Id. at § 45(c).
  44. Id. at § 45(e).
  45. See Regulatory Burden Relief, Hearing Before the Subcomm. on Fin. Insts. & Consumer Credit of the S. Comm. on Banking and Fin. Servs., 105th Cong. 158 (1998) (statement of Julie L. Williams, Acting Comptroller of the Currency).
  46. See Press Release, Conference of State Bank Supervisors, State Bank Regulators Back Burden Relief (Jul. 16, 1998), https://www.csbs.org/news/press-releases/pr1998/Pages/Statebankregulatorsbackburdenrelief.aspx.
  47. Ungaro-Benages v. Dresdner Bank AG, 379 F.3d 1227, 1232 (11th Cir. 2004).
  48. Id.
  49. Id. at 1232-33.
  50. Banco Nacional De Cuba v. Sabbatino, 376 U.S. 398, 425 (1964).
  51. Am. Civil Liberties Union v. Finch, 638 F.2d 1336, 1343 (5th Cir. Unit A Mar. 1981).
  52. Id.
  53. Id. at 4.