D.C. Circuit Review – Reviewed: “I vote for Chenery I, not Chenery II”

by Aaron Nielson — Friday, Nov. 24, 2017@Aaron_L_Nielson

Steve Calabresi “nearly broke the internet” with his remarks last week at the Federalist Society National Lawyers Convention. But something else was said at the Convention — with less fanfare — that strikes me as more significant. The speaker? White House Counsel Don McGahn. The subject? The two Chenery cases.

Here is what McGahn said*:

The first step in preserving individual liberty in the face of the burgeoning Leviathan is to insist on fair notice. The government has an obligation to clearly inform parties of the rules that will apply to them. Anyone who is engaged with the regulatory state in the last several decades knows that agencies have often taken precisely the opposite approach. Far too often agencies issue vague regulations or in some cases, no regulations at all. Then they interpret those vague regulations through byzantine interpretive rules, guidance documents, or so-called “Dear Colleague” letters. To administrative law experts, these are known by the Orwellian term “subregulatory actions.” But whatever you call them, they are illegitimate.

Madison explained that the separation of powers safeguards liberty by setting ambition against ambition. “If men were angels,” he famously said, “no government would be necessary.” But because ours is a “government administered by men over men, the great difficulty lies in this. You must first enable the government to control the governed and in the next place oblige to it control itself.”

These founding principles were inverted during the expansion of the administrative state during the middle of the 20th century, and they have been mocked and abandoned by the modern statists who fashionably call themselves the progressive movement. Rather than seek to protect citizens from government, we’ve been told the people can thrive only through government. Well-named agencies, full of so-called independent experts, have become the panacea for all social ills. That is the principle underlying the Supreme Court’s decision in Humphrey’s Executor which held, contrary to the plain text of Article II, that the President’s ability to control the actions of the executive branch must yield to the protections Congress has granted to the heads of so-called independent agencies. It is the principle underlying that notion that has courts deferring to agency interpretations of the statutes and regulations they administer.

And it’s the basis for the Supreme Court’s troubling decision in FCC v. Chenery from 1947 — Chenery II, commonly called — which has empowered agencies to issue retroactive regulations through adjudication, a doctrine that has empowered agencies like the NLRB to announce new rules during enforcement actions without any fair notice to the parties being regulated. Justice Jackson saw the problem instantly, speaking in dissent, in Chenery II. He said it “makes judicial review of administrative orders a hopeless formality for the litigant, even where granted to him by Congress. It reduces the judicial process in such cases to a mere feint.” He succinctly said that the thinking in Chenery II would in practice put most executive “administrative orders over and above the law.” Compare Chenery II with Chenery I, where the court said: “But before transactions otherwise legal can be outlawed or denied their usual business consequences, they must fall under the ban of some standards of conduct prescribed by an agency of government authorized to prescribe such standards.” I vote for Chenery I, not Chenery II.

I have heard many speeches about administrative law. But I’ve never heard Chenery II discussed. It is much easier to speak about deference doctrines. A speaker, if he or she is especially brave, may even take a stab at arguing that agencies should pay more attention to cost-benefit analysis. But no one talks about Chenery II. Indeed, most people have never even heard of Chenery II. After McGahn’s remarks, a professor who knows as much about the inner working of the administrative state as almost anyone alive, at least when it comes to rulemaking, said something to the effect of, “Remind me, what’s Chenery II about?” This person then asked me to please write my answer up as a blog post, and I said “sure.” So here goes. But brace yourself — this will take a while.

As I have explained before, there are two Chenery cases. Here is how the Court summarized the story in Chenery II:

The Commission had been dealing with the reorganization of the Federal Water Service Corporation (Federal), a holding company registered under the Public Utility Holding Company Act of 1935. During the period when successive reorganization plans proposed by the management were before the Commission, the officers, directors and controlling stockholders of Federal purchased a substantial amount of Federal’s preferred stock on the over-the-counter market. Under the fourth reorganization plan, this preferred stock was to be converted into common stock of a new corporation; on the basis of the purchases of preferred stock, the management would have received more than 10% of this new common stock. It was frankly admitted that the management’s purpose in buying the preferred stock was to protect its interest in the new company. It was also plain that there was no fraud or lack of disclosure in making these purchases.

