What Can Managers Privately Disclose to Investors?

* Harvard Business School. I would like to thank Jeff Guo (editor), Brian Bushee, Jihwon Park, and workshop participants at Temple University for their thoughtful feedback. This research is funded by the Harvard Business School.

Regulators have long been aware that differential access to information can undermine the efficiency and fairness of financial markets. In an effort to place investors on equal footing, the Securities and Exchange Commission in 2000 created Regulation Fair Disclosure (Reg FD), which prohibits public firms from disclosing material information to certain parties but not others. Nevertheless, managers have continued to meet privately with select investors, possibly sharing information in violation of Reg FD. A key weakness of Reg FD is that its definition of materiality remains unclear. Using a series of vignettes based on actual private investor meetings, I investigate how managers and regulators understand Reg FD. I find considerable uncertainty and disagreement among both managers and regulators as to what kind of information may be lawfully communicated. Many managers interpret Reg FD subjectively, often relying on individual industry norms to decide where to draw the line. Ultimately, the ambiguity of Reg FD leads to considerable variation in the information managers privately provide to investors, undermining the notion of a level playing field in financial markets.

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I. Leveling the Playing Field

Well-functioning equity markets are predicated on investors’ ability to acquire accurate and timely information about firms. This information is gathered from a variety of sources, including press releases, regulatory filings, conference calls, and private meetings with management. Historically, executives provided information selectively, sharing it with certain investors during private meetings. To the extent that only some investors had access to certain material information (e.g., advance knowledge of earnings-related information), it placed these investors in a more favorable trading position.1 Notably, the prohibition against insider trading did not restrict managers from providing information during private meetings with investors, since the information was neither being misappropriated nor traded upon for personal gain by insiders.2 Out of concern that the selective disclosure of news by managers could undermine investor confidence and the integrity of financial markets, the Securities and Exchange Commission (SEC) implemented Regulation Fair Disclosure (Reg FD) in October 2000. Reg FD requires any material information disclosed by managers to be released publicly so that all investors may consume it.3 The regulation effectively closed the gap that existed around insider trading restrictions that permitted managers to convey some non-public, material information legitimately to outsider parties.

When Reg FD was promulgated, some commenters raised concerns that the regulation could sharply curtail or even eliminate private dialogue between managers and investors.4 However, in the years since, private meetings have flourished despite the apparent restrictions on what may be conveyed during these offline interactions. For example, Brown, Call, Clement, and Sharp (2018) recently surveyed hundreds of investor relations officers and found that seventy percent of firms granted investors offline access to senior executives.5 Researchers have tried to understand how private meetings persisted in the wake of Reg FD. One explanation is that managers merely provide immaterial information to investors during meetings, which is permitted under the regulation. An alternative hypothesis is that managers commonly disclose material information, but that these violations are difficult to enforce because the meetings are private. Indeed, these private meetings appear to be quite valuable: Academic papers have found that those in attendance make more informed trading decisions—buying before the stock rises and selling before it falls.6 To better understand how both managers and regulators view the appropriateness of information disclosed during private meetings, I present a series of vignettes of private meeting interactions to managers and regulators to ascertain what types of dialogues they view as appropriate. As will be shown, the answers by both managers and regulators suggest that there is considerable uncertainty about what is acceptable. Managers operate in the penumbra of regulatory ambiguity when they privately meet with investors.

II. Assessing Managerial and Regulatory Views of Acceptable Private Dialogue

Reg FD requires that whenever a firm seeks to disclose material information, the information must be disclosed publicly (e.g., via press release, conference call, etc.). The regulation does not explicitly prohibit managers from speaking privately with investors and analysts, but restricts them to communicating information that is immaterial. However, Reg FD does not define what is meant by material information.7 In its preamble to the final rule, the SEC explicitly noted that Reg FD relies on existing definitions of materiality in the case law—i.e., “[i]nformation is material if ‘there is a substantial likelihood that a reasonable shareholder would consider it important’ in making an investment decision.”8 Numerous law firms have noted the uncertainty in the interpretation of the regulation and the difficult position it places managers in,9 Morrison & Foerster, Frequently Asked Questions About Regulation FD(2017), https://media2.mofo.com/documents/faqs-regulation-fd.pdf [https://perma.cc/DF52-D6X3].] and ultimately no clear guidance about what information could be conveyed privately under the regulation was provided.10.] Adding to the ambiguity, the SEC considers some information immaterial even if it can be used by investors and analysts in conjunction with their other information to make material insights.11 The continued ubiquity of private investor meetings suggests that some norms have developed about what information managers may convey. However, it is uncertain whether these practices comport with the expectations of regulators. To better ascertain the boundaries of permissible private dialogue under Reg FD, I asked both managers and regulators to evaluate a series of vignettes depicting private meetings between investors and managers.

To design the vignettes, I relied on a dataset collected by observing and recording the private interactions between investors and managers at nearly seventy private meetings at two publicly traded companies.12.] During these meetings, investors posed more than 1,200 questions to executives.I focused on questions that asked information about management impressions of the firm and those that sought more timely information since these inquires raise the most salient concerns with potentially conveying material information. I sought to also select questions that not only raised challenging issues, but ideally also ones that were routinely asked by investors.For instance, twenty-six different investors in the database asked managers of a biotechnology firm for an update on the firm’s cash position and cash burn rate.13 I worked with two investor relations officers (who have more than fifteen years of experience each and have collectively attended hundreds of private investor meetings) to script representative investor-manager conversations based on these questions.14In each vignette, the investor asks for a certain kind of information about the company, and the manager offers an answer (all seven vignettes are provided in the Appendix). Survey respondents read the vignettes and were asked: “Would you consider the information the investor received during the meeting with COMPANY to be a violation of Reg FD?”

Participating managers were randomly selected from a list of chief financial officers and investor relations officers of large publicly traded firms.15Participating “regulators”—specifically, individuals charged with investigating possible violations of the securities laws and helping enforce those laws—were shown the vignettes during an annual training conference.16 The order of the vignettes was randomized to avoid rank-order effects. I received completed surveys from thirty managers and seventy regulators.17 Managers responded to every vignette with significant disagreement, some seeing the disclosure as a potential violation of Reg FD and others deeming the information immaterial. In every case there were some managers who believed the disclosure was unambiguously illegal, while others found it “likely not” or “not” a violation of Reg FD. On average, 65% of the managers responding to each vignette stated that the depicted disclosure likely or certainly violated Reg FD. Even for the vignette that the most managers found acceptable (Situation A: expressing sell-side analyst interest), a significant minority—38%—still believed the information violated or likely would violate Reg FD. The aggregated responses for all the vignettes are shown in Table 1.

Perhaps even more notable is that regulators had equally mixed responses to the vignettes. Although these respondents are charged with supporting the enforcement of securities regulation like Reg FD, there was considerable heterogeneity in what regulators viewed as appropriate under the policy. On average, 62% of the regulators responding to a vignette stated that it likely or certainly violated Reg FD—a level nearly identical to the manager respondents. Regulators were not consistently more strict about finding Reg FD violations. In three of the seven vignettes, regulators were more prone than managers to view the dialogue as acceptable under Reg FD. None of the differences in responses between managers and regulators in the vignettes are statistically significant (as shown in last two columns of Table 1 through the χ2 test statistic).

The qualitative responses provide insight into how managers interpret Reg FD. Consider Situation A, where the hypothetical CFO tells investors that that additional analysts had expressed interest in covering the company. Here, 38% of managers and 48% of regulators said such a disclosure would likely or certainly violate Reg FD. Managers who believed this to be a violation of Reg FD explained that they felt the CFO’s disclosure would influence the company’s share price.

“Learning that specific analysts may initiate coverage on a company is insider information.”

“Launch of coverage can significantly impact the share price and is material information that an investor shouldn’t know. It’s a bad form of management to share that info, not to mention illegal under FD.”

In contrast, the 62% of managers who did not believe that Situation A violated Reg FD explained why they felt the information was immaterial:

“Additional sell-side coverage does not guarantee additional liquidity, neither does it indicate any movement in the company’s value up or down.”

“To allege a violation of Reg FD assumes coverage by the new analysts is both positive and differentiated from the existing analysts as to cause a material appreciation in share price.”

This variation in responses relies on the respondents’ assessments of whether additional analyst coverage is enough to move the price of a stock. Studies on analyst initiation decisions support the view that new analyst coverage is sufficient to generate changes in prices and liquidity, suggesting that the information could be viewed as material.18 At the same time, this does not resolve the question of a potential violation since these academic studies are not known to most investors. The regulation is based on the beliefs of “reasonable investors,” not academic researchers. Thus if analysts’ initiations are believed to be inconsequential to the average investor (despite academic research to the contrary), then under a strict interpretation of the regulation, it ought not be a violation. The variation in responses by managers reflects the ambiguity of what a “reasonable investor” understands about sell-side coverage and therefore what is material.

Others vignettes generated considerably higher percentages of respondents identifying a Reg FD violation. In Situation D, the hypothetical CEO discloses that she is likely to continue purchasing additional shares in the firm. Comporting with evidence that a CEO’s desire to purchase shares is a significant signal of a firm’s prospects, 69% of manager respondents judged that this was material information that had been disclosed in violation of Reg FD. However, some argued that a CEO’s personal views about the company stock are not material.

“Just because the CEO thinks the stock is worth purchasing doesn’t mean it will perform well.”

“I don’t feel like the intention to buy shares personally is significant enough to materially move the stock beyond what a track record of purchases would do.”

Notably, the second respondent stated, as did others, that the disclosure was not material because of how the situation “felt.” Thus, it appears that some managers evaluate the acceptability of providing a piece of information not by some well-defined definition of materiality or prior evidence of the impact of a particular action, but rather subjectively based on their intuitive impression of whether the information “feels” material. 19
“If you flipped the question to say he told the investor he would very likely be selling shares I would have said yes, a violation of Reg FD.”

Prior research finds that insider purchases tend to be more informative about future stock returns than sales because insider sales arise for both information and liquidity reasons.20
Thus, this manager appeared to rely on a different set of beliefs (i.e., sales occur for information, rather than liquidity reasons) to form his or her views of what conduct would be viewed as material.

In other instances, responses appear largely unguided by the regulation, but instead by what is perceived to be acceptable practice based on norms in the industry. This was most clear with Situation F, where the CEO discloses that there have been informal discussions about potentially selling the firm. Here, 72% of managers saw a likely violation of Reg FD. The 28% of managers who disagreeed cited the commonplace nature of such takeover discussions.

“M&A discussions between firms are common and disclosing that discussions have been held should not be considered material for disclosure purposes.”

“Most CEOs think their company is worth more than where it is trading . . . Informal meetings with competitors and strategic partners are not uncommon.”

Merger and acquisition (“M&A”) discussions are one of the few areas where the SEC has offered specific guidance related to Reg FD, suggesting that such information “should be reviewed carefully” because it is “more likely to be considered material.”21 But the guidance also includes the explicit warning that information about mergers is not per se material, and that determinations must still be made case by case.22 This vagueness may explain why even 24% of regulators said the M&A information conveyed in Situation F was unlikely to violate Reg FD.

In this situation, the guidance might have confused more than it clarified. One manager, an investment relations officer, strongly believed that the information discussed in the vignette would be a clear violation of Reg FD:

“Discussing M&A suitors, meetings, or discussions would be material non-public information. Period.”

Here, the IRO seems to be misinterpreting the SEC’s guidance by divining a bright-line rule where one does not actually exist.

The differences in perspectives suggest that there are discrepancies between how the regulation is written, how it is interpreted and, and how it is complied with by managers in practice. Managers may believe that some disclosures violate Reg FD, but still view it as acceptable behavior because it has become a widespread practice in their industry. In particular, several respondents explicitly discussed the divergence of Reg FD in practice from Reg FD “in theory.”

“By the letter of the law, if management is discussing anything they haven’t said publicly before about their strategy, it’s a violation of Reg FD. But realistically, management is going to answer strategic questions when asked.”

“Speaking from experience, investor relations and management routinely say things like ‘we have more analysts interested in us’ or ‘we’ve talked to this sell-side guy or that one’ in private investor meetings. It’s not best practice, but it’s also a reasonable assumption that anyone might make.”

One manager respondent suggested that how much information would be conveyed was less a function of what regulation guided, but more of a matter of who they were speaking with. In response to one vignette where the respondent believes the executive’s answer violated Reg FD, the respondent stated:

“I can say that the exact situation described here happens every day, and management typically wants to answer it. How clearly and how detailed they answer the question depends on who that investor is. If it’s Wellington or Fidelity, or a long-only type shop that they’d love to have as long-term investors, he’s going to bend over backwards and divulge information. If it’s a high-turnover hedge fund, he’ll be very careful. If it’s a no-name investment firm, the meeting wouldn’t even be happening.”

In practice, based on the few administrative proceedings that the SEC has initiated against firms for violating Reg FD, the SEC seems to take note of large, unexplained swings in the stock price.23 However, relying on stock price changes to identify Reg FD violations raises the problem of defining fraud by hindsight.24 Courts have consistently rejected the notion that information has to necessarily change an investor’s mind to be viewed as material. For instance, in SEC v. Mayhew, the court reasoned that “to be material, the information need not be such that a reasonable investor would necessarily change his investment decision.”25 None of the disclosures described in the vignettes would be considered per se material by a court. As the Supreme Court held in TSC Industries, Inc.. v. Northway, Inc., “only if the established omissions are ‘so obviously important to an investor that reasonable minds cannot differ on the question of materiality’ is the ultimate issue of materiality appropriately resolved ‘as a matter of law.’”26
Since both managers and regulators found the information disclosed as material in each vignette, none of the disclosures in the vignettes could be described as unambiguously material or immaterial.

Given the difficulty that managers—and regulators—seemingly have in assessing materiality in a consistent manner across the vignettes, one potential concern is that the vignettes themselves are unusually vague. Put differently, the concern is that there would be greater agreement among respondents if the vignettes included more specific information and facts.

There are two considerations which help mitigate this concern and support the premise that the responses accurately reflect the inability of individuals to consistently assess what is appropriate under Reg FD. First, although these vignettes were invented, they are representative of actual conversations as observed by two experienced investor relations officers and the author. Their realism was further confirmed by several of the surveyed managers. For example, one respondent commented:

“I’ve personally experienced this many times as an analyst and as an IRO. Of course, the investor is going to ask the question. And, of course, this is exactly how most management teams would answer the question.”

Thus the vignettes accurately reflected casual and vague nature of these private investor conversations in the real world. Any examination of how individuals interpret the restrictions created by Reg FD needs to be under representative circumstances as they arise in practice, rather than a more clinical and artificial context where any ambiguity has been removed. While greater information may help regulators resolve whether particular information ought to be conveyed under Reg FD, such detail is simply not representative of how most information is conveyed by managers during actual private meetings.

A second observation which suggests that managers’ inability to consistently ascertain what information can be provided under Reg FD is a function of the regulation and not the design of these particular vignettes is the conviction in managers responses which is unrelated to the specific information provided by firms. For example, the manager who wrote that “discussing M&A suitors, meetings, or discussions would be material non-public information. Period.” indicates that he/she felt that any conversation related to M&A was inappropriate. The specific information in the conversation about the M&A conversation was not pertinent to this manager’s determination (i.e., the only appropriate managerial response to an investor question about M&A is “no comment”). Perhaps even more significantly, numerous managers explicitly stated that that the amount of detail that would be appropriate to provide in response was not guided by Reg FD restrictions, but instead by who they were speaking with (e.g., “[h]ow clearly and how detailed they answer the question depends on who that investor is”). In this way, the determining factor such mangers consider in practice about what to convey is “who” the investor is, not what material information is formally restricted under Reg FD. Thus, even if more specific information was provided in each vignette, it is not clear that this would alter managers’ judgments since managers’ assessments of the appropriateness of the information conveyed is often divorced from the notion of materiality.

III. Clearer Expectations

The lack of agreement among managers leads to divergent practices that undermine Reg FD’s objective of creating a more level playing field where all investors have access to the same material information. As indicated by the survey responses, managers often confront this ambiguity by devising their own regulatory interpretations. For example, if managers observe competitors providing cash updates privately to investors during meetings, then such disclosures become tacitly accepted practice even when communicating such information violates both the spirit and literal reading of the regulation.

Managers also appear to decide how much information to convey based on who they are meeting with and whether providing the information is likely to benefit their relationship with the investor. Such decisions appear to more deliberately ignore regulatory restrictions, but the lack of enforcement limits the risk of such practices. Problematically, this means that Reg FD creates a greater burden on firms that more faithfully and conservatively adhere to the regulation, while posing little downside to managers who, at least in part, ignore it.

Private discussions have the opportunity to improve investors’ ability to more effectively allocate capital, thereby improving market efficiency. Yet, when some managers feel less constrained by the regulation than others, this creates a heterogeneous disclosure environment where some managers are providing more information to investors than others. To the extent that investors value this more privileged access, this can benefit managers and implicitly reward firms for violating the regulation. Moreover, to the extent that managers continue to provide quasi-material or material information to select investors they meet privately with, market participants as a whole gain a misleading impression that they are operating on a “level” information playing field—undermining the impetus for creating Reg FD.

