- Online Edition
- Print Edition
- Donahue Lecture Series
On October 23, 2013, the SEC released its proposed equity crowdfunding rules.1 The proposed rules, which come over a year and a half after the Jumpstart Our Business Startups Act (JOBS Act) was signed into law, outline the details of how the legislation’s new crowdfunding provisions will function. While many have lauded the new rules as potentially useful for capital-seeking startup companies, this new financing mechanism has two serious limitations. First, crowdfunding will require companies to incur significant costs in order to comply with the annual reporting requirements of the law.2 Second, crowdfunded companies may also face difficulty in acquiring traditional venture capital. This Essay discusses the potential pitfalls of crowdfunding and explores measures that crowdfunded companies can take to avoid them.
Equity crowdfunding is a method of financing in which, generally, large numbers of individuals purchase relatively small dollar amounts of equity in a private company through an online intermediary.3 Unlike other private-placement methods, such as those under Rules 505 and 506 of Regulation D, companies that sell equity through crowdfunding will be able to sell to an unlimited number of unaccredited investors without filing a registration statement.4 Consistent with the JOBS Act, the proposed rules allow companies to sell up to $1,000,000 worth of securities through crowdfunding within a one-year period,5 so long as the offering is conducted through a broker or a funding portal6 and the company meets a number of requirements.7 These requirements include, among other things, making initial and annual disclosures to investors and the SEC,8 and not advertising the terms of the offering except for notices that direct investors to the online intermediary.9
The legislation limits the amount that individual investors may contribute. Investors with an annual income and net worth of less than $100,000 are limited to the greater of $2000 or 5% of their annual income or net worth.10 Investors with an annual income or net worth equal to or exceeding $100,000 are allowed to invest 10% of either their annual income or net worth (whichever is greater) up to $100,000.11
III. Disclosures and De-Crowding
A. Disclosure Requirements
Under the proposed rules, an issuer relying on the crowdfunding provisions of the JOBS Act must make certain initial disclosures to the SEC, investors, and the crowdfunding intermediary.12 These disclosures include the names of the issuer’s directors, officers, and major equity holders;13 a description of the issuer’s business and its capital structure; the risk factors of the business; the terms of the securities being offered; the intended use of the offering proceeds; and the manner in which the offering will be conducted.14 The initial disclosures must also include the company’s financial statements.15 For an issuer raising less than $100,000, the financial statements must be certified by the company’s principal executive officer,16 while issuers raising between $100,000 and $500,000 must have their financial statements reviewed by a public accountant.17 For amounts over $500,000, the financial statements must be audited by a public accountant.18
In addition to these initial disclosures, crowdfunded companies will also be subject to ongoing reporting requirements. A company that raises capital through the crowdfunding provisions will have to file an annual report of its operations and financial statements with the SEC.19 Under the proposed regulations, the annual report must include most of the materials required in the initial filing, except for the information relating to how the offering was originally made.20 Also, the annual financial statements will have to be reviewed in the same manner as they were for the initial disclosures, based on the amount of the offering.21 An issuer will have to continue to comply with these ongoing reporting requirements until the company repurchases all of the securities issued through crowdfunding, becomes a reporting company under the Exchange Act, or liquidates or dissolves the business.22
While the initial disclosures may not be a heavy burden for startup companies because they are a one-time event, the ongoing reporting requirements could become particularly onerous for some enterprises. Indeed, as the SEC noted in the report accompanying the proposed rules, the cost of audited financials alone could be $28,700 per year.23 If a company raises just over $500,000, for example, it could pay over half of that amount just for its audited financials over the course of ten years. As one commentator has noted, companies raising smaller amounts could end up paying more for crowd capital than they would with a credit card.24 Thus, under the current proposal, the ongoing compliance costs may not be worth it for some companies in the long run.
Of course, a high long-term cost does not mean that a company will not crowdfund. Given the difficulty of getting traditional venture capital or angel financing and the near impossibility of receiving a bank loan without substantial cash flow, many companies may ignore the long term and crowdfund anyway. Moreover, there may be some companies whose later-stage growth did not pan out, making the disclosures relatively more costly than anticipated. We could see a whole generation of crowdfunded companies strangled by the reporting requirements and looking for a way out.
How will these companies terminate their disclosures? As previously mentioned, there are only three ways: buy back all of the crowd shares, go public, or go broke.25 Going public would, of course, be the most desirable option. But it is not a viable one for most companies, even if they have decent growth potential and cash flow. This leaves a share repurchase as the only other way. However, a share buy-back could present a serious issue: there is a potential holdout problem. Because the company will have to repurchase all of its crowdfunded shares26—and there could be thousands of shareholders—one stubborn shareholder could keep a company from de-crowding.
C. Share Buy-Back Rights
The easiest way to get around the holdout problem is to ensure that crowdfunded companies have the right to repurchase crowd shares. This can be done contractually or through a provision attached to preferred shares.27 Because of the difficulty of having potentially thousands of crowdfunders sign shareholder agreements, however, the better route will likely be the latter. Under this approach, the company would issue preferred shares to crowdfunders with an optional redemption right attached in favor of the company. This right would be written into the company’s certificate of incorporation and would carry over to any person who subsequently purchased the preferred shares.
The provision itself would likely be structured to give the company the right to purchase the crowdfunded shares for their fair market value28 only upon the occurrence of a particular event. For example, the right could be conditioned on the total number of crowdfunding shareholders falling below a certain threshold. Using this provision, the company could conduct a voluntary buy-back to acquire the majority of the crowd shares. Then, once the threshold has been reached, the company could exercise its optional redemption rights to eliminate any dissenting crowd shareholders.29
D. Squeeze-Out Mergers
Assuming a company’s crowd shares are not subject to an optional redemption right, the traditional way of getting around this problem is through a squeeze-out merger. Under this approach, a group of noncrowd shareholders would purchase as many crowd shares as possible. Afterwards, they would attempt to affect a merger with a newly created shell company to squeeze out the remaining crowd shareholders. Assuming the noncrowd shareholders acquire a sufficient number of the company’s shares,30 they would be able to effect the merger over the dissent of holdout shareholders. Under the merger agreement, the remaining crowd shareholders would receive at least the fair market value31 of their shares in cash, and the shell company would merge into the crowdfunded company. As a result, the shell would disappear, leaving only the formerly crowdfunded company with only noncrowd shareholders.
E. Potential Problems
Unfortunately, both of these approaches to reacquiring shares have potential problems. In the case of an optional redemption right, the inclusion of such a provision in a preferred share issuance would likely chill the initial sale to crowdfunders. Investors, hoping to achieve a high upside on their investment, may be wary of granting the company the right to buy back their shares prematurely. Regarding squeeze-out mergers, the risk of shareholder litigation and the cost of the associated legal legwork would be quite high. While the hurdles would not be as numerous as those for a public company going private, state corporate law would still present challenges. Because the directors of a company and any controlling shareholders owe fiduciary duties to minority shareholders,32 a company would need to take precautionary steps to ensure the transaction was conducted in a fair manner and on fair terms.33 If going-private transactions are any indication, we could see crowdfunded companies attaining fairness opinions and creating special committees,34 both of which are time consuming and expensive.
Most importantly, both of these techniques for de-crowding assume that the company and/or a group of noncrowd shareholders have sufficient funds on hand to effect the repurchase.35 In the startup space, this is a big assumption. These techniques will likely only be used by more established companies with substantial cash flow but not strong growth potential.36 Thus, of the companies that would want to de-crowd, only a very small section of those may be able to. Indeed, the companies most burdened by the costs of complying with the law would be the least likely to have the cash to afford such a repurchase.
IV. Acquiring Venture Funding
A. Potential Problems
Another problem with crowdfunding is that it may inhibit a company’s ability to acquire subsequent financing because venture capitalists are apprehensive about investing in companies with large numbers of unaccredited investors.37 Large numbers of shareholders can mean an investor relations nightmare and a substantial increase in the risk of shareholder litigation.38 These are both issues that venture capitalists would rather avoid.
Of course, this begs the question: why would a crowdfunded company want a subsequent round of venture financing? There are several reasons. First, one million dollars per year may not be enough to properly grow the business. Indeed, in the first quarter of 2013, the average venture capital investment was four million dollars.39 And for some industries, such as biotech, the capital demands tend to be even higher.40 Second, even if one million dollars per year is enough, a crowdfunded company may believe it can get a more favorable and less dilutive price per share from a venture deal than from another round of crowdfunding. Lastly, there are certain nonfinancial benefits to working with venture capitalists. Venture firms can provide guidance on how to run and grow the business and can introduce companies to valuable contacts, such as suppliers, customers, and potential acquirers.41
B. Potential Solutions: No Preemption and the Two-Entity Structure
A crowdfunded company that wants to raise a round of venture capital cannot simply de-crowd the company using the methods previously discussed. A crowdfunded company that is looking for additional capital likely would not have the cash to repurchase crowd shares. Moreover, venture capitalists are unlikely to make any capital injection for the purpose of cashing out crowd shares because they want their investment to be put towards growing the company. Thus, crowdfunded companies looking for funding will need to find other ways to soothe venture capitalists’ concerns.
The first and most important measure that companies should take is ensuring that crowdfunded shares do not have preemption rights.42 If the crowd shareholders have been granted preemption rights, this will likely be a deal breaker for venture funds because of the nature of Rules 505 and 506 under Regulation D. Per Rules 505 and 506, the number of nonaccredited investors allowed to participate in a private placement is limited to thirty-five.43 Should more than thirty-five nonaccredited crowd shareholders hold preemptive rights and want to participate in a round of funding, Rules 505 and 506 could not be used. This would severely hamper a company’s ability to raise capital through a private placement, presenting an unacceptable risk for most venture funds.
The second issue that companies will need to address is regarding the sheer number of shareholders. In order to deal with this, startup companies will want to carefully consider their capital structure before engaging in a round of crowdfunding. In particular, startups will want to consider ways of grouping and separating crowdfunders.
One way startup companies could do this is by assuming a two-entity structure. Under this approach, the founders would initially create a holding company—either a corporation or a LLC—which would, in turn, create a wholly-owned subsidiary to actually run the business (i.e., the operating company). After creating the subsidiary—a corporation44—the founders would cause the holding company to sell shares to crowdfunding investors. Once the holding company receives the cash from the crowfunding round, it would then make a capital contribution to the subsidiary through a share purchase. As a result, the subsidiary would hold all the proceeds from the crowdfunding round and be entirely owned by the holding company, while the holding company would be owned by a combination of the founders and the crowdfunders.
This arrangement would leave the company in a more venture-friendly structure than a single-entity arrangement because all the crowdfunders would be isolated to the holding company and represented as one large shareholder of the operating company. A venture fund looking to invest would simply purchase shares in the operating company, leaving it with only one shareholder to deal with: the holding company. The director(s) of the holding company would be responsible for crowdfunder relations, leaving the venture-appointed directors of the operating company to focus on growing the business. Moreover, this arrangement could simplify the de-crowding techniques discussed in Part III. Should the operating company want to de-crowd at any time in the future, it would only need to repurchase the shares of one shareholder, which would eliminate the potential holdout problem.
Is this type of arrangement (see Figure 1) allowed under the proposed crowdfunding rules? It appears so. Under the SEC’s proposal, the crowdfunding exemption does not apply to, inter alia, companies without business plans or whose only plan is to engage in an acquisition with an unidentified company.45 Also, the exemption does not apply to investment companies.46 This arrangement, however, does not fall within either of these categories because the company whose shares are to be acquired is known, and the holding company would not qualify as an investment company.47
C. Potential Problems with a Two-Entity Arrangement
Of course, this arrangement is not without its drawbacks. The holding company would add complexity as well as additional costs for annual filings and franchise taxes. Also, having two entities makes a future exit transaction more complicated than it otherwise would be, because it may be necessary to merge the holding and operating companies before an IPO or buyout. The two-entity arrangement could also impact the success of the crowdfunding round. Crowd-investors may not understand the need to corral them into a separate entity. Even if they do, individual crowdfunders may be concerned that they are more susceptible to being squeezed out under the two-entity arrangement, a risk that would need to be explained in the initial disclosure.48 This could mean less money or more founder dilution during the initial crowdfunding round.
Regarding the tax implications, a two-entity structure could be more costly for crowdfunders and founders. Depending on how much of the operating company is owned by the holding company, shareholders of the holding company could be taxed at the shareholder, holding company, and operating company levels.49 Fortunately, however, the triple taxation issue likely would not be a problem for most startups. Generally, even if a startup is profitable, all of its excess revenue is reinvested to grow the company and not distributed through dividends. Thus, the holding company and its shareholders would not be receiving any dividends to be taxed. Even if the company needed to make a cash dividend in the future, it could affect a tax-free merger50 beforehand to put the company back into a one-entity structure. Alternatively, the founders could simply structure the holding company as a LLC, making it a tax-transparent entity.51
Perhaps most importantly, this iteration of the two-entity arrangement would have the unintended effect of corralling the founders along with the crowdfunders. This could be problematic because the company would be unable to cash out crowdfunders through a repurchase of the holding company’s shares without also cashing out the founders at the same time. Also, the arrangement could complicate founders’ relationships with venture financiers and create potential conflicts of interest.
The corralling problem, however, could be avoided by tweaking the two-entity structure. This could be done by having the operating company initially owned by the founders instead of the holding company. Once the entities were set up, the founders would cause the holding company to sell shares to crowdfunders and dilute their holdings effectively to zero.52 After that, the holding company would use all of the proceeds to purchase newly issued shares in the operating company. The terms of the issuance could be governed by a contract between the holding company and the operating company that was executed before the crowdfunding and was disclosed to crowdfunders. Thus, the price and percentage of equity that the holding company would be purchasing would be known before the crowdfunding. The result of this arrangement would be that the operating company would hold all the cash and be owned by both the founders and the holding company. The operating company could then bring on venture investors in the same manner as in the first iteration.
It is less clear whether this second iteration (see Figure 2) is allowed under the proposed crowdfunding regulations. Under the SEC’s proposal, investment companies or companies that would be investment companies but-for the exemptions of Sections 3(b) and 3(c) of the Investment Company Act53 may not use the crowdfunding exemption.54 Investment companies, in turn, include any issuer which (1) “is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities” and (2) “owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets.”55 Under the second prong of the definition, “investment securities” do not include securities issued by majority-owned subsidiaries of the owner.56 This means the first iteration would be okay because, at the time of the crowdfunding, the operating company would be wholly-owned. Under the second iteration, however, the operating company would be owned by the founders, not the holding company. Thus, the holding company would arguably be in the business of owning the securities of the operating company, and it would certainly be proposing to acquire “investment securities” with a value of greater than 40% of its assets.
As discussed in Part III, the costs of annual reporting for crowdfunded companies could be quite high. As a result, it is likely that we will see some companies in the future looking to de-crowd. Doing so, however, will present challenges. Large numbers of relatively small investors and the SEC’s proposed rules mean that holdout shareholders could be a serious problem. In order to get around them, companies seeking crowdfunding will need to act with foresight and ensure they have a repurchase right. If not, they may be forced to undertake the more risky and costly approach of a squeeze-out merger.
Of course, because the SEC’s proposed rules are not final, the difficulty of de-crowding might still be mitigated. If the SEC changes its rule by terminating ongoing reporting requirements once the number of crowdfunders falls below a certain threshold—for example, thirty-five—this would greatly lower the risk of a holdout and make it easier for companies to de-crowd. However, even if the SEC adjusts the termination conditions, companies will still need to have the cash on hand to buy back crowd shares. This means many startups, short on cash, will likely be stuck eating the cost of annual disclosures.
As discussed in Part IV, crowdfunded companies who are seeking venture capital will need to act proactively to make themselves more appealing. Most importantly, crowdfunded companies should ensure that they do not grant crowdfunders preemption rights. Also, companies may want to consider isolating crowd shareholders in a separate legal entity before seeking venture financing. This will decrease the number of shareholders the venture fund has to deal with, allowing them to focus on growing the company. As far as what the structure should look like, it appears that the first iteration discussed would be allowed under the proposed regulations, but it has the draw-back of lumping founders in with crowd shareholders. The second iteration, while it eliminates this problem, may not be allowed under the proposed rules.
