The Weintraub Principle: Attorney-Client Privilege and Government Entities

From Volume 92, Number 1 (August 2018)
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The Weintraub Principle: Attorney-Client Privilege and Government Entities

Jason Batts[*]

Amidst the backdrop of a federal investigation into the actions of President Donald Trump, a previously unexplored legal question has emerged on a topic that forms the foundation of legal practice: Can a succeeding government official revoke a predecessor’s claim of the attorney-client privilege? Although the question is novel, its role within the government context is well established—having been asserted by Presidents Richard Nixon and Bill Clinton in their respective administrations. The context of current events, however, underscores the need to further define the operation of a privilege that is once again being relied upon by a president under investigation.

In this Article, I argue that a public official should be permitted to revoke a predecessor’s claim of the attorney-client privilege if made on behalf of the government entity. I justify this determination by applying the same corporate rationale put forth by the Supreme Court in Commodity Futures Trading Commission v. Weintraub to the government context. Termed the “Weintraub Principle,” I contend that government agents should have the same authority afforded to their corporate counterparts for three primary reasons: (1) corporate and government entities are restricted to operating through replaceable agents; (2) corporate and government agents are granted authority from others to act on behalf of the entity; and (3) agents in both contexts owe a duty to act in the best interests of the entity—as well as to shareholders in the corporate setting and to the public in the government environment. While acknowledging the likely counterarguments to my proposal, further analysis reveals how each criticism falls short of prohibiting the rule’s application to government entities. In conclusion, I summarize the rationale for my argument and highlight the Weintraub Principle’s real-world application.

Introduction

“Attorney-client privilege is dead!”[1] This announcement by President Donald Trump declaring the passing of one of the oldest concepts known to law, came as a surprise to many in the legal community and garnered headlines around the world.[2] Absent from the death certificate was the cause of the privilege’s untimely, alleged demise—the search and seizure by federal agents of files maintained by President Trump’s private attorney, Michael Cohen.[3] The taking of Cohen’s documents represented the latest maneuver by federal officials charged with investigating alleged wrongdoings by President Trump and his associates.[4]

Political scandals are as old as government itself.[5] While far from a uniquely American phenomenon,[6] the modern political investigations regarding Presidents Richard Nixon and Bill Clinton captivated a worldwide audience and set a precedent for future actions involving high-ranking government officials.[7] Although such legal actions can involve defendants who are as concerned about the court of public opinion as the court of legal decision,[8] the spotlight in such cases can grow as focused on the legal doctrines involved as easily as it can upon the parties to the action.[9] For example, during the impeachment of President Clinton, an American public that typically associated privilege with political leaders also became acquainted with a legal form of privilege between an attorney and client.[10] While the Clinton impeachment process played out, the privilege rose in notoriety as Clinton’s White House cited it in fighting to keep private certain conversations with in-house counsel.[11]

In the current tumultuous political environment, fueled by investigations into President Trump and those associated with his administration, the attorney-client privilege is again gaining notoriety as part of the legal toolkit for a president under investigation.[12] Following the seizure of documents from properties being used by the President’s attorney, President Trump and Mr. Cohen asked a court to throw out the material collected, arguing it was privileged.[13] In addition, the President’s son, Donald Trump, Jr., cited the attorney-client privilege as justification for refusing to answer questions in a hearing before the House Intelligence Committee.[14] This resurgent notoriety of the attorney-client privilege and discussion of how the privilege operates within the government context will likely grow as the investigations into the Trump administration continue.[15]

It would be disingenuous, however, to suggest that the attorney-client privilege was an ignored legal issue outside the realm of modern political events.[16] Presidential sagas—like those of Nixon, Clinton, and Trumpmerely provide a catalyst for media pundits and legal commentators to discuss a topic that is all too familiar to legal scholars[17] Much has been written about the privilege’s history and its application to courts in the United States and abroad.[18] Scholarship has also delved into the intricate theories of the privilege by discussing its potential application to government lawyers.[19] However, one question remains unanswered: Whether the successor to a government official can revoke a predecessor’s claim of attorney-client privilege? Faced with this unresolved issue, courts should apply the corporate principle outlined in Commodity Futures Trading Commission v. Weintraub[20] to government actors and permit a successive government agent to revoke a predecessor’s claim of the attorney-client privilege.

I.  Application of the Attorney-Client Privilege to Corporate and Government Entities

Although courts and scholars have relied upon various enunciations of the rule for attorney-client privilege, one replete with the intricacies of modern practice is found in the often-cited case United States v. United Shoe Machinery Corporation.[21] For entities, that analysis becomes complicated because they are restricted to acting through agents.[22] To assist with the task of applying the privilege in the entity context, courts have developed various tests that are largely focus on the status of the entity employee.

In 1950, a Massachusetts District Court put forth the first such test in a broad holding that permitted an employee to invoke the privilege on a corporation’s behalf if the majority of the employee’s job activities involved legal work and the communication remained secret from public disclosure.[23] In 1962, a District Court for the Eastern District of Pennsylvania created the “control-group test,” which narrowed application of the corporate privilege to include only those communications between corporate counsel and agents who controlled the corporation.[24] Under this test, the privilege would apply if the recipient possessed sufficient authority to implement changes within the corporation based upon the advice received.[25] Considering the different approaches, in 1970, the Seventh Circuit Court of Appeals created the “subject-matter test.”[26] This test required an employee to seek legal advice at the direction of a supervisor on a “subject matter” within the employee’s realm of work responsibility.[27] Finally, in 1981, the United States Supreme Court announced the Upjohn Test in an opinion that acknowledged the different tests, but refused invitations to endorse one over the other.[28] Instead, the Court used five factors to determine whether a communication is privileged in the corporate context.[29]

The boundaries for government application of the attorney-client privilege are not as established as their corporate counterparts.[30] This is particularly true in the criminal context, which—as the Second Circuit Court of Appeals wryly notedis ripe for a Supreme Court decision to resolve the current judicial split.[31] The public function served by government agents and the potentially high-ranking clients involved in such cases further demonstrates the need for clarity as to how the privilege operates within the government context.[32] Often with little underlying analysis, courts have seemingly deferred to a version of the control-group test by assuming that elected officials have authority to assert the privilege.[33]

In contrast to the disagreement over how the privilege operates with respect to entities, unanimity exists as to how the entity itself operates. Whether the entity is a business or a government agency, both act through agents.[34] The agents, in turn, possess authority and bear responsibility for asserting the attorney-client privilege on behalf of the entity when in its “best interests.”[35] This intersection—where the requirement of entity agents to invoke the privilege as well as their power to do so collide—highlights the unresolved issue of a succeeding government official’s authority.

This analysis has practical implications because it is not hard to imagine a scenario where a newly elected politician might revoke the privilege of her or his predecessor. For instance, the Obama administration could have sought to revoke the privilege that protected communications made during the Bush administration—a practice which frustrated some in Congress at the time.[36] In addition, a future president could seek to revoke any claims of privilege put forth by officials within the Trump administration on behalf of the executive branch.[37] Applying the Weintraub Principle in the government context permits a court to logically draw upon similarities to corporate entities, while furthering the distinctively public function of public agencies.[38]

II.  Development of the WeintrAUb Principle

In the seminal case Commodity Futures Trading Commission v. Weintraub, the Supreme Court set out to resolve a circuit split as to “whether the trustee of a corporation in bankruptcy has the power to waive the debtor corporation’s attorney-client privilege with respect to communications that took place before the filing of the petition in bankruptcy.”[39] Although not appearing in the title, the case stemmed from an inquiry into the Chicago Discount Commodity Brokers (“CDCB”) by the Commodity Trading Commission (“the Commission”).[40] After the CDCB filed bankruptcy, a permanent trustee was appointed to act on its behalf, thus setting the stage for a confrontation to determine which agent was authorized to assert attorney-client privilege on behalf of a corporate entity in bankruptcy.[41]

While the trustee moved forward with the corporation’s bankruptcy action, so too did the Commission with its investigation into allegations of misconduct by CDCB agents. As part of its inquiry, the Commission subpoenaed Mr. Gary Weintraub—the former counsel for the CDCB.[42] Although Weintraub provided sworn answers to the Commission, he “refused to answer 23 questions, asserting CDCB’s attorney-client privilege.”[43] In response, the Commission filed a motion requiring Mr. Weintraub to answer the remaining questions, while taking the unorthodox approach of communicating directly with the bankruptcy trustee to request the trustee use his authority to waive CDCB’s privilege. The trustee agreed to abandon any right to the privilege owned by the CDCB up to the date he was appointed. Although the district court found the trustee could waive the privilege, thus requiring Mr. Weintraub to testify, the Seventh Circuit overturned this decision, placing the power to waive privilege back in the hands of Mr. Weintraub.[44] Subsequently, the Supreme Court accepted the case to resolve the issue and the circuit split that had developed.[45]

As respondents, Mr. Weintraub and his counsel put forth five primary arguments for why the Court should permit management of a corporation in bankruptcy to retain the authority to assert attorney-client privilege. First, they argued that the allegiances of a trustee would be to the creditors that selected her or him, as opposed to the shareholders of the debtor corporation.[46] The Court dismissed this argument by noting that the fiduciary duties of a trustee are to “shareholders as well as to creditors.”[47] Furthermore, were there to be no trustee appointed, the managers of the insolvent corporation would share the same dual fiduciary duty as a trustee.[48] The Court also shrewdly observed that “out of all management powers” lost to a trustee during bankruptcy, the respondents had offered no justification as to why the attorney-client privilege should be the sole power treated differently.[49]

Second, the respondents argued that the Court’s decision “would also apply to individuals in bankruptcy.”[50] However, the Court rejected this notion by drawing upon the distinction between human and entity clients to convey that any such result would be an overly broad application of their ruling. As the Court noted, whereas a person makes his or her own decisions, “a corporation, as an inanimate entity, must act through agents.”[51] Therefore, the decision held that any subsequent ruling involving a person in the same context would require different legal reasoning than employed in Weintraub.[52]

Third, the respondents claimed that granting a bankruptcy trustee power over the privilege would “have an undesirable chilling effect on attorney-client communications.”[53] Corporate executives, the theory went, would be far less willing to communicate openly with entity attorneys if the conversations were discoverable in an ensuing bankruptcy matter. However, the Court dispelled this argument by noting that any hesitancy would be no greater than the amount already existing for corporations operating outside of bankruptcy. Future managers of corporations that are not going through bankruptcy could always “waive the corporation’s attorney-client privilege with respect to prior management’s communications with counsel.”[54]

Fourth, the respondents claimed that vesting authority to control an insolvent entity’s attorney-client privilege in a trustee is tantamount to “‘economic discrimination.’”[55] The Court acknowledged that solvent and insolvent corporations were treated differently, but noted that this was by legislative design. Bankruptcy laws grant courts the ability to “change radically and materially [the] rights and obligations” of an insolvent debtor, and the respondents failed to provide the Court with an explanation as to why the disparity in treatment was unwarranted.[56]

Finally, the respondents claimed that permitting a trustee to waive a corporate successor’s privilege would deter individuals and entities from pursuing the shelter of bankruptcy.[57] Ruling in favor of the Commission, according to the respondents, would “provide an incentive for creditors to file for involuntary bankruptcy.”[58] However, the Court disagreed, noting that there are a number of factors that might motivate a party to pursue or avoid bankruptcy.[59] The Court felt that any impact of its decision upon the calculus of a party weighing the possibility of bankruptcy, would be in accord with “congressional intent.”[60]

Having considered and refuted the arguments put forth by Mr. Weintraub, the Court overruled the Seventh Circuit and implemented the Weintraub Principle—that a corporate successor in interest can revoke a predecessor’s assertion of attorney-client privilege.[61]

III.  Applying the Weintraub Principle to Government Entities

With the well-articulated, point-by-point approach taken in Weintraub, the Court laid the groundwork for applying the rationale to similar scenarios. The characteristics of corporate entities described by the Court are also applicable to government agencies. Further analysis of each shared trait establishes strong evidence for employing the Weintraub Principle in both contexts.

A.  The Agent Requirement

The Court in Weintraub held that, “[a]s an inanimate entity, a corporation must act through agents [and] cannot directly waive the attorney-client privilege when disclosure is in [the entity’s] best interest.”[62] Likewise, a government agency is an inanimate entity that must act through its agents.[63] It cannot speak for itself, and similarly, it cannot directly waive the privilege when disclosure is in its best interest.[64] Furthermore, the agents operating within each type of entity are replaceable.[65] Whether the chief executive officer of a company or the president of the country, the end of their tenure does not result in the expiration of the entity.[66] By operating via agents who are replaceable, entities can carry on in perpetuity, with varying individuals speaking on its behalf throughout its lifespan.[67] Since both government and corporate entities are restricted to operating through interchangeable agents, courts should apply the Weintraub Principle to successive government agents.

B.  The Sources of Authority

The Court in Weintraub also justified its decision to allow corporate successorsininterest the power to revoke a predecessor’s claim of privilege by recognizing that the power wielded by entity agents stems from other authorities.[68] Corporate officers are empowered to act on behalf of the entity by the board of directors, who in turn are vested with authority by the shareholders.[69] Similarly, government agents are endowed by the people to act on their behalf.[70] Actors within a government entity may be elected by the people, appointed by the elected official, or hired by a subordinate to the officeholder.[71] The existence of empowering authorities, who select agents to act on their behalf, illustrates another similarity between the two entity types that justifies application of the Weintraub Principal in both contexts.[72]

C.  The Duty Owed to Others

Finally, operating as an agent carries certain obligations to act in the interests of the principle.[73] Private entities, for example, rely on senior officers to assert the privilege “in a manner consistent with their fiduciary duty to act in the best interests of the corporation.”[74] Likewise, government entities often act through high-ranking elected officials[75] who must take care to assert the privilege in accord with the official’s duty to the public in honest and open government.[76] Breach of duty in either context can result in judicial action against the agent.[77] Permitting a government official to revoke a predecessor’s assertion of the privilege is in furtherance of the official’s duty to “open government” since it would reveal government information.[78] Furthermore, a government agent’s decision to waive a predecessor’s claim of privilege would be a direct implementation of the people’s will since the people elected the new public official.[79]

IV.  Counterarguments to Applying the Weintraub Principle to Government Entities

Applying the Weintraub Principle to the government context will not be without critics. The attorney-client privilege is central to the practice of law, and any proposed hindrance to its operation might understandably inspire well-intentioned counterarguments. Ultimately, just as with corporate employees, an elected official can retain a private attorney to deliver independent advice that would be exempt from future revocation by a successor in interest.[80] After all, the Court in Weintraub acknowledged that its ruling applied solely to entities, given their unique structure, and that any similar conclusion reached by a court in the context of individuals would require different reasoning.[81] While the option of hiring private counsel remains available to an agent of either entity, it is not the only rebuttal available to courts responding to criticisms of applying the Weintraub Principle to government entities.

A.  Applying the Weintraub Principle to Government Entities Would Have a Chilling Effect

Opponents may argue that applying this corporate standard to government entities would produce a chilling effect on government communications.[82] As the respondents in Weintraub argued, permitting discovery of attorney-client communications could deter agents from having candid conversations with entity attorneys.[83] This point is significant as it cuts to the very purpose of the privilege—to induce open communications between attorneys and clients.[84] Ultimately, this argument is unpersuasive because the attorney-client privilege is not absolute and other opportunities exist to seek legal advice that are exempt from public inspection.

For example, the privilege does not protect communications pertaining to ongoing criminal or fraudulent activity.[85] Clients continue to successfully seek competent legal advice in spite of this exemption. In addition, “[e]xisting protections, including exemptions to the [Freedom of Information Act], special governmental privileges, and the attorney work product doctrine, offer sufficient protection for the government’s legitimate interests in confidentiality.”[86]

Considering the privilege exceptions already in operation, as well as the additional safeguards available for certain communications, revoking a predecessor’s claim of privilege would not “have an undesirable chilling effect on client-attorney communications.”[87] Furthermore, the lack of any cognizable chilling impact brought to light in the corporate context since Weintraub provides strong circumstantial evidence supporting the Court’s decision as well as my thesis.[88] In fact, some express skepticism as to whether or not the privilege actually promotes candor at all.[89]

B.  Applying the Weintraub Principle to Government Entities Will not Reflect the Will of the People

Critics may also argue that applying the Weintraub Principle to government entities is not in furtherance of the public duty owed by government officials.[90] Those opposed to the government’s application of the rule could note that it is impossible to know if the revocation would be representative of the people’s will because it is unlikely a candidate would run on the platform of “promising to revoke my predecessor’s claim of privilege on day one.” Although a candidate may face a variety issues in a campaign, an elected official faces a myriad of issues that are not thoroughly expounded on during a campaign—either because there were more important topics that occupied the limited time of the election or because it was not an issue yet.[91] Thus, government officials should be permitted to revoke a predecessor’s claim of privilege because the decision to do so may be one of many issues not discussed during the campaign.

C.  Applying the Weintraub Principle to Government Entities Would Endanger National Security

Even conceding the application of Weintraub to government officials, opponents may argue against allowing government successors the power to revoke claims of privilege by their predecessors because government lawyers have access to confidential material that should not be divulged to the public.[92]

While “the government entity has a unique public function”[93] involving access to “military secrets [and] sensitive negotiations with foreign governments,” it must also adhere to the strict regulations barring distribution of such information that would prevent the disclosure of national security secrets or other highly confidential matters.[94] For example, the Freedom of Information Act contains provisions that prevent the general public from accessing secretive information.[95] Such protections would adequately safeguard critical communications from being disclosed by a succeeding government official.

CONCLUSION

In summary, considering the inherent conflict between the public’s right to open government and an individual’s interest in having private communications with an attorney, it seems inevitable that a court will confront the question considered by this paper. In the context of current events, President Trump could invoke the privilege yet again—this time in his position as president—to defend against the federal inquiry that is ongoing at the time of this writing.[96] While it is impossible to predict the course of an investigationespecially one occurring within the political settingthe President’s assertion of the privilege already demonstrates its value to his defense strategy. If the investigations continue with the same scope and public intensity as have been exhibited thus far, the likelihood only grows that President Trump will invoke the privilege in the same manner as former Presidents Nixon and Clinton. If that occurs, the next president would face the question of whether revocation of Trump’s assertion serves the public interest.

Even absent further assertion of the privilege by President Trump, the surging popularity of the rule during his tenure highlights the need for an answer to the question posed in this paper.[97] Confronted with a case on this issue, a court should draw upon the parallels between private corporations and government agencies and apply the corporate Weintraub Principle to the government context. Both types of entities are restricted to acting through agents who acquire authority from others and must assert the privilege in keeping with their duty to shareholders or the public. Such an application applies sound legal principles to further the public interest, while also proving that the attorney-client privilege is not only alive and well, but healthy enough to survive the transition of government power in a democracy.[98]


[*] *. Prosecutor, Hickman County, Kentucky; B.A. 2005, Morehead State University; J.D. 2010, Washington University School of Law; Editor-in-Chief, Washington University Law Review, Volume 87. Special Victim’s Counsel to sexual-assault victims as a Judge Advocate in the United States Army Reserve. Military information does not imply endorsement by the Department of Defense or the Department of the Army. All analysis and opinions are my own. I remain very thankful to Professor Kathleen Clark for her helpful comments and express my sincere gratitude to Professor Brad Areheart and Professor Rebecca Hollander-Blumoff for their respective time, assistance, and encouragement.  In addition, I appreciate the staff on the Southern California Law Review, especially Daniel Brovman, for their helpful and professional guidance. I am forever grateful to Judge Hunter B. Whitesell, II and attorneys, Richard Major and Amanda Major, for their unending patience and teaching. I dedicate this Article to my family, without whom this would not be possible.

 

 [1]. Donald J. Trump (@realDonaldTrump), Twitter (Apr. 10, 2018, 6:07 AM), https://twitter.com/realdonaldtrump/status/983662868540346371.

 [2]. E.g., Andrew Buncombe, Trump ‘Bouncing Off Walls’ with Rage After FBI Raid on Personal Lawyer’s Offices, The Independent, Apr. 11, 2018, at 27; Ben Riley-Smith, Republicans Warn Trump not to Fire Mueller, Daily Telegraph, Apr. 11, 2018, at 11; Chidanand Rajghatta, Trump Goes Ballistic as FBI Closes in, Raids His Personal Lawyer, Times of India, (Apr. 10, 2018, 9:09 PM), https://timesofindia.indiatimes.com/world/us/trump-goes-ballistic-as-fbi-closes-in-raids-his-personal-lawyer/articleshow/63700727.cms; Lawrence Douglas, The Cohen Raid Is a Game Changer: Trump’s Reaction Tells Us So, Guardian, (Apr. 10, 2018, 11:03 AM) https://www.theguardian.com/us-news/2018/apr/10/donald-trump-michael-cohen-raid-comment. Research of news articles via Google News that included the terms “Trump attorney client privilege”, restricted to the twenty-four hours after the President’s Tweet regarding the privilege’s death, returned about 14,500 results. Similarly, a search of Lexis Advance that I limited to “major non-U.S. newspapers” for the same twenty-four-hour period returned twenty-six results within this more defined pool of news outlets.

 [3]. Matt Apuzzo, F.B.I. Raids Office of Trump’s Longtime Lawyer Michael Cohen; Trump Calls it ‘Disgraceful’, N.Y. Times (Apr. 9, 2018), https: //www.nytimes.com/2018/04/09/us/politics/fbi-raids-office-of-trumps-longtime-lawyer-michael-cohen.html; Josh Gerstein, Trump Lawyer Presses for Access to Seized Cohen Files, Politico (Apr. 15, 2018, 10:57 PM), https://www.politico.com/story/ 2018/04/15/trump-cohen-files-access-seized-526268.

 [4]. See Philip Bump & Devlin Barrett, Investigation of Trump Attorney Cohen Underway for Months, Filing Shows, Wash. Post, Apr. 14, 2018, at A5; Matt Apuzzo et al., Trump Sees Inquiry into Cohen as Greater Threat than Mueller, N.Y. Times (Apr. 13, 2018), https://nyti.ms/2JDyg0h.