In the eighteen years since the passage of the regulation, there have been thirteen Reg FD enforcement cases. One explanation for lack of cases, given the nearly ten million estimated private interactions that have occurred since Reg FD’s passage,27. On average, there were 4,640 publicly traded operating firms (i.e., non-REIT) each year since the passage of Reg FD, according to author calculations from CRSP data. Thus, there have been an estimated 9.5 million private meetings between managers and investors in the eighteen years since the passage of Reg FD.] is that managers largely abide by Reg FD’s restrictions, thereby creating few opportunities for SEC enforcement. Yet, in light of managers’ responses to the vignettes in this study, a more plausible explanation for the paucity of enforcement is that the SEC is effectively unable to “police” markets for Reg FD violations. Offline manager-investor meetings are, by definition, private. Thus, without any disclosure requirement on the part of firms, regulators cannot ascertain where or when such interactions occur, let alone the specifics of the discussion, unless information leaks out of a meeting. Lacking the ability to observe such interactions, the SEC is neither capable of evaluating such dialogue for its appropriateness (in contrast to public securities filings) nor capable of sanctioning private manager-investor communications that violate Reg FD.

A regulation that is heterogeneously interpreted by market participates and unable to be effectively enforced by regulators undermines rather than enhances market integrity. The heterogeneity in responses by both managers and regulators suggest that the regulation is failing to fulfill its original objective of creating a more level playing field with respect to information access. To amend the regulation and help it further achieve its original goal, four considerations must be taken into account. First, changes that would prevent or curtail institutional investors’ private access to senior executives could have negative externalities (e.g., hinder capital allocation decisions in the United States by large institutional investors) and face considerable political obstacles to passage. Practically speaking, some investors will continue to gain considerable private, one-on-one time with executives. Second, creating regulations that the SEC cannot effectively police is unsatisfactory policy. Therefore, changes to the regulations should recognize the impediments that the SEC currently faces in evaluating whether managers are providing information that violates Reg FD. Third, as the SEC itself acknowledged in its original rule, bright-line standards about what information is and is not material are unlikely to be effective and exhaustive. At the same time, for each vignette, at least some regulators found the dialogue appropriate and others inappropriate, suggesting a potential degree of arbitrariness depending on the individual characteristics of the specific regulator looking at the case. Creating a more consistent and rigorous set of guidelines of what can be appropriately disclosed, while avoiding bright-line standards, would help reduce ambiguity both among managers and regulators. Finally, in line with the original goal of the regulation, all investors should have access to information that may be viewed as material (i.e., that at least some investors see as material).

In line with these expectations, regulators could create a requirement that firms publicly disclose records of their private discussions shortly after each meeting in the form of detailed minutes or transcripts.28
Such a proposal would acknowledge the potential value of private interactions, but also provide for the fact that some information that managers convey to investors may be material to other investors. This disclosure requirement would also remedy regulators’ current inability to observe potential violations by making private material disclosure effectively moot.29 By disclosing all meeting contents, material information, even if privately communicated to an investor during a meeting, would be disseminated to all market participants. Regulatory enforcement could focus on firms that fail to disclose or do not adequately disclose their private interactions, rather than trying to assess whether a specific piece of information is material or not. This proposal would bolster transparency by providing investors access to all information disclosed by managers and place the SEC in a more effective position to enforce its policies.

There are several potential criticisms to the idea of requiring firms to publicly release meetings data in a timely manner. First, historically some institutional investors have conveyed proprietary insights during their private dialogue with executives. Timely public disclosure of an investor’s strategy could hinder an investor’s ability to capitalize on their plan. Investors could respond by becoming more nuanced in the information they convey to management to avoid its dissemination, or the investor could simply participate in public conversations (e.g., earnings conference call). Exceptions to public disclosure could also be made in some limited circumstances (e.g., private placement negotiation) where its immediate public disclosure could adversely impact firms. Second, between the time of the meeting and the public disclosure of the meeting conversation, investors who attended the meeting could be placed at an information advantage. Although this time could be short (perhaps less than 24 hours), other market participants would be at an information disadvantage during this time. One solution would be to prohibit investors who attend private meetings from trading until the records are publicly released. Alternatively, firms could publicly disclose when meetings are planned to occur so that other investors could choose to avoid trading during that time. While there are different externalities associated with each of these considerations, further analysis could seek to design policy to minimize any adverse effects. Finally, some firms are likely to object on the basis of the cost of preparing and releasing such records. However, many firms already prepare informal logs of questions that are frequently asked by investors during private meetings. The regulatory disclosure would simply be a more complete and rigorous compilation of the meeting dialogue. The monetary outlay associated with preparing minutes/transcripts would additionally not be a material expenditure for firms. Overall, it is possible to address many of the preceding concerns in designing an updated disclosure policy.

IV. Conclusions

Managers should not be forced to play a game of roulette when privately meeting with investors. While managers could take a conservative approach and either not engage in private meetings or not provide any information that any investor could view as material, such a choice would likely prove detrimental to both the firm and the efficiency of capital allocation within capital markets. At the same time, managers who divulge information risk violating Reg FD, albeit without necessarily intending or even appreciating that they are doing so.

Although Reg FD operates in a civil context, the constitutional doctrine of vagueness, which prohibits ambiguous criminal codes, offers an apt warning to regulators. The Supreme Court has held that it violates the Fifth Amendment to “take[] away someone’s life, liberty, or property under a criminal law so vague that it fails to give ordinary people fair notice of the conduct it punishes, or so standardless that it invites arbitrary enforcement.”30 It is not clear why securities regulations such as Reg FD, which have sweeping personal consequences for individuals and firms who are sanctioned, should be held to a lesser standard.31 When both regulators and the regulated disagree vehemently among themselves and between each other over the appropriate interpretation of a rule, it verges on being “standardless.” Such arbitrariness should give all parties pause.

 

Figure 1: Vignettes Responses

Figure 1 presents histograms showing the percentage of respondents that answered “no,” “likely not,” “likely yes,” or “yes” to the question “Would you consider the information the investor received during the meeting with COMPANY to be a violation of Reg FD?” after reading each vignette. The blue bar represents the frequency of responses by managers (n=29 except in Situation B where n=30) and the orange bar represents the frequency of responses by regulators (n=70). The seven vignettes (labeled Situation A through Situation G) are presented in the Appendix.







Table 1: Vignettes Responses Aggregated by “Yes” and “No” Responses

Table 1 shows the responses of both managers and regulators to the question “Would you consider the information the investor received during the meeting with COMPANY to be a violation of Reg FD?” after reading each vignette. The No column aggregates the “No” and “Likely Not” responses, and the Yes column aggregates the “Yes” and “Likely Yes” responses. The Pearson Chi-square test (χ2 test) evaluates observed differences between aggregated Yes and No responses between managers (n=29 except in Situation B where n=30) and regulators (n=70). The table shows the Pearson χ2 test statistic and the associated p-value. The seven vignettes (labeled Situation A through Situation G) are presented in the Appendix.

For the appendix to this essay, please see the PDF version.

  1. See, e.g., Lauren Cohen et al., Sell-Side School Ties,65 J. Fin.1409 (2010) (showing that prior to Reg FD, sell-side analysts outperformed their predictions by nearly ten percent a year on average when they shared an educational background with members of senior management at a firm); Andreas Gintschel & Stanimir Markov, The Effectiveness of Regulation FD, 37 J. Acct. & Econ.293 (2004) (showing that after Reg FD, the impact of analyst reports on stock prices diminished by 28%).
  2. See 17 C.F.R. § 240.10b-5 (2018).
  3. See Regulation FD, 17 C.F.R. § 243 (2018).
  4. See, e.g., Joanna E. Barnes, Regulation FD Will Result in Poorer Disclosure and Increased Market Volatility, 29 Pepp. L. Rev.3 (2002).
  5. Lawrence D. Brown et al., Managing the Narrative: Investor Relations Officers and Corporate Disclosure, J. Acct. & Econ.(forthcoming 2018).
  6. See Brian J. Bushee et al., Do Investors Benefit from Selective Access to Management?, 2 J. Fin. Reporting, no. 1, 2017, at 31; David Solomon & Eugene Soltes, What Are We Meeting For? The Consequences of Private Meetings with Investors, 58 J.L. & Econ.325 (2015).
  7. See 17 C.F.R. § 243.101 (2018).
  8. Selective Disclosure and Insider Trading, 60 Fed. Reg.51,716, 51,721 (August 24, 2000) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449(1976)).
  9. See, e.g., Latham & Watkins, The SEC’s Regulation FD—Fair Disclosure(2000), https://www.lw.com/upload/pubContent/_pdf/pub302.pdf [https://perma.cc/BUZ8-BCPG
  10. There have been only thirteen enforcement cases since the enactment of Reg FD. See Martin Bengtzen, Private Investor Meetings in Public Firms: The Case for Increasing Transparency, 22 Fordham J. Corp. & Fin. L.33, (2017). For a discussion of the ambiguity of Reg FD, see alsoJohn L. Campbell et. al., Selective Disclosure After Regulation Fair Disclosure: More than Simply ‘Completing the Mosaic’? (Kelley School of Business, Research Paper No. 16-52, 2017), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2803308 [https://perma.cc/SK7Y-5Z7Z
  11. See Selective Disclosure and Insider Trading, 60 Fed. Reg.51,716, 51,722 (August 24, 2000) (“At the same time, an issuer is not prohibited from disclosing a non-material piece of information to an analyst, even if, unbeknownst to the issuer, that piece helps the analyst complete a “mosaic” of information that, taken together, is material.”)
  12. See Jihwon Park & Eugene Soltes, What Do Investors Ask Managers Privately? (April 9, 2018) (unpublished manuscript), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3087369 [https://perma.cc/99GG-FJMC
  13. The cash questions served as the basis for the Situation C vignette shown in the Appendix.
  14. To protect firm managers, the dataset recorded the investors’ questions but not the managers’ answers. Thus, the manager responses provided in each vignette are plausible answers that reflect the experience of the investor relations officers who helped design the vignettes, rather than the literal response of managers in the Park and Soltes (2018) field work.
  15. Firms were selected from the CRSP/Compustat database if they met all of the following criteria: They held at least one earnings conference call in 2016, had a share price of greater than $5, were an operating firm (i.e., not a holding firm or REIT), and were incorporated in the United States. From these 2,695 firms, I randomly selected 150 firms and went to each firm’s website to find an e-mail contact for their investor relations officer or chief financial officer, of which I found 134 direct e-mail addresses.
  16. Under the terms of confidentiality that were agreed to in order to distribute this survey at the training conference, the author is not permitted to publicly disclose the name of the agency whose employees responded to the vignettes.
  17. The study was submitted to Harvard University’s Committee on the Use of Human Subjects (IRB). Harvard’s IRB exempted the study under 45 C.F.R. 46.101(b)(2). For the managers, twenty-nine completed all seven vignettes while one manager completed only the Situation B vignette (i.e., Describe Contract Proposals After Election). While this manager did not complete the survey in its entirety, I included this manager in the relevant analysis of Situation B.
  18. See Bruce C. Branson et al., Information Conveyed in Announcements of Analyst Coverage, 15 Contemp. Acct. Res.119 (1998); Cem Demiroglu & Michael Ryngaert, The First Analyst Coverage of Neglected Stocks, 39 Fin. Mgmt. 555 (2010); Paul J. Irvine, The Incremental Impact of Analyst Initiation of Coverage, 9 J. Corp. Fin.431 (2003); Kevin K. Li & Haifeng You, What is the Value of Sell-side Analysts? Evidence from Coverage Initiations and Terminations, 60 J. Acct. & Econ. 141 (2015).
  19. For a discussion of how intuition can contribute to the decision to engage in misconduct, see Eugene Soltes, Why They Do It: Inside the Mind of the White-Collar Criminal(2016).
  20. See, e.g., Josef Lakonishok & Inmoo Lee, Are Insider Trades Informative?, 14 Rev Fin. Stud.79 (2001).
  21. Selective Disclosure and Insider Trading, 60 Fed. Reg.51,716, 51,721 (August 24, 2000).
  22. Id.
  23. Yvonne Ching Lee Lee, The Elusive Concept of “Materiality” Under U.S. Federal Securities Laws, 40 Willamette L. Rev. 661, 677 (2004).
  24. For a discussion of fraud by hindsight, see G. Mitu Gulati et al., Fraud by Hindsight, 98 Nw. U.L. Rev. 773(2004).
  25. 121 F.3d 44, 52 (2d Cir. 1997).
  26. 426 U.S. 438, 450(1976) (quoting Johns Hopkins Univ. v. Hutton, 422 F.2d 1124, 1129 (C.A.4 1970)).
  27. According to an informal survey conducted by Ipreo, the average firm conducted 114 private, one-on-one investor meetings in 2015. Ipreo, Corporate Access Survey (2016), https://ipreo.com/blog/corporate-access-survey-2016/ [https://perma.cc/TBA2-KHW9
  28. An earlier precedent is with quarterly earnings conference calls. For background of the environment, see Brian J. Bushee et al., Open Versus Closed Conference Calls: The Determinants and Effects of Broadening Access to Disclosure, 34 J. Acct. & Econ.149 (2003).
  29.  Other markets have required disclosure of private meetings. Although there are questions about the quality of disclosure, beginning in 2009, listed firms on the Shenzhen Stock Exchange in China were required to disclose investor meetings within two days of their occurrence. SeeQiang Cheng, Seeing is Believing: Analysts’ Corporate Site Visits,21 Rev. Acct Stud.1245 (2016).
  30. Johnson v. United States, 135 S. Ct. 2551, 2557 (2015).
  31. See Nicholas Kappas, A Question of Materiality: Why the Securities and Exchange Commission’s Regulation Fair Disclosure is Unconstitutionally Vague, Note, 45 N.Y.L. Sch. L. Rev. 651 (2001).

Shaming Big Pharma

*Sharon Yadin is Associate Professor, PAC School of Law. sharon@yadin.com. She would like to thank Ron Shapira, Barak Orbach, Oren Perez, and Yoav Dotan for their helpful thoughts and comments and Peres Academic Center for supporting this research. She also wishes to thank the editorial team at the Yale Journal on Regulation.

The FDA recently published a list of top branded drug companies that are suspected of purposely blocking competition from the generic drug industry. Calling out big pharma by “naming and shaming” them into good behavior is an innovative, still largely experimental, regulatory tool designed to harness public opinion and build on pharma’s reputational sensitivities. This Essay analyzes the FDA’s new initiative as a form of regulation by shaming, points to crucial flaws in the agency’s use of the tactic, and suggests key points for improvement.

Introduction

Novartis, Mylan, Roche, Pfizer, Celgene, Actelion—all these are examples of mega pharmaceutical companies that were recently “named and shamed” by the Food and Drug Administration (FDA).1 This “shaming list,” which was uploaded to the FDA’s website, includes the names of more than 50 branded drug companies that allegedly tried to block competition from generic drug companies.2 The drugs that these generics are trying to produce and sell for a more affordable price to patients range from acne medication to blood thinners, pain killers, antipsychotic drugs, and drugs prescribed for treating cancer and other serious diseases.3 FDA Commissioner Scott Gottlieb has stated that he hopes that the publication of the list will discourage this type of bad behavior by branded drug companies.4 This initiative is indicative of the growing interest of the FDA and other health regulators in adopting “naming and shaming” tactics toward drug companies.5 Can such “regulation by shaming” work?

In general, the term “shaming” is often perceived negatively, causing shaming to be regarded as illegitimate.6 However, shaming can be useful when applied properly by regulatory agencies. In this Essay, I discuss the concrete characteristics and theoretical framing of the innovative regulation recently employed by the FDA, and I argue that, generally, shaming pharma can work but not in the manner in which it was executed in the case of the recent pharmaceutical company “shame list.” I explain how, in this instance, the FDA employed shaming tactics ineffectively, as it failed to convey the message to the public in a comprehensible and accessible manner. In conclusion, I suggest guidelines for successful regulatory shaming that the FDA can administer in the future, drawing on the regulatory shaming tactics employed by regulators in other fields and on regulatory shaming theory and principles. 7

I. Naming and Shaming by the FDA

“Naming and shaming” tactics have been used by the FDA with regards to the pharma industry in recent years, mainly through online publication of non-compliance and warning letters.8 For example, the FDA posted on its website a table listing companies that failed to meet the regulatory requirements of the Pediatric Research Equity Act (PREA),9 primarily the obligation to conduct pediatric studies, along with copies of non-compliance letters issued by the agency and the companies’ responses to these letters.10 According to the FDA, when a company fulfills the requirement to conduct relevant studies, the date it does so is added by the agency to the last column of the table,11 and thus this online database is kept updated.

It now seems that the FDA is interested in further exploring and experimenting with this approach. Only a few months ago, in May 2018, the agency published an online “black list,” in which it named dozens of branded drug companies that are supposedly using unlawful or unethical means to attempt to impede competition from generic drug companies.12

“Generics” are the unbranded versions of branded drugs that appear after the latter have lost patent and regulatory protection.13 Generics contain the same active ingredients, but not necessarily the same inactive ingredients, as branded drugs.14 As generics are not based on the expensive research and development efforts invested in the branded drugs, they cost between 80% and 85% less than the brand-name equivalent.15 Thus, generic drugs can provide an affordable alternative for patients in need.