But the Commission would not approve the fourth plan so long as the preferred stock purchased by the management was to be treated on a parity with the other preferred stock. It felt that the officers and directors of a holding company in process of reorganization under the Act were fiduciaries and were under a duty not to trade in the securities of that company during the reorganization period. And so the plan was amended to provide that the preferred stock acquired by the management, unlike that held by others, was not to be converted into the new common stock; instead, it was to be surrendered at cost plus dividends accumulated since the purchase dates. As amended, the plan was approved by the Commission over the management’s objections.

(I realize your eyes are starting to glaze over. But grit your teeth and persevere; the payoff is worth it.)

No law specifically prevented management from acting as it did. Nor did the SEC believe that management had “committed acts of conscious wrongdoing.” The SEC, however, had statutory authority to bar reorganizations that were “detrimental to the public interest” or not “fair and equitable.” And the SEC decided to use this power to attack this reorganization.

In the first Chenery case, the SEC concluded — erroneously — that management’s actions violated common law fiduciary duties. As the Supreme Court, per Justice Frankfurter, put it in Chenery I, the SEC’s “opinion plainly shows that the Commission purported to be acting only as it assumed a court of equity would have acted in a similar case. Since the decision of the Commission was explicitly based upon the applicability of principles of equity announced by courts, its validity must likewise be judged on that basis. The grounds upon which an administrative order must be judged are those upon which the record discloses that its action was based.”

This holding has come to be known as the Chenery I principle. Generally speaking, if an agency gives a reason, a reviewing court will focus on that reason alone. Thus, even if an agency could have offered a lawful reason, a court will not uphold the decision if the only reason given was an unlawful one. “If an order is valid only as a determination of policy or judgment which the agency alone is authorized to make and which it has not made, a judicial judgment cannot be made to do service for an administrative judgment.” (Kevin Stack has argued that Chenery I has “constitutional foundations.”) Hence, because the Commission misunderstood the common law (which did not forbid what management had done), the Court held that the SEC’s decision could not stand.

To be sure, the Court agreed that the SEC had authority from Congress to create new prohibitions beyond those from the common law — “In evolving standards of fairness and equity, the Commission is not bound by settled judicial precedents.” Yet the Court also stated:

But before transactions otherwise legal can be outlawed or denied their usual business consequences, they must fall under the ban of some standards of conduct prescribed by an agency of government authorized to prescribe such standards — either the courts or Congress or an agency to which Congress has delegated its authority. Congress itself did not proscribe the respondents’ purchases of preferred stock in Federal. Established judicial doctrines do not condemn these transactions. Nor has the Commission, acting under the rule-making powers delegated to it by § 11 (e), promulgated new general standards of conduct. It purported merely to be applying an existing judge-made rule of equity. The Commission’s determination can stand, therefore, only if it found that the specific transactions under scrutiny showed misuse by the respondents of their position as reorganization managers, in that as such managers they took advantage of the corporation or the other stockholders or the investing public. The record is utterly barren of any such showing. Indeed, such a claim against the respondents was explicitly disavowed by the Commission.

Management thought it had won.

Upon remand, the Commission did not engage in rulemaking to prohibit the sort of activities that management had done. Instead, through adjudication under the statute itself, the SEC determined that what happened was inequitable, and applied that determination retroactively. The Commission thus reached the same result as before — but this time, without purporting to ground its decision in a specific pre-existing legal prohibition.

In Chenery II, the Supreme Court (per Justice Murphy) upheld that second decision:

It is true that our prior decision explicitly recognized the possibility that the Commission might have promulgated a general rule dealing with this problem under its statutory rule-making powers, in which case the issue for our consideration would have been entirely different from that which did confront us. But we did not mean to imply thereby that the failure of the Commission to anticipate this problem and to promulgate a general rule withdrew all power from that agency to perform its statutory duty in this case. To hold that the Commission had no alternative in this proceeding but to approve the proposed transaction, while formulating any general rules it might desire for use in future cases of this nature, would be to stultify the administrative process. That we refuse to do.

Since the Commission, unlike a court, does have the ability to make new law prospectively through the exercise of its rule-making powers, it has less reason to rely upon ad hoc adjudication to formulate new standards of conduct within the framework of the Holding Company Act. The function of filling in the interstices of the Act should be performed, as much as possible, through this quasi-legislative promulgation of rules to be applied in the future. But any rigid requirement to that effect would make the administrative process inflexible and incapable of dealing with many of the specialized problems which arise. Not every principle essential to the effective administration of a statute can or should be cast immediately into the mold of a general rule. Some principles must await their own development, while others must be adjusted to meet particular, unforeseeable situations. In performing its important functions in these respects, therefore, an administrative agency must be equipped to act either by general rule or by individual order. To insist upon one form of action to the exclusion of the other is to exalt form over necessity.