What does all this mean for startups? Companies considering crowdfunding should evaluate their options very carefully. Once crowd shareholders are brought on board, they will be costly and difficult to get rid of. Moreover, crowd shareholders could prevent some companies from acquiring the venture financing they need. While crowdfunded companies can adopt a two-entity structure to make themselves more venture-friendly, this arrangement comes with a number of costs.
Byron Crowe, Essay, After Online Equity: De-Crowding and Accommodating Venture Capital, 2 Suffolk U. L. Rev. Online 1 (Jan. 31, 2014), http://suffolklawreview.org/crowe-crowdfunding.
Many have argued that the tax-return preparation industry is behind the licensing curve. The National Consumer Law Center and National Community Tax Coalition have even noted, “[m]ore regulation is required of hairdressers in many states.”1 The Internal Revenue Service (IRS) sought to change this by extending its regulatory reach to tax-return preparers. However, the IRS’s right to regulate this industry is currently being litigated. In Loving v. IRS,2 three paid tax-return preparers, who were not previously subject to IRS regulation, sued the IRS in the United States District Court for the District of Columbia seeking injunctive and declaratory relief. After discussing the district court’s holding in Loving and the parties’ appellate arguments, this Essay analyzes the legal and policy considerations on both sides of the issue. Ultimately, this Essay concludes that the debate surrounding the IRS’s right to regulate paid tax-return preparers will end in regulation. What remains to be seen is whether a regulatory scheme will take effect through judicial blessing or legislative action. Congress has shown an appetite for legislation that would allow the IRS to regulate tax-return preparers. Thus, regardless of Loving’s outcome, tax-return preparers appear destined for regulation, like many other professions.
A brief history of the regulation of “practice” before the IRS is necessary to frame the debate surrounding the regulation of paid tax-return preparers. The United States Department of the Treasury’s (the Treasury) authority to regulate tax professionals dates back to the Horse Act of 1884.3 The Horse Act arose primarily because of concerns regarding fraudulent claims against the government for the value of dead horses and lost property during the Civil War.4 The Act predates the modern income tax by twenty-nine years and its provisions are now codified in 31 U.S.C. § 330:
(a) Subject to section 500 of title 5, the Secretary of the Treasury may—(1) regulate the practice of representatives of persons before the Department of the Treasury; and (2) before admitting a representative to practice, require that the representative demonstrate—(A) good character; (B) good reputation; (C) necessary qualifications to enable the representative to provide to persons valuable service; and (D) competency to advise and assist persons in presenting their cases.5
This legislative grant of regulatory authority spurred the Treasury to publish circulars containing guidance for agents.6 In 1921, those circulars were combined with other statutes into the precursor of the IRS’s modern day Circular 230, entitled “Regulations Governing Practice Before the Internal Revenue Service.” Since 1921, Circular 230 has listed a wide spectrum of qualifications and entrance requirements for determining who may practice before the IRS. From early on, Circular 230 prohibited anyone other than attorneys and Certified Public Accountants (CPAs) from practicing. Revisions in 1951 removed this restriction allowing anyone who passed an entrance examination prepared by the American Institute of Certified Public Accountants (AICPA) to practice. Then, driven by high demand for practitioners, the rules changed again in 1959 to define practitioners as attorneys, CPAs, and anyone who could pass the Special Enrollment Exam developed by the Treasury. Those who can practice by virtue of having passed the enrollment exam are known as Enrolled Agents (EAs). Generally speaking, Circular 230 has remained static for the past fifty-four years in terms of who can practice.7
Before discussing the recent Circular 230 revision that launched the legal battle in Loving, it is important to define practice before the IRS and explain which practitioners were bound by Circular 230’s standards of conduct prior to the 2011 change. The crux of the issue is that Circular 230 defines practice broadly to include return preparation, but defines practitioner narrowly to exclude return preparers who are not attorneys, CPAs, or EAs.8 Practice before the IRS encompasses “all matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a taxpayer’s rights, privileges, or liabilities under laws or regulations administered by the Internal Revenue Service.”9 Attorneys, CPAs, and EAs do not make up the entirety of individuals allowed to practice before the IRS. Circular 230 allows for limited practice by unenrolled return preparers. These unenrolled preparers may prepare returns and represent taxpayers during audits of the returns, but may not represent taxpayers during the IRS appeals process.10 The issue is this: both practitioners and unenrolled preparers can practice by filing tax returns, but only practitioners are subject to Circular 230’s standards and sanctions. To provide an example of the type of preparer omitted from coverage, H&R Block, Jackson Hewitt, and Liberty Tax Service are the three largest employers of (primarily) unenrolled preparers.11
The consternation regarding lack of oversight of unenrolled preparers fueled a 2009 IRS study, which described the need for regulation in dramatic fashion.12 Accordingly, in August 2011, the IRS implemented a program to license and regulate paid tax-return preparers who were not already under the purview of Circular 230. The regulatory scheme creates a category of “Registered tax return preparer” (RTRP) in Circular 230’s definition of practitioner.13 This change brought RTRPs into the fold of Circular 230’s standards of conduct and sanctions for violations. In addition, it left unenrolled return preparers grappling with new registration requirements, including a one-time competency exam and fifteen hours of annual continuing education.14 Registration would not change the scope of their ability to practice because RTRPs, like unenrolled preparers before them, may not practice at the IRS appeals level. Under these changes, formerly unregulated preparers now face the double burden of registration requirements and mandatory standards of conduct, including sanctions for improper behavior.
III. Loving v. IRS
A. The District Court’s Decision
The IRS’s RTRP regulations went into effect on August 2, 2011. The following March, Sabina Loving, Elmer Kilian, and John Gambino (collectively, Loving et al.) filed a lawsuit challenging the legality of the new regulations under the Administrative Procedure Act (APA). The APA requires that courts strike down agency action that exceeds the agency’s statutory authority.15 The Supreme Court, in the seminal case of Chevron U.S.A., Inc. v. National Resources Defense Council,16 interpreted the APA using a two-step inquiry. Step one asks whether “the intent of Congress is clear;” or in other words, whether the statute authorizing agency action is ambiguous.17 If ambiguity exists, then step two asks whether the agency based its interpretation “on a permissible construction of the statute.”18 Step two defers to the agency’s interpretation unless it is “arbitrary, capricious, or manifestly contrary to the statute.”19 The Supreme Court’s language in Chevron represents the judiciary’s general policy to avoid substituting a court’s judgment for the reasonable judgment of agencies. Placing Loving into the Chevron framework, the question under step one is whether the authority granted to Treasury under § 330(a)(1) to “regulate the practice of representatives of persons before the Department of the Treasury” express Congress’s unambiguous intent to give the IRS power to regulate unenrolled preparers. The district court in Loving based its decision solely on step one of the Chevron two-step inquiry.20
1. The District Court’s Analysis of § 330
The district court concluded that the IRS’s statutory authority to regulate representatives who practice before it unambiguously did not include tax-return preparers. The court began by dividing a taxpayer’s interaction with the IRS into three potential stages: filing a tax return (“assessment and collection”), auditing the return (“examination”), and appealing the outcome of the audit with the IRS (“appeals”). For the second and third stages, the court explained that an attorney or CPA is typically involved to advocate for the taxpayer. All three stages are, of course, prior to a taxpayer having a dispute that would be litigated in federal court. It is obvious from the court’s description of these three stages of interaction with the IRS that it believes the first step is void of any “representative” feature. The court would engage in statutory analysis to support its conclusion.
The district court explained that although the statute does not define practice or representative, it tells us that representatives “advise and assist persons in presenting their cases.”21 The court reasoned that “[f]iling a tax return would never, in normal usage, be described as ‘presenting a case,’” because when a taxpayer files a tax return, there is no dispute or case to present.22 Thus, the court concluded that the statute’s language unambiguously prohibits the IRS from regulating the practice of unenrolled preparers, and therefore step two of the Chevron inquiry was not applicable. Accordingly, the court granted an injunction against the IRS—mandating a halt to the RTRP program—and refused to grant a motion to stay the injunction pending the outcome of the IRS’s appeal.23
The district court’s analysis stemmed from an earlier decision of the D.C. Circuit, which requires that, absent a definition, the “words of the statute should be read in context, the statute’s place in the overall statutory scheme should be considered, and the problem Congress sought to solve should be taken into account” to determine whether Congress has foreclosed the agency’s interpretation.24 Presenting a case may mean different things depending on the context. Presenting a case for promotion means something different than presenting a case for a not-guilty verdict in a murder trial. The former typically does not involve a legal dispute, while the latter does. The district court, however, stood firm that “[a]t the time of filing, the taxpayer has no dispute with the IRS; there is no ‘case’ to present. This definition makes sense only in connection with those who assist taxpayers in the examination and appeals stages of the process.”25
Yet, the meaning of presenting a case varies with context. Normally, statutory analysis of this kind would examine the legislative history surrounding the adoption of the particular statute. Unfortunately, the Horse Act was adopted twenty-nine years before the codification of the Internal Revenue Code (the Code). In addition, the later substitution of “representatives of persons” for “agents, attorneys, or other persons representing claimants before his department” was part of “An act to revise, codify, and enact without substantive change certain general and permanent laws, related to money and finance, as title 31, United States Code, ‘Money and Finance.’”26 The revisions were a housekeeping effort rather than a change in the underlying law. So, where do we turn for clues as to the meaning of presenting a case in this context? We know that the Horse Act was designed to curb fraudulent claims against the government for the value of property lost during the Civil War.27 The modern equivalent could be fraudulent claims by preparers (on behalf of taxpayers) for reduced tax liability, refund, or entitlement to various government assistance administered through the Code.
2. The District Court’s Broader Statutory Analysis
After concluding that the text of § 330 unambiguously forecloses the IRS’s ability to regulate unenrolled preparers as representatives who practice before the IRS, the district court offered additional statutory support for its holding. Specifically, the court cited the Code’s existing penalty and injunction scheme against unlawful return preparers.28 The court reasoned that giving the IRS the power to impose monetary penalties on unenrolled preparers and revoke their right to file returns would render the existing Code scheme obsolete. Furthermore, the court contended that it is only the existing scheme that represents Congress’s clear intent to punish unlawful preparers. That is, the specific scheme of the Code trumps the more general authority granted to the IRS under § 330.
The district court admitted the weakness in this line of reasoning.29 Indeed, the same overlap of Code penalties with Circular 230 penalties already exists for attorneys, CPAs, EAs, and others enrolled to practice before the IRS. One of the court’s main concerns with the RTRP program is that it would allow the IRS to strip unenrolled preparers of their ability to practice without the procedural protections, such as judicial review, provided in the Code.30 But these protections have already been eliminated for other practitioners without fanfare. The court rightly concluded that the IRS would almost never pursue injunctive relief under the Code when it could get the same result with far less work under Circular 230. But the court ignored that this overlap already exists, regardless of whether Circular 230 covers unenrolled preparers. Return preparation is an activity constituting “practice before the Internal Revenue Service” under Circular 230.31 What probably confused the court is that only practitioners—defined to exclude unenrolled preparers in the pre-2011 version of Circular 230—are subject to penalties and sanctions with respect to unlawful tax returns. In other words, the addition of the RTRP category only extends to unenrolled preparers the overlap of Code penalties and Circular 230 penalties that already exist for credentialed practitioners. In addition, attorneys are subject to regulation in triplicate because they are also governed by the rules of professional conduct. A lawyer who filed an unlawful tax return could be disbarred from practice before the IRS under Circular 230, enjoined from filing tax returns under Code § 7407, and disbarred from practicing law anywhere she has an active license. Unlawful tax-return preparation has always been the target of overlapping penalties, but prior to 2011, only with respect to credentialed preparers.32
B. The IRS’s Appeal
Not surprisingly, given the far-reaching implications of the district court’s decision and the cost the IRS incurred in developing the RTRP program, the IRS appealed the decision to the United States Court of Appeals for the District of Columbia. As previously discussed, the IRS both appealed the decision and filed a motion to defer the injunction pending the outcome on appeal. The court denied the deferral, but clarified that the IRS could proceed with its preparer tax identification number (PTIN) program.33 Effective January 1, 2011, all paid tax-return preparers must obtain a PTIN.34 A preparer must enter her PTIN on any tax return or claim for refund she prepares. Obtaining a PTIN is as easy as applying and paying the fee. The IRS issues PTINs regardless of the preparer’s competency or skill level. Preparers must pay an annual fee to renew their PTINs. The IRS may conduct a federal tax compliance check on a preparer who applies for, or renews, a PTIN. The PTIN requirement continues to apply to all preparers, including unenrolled preparers who are not regulated by the IRS in the wake of the Loving decision.
After the district court’s decision, five former Commissioners of the IRS filed an amicus brief35 with the Court of Appeals for the D.C. Circuit, supporting the IRS’s contention that the statute does not clearly exclude unenrolled preparers from IRS regulation.36 The essence of their argument is that because of the complexity and importance of our tax system, through which the government administers a wide variety of social welfare programs, unenrolled preparers are not simply calculating an individual’s tax liability, but are also presenting the case for entitlement to government assistance. Specifically, the Commissioners disagree with the district court’s assessment that “[f]iling a tax return would never, in normal usage, be described as ‘presenting a case.’” They argue that:
Given the content and scope of the modern Internal Revenue Code, a tax return preparer is no longer merely poring over a box of receipts in green eyeshades (if such a caricature ever described the full role of the tax return preparer). Instead, the preparer must explore with taxpayer-clients critical issues such as health care, child care, family relationships, education goals, home ownership, charitable giving, saving for retirement, and any number of other public policy goals that Congress has decided to address through the Internal Revenue Code.37
The Commissioners’ basis for attaching increased importance to the role of the modern tax-return preparer centers on “refundable credits,” which not only have the potential to wipe out a taxpayer’s tax liability, but also may result in a refund. Their examples of refundable credits include: the earned income credit,38 the child tax credit,39 the health insurance costs credit,40 the first-time homebuyer credit,41 the Making Work Pay credit,42 and the adoption expenses credit.43 The American Opportunity Tax credit also belongs on this list of refundable credits. For tax years 2009 to 2017, up to $1000 of this credit for educational expenses is refundable, subject to income-based eligibility constraints.44 A more detailed explanation of these credits and the difference from a nonrefundable credit will help make the point. The adoption expenses credit was originally enacted in 1996, providing for an initial maximum credit of $5000.45 The credit was adjusted for inflation over the years and was nonrefundable for years 1997 to 2009. For 2010 and 2011 the credit became refundable, with maximum amounts of $13,170 and $13,360, respectively.46 The credit has always been subject to elimination (phaseout) for higher-income taxpayers.47 Imagine a taxpayer with income below the phaseout threshold, who spent $10,000 adopting a child in 2009 and had a tax liability (before applying the credit) of $8000. The credit would eliminate the tax liability. But how much better off would that same taxpayer be if the adoption occurred in 2010? Under the same facts, but with a refundable credit, the taxpayer would receive a $2000 check from the federal government. Under this simplified example, there is a striking difference between a refundable and nonrefundable credit. The Commissioners’ argument is that the government administers social programs through refundable credits, which are offered independent of tax liabilities (at least to the extent of the refundable portion). Accordingly, tax-return preparers are not merely performing a simple calculation of tax liability, but are making the case for entitlement to government assistance in the form of payouts.