According to the FDA, potential applicants for generic drug approval are being prevented from obtaining samples of certain branded products named in the list, which are necessary for attaining FDA approval of generic drugs.16 Branded drug samples are vital for generic applicants because the applicants need to demonstrate to the FDA that their version of the product is bioequivalent to the branded drug.17 A generic drug developer generally needs 1,500 to 5,000 units of the branded drug to perform studies needed to gain FDA approval.18

The list names branded drug companies that failed to provide the necessary samples despite requests from prospective generic applicants, and despite the fact that no regulatory restrictions with regard to the samples’ safety and distribution were imposed.19 Generally, the FDA may impose distribution limitations on branded products, as part of an FDA safety program called REMS (Risk Evaluation and Mitigation Strategy).20 But according to the FDA, some companies are falsely arguing that safety issues prevent them from distributing drug samples to generic companies.21 For example, according to the list, one branded drug company (Celgene) that was authorized by the agency to distribute samples to generic companies was nevertheless the subject of 13 complaints received by the FDA from generic companies that were unable to receive such samples.22

The FDA’s publication included open condemnation of big pharma conduct. In the text accompanying the list of companies, the agency explained that “‘gaming’ tactics were being used to delay generic competition,”23 and in a statement, the FDA Commissioner asserted that the pharma companies on the list “have potentially been blocking access to the samples of their branded products.”24 Despite efforts made by the Commissioner to stress that publishing the list was merely an attempt to promote transparency,25 the data, the accompanying text, and the statement made to the press are all indicative of shaming.26

Indeed, this step was clearly intended to draw public attention to big pharma misconduct. As the FDA Commissioner stated regarding the list, “We’ll continue to look at more ways we can expand upon today’s action and call public attention to situations where the careful balance that Congress sought between product innovation and access may be being disrupted.”27 The Commissioner also stated that the agency’s decision to publish the list was rooted in the idea that “no patients should be priced out of medicines they need to support their health” and that it was intended to “increase competition as a way to help make drugs more affordable and improve access.”28

It is worth noting that the FDA’s efforts to maintain competition in the pharma industry are somewhat secondary to, or even beyond, its main mandate. Overall, the agency—which is located within the Department of Health and Human Services—is responsible for regulating drugs for safety and effectiveness and is thus considered “the gatekeeper of the American pharmaceutical marketplace.” Meanwhile, the main agency responsible for addressing anticompetitive business practices is the Federal Trade Commission (FTC). This possible tension was addressed directly by the FDA Commissioner, who stated that the agency’s efforts to improve generic drug competition aimed to improve access and affordability and that the FDA will cooperate in this with the FTC.

The existence of generic drug companies, ensuring fair competition in the market, is in the public interest and is therefore a regulatory goal. Laws such as the Federal Food, Drug and Cosmetic Act (FDCA)29 and the Drug Price Competition and Patent Term Restoration Act (“Hatch-Waxman”)30 to strike a balance between the need to encourage the development of new drugs, which is typically an expensive and lengthy process,31 and the need to make these drugs affordable to all patients. As long as the branded drug company enjoys exclusivity in marketing, based on its patent, the price of the drug can remain as high as the pharma company desires in order to recoup its research and development costs and make a profit.32 The term of a new patent is generally twenty years from the date on which the application was filed with the Patent and Trademark Office, which can occur anytime during the development of a drug.33 When a branded drug company no longer enjoys exclusivity in the market, generic drug companies can enter the market and supply patients with cheaper versions. In reality, though, branded drug companies constantly deploy various means to impede competition from generics—from filing frivolous drug patents and citizen petitions to engaging in various other anti-competitive strategies, such as paying generic manufacturers to delay their entry into the market, reaching anti-competitive agreements, shifting market demand to a new formulation of a drug, and withholding samples.34 These practices are an ongoing concern of legislators and regulators in the health industry.

II. Regulation by Shaming

Shaming is often perceived negatively as a phenomenon that needs to be eradicated35 in which citizens, and sometimes even the state in the criminal context,36 shame other citizens.37 It is often regarded as a despicable act that can cause irreparable harm to individuals.38 Civilian shaming may be based on nothing more than false accusations or insults39 designed to humiliate and inflict pain.40 But administrative shaming is something different. It can achieve regulatory goals effectively, since it is cheaper and faster than other forms of regulatory sanctions, either criminal or administrative, and when designed properly it can efficiently deter organizations from non-compliance.41 Unlike civilian shaming, regulatory shaming is subject to public law norms; it does not aim to humiliate or hurt individuals’ feelings, but to inflict reputational harm on business organizations42 and nudge them in the right direction. Regulation by shaming adds to a growing toolkit of innovative regulatory apparatuses that are meant to enforce norms without relying solely on “command and control.”43 Much like its sibling—disclosure regulation44—regulatory shaming takes place in the “expressive space” of regulation,45 in which the regulator conveys messages and “speaks” to the public. Shaming is not to be confused with the concept of transparency, as it is designed to encourage action by third parties against a non-compliant firm, and it focuses on a condemning rather than an informative message.46

Shaming initiatives by regulatory agencies are becoming more and more common.47 These policies take many forms, including “naming and shaming,” star ratings, color ratings, league tables, public statements, publication of enforcement actions, and publication of inspection results.48 All of them aim to harm the reputation of companies that fail to comply with regulations or that are thwarting regulatory goals in some other way. Shaming highlights actions by these regulated entities that may be illegal or unethical and allows the administrative agency to publicly condemn a specific action (or non-action) of a named company or companies. For instance, regulators shame companies for non-compliance with workplace safety regulations, environmental regulations, or health regulations.49 They also shame companies for “gaming the system” through legally grey area tactics,50 and for overly high salaries paid to CEOs.51

The idea of regulatory shaming is to convey a message to a shaming community—such as employees, investors, peers, consumers, interest groups, politicians, or the general public—which will then act in accordance with the negative feelings invoked by the adverse publication.52 The shaming community can feel betrayed, disgusted, appalled, outraged,53 or otherwise disappointed with the shamed organization or with its behavior. But the main point is that these feelings are translated into action. Without some form of response from the public or other third parties, regulatory shaming cannot work. Customers can protest, file complaints, or boycott the products sold by the condemned regulatee; shareholders may withdraw their investment; employees can demonstrate or even strike; peers and competitors may refuse to engage in any kind of business ventures with the company; and suppliers may refuse to work with it.

Regulation by shaming harnesses firms’ sensitivity to reputational damage. A qualitative research study into environmental regulation found that corporate officials care not only about complying with formal regulations but also with their “social license,” that is, public expectations with regard to environmental performance.54 Public opinion, influenced by a trustworthy organ of the state that openly condemns a company’s actions, can cause financial damage to firms.55 Adverse publications made by administrative agencies can thus become a powerful tool in regulatory enforcement endeavors.56

But in order for regulatory shaming to work, there are several essential components to the shaming process:

  1. Choosing a topic for regulatory shaming that third parties (shaming communities) will be interested in or passionate about
  2. Identifying the right shaming group—those people who can and will act in order to influence the company’s behavior
  3. Taking a regulatory moral stand that is non-controversial and that the shaming community can easily agree with
  4. Properly shaping a shaming message that is well-communicated and specifically designed for the chosen shaming group
  5. Disseminating the shaming message through suitable media channels

These are important steps that need to be carefully implemented in order for the shaming action to fulfill its public interest goal. Shaming initiatives that fail may cause more harm than good. Regulators that do not succeed in correcting market failures through adverse publications may suffer all kinds of consequences.57 For example, they may themselves be scolded by the targeted companies or by third parties, including the intended shaming community. They may harm their relationship with the industry in general and with the shamed entity in particular, causing irreparable damage to regulatory goals and hurting industry willingness to cooperate and comply with regulations and with the regulator in general. They may jeopardize their reputations as professional regulators, and they may become entangled in costly and prolonged legal battles with the shamed regulatees.58

 

III. What’s Wrong with the FDA’s Shaming Tactic?

 

Generally, shaming big pharma can be an effective part of the FDA’s regulatory agenda with regards to fair competition in the drug market, for several reasons.

First, the public can easily identify with the need to keep drugs affordable and can be expected to react strongly to branded companies’ attempts to manipulate the market.59 Obviously, patients who depend on a specific drug cannot afford to boycott it. However, public attention to adverse behavior of specific drug companies can, in principal, deter the drug industry in general (as well as specific companies) from engaging in unethical or illegal practices. For instance, Eli Lilly, one of three companies in the world that hold a patent for insulin, was recently the target of harsh public criticism and outrage due to a very steep increase in its product prices.60 It was subject to protests outside its Indianapolis headquarters, as well as calls for tighter regulation and more transparency, and for greater affordability and accessibility of insulin, from advocacy groups such as Patients for Affordable Drugs and the American Diabetes Association.61 Consequently, the House of Representatives is conducting an inquiry into insulin pricing, with the intent of eventually introducing legislation.62 Furthermore, many pharma companies, including those listed in the FDA’s shame list, also sell generics63 and are thus in competition with other companies in a manner that facilitates consumer leverage. Therefore, though medication is clearly different from sportswear in terms of consumer choice, regulatory shaming that is directed towards patients and patient advocacy groups can certainly be effective.

There are also other effective shaming audiences that the FDA can reach, such as potential investors and current shareholders in the pharma industry, and pharma employees. These stakeholders can also play an important role in the “private regulation” process being advanced by the FDA. For example, many investors are unwilling to invest in companies with whose values, actions, and goals they cannot identify,64 a common phenomenon with tobacco, alcohol, and arms companies.65 Sometimes, such investors are driven by fear that investing in such companies may in turn cause them to be personally shamed by others who consider such investments immoral.66 These issues are central to an approach known as “corporate social responsibility” (CSR), which now plays a prominent role in investors’ considerations.67 Under the terms of CSR, the corporate entity is understood through a communitarian prism, which focuses on the social and moral aspects of the corporation’s community activities, rather than its own individualistic interests.68 FDA shaming of pharmaceutical companies for intentionally manipulating the market in order to keep prices high, and hurting patients in need, may trigger a similar effect with pharma shareholders and potential investors. Additionally, pharma employees who learn that their company is acting in a way that is not considered socially responsible may elect to strike, thus causing the company not only indirect reputational harm but also direct financial losses.

The second reason why shaming can be an important tool for the FDA’s regulatory agenda is that the big pharma companies named in the FDA’s list generate annual revenues of billions of dollars.69 With such large sums at the disposal of the regulatees, monetary sanctions may well be an ineffective form of regulatory enforcement and deterrence.70 Indeed, drug prices have been and still remain a major concern of public health regulators and legislators, who have been largely unable to restrain rising drug prices.71 It is thus worth considering other, more sophisticated sanctions, even if only as a complementary measure. Furthermore, since this shaming is mostly directed toward big drug companies, the risk of over-deterrence and of causing disproportionate reputational damages is relatively small.72

Finally, because the drug industry is heavily regulated,73 it is familiar with regulatory intervention and is therefore less likely to be hostile to regulatory endeavors to enforce regulation, minimizing the regulatory risks of shaming.74

Therefore, in theory, shaming big pharma can work. However, the FDA’s recent list of shame was lacking in both form and in substance, failing to include items 4 and 5 (and possibly 2) in the list of critical stages for successful regulatory shaming, as presented in the previous section.75 The FDA’s shaming list is extremely uncommunicative in both the language used and in the ways in which the data has been processed, organized, and presented, and it was not distributed through appropriate channels for effective impact. These findings suggest that the agency has not fully considered the shaming process, its relevant participants, and its intended results and effects.

Figure 1 below shows the FDA’s list (for convenience, only the first few rows are presented).76 A quick glance reveals that the list is not at all designed to be easily accessible for the general public, which is not fluent with the pharma regulation terminology used by the FDA both in the table itself and in the “explanatory” text in the webpage in which the table appears.

 

Figure 1: Excerpt from the FDA’s Pharma “Shame List” (2018)

Yadin Figure 1

For instance, terms like RLD, REMS, and ETASU are used as the building blocks for this table, which is even called “RLD Access Inquiries.”77 Of the five columns in the table, only the names of the companies and the names of the drugs in columns 1 and 2 are easily understood. Footnotes to the accompanying text which attempt to explain some technical terms only add to the confusion by using even more pharma jargon.78 The table is thus immediately comprehensible only to people within the pharma industry; for a person from outside the pharma industry to understand it would require reading and re-reading the accompanying text (over 2,000 words) as well as the data provided in the table.

Even for those who are able to decipher the lingo in which the FDA describes the condemned behavior of big pharma, the data is very confusing. It includes both pharma companies on which regulatory restrictions on sharing drug samples have been imposed (for safety reasons) and companies that have no such restrictions. However, in an accompanying statement, the FDA Commissioner explains that branded drug companies should always make available “a path to securing samples of brand drugs for the purpose of generic drug development.”79 Also, different kinds of anti-competitive behaviors are described by the agency in the explanatory text, including contractual restraints imposed by branded drug companies on sellers, such as pharmacies.80

Thus, the FDA publication obscures, diffuses, and dilutes its main message, and thereby fails to realize the full potential of regulatory shaming of the pharma industry.

Examples of regulatory shaming by other regulatory agencies show how the FDA could have done a much better job of shaping its message and making it comprehensible to relevant shaming communities. For example, the webpage in which the FDA lengthily explains the idea of the list and its complex database uses dense pharma regulation terminology and lacks any graphic support besides the table itself.81 By contrast, the Department of Health and Human Services provides an online rating of nursing homes that is based on a highly intuitive five-star scale, incorporating an easily understood graphic measuring tool (see Figure 2).82 In this form of regulation by shaming, each rated facility is assigned a star rating based on its weighted score from recent health inspections, its staff-resident ratio, and clinical data, saving the public the task of wading through the underlying data and navigating technical language.83 The star ratings are posted online, which can shame poorly rated nursing homes into doing better in the inspected areas.

 

Figure 2: Medicare, “Nursing Home Compare”

Yadin Figure 2

 

Another example is the Environmental Protection Agency’s (EPA) Toxics Release Inventory (TRI) program (see Figure 3), in which the agency publishes facility-based information regarding air, water, and land pollution, as well as compliance status.84 Here, significantly non-compliant facilities are marked red, while compliant facilities are marked blue.

 

Figure 3: EPA Toxics Release Inventory Program

Yadin Figure 3

 

The methods used by the Department of Health and Human Services and the EPA, in which data are formulated and presented in a clear and communicative manner, can be very effective in soliciting public attention and facilitating corporate shaming to achieve regulatory goals.

The chosen distribution methods for the FDA’s message were also flawed. The list of pharma companies was only mentioned on a few of the FDA’s Twitter accounts,85 with a concise informative notification (see Figure 4) referring the readers to the FDA Commissioner’s statement.86

 

Figure 4: FDA Tweet about its “Shame List”

 

This relative paucity of communication is particularly surprising given that the FDA has a fairly heavy social media presence and conducts extensive interactive media activity. The agency sends out email alerts to subscribers and provides RSS feeds and also maintains a Facebook page in both English and in Spanish, a Pinterest page with dozens of infographics, more than 20 Twitter accounts, a blog, a YouTube channel, and a Flickr page, most of which are updated daily, even several times a day.87 (last visited Aug. 28, 2018).]

By contrast, an example from the Occupational Safety and Health Administration (OSHA) shows how social media, as well as administrative agencies’ webpages and news releases, can be properly harnessed for regulatory shaming. Figure 5 below is an example of OSHA’s almost daily tweets on enforcement actions taken against companies that violate workplace safety regulations.88 The tweet links to a webpage (news release) in which the agency clearly and concisely explains the case,89 without unnecessary OSHA jargon or undecipherable data (see Figure 6).

 

Figure 5: OSHA Shaming Tweet

 

Figure 6: OSHA News Release

 

In short, the FDA’s efforts at shaming big pharma would be much more effective if it was to follow the five-step process laid out in this Essay.90 First, it must choose a topic that people are interested in or passionate about. Drug companies’ behavior can generally be considered a fitting subject for shaming since patients are dependent on these companies for their health. Therefore, issues that relate to illegal or unethical practices of pharmaceutical companies, such as price gouging, exclusion of competitors, or poor transparency regarding their activities, can be considered good candidates for regulatory shaming. Second, the FDA should carefully identify the right shaming audience, and consider patients, health advocacy groups, investors in the pharma sector, pharma employees, and the pharma industry in general. Defining the right target group will improve the effectiveness of any regulatory shaming effort. Third, the FDA should consider whether its moral stand regarding the pharma industry is fully shared by the targeted shaming communities. In all of these first three steps, the FDA’s regulatory shaming of big pharma is on fairly solid ground, though some improvements may be needed in step two.

The final two steps, however, need significant improvement if the FDA’s shaming tactics are to achieve more effective results. The fourth step is that the FDA must shape its shaming message in a much more communicative manner. The message needs to be simple and direct. Instead of lengthy text embedded with pharma jargon, or undecipherable charts and data, use should be made of short statements; infographics; easily digestible numbers, scores, and ratings; and intuitive and attractive design. Messages of this type are far more suited to most shaming audiences, as well as to the media, and thus can be much more effective in changing drug companies’ behavior. In this regard, short messages that name specific companies can be more effective than general sector-wide shaming; and converting data into simple ratings and scores can offer a more straightforward message for widescale dissemination.

And fifth, proper use of social media and digital media in general is crucial for regulatory communication with the public in today’s world. Short shaming messages and related graphics are highly suited for platforms such as Facebook and Twitter. The FDA should harness multiple media outlets that have high visibility in order to disseminate the message as broadly as possible, and can issue repeated publications as needed. These communications can also include reports to the public on how FDA shaming efforts have helped change pharma companies’ behavior, thus encouraging further public participation in “private regulation” based on regulatory shaming.