In other words, problems may arise in a case which the administrative agency could not reasonably foresee, problems which must be solved despite the absence of a relevant general rule. Or the agency may not have had sufficient experience with a particular problem to warrant rigidifying its tentative judgment into a hard and fast rule. Or the problem may be so specialized and varying in nature as to be impossible of capture within the boundaries of a general rule. In those situations, the agency must retain power to deal with the problems on a case-to-case basis if the administrative process is to be effective. There is thus a very definite place for the case-by-case evolution of statutory standards. And the choice made between proceeding by general rule or by individual, ad hoc litigation is one that lies primarily in the informed discretion of the administrative agency.

Hence we refuse to say that the Commission, which had not previously been confronted with the problem of management trading during reorganization, was forbidden from utilizing this particular proceeding for announcing and applying a new standard of conduct. That such action might have a retroactive effect was not necessarily fatal to its validity. Every case of first impression has a retroactive effect, whether the new principle is announced by a court or by an administrative agency. But such retroactivity must be balanced against the mischief of producing a result which is contrary to a statutory design or to legal and equitable principles.

Applying that “mischief” standard, the Court concluded that retroactive application of the “new standard” was appropriate.

Justice Jackson, joined by Justice Frankfurter (the author of Chenery I), dissented. Here are some of the highlights:

  • “I feel constrained to disagree with the reasoning offered to rationalize this shift. It makes judicial review of administrative orders a hopeless formality for the litigant, even where granted to him by Congress. It reduces the judicial process in such cases to a mere feint. While the opinion does not have the adherence of a majority of the full Court [because of recusals], if its pronouncements should become governing principles they would, in practice, put most administrative orders over and above the law.”
  •  

    • “Neither is the order one merely to regulate the future use of property. It literally takes valuable property away from its lawful owners for the benefit of other private parties without full compensation and the Court expressly approves the taking.”
    •  

      • “The reversal of the position of this Court is due to a fundamental change in prevailing philosophy. The basic assumption of the earlier opinion as therein stated was, ‘But before transactions otherwise legal can be outlawed or denied their usual business consequences, they must fall under the ban of some standards of conduct prescribed by an agency of government authorized to prescribe such standards. . . .’ The basic assumption of the present opinion is stated thus: ‘The absence of a general rule or regulation governing management trading during reorganization did not affect the Commission’s duties in relation to the particular proposal before it.’ This puts in juxtaposition the two conflicting philosophies which produce opposite results in the same case and on the same facts. The difference between the first and the latest decision of the Court is thus simply the difference between holding that administrative orders must have a basis in law and a holding that absence of a legal basis is no ground on which courts may annul them.”
      •  

        • “As there admittedly is no law or regulation to support this order, we peruse the Court’s opinion diligently to find on what grounds it is now held that the Court of Appeals, on pain of being reversed for error, was required to stamp this order with its approval. We find but one. That is the principle of judicial deference to administrative experience.”
        •  

          • “Of course, thus to uphold the Commission by professing to find that it has enunciated a ‘new standard of conduct’ brings the Court squarely against the invalidity of retroactive law-making. But the Court does not falter. ‘That such action might have a retroactive effect was not necessarily fatal to its validity.’ ‘But such retroactivity must be balanced against the mischief of producing a result which is contrary to a statutory design or to legal and equitable principles.’ Of course, if what these parties did really was condemned by ‘statutory design’ or ‘legal and equitable principles,’ it could be stopped without resort to a new rule and there would be no retroactivity to condone. But if it had been the Court’s view that some law already prohibited the purchases, it would hardly have been necessary three sentences earlier to hold that the Commission was not prohibited ‘from utilizing this particular proceeding for announcing and applying a new standard of conduct.’ I give up. Now I realize fully what Mark Twain meant when he said, ‘The more you explain it, the more I don’t understand it.'”
          •  