 [5]. See Ramsay MacMullen, Corruption and the Decline of Rome (1988); Kyle Swenson, America’s First ‘Hush Money’ Scandal, Wash. Post (Mar. 23, 2018), http://wapo.st
/2u90MD2?tid=ss_tw-bottom&utm_term=.97f3aeccf148.

 [6]. See, e.g., Choe Hang-Sun, Park Geun-hye, South Korea’s Ousted President, Gets 24 Years in Prison, N.Y. Times (Apr. 6, 2018), https://nyti.ms/2EmuUec; Lula: Former Brazilian President Surrenders to Police, BBC News (Apr. 8, 2018), http://www.bbc.com/news/world-latin-america-43686174.

 [7]. See e.g., Caryn James, Testing of a President: The Speech; Apology and Defiance Echo a Nixon Address, N.Y. Times, Aug. 18, 1991, at A16; Suzanne Garment, Nixon’s Decisions During Watergate May Help Us Understand the Legal Trouble Trump Is in Now, NBC News (Apr. 5, 2018, 1:29 AM), https://www.nbcnews.com/think/opinion/nixon-s-decisions-during-watergate-may-help-us-understand-legal-ncna862821; Sex, Lies and Impeachment, BBC News (Dec. 22, 1998), http://news.bbc.co.uk/2/hi/special_report/1998/12/98/review_of_98/themes/208715.stm.

 [8]. State of the Union with Jake Tapper, CNN (Apr. 15, 2018, 9:00 AM to 10:00 AM), https://archive.org/details/CNNW_20180415_160000_State_of_the_Union_With_Jake_Tapper/start/1299/end/1359 (starts at 9:20 AM).

My guess is that his lawyers don’t want him to go about it that way. That there’s lots of evidence, not necessarily in this Tweet storm, but in other Tweet storms, that will be bad for him if Bob Mueller you know ends up coming around to bringing some kind of case together either in a report or otherwise relating to obstruction. Every single time the President makes clear that he doesn’t like an investigation of him or his associates, and wants that investigation to stop, that adds to the narrative that when he takes an action that actually can cause the investigation to stop that that was intentional and was potential obstruction. I’m not saying it is obstruction, but its adds grist for people to find that to be true.

Id. In addition, during investigations concerning President Clinton, the President boldly pronounced that he “did not have sexual relations with that woman.” Bill Clinton: ‘I Did Not Have Sexual Relations with that Woman.’, Wash. Post (January 25, 2018, 4:39 PM EDT), https://www.washingtonpost.com
/video/politics/bill-clinton-i-did-not-have-sexual-relations-with-that-woman/2018/01/25/4a953c22-0221-11e8-86b9-8908743c79dd_video.html (affirming this story under oath caused the President to commit perjury); Mr. Clinton’s Last Deal, N. Y. Times (Jan. 20, 2001), https://www.nytimes.com
/2001/01/20/opinion/mr-clinton-s-last-deal.html. Likewise, President Trump’s social media commentary may boost his standing among his political base but could prove detrimental to his legal interests. See Julie Bykowicz & Janet Hook, Trump Weekend Tweetstorm Responds to Mueller Indictment, Wall St. J. (Feb. 18, 2018, 11:11 AM), https://www.wsj.com/articles/trump-weekend-tweetstorm-responds-to-mueller-indictment-1518967910.

 [9]. The investigations into Presidents Nixon, Clinton, and Trump increased the popular notoriety of the privilege through its repeated appearance in media reporting. See, e.g., Lesley Oelsner, Ehrlichman Blames Nixon, N.Y. Times, Oct. 16, 1974, at A1; Jacqueline Thomsen, Trump Lawyers Argue Material Seized in Cohen Raid Is Protected by Attorney-Client Privilege, The Hill (Apr. 13, 2018, 11:41 AM), http://thehill.com/homenews/administration/383019-trump-lawyers-argue-material-seized-in-cohen-raid-is-protected-by.

 [10]. Bob Franken, White House Says Clinton Needs Attorney-Client Privilege for Impeachment Fight, CNN (Aug 21, 1998), http://edition.cnn.com/ALLPOLITICS/1998/08/21/lewinsky.

 [11]. Id.; H.R. Res. 611, 105th Cong., 144 Cong. Rec. 11774 (1998) (enacted).

 [12]. See, e.g., Kathleen Parker, We’ve Seen This Movie Before. It Ended in Impeachment., Wash. Post (Apr. 10, 2018), https://wapo.st/2qkNFJO?tid=ss_tw-bottom&utm_term=.f83b124ba01c; Mike Huckabee (@GovMikeHuckabee), Twitter (Jun 13, 2017, 1:04 PM), https://twitter.com
/govmikehuckabee/status/874719159585841152?lang=en (“Dems act like they never heard of atty/client privilege; AG is top atty in Exec branch; serves @POTUS and not stooge of Congress.”).

 [13]. Thomsen, supra note 9.

 [14]. Kyle Cheney, Trump Jr. Cites Attorney-Client Privilege in not Answering Panel’s Questions About Discussions with his Father, Politico (December 6, 2017, 7:37 PM), https://www.politico.com
/story/2017/12/06/donald-trump-privilege-questions-284841.

 [15]. It is worth noting that the current investigations concerning President Trump are occurring amidst the backdrop of a federal government controlled by members within the President’s own political party. Congress has immense investigatory powers, which are most practically limited by its willingness to utilize them. Should the Democratic Party take control of Congress, or simply the House of Representatives or Senate, members in the new majority would likely have a far greater willingness to investigate the Trump administration.

 [16]. See, e.g., 8 John Henry Wigmore, Evidence in Trials at Common Law § 2292 (McNaughton rev. 1961); John Damin, Thawing the Chill Between Government Attorneys and Their Clients: The Need for Legislative Intervention in Protecting the Governmental Attorney-Client Privilege, 111 Penn. St. L. Rev. 1009, 1010 (2007).

 [17]. See, e.g., Gregory I. Massing, The Fifth Amendment, the Attorney-Client Privilege, and the Prosecution of White-Collar Crime, 75 Va. L. Rev. 1179 (1989); Clinton’s Senate Trial: How It Will Work, Palm Beach Post, Dec. 20. 1998, at 22A.

 [18]. See, e.g., Paul R. Rice, Attorney-Client Privilege in the United States § 1:11 (2d ed. 1999); Damin, supra note 16, at 1013–15.

 [19]. See, e.g., Damin, supra note 16, at 1010–11 (quoting In re Bruce R. Lindsey, 158 F.3d 1263, 1271 (D.C. Cir. 1998)); Michael Stokes Paulson, Who “Owns” the Government’s Attorney-Client Privilege?, 83 Minn. L. Rev. 473, 475 (1998) (“My topic concerns one of the many important practical consequences that flows from this post-Morrison constitutional order: how control over the government’s attorney-client privilege works under a regime of divided executive management of USA, Inc.”) (providing analysis, in the context of the impeachment of President Clinton, of the privilege’s operation within the federal Executive Branch).

 [20]. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343 (1985).

 [21]. United States v. United Shoe Mach. Corp., 89 F. Supp. 357, 358–59 (D. Mass. 1950).

The privilege applies only if (1) the asserted holder of the privilege is or sought to be come [sic] a client; (2) the person to whom the communication was made (a) is a member of the bar of a court, or his subordinate and (b) in connection with this communication is acting as a lawyer; (3) the communication relates to a fact of which the attorney was informed (a) by his client (b) without the presence of strangers (c) for the purpose of securing primarily either (i) an opinion on law or (ii) legal services or (iii) assistance in some legal proceeding, and not (d) for the purpose of committing a crime or tort; and (4) the privilege has been (a) claimed and (b) not waived by the client.

Id. See also John E. Sexton, A Post-Upjohn Consideration of the Corporate Attorney-Client Privilege, 57 N.Y.U. L. Rev. 443, 445 n.5 (1982) (claiming Dean Wigmore’s definition is “the most widely cited formulation of the elements of the attorney-client privilege” before also reciting the definition put forth in United Shoe).

 [22]. See, e.g., Bellis v. United States, 417 U.S. 85, 90 (1974) (stating “the inescapable fact that an artificial entity can only act to produce its records through its individual officers or agents”); Braswell v. United States, 487 U.S. 99, 110 (1988) (citing Bellis, 417 U.S. at 90) (“Artificial entities such as corporations may act only through their agents.”).

 [23]. United Shoe, 89 F. Supp. at 361.

 [24]. Philadelphia v. Westinghouse Elec. Corp., 210 F. Supp. 483, 485 (E.D. Pa. 1962).

 [25]. Id. at 485–86.

 [26]. Harper & Row Publishers v. Decker, 423 F.2d 487, 491–92 (7th Cir. 1970).

 [27]. Id.

[A]n employee at a corporation, though not a member of its control group, is sufficiently identified with the corporation so that his communication to the corporation’s attorney is privileged where the employee makes the communication at the direction of his superiors in the corporation and where the subject matter upon which the attorney’s advice is sought by the corporation and dealt with in the communication is the performance by the employee of the duties of his employment.

Id.

 [28]. Upjohn Co. v. United States, 449 U.S. 383, 386 (1981).

 [29]. Id. at 394–95. The Court first considered whether the information was “available from upper-echelon management.” Id. Second, the Court examined whether the information was “needed to supply a basis for legal advice concerning compliance with securities and tax laws, foreign laws, currency regulations, duties to shareholders, and potential litigation in each of these areas.” Id. Third, the Court reviewed whether the “communications concerned matters within the scope of the employees’ corporate duties.” Id. Fourth, it asked whether “the employees themselves were sufficiently aware that they were being questioned in order that the corporation could obtain legal advice.” Id. Finally, the Court considered whether “the communications were considered ‘highly confidential’ when made . . . and have been kept confidential by the company.” Id. at 395.

 [30]. The evolutionary development of the corporate privilege spans decades and includes several tests developed by courts to determine the operation of the rule. See supra notes 2229 and accompanying text.

 [31]. United States v. Doe (In re Grand Jury Investigation), 399 F.3d 527, 536 n.4 (2d Cir. 2005) (“We are in no position, however, to resolve this tension in the law.”).

 [32]. See supra note 8 (stating examples of the potential high-ranking clients in government-privilege cases by comparing the investigations of Presidents Nixon and Clinton).

 [33]. See, e.g., In re Lindsey, 158 F.3d 1263, 1273 (D.C. Cir. 1998); In re Grand Jury Subpoena Duces Tecum, 112 F.3d 910, 920 (8th Cir. 1997). Unlike in cases involving corporations and other private entities, when the client is a public entity, courts often include a public-function element within their analysis. See, e.g., Lindsey, 158 F.3d at 1273 (“[T]he loyalties of a government lawyer therefore cannot and must not lie solely with his or her client agency.”); Duces Tecum, 112 F.3d at 920 (“[T]he general duty of public service calls upon calls upon government employees and agencies to favor disclosure over concealment.”).

 [34]. Deshaney v. Winnebago Cty. Dep’t of Soc. Servs., 489 U.S. 189, 194 (1989); Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 348 (1985); Bowen v. Watkins, 669 F.2d 979, 989 (5th Cir. 1982) (“At some level of authority, there must be an official whose acts reflect governmental policy, for the government necessarily acts through its agents.”). See also Anne Bowen Poulin, Party Admissions in Criminal Cases: Should the Government Have to Eat Its Words?, 87 Minn. L. Rev. 401, 404 (“Like a corporation, the government speaks and acts only through its agents.”); Carlos E. Gonzalez, Popular Sovereign Generated Versus Government Institution Generated Constitutional Norms: When Does a Constitutional Amendment not Amend the Constitution?, 80 Wash. U. L.Q. 127, 132 (2003) (considering the degree to which government entities represent the will of the people).

 [35]. See Weintraub, 471 U.S. at 34–49.

 [36]. See Cheney, Rice Approved Use of Waterboarding, Other Interrogation Tactics, FOX News (April 11, 2008), http://www.foxnews.com/story/0,2933,349948,00.html.

 [37]. See supra note 11 and accompanying text.

 [38]. See infra note 73 and accompanying text.

 [39]. Weintraub, 471 U.S. at 345.

 [40]. Id. The Commission sought to determine whether the Chicago Discount Commodity Brokers (“CDCB”) had “violated the Commodity Exchange Act, 7 U.S.C. § 1 et seq.” Id.

 [41]. Id. at 345–46. The bankruptcy court named Mr. John K. Notz, Jr. as the permanent trustee for CDCB, granting him authority to proceed with the bankruptcy action on behalf of the company, which occurred on the same day the Commodity Trading Commission (“the Commission”) filed a complaint against CDCB. Id.

 [42]. Id. at 346.

 [43]. Id.

 [44]. Id. at 346–47.

 [45]. Id. at 347.

 [46]. Id. at 354–55.

 [47]. Id. at 355–56.

 [48]. Id. at 355 (Respondents also ignore that if a debtor remains in possession—that is, if a trustee is not appointed—the debtor’s directors bear essentially the same fiduciary obligation to creditors and shareholders as would the trustee for a debtor out of possession.”) (citing Wolf v. Weinstein, 372 U.S. 633, 649–52 (1963).

 [49]. Id.

 [50]. Id. at 356 (emphasis in original).

 [51]. Id.

 [52]. Id. at 356–57.

 [53]. Id. at 357.

 [54]. Id.

 [55]. Id. 

 [56]. Id. (quoting McDonald v. Williams, 174 U.S. 397, 404 (1899)).

 [57]. Id. at 357–58.

 [58]. Id. at 357.

 [59]. Id. at 358.

 [60]. Id.

 [61]. Id. (noting that a corporate bankruptcy trustee “has the power to waive the corporation’s attorney-client privilege with respect to prebankruptcy communications”).

 [62]. Id. at 348.

 [63]. Rice, supra note 18, at § 4:28.

 [64]. Id.

 [65]. Trs. of Dartmouth Coll. v. Woodward, 17 U.S. 518, 636 (1819).

A corporation is an artificial being, invisible, intangible, and existing only in contemplation of law. Being the mere creature of law, it possesses only those properties which the charter of its creation confers upon it, either expressly, or as incidental to its very existence. These are such as are supposed best calculated to effect the object for which it was created. Among the most important are immortality, and, if the expression may be allowed, individuality; properties, by which a perpetual succession of many persons are considered as the same, and may act as a single individual. They enable a corporation to manage its own affairs, and to hold property without the perplexing intricacies, the hazardous and endless necessity, of perpetual conveyances for the purpose of transmitting it from hand to hand. It is chiefly for the purpose of clothing bodies of men, in succession, with these qualities and capacities, that corporations were invented, and are in use. By these means, a perpetual succession of individuals are capable of acting for the promotion of the particular object, like one immortal being. 

Id. Practically speaking, a potential counterargument could be the small, family-run corporation that may cease to exist beyond the original proprietors. This potential result, however, does not negate the well-stated case herein, nor the excellent article authored by Professor Schwartz. See Schwartz, infra note 66.

 [66]. Andrew A. Schwartz, The Perpetual Corporation, 80 Geo. Wash. L. Rev. 764, 766 (2012) (“Natural persons can get sick and die, and similarly, other forms of business organization, such as the partnership or sole proprietorship, have only limited lifespans. But one of the defining legal characteristics of the corporation is its capacity to live forever.”).

 [67]. Woodward, 17 U.S. at 636.

 [68]. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 349 n.4 (1985) (citing Melvin Aron Eisenberg, Legal Models of Management Structure in the Modern Corporation: Officers, Directors, and Accountants, 63 Calif. L. Rev. 375 (1975)).

 [69]. Id.; Schoonejongen v. Curtiss-Wright Corp., 143 F.3d 120, 127 (3d Cir. 1998) (citing 2 William M. Fletcher, Fletcher Cyclopedia of the Law of Private Corporations § 434, at 339 (perm. rev. ed. 1992)).

 [70]. See, e.g., Perry v. United States, 294 U.S. 330, 353 (1935) (“The congress cannot revoke the sovereign power of the people . . . .”); The Federalist No. 22, at 152 (Alexander Hamilton) (Clinton Rossiter ed., 1961) (“The Fabric of American empire ought to rest on the solid basis of THE CONSENT OF THE PEOPLE. The streams of national power ought to flow immediately from that pure, original fountain of all legitimate authority.”); The Federalist No. 49, at 313–14 (James Madison) (Clinton Rossiter ed., 1961) (stating that “the people are the only legitimate fountain of power, and it is from them that the constitutional charter, under which THE several branches of government hold their power, is derived.”).

 [71]. See, e.g., U.S. Const. art. I, § 2 (stating “the People of the several States” are to elect House of Representatives members).

 [72]. Although differences between public and private entities can emerge when examining how a senior agent may be terminated in either context, similarities between the two continue when discussing employees operating at other levels. Employment contracts can result in countless different scenarios; however, in the context of an at-will-employment relationship, public and private entities enjoy broad latitude in deciding whether to terminate an employment relationship. Engquist v. Dep’t of Agric., 553 U.S. 591, 599 (2008) (“In light of these basic principles, we have often recognized that government has significantly greater leeway in its dealings with citizen employees than it does when it brings its sovereign power to bear on citizens at large.”); Hugley v. Art Inst., 3 F. Supp. 2d 900, 908 (N.D. Ill. 1998) (quoting Kahn v. U.S. Sec’y of Labor, 64 F.3d 271, 279 (7th Cir. 1995)). Yet differences can emerge with respect to elected officials because their employment in a particular office is restricted to certain timespans as well as limits on the number of terms the official can serve. See, e.g., U.S. Const. amend. XIV, § 2; Haw. Const. art. V, § 1. This variance for elected officials does not dilute the number of similarities between public and private entities enough, however, to warrant a result other than applying the Weintraub Principle to public entities.

 [73]. Restatement (Third) of Agency § 1.01 (Am. Law Inst. 2006) (“Agency is the fiduciary relationship that arises when one person (a ‘principal’) manifests assent to another person (an ‘agent’) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act.”).

 [74]. Weintraub, 471 U.S. at 348–49. See also Quadrant Structured Prods. Co. v. Vertin, 102 A.3d 155, 171 (Del. Ch. 2014).

 [75]. See, e.g., In re Grand Jury Subpoena Duces Tecum, 112 F.3d 910 (8th Cir. 1997) (involving a president); United States v. Doe (In re Grand Jury Investigation), 399 F.3d 527 (2d Cir. 2005) (involving a governor).

 [76]. Subpoena Duces Tecum, 112 F.3d at 918 (finding that restricting communications involving the first family would be “in derogation of the search of the truth”) (quoting United States v. Nixon, 418 U.S. 683, 710 (1974)).

 [77]. Bailey v. Mayor of New York, 3 Hill 531, 538 (N.Y. Sup. Ct. 1842) (“If a public officer authorizes the doing of an act not within the scope of his authority, . . . he will be held responsible.”); Vertin, 102 A.3d at 171–72.

 [78]. Subpoena Duces Tecum, 112 F.3d at 918 (quoting Nixon, 418 U.S. at 710). A succeeding administration could also determine that revoking the prior claim of privilege undersuch circumstances would be contrary to a duty to maintain a truthful, open government that instills confidence in the people. See Chrysler Corp. v. Brown, 441 U.S. 281, 292 (1979) (“The Act is an attempt to meet the demand for open government.”).

 [79]. Hastings Ctr., The Ethics of Legislative Life 29 (1985). One theory of political representation describes an elected official’s duty as “carrying out [the] set of express or tacit instructions” expressed by her or his constituents. Id.

 [80]. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 356 (1985) (“An individual, in contrast, can act for himself; there is no ‘management’ that controls a solvent individual’s attorney-client privilege.”).

 [81]. Id.

 [82]. See, e.g., id. at 357.

 [83]. Id.

 [84]. Mitchell v. Superior Court, 691 P.2d 642, 646 (Cal. 1984) (citing People v. Flores, 139 Cal. Rptr. 546, 547–48 (1977) (“Clearly, the fundamental purpose behind the privilege is to safeguard the confidential relationship between clients and their attorneys so as to promote full and open discussion of the facts and tactics surrounding individual legal matters.”).

 [85]. United States v. Zolin, 491 U.S. 554, 562–63 (1989) (quoting 8 J. Wigmore, Evidence § 2298)).

 [86]. Lory A. Barsdate, Attorney-Client Privilege for the Government Entity, 97 Yale L.J. 1725, 1742 (1988).

 [87]. Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 357 (1985).

 [88]. Although I agree with the insufficiency of a “lack-of-evidence-to-the-contrary,” it is difficult to believe that the dire “chilling effect” warned of by the respondents in Weintraub has come to fruition in the more than thirty years since the Supreme Court’s decision, given the silence on the matter since. However, this question is primed for further research to shed light on this possibility.

 [89]. See, e.g., Melanie B. Leslie, Government Officials as Attorneys and Clients: Why Privilege the Privileged?, 77 Ind. L.J. 469, 482–84 (2002).

 [90]. See supra notes 7071 and accompanying text.

 [91]. If a predecessor invoked privilege in between the successor’s election and successor’s swearing-in ceremony, there is arguably less incentive for the successor to have spoken about the issue during the previous campaign. This likelihood stems from the fact that neither political party currently recognizes the operation of attorney-client privilege as a campaign issue. See, e.g., Our Platform, Democrats, https://www.democrats.org/party-platform (last visited Aug. 21, 2018); RNC Communications, The 2016 Republican Party Platform, GOP: Blog (July 28, 2016), https://www.gop.com/the-2016-republican-party-platform. As party platforms are updated in response to issues of significance to the electorate, the platforms could include the issue of privilege revocation if it became significant.

 [92]. See Barsdate, supra note 86, at 1742–44 (noting and then refuting the existence of concerns surrounding the “sensitive communications” government attorneys have access to).

 [93]. Id. at 1738.

 [94]. Roger C. Cramton, The Lawyer as Whistleblower: Confidentiality and the Government Lawyer, 5 Geo. J. Legal Ethics 291, 294–95 (1991) (citing 26 U.S.C §§ 6103, 6104, 6108, 6110 (1988); 5 U.S.C. §§ 552, 552(a) (1988); 18 U.S.C. § 1905 (1988)).