Conclusion

 

The FDA has been accused by some commentators of being an agency that engages in “regulatory silence”—that is, it is reluctant to take action that may be viewed as aggressive or outside the clear scope of product safety and efficiency.91 But in fact, the FDA has shown real initiative in the regulatory tools arena, experimenting with “naming and shaming” of drug companies that engage in anti-competitive behavior to impede competition from generics. Though some may consider shaming to be “soft” rather than “hard” regulation, it is definitely not passive or neutral, and it is a clear example of “thinking outside the box.” Naming and shaming practices are most certainly an embodiment of the FDA’s regulatory philosophy, developed in the 1970s, which advocates achieving the general objectives of the law in creative ways that do not violate statutory restrictions.92

The rising prices of drugs across the country are currently a major public policy problem, one with which regulators are still grappling.93 Under these circumstances, there is a great need for creative regulatory solutions. Only recently, the Department of Health and Human Services proposed requiring that TV ads for prescription drugs include their list price, in order to incentivize drug companies to lower their prices.94 Officials in the Department have also declared that they intend to shame drug companies that do not comply with the new rule once it is passed.95

It therefore seems that in the health industry, regulatory shaming is more relevant than ever. But can shaming big pharma work? Can it efficiently achieve regulatory goals, such as enhancing competition in the pharma industry and bringing down drug prices? Can shaming by the FDA in other regulatory fields work as well? And can it also work for other health regulators? The answer to all these questions, in my opinion, is yes.96 But first, the regulatory agency has to properly identify the intended shaming group (the general public, the pharma industry, investors, etc.) and then both correctly formulate the shaming message and select the appropriate media channels, so as to communicate its message in an efficient and accessible manner.

Although this Essay has focused on deficiencies in the implementation of the regulatory shaming approach by the FDA, some elements of its approach were entirely correct. One of the smartest things the FDA did was to publicly notify, in advance, that regulatory shaming was going to take place in a certain subject area. In fact, the head of the FDA stated almost a year in advance that the agency had identified that “gaming tactics” were being employed by branded drug companies to impede competition from generics and that the agency planned to publicize the letters it had received from authorized generics that had requested samples from branded drug companies and were denied.97 Announcing regulatory shaming ahead of time can create deterrence in the drug industry and reduce unwanted behaviors by big pharma companies, even before the shaming itself takes place.

In conclusion, regulatory shaming holds great promise for curtailing bad behavior by big pharma. Regulators in health and other sectors, as well as legal scholars, should further develop this interesting and innovative approach to regulation.

  1. See Reference Listed Drug (RLD) Access Inquiries, U.S. Food & Drug Admin. (FDA), https://www.fda.gov/Drugs/DevelopmentApprovalProcess/HowDrugsareDevelopedandApproved/ApprovalApplications/
    AbbreviatedNewDrugApplicationANDAGenerics/ucm607738.htm [https://perma.cc/K3E5-C9DZ] (last visited Aug. 27, 2018) [hereinafter FDA list]. The list was published on May 17, 2018. See FDA Statement, Statement from FDA Commissioner Scott Gottlieb, M.D., On New Agency Efforts to Shine Light on Situations Where Drug Makers May Be Pursuing Gaming Tactics to Delay Generic Competition, U.S. Food & Drug Admin. (FDA), https://www.fda.gov/NewsEvents/Newsroom/PressAnnouncements/ucm607930.htm [https://perma.cc/SA29-QNAN] [hereinafter Statement from FDA Commissioner].
  2. See id.; FDA list, supra note 1.
  3. See id.
  4. See Statement from FDA Commissioner, supra note 1.
  5. See, e.g., FDA Statement, Statement from FDA Commissioner Scott Gottlieb, M.D., On New Agency Actions to Further Deter ‘Gaming’ of the Generic Drug Approval Process by the Use of Citizen Petitions, U.S. Food & Drug Admin. (FDA), Oct. 2, 2018, https://www.fda.gov/NewsEvents/Newsroom/PressAnnouncements/ucm622252.htm [https://perma.cc/H9XB-K9N3].
  6. See, e.g., James Q. Whitman, What Is Wrong with Inflicting Shame Sanctions?, 107 Yale L.J. 1055, 1055-56 (1998).
  7. See Sharon Yadin, Regulatory Shaming, 49 Envtl. L. (forthcoming 2019), https://ssrn.com/abstract=3290017 (developing the theory and basic principles of “regulatory shaming”).
  8. See, e.g., Warning Letters and Notice of Violation Letters to Pharmaceutical Companies, U.S. Food & Drug Admin. (FDA), https://www.fda.gov/Drugs/GuidanceComplianceRegulatoryInformation/EnforcementActivitiesbyFDA/
    WarningLettersandNoticeofViolationLetterstoPharmaceuticalCompanies/default.htm [https://perma.cc/VDJ6-FSFR] (last visited Aug. 30, 2018).
  9. Pediatric Research Equity Act of 2007, Pub. L. No. 110-85, 121 Stat. 866 (codified as amended in 21 U.S.C. § 301).
  10. See Non-Compliance Letters under 505B(d)(1) of the Federal Food, Drug, and Cosmetic Act, U.S. Food & Drug Admin. (FDA), https://www.fda.gov/drugs/developmentapprovalprocess/developmentresources/ucm343203.htm [https://perma.cc/9ETR-C7EK] (last visited Aug. 30, 2018).
  11. See id.
  12. See Statement from FDA Commissioner, supra note 1.
  13. See Kathleen Craddock, Improving Generic Drug Approval at the FDA, 7 Mich. J. Envtl. & Admin. L. 421, 423 (2018).
  14. See Cheryl Spector, Generic Copies: Are They New Drugs, 3 Cardozo L. Rev. 131, 131 (1981).
  15. See Shyam Goswami, Windfall Profits and Failed Goals of the Bayh-Dole Act, 19 J. Gender Race & Just. 375, 382 (2016).
  16. See FDA list, supra note 1.
  17. See Statement from FDA Commissioner, supra note 1.
  18. See FDA list, supra note 1.
  19. See id.
  20. See Risk Evaluation and Mitigation Strategies (REMS), U.S. Food & Drug Admin. (FDA), https://www.fda.gov/Drugs/DrugSafety/REMS/default.htm [https://perma.cc/M9VL-VKK4] (last visited Nov. 3, 2018).
  21. See FDA list, supra note 1.
  22. See id.
  23. See id.
  24. See Statement from FDA Commissioner, supra note 1.
  25. See id. See also Beth Mole, Shame, Shame, Shame — FDA has Named Names of Pharma Companies Blocking Cheaper Generics, arsTECHNICA (May 17, 2018), https://arstechnica.com/science/2018/05/fda-to-start-naming-names-of-pharma-companies-blocking-cheaper-generics [https://perma.cc/EW6Y-XUPS].
  26. See also infra Part II; Yadin, supra note 7 (discussing the difference between shaming and transparency).
  27. See Statement from FDA Commissioner, supra note 1.
  28. See id.
  29. 21 U.S.C. § 301 (2015).
  30. Pub. L. 98-417, 98 Stat. 1585 (1984).
  31. See, e.g., Margaret Gilhooley, FDA and the Adaptation of Regulatory Models, 49 St. Louis U. L.J. 131, 132 (2004); Jordan Paradise, Regulatory Silence at the FDA, 102 Minn. L. Rev. 2383, 2395 (2018).
  32. See Craddock, supra note 13, at 425-26; Christine S. Paine, Brand-Name Drug Manufacturers Risk Antitrust Violations by Slowing Generic Production through Patent Layering, 33 Seton Hall. L. Rev. 479, 480-81 (2003).
  33. See 35 U.S.C. § 154(a)(2). For more information see Frequently Asked Questions on Patents and Exclusivity, U.S. Food & Drug Admin. (FDA), https://www.fda.gov/drugs/developmentapprovalprocess/ucm079031.htm#howlongpatentterm [https://perma.cc/XU3P-EH5R] (last visited Sep. 2, 2018). There are also “exclusivity periods,” given for six months to seven years upon approval of certain drugs, regardless of a patent. See id.
  34. See Paine, supra note 32, at 479-81; Paradise, supra note 31, at 2398.
  35. See, e.g., Whitman, supra note 6, at 1055-56.
  36. In criminal contexts, the government, mostly through the judiciary, shames offenders by publishing information about crimes and criminals after crimes are committed. See, e.g., Dan M. Kahan, What Do Alternative Sanctions Mean?, 63 U. Chi. L. Rev. 591, 631-32 (1996).
  37. See generally Kristine L. Gallardo, Taming the Internet Pitchfork Mob: Online Public Shaming, the Viral Media Age, and the Communications Decency Act, 19 Vand. J. Ent. & Tech. L. 721 (2017); Kate Klonick, Re-Shaming the Debate: Social Norms, Shame, and Regulation in an Internet Age, 75 Md. L. Rev. 1029 (2016).
  38. See, e.g., John Braithwaite, Crime, Shame, and Reintegration 68 (1989); Danielle Keats Citron, Hate Crimes in Cyberspace 11 (2014).
  39. See, e.g., Emily Chiang, Institutional Reform Shaming, 120 Penn St. L. Rev. 53, 84 (2015).
  40. See id.
  41. See Yadin, supra note 7.
  42. See id.
  43. See id. The legal concept of “regulation” is often perceived as control or constraint. See Barak Orbach, What is Regulation?, 30 Yale J. on Reg. Online 1, 4 (2012).
  44. Disclosure regulation focuses on requiring manufacturers and service providers to actively reveal information about their products. See Yadin, supra note 7.
  45. See generally Alex Geisinger, Reconceiving the Internal and Social Enforcement Effects of Expressive Regulation, 58 Wm. & Mary L. Rev. Online 1, 8-9 (2016).
  46. See Yadin, supra note 7.
  47. See id.
  48. See infra Part III. See also Yadin, supra note 7.
  49. See id.
  50. As discussed in the FDA example which is the focus of this Essay.
  51. The Securities and Exchange Commission (SEC) recently adopted a shaming strategy through a regulation that requires companies to disclose the compensation ratio between their median employee (by salary) and their CEO. See 15 U.S.C. § 78I note (2012); 17 C.F.R §§ 229, 240, 249 (2015).
  52. See Yadin, supra note 7.
  53. See generally Cass R. Sunstein, Growing Outrage, Behavioural Public Policy (Aug. 30, 2018), https://www.cambridge.org/core/journals/behavioural-public-policy/article/growing-outrage/07A7377940D8BA0E503DDB8C10EEC70F#.W4lw6NdmaBE [https://perma.cc/27Z7-CU3U].
  54. See Dorothy Thornton et al., General Deterrence and Corporate Environmental Behavior, 27 Law & Pol’y 262, 264 (2005).
  55. See, e.g., Andrea A. Curcio, Painful Publicity—An Alternative Punitive Damage Sanction, 45 DePaul L. Rev. 341, 372-76 (1996).
  56. See generally Yadin, supra note 7.
  57. See generally Barak Orbach, What is Government Failure?, 30 Yale J. on Reg. Online 44 (2012) (discussing the concept of “regulatory failure”).
  58. Regulatory shaming may sometimes be legally problematic. Examples of possible illegality of regulatory shaming include harsh reputational damage; publication of citations prior to final orders, which implicates due process; and lack of statutory authority to sanction by public shaming. See, e.g., Eric J. Conn & Casey M. Cosentino, Hot Off the Press: Two Attorneys Argue That OSHA’s Enforcement Press Releases Violate the Federal Administrative Procedure Act, EHSToday (Sep. 1, 2011), http://www.ehstoday.com/standards/osha/hot-off-press-0901 [https://perma.cc/EV8Z-TDPD]. Since shaming practices vary from one agency to another, and even within the same agency, each with a different legal basis, a complex generalized analysis in this regard will remain outside the scope of this Essay.
  59. See supra Part II (Items 1-3).
  60. See Nathaniel Weixel, Skyrocketing Insulin Prices Provoke New Outrage, The Hill (June 21, 2018), https://thehill.com/policy/healthcare/393378-skyrocketing-insulin-prices-provoke-new-outrage [https://perma.cc/W44W-PTEG].
  61. See id.; John Russell, Lilly Insulin Prices Come Under Microscope, IBJ (Aug. 26, 2017), https://www.ibj.com/articles/65163-lilly-insulin-prices-come-under-microscope [https://perma.cc/ZL8K-PMFQ].
  62. See Weixel, supra note 60.
  63. See, e.g., Sheila Kaplan, F.D.A. Names and Shames Drug Makers to Encourage Generic Competition, NY Times (May 17, 2018), https://www.nytimes.com/2018/05/17/health/drug-prices-generics-fda.html [https://perma.cc/7DLY-29C4].
  64. See, e.g., Douglas M. Branson, Corporate Social Responsibility Redux, 76 Tul. L. Rev. 1207, 1219 (2002).
  65. See id.
  66. See id.
  67. See id.
  68. See id. at 1217. See also Oren Perez, Reuven Cohen & Nir Schreiber, Governance through Global Networks and Corporate Signaling, Reg. & Governance (forthcoming 2019), https://ssrn.com/abstract=3265793 [https://perma.cc/XV4L-Q365] (discussing the reasons why companies adopt CSR schemes) (manuscript at 4-5).
  69. For instance, Roche grossed more than $42.2bn in 2017; Pfizer—$52bn; Novartis—$49bn; and Bayer—$29.1bn. See Vasanthi Vara, The World’s Biggest Pharmaceutical Companies by Revenue in 2018, Pharmaceutical Technology (June 20, 2018), https://www.pharmaceutical-technology.com/features/worlds-biggest-pharmaceutical-companies-2018 [https://perma.cc/PAY3-D3QA].
  70. Between 1991 and 2015, financial penalties imposed amounted to just five percent of the $711 billion in net profits made by the eleven largest global drug companies during just ten of those twenty-five years (2003-2012). See Twenty-Five Years of Pharmaceutical Industry Criminal and Civil Penalties: 1991 Through 2015, PUBLICCITIZEN (March 31, 2016), https://www.citizen.org/our-work/health-and-safety/twenty-five-years-pharmaceutical-industry-criminal-and-civil-penalties-1991-through-2015 [https://perma.cc/6EBH-97YL].
  71. See generally U.S. Dep’t. of Health & Human Servs., American Patients First: The Trump Administration Blueprint to Lower Drug Prices and Reduce Out-of-Pocket Costs (May 2018), https://www.hhs.gov/sites/default/files/AmericanPatientsFirst.pdf [https://perma.cc/ZAQ7-YLSQ].
  72. See Yadin, supra note 7.
  73. See, e.g., Adrian Towse & Patricia M. Danzon, The Regulation of the Pharmaceutical Industry, in The Oxford Handbook of Regulation 548, 548 (Robert Baldwin, Martin Cave & Martin Lodge eds., 2010).
  74. See supra Part II.
  75. See id.
  76. See FDA list, supra note 1.
  77. REMS stands for “Risk Evaluation and Mitigation Strategy”; ETASU, for “Elements to Assure Safe Use”; RLD for “Reference Listed Drug”.
  78. Such as GDUFA II, ANDA, and RS. See FDA list, supra note 1. GDUFA stands for “The Generic Drug User Fee Act”; ANDA for “Abbreviated New Drug Application”; and RS for “Reference Standard.”
  79. See Statement from FDA Commissioner, supra note 1.
  80. See FDA list, supra note 1.
  81. See id.
  82. See Nursing Home Compare, CTRS. for Medicare & Medicaid Servs., https://www.medicare.gov/nursinghomecompare/search.html [https://perma.cc/74WB-QGVS] (last visited Aug. 27, 2018). Figure 2 is an example of a low-star rating given to a specific nursing home in New York.
  83. See id.
  84. See Toxics Release Inventory (TRI) Program, Envtl. Prot. Agency,
    http://www.epa.gov/toxics-release-inventory-tri-program [https://perma.cc/X4YG-NWHT] (last visited Aug. 27, 2018). Figure 3 is an example of a rating that signals non-compliance, including significant non-compliance of a specific company found in the EPA’s database.
  85. See, e.g., FDA Media Affairs (@FDAMedia), Twitter (May 17, 2018, 6:57 AM), https://twitter.com/FDAMedia/status/997113935747829760 [https://perma.cc/WLS7-RX5R].
  86. In the statement page, another link provides access to the table itself.
  87. See Interactive Media, FDA, U.S. Food & Drug Admin., https://www.fda.gov/NewsEvents/InteractiveMedia/default.htm [https://perma.cc/Z63B-Q99P
  88. See OSHA (@OSHA_DOL), Twitter (June 29, 2018, 7:50 AM), https://twitter.com/OSHA_DOL/status/1012709797282680832 [https://perma.cc/M8YD-LQEK].
  89. Meanwhile, the FDA Commissioners’ statement was 1,200 words long. See Statement from FDA Commissioner, supra note 1.
  90. See supra Part II.
  91. See Paradise, supra note 31, at 2409-10; Carl Tobias, FDA Regulatory Compliance Reconsidered, 93 Cornell L. Rev. 1003, 1004, 1009 (2008).
  92. See Gilhooley, supra note 31, at 132.
  93. See generally American Patients First, supra note 71.
  94. See What You Need to Know about Putting Drug Prices in TV Ads, HHS.gov, (Oct. 15, 2018), https://www.hhs.gov/about/news/2018/10/15/what-you-need-to-know-about-putting-drug-prices-in-tv-ads.html [https://perma.cc/J7PE-4ZA].
  95. See Amy Goldstein & Carolyn Y. Johnson, Drugmakers May Have to Disclose Prices of Medicine in Television Ads, Wash. Post (Oct. 15, 2018), https://www.washingtonpost.com/national/health-science/tv-ads-for-drugs-will-send-patients-to-websites-with-pricing-information/2018/10/15/b74ac344-d090-11e8-b2d2-f397227b43f0_story.html?utm_term=.47f67cc81e3a [https://perma.cc/69E9-9BFP].
  96. These, of course, warrant additional study. But see generally Yadin, supra note 7.
  97. See Jayne O’Donnell, FDA Chief Says Drug Makers Are Gaming the System to Slow Generic Competition; Vows Action, USA Today (Aug. 15, 2017), https://www.usatoday.com/story/news/politics/2017/08/15/fda-chief-says-drug-makers-gaming-system-slow-generic-competition-vows-action/568698001 [https://perma.cc/A8ZX-KXQ4].