            • If it is of no consequence that no rule of law be existent to support an administrative order, and the Court of Appeals is obliged to defer to administrative experience and to sustain a Commission’s power merely because it has been asserted and exercised, of what use is it to print a record or briefs in the case, or to hear argument? Administrative experience always is present, at least to the degree that it is here, and would always dictate a like deference by this Court to an assertion of administrative power.”
            •  

              • “The truth is that in this decision the Court approves the Commission’s assertion of power to govern the matter without law, power to force surrender of stock so purchased whenever it will, and power also to overlook such acquisitions if it so chooses. The reasons which will lead it to take one course as against the other remain locked in its own breast, and it has not and apparently does not intend to commit them to any rule or regulation. This administrative authoritarianism, this power to decide without law, is what the Court seems to approve in so many words: ‘The absence of a general rule or regulation governing management trading during reorganization did not affect the Commission’s duties. . . .’ This seems to me to undervalue and to belittle the place of law, even in the system of administrative justice. It calls to mind Mr. Justice Cardozo’s statement that ‘Law as a guide to conduct is reduced to the level of mere futility if it is unknown and unknowable.'”
              •  

                • “The Court’s averment concerning this order, that ‘It is the type of judgment which administrative agencies are best equipped to make and which justifies the use of the administrative process,’ is the first instance in which the administrative process is sustained by reliance on that disregard of law which enemies of the process have always alleged to be its principal evil. It is the first encouragement this Court has given to conscious lawlessness as a permissible rule of administrative action. This decision is an ominous one to those who believe that men should be governed by laws that they may ascertain and abide by, and which will guide the action of those in authority as well as of those who are subject to authority.”
                •  

                  Justice Jackson lost — and the results are significant. Not only are agencies often free to create specific prohibitions retroactively through adjudication (there are limits, but they are, well, limited), but the fact that regulated parties know agencies have this power (whether they know the name of the case that creates the power or not) suggests that agencies may not have to formally exercise such power very often. After all, why are “agency threats” or guidance documents so effective? If an agency could only create new policy prospectively, regulated parties could say, “Show me the specific law I’m violating, and if you can’t, well, shove off until there is a regulation.” As it is now, however, regulated parties rightly fear that prohibitions can be sprung on them retroactively. Because that’s how it works, it matters a great deal what the regulator has to say, whether or not there already is a regulation on point. Hence, at least sometimes, “Chenery II is the anchor that gives many guidance documents their weight.

                  Chenery II thus can be dangerous — because retroactivity is dangerous. As Justice Scalia observed, “Rudimentary justice requires that those subject to the law must have the means of knowing what it prescribes. It is said that one of emperor Nero’s nasty practices was to post his edicts high on the columns so that they would be harder to read and easier to transgress.” Or as Judge Janice Rogers Brown once put it, changing the game retroactively is “literally Orwellian.”

                  On the other hand, not all applications of Chenery II are problematic. There are circumstances in which agencies should not be required to promulgate a regulation first. If the statute itself is sufficiently clear, regulated parties already have fair notice and there is no need for a rule. The problem arises when the statute itself does not provide fair notice — and loosey-goosey words like “public interest” certainly do not provide fair notice.

                  Why is all of this important? Because it looks like this wariness of Chenery II may extend across the Administration. The same day that McGahn addressed Chenery II, the Attorney General “issued a memo prohibiting the Department of Justice from issuing guidance documents that have the effect of adopting new regulatory requirements or amending the law.” This is a good first step — if implemented carefully — and other agencies should follow DOJ’s lead. But the real solution is to make it more difficult for agencies to retroactively create legal obligations, at least where there is not meaningful fair notice.

                  And that’s why I pay attention when I hear a senior White House official mention Chenery II.

                  The D.C. Circuit decided three cases this week, one of which is about — surprise! — Chenery I.

                  In Press Communications LLC v. FCC, Judge Pillard (joined by Judges Wilkins and Silberman) upheld the FCC’s order denying Press Communications’ application for a channel transfer. Press Communications wished to switch radio channels with Equity Communications, even though the result perhaps would be a violation of the FCC’s channel “spacing rules” (i.e., rules to prevent broadcast signals from being too close together). Press argued that the switch would not violate the spacing rules because Equity, as a “grandfathered” station, could exist in closer proximity to adjacent stations. The FCC, however, interpreting a note to one of its regulations (potentially triggering Auer deference), rejected the application, and the Court agreed. “In short, FCC regulations, decisions, and practice support the Commission’s contention that applications for minor modifications are subject to the spacing requirements articulated in Section 73.207. Any nonconforming application requires a waiver of that rule, and Press failed to justify such waiver. The Commission reasonably rejected its application as defective.” Press Communications argued that the FCC could not rely on the winning argument “without running afoul of the Chenery principle that a reviewing court may only affirm an agency’s action on the grounds the agency articulated.” The Court did not buy it: “We can reasonably discern the Bureau’s path in its decision enforcing the spacing requirements.”