Adequate disclosure requirements for certain positions taken on a tax return offer additional support for the argument that the statutory language presenting a case encompasses the filing of a tax return. Indeed, questionable positions on a tax return must be disclosed, explained, and substantiated in order to avoid penalties if the IRS later assesses a tax deficiency. The Code includes penalties against taxpayers and tax-return preparers for the underpayment of taxes resulting from an improper tax return.48 Both parties can avoid penalties by adequately disclosing the questionable position that resulted in reduced tax liability.49 The idea is that if a preparer gives the IRS an honest description of the position, there should not be any penalty on top of additional taxes owed. Noncash charitable contributions fall into the category of questionable positions because of valuation challenges. But determining value is a necessary step to claiming the charitable contribution deduction. The IRS provides Form 8283 to assist taxpayers in substantiating the value of a noncash charitable contribution. For example, a taxpayer who donates a painting worth more than $20,000 to the Metropolitan Museum of Art must obtain a qualified appraisal and attach the appraisal to Form 8283. In addition, the Metropolitan Museum of Art and the appraiser must sign Form 8283 indicating receipt of the painting and the veracity of the appraisal, respectively. A taxpayer who follows all of these steps meets the adequate disclosure requirement to avoid any potential penalty stemming from an IRS audit of the charitable contribution.50 The above process for claiming a noncash charitable-contribution deduction requires tax knowledge beyond the scope of that possessed by the average individual taxpayer. Its complexity goes beyond checking a box or entering a dollar figure. In that regard, the preparer is acting as an advocate for the taxpayer in presenting a case not only to claim the deduction, but also to avoid any penalties that could arise from an IRS audit of the contribution. The case is the detailed substantiation of the value of the artwork. Without the presentation of this case, the taxpayer gets no deduction. Clearly, this function of a preparer goes well beyond simply transferring wages from the Form W-2 Wage and Tax Statement to the Form 1040 U.S. Individual Income Tax Return.
Loving et al. did not object to IRS regulation of unenrolled preparers representing a taxpayer during audit. Rather, their only objection is to the regulation of unenrolled preparers who do nothing but file returns. The curious result of the district court’s holding is that the IRS lacks authority to regulate the preparation of a return, but would somehow be able to impose competency standards if the preparer decided to represent a taxpayer during an audit of that same return. The mechanics of that would be awkward, at best. Would the unenrolled preparer have to take a competency exam before becoming a practitioner and representing the taxpayer during the audit? Would the Circular 230 standards retroactively apply to the preparation of the return in question? For example, practitioners are bound by Circular 230’s prohibition against signing a return containing an unreasonable position.51 If an unenrolled preparer became subject to IRS regulation during an audit of a return, it would follow that she would be bound by this prohibition. So, we would arrive at the same result of the IRS regulating the act of return filing by unenrolled return preparers.
A three-judge panel for the D.C. Circuit heard oral arguments on September 24, 2013.52 For the most part, both sides reiterated their arguments from the initial trial. The attorney representing the IRS, Gilbert Rothenberg, argued that § 330 is ambiguous, while the attorney representing Loving et al., Dan Alban, argued that the statute is clear and excludes return preparers. Alban stressed the distinction between tax compliance and tax controversy, arguing return preparers engage only in the former and thus are not being covered by the statutory language about presenting a case.53 The judges bombarded Rothenberg with questions, leading one commentator to facetiously conclude “Court of Appeals Not Loving IRS Arguments.”54 Clever, and probably true.
Rothenberg could have done a more effective job of advocating for the IRS. He argued that there is a blurred line between professionals performing a tax compliance function and those performing a tax controversy function.55 But he should have attacked Alban’s repeated assertion that the tax compliance function is one of “mandatory self-assessment of one’s tax liability.”56 That could not be further from the truth. At this time, the Code is far too complex for the vast majority of taxpayers to be able to self assess. Indeed, most taxpayers require and seek assistance in complying with their reporting obligations.57 Even more striking, many taxpayers know so little about tax law that they are at the mercy of the assertions and conclusions the preparer makes on their behalf. For these reasons, return preparers do, in fact, “advise and assist persons in presenting their cases.”58
The D.C. Circuit’s panel of presiding judges hammered Rothenberg right out of the gate by asking him why, if the IRS always had the statutory power to regulate return preparers, did it wait 130 years to exercise that power?59 Rothenberg responded that the APA allows an agency’s interpretation of its governing legislation to evolve over time.60 Alban agreed.61 In fact, the Chevron case expressly provides for the evolution of agency decisions and interpretations: “[An] agency, to engage in informed rulemaking, must consider varying interpretations and the wisdom of its policy on a continuing basis.”62 This flexibility appears to authorize the IRS to change its definition of representative, as the increased complexity of the Code and its administration of various government assistance programs requires a tax professional to present a case on behalf of a taxpayer at a much earlier stage in the process than would have been the case historically. The Commissioners cite refundable credits to support their argument for the role of tax-return preparers as advocates. All of these credits are recent additions to the Code. The earned income credit was enacted in 1975 and is by far the oldest of the refundable credits, apart from the credit for excess wages withheld.63 The child tax credit was enacted in 1997,64 the health insurance cost credit was enacted in 2002,65 and all of the other listed credits were adopted (or made refundable) in 2008 or later.66 The recent advent of most refundable credits lends further support to the argument that the IRS’s definitions of representatives and practice should be able to change as the Code and role of return preparers change. It has been less than six years since the adoption of several refundable credits that changed the landscape of tax-return preparation, increasing the role of preparers in helping taxpayers present their case for entitlement to government assistance.
Along the same lines, Alban argued that return preparers cannot be considered representatives because the IRS does not require them to file a Form 2848 Power of Attorney and Declaration of Representative (POA) to act on behalf of the client.67 A POA is required when a tax professional wishes to represent a taxpayer during IRS audit or appeal. Alban’s argument is factually accurate, but ignored the IRS’s ability to change its definition of representative with the changing landscape of tax-return preparation.68 In other words, the fact that the IRS does not currently require a POA for tax-return preparation does not preclude it from later defining representative to include return preparers.
A discussion of legal arguments would not be complete without mentioning step two of the Chevron analysis. Both Loving and the IRS gave short shrift to step two, probably because if the IRS prevails on step one, its victory under step two is almost certain.69 If the court concludes under step one that the meaning of representatives in § 330 is ambiguous, step two gives deference to the IRS’s interpretation. Deference means that the IRS’s interpretation will prevail unless it is “arbitrary or capricious in substance, or manifestly contrary to the statute.”70 “When a challenge to an agency construction of a statutory provision . . . centers on the wisdom of the agency’s policy, rather than whether it is a reasonable choice within a gap left by Congress, the challenge must fail.”71 Indeed, “[i]n such a case, federal judges—who have no constituency—have a duty to respect legitimate policy choices made by those who do.”72 In other words, a reasonable interpretation by the IRS would be upheld under a step-two analysis, despite any policy arguments made by the plaintiffs. That is because the judicial branch is in the business of interpreting the law, not making policy arguments; the latter is left to Congress. This makes sense because if a court upholds the IRS’s interpretation of representatives and Congress disagrees for policy reasons, Congress can simply legislate a different result.
IV. Policy Considerations in Support of Regulation
The district court reiterated the principle that policy considerations cannot override its interpretation of the text and structure of a statute. The court remarked that “[i]n the land of statutory interpretation, statutory text is king.”73 But these considerations are worth exploring. If the IRS loses this battle in the judiciary, it may turn to Congress, where policy arguments are paramount. Indeed, there have been a number of bills introduced in Congress to give the IRS express authority to regulate tax-return preparers.74 The Senate Committee on Finance recently lamented the potential judicial defeat of the RTRP program explaining, “[i]f the IRS does not prevail in its appeal of the Loving case, it will lose an important tool to increase tax compliance and protect taxpayers from unethical tax-return preparers.”75 There is legislative appetite and enthusiasm for return preparer regulation.
A. Consumer Protection
Consumer protection is the argument most frequently made in support of preparer regulation. Prior to enacting the RTRP regulations, the IRS studied preparer compliance, largely by examining “mystery shopper” tests.76 As an example, the Treasury Inspector General for Tax Administration (TIGTA) had its auditors pose as taxpayers and “shopped” twenty-eight unenrolled return preparers, twelve of whom worked for commercial tax-return firms and sixteen of whom worked at or owned a small firm.77 The shopped preparers were asked to prepare a return from one of five scenarios, none of which dealt with complex tax topics. TIGTA summarized the results by breaking out the tax returns into sixteen topics and calculating accuracy on each topic. Accuracy ranged from 0% on business expenses to 100% on wage income, with lots of inaccuracy in between. There was only 60% accuracy on itemized deductions (such as the mortgage-interest deduction), only 50% on education credits, and only 8% on self-employment tax and deduction. The amicus brief filed by the National Consumer Law Center cites even more salacious studies.78 Results include ignoring dividend income in order to increase the tax refund, fabricating a $2000 church donation for a taxpayer who does not attend church, and overstating the time a child lives with the taxpayer in order to receive a dependency exemption.79 All such examples could be compiled into a page-turner of a novel. There is little debate about the existence of fraud in the unenrolled preparer community.
The argument made by opponents of regulation is that the relevant question is not whether there is fraud among unenrolled preparers, but whether there is the same level of fraud among regulated preparers (attorneys, CPAs, and EAs). There is essentially no data in this area, however, because these preparers are already regulated. Yet, in response to the IRS’s strategic plan for fiscal years 2009 to 2013, the TIGTA piloted the Return Preparer Visitation Project in 2010.80 Preparers included attorneys, CPAs, EAs, and unenrolled persons. Participants were selected based on a risk-assessment targeting the filing of schedules with high error potential. The result was the selection of 10,000 preparers based on error potential, not actual errors. These preparers received a letter from the IRS indicating the reason for their selection, describing the potential penalties for inaccurate tax returns, and explaining that the IRS would visit some of the recipients to check for tax compliance. Of the 10,000 receiving the letter, almost 2500 received in-person visits. It is unclear from the TIGTA report how many of the visits uncovered inaccuracies in tax returns. But the report concluded that the program should establish a baseline of accuracy among visited preparers and a mechanism for tracking improvement. So, while there may not be any current data on the accuracy of tax returns filed by credentialed preparers, the IRS has coupled its RTRP program with efforts to improve accuracy from all preparers. Furthermore, the absence of data on the accuracy of credentialed preparers is no excuse for not regulating the well-documented problem of inaccuracy from unenrolled preparers. From a consumer-protection standpoint, it does not make sense to regulate attorneys, CPAs, and EAs, but not unenrolled preparers performing exactly the same task. All taxpayers should be protected from fraudulent preparers. That protection starts with regulation.
The frequent use of tax preparation software by individuals and paid return preparers adds a level of complexity to analyzing the accuracy of tax returns. During the 2009 filing season, individuals filed thirty-two million tax returns using software, and preparers filed over sixty-one million returns using software.81 Currently, the IRS checks software packages to ensure compatibility with its e-filing systems, but there is no evaluation for accuracy.82
The regulation of the software industry should be secondary to the regulation of all preparers. Taxpayers and preparers are the ones who can be penalized for an inaccurate return. The onus is on individual taxpayers and preparers to ensure the accuracy of returns filed using software. Blaming the software is not an acceptable defense against penalties for inaccuracy. Regulating tax-return preparation software is important from the standpoint that consumers should not be paying for faulty software and vendors should not be falsely advertising a flawed product. But legal responsibility for the accuracy of a return ultimately rests with the taxpayer.
B. Compliance Costs
Loving’s chief complaint about the RTRP program is the cost of compliance.83 These costs are both monetary, and inclusive of the opportunity cost of lost business while studying for the competency exam or attending continuing education events. A RTRP would be subject to the following expenses: $116 for the one-time competency exam,84 $34.95 for annual continuing education,85 and $64.25 to obtain and $63 to annually renew a PTIN.86 Yet, the PTIN requirement is mandatory regardless of the fate of the RTRP program. In terms of quantifiable costs, only a one-time fee of $116 and an annual fee of $34.95 remain.
Loving operates her tax-return business in an economically depressed neighborhood on the South Side of Chicago and is concerned about having to pass the RTRP costs on to her low-income clients. For 2012, she anticipated preparing 100 returns.87 In her first year of compliance, this would mean increasing the cost for each return by approximately $1.50. In subsequent years, she would only have to charge an additional thirty-five cents on each return compared to pre-RTRP years. This cost analysis does not include the opportunity cost of time spent studying for the exam or attending continuing education classes. But study time should be minimal for experienced tax-return preparers and continuing education can be completed online, eliminating any travel costs.
Annual compliance costs, as low as $34.95 after the first year, appear very reasonable for the added consumer protection provided by the RTRP program. The program looks like even more of a bargain when you compare it to an attorney or CPA’s initial and annual licensing expenses. Consider Illinois, Loving’s state of residence: An attorney in Illinois who prepares tax returns must pay up to $850 to take the bar exam88 and $63 annually for a PTIN. In addition, she must earn thirty hours of continuing legal education over two years and pay annual member dues that increase with years of practice. The first year of admission is free, the fifth is $112, the tenth is $223, and so on, up to $320 for the twentieth year and beyond.89 Of course, none of this includes the cost of three years of law school that enabled her to sit for the bar exam. A licensed CPA in Illinois who prepares tax returns must pay a one-time academic credential evaluation fee of $175 to sit for the CPA exam, a one-time exam application fee of $120, $729.08 to take the exam,90 and $63 annually for a PTIN. In addition, every three years, she must complete 120 hours of continuing education and pay a $120 license renewal fee.91 Again, this does not include the cost of 150 semester credit hours of college or university study with an accounting concentration or equivalent. By comparison to an attorney or CPA, a RTRP license is a relative bargain.
One final cost-related attack that Loving et al. and their supporters launch against the RTRP program is the lack of a small-business exemption.92 Their argument is that small businesses are less able to bear the costs of the program than commercial chains, such as H&R Block and Jackson Hewitt. While this may be true, small businesses should not be exempted from quality control measures, such as the RTRP program. Consider how absurd it sounds to propose that an attorney who only practices “a little bit of law” should be exempt from going to law school, passing the bar examination, and complying with the professional code of conduct. Small business exemptions are appropriate for tax relief, as with the exemption in the Marketplace Fairness Act of 2013, which prevents states from requiring a remote business with less than one million dollars in remote sales to collect and remit sales and use tax.93 But they are not appropriate in the context of quality control measures.
C. Wiping out Competition
Loving et al. argue that large commercial chains, such as H&R Block, as well as interest groups, such as the AICPA, supported the RTRP program with the goal of eliminating competition.94 While this may be true for H&R Block, the overlap in clientele between unenrolled preparers and CPAs is probably minimal. As a broad generalization, CPAs are likely serving higher-income taxpayers, who seek expertise on more complex tax issues and are willing to pay higher fees. In addition, CPAs engage in many types of work other than tax-return preparation. The same is true of attorneys. While there may be some truth to the notion that tax-return preparation chains, and even EAs, would support the RTRP program in order to wipe out competition, that goal cannot account for the broad reaching support among CPAs, attorneys, and the general public.95
D. Effectiveness of Licensing
Debating the merits of professional licensing is largely pointless because it is the reality for roughly 29% of the U.S. workforce.96 Nonetheless, one of the primary alleged faults of licensing schemes is not present in the RTRP program—that is, required educational credentials and licensing exams do not accurately measure or predict the quality of a practitioner.97 Painful as this may be to admit, this is undoubtedly true for attorneys, where law school education and the bar examination cover a multitude of areas in which the attorney will never practice and may not cover the area in which she will. Even if the exam covers an attorney’s area of practice, it would only be able to address the narrowest of topics in the allotted time. But this fault does not exist with the RTRP competency exam. The exam tests only knowledge required to complete the Form 1040 U.S. Individual Income Tax Return. Every tax-return preparer should know the answers to the questions in order to accurately perform her job. There is a one-to-one correlation between test questions and knowledge needed to perform the job of tax-return preparer.
Though it is difficult to predict the judicial fate of the RTRP program, there are strong legal arguments on both sides. The United States District Court for the District of Columbia concluded that the law favored return preparers. Many commentators believe the Court of Appeals for the D.C. Circuit will reach the same result. But a judicial defeat will not mark the end of preparer regulation. Rather, the battle will then be fought in the legislative arena, where the policy arguments discussed above will carry tremendous weight. With substantial support for regulation from the general public and from Congress itself, perhaps a judicial defeat is exactly what the legislature is waiting for to give the IRS express statutory authority for its RTRP program. Whether through the judiciary or the legislature, regulation is inevitable.
Katherine M. Hetherington, Essay, Regulation of Paid Tax-Return Preparers: A Foregone Conclusion Regardless of the Result in the Loving Case, 1 Suffolk U. L. Rev. Online 105 (Dec. 4, 2013), http://www.suffolklawreview.org/hetherington-loving.
J.D., LL.M. Assistant Professor of Taxation, Robert Morris University. Moon Township, Pennsylvania.