The $1 Trillion Question: New Approaches to Regulating Stock Buybacks

*Lenore Palladino is Senior Economist and Policy Counsel at the Roosevelt Institute and a Lecturer at Smith College. Palladino is Of Counsel at the law firm of Jason Wiener P.C.. Palladino earned her Ph.D. from the New School University and her J.D. from Fordham Law School. Special thanks to William Lazonick and the Roosevelt Institute staff for their support.

Stock buybacks—transactions in which public companies buy back their own equity securities on the open market—are on track to reach $1 trillion in 2018. Such repurchases manipulate the market price for issuer securities. They represent a choice by firms to prioritize shareholder payouts over other uses of corporate funds, contributing to widening economic inequality. Currently, stock buybacks are regulated by the Securities and Exchange Commission’s Rule 10b-18, a “safe harbor” rule that does not ameliorate market manipulation. This Essay recommends a new regulatory regime, outlining several alternative approaches to ensure the integrity of capital markets and corporate productivity.

Introduction

Stock buybacks1 by America’s public companies are on track to hit $1 trillion in 2018.2 Stock buybacks are regulated by the Securities and Exchange Commission’s Rule 10b-18 (the “Rule”),3 but the Rule has not stopped a surge in buyback activity. In the recent hearings for Securities and Exchange Commissioner nominees, two future Commissioners agreed that they would be open to a fresh look at the Rule.4 More recently, Commissioner Robert Jackson Jr. followed up on this commitment and called for an open comment period on the Rule in response to a major increase in the dollar volume of stock buybacks.5 This Essay argues that it is past time to take a fresh look at the policies that govern stock buybacks and examines the range of policies available to rein in this practice.

Rule 10b-18 creates a “safe harbor” in which companies are free from risk of liability for manipulation under the Securities and Exchange Act as long as they follow the conditions as laid out in the Rule. The Rule allows for firms to conduct virtually unlimited stock buybacks, impacting the market in contravention of the spirit of Section 10b of the Securities and Exchange Act.6 The conditions concern the volume, manner, price, and timing of repurchases, and disclosure is required on quarterly reports. The justification for the Rule is to ensure that companies would not face liability for market manipulation for conducting buybacks. But the regulatory approach of Rule 10b-18 is broken. The original purpose behind the regulatory regime, “a scheme of regulation that limits the ability of an issuer . . . to control the price of the issuer’s securities,”7 is not met by Rule 10b-18’s framework or the enforcement approach the Commission has taken.

Beyond their impact on stock price, stock buybacks matter because they contribute to widening economic inequality. Corporations face an opportunity cost when allocating funds to shareholder payouts rather than to increasing employee compensation, funding retained earnings that are the foundation of firm growth, or investing in future productivity.8 This tradeoff is in part a result of incentives for corporate insiders to conduct buyback programs for their own personal profit.

I argue that there are two regulatory paths available: the Securities and Exchange Commission could adopt an entirely new regulatory regime for stock buybacks, or Congress could enact new legislation that would either ban or seriously constrain the practice. Congress can enact legislation that restricts repurchases outright; conditions repurchases according to another set of corporate variables; or places a tax on such transactions in order to disincentivize the behavior. Alternatively, the Securities and Exchange Commission can repeal Rule 10b-18 and replace it with new regulations that either revert to the pre-1982 status for buybacks, or create new regulations in line with other advanced economies: rules that place bright-line limits on the volume, manner, price, and timing of repurchases; mandate immediate disclosure; prohibit insider sales of their own holdings within a certain time period after a repurchase program; and put a new governance process in place for the initiation of repurchase programs. This Essay will describe and evaluate each of these policies with respect to the three core harms of stock buybacks: the potential for stock price manipulation, opportunity costs for other uses of corporate funds, and the perverse incentives for insiders to sell their own shares for personal gain.

This Essay proceeds in two Parts. Part I outlines the problems with stock buybacks and Rule 10b-18, both substantive and in terms of corporate governance. Part II first presents a landscape of other regulatory models and then proposes several paths forward for regulation.

I. The Problems with Stock Buybacks

In this Part, I describe why stock buybacks are justified by a “shareholder primacy” approach to the firm. I will then briefly describe their rise in dollar volume and the categories of harm: their effect on stock price; their relationship to broader economic inequality; and their incentive structure for corporate executives. Finally, I examine the flaws of Rule 10b-18’s regulatory approach.

A. Justifications for Stock Buybacks

Driving the practice of stock buybacks is the “shareholder primacy” corporate legal framework. This theory claims that shareholders are the “owners” of a firm and due the profits that the firm does not require for contractual obligations to other stakeholders, such as employees, suppliers, or customers, or for investment purposes.9 The idea that shareholders are a firm’s owners—the primary risk-takers because they invest capital with no guarantee of return, and thus the residual claimants of its wealth, popularized by Michael Jensen and Milton Friedman—is, according to corporate law scholar Lynn Stout, based on a misunderstanding of corporate law.10 Shareholders do not own “the firm”—they own their shares, which entitles them to an income flow, the right to sell their shares, and a certain set of limited rights to vote for the board of directors and shareholder resolutions,11 as well as the right to bring a claim for a breach of fiduciary duty.12 Other scholars claim that, regardless of whether or not shareholders “own” the firm, under the Delaware General Corporation Law (“DGCL”), maximizing shareholder wealth is the fiduciary duty of corporate boards of directors.13

Though its basis in corporate law is contested, shareholder primacy dominates business practices today, and justify widespread use of stock buybacks. The premise of stock buybacks is that shareholders should be “returned” this available cash when it has not found another productive use.14 This framework itself gives rise to two reasons to question stock buybacks. First, even if we accept the primacy of shareholders in corporate law, stock buybacks primarily benefit short-term shareholders who sell their stock after the price goes up, rather than longer-term shareholders who want corporations to invest in future productivity to ensure a long-term rising share price, not dependent on the company’s repurchase of its own shares. Even under shareholder primacy, corporations have variable needs for funds to ensure long-term growth, and we can see that stock buybacks constitute an opportunity cost for further investment, employee compensation, or even the build-up of reserves.15

The second problematic framework for repurchases has to do with the theory of the interaction between finance and the real economy. Defenders of repurchases argue that buybacks serve an important function by reallocating capital to where it would be most useful.16 Under this theory, when executives determine that they have no investment opportunities where the rate of return is above the cost of capital, they should logically return the cash to shareholders, who will invest the funds in companies that do have investment opportunities that are profitable to pursue. One problem with this argument is that the majority of shares are bought and sold on the secondary market, meaning that very little of the funds from a shareholder purchasing shares make their way back into a firm’s coffers. Firms have to issue new equity in order to directly benefit from any purchase of their stock. This points to a larger misunderstanding about the purpose of the stock market historically: that the primary reason companies issue shares has been to raise cash. Instead, shareholders primarily buy and sell stocks with each other, raising the value of shares without directly raising available funds for companies.

There is also little evidence that there is a financing constraint for the long-term capital necessary for the development of lower-cost, higher-quality products.17 Firms have large stocks of cash with which to conduct internal financing. Interest rates for corporate borrowing are historically low.18 And most importantly for evaluating stock buybacks, net issuances in the non-financial corporate sector have been negative for every year since 1997, sometimes sharply so.19 This means that more equity is pulled out of the market through buybacks than is created through new issuances. Even though buybacks could in theory be an efficient way for capital to be reallocated between companies with publicly-traded stock, the evidence does not show that this is occurring.

Furthermore, claims that buybacks are useful for the capital-allocation reason do not grapple with the other reasons why firms conduct buybacks: to raise the share prices and thus reward large share-sellers, especially executives. It could be that shareholders are taking the gains from buybacks and investing in private firms, but there is a decline in the rate of business startups in the economy.20 Wealthy shareholders may also be investing in large private companies, but the use of buybacks to transfer wealth from public to private companies means that the majority of investors, who are non-accredited investors, will be locked out of the potential for wealth appreciation.21 The problems with buybacks have magnified as the dollar volume has grown, particularly as companies (outside of the financial sector) have spent more on shareholder payouts than they had available in profits. Stock buybacks have grown from $469 million in 1979 to $748 billion in 2016.22 Projections for 2018, following the adoption of the TCJA, posit that repurchases could top $1 trillion for the first time.23 In many industries repurchases exceeded profit in multiple years.24

B. The Harms of Stock Buybacks

What are the specific harms of stock buybacks? I describe several types of harm as a result of stock buybacks. The first is their potential to manipulate stock price, in violation of Section 9(a)(2) of the Exchange Act. The second is the opportunity cost that they represent for other uses of corporate profits, from long-term investment to improvements in employee compensation. Finally, and perhaps the biggest driver of repurchases, is their perverse incentives on executives and other insiders who are compensated in stock in order to tie their personal motivations to firm outcomes to instead sell their shares. A distinct harm is the lack of accountability under Rule 10b-18 and the lack of other constraints on stock buybacks.

First, and most simply, repurchases may be used to manipulate stock prices because the very nature of buying back stock means that the remaining shares rise in value.25 Though the question of whether trading activity alone can be considered manipulation remains contested, and the legal framework for manipulation “lacks precision, cogency, and consistency of application,”26 large volumes of stock buybacks undoubtedly move securities prices, and before 1982 left firms open to liability for market manipulation. Stock buybacks have become a favorite corporate practice because they are a straightforward and fast mechanism to raise share prices and boost earnings per share (EPS). Rule 10b-18 enables firms to conduct buybacks, within its timing,27 volume,28 price,29 and manner conditions30 (although there is no assumption of liability if buybacks happen outside those conditions), so that, in theory, repurchases would not have a manipulative effect on the market. But the main effect of repurchases in the short term is to reduce the number of shares available on the open market for trading, meaning that the value of each remaining share goes up in value. Though there is no practical improvement in the sales of a company’s goods, customer satisfaction, or efficiency gains in the production process, share prices go up through the removal of share volume. At the volume of repurchases seen today, conducted intentionally by corporate executives, it is worth considering whether this could be considered manipulation of share prices.31 One study has shown that the probability of share repurchases is sharply higher for firms that would have just missed EPS forecasts in the absence of repurchases.32

A second harm of stock buybacks is their impact on wealth and income inequality. In terms of wealth inequality, stock buybacks only benefit those who hold stock. Less than half of households own any stock at all, and less than a third of households own at least $10,000 worth of stock.33 Stock ownership is concentrated at the top of the wealth distribution: 93% of households in the top one percent of households by income own more than $10,000 of stock.34 Stock ownership reflects broader racial stratification as well: while approximately 60% of white households own stock either directly or indirectly, only 34% and 30% of Black and Latino households, respectively, hold stock.35 All of this means that increasing stock value driven by stock buybacks disproportionately benefits wealthier families. Stock buybacks are also an opportunity cost for other uses of corporate funds, and their rise correlates with a long-term decline in corporate investment.36 If corporations redirected funds spent on buybacks to employee compensation, wage increases could lift low-income workers out of poverty.37

Another harm is the incentives created for corporate insiders, particularly executives. Only corporate insiders know about buybacks when they are actually conducted; disclosure comes after the fact. Corporate executives hold large amounts of stock and their compensation is often tied to an increase in the company’s earnings per share (EPS) metric. That gives executives a personal incentive to time buybacks so that they can profit off of a rising share price.38 That means that the decision of whether and when to execute a stock buyback can affect his or her compensation by tens of millions of dollars. Recent research by SEC Commissioner Robert Jackson Jr. found that the likelihood of insiders selling shares increased five-fold in the week after the announcement of a repurchase program.39 In other words, insiders have a personal incentive to announce buyback programs that they know will raise share price, because they can then turn around and sell their own personal holdings for profit.

Despite these facts—that stocks constitute a substantial proportion of executives’ pay, and that stock buybacks provide a way for executives to raise their pay by millions of dollars—the rules that govern how a company authorizes stock buyback programs fail to account for this significant conflict of interest. The decision to authorize a new stock buyback program is made by the board of directors.40 The actual execution of buybacks is left to the executives and financial professionals inside the companies, with no board oversight as to the timing or amount of such buybacks, as long as the buybacks stay within the limit previously authorized. As long as directors are using their best “business judgment” to authorize programs, and there is no other insider trading violations, there is no recourse to hold directors accountable for extremely high repurchase programs.41 Further, executives are required to disclose the monthly volume of actual open-market repurchases, but only after the fact.42 This means that longer-term investors who hold a small amount of stock, and who could be disadvantaged by the decision to execute a stock buyback program if it is at the expense of investments that could lead to the company’s long-term growth, have no say whatsoever in the company’s decision-making process, and no access to real-time disclosure about buybacks that could be used for selling decisions.

A distinct set of problems with stock buybacks is the lack of oversight as to whether companies are staying within the limits of Rule 10b-18. Stock buybacks that are higher than the safe harbor’s volume limits would, in theory, be subject to action by the SEC for market manipulation. However, assumptions of liability are not automatic even when the safe harbor is exceeded. Because the data is not actually collected as to whether or not a company’s buybacks are within the daily safe harbor limits or not (data is reported by month rather than by day),43 and is not required to be collected, it is impossible for the Commission to bring such actions, and thus all stock buybacks are protected from charges of market manipulation. In response to a letter from Senator Tammy Baldwin in 2015, then-SEC Chair Mary Jo White said, “because Rule 10b-18 is a voluntary safe harbor, issuers cannot violate this rule.”44 To date, the SEC has not investigated companies for violating the daily limit because “performing data analyses for issuer stock repurchases presents significant challenges because detailed trading data regarding repurchases is not currently available.”45 There have been only two enforcement actions related to Rule 10b-18.46 As it stands today, Rule 10b-18 has been insufficient to curb the harms of stock buybacks.

II. A New Regulatory Regime for Stock Buybacks

In this Part, I outlined the path forward for new regulation. In Part II, Section A, I give a broad landscape of regulatory alternatives from two sources: first, earlier rules proposed by the Commission that preceded Rule 10b-18 and differed significantly; and second, rules from a variety of international jurisdictions. In Section B, I develop more specificity to the new rules that the Commission could promulgate. In Section C, I outline new legislative approaches that could be complementary to new Commission rules.

A. A Landscape of Regulatory Alternatives

The Securities and Exchange Act of 1934 (the “Act”) governs secondary trading of equities and lays out anti-fraud and anti-manipulation provisions to govern such activity. Prior to the adoption of Rule 10b-18, stock buybacks were subject to potential liability under several anti-fraud and manipulation statutes of the Act: Sections 9(a)(2)47 and 10(b)48 of the Act and its promulgating Rule 10b-5.49 Because there was no explicit permission nor denial of permission for stock buybacks, they operated in a legally hazy area, inhibiting their use. Congress passed the Williams Act Amendment to the Securities and Exchange Act in 1968,50 which focused on the tender offer process. It gave the Commission authorization to adopt rules and regulations to prohibit buybacks, by defining them as fraudulent, deceptive or manipulative, based on their role protecting investors and the interest of the public. Section (2)(e)(1) stated specifically that it is unlawful for issuers to repurchase their own securities if the purchase “is in contravention to such rules and regulations as the Commission . . . may adopt (A) to define acts and practices which are fraudulent, deceptive or manipulative and (B) to prescribe means reasonably designed to prevent such acts or practices.”51

Throughout the 1970s, the Commission proposed but failed to adopt a series of rules to regulate repurchases. In 1970, Rule 13e-2 was proposed to make stock buybacks “unlawful as acts and practices which are fraudulent, deceptive or manipulative” unless the transactions were conducted according to a certain set of conditions.52 The conditions included: one broker per transaction; no sales before the opening transaction and a half-hour before the close of daily trading; prices could not exceed the highest current independent bid price or the last sale price, whichever is higher; and the volume was limited to not exceeding fifteen percent of the average daily trading volume in the four calendar weeks preceding the week in which the buybacks were conducted.53 These same conditions, with the volume increased by ten percentage points, would become the conditions for the safe harbor. The critical difference in proposed Rule 13e-2 was that all other transactions were unlawful. The proposed Rule did not include specific disclosure requirements but did include a provision under which the Commission could approve repurchases on a case-by-case basis that would otherwise be unlawful.54

In 1973 and 1980, amendments to proposed Rule 13e-2 were added, including a significant proposal for disclosure. In 1973, the Commission was more forthright about its purpose for the rule, describing it as “prescrib[ing] means . . . to prevent an issuer from effecting repurchases which may have a manipulative or misleading impact on the trading market in the issuer’s securities.”55 The Commission later described the conditions for repurchases as “designed to ensure that an issuer neither leads nor dominates the trading market in its securities.”56 This language points to the rationale behind the types of conditions outlined, such as disallowing issuers to set the first or last price for a trading day. The Commission included an initial disclosure regime, including several questions about whether officers or directors should be required to disclose if they are considering buying or selling securities in conjunction with a repurchase that they are in charge of executing. The language points to awareness by the Commission that officers and directors face conflicts of interest, requesting comments on “[w]hether any officers or directors intend to dispose of the issuer’s securities they might presently hold.”57 The proposal invited comments on the idea that the source of funds to be used for the repurchases should be disclosed, and how public such disclosures should be made, along with volume and manner disclosure requirements.58