 [95]. 5 U.S.C. § 552(b)(1)–(9) (2007).

 [96]. Prior invocation of the attorney-client privilege by Presidents Richard Nixon and Bill Clinton—as well as the current assertions by President Donald Trump and others associated with his administration—signal the possibility that the test case may involve a president. However, application of my thesis is by no means limited to members of the White House, as the rationale and logic put forth herein apply to local- and state-government agencies, as well.

 [97]. Analysis of the news articles regarding the privilege and President Trump’s references to the long-standing rule have resulted in a public-relations campaign that has promoted the privilege. With so much scholarship devoted to attorney-client privilege in recent years, such publicized talk of the privilege’s application to the President prove the need to resolve this unexplored question. Yet the test case may not end up involving a president or even federal officials; however, no matter the level of government agent involved, the current discussions stemming from President Trump illustrate the importance of the privilege in a government official’s day-to-day operations.

 [98]. See supra note 1 and accompanying text (discussing President Trump declaring the privilege dead).

Volume 91, Number 5 (July 2018)

Volume 91, Number 5 (July 2018)

Unbundling Freedom in the Sharing Economy – Article by Deepa Das Acevedo

From Volume 91, Number 5 (July 2018)
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Unbundling Freedom in the Sharing Economy

Deepa Das Acevedo[*]

Courts and scholars point to the sharing economy as proof that our labor and employment infrastructure is obsolete because it rests on a narrow and outmoded idea that only workers subjected to direct, personalized control by their employers need work-related protections and benefits. Since they diagnose the problem as being our system’s emphasis on control, these critics have long called for reducing or eliminating the primacy of the “control test” in classifying workers as either protected employees or unprotected independent contractors. Despite these persistent criticisms, however, the concept of control has been remarkably sticky in scholarly and judicial circles.

This Article argues that critics have misdiagnosed the reason why the control test is an unsatisfying method of classifying workers and dispensing work-related safeguards. Control-based analysis is faulty because it only captures one of the two conflicting ways in which workers, scholars, and decisionmakers think about freedom at work. One of these ways, freedomasnon-interference, is adequately captured by the control test. The other, freedomasnon-domination, is not. The tension between these two conceptions of freedom, both deeply entrenched in American culture, explains why the concept of control has been both “faulty” and “sticky” when it comes to worker classification.

Drawing on a first-of-its-kind body of ethnographic fieldwork among workers and policymakers across several sharing economy industries, this Article begins by showing how workers themselves conceptualize freedom as both non-interference and non-domination. It then goes on to show that both these conceptualizations of freedom also exist in case law and statutory law pertaining to work. In doing so, the Article demonstrates that there is no great divide between work law and work practices and that, if anything, the problem is that classification doctrine reflects and reinforces an irresolvable tension in the way lay and legal actors think about freedom at work.

Introduction

In 2015, the Northern District of California issued one of the most widely cited opinions on employment regulation in the sharing economy.[1] The dispute in Cotter v. Lyft was a relatively standard one—whether a company had misclassified a particular set of workers as independent contractors when in fact they ought to have been employees[2]—and the substance of the court’s analysis and ruling were similarly routine.[3] What made the Cotter opinion stand out, aside from its efforts to grapple with an unfamiliar economic space, was Judge Chhabria’s snappy summary of a widely recognized problem in worker classification law. Because the standard “control” based test for worker classification suggested that Lyft both did and did not control the drivers who operate on its platform (and that consequently the drivers could be either employees or independent contractors) “the jury,” Judge Chhabria observed in closing, “will be handed a square peg and asked to choose between two round holes.”[4]

The common law control test purports to distinguish employees from independent contractors on the grounds that employees enjoy less freedom in the “manner and means” of their work and thus merit a host of work-related safeguards.[5] Judge Chhabria argued that the misfit between legal categories and work practices stemmed from the fact that a “20th Century” test was being applied to a “21st Century problem” like the sharing economy[6]—but in truth, the control test seems to have always suffered badly from cubism­. Before Lyft drivers, for instance, there were FedEx drivers whose facial hair and sock color were dictated by FedEx and McDonald’s workers whose speech and hand motions were mandated by McDonald’s, all of whom were sometimes found to be independent contractors (and sometimes not).[7] Indeed, for virtually the entirety of its existence, the control test has proven unsatisfactory to courts and scholars—and, at least once, to Congress—because it is inefficient and often seems inaccurate.[8] But if control-based analysis is so deeply problematic, why has it also been so tough to get away from?

The concept of control has proven both “faulty” and “sticky” when it comes to worker classification because it captures one—but only one—of the two conflicting ways in which courts, scholars, and workers themselves think about freedom at work. One of these ways, which is more prominent as well as adequately captured by the control test’s “manner and means” analysis, is a classically liberal understanding of freedom as non-interference.[9] The second, less influential (but still widely visible) model is a thicker vision of freedom as non-domination.[10] These competing conceptions shine through with striking clarity in the sharing economy, but they are also apparent in other business contexts and clearly discernible from a skyview analysis of our labor and employment infrastructure. The tension between these two visions of freedom is why scholarship and jurisprudence on worker classification has been filled with criticisms of the control test, yet unable to meaningfully move beyond it.

This paper makes two contributions to legal scholarship. First, it speaks to labor and employment law scholars by showing that control-based worker classifications, problematic as they may be, are linked to a particular vision of individual autonomy that is very compelling in America. While the consequences of courts’ reliance on control often seem perverse (as when innumerable workers are denied employee status because they are not directly or sufficiently controlled by their respective employers), the conception of personal freedom behind that analysis demands serious and careful treatment. Critics of the current classification regime do themselves no favors by trying to eliminate, supplant, or declaw control-based analysis. This is not so much because doing so constitutes the usual mistake involving babies and bathwater, but because critics fail to recognize that the baby and the bathwater are in some ways indistinguishable.

Second, this paper contributes to a broader conversation within the legal academy about the role of qualitative social science in the study of law. As I have argued elsewhere, the kinds of insights gleaned from ethnographic research are different from those facilitated by other empirical (and especially quantitative) forms of social science, but they are hardly incommensurable with the interests or the intellectual values of legal scholars.[11] Here, I use ethnographic fieldwork on the sharing economy as well as legal analysis of our labor and employment infrastructure to reveal the twin conceptions of freedom described above and to show why the tension between them creates problems for employee classification doctrine. The type of cultivated attentiveness that makes such a doctrinal critique possible is precisely why ethnographic research is a different but profoundly valuable mode of interdisciplinary legal scholarship.[12]

Part I begins with a brief overview of the origins of our classification system that highlights the centrality of freedom as an analytic rubric. I then detail the stakes of employee status as well as the criticisms that the existing system has provoked. Part II contains the ethnographic heart of the Article. Section II.A uses ethnographic research to demonstrate that workers in the sharing economy sometimes value independent contractor status and associate it with freedom-as-non-interference, while Section II.B shows that sharing economy workers and their advocates rely on a conception of freedom that is more akin to non-domination when they express concern about the lack of autonomy in this type of labor. Part III draws on case law and statutory law to demonstrate that these conflicting visions of freedom also exist in our labor and employment law infrastructure.

I.  Defining Work Relationships

The building blocks of work law are imports from elsewhere: the categories “employer” and “employee” arrived from the law of agency via vicarious liability, while the characterization of the employment relationship itself comes from contract law.[13] Labor and employment scholars have long bemoaned this lack of locally cultivated concepts (particularly as it relates to worker classification) because they believe that it creates a misfit at the foundation of our regulatory infrastructure.[14] And, they argue, the primary cause of that misfit is the importance of control in the allocation of the protections and benefits described below.[15]

But scholars and courts misdiagnose the precise nature of the problem: control is important, to be sure, and that importance derives from classification doctrine’s link with agency lawbut control is really just a proxy for measuring worker freedom.[16] As the categories “employee” and “independent contractor” developed over the nineteenth century, placing individual workers into one bucket or the other was meant to reflect a sense that some workers were merely agents of their employers and not really free to act independently.[17] It followed that employers sometimes ought to be responsible for injuries caused or incurred by those workers (“employees”) who relinquished freedom in the performance of their tasks because, after all, it was the employers themselves who had dictated the “manner and means” in which tasks were to be performed.[18] As it turns out, however, “manner and means” analysis only captures one of the ways in which workers, scholars, judges, and even occasionally legislators have thought about what it means to be free at work.

That is where the trouble really liesin the overlooked complexity of the concept of freedom. Unlike critiques that emphasize the narrowness of control-based analysis or the different goals of agency versus work law, an analysis that focuses on freedom can explain both the faultiness and the stickiness of the control test. Otherwise it becomes mystifying, as indeed it has been to generations of critics, why a test that dispenses the safeguards of employee status as inefficiently and stingily as the control test nonetheless retains such conceptual punch.[19]

A.  What’s in a Name?

The United States funnels an extraordinary range of protections and benefits through work relationships. Moreover, the vast majority of these safeguards, at both federal and state levels, are only available to workers who are categorized as employees.[20] Core safeguards linked to employee status include anti-discrimination and harassment protections based on protected categories like race, religion, sex, national origin, disability, and age (including the duty to accommodate, where applicable);[21] job protections for family and medical leave;[22] equal pay guarantees as between men and women;[23] minimum pay guarantees and rules about when over-time rates of pay should kick in;[24] fiduciary standards regarding health and retirement benefits (as well as the bulk of such benefits themselves);[25] workplace safety protections;[26] and, of course, protections for workers who engage in concerted or union activity.[27] All of these and more hinge on being the right kind of worker for the right kind of employer and even, sometimes, being in the right kind of industry.

To be sure, some of these safeguards, like unionization rights or workplace safety protections, are self-evidently related to work, although not necessarily to employee status. Others, like the imposition of certain fiduciary standards regarding the management of health and retirement benefits, have no necessary connection to work at all—as Americans partly began to experience under the Affordable Care Act.[28] This is not the place to rehash longstanding debates on the wisdom of tying safeguards to work in general; for better or worse, our social safety net is unlikely to become meaningfully detached from the work relationship in the foreseeable future.[29] Rather, it is simply worth noting that the range of benefits tied to work is largely co-extensive with the range of benefits tied to employee status because doing so explains why so many scholars (to say nothing of workers, worker advocates, and governmental actors across branches and jurisdictions) have been vexed by the issue of worker classification: many of the procedural and substantive safeguards that greatly contribute to a decent life are funneled through employee status.[30]

Despite the undeniable importance of worker classification, it is notoriously difficult to determine whether any individual worker is an employee or an independent contractor.[31] Statutes are of little help: several of the most significant federal acts contain delightfully circular language like “[t]he term ‘employee’ means an individual employed by an employer.”[32] In a 1992 case involving the Employee Retirement Income Security Act (ERISA), the Supreme Court held that such circular language reflected congressional reliance on the “common understanding . . . of the difference between an employee and an independent contractor” that in turn mandated judicial reliance on the common law control test.[33] Courts soon extended the holding to statutes beyond ERISA so that now the control test is the default for federal work law protections.[34]

Case law has also been of little help despite the fact that “the real work of identifying ‘employees’ . . . has always been in the courts.”[35] In the course of trying to implement the Fair Labor Standards Act’s (“FLSA”) broader definition of what it means to be an employer—to “suffer or permit to work,” rather than to control the means and manner of performance—some courts developed the “economic realities” test as an alternative to control-based analysis.[36] This new test was meant to expand the scope of analysis by considering workers’ economic dependence on their employers and functional (rather than merely nominal) employer control.[37] But the economic realities test has also come to draw criticism, partly because its multiple factors are open to divergent interpretations and partly because many of those factors bear a curiously strong resemblance to factors that are considered under the common law test.[38]

B.  What’s the Matter with Control?

The two criticisms of the economic realities test mirror the primary complaints about worker classification doctrine more broadly: it offers little guidance and it really always boils down to control-based analysis.[39] That tendency to revert to measuring and weighing control is in turn troubling because the control test seems prone to excluding workers with diminished freedom from the agreed upon suite of employment related safeguards.[40] Sometimes the exclusion simply occurs when workers are labeled independent contractors rather than employees of the companies they work for. This is the case with the decades-long litigation over FedEx delivery drivers, whom the Ninth Circuit described as being subjected to “exquisite” forms of control, notwithstanding FedEx’s claims that they were independent contractors.[41] But critics also fault the control test for narrowly construing who counts as an “employer” and thus absolving companies of their obligations under various statutes. This is the impetus behind efforts to hold franchisors like McDonald’s liable as joint employers of their franchisees’ direct employees.[42]

It is precisely this narrowness, critics argue, that led Congress to abandon the common law definition of “employee” when drafting the FLSA and to instead adopt the wider “suffer or permit” standard used in state child labor laws;[43] that led the Supreme Court in NLRB v. Hearst to argue for a “purposive” reading of the National Labor Relations Act, with its more expansive understanding of “employee” status;[44] and that led various federal courts to embrace an economic realities analysis that accounts for worker dependence.[45] A survey of worker classification literature brings such efforts to minimize or supplant control-based analysis into sharp relief, but it also reveals that courts, regulators, and even scholars continue to think about classification in terms of control.[46] Why?

One set of explanations argues that they keep returning to control because some particular feature of the law or its application pushes them to do so. The “feature” in question is often broad, like a failure to adapt given changing modes of production, or the fact that courts often engage in formalist rather than purposive analyses of employment statutes.[47] It is also often foundational to labor and employment law, like when scholars argue that our troubles arise from the inherent difficulty of distinguishing between the “contracting” and “producing” phases of employment relationships as the law essentially requires us to do.[48] Whatever the cause, the end result is that law fails to accurately regulate labor because it ties employee status to a kind of direct and active interference in worker autonomy.

Because law is the problem in these accounts, law is also the solution. Regulators should have different tests, different defaults, or different interpretive rubrics, so they can more accurately identify control in work relationships. In a pinch, they can draw on other areas of the law—antitrust is an emerging favorite—to mitigate the failings of the specific legal infrastructure governing work.[49] But arguing that some longstanding feature of “law” is responsible for failures to accurately understand and regulate some feature of “society does not explain why even critics find it so difficult to let go of that feature, and it has the unfortunate side effect of reifying law as a thing that exists apart from and above the social world.

Conversely, another approach has been to say that courts, scholars, and even workers keep returning to control because they embrace the law’s narrow, formalist conception of freedom as non-interference and find it meaningful.[50] For example, some taxi drivers might prefer to be independent contractors because they genuinely feel this classification signals and enables greater autonomy than the category “employee.”[51] Likewise, courts might find independent contractor status to be both an accurate signal and effective source of “entrepreneurial opportunity.”[52] Since this type of argument also posits that legal categories are themselves historically contingent—say, in the way that the independent contractor classification became linked with entrepreneurship and freedom during the heyday of twentieth century neoliberalism—it is especially adept at acknowledging the mutually constitutive nature of law and society.[53] But precisely because it is so good at explaining why legal constructions of control gain social salience as well as how they are socially informed to begin with, this approach tells us little about why generations of scholars, workers, legislators, and judges have felt that control-based analysis just isn’t doing the trick.

In the end, we cannot explain the stickiness of control-based analysis without also accounting for the longstanding sense that it is inadequate. Likewise, we cannot explain control’s shortcomings without accounting for the fact that year after year, in court after court, and even for some of the workers whom it seemingly shortchanges, control and the categories it gives rise to continue to present a compelling vision of what it means to have or lose freedom at work. We can resolve both halves of the puzzle by understanding that our classification system has really been predicated on measuring freedom (not control), and that the common law control test captures one—but only one—of the two conflicting ways in which lay and legal actors think about freedom at work.

Because this is an exercise in chasing complicated concepts, it can be helpful to begin with the lived experiences of actual people and in environments that are relatively transparent. The ethnography that follows combines these advantages to reveal a tension in the way workers think about freedom that, in later sections, can also be seen in work law itself.

II.  Freedom at Work in the Sharing Economy

The “sharing economy” refers to a broad set of companies that use technology to offer products and services in a highly disaggregated, individualized way. Not all sharing economy companies actually present work regulation issues, which is why most scholarly and policy commentary (not to mention judicial and legislative engagement) has been concerned with a limited subset of this space. I refer to those companies that actually pose labor and employment law issues as “platforms” and I distinguish them from others within the broader sharing economy (that I have elsewhere referred to as “renters” and “swappers”) on the grounds that platforms do more than apply new technology to old practices and are more than virtual bulletin boards for third parties.[54] Rather, platforms actively participate in the transactions they give rise to and occasionally substitute themselves for government safeguards.[55] For this reason, when we talk about work regulation in the sharing economy, we are really just talking about platforms.

The ethnography presented in this Article was conducted largely but not exclusively in Philadelphia from 2016 to 2017. I participated in application and training processes for sharing economy companies, worked for a few of those companies, and engaged in distance-education classes for aspiring online workers.[56] I also observed online chat forums and discussion threads catering to platform workers at a national (and sometimes international) level.[57] In addition to these forms of participant-observation, I conducted semi-structured interviews or informal conversations with platform workers, worker advocates, policy analysts, and municipal officials.[58] Lastly, I benefited from the prior efforts of journalists, analysts, industry experts, and advocates who conducted their own research and whose work, whether published for a general audience or directly shared with me, complemented and enriched my own ethnography.[59] One of these interlocutors rightly observed that fine-grained, qualitative data is essential to the task of questioning the cohesive, statistics-based narratives put forward by platforms regarding the true nature of this work and what it means for our regulatory system.[60] This Article uses ethnography to further that goal.

A.  Freedom as Non-Interference

Workers suggest that the freedom afforded by platform labor is of three types: nobody tells me when to work, how to work, or how much I can earn. When stated this way, the autonomy-enhancing potential of the sharing economy is striking, as is the degree to which it contrasts with anything we might legally understand as employment. Although subsequent sections of this Article will show that this view of platform work rests on a narrow conception of freedom, there is no gainsaying the set of choices that platform workers can and do make as well as the real value of being able to describe your work using “I” statements.[61]

Consider Sam, a late 30s African-American man who drives for UberX (one of the company’s lower cost services) and occasionally works as a TaskRabbit tasker.[62] Sam has been driving for Uber ever since he lost his job last year as a technician for a major cable and internet provider, and he recently started doing some light furniture assembly and home repair work via TaskRabbit. He aims to drive around five hours per day and usually does this weekdays from 5–10 a.m. in order to catch the morning hospital and office crowds, and because it allows him to take care of his two children after school while his wife works. He never works weekends.

Driving is not Sam’s passion, but he enjoys chatting with passengers, setting his own schedule, and listening to his favorite music or playing games on his smartphone in between rides. He especially doesn’t miss the erratic schedules of his old technician job, which stressed him out and tied him up for most of the day, nor does he miss the local coordinator who (Sam feels) gave him especially rough timings because of personal animosity and who frequently criticized him for not completing jobs quickly enough. Moreover, he very much enjoys his TaskRabbit assembly work because it allows him to build tangible objects instead of just installing modems or fixing wires.

Sam does not know exactly how much he earns from his platform work. For a month before Christmas he also drove weekday afternoons, which got the family through the holidays but made it harder for him to estimate his average weekly take-home. He has not calculated his net income, but knows whether he earned less in a day than he spent on fuel that morning, he saves all his fuel receipts for tax purposes, and he figures that his TaskRabbit work involves no expenses at all except that new tool belt he bought two weeks ago.[63] When he first lost his job, Sam briefly thought about moving to an industry competitor or even getting a temporary retail or fast food job because of the hourly wage guarantee. In the end, however, he and his wife decided that their scheduling needs and his well-being pointed them towards platform work instead.

Sam’s story reads as one of intrepidity and relative convenience in the face of economic volatility, and indeed many platform workers (to say nothing of platform companies) articulate a similar, largely positive narrative of what it means to work in the sharing economy. But just as the glib presentation of platform work as easy and entrepreneurial hides far less pleasant realities, it also masks or trivializes the more meaningful positive aspects of this work.[64]

To begin with, setting one’s own schedule is about far more than mere convenience.[65] Indeed, many workers describe this aspect of their platform participation using language that smacks of empowerment and independence: “I never drive more than six hours a day” or “I only drive weekends.”[66] On the one hand, the ability to turn off an app or put a profile on hold allows workers to assert the primacy of their own priorities rather than allow them to play second fiddle to an employer’s timetable. On the other hand, platform work involves no reporting to supervisors—human or otherwise. There are no punch cards, no time sheets, and no bosses walking past desks. “I like Uber,” one driver said, “because [driving a] taxi is eight to eight, nine to nine.”[67] He added that he chose to drive full time rather than work in a casino like one of his brothers or in the family gas station business like another brother because he doesn’t like having to keep a schedule or deal with a boss.[68]

Likewise, not having a boss means more than having flexible schedules: it can also mean (within boundaries) the ability to embody flexible work styles to a degree where workers seem to be determining what the work is. An Uber driver can choose to put on some Hip Hop music in between passengers (or some high-decibel classical music with passengers in the car), just as she can decide to stay parked between rides instead of immediately driving to a high-density area or vice versa.[69] An Airbnb host can decide to allow guests to check themselves in (or not), to provide breakfast (or not), and to decide how many sets of linens are essential to successful hosting.[70] In other words, platform workers lack the over-the-shoulder supervision paradigmatic of traditional production or service jobs. Although this by itself does not make them unusual—taxi drivers and long-haul truckers are wellknown examples[71]—it adds to the sense that they conduct their work lives in the relative absence of supervisory intervention.