                  In Knapp Medical Center v. Hargan, Judge Henderson (joined by Judges Griffith and Williams) affirmed the district court’s interpretation of the preclusion-of-review provision in the Stark Law. The Stark Law is a provision of Medicare which “forbids ‘self-referrals’ by which a physician could profit from Medicare reimbursements to healthcare providers with which he has a financial relationship.” There is an exception, however, for physician-owned hospitals. Under the Affordable Care Act, that exception has been amended to limit the expansion of such hospitals. The statute also includes a provision limiting judicial review. When a hospital tried to expand, Knapp Medical Center objected. When the agency rejected Knapp’s objections, “Knapp sued to set aside the decision.” The Court agreed it had no jurisdiction to review the decision. Especially relevant here, the Court rejected Knapp assertion of absurd results as “unfounded”: “The Secretary acknowledges that ‘judicial review may be available when the actions charged are claimed to be ultra vires’ — which is to say, actions ‘beyond [HHS’s] statutory authority.’ Knapp has not argued that the approval of DHR’s expansion application was ultra vires so we need not decide whether the district court would have jurisdiction of such a challenge.”

                  Finally, in Detroit Int’l Bridge Co. v. Canada, Judge Rogers (joined by Chief Judge Garland and Judge Sentelle) addressed whether a new bridge can be built between Michigan and Canada. The story is complicated so I will focus on the part of the opinion addressing the Compact Clause and nondelegation. Under statutory law, the Secretary of State must sign off on such arrangements (“The effectiveness of such agreement shall be conditioned on its approval by the Secretary of State”), and “Count 1 [of the complaint] alleged Congress unconstitutionally delegated Compact Clause authority to the Secretary of State without an intelligible principle ….” The Court rejected that argument because “the delegation need not be tested in isolation and derive[s] much meaningful content from the purpose of the Act.” Here, “the Secretary’s authority is limited by an ‘area’ — navigable waters between the U.S. and Canada or Mexico — and a ‘purpose’ — the construction of international bridges. Thus, the intelligible principle is that in view of the Secretary’s mission relating to foreign affairs, the Secretary will review international bridge agreements for their potential impact on United States foreign policy.” (The Court also concluded it could not review presidential approval of the bridge; “even if the Presidential Permit issuance were agency action [as the President delegated his authority to the Secretary of State], it is unreviewable under the APA because it is ‘committed to agency discretion by law'” since “the context surrounding issuance of a Section 4 Presidential Permit … involves a determination rife with executive discretion in an area that the U.S. Constitution principally vests in the political branches.”)

                  I apologize — this is a long post. No one ever said administrative law is easy.

                  * This transcript comes from C-SPAN; I cleaned it up a bit. UPDATE: I didn’t clean it up enough. The transcript says “FCC” when it should be “SEC.” I don’t blame the transcriber — it is an easy mistake.

                  UPDATE II: I also fixed a typo.

                   

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About Aaron Nielson

Professor Nielson is an associate professor at Brigham Young University Law School, where he teaches and writes in the areas of administrative law, civil procedure, federal courts, and antitrust. He currently serves as a public member of the Administrative Conference of the United States, a federal agency that studies the administrative process and makes recommendations on ways to improve it. He also co-chairs the Rulemaking Committee of the American Bar Association’s Section of Administrative Law & Regulatory Practice. Previously he chaired the Section's Antitrust & Trade Regulation Committee. Before joining the academy, Professor Nielson was a partner in the Washington, D.C. office of Kirkland & Ellis LLP (where he remains of counsel). He also has served as a law clerk to Justice Samuel A. Alito, Jr. of the U.S. Supreme Court, Judge Janice Rogers Brown of the U.S. Court of Appeals for the D.C. Circuit, and Judge Jerry E. Smith of the U.S. Court of Appeals for the Fifth Circuit. Follow him on Twitter @Aaron_L_Nielson.

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