A revised proposed Rule 13e-2 also laid out the rationale for a need to limit stock buybacks. The Commission explained that the “regulatory predicate . . . [is a] need for a scheme of regulation that limits the ability of an issuer . . . to control the price of the issuer’s securities.”59 Such a need “stems in part from the unique incentives60 that an issuer . . . [has] to control the price of the issuer’s securities.”61 The Commission explained that the guidance was intended to help issuers avoid securities law liability that they could not otherwise predict, since the antifraud and anti-manipulative provisions of the Act are general in nature.62 The Commission once again explained that limits it was proposing were intended to “prevent the issuer from leading or dominating the market through its repurchase program. In fashioning those limitations, the Commission has balanced the need to curb the opportunity to engage in manipulative conduct against the need to avoid excessively burdensome restrictions.”63 Again the Commission left room for a case-by-case exemption of transactions that otherwise would exceed the proposed Rule.64

Even though the elaborate description of the need for the proposed rule was new, the substantive conditions put in place were mainly the same as in the 1970 and 1973 proposals, with one significant difference: transactions that took place outside of its conditions would not be automatically suspect.65 The Commission gave specific reasoning as to why each of the volume, timing, pricing, and manner conditions were critical to designing procedures that would limit the impact of repurchases on the market.66 The Commission also proposed specific disclosure requirements for large-volume repurchase programs but noted that disclosure was not a substitute for substantive regulation, explaining at some length that disclosure would not be enough to curb activity that could be manipulative to the market.67 Disclosure would, however, “give the market an opportunity to react to the fact that the issuer may account for a substantial amount of purchasing activity in its securities.”68

In 1982, rather than proposing another revision to proposed Rule 13e-2, the Commission instead proposed Rule 10b-18, which was adopted later in the year.69 An analysis published at the time claimed that this was a “regulatory about-face,” and that the new safe harbor should be viewed as “constructive deregulatory action . . . [that] contrasts markedly with past Commission views on the regulation of issuer repurchases.”70 Rule 10b-18 stood in contrast to proposed Rule 13e-2, which had the purposes of preventing manipulation by prohibiting the issuer from raising the market price; prohibiting the perception of wide-spread interest by the use of several broker-dealers, and limiting domination of the market with high repurchase volumes.71 The purpose of Rule 10b-18 instead was to facilitate repurchases and limit intrusive regulation into corporate decision-making.72

It is useful to be aware of how stock buybacks are regulated in other jurisdictions. Internationally, most countries with robust capital markets have some regulation in place for curbing stock buybacks, including both disclosure and substantive limitations.73 To summarize, the significant differences from the U.S. model of regulation include: requiring shareholder rather than board approval; placing bright-line limits on buybacks rather than adopting a safe-harbor approach; requiring immediate disclosure; and requiring insiders to not trade during buyback programs.74 Many countries follow the U.S. model with restrictions on timing, price, volume, and manner. Among the ten countries with the largest capital markets, all others place clear limits on repurchase activity, and most have more specific repurchase requirements.75 In the United Kingdom, approval is required at a shareholder meeting, not just from the board of directors.76 Open market share repurchases must be reported immediately to the Financial Supervisory Authority, and disclosure of volume and price is required.77 Requirements put in place by the Tokyo Stock Exchange restrict repurchases in terms of price, quantity and timing, and disclosure is required on execution at the close of the trading day.78 There are also restrictions on insiders, including limiting trading of an insider’s own holdings while a buyback program is underway, and mandating the establishment of trading rules to avoid conflicts of interest.79

In European Union member states, approval at a shareholder meeting is also required, and the authorization is valid for eighteen months.80 In France, significantly, the regulatory agency (the Commission des Operations de Bourse) must also approve the program.81 In Italy, shareholders must also approve the maximum number of shares to be acquired and the minimum and maximum purchase price.82 There is a bright-line limit that a firm cannot buy back more than 10% of outstanding shares in France, Germany, Italy, Switzerland, and the Netherlands.83 E.U. countries require repurchases to be made out of distributable profits, i.e., not purchased with debt.84 Canada’s Toronto Stock Exchange (“TSE”) also requires the board to seek authorization from the TSE and repurchase activity must be filed with the TSE within ten days after the end of each month. Repurchasing firms must also disclose whether insiders plan to sell their holdings during the firms’ buyback program.85 In Switzerland, buybacks are conducted according to a second trading line, and these transactions are fully disclosed on a real-time basis, visible to the public because the firm is the only buyer of this trading line. When a repurchase program is completed, a firm must immediately make a public announcement.86 Several countries also disallow buybacks within ten days prior to earnings announcements.87

B. New Rules at the Securities and Exchange Commission

Rule 10b-18 has not stopped the tremendous growth in stock buybacks. Additionally, because the Commission does not track whether companies are complying with the conditions of the Rule, there is virtually no accountability for potential market manipulation. In order to address the narrower potential problem of market manipulation and the wider problems of the social role of the corporation and widening economic inequality, a new regulatory regime is required.88

There are a variety of new rules that could be promulgated by the Commission to curb repurchases. The Commission can issue new rulemaking to again allow for companies to be held liable for open market share repurchases as market manipulation, in violation of Section 10(b) of the Securities and Exchange Act, pursuant to the authorization given to it by the Williams Act Amendment of 1968, § 2(e)(1). This would return essentially stock buybacks to pre-1982 regulation, in which the potential for liability led companies to largely avoid buybacks. Another approach is to place a bright-line limit on the dollar amount of buybacks that a company can conduct. The Commission places many bright-line limits on companies’ securities offerings pursuant to the 1933 and 1934 Acts.89 A bright-line rule prohibiting companies from conducting repurchases over certain limits would have the effect of lowering the potential for market manipulation, while leaving room for repurchases at the lower level.

In the alternative, the Commission could decide that it must authorize a company’s use of stock buybacks and could promulgate rules giving it wide latitude to reject buybacks that come at the expense of other corporate stakeholders. As proposed by Senators Baldwin and Schumer in an amendment to the 2018 banking reform bill, the Commission would have the authority to require detailed disclosure of buyback plans and execution, reject buybacks plans, and require boards and the CEO to certify that the buybacks are in the long-term “best interest” of the company.90 Elements of the above approaches were in the proposed Rule 13e-2 versions from the 1970s.

Alternately, the Commission could focus on corporate governance rather than substantive limitation, and could require that disinterested directors only authorize repurchase programs, or that companies must meet financial benchmarks to conduct repurchases. In the United Kingdom, a public company can only use distributable profits or the proceeds from a fresh share issuance to conduct a repurchase.91 Insiders could also be either prohibited from trading during repurchase programs or at least required to disclose such plans. As discussed above, boards and executives face conflicting incentives when authorizing stock buybacks. In many of the countries with the largest stock market capitalization—Japan, France, Canada, the Netherlands, Hong Kong, and the United Kingdom—there are explicit restrictions on trading by insiders during a period of buyback activity. For example, Japan delegates the setting of guidelines to the Tokyo Stock Exchange, which requires that “an insider who is in a position to make a firm’s share repurchase decisions should not trade his own holdings of the firm’s shares while a buyback program is underway.”92 In France, monthly disclosure is required to the state agency regulating the stock market (the Commission des Operations de Bourse).93 In Canada and the Netherlands, proactive disclosure is required if interested individuals are planning to sell their holdings during the course of a repurchase program.94 The Commission could put both limitations on insider selling of shares and immediate disclosure requirements in place.

General company disclosure requirements, though not sufficient to curb substantive behavior, would at minimum inform the Commission when bright-line rules are violated, and put directors and officers on notice that repurchase activity will be scrutinized in real time. As noted above, other countries like Japan and the United Kingdom mandate daily disclosure of repurchases. Former Chair Mary Jo White stated that the Commission did not have the data necessary to tell when the Rule was violated.95 Perhaps the simplest solution of all would be to require firms to disclose repurchases immediately and publicly, as is required in several countries. It is certainly within the technological capabilities of firms and the Commission to collect and immediately disclose daily data.

C. Congressional Approaches to Reining in Stock Buybacks

Congress can take steps that the Commission cannot. Congress can ban open market share repurchases by passing affirmative legislation that prohibits purchases by an issuer of its own equity on the national securities exchanges. Such legislation was proposed by Senator Tammy Baldwin in the “Reward Work Act,” which adopts this prohibition and additionally gives Rule 10b-18 “no force or effect.”96 Another approach, similar to what was proposed above for the Commission, is to limit the volume or other conditions for repurchases to a bright-line rule. The rationale behind these policies is that the main purpose of buybacks is to increase the price per share without an increase in real productivity inside the firm. In other words, shares are supposed to rise in value as companies become more profitable, though efficiencies, increased market share, more customers, etc. An increase in share price purely driven intentionally by a reduction in the number of shares on the market is out of step with larger social values that Congress seeks to uphold.

Congress could choose to condition or prohibit the ability of a company to conduct repurchases based on other corporate variables. For example, Congress could amend the Internal Revenue Code to levy a tax of equal amount on a public company if the company does not pay a “workers’ dividend” that is commensurate with company spending on stock buybacks.97 Congress could prohibit buybacks if companies have unfunded pension liabilities, have engaged in layoffs, have failed to meet a certain level of productive investment, have wage dispersion below a certain threshold, or have executive compensation above a certain limit. In the alternative, Congress could condition the ability of a company to engage in buybacks only if they meet certain affirmative thresholds, based on conditions like a median worker-to-CEO compensation ratio or job creation metrics.

Congress could use its tax-and-spend power to directly impose a specific tax on stock buyback transactions by amending the Internal Revenue Code, regardless of other corporate behavior. Taxation would disincentivize firms to conduct stock buybacks. Financial transaction taxes are a broad category of taxes that applies small levies on financial transactions, analogous to sales taxes for transactions of goods and services.98 Such taxes are common globally and have historically been used in the United States. Financial transaction taxes serve to raise revenue but also dampen the trading volume of whatever financial asset is being traded because they take a percentage of profits per trade. They can be structured in a variety of ways on a variety of financial assets, from a very low basis point level that would likely serve to only reduce the lowest-margin trading, to higher rates that would affect trading volume significantly.

In this case, the relevant policy is to institute a stock buyback transaction tax, in which each stock buyback transaction costs the firm a certain percentage of the dollar value of the trade in taxes. Critics of transaction taxes often claim that the tax would serve to dampen market liquidity and lower trading volume; in this case that would be the purpose of the tax. Revenue would be a secondary consideration. Though it is extremely difficult to estimate the elasticities of trading volume with respect to financial transaction taxes generally, it is likely that a tax on repurchases would serve to significantly reduce their use, if the tax was set higher than capital gains taxes.99

Conclusion

The volume of stock buybacks suggests that such repurchases have the potential to lead and dominate the entire market for that issuer’s securities. Rule 10b-18 has both substantive and democratic flaws in its implementation and is not an effective mechanism to appropriately curb issuer repurchasing behavior. Two paths are available for updated regulation: the Commission could repeal Rule 10b-18 and replace it with a regime in which companies are again subject to liability for market manipulation if appropriate; bright-line substantive rules with true enforcement capabilities; or promulgate new processes for ensuring that insiders cannot benefit from buybacks and that decisions to conduct buybacks are made in the true best interest of the company. Alternately, Congress could create new statutes to ban repurchases as impermissible, tax repurchases to dampen activity, impose rules where firms cannot conduct repurchases without meeting other criteria for corporate behavior, or impose governance requirements so that shareholders and disinterested parties authorize repurchase activity. In order to ensure that capital markets are not manipulated by tremendous repurchase activity and that firms undertake true innovative enterprises that sustain prosperity, a new regulatory regime is required.