Finally, just as there is no supervisor to set Sam’s schedule or tell him how to go about doing his work, there is also no supervisor rejecting his application for a raise or limiting his overtime hours. I do not mean to say that platform workers believe they can earn exceptionally large (much less unlimited) sums because they are only restricted by their own willingness to work or, more cynically, because they are only limited by their ability to game the platform’s algorithm. Some workers undoubtedly do still approach their platform labor with this attitude,[72] but they are likely rare; the conversation among workers and observers alike has come a long way from Uber’s childhood boasts of $90,000 annual incomes.[73]

Instead, when platform workers speak of their ability to control their own earning potential they tend to describe definite, but decidedly circumscribed goals: $200 per day, for example, or $200 per week, or enough to cover a particular expense like travel or car payments; the specificity of these goals represents a balance between their financial needs and their other priorities.[74] That is to say, the “freedom to earn” associated with the sharing economy is often understood as the freedom to set income ceilings rather than the freedom to break them, but it is nonetheless valuable to workers.

Platform workers are neither deluded nor unusual for valuing the freedom to make their own decisions regarding scheduling, work style, and earning potential—nor, for that matter, are they alone in associating this freedom with independent contractor classification. Non-white immigrant taxi workers in the Bay Area, for instance, have strongly preferred to be independent contractors rather than employees (to the point that San Francisco taxi drivers as a whole were unable to vote themselves into employee status when given the opportunity to do so by city government) because they attach symbolic and practical consequences to each classification.[75]

For these drivers, the often degrading experience of being a non-white taxi driver is somewhat mitigated by the knowledge that they do not work for anybody and by the cultural capital that this generates within their social circles.[76] More concretely, immigrant drivers worry that employee status will allow leasing officials to give free rein to their prejudices by enforcing specific dress and grooming requirements as well as by giving immigrant drivers the worst cars and schedules.[77] Drivers also (quite rightly) associate the universally despised practice of short-term or “day” leasing with employee status and worry that the problems of day leasing—such as long hours wasted in line waiting to be assigned a car, daily bribe payments to get better cars, and the generally demeaning treatment meted out by leasing officials—will only be exacerbated by a return to the classification scheme under which it was originally developed.[78]

As the worries of taxi drivers and the satisfactions of platform workers suggest, conceptualizing freedom at work as non-interference (“nobody tells me when to work, how to work, or how much I can earn”) is just that and no more: the freedom to not have another human being interfere in one’s work-related choices. Perhaps the salience of this limited vision of freedom means that it is uniquely disempowering to have a fellow person order us about.[79] This would certainly be in line with arguments that human action is uniquely effective at stopping the flow or impact of accountability—of acting as a “moral crumple zone” when essentially autonomous technologies malfunction—because it too emphasizes that our cultural and legal conceptions of responsibility are still centered on the individual agent.[80] Or, perhaps it suggests that interference is more demeaning when it is discrete and direct (like an order to report for work at 7 a.m), rather than when it is incremental, structural, or indirect (like when implicit bias in customer reviews eventually triggers deactivation from an app).[81] Regardless, the meaningfulness of this vision of freedom is real and it is reasonable, even if the underlying concept is exceptionally narrow and thus problematic. And because this understanding of freedom is explicitly defined by the presence or absence of control, it can make control-based categories powerfully meaningful for workers even when there is good reason to think those workers ultimately suffer as a result of a classification system based on control.

Even policy analysts and workers’ advocates sometimes find the idea of freedom-as-non-interference compelling, inasmuch as they sometimes use it to typologize platforms for the purposes of analyzing and responding to platform-related problems.[82] But separating “labor platforms” (like TaskRabbit and Rover) from “capital platforms” (most notably, Airbnb) is neither conceptually easy nor, if we are concerned with workers’ welfare, is it manifestly desirable. For instance, ridesharing is usually slotted into the “labor” category even though it requires a significant capital investment because ridesharing, like dog-walking or furniture assembly, involves personal services performed by the worker. But UberBLACK drivers can have commercial accounts listing multiple individuals who actually do the driving and who split earnings with the account holder;[83] conversely, many Airbnb hosts personally undertake part or all of the considerable labor involved in hosting.[84] The fact that most Uber drivers actually do the driving themselves while many Airbnb hosts outsource their maintenance work does not reflect anything intrinsic to the way the platforms work.

From a workers’ advocacy perspective, the suggestion that capital platforms are different—that they merely constitute a “side income” stream and are meaningfully less like employment than labor platforms—relies on the idea that a task is not “work” if someone has not directly forced you to undertake it at a given moment, in a given manner. Yet the same analysts and advocates who distinguish between labor and capital platforms often point out that algorithmic management techniques significantly restrict workers’ freedom (making them more like employees) even though the techniques generate few discrete, unavoidable demands and involve little direction by any human being.[85] Moreover, algorithmic management is hardly limited to a specific platform or even a specific kind of platform: Airbnb and Rover equally engage in algorithmic management when they rely on data-driven evaluation systems.[86] There may be other reasons to distinguish between “labor” and “capital” platforms, like understanding how class and race operate in the sharing economy, but understanding how to regulate work and how to safeguard workers’ rights are not self-evidently among them.[87]

This is not to say that any particular commentator wholly subscribes to a negative conception of freedom-as-non-interference—again, the central argument of this Article is that lay and legal actors do not wholly subscribe to any one way of thinking about what it means to be free at work (and neither does our work law). Rather, it simply goes to show that the idea of individual autonomy undergirding control-based analysis tends to inform analytic categories regardless of both one’s policy preferences and the role one inhabits with respect to the sharing economy.

There is also no question that the freedom described here is thin, not simply because it is contained in a few discrete and sometimes trivial types of decision-making, but also because those instances of decision-making are only free from interference if we draw a tight circle around what actually constitutes “interference.”[88] Platforms restrict workers’ choices by establishing cutoffs and penalties for various behaviors, including the rate at which workers accept client requests, the speed with which they accept them, and the rate at which they cancel accepted requests.[89] Some platforms establish fairly specific codes of conduct or limit the services a worker can offer unless she reaches an elite status.[90] And of course, Uber and Lyft seek to manipulate drivers’ personal choices regarding where and when to drive by using dynamic pricing.[91] The thinness of freedom-as-non-interference is such that the very things workers value—say, the ability to set earnings goals—are the means for platforms to shape worker behavior in ways that benefit platforms but not workers.[92]

Although scholars and policy analysts increasingly view these practices as restricting worker choice in meaningful ways, the practices are unevenly viewed as interferences in personal freedom by workers themselves and (with the equally uneven exception of ridesharing) are unrecognized as such by courts.[93] But that is precisely the point: platform control remains largely invisible because it does not follow the model of a X dictating to a Y on discrete matters at particular moments.[94] This does not mean that workers and observers feel that platform labor involves no loss of freedom—simply, as we will see, that the freedom they see being threatened is of a very different sort than the type of non-interference described above.

B.  Freedom as Non-Domination

Critics of the sharing economy argue that the liberating potential of this space has been drastically oversold and that platform labor generates uncertainty, conformity, and obsequiousness—all symptoms of domination—that are incompatible with freedom at work. According to this view, it does not matter so much that Uber, Rover, and Airbnb regularly discipline workers who cancel client requests, or that customers on these platforms discipline workers who do not meet their personal expectations—it is not the actual interference in worker choice that produces domination.[95] Rather, it is that platforms and customers have the power to discipline (and thus the power to restrict choice) if and when they feel like it and in essentially unpredictable or unknowable ways.[96] As a result of this unchecked authority, workers live in a state of uncertainty to which they respond by conforming their desires to the limits of the system and by behaving with obsequiousness towards those who dominate them.[97]

Take Alex, a retired Caucasian woman who rents her family’s spare bedroom via Airbnb and is also a Lyft driver.[98] After a few years of retirement, Alex and her husband decided to try homesharing because they felt they should do more to ensure their own financial stability during their golden years and because they wanted to help their struggling son with his daughter’s college tuition. Once they were more or less settled with their Airbnb listing, Alex decided to give ridesharing a try as well, mostly out of curiosity. Her husband does the cleaning and maintenance for their rental, while Alex manages their online profile and is primarily responsible for interacting with their clients.[99]

Alex has always considered herself a friendly, easy-going person so she was somewhat surprised to discover how invasive it initially felt to have strangers in her car and her home. She understood how some drivers could say that inviting strangers into their cars and making small talk for money made them feel like “pimps,” and although she didn’t feel quite as strongly, she was very aware of the fact that she had to provide a “service” while in her own home and her own car.[100]

Eventually, though, she started focusing on how to be a better host and driver. She would look carefully for mannerisms and word choices that indicated her clients’ moods, and experiment with different behaviors, questions, and phrasings to see what reactions she got.[101] As she got better at doing all of this, and as she started thinking of her work as providing something that people really needed, she started to enjoy herself more. One of her favorite tricks now is to ask for restaurant recommendations from her rideshare passengers but give restaurant recommendations to her homeshare guestsshe doesn’t need to ask any more than her guests (who could always check Yelp) need to be told, but in each context her tactics seem to make clients feel good.

Still, Alex remains slightly worried about some aspects of her platform work. For instance, she is especially sensitive to the fact that guests might complain about food odors in her home since her husband is Indian and cooks often.[102] One of her very first guests did in fact note the smell in his review. It wasn’t a major criticismhe made a few other suggestions as wellbut Alex is convinced that the smell was the reason he gave her a fourstar rating. More experienced hosts whom she encountered on an online chat forum reassured her by saying that four stars was fine for an early review and even gave her tips on how to moderate food odors. Still, Alex is always a bit anxious when a guest walks in for the first time—and also when they walk out for the last time at the end of their stay.

She’s also a little concerned that one of her guests will have a problem with the fact that her family is interracial. She hasn’t faced any explicit instances of discrimination yet, but she has heard stories of frosty guests and inexplicably low reviews and is wary. Still, she knows that there is little she can do since Airbnb’s anti-discrimination policy—which she has read in painstaking detail—is more geared towards protecting guests than protecting hosts.[103] So she does her best to preempt the situation by being extra friendly and accommodating.

Food odors and prejudices against interracial couples are obviously not a problem in her work as a driver but Alex is worried that, now that she’s finally got the hang of it, Uber is going to switch to driverless cars and all the other rideshare companies, including Lyft, will follow suit. She’s actually really grown to like her driving: doctors rushing to work in the morning and businesspersons late for meetings are always so grateful that she feels like a hero, and thanks to Lyft’s tip feature they can and do express their gratitude.[104] There was a week back in December when the money was so good (and their granddaughter’s spring tuition was almost due) that she couldn’t stop driving and started to get worn down from the lack of sleep.[105]

Alex’s story does not read as one of terrible sadness or subordination to either her platforms or her customers, and it is not meant to. Yet the absence of freedom is a terrible thingif Alex is not considerably unhappy and does not feel constantly thwarted in her work by being made to do things or obey orders that impinge upon her autonomy, why would we consider her unfree?[106]

In a word: uncertainty. Workers and observers are noting with heightened frequency and levels of eloquence that the experience of providing services in the sharing economy is marked by an overwhelming level of uncertainty—uncertainty regarding the requirements for gaining or maintaining access to the app, uncertainty regarding client expectations, uncertainty regarding situations where the two clash, and even uncertainty regarding how long the entire system will exist in its current form.

None of these uncertainties need actually produce bad outcomes for workers. The unknown platform requirements might be effortlessly met, clients might not have idiosyncratic expectations, the two sets of demands might never come into conflict, and (notwithstanding Alex’s fear of driverless cars) major changes might always hover just beyond the horizon.[107] Indeed, regulatory and technological hurdles make the worry about rideshare drivers training their own replacements less compelling than is sometimes suggested.[108] Nevertheless, it remains that the only thing that workers like Alex can be sure of is the power of the platform and of the client to constrain their options in any circumstance. It is an authority that is always there, waiting to be exercised, and the waiting creates uncertainty.[109]

To be sure there is uncertainty in all things and all jobs, and it is equally true that American work law has a peculiarly high tolerance for uncertainty as signaled by its embrace of at-will employment.[110] The problem is not so much that workers lack a script laying forth all the future twists and turns of their gigs, jobs, or working lives, but that the script they do have, bare bones as it is, is also at any time susceptible to alterations that are not of their choosing and may be intentionally hidden from them.

Uncertainty of this type constrains autonomy without ever rising to the level of direct interference because it makes it impossible for workers to exercise meaningful choice. When an Uber driver accepts every ride request she receives but is told she did not meet the acceptance rate requirement to qualify for a guaranteed hourly wage, she has no information with which to counter Uber’s assertion and, consequently, no way to judge her best future course of behavior.[111] Her safest bet is to continue accepting all possible ride requests in the hope that Uber’s assessment and her own assessment of her acceptance rate will eventually match up. Similarly, when a Fiverr worker does not know what will catapult her into the highest category of elite workers (“Top Rated Seller”) she has no way of choosing among an array of possible behaviors or business decisions in order to access the very real benefits that come with Top Rated Seller classification.[112]

Inasmuch as it forces workers to operate blindly, uncertainty also leads workers to literally and figuratively embody the domination they experience.[113] One paradigmatic way to respond to the unchecked authority of another is to curry favor with the authority figure so that she will minimize her interference in your choices.[114] Obsequiousness is neither necessarily painful nor gaudy: most of us like to please, and—as many rideshare drivers attest—sometimes silence itself is pleasing enough. What obsequiousness (even the silent variety) expresses, however, is the powerlessness of the person who embodies it. “Several [Uber] drivers said the best way to behave is like a servant,” noted one journalist, before going on to quote a driver in Sacramento who characterized her own role by saying that “‘[t]he servant anticipates needs, does them effortlessly, speaks when spoken to, and you don’t even notice they’re there.’”[115]

Though it may seem otherwise, obsequiousness is about more than exercising “natural” tact. Rather, it is a way of recognizing the particular social game being played and of obeying its rules.[116] Smiling to make others happy, curating conversations to boost others’ egosthe emotional labor performed by platform workers concretizes the power of clients and algorithms through the worker’s own physical gestures and speech patterns.[117] For instance, after a Lyft driver noted a sudden decrease of 0.1 in his rating, he started attempting to establish a conversational rapport with passengers “very quickly” because “[t]hat’s what they”—meaning both passengers and Lyft—“want. Accommodate and connect.”[118] Emotional labor is nothing new, of course, and even within the sharing economy, it is hardly limited to either rideshare drivers or verbal interactions.[119] But the sheer ubiquity of emotional labor makes it no less telling a sign of dependence on another’s will.

Because emotional labor and obsequiousness are unsuccessful where they are obviously insincere, workers must also at least partly conform their preferences to the constraints, actual or potential, that are placed upon them.[120] This too is neither necessarily painful nor outlandish. If one’s options are good ratings that produce a host of benefits—more income, elite statuses, perhaps an hourly wage guarantee—and bad ratings that produce their inverseand perhaps deactivationthen it is natural to honestly prefer the former, and indeed, it is difficult to do otherwise.[121] Account after account of platform work emphasizes how seriously workers take such markers of success, not only because they translate into more desirable outcomes, but because they validate the decision to commit to platform labor itself. “I’ve got currently twelve excellent-service and nine great-conversation badges,” boasted one Uber driver (who is nonetheless looking for another job).[122] “It tells me where I’m at.”[123] But in the neo-republican account, while happiness—or at least, reduced frustration—may lie in learning to want what you have rather than having what you want, freedom emphatically does not.[124]

This is not to say that platform workers are automatons who feel what is wanted and want what is given (even though it can sometimes seem that way).[125] Critique and resistance abound, whether this consists of venting on chat forums, contesting client accounts of interactions, strategizing within the bounds of the systemas when workers try to game the algorithms that determine search results or that allot front page placement on their platforms’ websitesand it may even involve operating outside the bounds of the system itselfas when workers go “off app.[126] But these acts of agency occur within a particular framework and using a particular set of idioms and intuitions; they are part and parcel of the system they ostensibly subvert. Consequently, while they might demonstrate dissatisfaction with the rules of the game, they do not fundamentally break with the game itself.[127]

When critics decry the imbalance of power between clients and platforms on the one hand and workers on the other, they are appealing to an understanding of freedom of non-domination rather than as non-interference. If only interference was at issue, the ability to ingratiate oneself with clients (and also with algorithms) and to thereby pursue one’s livelihood relatively unmolested would draw analogies to liberation, not servility. Likewise, if the sum total of freedom was the ability to avoid frustration, it would be enough to constantly recalibrate one’s preferences in light of new constraints and interferences. That neither the one nor the other is the case suggests that workers and observers also subscribe to a vision of freedom that the sharing economy does not enable. It is this failure that drives talk of regulatory dysfunction or breakdown with respect to platform work, and that underlies dissatisfaction with control-based classification even outside the platform context.

C.  Conflicting, Not Concentric Freedoms

Taken together, Sam and Alex reflect worker experiences across a range of platforms, but, more importantly, they embody two distinct ways of experiencing (or not experiencing) freedom at work. Sam’s ability to make choices about when he works, how he works, and how much he earns, as well as the absence of a supervisor monitoring his performance, all reasonably contribute to a sense that he is free because someone else is not directly forcing him to engage in or refrain from particular actions. Conversely, Alex’s worries about dealing with prejudicial or idiosyncratic clients, her reservations about having to behave obsequiously in her own car and home, and even her gradual enjoyment of the subservient role she had initially disliked, all signal her loss of freedomasnon-domination. One is not simply broader than the other; rather, freedomasnon-interference and freedomasnon-domination are conflicting rather than concentric or additive concepts.

Non-interference is grounded in discrete, direct exercises of authority (“Pick up Joe Smith on Main Street, now!”). This is the kind of instruction someone like Sam is glad to be rid of, and labor and employment scholars rightly associate it with industrial and factory-based forms of labor that are a diminishing component of our work landscape. But the sort of freedom that someone like Alex is missing out on, freedom-as-non-domination, would not be captured by a broader “functional” understanding of authority because it is fundamentally distinct.

For example, even though Alex may not be given a specific order to “pick up Joe Smith,” she might know that if she does not pick up a large enough percentage of Joe, Jack, and John, she will be terminated from the app. The trouble is that Alex is not quite sure what that magic percentage is or whether she and Lyft will agree on when she’s met it, so Alex is not really free to reject any of those passengers. A broader definition of control would not solve her problem. Likewise, the constraints on her freedom do not arise from whether or not Lyft actually directs her to “pick up Joe on Main Street, now.” What would make Alex feel freer in the non-domination sense if she knew beforehand that picking up Joe and Jack would ensure that she met her daily acceptance rate.

This means that the difference between freedom-asnon-interference and freedom-as-non-domination is one of kind rather than degree. More importantly, it means that regulators cannot satisfy both conceptions of freedom by simply expanding the circle of “employees” or by understanding “control” more expansively. Control-based analysis is inherently tied to the idea that a worker’s freedom is impinged upon when an employer dictates the “how, when, and where” of her work—that is to say, the “means and manner” of performance. freedom-as-non-domination need have nothing to do with this sort of means and manner analysis. And because workers are not alone in valuing both types of freedom, our labor and employment statutes and case law reflect traces of freedom-as-non-interference as well as freedom-as-non-domination.

III.  Freedom(s) In, and Through, Work Law

This Part explores how the ethnography discussed above illuminates a fundamental tension in labor and employment law itself. It is one thing to say that platform workers and observers are genuinely attached to different visions of freedom at work, another thing to suggest that this dynamic can also be found in our work law, and yet a third thing to argue that the tension between these two conceptualizations of freedom explains our fixation—and our dissatisfaction—with control-based analysis. So far, I have only made the first of these claims, but in what follows I will make the second and third. These arguments necessarily take us from the fine-grained, ethnographic study of platform labor to the historical and doctrinal analysis of labor and employment law writ large.

A.  Non-Interference and Non-Domination in Work Law

Freedomasnon-interference is undoubtedly more prominent within labor and employment law (and arguably beyond it) than freedom-as-non-domination. Few things convey the centrality of this way of thinking as well as the overall primacy of the common law control test, but we can pick out other, more specific instances where an understanding of freedom at work as non-interference shines through with especial clarity. Take the practice of upfront contractual specifications (“UCS”), in which detailed descriptions of the way work is to be done are included in independent contractor agreements, but are presented by companies and often understood by courts as evidence of the end product or service that is contracted for.[128] When courts read UCS clauses as detailing the “ends” rather than the “means” of performance, they understand them to support independent contractor classification because, in part, UCS obviates the need for human monitoring and scheduling.[129] In other words, some courts—like some platform workers—conceptualize freedom at work to be the absence of direct, interpersonal authority rather than as the absence of the power to exert such authority indirectly and without restriction.

For example, FedEx has successfully argued in several courts that the terms of its lengthy and non-negotiable Operating Agreement did not transform its drivers into employees because, among other things, the agreement “suggested a limited need or interest in real-time supervision.”[130] To be sure, FedEx’s position has been widely criticized and the judicial tide may have started to turn against the company on this issue,[131] but UCS is hardly limited to one company or even one industry.[132] Moreover, once we grant the paramount importance of identifying control over the means of performance, the frequently counterintuitive results in UCS cases become an intractablebecause they are unavoidable—problem.[133]

We can see the importance of control and freedom-as-non-interference outside the realm of worker classification, too. Consider the practice of having workers contractually waive statutory protections like the ability to litigate rather than arbitrate future claims, or the ability to mount claims based on current or prior employment decisions in any forum.[134] The logic in doing so is that when waivers are signed under conditions that are not explicitly coercive, they represent choices made free of interference.[135] They may even be said to advance freedom, inasmuch as they empower workers to assess and realize the value of certain statutory protections by their own lights.