[T]he Secretary of the Treasury may prescribe rules and regulations governing the recognition of agents, attorneys, or other persons representing claimants before his Department, and may require of such persons, agents and attorneys, before being recognized as representatives of claimants, that they shall show that they are of good character and in good repute, possessed of the necessary qualifications to enable them to render such claimants valuable service, and otherwise competent to advise and assist such claimants in the presentation of their cases.
Id. at 258-59. ↩
During the most recent financial crisis, the Obama Administration took what appeared to be a promising initiative to slow down the increasing number of foreclosures occurring throughout the country. The Home Affordable Modification Program (HAMP), which was intended to be a win-win for creditors and debtors, would allow creditors to prevent greater losses associated with a foreclosed loan and allow debtors to keep their home. However, after several years of mediocre success, federal courts have begun to place liability on creditors for their perceived failure to save more homes from foreclosure. Although HAMP itself does not contain a private right of action, federal judges have been quick to use other legal doctrines, such as state consumer-protection and contract law, to hold creditors liable for issues arising during the mortgage-modification process. This Essay attempts to outline the various ways in which courts impose this liability, and offers some suggestions for creditors who wish to avoid liability for their perceived shortcomings.
Although there has been serious discontent concerning the effectiveness of HAMP, with some attorneys going so far as to say that the modification process is “a dismal failure for struggling homeowners,”1 judicial activity is beginning to change debtors’ views of the loan-modification process. Increased pushback from debtors’ attorneys following modification denials are prompting courts to take a closer look at the process used by mortgage lenders in evaluating under-performing loans. Because there is no private right of action under HAMP, courts have created other equitable avenues of liability, including holding lenders and loan servicers liable under state unfair or deceptive trade practices acts and breach of contract claims for violations of HAMP protocols in the modification process. Both federal and state laws concerning mortgage modification, especially in the face of HAMP’s extension, are becoming increasingly relevant to creditors hoping to avoid the ever-increasing reach of liability.2 This Essay will explore the numerous ways by which federal courts have attempted—or are attempting—to expand creditor liability for malfeasance or inaction during the mortgage-modification process, and will propose ways that creditors can avoid liability.
II. Background Information About HAMP
HAMP was an initiative undertaken by the Obama Administration in the midst of the worst financial and foreclosure crises the country had experienced since the Great Depression. Although HAMP was created under the assumption that the mortgage-modification process was a win-win for creditors and debtors by allowing owners to avoid foreclosure and creditors to mitigate the losses that a default would bring, it quickly alienated both parties.3 Neither borrowers nor lenders saw the immediate results that they had hoped for, and the program subsequently received negative reviews from creditors, borrowers, policymakers, and academics.
In the wake of the most recent financial collapse and housing bubble burst, HAMP, which was overseen by the Treasury Department and funded by the Temporary Asset Relief Program, attempted to lower mortgage payments for distressed borrowers.4 This was not, however, a legislative mandate for mortgage modification, but rather an agreement between the Obama Administration and lenders and loan servicers to allow them, pursuant to Treasury guidelines, to modify home loans.5 The federal government provides banks with financial incentives to modify mortgages for eligible borrowers through “Servicer Participation Agreements” (SPAs).6 The goal of the program was to “assist at-risk homeowners by promoting loan modifications and reducing monthly mortgage payments” to stave off an increasing number of foreclosures.7 Nevertheless, since its inception and original implementation, HAMP has produced a great deal of criticism for its perceived failure to effectively help homeowners. Among claims of lender dishonesty8 and excessive⎯possibly intentional⎯convolution of the mortgage-modification process,9 courts have readily shown their eagerness and ability to subject lenders to liability, both legally and in equity, for many perceived shortcomings in the modification process.
III. Potential Liability for Creditors
Although both case law and federal statutes explicitly state that HAMP does not provide a private right of action for debtors who feel mistreated before or during the mortgage-modification process, federal courts have interpreted HAMP to impose liability on creditors through other legal doctrines.10 Courts have expanded their influence in the processing of loan-modification applications by creating a system of mandatory mediation for mortgages in default (complete with judicial sanctions for creditors who do not participate); imposing liability for fraudulent application processing; recognizing private rights of action under state or federal unfair or deceptive trade practices laws; and permitting contractual remedies based upon correspondence between the lender and borrower.
While it is easy to view this as an alarming trend of judicial activism, given the stakes for borrowers and the opportunities litigation provides them, the increased judicial scrutiny is unlikely to recede. Therefore, it is important for mortgage lenders and loan servicers to be fully aware of the various approaches that courts take in different jurisdictions to ensure they can enact comprehensive reforms of their mortgage-modification processes to avoid liability.
A. The Possibility of Mandatory Mediation/Modification
Because HAMP is a contract between the federal government and lenders, it leaves homeowners without privity; therefore, judges cannot force lenders to modify debtors’ mortgages.11 However, fourteen states have adopted some form of mortgage mediation,12 with the Florida Supreme Court even adopting a statewide program13 and individual bankruptcy courts within the state adopting mandatory mediation programs for borrowers who qualify.14 The programs require lenders, under penalty of judicial sanction, to substantially increase the level and effectiveness of their communication with homeowners. Therefore, mortgage lenders are not only “incentivized to attend mediation sessions,” and to “bring required documents to the mediation,” but also to “participate in good faith.”15 In states that have enacted these mandatory mediation programs, failure to participate in good faith, even if a modification cannot be reached, may impair the mortgagee or lender’s right to foreclose.16
B. Liability for Fraudulent Modification Processes
1. Judicial Examination of the Actual Processes Used by Lenders
One of the main criticisms that debtors and their attorneys have made against the mortgage-modification process is that the “programs simply provide homeowners with an opportunity to talk with mortgagees to possibly avoid foreclosure . . . . However, servicers or mortgagees have ignored requests for modification or inconsistently applied modification standards.”17 A number of lawsuits have been filed against lenders claiming that they use flawed or even fraudulent methods during their processing and review of loan-modification requests.18 While courts have been hesitant to employ judicial scrutiny of lender’s internal policies and processes, this may change in the future.19 If recent class-action lawsuits proceed to discovery and lender/loan servicers’ processes are exposed to courts, judges may be willing to permit claims for improper denials once they see the staggering number of such denials, and the lack of oversight of the modification process.
Additionally, some courts will impose obligations of good faith during the mortgage-modification negotiation stage, even if those negotiations do not occur through court-ordered or statutory mediation. This good-faith standard is not mere judicial abstraction, as courts have taken hardline stances against lenders and loan servicers who fail to adequately participate in talks with the mortgagor. In IndyMac Bank F.S.B. v. Yano-Horoski,20 a New York trial court held that if a lender’s conduct is willful or unconscionable and “of such a nature that honest and fair minded folk would roundly denounce” it, then a court may dismiss the lender’s foreclosure action and leave the lender without a cause of action in a court of equity.21 The court’s failure to find that the lender acted in good faith resulted in not only the mortgage debt being canceled, but also the discharge of the recorded mortgage and an award of monetary sanctions to the plaintiff-homeowner.22 The obligation to negotiate in good faith only attaches once the mortgagor or loan servicer begins negotiations, as courts will not read in an implied duty of good faith to negotiate a modification or offer a modification to distressed homeowners.23 Courts are, however, willing to consider abstentions from modification negotiations as a breach of good faith under certain circumstances. For example, courts may find such a breach if mortgage lenders willfully fail to modify mortgages, or borrowers plead that lender or loan servicers instructed employees to falsify documents so that a modification would not have to be processed.24
Additionally, state prosecutors are enforcing procedural-fairness requirements imposed by the recent settlements reached by lenders and the attorneys general of forty-nine states over foreclosure abuses.25 Claiming that the banks did not follow the agreed upon guidelines implemented by the settlement agreement pertaining to “how the banks field and process requests from homeowners trying to modify their mortgages,” New York Attorney General Eric Schneiderman is preparing a lawsuit against Wells Fargo. Bank of America may avoid the same lawsuit, however, by announcing “a series of additional protections that it has adopted after discussions with Mr. Schneiderman’s office.”26 If the claims made by the New York Attorney General are true, then lenders that are parties to the settlement agreement need to be sure that they are in strict compliance with the 302 guidelines adopted by the agreement, otherwise state authorities can impose yet another layer of liability for failure to properly handle mortgage-modification requests.
Servicers and lenders have enjoyed greater success on issues regarding whether borrowers can attack loan-modification processing using the class-action process. The United States District Court for the District of Massachusetts recently declined to certify a class consisting of:
All individuals with home mortgage loans on properties in [state] whose loans have been serviced by Bank of America and who, since April 13, 2009, have entered into a Trial Period Plan Agreement with Bank of America and made all trial payments required by their Trial Period Plan Agreement, other than borrowers to whom Bank of America tendered either:
(a) A Home Affordable Mortgage Agreement sent to the borrower prior to the Modification Effective Date specified in the Trial Period Plan Agreement; or
(b) A written denial of eligibility sent to the borrower prior to the Modification Effective Date specified in the Trial Period Plan Agreement.27
The proposed class action would have consisted of twenty-six classes from twenty-six different states. The court found that the classes would meet the requirements of Rule 23(a) of the Federal Rules of Civil Procedure, consisting of numerosity, commonality, typicality, and adequacy.28 However, the court found that the classes failed to show under Rule 23(b)(3) that the question of law or fact common to class members predominate over any questions affecting only individual members.29
In declining to certify the class, the court reviewed the issues of predominance as related to all the claims alleged by the plaintiffs⎯breach of contract, breach of the implied covenant of good faith and fair dealing, promissory estoppel, and unfair or deceptive trade practices. The court’s analysis of the breach of contract claims was the most extensive. With respect to breach of contract, the court favorably cited Young v. Wells Fargo Bank, N.A. ex rel. Option One Mortgage Loan Trust30 for the proposition that a trial period plan (TPP) could plausibly be read to require the servicer to offer a permanent modification if the borrower met the obligations under the agreement.31 However, the court’s critical finding was that the “common question [was] outweighed by the numerous individual questions affecting liability.”32 Particularly individualized questions would arise concerning the borrower-plaintiffs’ compliance with the following requirements cited by the court:
Each borrower had to certify, represent . . . and agree that he was unable to afford his mortgage payments; that he live[d] in the Property and it was his principal residence; that there had been no change in the ownership of the property; that he would provide  documentation for all income; that all the documents and information he had provided were true and correct; and that he would obtain credit counseling if required to do so. In addition, each borrower had to make the required trial payments on a timely basis.33
Despite somewhat holding off the trend of advancing servicer liability, the Massachusetts federal district court made a point that individual questions, rather than class-wide questions, predominate servicing issues related to loan-modification review. This pronouncement is the converse of other courts ruling on cases of individual liability, such as Young and Wigod, which have allowed claims for lender liability under TPPs past the 12(b)(6) stage. The common thread is that situation-specific facts are critical. Moreover, the same situationally specific facts, which are necessary components of a well-pleaded complaint seeking lender liability, also cut against the possibility of creating a class of similarly situated plaintiffs harmed by the loan-modification process.
2. Federal Oversight of the Mortgage-Modification Process Heats Up
Although this Essay is concerned about addressing potential creditor liability that courts have continually increased, it is worth noting that there is a simultaneous, although related, uptick in federal oversight. Recently, federal regulators have begun to increase their oversight of the processes that lenders and loan servicers use during the modification process. The processes subject to oversight include how the companies contacted debtors, the method of evaluation that lender’s used in determining homeowner eligibility for the program, and how the creditor assisted the debtor with questions or procuring missing documents.34 This trend is important not only as an additional source of concern for creditors, but also because debtors’ attorneys are increasingly turning their attention to the processes that creditors employ in determining homeowner eligibility and in customer service departments.35 Failure to meet basic fairness and procedural requirements, such as timely processing of applications, inadequate communication with the debtor, and unexplained denials for modification, can give rise to lender liability and sanctions imposed not only by federal regulators, but by courts as well.
C. Potential Liability Under State Unfair or Deceptive Trade Practices Laws
Creditors, including loan originators and loan servicers, are also liable for actions taken in the mortgage-modification process under state consumer-protection laws. For example, the Nevada Attorney General brought suit against Bank of America under the Nevada Deceptive Trade Practices Act for misleading consumers about “the terms and operations of its mortgage modification and foreclosure processes.”36 Additionally, federal courts will find rights of action for individual debtors by finding a violation of state consumer-protection laws where HAMP regulations have been violated during the mortgage-modification process. This liability under consumer-protection statutes does not only encompass the processes that lenders use to come to a decision, but also extends to post denial actions that they take.37
North Carolina courts are not opposed to debtor’s litigation over mortgage modification, although they have followed the majority rule that HAMP does not create a private right of action.38 However, federal courts in North Carolina have imposed HAMP liability on creditors for their behavior during the mortgage-modification process, reasoning that “violations of a statute designed to protect the public . . . may constitute unfair or deceptive practices under state law, even where the statute violated does not provide for a private right of action.”39 This rationale conforms to the approach used by an increasing number of jurisdictions, in which HAMP violations are explicitly stated to give rise to claims under a state’s unfair or deceptive trade practices act.40 Therefore, lenders and mortgage servicers who fail to follow the HAMP guidelines established by the Treasury Department, such as sending the borrower timely notification of approval for modifications, extending the borrower a TPP Notice,41 or conducting a foreclosure sale on a property before evaluating and determining the borrower’s eligibility under HAMP,42 could face potential liability for their actions.
Although Illinois gave their consumer-protection statutes another name⎯the Illinois Consumer Fraud and Deceptive Business Practices Act (ICFA)43⎯federal courts have still found state unfair or deceptive trade practices law to apply in situations involving mortgage modifications. In Boyd v. U.S. Bank, a seminal case in the jurisdiction on this issue, an Illinois federal district court held that violations of HAMP procedures created a sustainable private right of action for debtor-homeowners under the ICFA.44 In Boyd, the defendant-lender failed to consider a homeowner in default for mortgage modification, which violated Treasury Department directives promulgated as guidelines for implementing HAMP.45 Because of this, the plaintiff-borrower suffered damages, including repossession and damage to his credit score.46 This decision is notable not just because it is another instance of creditor liability for failing to follow HAMP procedures, but also because the court held that the scope of relief could possibly be expanded to situations in which the defendant-creditor’s actions are not necessarily deceptive, just unfair.47
North Carolina, Illinois, and Massachusetts48 state court decisions all represent an ever-growing trend of courts seeking to expand creditor liability for violations of HAMP protocols through state consumer-protection laws. As popular sentiment towards lenders and loan servicers continues to sour, and stories about dual tracking49 and improper denials for modifications continue to hit the press, courts will increasingly look to state consumer-protection laws to ensure that mortgage-modification processes accord with federal guidelines. Otherwise, courts will impose liability on lenders and loan servicers in the form of judicial sanctions or impairments on the foreclosure process.