  1. Stock buybacks are known by a variety of terms, including issuer repurchases and open-market share repurchases. All refer to the same activity.
  2. Jeff Cox, Companies Set to Buy Back $1 Trillion Worth of Shares This Year, and That Should Keep Market Afloat, Goldman Says, CNBC (Aug. 6, 2018, 11:01 AM), https://www.cnbc.com/2018/08/06/companies-set-to-buy-back-1-trillion-worth-of-shares-this-year-to-kee.html [https://perma.cc/VE5J-BBW2].
  3. 17 C.F.R. 240.10b-18 (2018).
  4. Both Commissioner Robert Jackson Jr. and Commissioner Hester Pierce responded affirmatively to a question posed by Senator Brian Schatz as to whether they would be willing to reconsider the Rule. SeeNominations of David J. Ryder, Hester M. Peirce, and Robert J. Jackson, Jr.:Hearing Before the S. Comm. on Banking, Hous., and Urban Affairs, 115th Cong. 34 (2017).
  5. Commissioner Robert J. Jackson Jr., Speech at the Center for American Progress: Stock Buybacks and Corporate Cashouts (June 11, 2018), https://www.sec.gov/news/speech/speech-jackson-061118 [https://perma.cc/CBP3-ASWG].
  6. Securities and Exchange Act of 1934 § 10(b), 15 U.S.C. § 78j (2018).
  7. Purchases of Certain Equity Securities by the Issuer and Others, 45 Fed. Reg. 70,890 (Oct. 27, 1980).
  8. For a full discussion of the relationship between stock buybacks and employee outcomes, see generally Lenore Palladino,Stock Buybacks: Driving a High-Profit, Low-Wage Economy, Roosevelt Inst.(Mar. 20, 2018), http://rooseveltinstitute.org/stock-buybacks-high-profit-low-wage [https://perma.cc/4HKX-X3CJ].
  9. See Kent Greenfield, the Failure of Corporate Law: Fundamental Flaws and Progressive Possibilities 1 (2006).
  10. Lynn A. Stout, The Shareholder Value Myth3 (Cornell Law Faculty Publ’n No. 771, 2013), https://scholarship.law.cornell.edu/cgi/viewcontent.cgi?referer=&httpsredir=1&article=2311&context=facpub [https://perma.cc/YT3W-Z3SH] (discussing the rise of the ideology of shareholder primacy and its critical flaws as a matter of law).
  11. Id.
  12. Activist shareholders are able to dominate board elections through the proxy voting system. See generally Jang-Sup Shin, The Subversion of Shareholder Democracy and the Rise of Hedge-Fund Activism,Institute for New Economic Thinking, Working Paper No. 77 (2018).
  13. See, e.g., David Yosifon, Corporate Friction: How Corporate Law Impedes American Progress and What to Do About It (2018).
  14. For a full discussion of the the role of investors in providing investment capital to public companies, see William Lazonick, The Theory of Innovative Enterprise: A Foundation of Economic Analysis4–16 (Acad.-Indus. Research Network, Working Paper No. 13-0201, 2013, revised 2015), http://www.theairnet.org/v3/backbone/uploads/2015/08/Lazonick.TIE-Foundations_AIR-WP13.0201.pdf [https://perma.cc/C8J5-429A].
  15. There are important reasons to question whether shareholder primacy is the most useful approach to corporate law normatively, but those considerations are outside the scope of this paper.
  16. See, e.g., Jesse M. Fried & Charles C.Y. Wang, Short-Termism and Capital Flows (Harvard Bus. Sch. Accounting & Mgmt. Unit Working Paper No. 17-062, European Corp. Governance Inst. (ECGI)- Law Working Paper No. 342/2017, Feb. 9, 2017), http://www.law.harvard.edu/programs/olin_center/papers/pdf/Fried_897.pdf [https://perma.cc/78YS-NT5L].
  17. See id.
  18. See, e.g., Moody’s Daily Corporate Bond Yield Averages, https://fred.stlouisfed.org/series/AAA [https://perma.cc/QN4Z-WMCE].
  19. Financial Accounts of the United States: Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts, Bd. of Governors of the Fed. Reserve Sys. 68 tbl.F-223 (Sep. 20, 2018, 12:00 PM ET), https://www.federalreserve.gov/releases/z1/20180920/z1.pdf [https://perma.cc/BAT4-4JKE]; see also Palladino, supra note 8. In the financial sector, new equity issuances ballooned after the financial crisis because banks issued new equity to the U.S. government in order to be bailed out. Therefore these new equity issuances cannot be considered along with standard issuances of equity in private markets. See generally Lazonick, supra note 14.
  20. Mike Konczal & Marshall Steinbaum, Declining Entreprenurship, Labor Mobility, and Business Dynamism: A Demand-Side Approach, Roosevelt Inst. (July 21, 2016), http://rooseveltinstitute.org/wp-content/uploads/2016/07/Declining-Entrepreneurship-Labor-Mobility-and-Business-Dynamism-A-Demand-Side-Approach.pdf [https://perma.cc/VP76-8T25].
  21. This is not an argument to remove limits on investing in private markets, because doing so risks increasing the negative impact of the hype and even fraud that takes advantage of limited disclosure requirements.
  22. Author’s analysis of data from S&P Compustat (on file with author).
  23. Cox, supra note 2.
  24. Author’s analysis of data from S&P Compustat (on file with author).
  25. What constitutes market manipulation legally is complex. See generally Merritt Fox et al., Stock Market Manipulation and Its Regulation, 35Yale J. on Reg.67 (2018); seealsoWilliam Lazonick, Profits Without Prosperity, Harv. Bus. Rev.(Sept. 2014), https://hbr.org/2014/09/profits-without-prosperity [https://perma.cc/53WG-TAGR] [hereinafter Profits Without Prosperity] (describing the rise of stock buybacks and their role in corporate investment decisions).
  26. Fox et al., supra note 25 at 71.
  27. 17 C.F.R. 240.10b-18(b)(2) (2018).
  28. 17 C.F.R. 240.10b-18(b)(4) (2018).
  29. 17 C.F.R. 240.10b-18(b)(3) (2018).
  30. 17 C.F.R. 240.10b-18(b)(1) (2018).
  31. See generally Fox et al., supra note 25.
  32. Heitor Almeida et al., The Real Effects of Share Repurchases, 119 J. Fin. Econ.168 (2016).
  33. Edward Wolff, A Century of Wealth in America125 (2017).
  34. Id.at 127.
  35. Lisa J. Dettling et al., Recent Trends in Wealth-Holding by Race and Ethnicity: Evidence From the Survey of Consumer Finances, Bd. of Governors of the Fed. Reserve Sys.(Sep. 27, 2017), https://www.federalreserve.gov/econres/notes/feds-notes/recent-trends-in-wealth-holding-by-race-and-ethnicity-evidence-from-the-survey-of-consumer-finances-20170927.htm [https://perma.cc/6ZS7-KJBQ].
  36. J.W. Mason, Disgorge the Cash: The Disconnect Between Corporate Borrowing and Investment, Roosevelt Inst.(2015), http://rooseveltinstitute.org/wp-content/uploads/2015/09/Disgorge-the-Cash.pdf [https://perma.cc/8FCT-A4BJ].
  37. See Lenore Palladino, Making the Case: How Ending Walmart’s Stock Buyback Program Would Help to Fix Our High-Profit, Low-Wage Economy, Roosevelt Inst.(2018), http://rooseveltinstitute.org/making-case [https://perma.cc/CN8E-DSQH].
  38. See Jackson, supra note 5.
  39. Id.
  40. While stock buybacks do not generally require board action (DGCL § 160), generally boards do approve stock buyback programs. See generally James D. Honaker & Eric S. Wilensky, Dividends, Redemptions and Stock Purchases, Practical Law Company (2012), https://www.mnat.com/files/1-519-2507.pdf [https://perma.cc/NV4J-YYDD].
  41. Id.
  42. 17 C.F.R. 229.703 (2018).
  43. Id.
  44. See David Dayen, SEC Admits It’s Not Monitoring Stock Buybacks to Prevent Market Manipulation,The Intercept(Aug. 13, 2015, 9:08 AM), https://theintercept.com/2015/08/13/sec-admits-monitoring-stock-buybacks-prevent-market-manipulation [https://perma.cc/6RW9-NDQ5].
  45. Id.
  46. Email from Steven G. Johnston, Special Counsel, the Office of Investor Education and Advocacy, Securities and Exchange Commission (June 19, 2018) (on file with author); see also Incomnet, Inc., SEC Release No. 40281 (July 30, 1998), https://www.sec.gov/litigation/admin/3440281.txt [https://perma.cc/89CN-3JJV]; SEC v. Wachovia Corp.,SEC Litigation Release No. 18958 (Nov. 4, 2004), https://www.sec.gov/litigation/litreleases/lr18958.htm [https://perma.cc/L2DN-RQPV].
  47. 15 U.S.C. § 78i (2018).
  48. 15 U.S.C. § 78j (2018).
  49. 17 C.F.R. 240.10b-5 (2018).
  50. Williams Act, Pub. L. No. 90-439, 82 Stat. 455 (1968).
  51. Id.
  52. Purchase of Equity Securities by Issuer Thereof, 35 Fed. Reg. 11,411 (July 16, 1970).
  53. Id.
  54. Id. at 11412.
  55. Repurchases of Securities and Prohibitions Against Certain Trading, 38 Fed. Reg. 34341 (Dec. 13, 1973).
  56. Id.
  57. Id.at 34342.
  58. The revisions dealt with: broker-dealers who are the issuers; “block” trading; volume quotes with respect to NASDAQ, a new entity, and other minor revisions. See id. at 34341–42. Several additional exemptions were included because “neither situation appears to present any appreciable potential for market impact,” again demonstrating that the Commission was grappling with how to prevent the issuer from interfering in the market for its own securities. Id. at 34343.
  59. Purchases of Certain Equity Securities by the Issuer and Others, 45 Fed. Reg. at 70890.
  60. They went on to describe the incentives that face directors and officers, both as to giving an appearance of prosperity for the firm, and for insiders who may be conflicted in their own transactions. Id.
  61. Id.
  62. Id.
  63. Id.at 70891.
  64. Id. at 70896.
  65. Id.
  66. Id.at 70898.
  67. Id.at 70897.
  68. Id.
  69. 17 C.F.R. 240.10b-18 (2018).
  70. Lloyd H. Feller & Mary Chamberlain, Issuer Repurchases,17 Rev. Sec. Reg. 993 (1984).
  71. See id. at 995.
  72. See id.
  73. See Jaemin Kim, Ralf Schremper & Nikhil Varaiya, Survey on Open Market Repurchase Regulations: Cross-Country Examination of the Ten Largest Stock Markets, 9 Corp. Fin. Rev. 29 (2005).
  74. Id.
  75. Id.
  76. Id.at 32.
  77. Id.
  78. Id. at 32.
  79. Id.
  80. Id. at 35.
  81. Id. at 32.
  82. Id. at 34.
  83. Id.
  84. E.U. rules stem from a 1976 EC Directive on share repurchase regulations, which specified that share repurchases should be made out of distributable profits only, not out of cash proceeds from debt issuances. Id. at 35.
  85. Id. at 33.
  86. Id. at 34.
  87. Id.
  88. Though critics may say curbing buybacks will simply lead companies to raise dividends, proper regulation of buybacks will limit the potential for insider incentives, and promote increased attention to long-term corporate profitability, as dividends benefit shareholders while buybacks benefit share-sellers.
  89. See generally 17 C.F.R. 230.501 (2018) (rules defining dollar thresholds for accredited investors).
  90. See U.S. Senator Tammy Baldwin and Senate Democratic Leader Chuck Schumer Introduce Amendment to Rein in Corporate Stock Buybacks in Banking Deregulation Bill, Office of Senator Tammy Baldwin (Mar. 7, 2018), https://www.baldwin.senate.gov/press-releases/amendment-to-rein-in-corporate-stock-buybacks [https://perma.cc/CDB4-847Q].
  91. Companies Act 2006, c. 46 (Eng). The Act covers England and Wales; Scotland; and Northern Ireland.
  92. Kim,supranote 73 at 32.
  93. Id.
  94. Id. at 33 – 34.
  95. Dayen,supra note 44.
  96. The Reward Work Act of 2018, H.R. 6096, 115th Cong. (2018).
  97. The Worker Dividend Act of 2018, S. 2505, 115th Cong. (2018).
  98. Wall Street Trading and Speculators Tax Act of 2011, H.R. 3313, 112th Cong. (2011).
  99. For the relevant literature on financial transaction taxes and their effect on stock trading volume, see generally Robert Pollin et al., The Revenue Potential of a Financial Transaction Tax for U.S. Financial Markets,Pol. Econ. Research Inst.(2017), https://www.peri.umass.edu/publication/item/698-the-revenue-potential-of-a-financial-transaction-tax-for-u-s-financial-markets [https://perma.cc/MR8P-353N]. For additional analysis on the effects of a stock buybacks transaction tax, unpublished research is on file with the author.

The Mandatory Repatriation Tax Is Unconstitutional

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

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

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

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

Introduction

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

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

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

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

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

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

I. The Mandatory Repatriation Tax

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

A. International Taxation of U.S. Multinationals

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

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

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

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

B. Past Attempts at Repatriation Taxes.

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

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

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

C. The TCJA and the New Quasi-Territorial Regime

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

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

1. New Section 965: The Mandatory Repatriation Tax.

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

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

II. Constitutional Challenges to the Mandatory Repatriation Tax

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

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

1. The Mandatory Repatriation Tax is Not an Income Tax

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

a. Defining Income Tax.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1. Carlton and Retroactive Taxes.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

Regulating Equality, Unequal Regulation: Life after Obergefell

* I am grateful to Luke Boso, Visiting Professor, University of San Francisco School of Law, for reading and offering comments on initial drafts of this Essay, and for his continued feedback and support. Additionally, to Brian Mikulak, Assistant Professor, University of San Francisco School of Law, and Lee Ryan, Co-Director of University of San Francisco’s Dorriane Zief Law Library, for their research assistance. I would further like to thank the editors of the Yale Journal on Regulation for their hard work and incisive edits, which greatly improved this Essay.

This Essay examines the interplay between state statutes that created and regulate civil unions for same-sex couples and the landmark ruling in Obergefell v. Hodges. It observes Obergefell was silent on how to treat civil unions, and argues that Obergefell presents two competing definitions of marriage. These competing definitions expose the costs and legal complications queer Americans continue to bear in both family-formation and dissolution. The Essay contends these costs are mediated by the formal disjunction between substantive equality in Obergefell and the regulatory processes which incepted and proceeded it. The Essay concludes with a survey of developments in post-Obergefell litigation around civil unions.

Introduction

For all its lofty evocations of equality, the Constitution’s most historically contested guarantee, Justice Kennedy’s discourse in Obergefell v. Hodges is interrupted by a telling aside: “[S]ociety pledge[s] to support the couple, offering . . . material benefits to protect and nourish the union.”1 The materiality and immateriality of same-sex2 marriage is framed throughout Kennedy’s opinion by a surprisingly heteronormative anxiety: what damage have we done to America’s children, allowing them to suffer the “significant material costs” of living with unmarried same-sex parents?3

If the undergirding logic of Obergefell is—in a way that marriage equality demonstrates rather than refutes—the maintenance of marriage as the embodiment of “the highest ideals,” is there any way its holding could even allow two non-married queer Americans to become “something greater than once they were”?4 Obergefell is simultaneously (and paradoxically) valuable for its definitions of marriage, as well as for the possibilities it presents for exploding the legal differentiations between “spouse” and “non-spouse.” To the extent that the Obergefell decision has not explicitly indicated a societal acceptance of radical queer politics, the decision nonetheless presents opportunities for these politics to re-emerge in lower court proceedings.5 The following analyses consider lower court interpretations of Obergefell, and how these court proceedings have resisted or deepened Kennedy’s conceptualization of queer bodies and their configuration into “one of civilization’s oldest institutions.”6 The heteronormative anxieties of Obergefell extend beyond the wellbeing of American children and work additionally to situate new material parameters of queer intimacy within the institutional framework of marriage. This Essay examines how these anxieties drive lower court proceedings.7

Part I of this Essay opens with a case concerned with the regulatory problems Obergefell leaves unresolved.8 In the struggle for and legal history of marriage equality, state legislatures and statutes have been primarily focused on developing alternative forms of union for same-sex couples. As praxis, regulation has both distributed and integrated common law approaches to equality. I also argue in Part I that Obergefell presents two distinct definitions of “marriage.” These competing definitions afford a reconsideration of how alternative forms of union and marriage’s enhanced liberties can open new avenues toward material benefits for queer Americans. Part II examines a case involving a same-sex partnership’s dissolution and custody dispute. This analysis exposes the material costs queer couples continue to bear in family-formation, and how post-Obergefell union dissolution litigation requires distinguishing between categories such as “partner” and “spouse.” These costs and requirements destabilize the foundation of equality on which Obergefell was trumpeted. Part III concludes this Essay with a brief consideration of how civil union litigation can anchor strategies for activism after marriage equality.

I. Sexuality, Equality, and Legislative Histories

Same-sex couplings have a storied history beyond twenty-first century American legal proceedings.9 Sexuality as a primary concern of and arguable cause for psychoanalysis opened what Michel Foucault calls a substantial shift in tactics, consisting of “reinterpreting the deployment of sexuality in terms of a generalized repression [and] tying this repression to general mechanisms of domination and exploitation.”10 This analysis of sexuality as historical foils the forked possibilities queer activists faced in presenting a national campaign for marriage equality in the wake of the Hawaii Supreme Court’s 1993 decision in Baehr v. Lewin11 and more recently in United States v. Windsor.12

As the possibility of marriage equality slowly became a legal reality, queer scholars remained divided. Was marriage valuable as a generative framework for this newly allowed participation in federal civil liberty, or simply the continued and well-costumed regulation of queer sexuality?13 The former position—that marriage equality fundamentally improves the standing and lives of queer Americans—is held by many laypeople and activists.14 The latter, in which queer sexuality is hardly “advanced” by the formalization of equality through marriage, has been articulated variously by many scholars.15 The tension between these conceptualizations of equality reasserts the relevance of Foucault’s analyses of how, and by whom, sexuality is “deployed.”16

Out of both shrewdness and necessity, same-sex litigants have begun deploying their own sexuality within a latticework of regulations to achieve otherwise commonplace legal outcomes. Solomon v. Guidry presents a series of complications to the otherwise straightforward problem of how a same-sex couple might divorce.17 This process is complicated by the failure of Obergefell to consider civil unions as distinct from formal marriages and how same-sex couples can dissolve them. In Solomon, the plaintiff and defendant entered in 2001 into a civil union in Vermont. In 2015, after returning to Vermont from North Carolina, the couple sought to dissolve their civil union. The Vermont Legislature created the civil union in 2000, which extended “the benefits and protections of marriage to same-sex couples” through a system entirely separate from civil marriages.18 “While a system of civil unions [did] not bestow the status of civil marriage, it [did] satisfy the legal relationships of the Common Benefits Clause.”19

While Vermont legalized same-sex marriage in 2009, its legislature ensured that civil marriages would not dissolve civil unions. Any same-sex civil union would continue to be recognized in Vermont regardless of whether the couple chose to marry.20 Between the passage of this legislation and Obergefell, Vermont revised its statutory parameters for nonresident civil union dissolution. Because couples joined by civil unions or marriages in Vermont did not have access to divorce proceedings in states that refused to recognize same-sex unions or marriage, Vermont codified means by which its once-residents could dissolve unions or marriages.21

Solomon introduces a regulatory concern within the debated strength of Justice Kennedy’s Equal Protection guarantee. The problem animating the case is the Supreme Court’s failure to mandate that states recognize lawful same-sex civil unions alongside same-sex marriages. Obergefell is silent regarding how states must treat extant civil unions.22 The legislative purpose of civil unions was the provision of the same material benefits otherwise afforded by marriage.23 Underpinning Solomon is how civil unions paradoxically disrupt the regulatory scheme through which marriage equality in Obergefell is realized. Because Obergefell did not account for civil unions, the statutory infrastructure governing them, particularly with respect to custody disputes and dissolutions, is still required even after Obergefell. While no new same-sex civil unions have been formed post-Obergefell, the impact and necessity of union-oriented statutes remain for same-sex couples still bound by civil unions. Accordingly, Vermont statutes governing disputes and dissolutions between union-bound couples remain intact and have not been revised since Obergefell.24

Glaringly, Justice Kennedy’s analysis excludes bisexual and transgender citizens and their configuration into the new equality schema.25 This exclusion correlates to the disregard for civil unions in post-Obergefell marriage equality. Rather than foreclose the possibility of “queering” marriage as an institution,26 this disregard preserves possibilities for how lower courts can reconcile the complexities of queer theory excluded from the Constitutional considerations dominating the holding through regulatory mechanisms. This preserves the possibility for advancing queer politics in a post-Obergefell society.

The history of queer radical resistance is intertwined with the history of legal victories for LGBT Americans. Through a series of decisions that disentangled LGBT bodies from criminal penalties or found those regulations altogether unconstitional,27 queer sexuality was incrementally legitimated and normalized into society. As Solomon forecasts, the consequence of welcoming queer bodies into the mainstream was realizing the inevitably expanded role that they would play in the nation’s political economy. This role moved beyond a consumers/consumed dyad of cultural-commodity exchange.28 With a sudden “explosion” of visible gay and lesbian bodies in the workplace and in media representations, emancipatory de-regulation became the symptom of inequality early-stage radical activists feared and against which they imagined a resistance.29 Obergefell generates no new liberties; it only introduces same sex couples into the central premises and federal rights of marriage.30 The ideology of access as achieved by “regulating” equality into marriage (as typified more by Kennedy’s introductory language) ensures queer participation in an essentially unchanged system.31 This fails to change social conceptions of what “sacred” and “essential” marriage is or could be, despite the religious resistance to same-sex marriage in the opinion’s wake.32

This definition conceals the opinion’s other ideological function. If read through the lens of Kennedy’s later definition of marriage as a guarantee of “material benefits” that preserve the union,33 I further argue Obergefell succeeds on a second plank. Before Obergefell, queer Americans gradually accumulated rights and visibility while many before 2015 (and many after) remained unmarried.34 After Obergefell, not only do unmarried couples have no alternative to marriage for securing specific rights and “material benefits,” but higher rates of marriage increase married queer participation in a political economy for which marriage is a threshold barrier.35 Pre-Obergefell state-recognized marriage was not the only way for same-sex couples to gain rights.36 However, state-recognized marriage is the guaranteed way for same-sex couples to have their shared lives regulated by the state.37 A tension emerges between the “much needed clarity” Obergefell affords by locating gay rights cases within the Court’s “fundamental rights line of cases”38 and a question exposed by Chief Justice Robert’s dissenting remark: “[t]he equal protection analysis might be different . . . if we were confronted with a more focused challenge to the denial of certain tangible benefits.”39 How has marriage under Obergefell left open the possibility for developments or challenges to certain tangible and material benefits, and for whom?