But of course, waivers are signed in situations where choice is severely constrained by asymmetrical knowledge and by asymmetrical power over goods like jobs and severance packages.[136] (There is also the very real concern that waivers defeat public interests even when they truly advance private ones, but “deregulat[ion] by contract” is an entirely different sort of objection to statutory waivers.[137]) Even where there is no interference of the stranger-in-a-back-alley variety, it requires single-minded focus on the bare act of assent to be able to say that the waiver itself expresses worker autonomy.[138] That assent is important, to be sure, and it meaningfully differentiates contractual waivers from agreements made under conditions of actual intimidation. But for our purposes, contractual waivers are interesting for their signaling value more than for their substantive effect: the fact that courts almost universally enforce waivers suggests that courts dealing with employment contracts—like lay actors dealing with consumer contracts—find a strictly non-interference model of free choice to be compelling in some circumstances, however thin that freedom might appear to critics.[139]

While work law is undoubtedly flush with examples of freedom-as-non-interference, it is also relatively easy to spot instances where individuals have tried—with varying success—to push the law toward a conception of freedom-as-non-domination.[140] Perhaps most strikingly, labor republicans of post-Civil War America directly drew on and refined the classical republican understanding of freedom as part of their efforts to advertise the “structural and personal domination to which a modern wage-laborer was subject.”[141] The open-ended authority of the labor contract, according to this new, more radical interpretation, merely replaced the unfreedom of slavery with the unfreedom of wage slavery.[142]

Nevertheless, republicanism petered out as the labor struggles of the late nineteenthcentury segued into the Lochner era and later on as New Deal legislation sustained legislative and judicial onslaughts that revived the common law test and its control-based analysis.[143] The star surviving example of this is the FLSA’s definition of an employee as anyone who an employer “suffer[s] or permit[s] to work,” as well as its accompanying, judicially-created test, that purports to measure the “economic realities” of a work relationship rather than the quantum of control it involves.[144] The FLSA’s emphasis on knowledge and power along with the economic realities test’s complementary emphasis on dependence make the overarching—and not always actually exercised—authority of the employer the basis of worker classification.[145] As Section I.B noted, both the Act and the test are open to numerous criticisms, not least of which is that their vagueness produces judicial analysis suspiciously similar to what happens under the common law test. But it remains that the FLSA and the economic realities test represent concerted efforts to move away from a system that compensates only for the loss of freedom represented by direct interferences in a worker’s will.[146]

A similar conceptual move underlies the 2015 reassessment of the standard for determining “joint employer” relationships as well as the NLRB General Counsel’s investigation regarding McDonald’s liability for the working conditions of its franchisees’ employees. Together, Browning-Ferris[147] and the consolidated McDonald’s inquiry created uproar in the franchising world because they discarded an analytic framework that based employee classification on direct interference in worker autonomy as the basis for labor and employment protections.[148] Browning-Ferris announced that the NLRB (“the Board”) would henceforth only require a potential joint-employer “possess the authority to control employees’ terms and conditions of employment” rather than actually exercise such authority.[149] Likewise, it announced that the Board would acknowledge forms of control that were not directly and immediately exercised by the potential employer; instead, control exercised via an intermediary would count as well.[150] The McDonald’s investigation put this approach into practice (although it is worth noting that the General Counsel had initiated its inquiry well before a decision was issued in Browning-Ferris).[151]

In both instances, the Board abandoned a narrower understanding of freedom where only direct commands framed as commands are held to impinge a worker’s autonomy, and instead adopted a broader understanding of freedom in which the ability to elicit desired behavior warrants protection even if it is not exercised via direct command or remains unexercised altogether. The shift has been questionably successful: even though the Board confirmed its approach in subsequent cases,[152] Browning-Ferris was eventually overturned by Hy-Brand Industrial Contractors (which was itself later vacated).[153] But even though the new joint employer standard has been neither particularly impactful nor long lasting—in fact, especially because it has been neither impactful nor long lasting—it speaks to both the gravitational pull of control-based analysis and the dissatisfaction it occasionally produces.

B.  Tension, Confusion, or Failure?

Even if distinct visions of freedom-as-non-interference and as non-domination exist inside and outside work law, how can we be sure that the tension between them is responsible for critics’ seeming desire—and inability—to move beyond control-based analysis? Perhaps legislators are just responding to political pressure when they enact laws that promote control and non-interference in spite of its poor fit with the realities of work. Or, perhaps judicial actors are simply doing the best they can with vague laws and complicated facts, but their efforts also fit poorly with the realities of work. Bad statutes or bad case law—with “bad” meaning sinister, ill-conceived, archaic, or subject to internal contradiction (among other things)—are, overwhelmingly, the way labor and employment scholars have explained the continuing fixation and dissatisfaction with control-based analysis among themselves and decisionmakers.[154] Both of these explanations are undoubtedly part of the answer, but they are not, individually or even together, the whole answer. What’s more, considered by themselves, they paint a crude and starkly ungenerous view of all parties involved.

Take the idea that control-based analysis persists because labor and employment statutes overwhelmingly reflect the interests of elite actors (the “legislative failure” argument).[155] Political interests and constraints can certainly explain some of the stranger features of our classification system, including, for example, the exclusion of domestic and agricultural workers from the NLRA or that of tipped servers and farm workers from the FLSA.[156] Politics can even explain some of the back-and-forth between differing approaches to freedom at work, like the Taft-Hartley Act’s restrictions of the meaning of “employee” under the NLRA and Hearst.[157]

But “legislative failure,” though it offers some insights about our lovehate relationship with control-based analysis, cannot explain that relationship on its own. Suggesting otherwise invites a kind of legal nihilism because it requires viewing law as nothing but a tabula rasa waiting to be written on by select actors. It also invites a kind of legal exceptionalism because it would mean that law has a singular power to change hearts as well as actions even among those whose interests it undermines. In other words, this explanation requires us to think of law as both acultural and as wholly constitutive of cultural traditions, and it calls on us to view any values discernible in law as little more than “glosses on property relations.”[158] To write this down is to demonstrate its impossibility. Beyond all this, “legislative failure” sadly underestimates the importance of courts in constructing, defending, and reformulating the building blocks of labor and employment law.[159]

The second argument (“implementation confusion”) corrects for that last shortcoming by putting the blame squarely on the way courts handle labor and employment cases. In one understandably popular version of this explanation, judges both perpetuate control-based analysis and occasionally undermine it because the relevant legal precedent is confusing and statutory guidance is in woefully short supply.[160] Another less frequently articulated version of this argument suggests that courts have repeatedly embraced a restricted vision of freedom-as-non-interference because it better aligns with employers’ interests and because, consciously or not, judges are predisposed to sympathize with employers.[161] When courts recognize thicker understandings of freedom at work—as in Hearst, for instance, or in the FedEx litigation, Browning-Ferris,[162] or Cotter[163]—it is because the realities of work (and the interests of workers) have managed to assert themselves despite these limitations.

“Implementation confusion” cannot offer an exhaustive solution to the puzzle of control-based analysis any more than “legislative failure” because it repeats the latter’s errors, albeit in more complex fashion. To the idea that the stickiness of control originates in legal infrastructure, “implementation confusion” adds a new type of law (adjudicatory outcomes, whether by courts or by agencies) and a new type of actor (courts, rather than just legislatures). This adds nuance to the legal nihilism and exceptionalism from earlier, but it does not fundamentally challenge the premise that law may construct social norms without also being constructed by them. Likewise, to the argument that the faultiness of control-based analysis stems from a class-inflected divide between law and reality, “implementation confusion” adds subtlety via implicit bias“judges naturally think like employers”rather than explicit preference. But of course, this merely casts lures to the legal realists inside many of us without doing justice to the sort of measured, multivariate analysis of judicial behavior pursued by many New Legal Realists themselves.[164]

Perhaps the most significant problem with these two explanations is that they do not really notice or explain the fact that the tension between non-interference and non-domination exists outside the law itself, in the vast realm of “society.” As Parts I and II showed, workers—and even some commentators—who might be expected to find a thicker vision of freedom at work uniquely compelling (and who often do find it compelling) also often think of freedom-as-non-interference. This matters. Since critics of control-based analysis fail to see that its faultiness and stickiness exist outside the law as well as within it, they reasonably view the tension in work law as emanating from a disjuncture between law and society. Once we see that this tension exists both inside and outside the law, it becomes impossible to think that a disjuncture between law and society—whether stemming from statutes and legislators or case law and judges—is all that lies behind it. Something else must also be at issue, something that does not reduce law to “glosses on property relations,” lawmakers to puppets (or puppeteers), or lay actors to dupes. The missing piece of the puzzle is that we—workers, scholars, and decision makers alike—have genuine commitments, visible in law and in everyday practice, to two different conceptions of freedom at work.

Conclusion

The tension between non-interference and non-domination that I have outlined here explains decisions like Cotter v. Lyft far better than any transformations in technology or employment practices. Precisely because it was thorough and measured, Judge Chhabria’s analysis exemplifies how work law uses a single concept (“control”) to try to capture a complex empirical phenomenon (“freedom”) as well as how the attempt often produces stalemates and confusion.

For instance, several of the factors Judge Chhabria considered link the concept of control to an understanding of freedomasnon-interference: the “great flexibility” drivers enjoy regarding “when and how often to work;[165] their ability to select “parts of San Francisco in which they accepted ride requests;[166] and the “minimal contact with Lyft management” while working as drivers.[167] All of these factors interpret control to mean discrete or direct restraints on driver autonomy; because the restraints did not exist, control was also found to not exist.

Conversely, other factors considered by Judge Chhabria link control to an understanding of freedomasnon-domination: the “right to penalize” that Lyft reserves to itself (whether or not that right is actually exercised);[168] the ambiguous standards on which such penalties can be based;[169] and, above all else, the power that comes from the ability to terminate at will.[170] All of these factors interpret control to mean a potential, and potentially unrestrained, ability to limit driver autonomy; because Lyft did indeed possess such an ability, it was found to enjoy control over its drivers.

Cotter makes clear that work law cares about how people experience freedom, that there are distinct ways to experience freedom, and that decisionmakers cannot effectively subsume these distinct visions under a single concept like control. When they do so, as Judge Chhabria was forced to do based on prevailing California law, they are left with little but a morass of crossed signals and repeat errors. So where do we go from here?

First, we acknowledge that freedom-as-non-interference is a relatively thin concept with a remarkably thick and rich tradition in the United States. This is true both among lay and legal actors, as well as in “law on the books” and “law in society.” It is simply not productive to dismiss a Lyft driver’s valuation of, say, scheduling flexibility on the grounds that it seems like a shallow sort of freedom.

Second, we recognize that middle-of-the-road attempts to fix classification doctrine by introducing new tests or new factors do not succeed. This is not because non-interference and non-domination are mutually exclusive in the abstract, but because, in practice, it is difficult to consistently identify losses of freedom when freedom means two distinct things. Decades of classification case law and scholarship attest to this fact. The failure of median approaches suggests that our options for improving classification doctrine lie at the extremes: either we enact piecemeal regulatory reforms that address specific aspects of work relationships but leave core conceptual issues as they are,[171] or we undertake the profoundly challenging task of regulating work relationships on the basis of something other than the amount of control and freedom they permit.[172] Piecemeal regulations need not be inconsequential, and conversely, systemic change may not be better or feasible, but either approach would depart from previous reform efforts by respecting and building on our dual conception of what it means to have freedom at work.

 

 


[*] *.. Sharswood Fellow, University of Pennsylvania Law School; A.B. 2006, Princeton; Ph.D. 2013, University of Chicago; J.D. 2016, University of Chicago. My thanks to Daniel Abebe, Brad Areheart, Shyam Balganesh, Stephanos Bibas, Richard Carlson, Miriam Cherry, Ryan Doerfler, Veena Dubal, Eric Feldman, Lee Fennell, Andrea Freeman, Camille Gear Rich, Michael Green, Dave Hoffman, Genevieve Lakier, Sophia Lee, Brian Leiter, Serena Mayeri, Sandy Mayson, César Rosado Marzán, Shayak Sarkar, Paul Secunda, Beth Simmons, Megan Stevenson, Lior Strahilevitz, Julia Tomasetti, Laura Weinrib, Tess Wilkinson-Ryan, Noah Zatz, Adnan Zulfiqar, and, as always, John Felipe Acevedo, for comments on various aspects or versions of this paper. Commentators at the 2016 and 2017 Law & Society Association meetings, 2017 AALS meeting, Third Labor Law Research Network Conference, Fifteenth Annual Marco Biagi Conference, Michigan Law Young Scholars Conference, 2017 Southeastern Association of Law Schools Conference, the University of Pennsylvania Law School, and the University of Chicago Law School also provided valuable feedback. This research was funded in part by the generous support of Dean Ted Ruger and the University of Pennsylvania Law School.

 [1]. See generally Cotter v. Lyft, Inc., 60 F. Supp. 3d 1067 (N.D. Cal. 2015). Cotter has been cited in at least twelve decisions and as many as thirty-seven law review articles in the three years following the decision. See, e.g., Bowerman v. Field Asset Servs., Inc, 242 F. Supp. 3d 910, 928 (N.D. Cal. 2017); Bekele v. Lyft, Inc., 199 F. Supp. 3d 284, 303 (D. Mass. 2016); Ryan Calo & Alex Rosenblat, The Taking Economy: Uber, Information & Power, 117 Colum. L. Rev. 1623, 1626 n.14 (2017).

 [2]. Cotter, 60 F. Supp. 3d at 1069.

 [3]. See id. (“We generally understand an employee to be someone who works under the direction of a supervisor, for an extended or indefinite period of time, with fairly regular hours, receiving most or all his income from that one employer . . . .”). See also Cmty. for Creative Non-Violence v. Reid, 490 U.S. 730, 751–52 (1989) (listing various factors that courts consider in making determinations of employee status); United States v. Silk, 331 U.S. 704, 716 (1947) (same); Restatement (Second) of Agency § 220(2) (Am. Law Inst. 1958) (same); Richard R. Carlson, Why the Law Still Can’t Tell an Employee When It Sees One and How It Ought to Stop Trying, 22 Berkeley J. Emp. & Lab. L. 295, 310 (2001) (same).

 [4]. Cotter, 60 F. Supp. 3d at 1081.

 [5]. Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 323 (1992) (citing Reid, 490 U.S. at 740). While there is no definitive articulation of the control test, I will refer to it in the singular for ease of reading and because all versions of the test emphasize the importance of employer control over the “manner and means” of performance. Accord Carlson, supra note 3, at 299.

 [6]. Cotter, 60 F. Supp. 3d at 1081. See also Senator Mark R. Warner, The American Dream Is Fading for Millions of Freelancers. Portable Benefits Could Save It, Senate.gov (July 5, 2017), https://www.warner.senate.gov/public/index.cfm/2017/7/the-american-dream-is-fading-for-millions-of-freelancers-portable-benefits-could-save-it (calling the United States’ approach of linking social safety benefits to employers a “20th-century approach” that is “failing workers in the 21st-century economy”).

 [7]. See Deepa Das Acevedo, Invisible Bosses for Invisible Workers, or Why the Sharing Economy Is Actually Minimally Disruptive, 2017 U. Chi. Legal F. 35, 50, 58 (discussing specific work practices that allow franchisors like McDonald’s to exercise control over their franchisees’ direct employees as well as some companies like FedEx to exercise control over their independent contractors). Compare Alexander v. FedEx Ground Package Sys., 765 F.3d 981, 997 (9th Cir. 2014) (finding FedEx drivers are employees), and Ochoa v. McDonald’s Corp., 133 F. Supp. 3d 1228, 1241 (N.D. Cal. 2015) (denying summary judgment for defendant McDonald’s on grounds that McDonald’s may be liable for labor code violations involving its franchisees’ employees under a theory of ostensible agency), with FedEx Home Delivery v. NLRB, 849 F.3d 1123, 1124 (D.C. Cir. 2017) (finding FedEx drivers are independent contractors), and Salazar v. McDonald’s Corp., No. 14-cv-02096-RS, 2016 U.S. Dist. LEXIS 108764, at *49–50 (N.D. Cal. Aug. 16, 2016) (finding that McDonald’s is not a joint employer of its franchisees’ employees).

 [8]. See infra notes 14, 15, 30, 31, 47 and accompanying text (discussing scholarship and jurisprudence critical of the existing classification regime and control based analysis). See also Bruce Goldstein et al., Enforcing Fair Labor Standards in the Modern American Sweatshop: Rediscovering the Statutory Definition of Employment, 46 UCLA L. Rev. 983, 1106 (1999) (arguing that in adopting the much broader “suffer or permit” standard of employee status instead of the control test, “Congress’s purpose was precisely to expand coverage under the [Fair Labor Standards Act] far beyond the common law”).

 [9]. Throughout this paper I will rely on Isaiah Berlin’s canonical definitions of positive and negative freedom and Philip Pettit’s interpretation of freedom as non-domination. Isaiah Berlin, Two Concepts of Liberty 7–8, 16 (1958); Philip Pettit, On the People’s Terms: A Republican Theory and Model of Democracy 1–18 (2012); Philip Pettit, Republicanism: A Theory of Freedom and Government 19–27 (1997). See also Alex Gourevitch, From Slavery to the Cooperative Commonwealth: Labor and Republican Liberty in the Nineteenth Century 7–17 (2015); Gerald M. Stevens, The Test of the Employment Relation, 38 Mich. L. Rev. 188, 197–98 (1939) (arguing that American courts have “turned for guidance to a more certain and indisputable principle” in which “control must have meant . . . actual interference and superintendence”).

 [10]. Non-domination is most concerned with the presence or absence of boundaries on external interferences rather than with the interferences themselves. For illustrations using the sharing economy, see infra Section II.C. See also Pettit, On the People’s Terms, supra note 9, at 1–18.

 [11]. Deepa Das Acevedo, Temples, Courts, and Dynamic Equilibrium in the Indian Constitution, 64 Am. J. Comp. L. 555, 560 (2016).

 [12]. Kaushik Sunder Rajan, Anthropological Fieldwork Methods 1 (2015) (unpublished syllabus) (emphasis in original) (on file with author). Ethnography is often described as a research method based on participant-observation, and this description is not wrong. But Kaushik Sunder Rajan offers a far more nuanced take on the ethnographic method and its value in his syllabus for a graduate-level methods class at the University of Chicago. “What makes good ethnography work . . . ,” Sunder Rajan writes, “is the fact that the ethnographer is capable of attending to things that her interlocutors might attend to differently (ignore, naturalize, fetishize, valorize, take for granted, etc.).” Id. Consequently, “the fundamental problem of fieldwork involves the cultivation of attentiveness.” Id.

 [13]. See Coppage v. Kansas, 236 U.S. 1, 17 (1915), noted in Alan Story, Employer Speech, Union Representation Elections, and the First Amendment, 16 Berkeley J. Emp. & Lab. L. 356, 406–07 n.264 (1995); Bower v. Peate, 1 Q.B.D. 321 (1876), noted in O.W. Holmes, Agency, 4 Harv. L. Rev. 345, 347 n.3 (1891) (discussing the proposition that a master/servant relationship is no different than other agency relationships inasmuch as the servant’s actions are attributable to the master).

 [14]. See, e.g., Brishen Rogers, Am. Constitution Soc’y, Redefining Employment for the Modern Economy 3 (2016); Franklin G. Snyder, The Pernicious Effect of Employment Relationships on the Law of Contracts, 10 Tex. Wesleyan L. Rev. 33, 36 (2003); Roscoe T. Steffen, Independent Contractor and the Good Life, 2 U. Chi. L. Rev. 501, 507 (1935); Noah D. Zatz, Beyond Misclassification: Tackling the Independent Contractor Problem Without Redefining Employment, 26 ABA J. Lab. & Emp. L. 279, 282 (2011).

 [15]. V.B. Dubal, Wage Slave or Entrepreneur?: Contesting the Dualism of Legal Worker Identities, 105 Calif. L. Rev. 65, 93 (2017); Julia Tomasetti, The Contracting/Producing Ambiguity and the Collapse of the Means/Ends Distinction in Employment, 66 S.C. L. Rev. 315, 356 (2014); Nancy E. Dowd, The Test of Employee Status: Economic Realities and Title VII, 26 Wm. & Mary L. Rev. 75, 86 (1984).

 [16]. On the centrality of “freedom” in American work law see Christopher L. Tomlins, Law, Labor, and Ideology in the Early American Republic, at xv (1993) (describing various areas of nineteenth century law as “tending during the period under study to move toward a representation of working life in voluntaristic terms . . . [an] empowering definition of individual freedom”) and Marion Crain, Work, Free Will and Law, 24 Employ. Resp. & Rts. J. 279, 280 (2012) (discussing competing meanings of “work” in the United States but stating that “[t]he dominant image of work in American law is as an exercise of free will”).

 [17]. See, e.g., Boswell v. Laird, 8 Cal. 469, 489 (1857) (holding that “[s]omething more than the mere right of selection, on the part of the principal, is essential” to a master and servant relationship). Boswell added that “[t]he relation between the parties was that of independent contractors” because the co-defendants “were engaged in an independent employment in the construction of a work which was entrusted entirely to their skill.” Id at 490, 494. For discussions of the development of “employee” as a category of free labor during the nineteenth century, see generally Karen Orren, Belated Feudalism: Labor, the Law, and Liberal Development in the United States (1991); Robert J. Steinfeld, The Invention of Free Labor: The Employment Relation in English & American Law and Culture, 1350–1870 (1991); Tomlins, supra note 16; Christopher L. Tomlins, Law and Power in the Employment Relationship, in Labor Law in America 71 (Christopher L. Tomlins & Andrew J. King, eds., 1992); John Fabian Witt, Rethinking the Nineteenth-Century Employment Contract, Again, 18 Law & Hist. Rev. 627 (2000).

 [18]. Gasal v. CHS Inc., 798 F. Supp. 2d 1007, 1013 (D.N.D. 2011) (“The rationale for the doctrine of respondeat superior is based on the employer’s right to control the employee’s conduct.”).

 [19]. Perhaps the best indication that the control test’s persistence is itself an object of puzzlement and anxiety for labor and employment scholars is the frequency with which they refer to its inadequacy, complexity, unfairness, and attempted replacement. See, e.g., Guy Davidov, The Reports of My Death are Greatly Exaggerated: ‘Employee’ as a Viable (Though Overly-Used) Legal Concept, in Boundaries and Frontiers of Labour Law: Goals and Means in the Regulation of Work 133 (Guy Davidov & Brian Langille eds., 2006); Marc Linder, Dependent and Independent Contractors in Recent U.S. Labor Law: An Ambiguous Dichotomy Rooted in Simulated Statutory Purposelessness, 21 Comp. Lab. L. & Pol’y J. 187, 190 (1999); Stevens, supra note 9, at 203; Tomasetti, supra note 15, at 317–18.