D. Liability for Mortgage Servicers Under State Contract Law
The HAMP mortgage-modification framework provides for government subsidization of lenders’ mortgage modifications if the loan servicers agree to participate in a standardized modification process.50 In order to participate in this program, the loan servicers must execute a SPA.51 These SPAs place rather rigorous demands on loan servicers, who must, among other things: screen borrowers for HAMP eligibility for all properties that are two or more payments behind; proactively solicit these borrowers’ participation in the HAMP program; acknowledge receipt of the original application within ten days; and respond within thirty days with their final decision (or with a request for more information).52
These SPAs do more than just lay out a list of ideal practices for the creditor. They were enacted to directly benefit homeowners who were going through, or who were about to enter, the foreclosure process. Under federal common law, a third party can recover under a contract if it can show that the contract was made for its direct benefit, and that it is an intended beneficiary of the contract.53 Even though an SPA signed by the loan servicer/lender and the government does not expressly say that it was entered into for the benefit of third-party homeowners, courts have been willing to look past recitals that they deem ritualistic.54 In fact, some judges believe there is no ambiguity as to the intended beneficiaries of the SPAs, noting that “there is nothing in the standard-form SPA to suggest that borrowers⎯who were obviously and primarily intended to benefit from the contractual commitments made by servicers . . . ⎯should not be allowed to enforce the [SPA] commitments.”55 Therefore, courts will sometimes permit a HAMP-eligible homeowner’s breach of contract claim predicated on a third-party-beneficiary theory to proceed to trial when the homeowner contacts his servicer and the servicer fails to properly evaluate their mortgage.56
However, the most recent strategy being used to force mortgage lenders to reconsider or reissue a mortgage-modification decision is that the lender, if it puts a borrower on a HAMP trial plan and denies them a permanent modification, violates a direct contract with the homeowners.57 These breach of contract claims are derived from a letter lenders send to borrowers, which often stipulates that if the borrower complies with the trial plan and payment schedule, the servicer will provide them with a permanent HAMP modification.58 Because the expectation of many consumers entering into the trial period was to obtain a permanent modification, many debtors have felt personally slighted and frustrated by lenders who did not grant them a permanent modification after successful completion of the TPP.59 The denial of a permanent modification for a HAMP-qualifying borrower who has successfully completed a TPP is potentially problematic for lenders, as attorneys have brought, and will continue to bring, class-action lawsuits against lenders alleging breach of contract.60
Recently, these claims of breach of a direct contract between the lender and borrower have recently been successful in sustaining a cause of action against lenders for their denial of mortgage-modification requests.61 In a recent decision, the Seventh Circuit Court of Appeals focused on the denial of a permanent modification as a breach of contract, calling it the “heart of [the plaintiff’s] complaint.”62 A significant portion of the court’s decision is dedicated to a thorough analysis of the “contract” formed between Wigod (the plaintiff) and Wells Fargo (the lender), which was alleged to have been formed when Wells Fargo sent Wigod a TPP Agreement.63 The TPP Agreement, which promised permanent modification if Wigod made her payments on time and her representations remained true and accurate, was the main source of the appellate court’s inquiry. After running the TPP Agreement through a standard contractual analysis, including determinations of whether there was a valid offer and consideration,64 the court determined that there were sufficient allegations to support a cause of action under contract law.65 By extending liability to banks who do not give permanent modifications to borrowers who have successfully completed the TPP,66 this decision has tremendous potential to impose liability on banks for denying mortgage-modification proposals, which could exceed the $25 billion paid out in the settlement reached last year with the attorneys general of forty-nine states.
Although Wells Fargo argued that the TPP Agreement was not a contractual offer, as it required further review by Wells Fargo before a permanent modification could be given, the court found that argument was unpersuasive.67 Because the permanent modification was only conditioned on Wigod’s successful completion of two requirements to secure a permanent modification, the court held that the TPP constituted a valid offer because the granting of a permanent modification was conditioned on future action by the promissee.68 Continuing with their contractual analysis, the court found valid consideration to exist, as Wigod “incurred cognizable legal detriments,” including the promise to open new escrow accounts, to undergo credit counseling, and provide accurate financial information.69 Finally, definite terms were found to exist, even though the court recognized that Wells Fargo had some discretion to modify the permanent loan amount. Although the court hints that this would not require the same payments made during the TPP, it appears that at least a good-faith attempt to make a permanent modification, consistent with HAMP-modification guidelines is a prerequisite.70
This approach has not been limited to just the Seventh Circuit, as district courts in a number of other circuits have followed the contractual-based approach laid out in Wigod. More recently, both the First and Ninth Circuits followed the reasoning of the Wigod court in holding that the language of a TPP sent to borrowers created a contractual relationship between a servicer and a borrower.71 Both the Corvello and Young courts noted that they analyzed the TPP documents at issue under relevant state contract law (as opposed to Illinois law, which was the case in Wigod).72
It is also important to note that the procedural posture of Corvello, as well as Wigod, was the 12(b)(6) motion-to-dismiss stage, and both courts were required to unquestioningly accept the plaintiffs’ allegations that they had fulfilled all of their obligations under the TPP.73 For example, the United States District Court for the Northern District of California found that a TPP was backed by sufficient consideration as the debtor expended time and energy and made financial disclosures to fulfill the terms of the TPP.74
IV. Conclusions and Recommendations for Creditors and Loan Servicers
Although a large segment of consumers are angry over the perceived ineffectiveness of the HAMP framework for mortgage modification, it is not a toothless initiative that lenders and loan servicers can ignore. Especially because courts have now had ample opportunity to add their own interpretations of SPAs and rule on modification best practices, creditors—including lenders and loan servicers—face substantial regulatory hurdles and potential liability to consumers for noncompliance with HAMP procedures. From breach of contract claims to unfair or deceptive trade practices lawsuits, lenders and loan servicers must act with caution when entering into the realm of mortgage modification.
First, private creditors and loan servicers for non-Fannie- and non-Freddie-backed loans could streamline the process for debtor-homeowners. The primary way that this could be accomplished is through the adoption of streamlined programs similar to the ones federal regulators introduced for Fannie- and Freddie-backed loans. This streamlined process drastically reduces the documentation requirement for debtors, as it requires only two initial instances of communication.75 Borrowers frequently complain about their inability to get lenders to compile or accept packages, and cite reasons such as changed fax numbers, high staff turnover on staffers working their file, and their inability to secure a confirmation of receipt. The streamlined process drastically reduces the flurry of documents that is initially exchanged between the two parties, which often results in creditors failing to acknowledge timely receipt of the necessary documents, and homeowners not responding to mortgage-modification proposals when asked for an imposing list of documents.76 Hopefully, this type of reform would address some of the most frequently cited problems in the modification process, namely lost documents, inexplicable denials for modifications, and dual tracking.77
While the Consumer Financial Protection Bureau (CFPB) has enacted a new list of rules and restrictions on lenders and servicers who seek to foreclose on properties,78 strict adherence by creditors is not enough. One potential reason for the judicial creation of consumer-protection rules, as they relate to the modification process, could be the lack of perceived transparency or fairness with which creditors treat homeowners. While legalistic adherence to these new best practices is a great way for creditors to shield themselves from liability, merely hiding behind a formulaic checklist will never be enough to stem the tide of judicial activism. Instead, lenders and loan servicers must voluntarily modify and adopt new best practices in “the spirit of consumer protection.”79 This may include hiring additional staff members to overstaff mortgage-modification centers, instituting extra training, or adding additional supervisors for added oversight. Additionally, the retention of outside counsel who can regularly audit mortgage-modification files to check on lender or loan servicer inaccuracies that would have resulted in rejected modifications, could help quell popular ill will. Implementing these safeguards, although somewhat of a costly endeavor, would be a crucial step for lenders to change the public’s opinion that they made empty promises to better assist homeowners in order to secure government bailout funds.
Neil Jonas & Cory Howard, Essay, Avoiding Liability for Mortgage Lenders and Servicers Under HAMP and State Consumer Protection Laws During the Mortgage Modification Process, 1 Suffolk U. L. Rev. Online 83 (Nov. 14, 2013), http://www.suffolklawreview.org/Jonas-Hamp.
Mr. Jonas, a senior associate in the Charlotte office of Rogers Townsend & Thomas, a Columbia, South Carolina based law firm, specializes in representing creditors’ rights during bankruptcy proceedings. Mr. Jonas is a graduate of the Wake Forest University School of Law and holds a B.A. from the University of North Carolina-Chapel Hill.
Mr. Howard is a third-year law student at the Wake Forest University School of Law. Mr. Howard is a 2011 graduate of the George Washington University, from which he holds a B.A. in International Affairs.
Justice Kennedy’s majority opinion in Fisher v. University of Texas at Austin1 on the constitutionality of the University of Texas at Austin’s (the University) affirmative action admissions program appears to have something for everyone. Six other justices who had staked out starkly contrasting positions on affirmative action in the past joined the opinion. The parties to the case each claimed they were pleased with the outcome, and both supporters and opponents of affirmative action hailed the decision a victory for their respective sides of the debate.
In most respects, the Fisher decision dodged the key questions about affirmative action in college admissions: Does the Equal Protection Clause of the U.S. Constitution totally ban consideration of race in college admissions? If not, what types of limited consideration of race are permissible? The Supreme Court refused to decide whether Grutter v. Bollinger,2 which narrowly upheld a very limited use of race in college admissions, is still “good law” after the Court’s change in makeup and subsequent decision in Parents Involved in Community Schools v. Seattle School District No. 1.3 Rather than creating a consensus on affirmative action, which might be inferred from the 7-1 vote, Justice Kennedy’s very narrow opinion left open for another day the resolution of the controversial issues.4 Given the 4-4 split among justices other than Justice Kennedy, it seems inevitable that there will be no definitive pronouncement on affirmative action until there are new appointments to the Court.
In the meantime, Justice Kennedy was able to use Fisher to advance his particular middle-of-the-road approach to become the governing doctrine in affirmative action cases. In Fisher, he acknowledged (as he did in Grutter) that colleges have a compelling interest in a diverse student body, but he significantly narrowed the scope of legitimate consideration of race to attain that goal (which had been the basis for his dissent in Grutter). Without explicitly overruling or disagreeing with the Court’s opinion in Grutter, he effectively turned his dissent in Grutter into a majority opinion in Fisher.
This Essay will explore what was, and what was not, resolved in the Fisher decision, and will look ahead to the next affirmative action case on the Court’s docket—Schuette v. Coalition to Defend Affirmative Action.5 In Schuette, the Court will review the constitutionality of an amendment to the Michigan Constitution that prohibits any consideration of race in public education. That amendment achieves, for the State of Michigan, a total ban on affirmative action.
If the Supreme Court upholds the constitutionality of the Michigan amendment, it would achieve what opponents of affirmative action might consider a “second best” option. That is, the four “conservative” justices were unable in Fisher, and in earlier Supreme Court decisions, to have the Court create a national ban on affirmative action (as part of U.S. constitutional law). Nevertheless, if the Court upholds the Michigan amendment, it would allow for state-by-state bans on affirmative action that would not be subject to Supreme Court review.
II. The Context of Fisher v. University of Texas at Austin
Abigail Fisher, a white female, brought suit against the University after she was denied admission to its undergraduate program. She asserted that the University’s admission criteria, which included consideration of race along with other factors, violated the Fourteenth Amendment’s Equal Protection Clause.6 The district court and the Fifth Circuit Court of Appeals upheld the University’s limited use of race to achieve a diverse student body, based on their readings of the Supreme Court’s decision in Grutter v. Bollinger.
There were several reasons why Fisher’s appeal was not a particularly good vehicle for a broad-brush review of the Court’s affirmative action doctrine. First, the governing precedents of Grutter and Gratz v. Bollinger7 were relatively recent (2003). Second, only eight justices participated because of Justice Kagan’s recusal. Third, there were strong arguments that Fisher’s lawsuit was not justiciable on standing and mootness grounds.8 Finally, the Texas admissions plan included a relatively unusual mechanism, making it much less likely that a ruling would be applicable to most college and graduate school admissions.9
The Supreme Court’s decision to grant review in Fisher despite these factors, led to speculation that the Court might be ready to issue a definitive pronouncement that race can never be considered in order to achieve a diverse student body. There certainly was some basis for that speculation. In prior decisions, four of the justices had endorsed the principle that the Constitution requires the government to be “colorblind”—that is, it can never take race into account in its treatment of individuals. In Grutter and Gratz, Justices Scalia and Thomas wrote and joined in opinions that rejected the University of Michigan’s purported compelling interest in a diverse student body, and concluded that the school could never consider race in its admissions process. In Parents Involved, Chief Justice Roberts wrote the majority opinion, joined by Justices Scalia, Thomas, and Alito, that rejected student-body diversity as a compelling interest in pupil assignments to elementary and secondary schools. The opinion espoused a colorblind approach, which is summarized in the Chief Justice’s concluding sentence: “The way to stop discrimination on the basis of race is to stop discriminating on the basis of race.”10 As shorthand in this Essay, these justices will be referred to as the “conservatives” with respect to affirmative action issues.11
In contrast, there are four justices who had voted against, or were likely to oppose, such a categorical ban on considering race in university admissions. Justices Ginsberg and Breyer supported the limited use of race in both Grutter and Parents Involved. Justices Sotomayor and Kagan were new to the Court since those decisions, but there were clear indicators of their sentiments. For instance, Justice Sotomayor has made public comments indicating her disagreement with Robert’s approach in Parents Involved;12 and Justice Kagan was involved in developing the federal government’s position supporting affirmative action in the lower court litigation of Fisher and in Schuette, which led to her recusal in both cases at the Supreme Court. As short-hand in this essay, these justices will be referred to as the “liberals” with respect to affirmative action issues.
Everyone recognized that Justice Kennedy was going to be the key vote in Fisher and in clarifying the future of affirmative action because of the independent approach he had articulated in the Grutter, Gratz, and Parents Involved cases.13 Justice Kennedy had consistently voted against the use of race as it was employed in those cases, agreeing in the outcome with Justices Scalia and Thomas in Grutter and Gratz, and with the four conservatives in Parents Involved. Nevertheless, in separate concurring and dissenting opinions he staked out an idiosyncratic position—one that left open the possibility of affirmative action under very narrow circumstances.
On the issue of whether diversity was a compelling interest, Justice Kennedy concluded that it could be, both in university admissions and in public school pupil assignment. In this respect, he disagreed with the conservatives. He also disagreed with the colorblind principle that race can never be considered in government action. Instead, he endorsed a very narrow standard for when race is permissible as a means to achieve diversity, and disagreed in each case with the conclusion of the liberals that the affirmative action programs had done so appropriately.
III. Ramifications of the Fisher Decision
In Fisher, the Supreme Court reversed the decision of the Fifth Circuit Court of Appeals that had upheld the University’s admissions process. Justice Kennedy’s majority opinion, on behalf of seven of the justices, concluded that the lower court was too deferential to the University and not did employ a rigorous form of strict scrutiny in reviewing its justification for considering the race of applicants. The Court vacated the Fifth Circuit’s judgment and remanded the case “so that the admissions process can be considered and judged under a correct analysis.”14 While they joined Justice Kennedy’s opinion, Justices Scalia and Thomas wrote separate concurring opinions in which they reiterated the view that they had expressed in their dissenting opinions in Grutter—that the Equal Protection Clause categorically prohibits a state’s use of race in university admissions. Justice Ginsburg was the sole dissenter. She argued that the University had carefully tailored its admission process after the model approved in Grutter. She concluded that Grutter controlled and the Texas plan should be upheld on that basis, without the need for remand to the Court of Appeals.
A. Is Grutter Still Good Law?
One of the intriguing aspects of Justice Kennedy’s majority opinion is how (and why) he maintained “neutrality” about the status of Grutter and its method of analysis. For example, at the outset of the opinion, Justice Kennedy referenced Regents of the University of California v. Bakke,15 Grutter, and Gratz as precedents addressing affirmative action in higher education. While he drew from them to develop his method of analysis, he carefully avoided endorsing or reaffirming them stating, “[w]e take those cases as given for purposes of deciding this case.”16
Later, in analyzing the first step of strict scrutiny—whether the University had a compelling interest in a diverse student body—he maintained that “[a]ccording to Grutter,” the Court should defer to the University’s educational judgment.17 He acknowledged that “[t]here is disagreement about whether Grutter was consistent with the principles of equal protection in approving this compelling interest in diversity,” but he avoided that question by stating, “the parties here do not ask the Court to revisit that aspect of Grutter’s holding.”18 Later, his opinion again backs off from endorsing or rejecting Grutter’s determination about the unavailability of “workable race-neutral alternatives” for a university to achieve diversity, and notes that “the parties d[id] not challenge, and the Court therefore [would] not consider, the correctness of that determination.”19
These assertions that the parties had not asked the Court to revisit Grutter are misleading. Petitioner presented and argued the case as a potential vehicle for reconsidering Grutter. In both the Petition for Certiorari and the Petitioner’s Brief on the Merits, she presented her arguments in the alternative: The Texas admissions plan violates Grutter; but if Grutter is read to permit the Texas plan, then the Court should “reconsider” and “overrule” Grutter.20 The Respondent’s Brief opposed that invitation to revisit Grutter, asserting that “[t]here is no basis to reconsider or overrule [Grutter].”21
Justice Kennedy clearly could have used Fisher as an opportunity to reconsider Grutter, a 5-4 decision in which he was a dissenter. Following the replacement of Justice O’Connor (the author of Grutter) with Justice Alito (who endorsed a colorblind approach in Parents Involved), Justice Kennedy presumably had five votes to write an opinion reversing Grutter if he wanted to. Why did Justice Kennedy go out of his way to maintain this neutrality towards Grutter? The most likely explanation is Justice Kennedy’s moderation in directly overruling precedent, especially when he can achieve his goals through more subtle manipulation of doctrine. The most notable example of this is Planned Parenthood of Southeastern Pennsylvania v. Casey, in which he and Justices O’Connor and Souter authored a joint opinion that declined to overrule Roe v. Wade.22 Nevertheless, in the process they significantly modified the method of analysis in abortion cases (by adoption of the “undue burden” test) in a way that made it easier for states to restrict access to abortions.