II. Partners and Spouses: The Possibilities of Substantive Equality and Regulation

The lingering question of what to do with civil unions after Obergefell goes beyond a disregard for the complicated lived and legal experiences of some same-sex couples’ frustrations with divorce or custody proceedings. The emergence of cases seeking to resolve seemingly ordinary complaints (divorces, custody disputes) between same-sex couples bound by civil unions destabilizes the foundations of equality on which Obergefell is opined. Gardenour v. Bondelie, unlike Solomon, is premised on the idea that a registered domestic partnership (RDP) is not a surrogate for marriage or the legal rights it confers.40

In Gardenour, the Indiana Court of Appeals applied California law to determine if an RDP issued in California could be terminated in Indiana and how this termination could be applied to plaintiff’s child custody claim.41 This RDP was one of many issued since 2003 from California.42 From 2003 to 2015, Californians bound under RDPs did not enjoy any of the approximate 1,100 federal rights accorded married couples. This was the key feature distinguishing California’s RDPs from the rights and protections accorded married couples at the federal level.43 Despite their progressive tones, many equality advocates criticized RDP bills and regulations as pacifying efforts for LGB citizens by conferring rights that were visually appealing but substantively hollow.44

The Gardenour court applied relevant California law in its opinion. Gardenour’s argument at the trial level was that, assuming the RDP agreement in question did establish a relationship identical to marriage, the trial court erred in recognizing such a relationship in Indiana.45 Gardenour argued that recognizing a same-sex relationship is counter to Indiana public policy, which the court found “outdated.”46 The court wrote that “this court and the [Indiana Supreme Court] previously acknowledged a public policy against recognizing same-sex marriage” because of state legislation which stated same-sex marriage was void even if lawful in the state where it was celebrated.47 However, the court cited Obergefell in explanation for how this legislation has been struck down as unconstitutional.48 There is an obvious tension between the argument of Gardenour and the original, conservative reasoning of the Indiana legislature’s policy against same-sex marriage.

RDPs are equivalent to same-sex marriages only insofar as marriages offered a model for regulating RDPs. Gardenour’s first argument to the Indiana court that recognizing an out-of-state RDP is counter to state policy interests signals (perhaps in a way supported by the court’s lengthy citations) precisely the fractious social realities and federalist discrepancies regarding same-sex marriage that Obergefell failed to unify. This argument concludes that the experience of bounded partnership for same-sex couples has, and will continue to have, legal complications that cannot be experienced by their heterosexual counterparts. The Gardenour opinion raises a question about how and by whom Obergefell may be used as a piece of discursive strategy for either conservative or radical ideologies.

Gardenour’s attempted differentiation between “partner” and “spouse,” and the Gardenour Court’s reliance on contract theory to reconcile the statutory strictures of the RDP and custody proceeding, undercuts Obergefell in another sly way. Implicit here is the idea that partners and spouses are distinct, as demonstrated by the litany of California Code requirements cited by the Gardenour Court. Statutes structuring domestic partnerships, as the Gardenour court unpacks, impose specific concrete terms with financial and affective requirements.49 While scholars like Mary Ann Case argue marriage offers more, not less, flexibility than domestic partnerships, Gardenour’s point as a litigant remains clear: the processes and experiences of a partner, defined under California statute, are distinguishable from those of spouses.50 This differentiated experience of partnership is expressed at both the substantive level of law, in terms of requirements to secure a RDP versus a marriage, as well as how the material realities of these two legal and relational structures persist as lived experiences for same-sex and queer couples even after Obergefell.

The Gardenour court’s application of its legal authority and newly acknowledged, post-Obergefell policy interests in same-sex domestic life are immediately presented in its following paragraph:

Here, California law makes clear a RDP is identical to marriage. If we did not recognize California RDPs as the equivalent of marriage, it would seem to allow individuals to escape the obligations California imposes upon domestic partners, namely with respect to children . . . In addition, not recognizing their status would ultimately harm [their child] because a child’s welfare is promoted by ensuring she has two parents to provide financial support.51

The court’s conditional framework is necessary to effectively recycle Justice Kennedy’s language: the Gardenour court’s concern for “a child’s welfare” and its promotion with “two parents to provide financial support” is not far removed from minimizing the “significant material costs” against America’s children under their unmarried queer parents.52 The recognition of a same-sex spousal relationship as “not go[ing] against Indiana public policy” flows from the court’s concern over a child’s welfare.53 The court also recognized Bondelie, the child’s non-biological parent, as a legal parent.54 Gardenour echoes Justice Kennedy’s concerns for children.55 The court’s concerns and recognitions illuminate the “significant material costs” borne by many queer parents to simply have children.56 These costs are borne in attempts to participate in legal processes (dissolutions, custody disputes) that are continually mediated by the formal disjunction between substantive equality in Obergefell and the regulatory processes which incepted and necessarily preceded it.57

III. Beyond Obergefell and Marriage Equality

In a continued study of case law and legislative responses to activism for bisexual, transgender, and domestic partnerships or arrangements after marriage equality, the task is twofold. First, understanding how the “contemporary legal imagination”58 of lower courts variously interpret the competing definitions of “marriage” from Obergefell. Second, asking how do these interpretations foreclose or preserve possibilities for persons outside the framework of Obergefell? Perhaps an initial answer to this question is a formal one. Litigation surrounding pre-Obergefell civil unions and RDPs affords a place from which both scholars and practitioners may begin to address these questions. Where, again, scholars like Case make a compelling argument for the comparative flexibility of marriage-as-institution versus the statutory domestic partnership, the legal victories and disputes for queer couples, married and unmarried, before and after Obergefell are consequences of the same goal. This goal is to extract a radical alternative to our (still existing) marginalized world from the lineaments of its own description of itself.59

The paradox put before queer Americans, married and unmarried, in the wake of Obergefell is dialectical. The struggle for how to reassert a positionality from which a more “radical” conceptualization of sexuality and intimacy can be deployed—if such a position, per scholars like Case, was or in the statutory framework ever asserted—is not suppressed by Obergefell. Rather, Solomon and Gardenour are initial glimpses or openings of the space for the relative autonomy of a potentially new “struggle”: the struggle for equality, for example, is made newly possible through the still-pliant regulatory passages through which queer life must pass.

  1. 135 S. Ct. 2584, 2601 (2015) (emphasis added). The Court affirmatively answered the central question presented by the case: “Does the Fourteenth Amendment require a state to license marriage between two people of the same sex?” The Court’s emphasis on “the entwined emphasis of liberty and equality” became a “game changer for substantive due process jurisprudence.” See Kenji Yoshino, A New Birth of Freedom?: Obergefell v. Hodges, 129 Harv. L. Rev. 147, 148 (2015). It is outside the scope of this Essay to consider the growing and urgent analyses of Obergefell as differently experienced along lines of class, race and citizenship. For more, please see: R.A. Lenhardt, Race, Dignity, and the Right to Marry, 84 Forham L. Rev.,/span> 53 (2015); Elvia Rosales Arriola, Queer, Undocumented, and Sitting in an Immigrant Detention Center: A Post-Obergefell Reflection, 84 UMKC L. Rev. 617 (2016).
  2. Textually, Obergefell refers only to “same-sex” marriages and couplings. This Essay adopts this limiting language only as necessary for references and citations. Its usage is meant to distinguish the queer activism and theory which includes bisexual, transgender, and gender non-conforming individuals from the opinion’s language. See Luke A. Boso, Dignity, Inequality, and Stereotypes, 92 Wash L. Rev. 1119, 1120 (2017).
  3. 135 S. Ct. at 2590.
  4. Id. at 2608.
  5. This Essay opens with the historicized assumption that any Supreme Court decision—despite its posturing to the contrary—initiates the social change it alleges to ratify.
  6. Id. at 2608.
  7. See Cary Franklin, Marrying Liberty and Equality: The New Jurisprudence of Gay Rights, 100 Va. L. Rev. 817, 851 (2014) (noting the historical relationship between anti-gay discrimination and constitutional equality norms).
  8. Solomon v. Guidry, 155 A.3d 1218 (Vt. 2016).
  9. Lawrence v. Texas, 539 U.S. 558 (2003); see also Bowers v. Hardwick, 478 U.S. 186 (1986) (holding that an anti-sodomy statute did not violate fundamental rights of homosexuals), overruled by Lawrence, 539 U.S. 558.
  10. Michel Foucault, The History of Sexuality: Volume I, 130-31 (1980).
  11. 52 P.2d 44 (Haw. 1993).
  12. 570 U.S. 744 (2013).
  13. Douglas NeJaime, Before Marriage: The Unexplored History of Nonmarital Recognition and Its Relationship to Marriage, 2014 Calif. L. Rev. 87, 102.
  14. See id. at 90-91.
  15. See, e.g., Melissa Murray, What’s So New About the New Illegitimacy?, 20 Am. U. J. Gender, Soc., Pol’y & L. 387, 433 (2012); Nancy D. Polikoff, Ending Marriage as We Know It, 32 Hofstra L. Rev. 201, 203 (2003); Katherine Franke, The Politics of Same-Sex Marriage Politics, 15 Colum. J. Gender & L. 236, 242 (2006).
  16. It is outside the scope of this Essay to consider the ways in which non-married heterosexual partnerships during this period were simultaneously enduring discriminatory holdings against their access to state resources like unemployment benefits, or how queer activists responded to these holdings directed at their hetero-counterparts. For more, see Norman v. Unemployment Insurance Appeals Board, 663 P.2d 904 (Cal. 1983).
  17. 155 A.3d 1218 (2016). Plaintiff filed a petition to dissolve his nonresident same-sex civil union and appealed to the Vermont Supreme Court.
  18. Id. at 1219; 15 Vt. Stat. Ann. Tit. 15, § 23 (1999).
  19. Id. (citation omitted). The Common Benefits Clause provides “[t]hat government is, or ought to be, instituted for the common benefit, protection, and security of the people, nation, or community, and not for the particular emolument or advantage of any single person, family or set of persons, who are a part only of that community; and that the community hath an indubitable, unalienable, and indefeasible right, to reform or alter government, in such a manner as shall be, by that community, judged most conducive to the public weal.” Vt. Const. art. VII.
  20. 2009 Vt. Acts & Resolves 33. This language comes from a summary provided along with the status of the bill.
  21. 15 Vt. Stat. Ann. tit. 15, § 1206 (2018). This measure was, of course, mooted by Obergefell’s holding that states must recognize lawful same-sex marriages in other states.
  22. See 135 S. Ct. 2584, 2603 (2015).
  23. 15 Vt. Stat. Ann. tit. 15, § 1204 (1999).
  24. 15 Vt. Stat. Ann. Tit. 15, § 23 (2018).
  25. See Boso, supra note 2, at 1120.
  26. See Ajnesh Prasad, On the Potential and Perils of Same-Sex Marriage: A Perspective from Queer Theory, 7 J. Bisexuality 191 (2008).
  27. E.g., United States v. Windsor, 570 U.S. 744 (2013); Lawrence v. Texas, 539 U.S. 558 (2003).
  28. Richard R. Cornwell, Queer Political Economy: The Social Articulation of Desire, in Homo Economics: Capitalim, Community, and Lesbian and Gay Life 89, 103 (Amy Gluckman & Betsy Reed, eds. (1997). (The extent to which queer social codes, and the experiences that produce them, get used depend on whether they sweep “in a wave, like an epidemic, through society.” Queer political economy, through increasing social and legal acceptance of homosexuality, created a kind of “social epidemic” in which queers were not only consumers but “introduce[d] a possible new type of externality among all actors’ actions/voices.”)
  29. See John D’Emilio, Sexual Politics, Sexual Communities: The Making of a Homosexual Community in the United States, 1940-1970 (1983). This backdrop of social history is crucial for reading the definitions marriage offered in Obergefell.

    The opinion presents two definitions of marriage. Kennedy’s first definition of marriage is as a “lifelong union” that is “sacred” and “essential to our most profound hopes and aspirations.”[30. Obergefell, 135 S. Ct. at 2594.

  30. Id. at 2600.
  31. Yoshino, supra note 2, at 163.
  32. Ira C. Lupu, Moving Targets: Obergefell, Hobby Lobby, and the Future of LGBT Rights, 7 Ala. C.R. & C.L. L. Rev. 1, 2 (2015).
  33. Obergefell, 135 S. Ct. at 2601.
  34. Id. at 2596-97.
  35. Melissa Murray, Obergefell v. Hodges and Nonmarriage Inequlity, 7 Calif. L. Rev. 1207, 1251 (2016).
  36. Id.
  37. See Peter Nicolas, Fundamental Rights in a Post-Obergefell World, 27 Yale J.L. & Feminism 331, 361 (2016).
  38. Id.
  39. Obergefell, 135 S. Ct. at 2623 (Roberts, C.J., dissenting); see also Murray, supra note 36, at 1251.
  40. 60 N.E.3d 1109 (Ind. Ct. App. 2016). Biological mother Kristy Gardenour filed an action to terminate her RDP with partner Denise Bondelie, which was issued in California while living in Indiana. On appeal, Gardenour argued that the couple’s RDP was never intended to confer equal rights as married couples or a spousal relationship for determining child custody or support in termination proceedings.
  41. Id.
  42. Cal. Fam. Code § 297.5(a) (West 2018) (“Registered domestic partners shall have the same rights, protections, and benefits, and shall be subject to the same responsibilities, obligations, and duties under [California state] law, whether they derive from statutes, administrative regulations, court rules, government policies, common law, or any other provisions or sources of law, as are granted to and imposed upon spouses.”).
  43. The California Code later confirms this twelve-year distinction: See id § 297.5(e) (“To the extent that provisions of California law adopt, refer to, or rely upon, provisions of federal law in a way that otherwise would cause registered domestic partners to be treated differently than spouses, registered domestic partners shall be treated by California law as if federal law recognized a domestic partnership in the same manner as California law.”).
  44. See, e.g., William C. Duncan, Domestic Partnership Laws in the United States: A Review and Critique, 2001 BYU L. Rev 961 (2001).
  45. 60 N.E.3d at 1116.
  46. Id. at 1117.
  47. Id. at 1118.
  48. Id.
  49. Mary Anne Case, Couples and Coupling in the Public Sphere: A Comment on the Legal History of Litigating for Lesbian and Gay Rights, 79 Va. L. Rev. 1643, 1664–65 (1993).
  50. .Gardenour, 60 N.E.3d at at 1115-16; see also Cal. Fam. Code § 297.5(e) (West 2018).
  51. Gardenour, 60 N.E.3d at 1118 (emphasis added).
  52. Obergefell v. Hodges, 135 S. Ct. 2584, 2590 (2015).
  53. Gardenour, 60 N.E.3d at 1118.
  54. ”That said, the evidence establishes Kristy [Gardenour] and Denise [Bondelie] agreed to co-parent a child conceived via artificial insemination with Kristy being the birth parent . . . . Denise and Kristy still considered C.G. to be Denise’s son . . . . We therefore conclude Kristy and Denise, as spouses, knowingly and voluntarily consented to artificial insemination. Denise is C.G.’s legal parent.” Id.
  55. ”[N]ot recognizing their status would ultimately harm [their child] because a child’s welfare is promoted by ensuring she has two parents to provide financial support.” Id.
  56. Douglas NeJaime, Marriage Equality and the New Parenthood, 129 Harv. L. Rev. 1185, 1253 (2016) (“Family-based LGBT equality may be particularly significant to the status of assisted reproduction, which is central to same-sex family formation.”). Arguably, for courts concerned with children’s welfare the costs and process of family-formation through assisted reproduction make certain same-sex couples more invested (literally and figuratively) in the welfare of their children.
  57. For some illustrative cases emergent post-Obergefell, see Marie v. Mosier, 196 F. Supp. 3d 1202 (D. Kan. 2016), in which same-sex couples brought action against state officials declaring Kansas state law violated due process and equal protection rights in its failure to recognize previous and out-of-state same-sex marriages and unions, and Mabry v. Mabry, 882 N.W.2d 539 (Mich. 2016) (McCormack, J. dissenting), arguing that the appeal should be granted to determine whether Obergefell compels the application of equitable-parent doctrine to custody disputes between same-sex couples previously and unconstitutionally barred from legal marriage. The Mabry dissent signals the vibrancy with which Obergefell may (and must) be debated not merely on ideological terms, but also within doctrinal and statutory frameworks for the continued pursuit of truly equal protection. See also Blumenthal v. Brewer, 69 N.E.3d 834 (2016) (holding, against litigant’s argument that despite affective and financial near similarity, the prohibition of unmarried cohabitants bringing common-law claims based on marriage-like relationship did not violate due process or equal protection, essentially barring a former same-sex domestic partner, who sought restitution from use of funds in previously joint account, by the public policy implicit in a statutory prohibition disfavoring grant of property rights to unmarried cohabitants.)
  58. See Murray, supra note 36, at 1250.
  59. “Judicial opinions addressing the issue have been informed by the contentions of parties and counsel, which, in turn, reflect the more general, societal discussion of same-sex marriage and its meaning that has occurred over the past decades. As more than 100 amici make clear in their filings, many of the central institutions in American life . . . have devoted substantial attention to the question.” Obergefell, 135 S. Ct. at 2605. While Justice Kennedy summarizes a century of discourse on the topic, this acknowledgment makes clear how equality, qua Obergefell, is constructed—or contoured by—this discursive context.