 [20]. See infra notes 2227 and accompanying text.

 [21]. Civil Rights Act of 1964, 42 U.S.C. §§ 2000e-2–3 (2012). Note that the Civil Rights Act of 1866 does not limit its protection against racial discrimination in the formation of contracts (including employment contracts) to “employees.” 42 U.S.C. § 1981(a) (2012).

 [22]. Family and Medical Leave Act of 1993, 29 U.S.C. § 2611(4) (2012). Note that the FMLA adopts the FLSA’s “suffer or permit” definition of “employ.” Fair Labor Standards Act of 1938, 29 USC § 201, § 203(g) (2012).

 [23]. Equal Pay Act of 1963, 29 U.S.C. § 206(d) (2012).

 [24]. 29 USC § 201, §§ 203(d)–(e) (2012) (defining “employees” and “employers” to whom the Act applies); id. § 206 (establishing minimum wage provisions for employees); Portal to Portal Act of 1947, 29 U.S.C. §§ 251–262 (2012).

 [25]. Employee Retirement Income Security Act of 1974, 29 U.S.C. § 1002 (2012) (stating that ERISA only applies to “employees”). Note that ERISA does not require employers to offer any kind of health or retirement benefit plan at all—“it merely regulates retirement promises that are made.” Paul M. Secunda, The Behavioral Economic Case for Paternalistic Workplace Retirement Plans, 91 Ind. L.J. 505, 540 (2016). This is why “[t]he aggregate national retirement deficit number is currently estimated to be $4.13 trillion for all U.S. households where the head of household is between 25 and 64.” Id. at 507–08. Employer sponsored health and welfare plans were similarly voluntaristic; however, this began to change as a result of the “employer mandate” contained within the Patient Protection and Affordable Care Act, 42 U.S.C. §18001 (2012).

 [26]. Occupational Safety and Health Act of 1970, 29 U.S.C. §§ 651–52 (2012).

 [27]. National Labor Relations Act of 1935, 29 U.S.C. § 157 (2012).

 [28]. Although the Affordable Care Act did not entirely detach health insurance savings from work relationships, it created a system of “exchanges” on which individuals can purchase health insurance plans that are not contingent on employer sponsorship. King v. Burwell, 135 S. Ct. 2480, 2487 (2015) (“[T]he Act requires the creation of an “Exchange” in each State where people can shop for insurance, usually online.”) (citing 42 U.S.C. § 18031(b)(1)).

 [29]. See Alain Supiot, Beyond Employment: Changes in Work and the Future of Labour Law in Europe 26–57 (2001) (not rejecting the logic of tying safeguards to work even though one of its central conclusions was that the “employment relationship in its existing form has reached its limits”), noted in David Marsden, Introduction: Can the Right Employment Institutions Create Jobs?, in Labour Law and Social Insurance in the New Economy: A Debate on the Supiot Report 1, 3, 9 (David Marsden & Hugh Stephenson eds., 2001).

 [30]. Catherine K. Ruckelshaus, Labor’s Wage War, 35 Fordham Urb. L. J. 373, 378–83 (2008) (discussing the prevalence, costs to workers, and advantages to employers of misclassifying employees as independent contractors).

 [31]. See, e.g., NLRB v. United Ins. Co. of Am., 390 U.S. 254, 258 (1968); NLRB v. Hearst Publ’ns, Inc., 322 U.S. 111, 120–22 (1944), overruled in part by Nationwide Mut. Ins. Co., v. Darden, 503 U.S. 318 (1992); FedEx Home Delivery v. NLRB, 563 F.3d 492, 496–99 (D.C. Cir. 2009). Indeed, the Supreme Court of Mississippi’s frustration was such that it declared (in 1931) that,

[t]here have been many attempts to define precisely what is meant by the term “independent contractor;” but the variations in the wording of these attempts have resulted only in establishing the proposition that it is not possible within the limitations of language to lay down a concise definition that will furnish any universal formula, covering all cases.

Kisner v. Jackson, 132 So. 90, 91 (Miss. 1931).

 [32]. For this type of circular definition see, for example, Age Discrimination in Employment Act (ADEA) § 11(f), 29 U.S.C. § 630(f) (2012); Family and Medical Leave Act, 29 U.S.C. § 2611(3) (2006); Title VII, 42 U.S.C. § 2000e(f) (2012); Americans with Disability Act (ADA) § 101(4), 42 U.S.C. § 12111(4) (2012); Employee Retirement Income Security Act (ERISA) § 3, 29 U.S.C. § 1002(6) (2012).

 [33]. Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 325, 327 (citing Cmty. for Creative Non-Violence v. Reid, 490 U.S. 730 (1989) for the principle that “Congress means an agency law definition for ‘employee’ unless it clearly indicates otherwise” and stating that “[a]gency law principles comport . . . with our recent precedents and with the common understanding, reflected in those precedents, of the difference between an employee and an independent contractor”).

 [34]. See, e.g., Slingluff v. Occupational Safety & Health Review Comm’n, 425 F.3d 861, 867–68 (10th Cir. 2005) (applying Darden to the Occupational Safety and Health Act of 1970); Birchem v. Knights of Columbus, 116 F.3d 310, 312–13 (8th Cir. 1997) (applying Darden to the American with Disabilities Act of 1990); Frankel v. Bally, Inc., 987 F.2d 86, 89–90 (2d Cir. 1993) (applying Darden to the Age Discrimination in Employment Act of 1967).

 [35]. Carlson, supra note 3, at 298.

 [36]. See, e.g., West v. J.O. Stevenson, Inc., 164 F. Supp. 3d 751, 763 & n.6 (E.D.N.C. 2016) (noting that “in the labor relations context, the Fourth Circuit has instructed courts to examine only the economic realities of the employment relationship” because of “the more expansive definition of ‘employ’ used in the labor relations statutes” including the “FMLA or similarly-defined [FLSA]”).

 [37]. See id. See also U.S. v. Rosenwasser, 323 U.S. 360, 362–63 (1945) (noting that the FLSA definition of employment was created intentionally broad in order to fulfill the remedial purpose of the act); Zheng v. Liberty Apparel Co. Inc., 355 F.3d 61, 66 (2d Cir. 2003) (same).

 [38]. See, e.g., Lewis L. Maltby & David C. Yamada, Beyond “Economic Realities”: The Case for Amending Federal Employment Discrimination Laws to Include Independent Contractors, 38 B.C. L. Rev. 239, 249–50 (1997) (citing the pre-Darden case, Broussard v. L.H. Bossie, Inc., 789 F.2d 1158 (5th Cir. 1986), as an example of the continued importance of control even under the economic realities test).

 [39]. See id. at 249.

 [40]. See NLRB v. Hearst Publ’ns, Inc., 322 U.S. 111, 127 (1944) (“Unless the common-law tests are to be imported and made exclusively controlling, without regard to the statute’s purposes, it cannot be irrelevant that the particular workers in these cases are subject, as a matter of economic fact, to the evils the statute was designed to eradicate . . . .”). See also Keith Cunningham-Parmeter, From Amazon to Uber: Defining Employment in the Modern Economy, 96 B.U. L. Rev. 1673, 1677 (2016); Guy Davidov, The Three Axes of Employment Relationships: A Characterization of Workers in Need of Protection, 52 U. Toronto L.J. 357, 363–64 (2002); Linder, supra note 19, at 190.

 [41]. Alexander v. FedEx Ground Package Sys., 765 F.3d 981, 990–91 (citing Estrada v. FedEx Ground Package System, Inc., 64 Cal. Rptr. 3d 327, 336 (Ct. App. 2007), in which drivers subject to the same Operating Agreement as the Alexander plaintiffs were found to be employees based on “FedEx’s control over every exquisite detail of the drivers’ performance”).

 [42]. Ochoa v. McDonald’s Corp., 133 F. Supp. 3d 1228, 1239–40 (N.D. Cal. 2015) (allowing plaintiffs to move forward with their claim that McDonald’s is a joint employer alongside its franchisees on a theory of ostensible agency); Browning-Ferris Indus. of Cal., Inc., 362 N.L.R.B. No. 186, at 2 (2015) (revising the Board’s joint employer standard to require only “[r]eserved authority to control terms and conditions of employment” and that such control need not “be exercised directly and immediately”) (emphasis added).

 [43]. Goldstein et al., supra note 8, at 1094–1101 (arguing that Congress adopted the FLSA’s “suffer or permit” language from state child labor laws with the specific intention to ensure that the Act would cover workers not considered employees under the common law control test). Similarly, a 2016 Administrator’s Interpretation (AI) issued by the Obama Department of Labor specified that the Department would henceforth distinguish between “vertical” and “horizontal” joint employment and apply the “economic realities” test to determine vertical joint employer status instead of current FLSA regulations—a move that commentators immediately interpreted as reflecting “the agency’s longstanding priority to loosen joint employment standards.” Tammy McCutchen & Michael J. Lotito, DOL Issues Guidance on Joint Employment Under FLSA, Littler (Jan. 20, 2016), https://www.littler.com
/publication-press/publication/dol-issues-guidance-joint-employment-under-flsa. The AI was later withdrawn by the Trump Department of Labor. News Release, U.S. Dep’t of Labor,  US Secretary of Labor Withdraws Joint Employment, Independent Contractor Informal Guidance, Release No. 17-0807-NAT (June 7, 2017), https://www.dol.gov/newsroom/releases/opa/opa20170607.

 [44]. Dubal, supra note 15, at 85. A similar impulse led the Fourth Circuit to find that although Darden probably would not qualify as an employee under the control test, that outcome was inconsistent with ERISA’s purpose; consequently, they rejected it. Darden v. Nationwide Mut. Ins. Co., 796 F.2d 701, 705–06 (4th Cir. 1986), overruled in part by Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318 (1992).

 [45]. Davidov, supra note 40, at 367–68 (“Over the years, however, some courts—unsatisfied with the tests in their arsenal—have begun formulating a second test, this one aimed at the economic dependence of the worker.”).

 [46]. See, e.g., Cotter v. Lyft, Inc., 60 F. Supp. 3d 1067, 1075 (N.D. Cal. 2015); Cunningham-Parmeter, supra note 40, at 1677 (“scrutinizing the many sublayers of control” in order to outline “new methods for thinking about the concepts of ‘control’ and ‘employ’ that remain central to modem employment”).

 [47]. See, e.g., Katherine V. W. Stone, From Widgets to Digits: Employment Regulation for the Changing Workplace, at ix (2004) (discussing changes in work practices that demand new forms of regulation); Cynthia L. Estlund, The Ossification of American Labor Law, 102 Colum. L. Rev. 1527, 1530–32 (2002). On the importance of purposive statutory analysis, see, e.g., Brian A. Langille & Guy Davidov, Beyond Employees and Independent Contractors: A View From Canada, 21 Comp. Lab. L. & Pol’y J. 7, 12 (1999); Linder, supra note 19, at 187. See also Rachel Weiner & Lydia DePillis, How Congress Can Make Life Better for Uber Drivers and Bike Messengers, Wash. Post (June 3, 2015), http://wapo.st/1cytlM6?tid=ss_tw-bottom&utm_term=.3e485df68733 (quoting Sen. Mark Warner, D.-Virginia, as saying that “[the sharing economy] is a tidal change in the relationship between an individual and the workplace . . . . It’s stunning that nobody in Washington is talking about this”). It might even be that courts misrecognize the purpose of work law, in that they wrongly prioritize efficiency over other values like the ability to be free from subordination in a democratic society. Stephen F. Befort & John W. Budd, Invisible Hands, Invisible Objectives: Bringing Workplace Law and Public Policy into Focus 4–7 (2009) (making a similar argument with respect to work law’s devaluation of equity and voice); Brishen Rogers, Employment Rights in the Platform Economy: Getting Back to Basics, 10 Harv. L. & Pol’y Rev. 479, 500–05 (2016).

 [48]. Tomasetti, supra note 15, at 315.

 [49]. See, e.g., Sanjukta M. Paul, Uber as For-Profit Hiring Hall: A Price-Fixing Paradox and its Implications, 38 Berkeley J. Emp. & Lab. L. 233, 235 (2017); Dubal, supra note 15, at 123 (“Advocacy on behalf of taxi workers, for example, may involve engaging antitrust laws, regulatory laws, unfair competition laws, and even corporate laws.”). See also Ryan Calo & Alex Rosenblat, The Taking Economy: Uber, Information, and Power, 117 Colum. L. Rev. 1623, 1675 (2017) (advocating the use of consumer protection law). Intriguingly, both the antitrust and consumer protection arguments depend on taking seriously the platform argument that workers are consumers vis-à-vis the platforms through which they provide services.

 [50]. See Dubal, supra note 15, at 112 (drawing on ethnographic research among San Francisco taxi drivers for the observation that “though many [immigrant and non-white] drivers recognized the potential stability of being an employee, the status made them feel more out of control of their everyday lives”).

 [51]. Id. See also Yuval Feldman et al., What Workers Really Want: Voice, Unions, and Personal Contracts, 15 Emp. Rts. & Emp. Pol’y J. 237, 248 (2011) (“In other words, employees might gain more from personal contracts in terms of sense of influence and control, although in many cases they will have more limited bargaining power compared to unionized employees.”).

 [52]. FedEx Home Delivery, Inc. v. NLRB, 563 F.3d 492, 497 (D.C. Cir. 2009).

 [53]. Dubal, supra note 15, at 89–95 (tying the increasing importance of entrepreneurial opportunity in classifying workers to the rise of neoliberal ideology beginning in the 1970s).

 [54]. See Deepa Das Acevedo, Regulating Employment Relationships in the Sharing Economy, 20 Emp. Rts & Emp. Pol’y J. 1, 3–10 (2016) (arguing that platforms participate in the transactions they facilitate and substitute themselves for governmental safeguards, in contrast to “Renters” like Zipcar or “Swappers” like Couchsurfer).

 [55]. Id. It has become commonplace to preface any discussion of the sharing economy with the claim that there are no satisfactory taxonomies or definitions of this new space and by presenting a new taxonomy that can fill this definitional gap. See, e.g., Calo & Rosenblat, supra note 49, at 1466. But scholarship on the sharing economy is a few years old now and most commentators speaking from within scholarly or policy contexts have an understanding of what they and others are really interested in, even if that understanding is Potter Stewart-like in its articulation. See Jacobellis v. Ohio, 378 U.S. 184, 197 (1964) (Stewart, J., concurring).

 [56]. I applied for admission to the following sharing economy companies, not all of which are “platforms” according to the definition I use here and elsewhere, see supra note 54 and accompanying text: TaskRabbit, Instacart, Postmates, Rover, and Gigwalk. I was accepted by Instacart, Rover, and Gigwalk, and completed Instacart’s in-store training session, but did not work any shifts; I performed one “gig” on Gigwalk; and I established one client relationship (involving multiple visits) on Rover. I also viewed videos and completed online quizzes for the introductory course offered by Samaschool, an online provider of digital skills and internet-based work training that heavily incorporates platforms into its curriculum but does not exclusively focus on them. See Samaschool, http://www.samaschool.org (last visited Aug. 14, 2018).

 [57]. Scholars working on the sharing economy are increasingly mining online chat forums because of the relative difficulty in accessing sufficient numbers of platform workers for large-scale analysis and because opinions voiced on the forums have not been elicited for research purposes. See, e.g., Shu-Yi Oei & Diane M. Ring, The Tax Lives of Uber Drivers: Evidence from Internet Discussion Forums, 8 Colum. J. Tax L. 56, 66­–72 (2017) (using data from Reddit.com, Uberpeople.net, and the Intuit TurboTax AnswerXchange Forum and discussing methodological approaches to the use of online discussion forums as data sources); Alex Rosenblat & Luke Stark, Algorithmic Labor and Information Asymmetries: A Case Study of Uber’s Drivers, 10 Int’l J. Comm. 3758, 3760 (2016) (using data from five unnamed Uber driver chat forums).

 [58]. Although all the non-workers with whom I spoke are identified by name in this Article, I have anonymized all conversations with workers. This choice reflects a concern expressed to me by many workers about being identified while making critical comments regarding their platforms, even in the context of an academic research project. Indeed, I generally did not note down worker names in my field notes even though many of the workers I spoke with gave me their personal phone numbers for follow up conversations (I instead identified them by an interlocutor number, date, and location of interaction, much as they are referenced in footnotes below). I did record names for a few workers with whom I developed closer relationships, but our conversations continued based on an assumption of anonymity and are presented here accordingly.

 [59]. A few of these interlocutors, all of whom have been giving the issues surrounding platform labor careful thought for some time now and were generous enough to share their insights with me, include Kate Bahn, Todd Brogan, Harry Campbell, Ben Davis, Nicole DuPuis, Emily Guendelsberger, Kirk Hovenkotter, Michael McCall-Delgado, Jeremy Mohler, Mel Plaut, Alex Rosenblat, Becki Smith, and Katie Unger.

 [60]. Telephone Interview with Alex Rosenblat, Analyst, Data and Society (Aug. 11, 2016). See also Calo & Rosenblat, supra note 49, at 1634 (drawing on Rosenblat’s ethnography of Uber drivers).

 [61]. A survey of nearly 1,200 Uber and Lyft drivers revealed that 75.9 percent prefer to be independent contractors. Harry Campbell, 2018 Uber and Lyft Driver Survey Results, TheRideshareGuy (Feb. 26, 2018), https://therideshareguy.com/2018-uber-and-lyft-driver-survey-results-the-rideshare-guy.

 [62]. Sam is a composite figure based on my conversations with many platform workers. Sam’s demographic qualities are not intended to be representative of workers in any industry vertical or region: the few independent, large scale surveys we have of platform workers suggest that they are mostly young, white, and male. Still, his story reflects those of many of my interlocutors. On the profile of sharing economy workers, see, for example, Diana Farrell & Fiona Greig, JP Morgan Chase & Co. Inst., Paychecks, Paydays, and the Online Platform Economy: Big Data on Income Volatility 22 (2016); Andrew Jiang et al., The 2015 1099 Economy Workforce Report, Requests For Startups  30–39 (2015); Campbell, supra note 61.

 [63]. Many observers comment on the degree to which worker participation and satisfaction is dependent on a poor grasp of the financial realities of platform work or, at the very least, as a kind of bimodal distribution where the peaks represent considerable savvy and considerable ignorance. One researcher noted that many workers’ “financial logic is ‘whenever you’re making money you’re doing well’” but that “former professionals . . . are keeping spreadsheets at home.” Another felt that “even the folks who are making it work” fail to account for things like sick days, unexpected expenses, and vacation time as lost earning time. Telephone Interview with Alex Rosenblat, Analyst, Data and Society (Aug. 11, 2016); Telephone Interview with Katie Unger, Independent Labor Consultant (Aug. 8, 2016). My own fieldwork reflects the bimodal distribution of financial sophistication. See, e.g., Telephone Interview with TaskRabbit Tasker #1 (Sept. 12, 2016) (“I don’t do enough to pay any taxes on it, I’m exempt from taxes on it . . . because (a) I’m on a woman-owned business . . . and (b) I don’t make enough . . . to pay B&O taxes on it . . . I still have to claim the income but you know it’s nominal.”); Interview with Uber Driver #8, in Phila., Pa. (July 30, 2016) (“I’m supposed to be [tracking my expenses but] it’s too complicated . . . I’m gonna see after tax season how it worked out.”).

 [64]. Some of the more striking accounts of the realities of platform work include, Josh Dzieza, The Rating Game: How Uber and Its Peers Turned Us into Horrible Bosses, The Verge (Oct. 28, 2015), https://www.theverge.com/2015/10/28/9625968/rating-system-on-demand-economy-uber-olive-garden; Emily Guendelsberger, I Was an Undercover Uber Driver, My City Paper (May 7, 2015), http://mycitypaper.com/uberdriver; Sarah Kessler, Pixel and Dimed: On (Not) Getting By in the Gig Economy, Fast Company (Mar. 18, 2014), https://www.fastcompany.com/3027355/pixel-and-dimed-on-not-getting-by-in-the-gig-economy.

 [65]. Some commentators have suggested that platform workers enjoy even more freedom than the ability to decide when they will be available for work by opening a smartphone app or activating an online profile. In this view, even when workers are “active” on the platform, they can decide not to work because they have the option to decline client requests. However, as others have pointed out, this is simply the freedom we all possess to resist the demands of our jobs knowing that such resistance will produce disciplinary action or termination. Compare Seth D. Harris & Alan B. Kreuger, The Hamilton Project, A Proposal for Modernizing Labor Laws for Twenty-First-Century Work: The “Independent Worker” 9 (2015) (“Even if she does not turn off either app, she is not obligated to pick up any particular customer.”), with Ross Eisenbrey & Lawrence Mishel, Uber Business Model Does not Justify a New ‘Independent Worker’ Category, Econ. Pol’y Inst. (Mar. 17, 2016), https://www.epi.org/publication/uber-business-model-does-not-justify-a-new-independent-worker-category (“Uber drivers cannot keep their app on and monitoring potential riders and refuse to accept rides without incurring serious consequences, including being deactivated (i.e., fired) for having too low an ‘acceptance rate.’”). Note that Uber changed its official policy regarding deactivation in 2016 and that now, drivers should not be deactivated for low acceptance rates, but rather be subject to the smaller disciplinary measure of a temporary “time out” by being involuntarily logged out of the app. Harry Campbell, How to Take Advantage of Uber’s New Acceptance Rate Policy, TheRideshareGuy, (Aug. 5, 2016), https://therideshareguy.com/how-to-take-advantage-of-ubers-new-acceptance-rate-policy (describing the old acceptance rate policy, the new “time out” policy, and the benefits of being able to take longer to accept requests).

 [66]. Interview with Uber Driver #19, in Phila., Pa. (Aug. 14, 2016) (stating no more than 6 hours per day); Interview with Uber Driver #34, in Phila., Pa. (Sept. 3, 2016) (stating only weekends).

 [67]. Interview with Uber Driver #35, in Phila., Pa. (Sept. 3, 2016).

 [68]. Id.