In Fisher, Kennedy was able to do much the same. Without explicitly referring to his dissenting opinion in Grutter, he imported the language and standards of that dissent into the Fisher majority opinion and won the endorsement of six other justices. A common theme in both his dissent in Grutter and his majority opinion in Fisher is extensive reliance on Justice Powell’s opinion in Bakke. He began his summary of the governing doctrine in Fisher with an extended discussion of Bakke, just as he did in his dissent in Grutter. In Fisher, he characterized the Grutter decision as having “endorsed the precepts stated by Justice Powell.”23 In his statement of the holding in Fisher, he refers to Bakke as well as Grutter.24 And, the Fisher opinion concludes with a quote by Justice Powell in Bakke.
The reliance on Bakke is most noticeable in the portion of the Fisher opinion in which he stresses the rigorous nature of the “means” test—that is, whether it is necessary for the University to consider race in order to achieve a diverse student body. That was the analytical step in Grutter that was the basis for Justice Kennedy’s dissent. He faulted the majority in Grutter for showing deference to the University of Michigan Law School’s claim of a need to consider race—the very same failing that he found in reversing the Fifth Circuit’s decision in Fisher.
The language that Kennedy used in Fisher (reversing the Fifth Circuit) and in his dissent in Grutter (critical of the majority opinion), are strikingly similar. In both instances he concludes that the standard of strict scrutiny, required by Justice Powell in Bakke and in subsequent decisions, was not rigorously applied, and that deference was inappropriately given to the universities.25
Justice Kennedy’s heavy reliance on Justice Powell’s opinion in Bakke is somewhat surprising because Justice Powell’s opinion was not joined by any other justices, and it predated the majority opinion in Grutter, which was joined by five justices. But, given that his goal was to “tighten up” the level of scrutiny in Grutter (consistent with his dissent), it was helpful to draw on Justice Powell’s strong statements about strict scrutiny. Moreover, Justice Kennedy seems to view himself in the moderate, centrist tradition of Justice Powell, particularly on matters of race. In Bakke, Justice Powell was the single vote in a 4-4-1 split, with the remaining justices divided into liberal and conservative blocs, much the same as Justice Kennedy straddles two blocs on the current Court. Yet, to the credit of Justice Kennedy’s artfully crafted opinion in Fisher, with its caveats and compromises, he was able to garner the support of six other justices.
Returning to the question posed earlier—is Grutter still good law?—Justice Kennedy’s opinion studiously avoids answering that question directly. He neither reaffirms nor challenges Grutter as precedent. But his opinion effectively raises the level of scrutiny to be applied to affirmative action admissions policies, so that what is now good law in Grutter is his dissenting opinion, rather than Justice O’Connor’s majority opinion.
B. Why Remand to the Court of Appeals?
Another intriguing aspect of Justice Kennedy’s opinion in Fisher is the decision to remand the case to the Court of Appeals. After concluding that the Fifth Circuit had not employed a sufficiently rigorous form of strict scrutiny, he declined to apply the proper standard to the Texas admissions scheme. Instead, he chose to send the case back to the lower court “so that the admissions process can be considered and judged under a correct analysis.”26
Given his critique of the Michigan admissions plan in his Grutter dissent, and his articulation in Fisher of the high standard that the state must meet in the means test of strict scrutiny, it seems clear that the Texas plan would not be acceptable to Justice Kennedy. The vast majority of students of color enrolled in the University are admitted pursuant to the state’s “Top Ten Percent Law.”27 Under that law, the top ten percent of graduates from public high schools in Texas are assured admission to a state college, including the University. Because of the demographics of Texas high schools, there is substantial racial and ethnic diversity in the students admitted under the Top Ten Percent Law.28 A very small percentage of minority students are admitted pursuant to the “Personal Achievement Index” (PAI), which is the only factor that considers race (as one of many factors).29 Because the Top Ten Percent Law is an apparently race-neutral means of achieving substantial diversity, it is hard to see how the University can satisfy its burden as set out by Justice Kennedy in Fisher:
Narrow tailoring also requires that the reviewing court verify that it is “necessary” for a university to use race to achieve the educational benefits of diversity. This involves a careful judicial inquiry into whether a university could achieve sufficient diversity without using racial classifications. . . . The reviewing court must ultimately be satisfied that no workable race-neutral alternatives would produce the educational benefits of diversity.30
The University’s argument on this point was that the level of diversity produced by the Top Ten Percent Law was not sufficient to create a “critical mass” of students of color within the student body; therefore, the additional use of race as one factor within the PAI was necessary to achieve that. However, Justice Kennedy strongly rejected the concept of a critical mass as a legitimate goal in his Grutter dissent.31 It is hard to see why he would not have ruled against the University on this point—which he did not reach, of course, because of the decision to remand the issue to the Court of Appeals. It is even clearer that the four conservative justices would have found the use of race by the University to be unconstitutional. They share Justice Kennedy’s rejection of the critical mass argument and definitively reject any consideration of race in earlier affirmative action decisions.32
If Justice Kennedy had five votes to declare the Texas scheme unconstitutional, why did he pull back from doing so? Is there something that he accomplished by leaving that issue open on remand? Something that was more important to him than a definitive ruling on the particular Texas statute? The primary “gain” in deciding to remand is that Justice Kennedy had a chance to bring Justices Breyer and Sotomayor into the majority. If he had invalidated the Texas law, it would have been a stronger anti-affirmative action decision, but it is likely that only the four conservatives would have joined it. Instead, he wrote an opinion that achieved what he wanted in terms of moving doctrine towards his Grutter dissent, and it garnered legitimacy (and possibly more durability) as a result of the support of a coalition of conservatives and liberals.
There was a long delay between the oral argument in October 2012, and the issuance of the decision in June 2013. Clearly, the justices did not come to this decision quickly or easily. Presumably it is the result of quite a bit of back-and-forth, circulating draft opinions, and responding memoranda. Justice Thomas’s extensive concurring opinion, for example, seems out of proportion to the modest majority opinion that ended up being issued. Viewed this way, the final Fisher decision seems like a “truce” in the debate within the Supreme Court about affirmative action. The conservatives accepted the fact that they do not have the votes to establish a per se ban on considering race in university admissions, and were willing to join Justice Kennedy’s opinion as long as Grutter was not reaffirmed, thus leaving its continued validity an open question.
Two of the liberals (Justices Breyer and Sotomayor) were willing to join Kennedy’s opinion because it does not overtly disturb Grutter’s approval of some forms of affirmative action, and it leaves open the question of the validity of the Texas admissions criteria. They presumably saw a benefit from a decision that avoided potential damage to affirmative action. Justice Ginsburg, of course, chose not to join the compromise. She was not satisfied with the neutrality towards Grutter in Justice Kennedy’s opinion, and she disagreed with the remand, wanting a clear affirmation of the Fifth Circuit’s decision upholding the Texas admissions scheme.
How long will this truce hold? Could it endure as long as the twenty-five year “sunset provision” Justice O’Connor suggested in Grutter?33 Given the entrenched positions of the four conservatives and the four liberals, along with the fact that Justice Kennedy has now established his point of view as governing doctrine, nothing is likely to change until there are new appointments to the Court that change the balance of power.
IV. But Wait—Isn’t the Next Affirmative Action Case Already Before the Court?
While the Fisher case was still pending, the Supreme Court granted review of Schuette v. Coalition to Defend Affirmative Action. As the name of the case suggests, it involves affirmative action and an equal protection claim—might it provide a resolution of the issues that were dodged by Justice Kennedy in Fisher? In a word, no. Fisher and Schuette raise distinct constitutional issues and rely on different lines of precedent. A ruling in Schuette will not affect, doctrinally, the “Fisher truce.” However, Schuette does involve an important interpretation of the Equal Protection Clause that has future affirmative action ramifications.
The Schuette litigation arises out of efforts by opponents of affirmative action to use state referenda processes to ban affirmative action as a matter of state constitutional law. The initiative in Schuette—known as “Proposal 2”—was placed on the ballot in Michigan in 2006, and was designed to circumvent the Supreme Court’s decision in Grutter upholding the University of Michigan Law School’s consideration of race in admissions. Section 1 of Proposal 2 provides:
The University of Michigan, Michigan State University, Wayne State University, and any other public college or university, community college, or school district shall not discriminate against, or grant preferential treatment to, any individual or group on the basis of race, sex, color, ethnicity, or national origin in the operation of public employment, public education, or public contracting.34
Section 2 of Proposal 2, which is not the focus of the Schuette litigation, is a broader prohibition on the consideration of race by the state (not just by colleges and schools). Proposition 2 was styled after California’s Proposal 209, which was ratified by California voters in 1996. The California Supreme Court and the Ninth Circuit Court of Appeals subsequently upheld Proposal 209 after it was challenged on equal protection grounds.
Supporters of affirmative action, asserting that the state constitutional amendment violates the Equal Protection Clause of the Fourteenth Amendment, brought the challenge to Michigan’s Proposal 2. Thus, the equal protection issue in Schuette is the converse of Fisher: In Fisher, the question was whether a state university can choose to take race into account in university admissions, whereas in Schuette, the question is whether a state university can be barred from taking race into account. While both cases involve interpretation of the Equal Protection Clause, they are based on two distinct doctrines within the realm of equal protection.
In Schuette, the Supreme Court is reviewing an 8-7 en banc decision by the Sixth Circuit Court of Appeals that Proposal 2 violates the Equal Protection Clause. That ruling is not based on what the court termed a “conventional” claim of an equal protection violation—that a state law discriminates on the basis of race. Indeed, the essence of Proposal 2’s prohibition, banning any consideration of race, seems totally consistent with the antidiscrimination principle of the Fourteenth Amendment. Instead, the ruling is based on a “political-process” or “political restructuring” doctrine,35 which the Sixth Circuit described as the “Equal Protection Clause’s guarantee that all citizens ought to have equal access to the tools of political change.”36 The Sixth Circuit concluded that by establishing a constitutional barrier to universities considering race in admissions, Proposal 2 burdens a minority group’s ability to achieve its goals in the usual political process.
The underlying doctrine derives from the Supreme Court’s decision in Hunter v. Erickson.37 In Hunter, the Akron City Council had enacted a fair housing ordinance prohibiting discrimination based on race or religion. In response, voters mounted a successful referendum campaign to amend the city charter to repeal that ordinance and to prevent the enactment of any similar law, unless approved in a city-wide referendum. The Court struck down the charter amendment because it created a higher and more difficult political burden—approval by a city-wide referendum—for those who wanted protection from racial discrimination than it did for any other type of housing ordinance, which only needed the support of the City Council. Even though on its face it did not draw distinctions based on race, it was, in effect, “an explicitly racial classification treating racial housing matters differently from other racial and housing matters.”38 The amendment was unconstitutional because “[a] State may no more disadvantage any particular group by making it more difficult to enact legislation in its behalf than it may dilute any person’s vote or give any group smaller representation than another of comparable size.” 39
In Washington v. Seattle School District No. 1,40 the Supreme Court reaffirmed and applied Hunter to invalidate a statewide initiative that prohibited school boards from using busing to achieve racial integration. The Seattle School Board had approved a busing plan to address de facto segregation in the city’s schools. The statewide initiative had the effect of not only invalidating that busing plan, but also of imposing a more onerous political burden on those seeking to promote racial integration than on those seeking to use busing to achieve other (nonracial) policy goals.41
Based on Hunter and Seattle School District, the Sixth Circuit majority in Schuette held that a political enactment deprives minority groups of equal protection when the enactment: “(1) has a racial focus, targeting a policy or program that ‘inures primarily to the benefit of the minority’; and (2) reallocates political power or reorders the decisionmaking process in a way that places special burdens on a minority group’s ability to achieve its goals through that process.”42 The Court concluded that Proposition 2 met both of these criteria. It noted that a student seeking to benefit from a nonracial preference for admission to a state university, such as her family’s alumni connections, can achieve that goal by lobbying the admissions committee, the university leadership, or the school’s governing board; and only as a last resort would she need to seek to amend the state constitution to provide for such a preference:
The same cannot be said for a black student seeking the adoption of a constitutionally permissible race-conscious admissions policy. That student could do only one thing to effect change: she could attempt to amend the Michigan Constitution—a lengthy, expensive, and arduous process—to repeal the consequences of Proposal 2. The existence of such a comparative structural burden undermines the Equal Protection Clause’s guarantee that all citizens ought to have equal access to the tools of political change.43
The dissenters in the Sixth Circuit disputed the application of Hunter and Seattle School District, and accepted the conclusions of the state and federal courts that previously upheld California’s Proposition 209, upon which Michigan’s amendment was based. They criticized the idea of a “constitutional protection for racial and gender preference—a concept at odds with the basic meaning of the Equal Protection Clause, as understood and explained through decades of jurisprudence.”44 They distinguished Hunter as involving the political process implications of repealing a law that required equal treatment based on race; and they contended that it should not be extended to Schuette where the law being repealed requires preferential treatment based on race. Finally, they concluded that Proposition 2 did not reallocate political power in a way that violates equal protection. In their view, voters did not “restructure” the political process, they “employed” it.
V. How Will the Supreme Court Rule in Schuette?
Predicting what the Supreme Court will decide in Schuette is hampered by the fact that none of the current justices have ruled on a political-restructuring equal protection claim. Indeed, the Court has not based a decision on Hunter’s rationale since 1982. In 1969, the Court that decided Hunter by an 8-1 margin was considerably more liberal on racial issues than later Courts. By 1982, when Seattle School District was decided, the Court had begun to shift; that case was decided by a 5-4 vote with Justices Powell and O’Connor, two moderates, in dissent along with Justices Rehnquist and Burger. On the current Court, the votes of the four conservatives seem predictable. Their position—expressed in the Grutter dissents of Justices Scalia and Thomas, and in the majority opinion in Parents Involved on behalf of all four—is that equal protection prohibits any consideration of race. There is no reason to think that they would find that equal protection is violated by a state constitutional amendment that says exactly that.
As to the liberals, Justice Kagan is again recused because of her earlier involvement as Solicitor General. It seems very likely that Justices Ginsburg and Breyer would support the political restructuring argument in Schuette. In addition to their support of race-conscious policies in Grutter, Parents Involved, and Fisher, they joined the Court’s opinion in Romer v. Evans,45 which employed reasoning similar to the political restructuring doctrine. There is less evidence to base a prediction for Justice Sotomayor’s vote because she was not on the Court for Romer, Grutter, or Parents Involved, but there are reasons to suggest she will be supportive of the restructuring argument as well. She has acknowledged the importance of affirmative action in her own career, which allowed her to attend Princeton University as an undergraduate; she has spoken against the colorblind approach of the four conservatives, which would bar affirmative action; and her vote in Fisher indicates her support of diversity in higher education as a compelling interest. In general, her voting has been most closely aligned with Justices Kagan, Ginsburg, Breyer, and Kennedy, and with the exception of Kagan (who was not on the Court at the time), they were all part of the Romer majority.46 Justice Souter, whom she replaced and who also joined the Romer majority, had very high agreement rates with the justices that Justice Sotomayor most often agrees with.47 Thus, on balance, the best prediction for Justice Sotomayor in Schuette is that she will vote to strike down Proposition 2 on the basis of the political restructuring argument.
This leads us again to Justice Kennedy. There is good reason to think that he will again be the key vote. If he sides with the conservatives, it would be a 5-3 decision upholding Proposition 2. If he sides with the three liberals participating in the appeal, the resulting 4-4 split would mean that the Court of Appeals decision striking down the amendment will stand.
What insights do we have about his point of view? There are conflicting signals. One potentially important clue is an opinion by Justice Kennedy—Romer v. Evans—which has been largely overlooked in the Schuette litigation thus far.48 Justice Kennedy’s majority opinion in Romer, which was joined by Justices Ginsburg and Breyer (as well as departed Justices O’Connor, Stevens, and Souter), could be an indicator of his support for the political restructuring doctrine. In Romer, the sequence of events was analogous to what occurred in Hunter, Seattle School District, and Schuette. Local antidiscrimination laws protecting homosexuals were invalidated by a voter referendum that amended the Colorado Constitution. Justice Kennedy’s opinion held that the amendment violated the Equal Protection Clause and, in explaining his reasoning, the language sounded quite similar to that of the political restructuring doctrine:
Amendment 2, in explicit terms, does more than repeal or rescind these provisions. It prohibits all legislative, executive or judicial action at any level of state or local government designed to protect the named class, a class we shall refer to as homosexual persons or gays and lesbians.
. . . .
. . . The amendment withdraws from homosexuals, but no others, specific legal protection from the injuries caused by discrimination, and it forbids reinstatement of these laws and policies.
. . . .
. . . [W]e cannot accept the view that Amendment 2’s prohibition on specific legal protections does no more than deprive homosexuals of special rights. To the contrary, the amendment imposes a special disability upon those persons alone. Homosexuals are forbidden the safeguards that others enjoy or may seek without constraint. They can obtain specific protection against discrimination only by enlisting the citizenry of Colorado to amend the state constitution or perhaps, on the State’s view, by trying to pass helpful laws of general applicability.
. . . .
. . . A law declaring that in general it shall be more difficult for one group of citizens than for all others to seek aid from the government is itself a denial of equal protection of the laws in the most literal sense.49
This language in Romer would seem to indicate Justice Kennedy’s support for the political restructuring doctrine, and for applying it beyond the racial context to sexual orientation. However, one aspect of Justice Kennedy’s opinion in Romer raises a question about this thesis. The Colorado Supreme Court decision that was reviewed in Romer had relied on the restructuring theory, and explicitly on the Hunter and Seattle School District decisions. Yet, Kennedy stated that he was not basing his decision in Romer on that rationale:
[T]he State Supreme Court held that Amendment 2 was subject to strict scrutiny under the Fourteenth Amendment because it infringed the fundamental right of gays and lesbians to participate in the political process. To reach this conclusion, the state court relied on our voting rights cases, and on our precedents involving discriminatory restructuring of governmental decisionmaking, see, e.g., Hunter v. Erickson; . . . Washington v. Seattle School Dist. No. 1 . . . . We granted certiorari and now affirm the judgment, but on a rationale different from that adopted by the State Supreme Court.50
Despite his reliance on reasoning similar to Hunter and Seattle School District, he explicitly distanced his decision from those cases. Why did he do that? It could be a reflection of his disagreement with the political restructuring doctrine, but then why would he write an opinion so closely tracking that rationale? Another possibility is that it was necessary for him to disclaim that basis for the decision in order to gain support from other justices. For example, Justice O’Connor joined his Romer opinion, but she had been a dissenter in Seattle School District. In order to bring her into the majority in Romer, he may have had to include the language disclaiming reliance on Hunter and Seattle School District.
It is also possible that Justice Kennedy’s opinion in Romer is not a clear indicator of his support, or lack thereof, for the political restructuring doctrine, but is instead a reflection of his strong objection to classifications that disadvantage homosexuals. The latter was the basis for his subsequent majority opinions in Lawrence v. Texas and United States v. Windsor, when there were no political restructuring arguments involved.
Another reason to question the likelihood of Justice Kennedy using the political restructuring doctrine to strike down Proposition 2 in Schuette is the fact that Justice Powell wrote the dissenting opinion (on behalf of four justices) in Seattle School District. In his critique of the majority opinion, Powell anticipated the very question raised in Schuette:
The Court’s decision intrudes deeply into normal state decisionmaking. Under its holding the people of the State of Washington apparently are forever barred from developing a different policy on mandatory busing where a school district previously has adopted one of its own. This principle would not seem limited to the question of mandatory busing. Thus, if the admissions committee of a state law school developed an affirmative-action plan that came under fire, the Court apparently would find it unconstitutional for any higher authority to intervene unless that authority traditionally dictated admissions policies. As a constitutional matter, the dean of the law school, the faculty of the university as a whole, the university president, the chancellor of the university system, and the board of regents might be powerless to intervene despite their greater authority under state law.
After today’s decision it is unclear whether the State may set policy in any area of race relations where a local governmental body arguably has done “more” than the Fourteenth Amendment requires. If local employment or benefits are distributed on a racial basis to the benefit of racial minorities, the State apparently may not thereafter ever intervene.51
Given that Justice Kennedy identifies strongly with Powell’s views on race—demonstrated by his reliance on Justice Powell in Grutter and Fisher—and that he purposefully avoided basing the Romer opinion on Hunter and Seattle School District, it could well be that he shares Powell’s concern about the scope of the political restructuring doctrine. The federalism concern underlying Justice Powell’s dissent in Seattle School District is likely to strongly influence Justice Kennedy’s vote in Schuette. He has been protective of state sovereignty and autonomy in other contexts, most notably as a limiting principle for the Federal Commerce Clause power,52 and in this past term’s decision striking down the Defense of Marriage Act.53 While his Fisher decision keeps a space, albeit a narrow one, for affirmative action programs against an equal protection challenge, he is likely to be sympathetic to allowing each state to decide for itself whether it wants to allow or ban affirmative action.
It is likely that the Court will reverse the Sixth Circuit Court of Appeals in Schuette, and will hold that the Equal Protection Clause is not violated by the Michigan constitutional prohibition on affirmative action. Justice Kennedy and the four conservatives will form the majority, with Justices Ginsburg, Breyer and Sotomayor in dissent. However, Justice Kennedy is not likely to reject the political restructuring doctrine completely, which would presumably require overruling Hunter and Seattle School District. He is more likely to write an opinion that distinguishes those decisions, and declines to extend them to control in Schuette.
For example, he could distinguish Hunter, Seattle School District, and Romer (if he wants to address it) on the grounds that they involved state laws that made it politically more difficult for minorities to protect themselves against discrimination, thereby interfering with the core value of nondiscrimination in equal protection. In contrast, Proposition 2 makes it harder for minorities to gain preferential treatment, which arguably runs counter to the core value of nondiscrimination, and which he has said is presumptively unconstitutional unless able to survive strict scrutiny. He might well conclude that a measure that makes it politically more difficult to gain preferential treatment (which is not constitutionally protected) does not offend equal protection principles in the way that Hunter and Seattle School District viewed measures that made it more difficult to protect against racial discrimination (which is constitutionally protected).
If that is the outcome, the net effect of Fisher and Schuette will be that the opponents of affirmative action will not have achieved their primary goal—a national ban based on the U.S. Constitution—but they will be able to lobby for state-by-state prohibitions, without Supreme Court review. Justice Kennedy may have been the key vote that kept affirmative action “alive” (albeit barely) in Fisher, but his support of even that limited form of affirmative action will likely yield in Schuette to his state-sovereignty view of federalism.
Robert H. Smith, Essay, Affirmative Action Survives Fisher (Sort of), but What About Schuette?, 1 Suffolk U. L. Rev. Online 65 (Sept. 29, 2013), http://www.suffolklawreview.org/Schuette-Smith.
Professor of Law, Suffolk University Law School. The author appreciates the helpful comments of Professor Renee Landers, Professor Gerard Clark, and Justice John Greaney on a prior draft of this Essay.
On the other hand, [Justice Sotomayor] said she disagreed with Chief Justice Roberts’s approach to cases concerning racial equality. In a 2007 opinion in a decision limiting the use of race to achieve public school integration, Chief Justice Roberts wrote that “the way to stop discrimination on the basis of race is to stop discriminating on the basis of race.”
That approach, Justice Sotomayor said, was “too simple.”
“I don’t borrow Chief Justice Roberts’s description of what colorblindness is,” she said. “Our society is too complex to use that kind of analysis.”
Having approved the use of race as a factor in the admissions process, the majority proceeds to nullify the essential safeguard Justice Powell insisted upon as the precondition of the approval. The safeguard was rigorous judicial review, with strict scrutiny as the controlling standard. . . . The Court confuses deference to a university’s definition of its educational objective with deference to the implementation of this goal. In the context of university admissions the objective of racial diversity can be accepted based on empirical data known to us, but deference is not to be given with respect to the methods by which it is pursued.
Grutter v. Bollinger, 539 U.S. 306, 388 (2003) (citations omitted), with his majority opinion in Fisher:
The Court of Appeals thus concluded that “the narrow-tailoring inquiry—like the compelling-interest inquiry—is undertaken with a degree of deference to the Universit[y] [of Michigan Law School].”
. . . .
. . . Strict scrutiny does not permit a court to accept a school’s assertion that its admissions process uses race in a permissible way without a court giving close analysis to the evidence of how the process works in practice.
. . . .
. . . The District Court and Court of Appeals confined the strict scrutiny inquiry in too narrow a way by deferring to the University’s good faith in its use of racial classifications and affirming the grant of summary judgment on that basis.
Fisher, 133 S. Ct. at 2420-21 (citations omitted). ↩
The title of Edward Albee’s play, Who’s Afraid of Virginia Woolf?,1 is a pun on the song “Who’s Afraid of the Big Bad Wolf” from Walt Disney’s 1933 cartoon Three Little Pigs.2 At the end of the play, the lead female character, Martha, says to her husband George, “I . . . am . . . George. . . . I . . . am. . . .”3 She is not saying she is afraid of wolves, pigs, Walt Disney, or the famous English novelist, but rather that she is afraid of living life honestly, without illusion.
We all have illusions; the longer we live, the greater the illusions as we simultaneously forget and recreate our past. We then use our new, illusory past to chart a different—and we hope, better—future. Is this realistic, though? Psychologist and Nobel Prize winner in economics Daniel Kahneman thinks not. To Dr. Kahneman, it is a pernicious illusion that we can accurately recall our own past, much less use that past as a guide for future action. For Kahneman:
A general limitation of the human mind is its imperfect ability to reconstruct past states of knowledge, or beliefs that have changed. Once you adopt a new view of the world (or of any part of it), you immediately lose much of your ability to recall what you used to believe before your mind changed.
. . . .
. . . The tendency to revise the history of one’s beliefs in light of what actually happened produces a robust cognitive illusion.4
There is a neurological basis for this simultaneous recreation of a false past as an unreliable aid to an unknowable future: “Brain-imaging studies show that the same brain structures that are engaged when we recollect our past are called upon when we think of the future.”5 From an evolutionary standpoint, the obvious question is: Why this double duty for the brain? A more painful question is: Why would the human species evolve in a way that leads us to live a lie?
In 2011, Tali Sharot published a book called The Optimism Bias: A Tour of the Irrationally Positive Brain, which attempts to answer these questions.6 Her book, like many recent studies in a wide range of fields, makes use of advances in neurological imaging of the brain to study how the brain responds to various cognitive stimuli. Dr. Sharot sought to understand two phenomena. She calls the first the optimism bias, which consists of our tendency to overestimate the likelihood of positive things happening and to underestimate the likelihood of experiencing negative events. Voltaire made fun of this bias in his satire Candide, or Optimism, when he had Candide’s mentor, Dr. Pangloss, constantly repeat Leibniz’s statement that “in this best of all possible worlds . . . all is for the best.”7 Unlike Leibniz, Voltaire took an evidence-based approach, using the 1755 All Saints Day earthquake and the resultant tsunami and fires that all but leveled Lisbon, to question Leibniz’s optimism.8
Dr. Sharot calls the second phenomenon the superiority bias: our tendency to believe we are better than others, seen in a study in which 93% of those answering said they were in the top fiftieth percentile for driving ability.9 This is different from Garrison Keillor’s Lake Wobegon, a place where “all the women are strong, all the men are good looking, and all the children are above average.”10 Unlike the Lake Wobegon effect, where everyone is exceptional, usually we see ourselves as better than others. We tend to think others have illusions, but that we do not.
There are obvious dangers in both the optimism and superiority biases: we misjudge our own abilities and others’ abilities too; bad things can happen that might have been prevented if only we had been clear-eyed about what we faced and if we had been clear-eyed about others. Dr. Sharot’s thesis is that both biases are adaptive and functional: they reduce the stress and anxiety that can prevent us from being able to improve ourselves, permitting us to overcome difficult obstacles or setbacks, and they allow us to take entrepreneurial risks that we otherwise would not.11 President Obama referred to this in his victory speech when, although encouraging his audience to keep their hope in our country’s future, he added that “I’m not talking about blind optimism—the kind of hope that just ignores the enormity of the tasks ahead or the roadblocks that stand in our path.”12
Dr. Kahneman has described the optimism bias as likely “the most significant of the cognitive biases.”13 And it may be significant that it is a characteristic that distinguishes humans from other animals. Outside of short-term, seasonally occurring triggers such as squirrels saving for the winter,14 Dr. Sharot argues that humans, unlike other animals, engage in mental projection into the future,15 whether in the form of abstract strategic planning, as when we play a game of chess, or out of the self-awareness that certain physical steps have to be taken now for the future, such as preparing for a hurricane. Dr. Sharot believes this ability is evolutionary, writing:
While the capacity for both awareness and prospection has clear survival advantages, conscious foresight also came at an enormous price—an understanding that somewhere in the future, death awaits us. This knowledge—that old age, sickness, decline of mental power, and oblivion are around the corner—is less than optimistic. It causes a great deal of anguish and fear. [T]he awareness of mortality on its own would have led evolution to a dead end. The despair would have interfered with daily function, bringing the activities and cognitive functions needed for survival to a stop. Humans possess this awareness, and yet we survive. How?
The only way conscious mental time travel could have been selected for over the course of evolution is if it had emerged at the same time as false beliefs. In other words, an ability to imagine a future had to develop side by side with positive biases. The knowledge of death had to emerge at the same time as its irrational denial.16
Those of you still in law school may doubt this. Those of us nearer our end, do not. Regardless of where you fall on life’s spectrum, Dr. Sharot’s and others’ research points toward possible biological reasons for our tenuous relationship with reality, biological reasons that explain why the human species has evolved in a way that leads us to live a lie. If Dr. Sharot’s thesis is true,17 those of us who advocate an objective, evidence-based approach to decision making face an uphill battle. This is not news, of course, fancy neurological theories aside. Public choice theorists have long argued that special, monied interests exercise disproportionate influence over the political process, including the making of copyright laws. 18 Somewhat less cynical political theorists, like Mancur Olson, have explained the asymmetrical nature of such influence by reference to the nature of collective action, whereby a minority of concentrated interests can repeatedly triumph over a larger, but diffuse majority.19 The defeat this year in the United States of the Stop Online Piracy Act (SOPA)20 by a grassroots effort, and the rejection of the Anti-Counterfeiting Trade Agreement (ACTA)21 by the European Parliament after a similar effort, are evidence that an organized majority can defeat a minority group consisting of concentrated and wealthy industry groups. Whether we should be optimistic about the future based on these successes is unknown, and likely, of course, to be biased.
Behavioral economists and psychologists have argued that our judgment and decision making are a complex mix of rational and irrational factors, with irrational or at least subconscious factors often predominating, even among those who pride themselves on their rationality.22 Here, for example, is a sentence from The Economic Structure of Intellectual Property Law, a book by University of Chicago economist William Landes and Seventh Circuit Judge Richard Posner: “Today it is acknowledged that analysis and evaluation of intellectual property law are appropriately conducted within an economic framework that seeks to align that law with the dictates of economic efficiency.”23 Efficiency, for our purposes, is a rational wealth-maximizing copyright owner, acting in response to rational, incentive-based, but-for copyright laws. Indeed, Landes and Posner added that they are “skeptical that the noneconomic theories of intellectual property have much explanatory power or normative significance . . . .”24 Yet, only four pages later, they concede “neither economic theory nor empirical evidence enables a ringing endorsement of any complete body of intellectual property law . . . .”25
If we cannot find support for all of the parts, can we find support for some of them? In deciding the economically efficient level for protection for the parts, Professor Landes and Judge Posner believe “one would want to classify different forms of intellectual property according to the output likely to be produced with and without the recognition of such a right and grant such recognition only to those forms in which output would be seriously suboptimal without it.”26 In other words, we would have an evidence-based approach, by which we would tailor the amount of particular rights to the need for those rights. I agree completely. Professor Landes and Judge Posner acknowledge, though, that “the empirical studies required to make such a classification have never been undertaken . . . .”27 As I discuss below, since the time this was written, a number of such studies have been undertaken, including one by Professor Jessica Silbey of Suffolk University Law School.