 [69]. Interview with Uber Driver #42, in Phila., Pa. (Sept. 12, 2016) (“You leave, I put on some Spanish music . . . some hip hop . . . . I like it.”); Interview with Uber Driver #37, in Phila., Pa. (Sept. 4, 2016) (playing loud classical music during the ride); Interview with Uber Driver #57, in Phila., Pa. (Oct. 3, 2016) (waiting for twnty to thirty minutes, then targeting high-demand areas); Interview with Uber Driver #14, in Phila., Pa. (Aug. 6, 2016) (remaining parked in between rides).

 [70]. See generally What 2 Things Do You Wish You Knew Before You Started Hosting, Airbnbhostsforum.com (Sept. 27, 2016), https://airhostsforum.com/t/what-2-things-do-you-wish-you-knew-before-you-started-hosting/8133/37 (allowing users to recommend how to host).

 [71]. Marc Linder, Towards Universal Worker Coverage Under the National Labor Relations Act: Making Room for Uncontrolled Employees, Dependent Contractors, and Employee-Like Persons, 66 U. Det. L. Rev. 555, 556 (1989).

 [72]. See, e.g., Over/Uber, Comment to Advice to Addictive Personalities, UberPeople.net (Jan. 30, 2017), https://uberpeople.net/threads/advice-to-addictive-personalities.137449 (describing the “rush of thinking the ‘system’ or competing drivers have been outsmarted, the rider outwitted”).

 [73]. See Matt MacFarland, Uber’s Remarkable Growth Could End the Era of Poorly Paid Cab Drivers, Wash. Post (May 27, 2014), https://wapo.st/TOpLVu?tid=ss_tw-bottom&utm_term
=.282f4583ee7d  (“According to Uber, the median wage for an UberX driver working at least 40 hours a week in New York City is $90,766 a year.”).

 [74]. Interview with Uber Driver #34, in Phila., Pa. (Sept. 3, 2016) (describing a $200 per week goal); Interview with Uber Driver #51, in Phila., Pa. (Sept. 30, 2016) (describing a $200 per day goal); Interview with Lyft Driver #2, in Phila., Pa. (Mar. 22, 2017) (stating that he drives enough to cover his car payments).

 [75]. Dubal, supra note 15, at 69, 112–20. There may be parallel divisions in the rideshare context based on full-time versus part-time status rather than on race. See Campbell, supra note 61 (“When comparing full-time vs part-time drivers, we see a slight preference toward employee status from full-time drivers but a majority still want to be independent contractors.”).

 [76]. Dubal, supra note 15, at 117–20.

 [77]. Id. at 113–15.

 [78]. Id. at 111–14.

 [79]. Indeed, Pettit—quoting Kant, who was responding to Rousseau—says something like this when he observes that “[f]ind himself in what condition he will, the human being is dependent on many external things . . . But what is harder and more unnatural than this yoke of necessity is the subjection of one human being under the will of another. No misfortune can be more terrifying . . . .” Pettit, On the People’s Terms, supra note 9, at 44.

 [80]. M.C. Elish, Moral Crumple Zones: Cautionary Tales in Human-Robot Interaction 1–2 (We Robot, Working Paper Presented at We Robot Conference, 2016) (on file with author) (explaining “moral crumple zones” in the context of human-machine systems like airplane cockpit control and nuclear plant emergency protocols, and stating that “humans at the interface between customer and company are like sponges, soaking up the excess of emotions that flood the interaction but cannot be absorbed by faceless bureaucracy or an inanimate object”). Not having a human “crumple zone” is important for “employer” perceptions of self as well as lay or legal perceptions of the alleged employer. See, e.g., Lilly Irani, Difference and Dependence among Digital Workers: The Case of Amazon Mechanical Turk, 114 S. Atl. Q. 225, 226–27 (2015) (“The transformation of workers into a computational service . . . serves not only employers’ labor needs and financial interests but also their desire to maintain preferred identities; that is, rather than understanding themselves as managers of information factories, employers can continue to see themselves as much-celebrated programmers, entrepreneurs, and innovators.”).

 [81]. Noah Zatz, Beyond Misclassification: Gig Economy Discrimination Outside Employment Law, On Labor (Jan. 19, 2016), https://onlabor.org/beyond-misclassification-gig-economy-discrimination-outside-employment-law (discussing “the simmering concern about how customer feedback ratings may hard-wire discrimination into the supervisory techniques of gig economy platforms”).

 [82]. Farrell & Greig, supra note 62, at 5; Aaron Smith, Gig Work, Online Selling and Home Sharing, Pew Research Ctr. (Nov. 17, 2016), http://www.pewinternet.org/2016/11/17/gig-work-online-selling-and-home-sharing; Interview with Sarah Leberstein, Attorney, Nat’l Emp’t Law Project, in N.Y.C., N.Y. (July 28, 2016); Telephone Interview with Rebecca Smith, Deputy Director, Nat’l Emp’t Law Project (Aug. 30, 2016).

 [83]. Add Me to Another Driver-Partner’s Profile, Uber, https://help.uber.com/h/c736a696-3eac-422a-a7f7-7d61e532d7c8 (last visited Aug. 16, 2018).

 [84]. Indeed, the personal labor of Airbnb hosts has interesting implications for the acceptability of pink- and blue-collared work. Juliet B. Schor, Does the Sharing Economy Increase Inequality Within the Eighty Percent?: Findings from a Qualitative Study of Platform Providers, 10 Cambridge J. Regions, Econ. & Soc’y 263, 272–75 (2017) (discussing how platforms are getting white collar workers to perform pink- and blue-collar work by presenting the work as novel and technologically advanced). Pink collar work is work that is neither “white collar” (professional or managerial) nor “blue collar” (manual, whether skilled or unskilled); it is traditionally associated with clerical and secretarial office work, but often extends to other forms of personal service work that are similarly dominated by women. Emily Stoper, Women’s Work, Women’s Movement: Taking Stock, 515 Ann. Am. Acad. Pol. & Soc. Sci. 151, 156 (1991) (discussing pink collar jobs in the course of analyzing approaches to reducing the wage gap between men and women).

 [85]. Rebecca Smith & Sarah Leberstein, Nat’l Emp. L. Project, Rights On-Demand: Ensuring Workplace Standards and Worker Security in the On-Demand Economy 4 (2015).

 [86]. Lee et al., who first applied the term “algorithmic management” to platform work, describe it as a phenomenon enabled by “software algorithms that assume managerial functions and surrounding institutional devices that support algorithms in practice.” See Min Kyung Lee et al., Working with Machines: The Impact of Algorithmic and Data-Driven Management on Human Workers, 33 Ann. ACM Conf. on Hum. Factors in Computing Sys. 1603 (2015). They go on to study three “algorithmic features” of rideshare platforms: “passenger-driver assignment, the dynamic display of surge-priced areas, and the data-driven evaluation that uses acceptance rates and ratings.” Id at 1604. See generally Rosenblat & Stark, supra note 57 (seeming to expand this understanding of algorithmic management by also including minimum fares, rate cuts, and dispute resolution within its ambit). Regardless of one’s exact definition of algorithmic management, both “labor” and “capital” platforms clearly engage in it.

 [87]. Indeed, not all of the labor and employment problems considered by commentators who draw this distinction pertain to the regulation of work: sometimes, as with the JPMorgan report, labor and capital platforms are distinguished from one another because doing so tracks meaningful differences in who is participating, as well as how and why they are participating.

 [88]. I understand interference as the “removal, replacement or misrepresentation of one or more options” available to an individual. Pettit, On the People’s Terms, supra note 9, at 46. It is worth noting that Pettit views the attachment of a penalty as the “replacement” of one option with another that is different and less desirable (though perhaps not by much). Id. at 53. He also considers “misrepresentation” to include any action that “denies you the possibility of making a choice on the basis of a proper understanding of the options on offer” and lists “mesmerizing you with the prospect of extraordinary rewards” as one way of doing this. Id. at 55.

 [89]. Das Acevedo, supra note 7, at 42–43 (discussing these and other types of discipline established by platforms); Rosenblat & Stark, supra note 57, at 3761.

 [90]. Id. at 43–44 (discussing elite statuses). On codes of conduct, see Katie Benner, Airbnb Adopts Rules to Fight Discrimination By its Hosts, N.Y. Times (Sept. 8, 2016), https://nyti.ms/2cw2IsD, for a description of Airbnb’s new “community commitment” to non-discrimination that new and returning users must agree to before they can make bookings on the platform and Airbnb’s Nondiscrimination Policy: Our Commitment to Inclusion and Respect, Airbnb https://www.airbnb.com/help/article
/1405/airbnb-s-nondiscrimination-policy–our-commitment-to-inclusion-and-respect (last visited Aug. 16, 2018), for a description of Airbnb’s detailed non-discrimination policy—mostly geared towards hosts—that is powerfully reminiscent of Title VII and the ADA.

 [91]. See Rosenblat & Stark, supra note 57, at 3765–71 (discussing surge pricing). This is not to say that surge pricing succeeds in “mesmerizing” drivers into behaving according to the wishes of platforms—“don’t chase the surge” is standard advice to new drivers—but interference is not predicated on successful manipulation. Pettit, On the People’s Terms, supra note 9, at 55–56; Rosenblat & Stark, supra note 57, at 3766.

 [92]. Noam Scheiber, How Uber Uses Psychological Tricks to Push Its Drivers’ Buttons, N.Y. Times (Apr. 2, 2017), https://nyti.ms/2nMmDtc (discussing the use of earnings goals, among other things, to shape driver behavior “without giving off a whiff of coercion”).

 [93]. For instance, rideshare drivers complain frequently about acceptance rate and surge pricing policies, but seem to take less issue with elite status policies. See Lee et al., supra note 86, at 1603, 1608 (discussing disapproval of acceptance rate and surge pricing policies).

 [94]. An English employment tribunal poked fun at the interpretation of worker behavior as the result of good, but independently exercised business sense rather than as the product of a centralized authority, stating that “[t]he notion that Uber in London is a mosaic of 30,000 small businesses linked by a common ‘platform’ is to our minds faintly ridiculous.” Aslam v. Uber B.V., No. 2202550/2015, at 28 (Emp.’t Tribunals Oct. 28, 2016).

 [95]. In the neo-republican account, domination destroys freedom because it involves the power to restrict choice regardless of whether or not that power is actually exercised. To be sure, where domination leads to actual interference, the interference is itself also a manifestation of unfreedom. See, e.g., Pettit, On the People’s Terms, supra note 9, at 50.

 [96]. Much of the neo-republican literature refers to this state of affairs as vulnerability to the “arbitrary” will of another being, but Pettit rightly points out that modern English usage makes arbitrary a misleading choice of words: what matters isn’t the irrationality or unpredictability of the external will imposing itself upon you, but the fact that that will is uncontrolled by you in any meaningful sense. Compare Rogers, supra note 47, at 500 (using “arbitrary”), with Pettit, On the People’s Terms, supra note 9, at 58 (preferring “uncontrolled interference” to “arbitrary interference”).

 [97]. Pettit uses the terms “adaptation” and “ingratiation” instead of servility, but—at least in the employment context—these do not quite capture the sense of self-abnegation that I think worries critics. Pettit, On the People’s Terms, supra note 9, at 64–65.

 [98]. Like Sam, Alex is a composite figure.

 [99]. See Schor, supra note 84, at 272–74 (discussing the performance of pink and blue-collar tasks by white collar platform workers).

 [100]. One of the Uber drivers I interviewed said just this about his early experiences as a driver. He coped by switching off the app after completing just one ride per day until, after a few days, he felt he was sufficiently desensitized to handle more passengers without communicating his discomfort through his conversation. It took two more weeks for him to be comfortable driving full time. Interview with Uber Driver #24, in Phila., Pa. (Aug. 20, 2016).

 [101]. Another driver who emphasized his interests in psychology noted: “Sometimes somebody gets in your car and the best customer service you can provide is to say nothing . . . you can tell almost automatically . . . some people don’t have that gear but I know when to talk, when not to talk.” Interview with Uber Driver #26, in Phila., Pa. (Aug. 31, 2016).

 [102]. Food smells are a common topic of conversation on the Airbnb hosts’ forum. See, e.g., Guest Refuses to Stay Due to Smell?, Airbnbhostsforum.com (June 28, 2016), https://airhostsforum.com
/t/guest-refuses-to-stay-due-to-smell/5859; How Much Does Indian Food Smell Matter to Others?, Airbnbhostsforum.com (Oct. 11, 2016), https://airhostsforum.com/t/how-much-does-indian-food-smell-matter-to-others/8855.

 [103]. See Airbnb’s Nondiscrimination Policy, supra note 90.

 [104]. Workers—not just within the sharing economy—do often describe their efforts in somewhat heroic language. See, e.g., Dubal, supra note 15, at 119 (“As a taxi driver, I’m navigating San Francisco streets. My customer’s lives are in my hands as I take them from place to place. I am handling a weapon.”); Interview with Uber Driver #50, in Phila., Pa. (Sept. 19, 2016) (“I’m a superhero [because I get people to work].”). Uber has also added a tip feature in its app. Darrell Etherington, Uber Tipping Is Rolling Out to 121 U.S. and Canadian Markets Today, TechCrunch (July 6, 2017), https://techcrunch.com/2017/07/06/uber-tipping-is-rolling-out-to-121-u-s-and-canadian-cities-today.

 [105]. One of the drivers I spoke with expressed all these sentiments at once. Interview with Uber Driver #55, in Phila., Pa. (Oct. 1, 2016) (“I was Ubering so much I wasn’t getting much sleep . . . . Sometimes I do get a little angsty, I wanna get out there . . . you know, tuition’s due. The sad part [is that] I was thinking about retiring in four years . . . now Uber’s talking about driverless cars in four years so what I’m gonna do?”).

 [106]. To be clear, I am not using “unfree” in the sense that historians of nineteenth century labor law do. See, e.g., Robert J. Steinfeld, Coercion, Contract and Free Labor in the Nineteenth Century 33 (2001) (calling “unfreedom” the “coercion of labor through threats of corporal punishment or confinement”). Rather, I am using “unfreedom” to signal a less technical sense (albeit more aligned with agency law) that an individual’s actions are not her own to control.

 [107]. Changes need not only be of the job-negating variety. When TaskRabbit overhauled its system in 2014 from a bidding format to a selection and assignation format, it too effected systemic changes of the type being discussed here. Colleen Taylor, Through the Fire: What TaskRabbit Learned From Its Big Backlash, TechCrunch (Jan. 21, 2015), https://techcrunch.com/2015/01/21/through-the-fire-what-taskrabbit-learned-from-its-big-backlash.

 [108]. But cf. Calo & Rosenblat, supra note 49, at 1631. As rideshare expert Harry Campbell notes, technological obstacles to driverless cars are often both overestimated and underestimated. On the one hand, Tesla models are just a shade away from being able to do the work of navigating roadways. On the other hand, driving—especially driving for hire—involves far more than successfully decelerating or changing lanes. What happens when an Uber passenger vomits in a driverless vehicle? Or when a temporary roadblock is erected halfway down a one-way street? There will surely be technological fixes for these issues, but Campbell suggests that we are far from having them on hand. Moreover, he suggests that given the thickness of regulatory infrastructure in the United States, driverless transportation—whether in the form of individual cars or something analogous to Hyperloop—is likely to debut in a more flexible environment (with his personal pick being Dubai). Telephone Interview with Harry Campbell, TheRideshareGuy.com (Apr. 17, 2017).

 [109]. There are certainly strong connections between “uncertainty” on the one hand and “vulnerability” (as in the work of Martha Albertson Fineman) and “dependence” (as under the economic realities test) on the other hand. However, I have used uncertainty because it seems to best capture the source of platform workers’ vulnerability to and dependence on their platforms and consumers. See generally Sec’y Labor v. Lauritzen, 835 F.2d 1529, 1534 (7th Cir. 1987) (“For purposes of social welfare legislation, such as the FLSA, ‘employees are those who as a matter of economic reality are dependent upon the business to which they render service.’”) (citations omitted); Martha Albertson Fineman, The Vulnerable Subject and the Responsive State, 60 Emory L.J. 251 (2010) (arguing that vulnerability and dependence are inescapable aspects of the human condition and criticizing the extent to which they are overlooked in liberal law and policy analysis). Vulnerability has also been important to calls for a purposive approach to worker classification. See, e.g., Davidov, supra note 40, at 361.

 [110]. Over the course of the nineteenth century, the default rule for employment in the United States came to be that it exists “at will”—that is, so long (and only so long) as both parties are willing to uphold the contract. An employer does not have to offer cause or notice for terminating an employee, and vice versa. This principle, often called Wood’s Rule for its ostensible origins in Horace Gray Wood’s 1877 treatise Master and Servant, is usually captioned as allowing termination for “good reason, bad reason, or no reason at all.” See, e.g., Paul M. Secunda, Constitutional Employment Law: Zimmer’s Intuition on the Future of Employee Free Speech Law, 20 Emp. Rts & Emp. Pol’y J. 393, 405 (2016). The uniquely American nature of Wood’s Rule does not explain the dissatisfaction with control-based analysis I describe here because similar criticisms of control as an analytic rubric have been voiced in other contexts lacking at-will employment. See Jeremias Prassl, The Concept of the Employer 1–7 (2015) (discussing, primarily in the context of English law, the problem with control-based analysis that seeks to identify “employees”); Rachel Arnow-Richman, Just Notice: Re-Reforming Employment at Will, 58 UCLA L. Rev. 1, 48–57 (2010) (discussing the non-at-will systems in Canada, the UK, and various European countries); Langille & Davidov, supra note 47, at 15–16 (noting the importance of control to Canadian worker classification doctrine in a section titled “Our ‘Traditional’ Problem”).

 [111]. Calo & Rosenblat, supra note 49, at 1665.

 [112]. Fiverr’s Level System, Fiverr, https://www.fiverr.com/levels (last visited Aug. 16, 2018). Fiverr is an odd-job platform where clients can hire workers to perform a range of tasks, including anything from translating a document to designing a website. The platform began with the premise that all tasks would cost just $5, but it has since expanded its pricing approach into a complex system whereby workers gain the right to tailor the cost and nature of the services they offer as they climb Fiverr’s internally constructed hierarchy of elite service provider statuses. See Das Acevedo, supra note 7, 42–43 (discussing vetting and termination standards and the benefits that come with elite statuses across several platforms).

 [113]. See Noopur Raval & Paul Dourish, Standing Out From the Crowd: Emotional Labor, Body Labor, and Temporal Labor in Ridesharing, 19 ACM Conf. Comp.-Supported Cooperative Work & Soc. Computing 101 (“‘Pleasing the passenger’ is clearly an aspect of any ridesharing system, including traditional taxis, but it plays a much bigger role in crowd labor due to the specific intermediation of quantitative scores.”).

 [114]. Pettit, On the People’s Terms, supra note 9, at 64–67.

 [115]. Dzieza, supra note 64.

 [116]. Erving Goffman’s classic account of face-to-face encounters as “games” is particularly visible in the one-to-one or one-to-many interactions of the sharing economy. Goffman notes that in games like checkers or chess, the rules of the outside world are more or less suspended during the course of the interaction. Erving Goffman, Encounters: Two Studies in the Sociology of Interaction 26 (1961). When platform workers perform emotional labor, they are following their own internal “rules of the game” by ignoring gender and class stereotypes attached to pink and blue-collar tasks. Schor, supra note 84, at 272–74.

 [117]. Arlie Hochschild’s understanding of emotional labor remains definitive, as does her classic “flight attendant” illustration:

The flight attendant does physical labor when she pushes heavy meal carts through the aisles, and she does mental work when she prepares for and actually organizes emergency landings and evacuations. But in the course of doing this physical and mental labor, she is also doing something more, something I define as emotional labor. This labor requires one to induce or suppress feeling in order to sustain the outward countenance that produces the proper state of mind in others—in this case, the sense of being cared for in a convivial and safe place. This kind of labor calls for a coordination of mind and feeling, and it sometimes draws on a source of self that we honor as deep and integral to our individuality.

Arlie Russell Hochschild, The Managed Heart: Commercialization of Human Feeling 6–7 (1983).

 [118]. DRider85, Comment to Uber and Lyft Should Get Rid of 5 Star Ratings, UberPeople.net (Feb. 1, 2017), https://uberpeople.net/threads/uber-and-lyft-should-get-rid-of-5-star-ratings.137751.

 [119]. Written communication style—punctuation, vocabulary, and the use of politeness conventions, for example—reflects and shapes “real-world” dynamics. Naomi S. Baron and Rich Ling, Necessary Smileys and Useless Periods: Redefining Punctuation in Electronically-Mediated Communication, 45 Visible Language 46, 55 (2011) (observing that female study participants “were vocal about the importance of using emotion-tinged punctuation markers . . . both to express their ‘enthusiasm’ for the communications they were crafting as well as to soften messages that might otherwise seem overly direct”). When a TaskRabbit tasker texts immediately after receiving a client request with a series of short, enthusiastic questions liberally sprinkled with exclamation marks, she is not simply responding in a naturally excited or voluble way, she is trying to ingratiate herself with her client by demonstrating her interest in service as much as the Uber driver who unnecessarily asks her clients about restaurants.

  The centrality of emotional labor simply places platforms at the tail end of a very long line of service jobs in which the work to be done encompasses much more than the cleaning of a bathroom or the distribution of in-flight beverages, and where the affective dimensions of that work—and the display of pleasure in service—serve to refashion power disparities as good customer service. See generally Hochschild, supra note 117; Robin Leidner, Emotional Labor in Service Work, 561 Annals Am. Acad. Pol. & Soc. Sci. 81 (1999) (discussing McDonald’s fast food restaurants).

 [120]. In this vein, Hochschild distinguishes “surface acting”—in which “we deceive others about what we really feel, but we do not deceive ourselves”—from “deep acting”—in which “we make feigning easy by making it unnecessary.” Hochschild, supra note 117, at 33. She notes that “[t]he matter would be simpler and less alarming” if workers were “allowed to see and think as they like and required only to show feeling (surface acting) in institutionally approved ways” but that “[s]ome institutions have become very sophisticated in the techniques of deep acting; they suggest how to imagine and thus how to feel.” Id. at 49.