But even if we had such studies, there is reason to believe they would be ignored in favor of theory. Here is what Professor Landes and Judge Posner say about derivative rights: “The case for giving the owner of a copyrighted work control over derivative works is a subtle one. It is not, as one might think, to enable the creator of the original to recoup his cost of expression.”28 They offer a number of alternative reasons for supporting the grant of derivative rights, none compelling, some noneconomic in nature, until they finally settle on minimizing transaction costs.29 This argument, though, commits the logical fallacy of assuming the answer, because it assumes that the copyright owner should have control in the first place. If the copyright owner did not have the right to prevent the creation of unauthorized derivative works, there would be no transaction costs, and thus no costs to minimize. I do not mean to suggest copyright owners should not have control over derivative uses, or at least some of them. I am only pointing out that Professor Landes and Judge Posner are unable to apply their neoclassical rational choice theories to the real world.30 We are left with theories offered without the backing of any empirical evidence.
Professor Landes and Judge Posner’s shortcomings are not as uncommon as we would think, even for such brilliant thinkers. Their mistakes are “predictably irrational.”31 They flow naturally from the way we all make sense of the world, which is through stories. “Thought flows in terms of stories . . . . We learn in the form of stories . . . . We cannot help thinking in terms of stories . . . . [Stories are] the only way we can make sense of the world.”32 Data are fit into preexisting stories we already believe. The data do not make up the stories, but rather are made to fit those stories. As the twentieth-century American Quaker Jessamyn West wrote: “We want the facts to fit the preconceptions. When they don’t, it is easier to ignore the facts than to change the preconceptions.”33 This is not to argue for an absence of beliefs: beliefs, passionately held, are common; the danger comes when the facts belie our beliefs. At that point, we need to follow historian A.J.P. Taylor’s admonition to have “strong views, weakly held.”34 In the debates about the proper level of copyright, beliefs are trumpeted as facts; they are not. And they are very strongly held, crowding out everything which conflicts with those beliefs.
Professor Landes and Judge Posner offer a story, and not a factual description of how either creators or the copyright laws actually function. Their story has two parts: first, that neoclassical economics by itself can explain marketplace behavior, and second, that such behavior is causally related to rational laws. They assert that our laws are a directly causal reason why copyrighted works are created, and why copyright owners and those who use copyrighted works act the way they do. According to this view, incentives in the form of exclusive rights are believed to be but-for reasons behind the creation of new works.35 That Professor Landes and Judge Posner admitted they had no evidence to support their story was not apparently an impediment to them in explaining how, allegedly, copyright laws actually function in practice.
There is evidence to suggest that many works are created without the need for the super-sized incentives that our copyright laws currently provide. The scope of copyright today is vast; in addition to traditional forms of creativity, such as books, music, and motion pictures, our laws protect personal letters, diaries, emails, business works, and advertising, none of which have any need for the incentive of copyright. The explosion in video creativity, seen on YouTube, and in written creativity, seen in web writing, including blogs, has not been driven by the dramatic expansion of exclusive rights; quite the contrary. What was the cause of this new creativity, and what can policymakers do to further encourage and support it? These examples suggest that limitations and exceptions, such as fair use and the safe harbors in the Digital Milennium Copyright Act (DMCA)36 can sometimes be at least as powerful an incentive as rights. New platforms for low-cost distribution are unlocking previously untapped creators. The DMCA safe harbors may turn out to be the most important thing we have done in the last fifteen years to encourage creativity. In any event, the alleged causal, a priori link between strong copyright laws and the creation of creative works is not close to being established, despite the religious fervor with which it is espoused.
In 1945, Belgian experimental psychologist Albert Michotte published his classic book, The Perception of Causality,37 which Amos Tversky and Daniel Kahneman have described as “a compelling demonstration of the irresistible tendency to perceive sequences of events in terms of causal relations, even when the perceiver is fully aware that the relation between the events is incidental and that the imputed causality is illusory.”38
[C]auses are a strange kind of knowledge. This was first pointed out by David Hume, the 18th-century Scottish philosopher. Hume realized that, although people talk about causes as if they are real facts—tangible things that can be discovered—they’re actually not at all factual. Instead, Hume said, every cause is just a slippery story, a catchy conjecture, a “lively conception produced by habit.” When an apple falls from a tree, the cause is obvious: gravity. Hume’s skeptical insight was that we don’t see gravity—we see only an object tugged toward the earth. We look at X and then at Y, and invent a story about what happened in between. We can measure facts, but a cause is not a fact—it’s a fiction that helps us make sense of facts.39
In the field of copyright, there are a number of stories, besides Professor Landes and Judge Posner’s. Here is one, expressed as a syllogism:
Copyright is the basis for creativity[.]
Creativity is the basis for culture[.]
Therefore, copyright is the basis for culture.40
Here is another, again expressed as a syllogism:
Copyright is the basis of a knowledge-based economy.
The knowledge-based economy is the basis for competitiveness.
Therefore copyright is the basis for competitiveness.41
Here is a third, and final story, expressed as a tautology: “[T]he creative industries are those industries dependent on copyright laws and therefore copyright laws are essential to their growth.”42 These three stories set out a causal connection between law and positive consequences. Who would not want such wonderful things to come to pass? But believing in wonderful things is not the same as those wonderful things actually coming to pass, just as believing someone is your true love does not mean that she really is your one-and-only soulmate. Believing that copyright is the basis for culture and for competitiveness does not mean it is. Yet, copyright laws are constantly being passed on the basis that there is a direct, immediate causal relationship in the stories lobbyists and politicians tell, shown by the two syllogisms and the one tautology I just discussed.
How should we approach matters? How should we ensure that the noble goals of copyright laws can be fulfilled? One might use a bottoms-up approach, an approach that creates an empirical record through interviewing actual creators about why they create and how the existence of copyright fits into their creative actions, and centers on examining data about past changes in the law and how those changes correlate to actually achieving the goals of the legislation.
Professor Silbey has done excellent bottoms-up research. Her forthcoming book, Harvesting Intellectual Property: IP Interventions and the Roles of Intellectual Property in Creative and Innovative Work, will provide an extremely useful basis for evidence-based policymaking.43 Lord knows it is long overdue.
In addition to lacking the type of research provided by Professor Silbey, the problems of evidence-based decision making in drafting our copyright laws are twofold. First, does the decision maker have the intelligence or expertise to evaluate whatever evidence there is? I am going to avoid landmines here by assuming the answer is yes, those members of Congress who make copyright policy have the necessary intelligence, but it is unlikely that they have the necessary expertise. This is not a criticism. Our legislators are, by design, generalists. They must vote on a vast array of issues, many of which are both politically charged and complex. In the greater scheme of Congress’s work, copyright issues are small potatoes indeed, compared to the fiscal cliff and the war in Afghanistan, for example. Over time, through committee work, some members of Congress may develop a form of expertise, but in a fast-paced private sector, driven by rapid technological and market changes, past expertise can become quickly outdated. As a result, legislators and their staff must rely on lobbyists. This, of course, comes at considerable peril.
Whether as a result of lobbyists’ partisan slanting or withholding of information, or because the future is always uncertain, legislators must act on incomplete information, under uncertainty. The second problem in evidence-based decision making is the decision maker’s possession of limited data of limited validity. These real-world problems should be cause for concern.
There is a great deal of academic literature on decision making in uncertain circumstances, and how those uncertain circumstances lead to the use of short-hand, intuitive judgments, or, less charitably, guesses.44 Reliance on intuition is not, of course, inherently wrong. Where our intuitive judgments are based on a wealth of past experience and expertise, those judgments may be invaluable. But intuitive judgments can also lead to serious errors, especially where they are utilized to the exclusion of other facts, even objective ones. Moreover, where those judgments are not based on a wealth of past experience and expertise, we should not grace the decision made with the word judgment. Guess is more appropriate.
Daniel Kahneman and Gary Klein wrote a paper together about the different types of judgments, called Conditions for Intuitive Expertise: A Failure to Disagree.45 Klein has written extensively and positively about the use of intuition in decision making; Kahneman has written negatively about it. They collaborated on a joint study and found out they agreed more than they disagreed. They particularly agreed with the late polymath Herman Simon, who described intuition as bringing up memories of previously stored information or experience.46 They rejected a conception of intuition as knowing without knowing. In short, they concluded, as should we, that intuition can form the basis for meaningful judgment only when it is based on solid expertise and solid information.
Now, to finally answer the question posed by the title of this talk: Why are we afraid of evidence-based copyright laws? In addition to the asymmetrical lobbying power of the copyright industries, a fact of political life in the United States for more than 100 years, I think the answer is that evidence is supplanted by stories. Supplanted may be too weak a word; rejected may be more accurate. We reject evidence that does not comport with our story, or as we saw with Professor Landes and Judge Posner, we proceed ahead full steam as if it the evidence were not there, or did not matter.
We cannot have evidence-based policymaking if policymakers refuse to change their minds when confronted with the actual facts, and instead cling to false stories. John Kenneth Galbraith observed that “[f]aced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy” proving that there is no need to change.47 Yet, as my friend, Second Circuit Judge Pierre Leval pointed out to me, “the best way to know you have a mind is to change it.” We can change our minds; we can work around our biases if we are aware of them and if we compensate for their influences on us.48
Hopefully, our copyright laws will change too; not to become weaker or stronger, but rather to become effective, become evidence based, become less an ideological or quasi-religious cause,49 and become more of a tool for doing good and avoiding harm.
Bill Patry, Essay, Who’s Afraid of an Evidence-Based Copyright Law? , 1 Suffolk U. L. Rev. Online 55 (Sept. 18, 2013), http://www.suffolklawreview.org/Copyright-Patry.
Senior Copyright Counsel, Google Inc. The views expressed are solely those of the author. These remarks are based on a lecture delivered on November 8, 2012 as part of the Donahue Lecture Series at Suffolk University Law School.
A quarter century ago, the Lexington, Kentucky Veterans Affairs (VA) Medical Center pioneered a risk management program now known as “disclosure and offer.” Its guiding principal was that patients injured by malpractice should be told about the incident and “made whole” without having to litigate.
After a patient suffered an injury that the VA judged to have been caused by a departure from the standard of care, the VA contacted the patient and, along with an attorney of his choosing, invited him to meet with VA staff. At the meeting, the VA disclosed the error to the patient and discussed a plan about how to meet the patient’s medical needs. With guidance from his own legal counsel, the patient was offered fair, negotiated compensation (defined as what a judgment would be, including pain and suffering, if the case went to trial).
The VA program’s creators believed advising patients to seek counsel was necessary to protect the program’s integrity: Negotiating compensation for malpractice requires experience and expertise in law and medicine alike. Risk managers have this experience, unrepresented patients do not. And, because the goal was to be completely transparent and honest, the fact that a patient had legal representation was not seen as a threat. If the attorney made an unrealistic demand, VA risk managers simply said no to it.
In 1999, the Lexington VA team published a paper describing their experience using this method. 1 They concluded that payouts were similar to hospitals in a comparison group that did not have disclosure-and-offer protocols. It also appeared to save the VA money by reducing legal expenses that would have been incurred had these cases been litigated. This was deemed a success: The program treated patients ethically, helped the VA realize savings, and facilitated patient safety analyses without fear of legal ramifications.
Today, disclosure-and-offer programs are fixtures at facilities nationwide. 2 The current generation of programs, however, appears to have adopted a self-serving approach that eliminates safeguards designed to assure patients get fair advice regarding compensation. The most recent data revealed that only four percent of disclosure programs advise patients to seek independent legal advice.3
This should not be. To disclose an error and not to offer full compensation—or to disclose an error, but then leave a patient to negotiate with a trained risk manager with adverse financial interests—puts physicians on the wrong side of a conflict of interest.4
Recent research shows why programs that avoid attorney involvement may, intentionally or not, take advantage of patients.5 Only sixty percent of the study participants (each of whom was asked to assume they had suffered an injury and then had it disclosed to them as having been caused by a clear act of malpractice) described themselves as being very likely or somewhat likely to seek counsel regarding their legal rights. The potential for abuse becomes clear when coupling this with the finding that 78.8% of those surveyed stated they would be very likely or somewhat likely to accept waiver of medical expenses only (as opposed to full damages) as compensation.
The VA believed that the disclosure-and-offer programs’ collaborative tone made it difficult for unrepresented patients to recognize the need to ask nuanced questions that were likely beyond their legal understanding. Risk managers have a primary financial responsibility to their employers that should be balanced by a skilled representative for the patient. Without this, unrepresented patients would likely never know whether an offer was sufficient to pay future injury-related expenses (for medical costs and lost earnings); whether offered pain and suffering damages (if any) approximated a likely jury value; or if the offer had been discounted for any reason (e.g. unclear liability or to build-in room with the expectation the patient would attempt to negotiate).
To prevent miscommunications or misunderstandings, we recommend that disclosure programs adopt a two-part protocol as part of any discussion of malpractice with a patient:
Nothing in these protocols should be considered revolutionary. In fact, attorneys who suspect they have committed legal malpractice must exercise these same practices with their own clients.6
Advising patients to seek counsel protects their interests and the process’s integrity too. Without it, patients may not recognize that the discussion about compensation is inherently a legal negotiation in which those making the offer have a conflict of interest. It is also important to allow patients to have a cooling-off period if they initially decline to consult an attorney. Ultimately, some patients may decide not to seek counsel, or even not to take compensation. Making this decision, however, presupposes the patient has a fair opportunity to consider the options and the effects of foregoing compensation. For that reason, no decisions should be made with unrepresented patients until they have had a fair opportunity to understand the significance of their decisions.
These best practices are not intended as a windfall for plaintiffs’ attorneys. Instead, plaintiffs’ attorneys are ethically bound to do the right thing by significantly reducing their fees if claims are resolved as a result of the disclosure-and-offer process.7 If patients are able to afford it, plaintiffs’ attorneys should work for a reasonable hourly fee. If not (or if patients would prefer to pay on a contingency fee basis), the plaintiff’s attorney is obligated to offer a contingent fee significantly less than the traditional one-third.
Compensation is a tricky issue and one in which a patient both deserves and requires advice from experienced advisors whose only loyalty is to the patient. By adopting these protocols, medical facilities and patients alike can resolve a bad situation in an ethically sound way. In the event that negotiations fail and result in a trial, hospitals are in a strong position to prove that their postincident activities were fair and patient-centered rather than self-serving.
Gabriel Teninbaum and Steve Kraman, Essay, Disclosure and Offer at Twenty-Five: Time to Adopt Policies to Promote Fairly Negotiated Compensation, 1 Suffolk U. L. Rev. Online 1 (Feb. 25, 2013), http://www.suffolklawreview.org/teninbaum-kraman.
Gabriel Teninbaum, Associate Professor of Legal Writing, Suffolk University Law School. Professor Teninbaum has written extensively in the area of medical apology. His other publications include How Malpractice Apology Programs Harm Patients, 15 Chap. L. Rev. 307 (2011) and Medical Apology Programs and the Unauthorized Practice of Law, 46 New Eng. L. Rev. 505 (2012).
Dr. Steve Kraman, Professor, Division of Pulmonary, Critical Care and Sleep Medicine, Department of Internal Medicine, University of Kentucky. Dr. Kraman is the former chief of staff of the Lexington, Kentucky VA Medical Center. Together with medical center counsel, he started and managed that facility’s disclosure-and-offer program.
A lawyer shall not: (1) make an agreement prospectively limiting the lawyer’s liability to a client for malpractice unless the client is independently represented in making the agreement; or (2) settle a claim or potential claim for such liability with an unrepresented client or former client unless that person is advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent legal counsel in connection therewith.