 [121]. Indeed, in one of the earliest first-hand journalistic accounts of platform work (and in the context of an article that was otherwise rather critical of the workings of ridesharing), Emily Guendelsberger observes that she was “weirdly proud” of the fact that she maintained a perfect five-star rating during her first few days as an Uber driver. Emily Guendelsberger, supra note 64.

 [122]. Scheiber, supra note 92.

 [123]. Id.

 [124]. Pettit, On the People’s Terms, supra note 9, at 65.

 [125]. See Scheiber, supra note 92 (describing various tools or approaches that Uber has developed using behavioral science insights to control driver desires as well as driver actions, including: having Uber employees adopt female personas when interacting with drivers, exploiting the “ludic loop” phenomenon by setting random, but concrete and constantly-shifting goals (e.g., “you’re $5.25 away from earning $330!”), offering work statistics and feedback in formats akin to video game scores to trigger competitive urges, and capitalizing on inertia and loss aversion by using automatic queuing features like “forward dispatch” to keep drivers on the road).

 [126]. Anthropologists have been thinking of resistance as more than self-conscious group protest for some time now. Sally Engle Merry, Resistance and the Cultural Power of Law, 29 Law & Soc’y Rev. 11, 15 (1995) (describing the movement toward understanding resistance as consisting of “subtle, unrecognized practices, such as foot-dragging, sabotage, subversive songs, and challenges to the law’s definition of personal problems in court”). See generally Rosenblat & Stark, supra note 57 (conducting a study of Uber driver chat forums that also speaks to the way drivers contest passenger and platform narratives). On “gaming” the system, see, for example, Nick Loper, How I Got on the Homepage of Fiverr and Earned $920 in 10 Days, Side Hustle Nation (Apr. 21, 2014), https://www.sidehustlenation.com
/fiverr-homepage-earned-920-in-10-days (describing several strategies for achieving a high-ranking on search results or a platform webpage). See also Advice to Addictive Personalities: Post of Over/Uber, UberPeople.net (Jan. 30, 2017), https://uberpeople.net/threads/advice-to-addictive-personalities
.137449 (describing the “rush of thinking the ‘system’ or competing drivers have been outsmarted, the rider outwitted”).

  Lastly, several commentators as well as several of my own interlocutors have described the practice of “going off app” by concluding an initial transaction or establishing repeat transactions directly between the worker and consumer. See, e.g., Kessler, supra note 64 (describing her initial guilt at accepting payment “off app,” but subsequent willingness to do so because of the unexpected difficulty in acquiring gigs); Conversation with Rover client #1, in Phila., Pa. (Jan. 19, 2017) (during which the client assumed we would schedule all sessions off the app); Interview with Uber Driver #25, in Phila., Pa. (Aug. 31, 2016) (describing the same practice involving ridesharing); Telephone Interview with Blow Me Worker #1 (Aug. 11, 2016) (describing how the stylist met new clients via the app and scheduled subsequent sessions with them directly).

 [127]. In other words, the uncertainty generated by the power dynamics of platform work—as well as the conformity and obsequiousness it prompts—constitute a “habitus,” or system of embodied tendencies that are “structured structures predisposed to function as structuring structures.” Pierre Bourdieu, Outline of a Theory of Practice 53 (1977).

 [128]. Tomasetti, supra note 15, at 366 (describing UCS as “the setting forth of detailed and extensive work rules in the written contract governing the work” and noting that it “is not just artifice disguising the alleged employer’s open-ended authority over production . . . but to some extent meaningfully directs the worker”).

 [129]. Id. at 368 (describing how many courts view upfront specification as removing the need for supervision rather than encoding supervision into the contract).

 [130]. Id. at 374 (discussing In re FedEx Ground Package Sys., Inc., 869 F. Supp. 2d 942 (N.D. Ind. 2012)).

 [131]. See, e.g., Alexander v. FedEx Ground Package Sys., 765 F.3d 981, 997 (9th Cir. 2014) (finding that FedEx drivers are employees).

 [132]. Tomasetti, supra note 15, at 368–76 (discussing several other examples of UCS analysis, including EEOC v. North Knox School Corp., 154 F.3d 744, 748 (7th Cir. 1998) (describing UCS analysis in a case involving school bus drivers); SIDA of Hawaii, Inc. v. NLRB, 512 F.2d 354, 358 (9th Cir. 1975) (containing similar analysis involving taxi drivers); and Brown v. Sears, Roebuck & Co., 31 Employee Benefit Cas. (BNA) 2467, 2470 (N.D. Ill. Sept. 24, 2003), aff’d, 125 F. App’x 44 (7th Cir. 2004) (containing similar analysis, but involving the employees of a Sears contractor that was responsible for selling and installing home improvements like roofs, gutters, and fences)).

 [133]. Tomasetti, supra note 15, at 325 (noting that the “UCS poses an intractable quandary for evaluating claims of control in employment status disputes and that the conundrum is rooted in the contradictory incorporation of master-servant authority into contract”). The results in FedEx cases where drivers are not found to be employees despite various forms of UCS-enabled authority seem counterintuitive because they clash with a vision of freedom as non-domination. Take two of the practices that FedEx presents in support of its position: drivers are free to subcontract their routes and they are not required to work specified hours. Alexander, 765 F.3d at 984–85. Both rightly suggest that FedEx does not engage in the kind of over-the-shoulder monitoring that would constitute violations of freedom-as-non-interference because the company is not telling a particular driver that she herself has to work these particular hours. Id. at 985. But drivers—and many commentators—feel that their freedom is nonetheless compromised for reasons that reflect an understanding of freedom as non-domination. For instance, drivers’ ability to subcontract is at the unlimited discretion of company officials, which raises familiar concerns like uncertainty and obsequiousness. Id. at 994. Likewise, drivers are not really free to work any hours they want because FedEx engages in highly sophisticated calculations to ensure that every driver works 9.5–11 hours daily, reports for pickup in the mornings, remains until all her packages are collected, and delivers certain packages at specific times—in other words, FedEx artificially and unilaterally limits drivers’ freedom ex ante so that they can “choose” to do exactly what FedEx desires. Id. at 984–85.

 [134]. See Eileen Silverstein, From Statute to Contract: The Law of the Employment Relationship Reconsidered, 18 Hofstra J. Lab. & Emp. L. 479, 482 (2001).

 [135]. Id. at 511.

 [136]. Waivers are generally assessed for indications that they were “knowing and voluntary,” and most courts make this determination using the capacious (and thus employer-friendly) “totality of the circumstances” standard. Id. at 484, 491 n.67. Congress did enact more stringent requirements for determining that a waiver was “knowing and voluntary” via the Older Workers Benefit Protection Act of 1990 (OWBPA), but most courts only apply the OWBPA’s seven-step analysis in cases involving the Age Discrimination in Employment Act. Id. at 488–92 & nn. 61–67.

 [137]. Id. at 493.

 [138]. And indeed, situations in which X changes the set of options available to Y (even by attaching a reward to one of the options) or situations in which X deceives or manipulates Y into picking a specific option are equally unlikely to constitute “free choice” under a vision of freedom as non-domination. Pettit, On the People’s Terms, supra note 9, at 50–56.

 [139]. See Silverstein, supra note 134, at 484; Tess Wilkinson-Ryan, Intuitive Formalism in Contract, 163 U. Pa. L. Rev. 2109, 2110, 2127 (2015) (stating that just as modern contract doctrine posits that “potentially enforceable deals (i.e., those that are supported by consideration and not illegal or unconscionable)” should be upheld “when the parties have objectively manifested assent,” “[t]he fact of assent seems, for the average consumer, to cleanse the transaction—to press the reset button, morally as well as legally” on the issue of enforceability).

 [140]. Gourevitch, supra note 9, at ch. 4. See also Carlson, supra note 3, at 310 (noting that “control over work was never the exclusive test of status for either respondeat superior or other statutory purposes”).

 [141]. Gourevitch, supra note 9, at 103.

 [142]. Id.

 [143]. See infra notes 155–56, 159–60.

 [144]. Fair Labor Standards Act of 1938, 29 USC § 201, §§ 203(d)–(e) (2012); Rutherford Food Corp. v. McComb, 331 U.S. 722, 727–30 (1947) (applying the economic realities test to the FLSA). Of course, the economic realities test was not originally limited to, or even articulated with respect to, the FLSA. See, e.g., United States v. Silk, 331 U.S. 704, 717–20 (1947) (elaborating the economic realities test in a case involving the Social Security Act); NLRB v. Hearst Publ’ns, Inc., 322 U.S. 111, 127–29 (1947) (articulating the rationale underlying the economic realities test in a case involving the NLRA);  Carlson, supra note 3, at 311–14 (discussing analysis consonant with the economic realities test in Lehigh Valley Coal v. Yensavage, 218 F. 547 (2d Cir. 1914).

 [145]. See, e.g., Katherine V. W. Stone, Legal Protections for Atypical Employees: Employment Law for Workers Without Workplaces and Employees Without Employers, 27 Berkeley J. Emp. & Lab. L. 251, 257­–59 (2006).

 [146]. Bruce Goldstein et al., Enforcing Fair Labor Standards in the Modern American Sweatshop: Rediscovering the Statutory Definition of Employment, 46 UCLA L. Rev. 983, 1043 (1999) (tracing the historical meaning of “suffer or permit” and arguing that, in the state child labor statutes from which it originates, the phrase meant that “when a business owner had the means to know and the power to prevent acts proscribed by the legislature, it made no difference whether the owner’s employee or an independent contractor engaged a minor child to perform the work”).

 [147]. Browning-Ferris Indus. of Cal., Inc., 362 N.L.R.B. No. 186 (2015).

 [148]. Erin Conway & Caroline Fichter, Surviving the Tempest: Franchisees in the Brave New World of Joint Employers and $15 Now, 35 Franchise L.J. 509, 515 (2016) (observing that the “change in the NLRB employer test is vehemently opposed by the International Franchise Association (IFA) and bemoaned as the end of franchising altogether by some”) (citations omitted); David J. Kaufmann et al., A Franchisor Is Not the Employer of its Franchisees or Their Employees, 34 Franchise L.J. 439, 448–52 (2015) (discussing the dangerous implications of Browning-Ferris and the McDonald’s inquiry on business-format franchisors).

 [149]. Browning-Ferris, 362 N.L.R.B. No. 186, at 2 (emphasis in original).

 [150]. Id.

 [151]. NLRB Office of the General Counsel Issues Consolidated Complaints Against McDonald’s Franchisees and Their Franchisor McDonald’s, USA, LLC as Joint Employers, NLRB.gov (Dec. 19, 2014), https://www.nlrb.gov/news-outreach/news-story/nlrb-office-general-counsel-issues-consolidated
-complaints-against.

 [152]. In 2016, the Board affirmed and built on its Browning-Ferris precedent by holding that solely employed workers and jointly employed workers need not obtain employer assent if they wish to form a single (and otherwise appropriate) bargaining unit. Miller & Anderson, Inc., 364 N.L.R.B. No. 39, at 13–14 (2016).

 [153]. See generally Hy-Brand Indus. Contractors, 365 N.L.R.B. No. 165 (2017). However, the NLRB later vacated Hy-Brand and in 2018 undertook an unusual notice-and-comment rulemaking process on the joint-employer standard. Board Vacates Hy-Brand Decision, NLRB.gov (Feb. 26, 2018), https://www.nlrb.gov/news-outreach/news-story/board-vacates-hy-brand-decision; NLRB Considering Rulemaking to Address Joint-Employer Standard, NLRB.gov (May 9, 2018), https://www.nlrb.gov
/news-outreach/news-story/nlrb-considering-rulemaking-address-joint-employer-standard.

 [154]. See infra notes 155, 159–60.

 [155]. See, e.g., Linder, Towards Universal Worker Coverage Under the National Labor Relations Act, supra note 71, at 555 (calling the Taft-Hartley amendments to the NLRA “[s]tatutory encouragement” for “[o]ne of the successful tactics employers have used in recent years to rid themselves of existing labor unions and to avoid collective bargaining”—namely the reclassification of employees as independent contractors).

 [156]. Sean Farhang & Ira Katznelson, The Southern Imposition: Congress and Labor in the New Deal and Fair Deal, 19 Stud. Am. Pol. Dev. 1, 12–15 (2005) (describing southern efforts to shield the remnants of antebellum work structures from the New Deal by carving out statutory exclusions for predominantly black labor); Marc Linder, Farm Workers and the Fair Labor Standards Act: Racial Discrimination in the New Deal, 65 Tex. L. Rev. 1335, 1336 (1987) (same). See also Vivien Hart, Minimum-Wage Policy and Constitutional Inequality: The Paradox of the Fair Labor Standards Act of 1938, 1 J. Pol’y Hist. 319, 337 (1989) (discussing the original version of the FLSA and observing that “because of the segregated, stereotyped, and regional structure of the job market, excluded workers were disproportionately women and from minorities”).

 [157]. NLRB v. Hearst Publ’ns, 322 U.S. 111 (1944); Carlson, supra note 3, at 322–24 (discussing Taft-Hartley as a response to Hearst); Dubal, supra note 15, at 82–84 & nn. 48–53 (discussing the importance of business interests in motivating the 80th Congress’s efforts to unravel New Deal legislation and referencing prior scholarship arguing the same).

 [158]. Clifford Geertz, Deep Play: Notes on the Balinese Cockfight, in The Interpretation of Cultures 412, 449 (1973).

 [159]. Carlson, supra note 3, at 298; Jeffrey M. Hirsch, Employee or Entrepreneur?, 68 Wash. & Lee L. Rev. 353, 360–61 (2011) (discussing the power of federal appellate courts, and especially of the D.C. Circuit, with respect to labor law generally and the NLRB in particular).

 [160]. See, e.g., Cunningham-Parmeter, supra note 40, at 1704 (“Many judges narrowly construe the meaning of control because no clear standard exists to outline the boundaries of employer-employee relationships.”); Tomasetti, supra note 15, at 336 & n.110 (citing various scholars who argue that one explanation for “the legal uncertainty regarding employment status is that the legal standards are hopelessly imprecise and unwieldy”).

 [161]. Charles W. McCurdy, The “Liberty of Contract” Regime in American Law, in The State and Freedom of Contract 161, 165 (Harry N. Scheiber ed., 1998) (“[N]o amount of thoughtful revisionism can erase the fact that the ‘principle of neutrality’ did not have a uniform operation . . . the freedom of contract decisions handed down by American courts beginning in the 1880s showed ‘a definite bias of policy’ against statutes favoring ‘the interest . . . of labor.’”); Matthew J. Lindsay, In Search of “Laissez-Faire Constitutionalism,” 123 Harv. L. Rev. F. 55, 55, 57 (2010) (describing the “progressive” critique of Lochner era jurisprudence as emphasizing the judiciary’s identification “with the nation’s capitalist class” and its “contempt for any effort to redistribute wealth or otherwise meddle with the private marketplace,” and juxtaposing this with a second critique, according to which “the Lochner era is best understood not as a politically motivated binge of judicial activism, but rather as a sincere and principled, if sometimes anachronistic effort” to distinguish valid economic legislation and invalid “class” legislation).

 [162]. Browning-Ferris Indus. of Cal., Inc., 362 N.L.R.B. No. 186 (2015).

 [163]. Cotter v. Lyft, Inc., 60 F. Supp. 3d 1067 (N.D. Cal. 2015).

 [164]. Scholars who might subscribe to the label “New Legal Realist” employ a variety of approaches. See, e.g., Bryant Garth & Elizabeth Mertz, Introduction: New Legal Realism at Ten Years and Beyond, 6 U.C. Irvine L. Rev. 121, 123 n.10 (2016) (describing a “big tent” New Legal Realism that extends beyond the quantitative and economics-oriented framework represented by Miles and Sunstein); Thomas J. Miles & Cass R. Sunstein, Introduction: The New Legal Realism, 75 U. Chi. L. Rev. 831, 831, 834 (2008) (describing the understanding of judicial personality using “testable” metrics as “[a] distinguishing feature of the New Legal Realism”).

 [165]. Cotter, 60 F. Supp. 3d at 1081.

 [166]. Id.

 [167]. Id. See also id. at 1078–79 (listing various behavioral controls imposed by Lyft, like “not to talk on the phone with a passenger present”).

 [168]. Id. at 1079.

 [169]. See id. (observing that “Lyft reserves the right to ‘investigate’ and ‘terminate’ drivers who have ‘behaved in a way which could be regarded as inappropriate’” and that termination might result from declining or accepting and then declining “too many” ride requests).

 [170]. Id. The “at-will” rule has interesting, shifting implications for the dual conceptions of freedom I describe here. At-will employment is characterized by uncertainty and potential power—formally enjoyed by both parties, but in practice mostly beneficial to the employer. When the at-will nature of a particular relationship is used to characterize it as one of employer-employee, the at-will rule is indexing a loss of freedom as non-domination. But when taken generally, the rule represents a valuation of freedom as non-interference: it is liberty-enabling because it eliminates all but the most minimal intrusions on an employee’s decision to work and an employer’s decision to offer work. On the practical effect of the at-will rule see, e.g., Jay M. Feinman, The Development of the Employment-at-Will Rule Revisited, 23 Ariz. St. L.J. 733, 736 (1991) (“Whatever its status as a formal presumption, Wood’s rule represented a signal to the courts to view skeptically employees’ evidence of contracts of long duration.”).

 [171]. Whether they are “piecemeal” or “systemic,” the approaches I have in mind would focus both on (1) reducing the importance of the “employer”–worker binary as a funneling mechanism for safeguards and (2) searching for an analytic rubric other than control and freedom with which to funnel those safeguards. In terms of piecemeal reforms, we might continue to distance health and retirement benefits from worker classification in the vein of the Affordable Care Act and various “portable benefits” plans. See supra note 28 and accompanying text; Deepa Das Acevedo, Addressing the Retirement Crisis with Shadow 401(k)s, 92 Notre Dame L. Rev. Online 38, 41& nn. 16–17 (2016). Or, we might say that since Uber creates public risk when it facilitates transportation, it has to account for that risk to the public by providing auto insurance or personal liability coverage to individual drivers. That kind of rule would not require use to measure the amount of control in an “employer”–worker binary, but it would still use that binary to channel work-related safeguards.

 [172]. Constructing a new analytic rubric for determining who gets work-related safeguards and obligations may not be an impossible task, but it is certainly a daunting one and outside the scope of this Article.

A Regulatory Framework for Exchange-Traded Funds – Article by Henry T. C. Hu & John D. Morley

From Volume 91, Number 5 (July 2018)
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A Regulatory framework for EXCHANGE-TRADED fUNDS[*]

Henry T. C. Hu and John D. Morley[†]

This is the first academic work to show the need for, or to offer, a regulatory framework for exchange-traded funds (ETFs). The economic significance of this financial innovation is enormous. U.S.-listed ETFs now hold more than $3.6 trillion in assets and comprise seven of the country’s ten most actively traded securities. ETFs also possess an array of unique characteristics raising distinctive concerns. They offer what we here conceptualize as a nearly frictionless portal to a bewildering, continually expanding universe of plain vanilla and arcane asset classes, passive and active investment strategies, and long, short, and leveraged exposures. And we argue that ETFs are defined by a novel, model-driven device that we refer to as the “arbitrage mechanism,” a device that has sometimes failed catastrophically. These new products and the underlying innovation process create special risks for investors and the financial system.

Despite their economic significance and distinctive risks, ETFs remain a regulatory backwater. The United States has neither a dedicated system of ETF regulation nor even a workable, comprehensive conception of what an ETF is. A motley group of statutes divide similar ETFs into a plethora of different regulatory cubbyholes that were originally intended for very different vehicles such as mutual funds, commodity pools, and operating companies. Other regulatory constraints center on a process of discretionary review that generally allows the Securities and Exchange Commission (“SEC”) to assess the merits of each proposed ETF on an ad hoc, individualized basis. This process of review is opaque and unfocused. It is also inconsistent over time, with the effect that older funds often operate under lighter regulation than newer ones. And because it has its roots in statutes originally designed for other kinds of vehicles, the regulation of ETFs fails to address the ETF’s distinctive characteristics. Rooted in a disclosure system largely designed for mutual funds, the SEC’s disclosure mandates for ETFs fail to comprehend the significance and complexities of the arbitrage mechanism and often require no public disclosure of major breakdowns in the mechanism’s workings.

Our proposal contemplates a single regulatory framework for all ETFs. The treatment of all ETFs would be unified. This systematic approach, rooted in the arbitrage mechanism common to all ETFs, would largely displace the hodge-podge of regulatory regimes that vary widely across both the different ETF regulatory cubbyholes in use today and different ETFs within each such cubbyhole. The functional elements of the framework would streamline and rationalize the creation, substantive operations, and disclosure of all ETFs. Such elements would include a shift away from ETF-by-ETF discretionary review and toward written rules of general applicability. In terms of the creation of ETFs, we would narrow the range of ETFs subject to close substantive scrutiny while retaining some discretion for the SEC to address concerns related to the arbitrage mechanism or related structural engineering issues, risky or complex ETFs not adequately addressed by suitability rules and investor education, and large negative externalities. In terms of disclosure, we contemplate quantitative and qualitative information addressing what we here call “trading price frictions,” such as those relating to the performance of the arbitrage mechanism and related engineering during the trading day, model-related complexities, and evolving understandings and conditions.

Table of Contents

INTRODUCTION

I. The ETF’s Defining Characteristic: The Arbitrage Mechanism

A. The Theory

B. Patterns in Real World Performance

II. The Existing Regulatory State of Affairs: Substantive Aspects

A. Overview, with a Focus on Pathologies in
Administrative Process

B. Fragmentation

C. Discretion

D. An Example: The ForceShares Funds

III. The Existing Regulatory State of Affairs: Disclosure Aspects

A. Overview, with a Focus on Failures to Respond to Unique Characteristics of ETFs

B. The Arbitrage Mechanism: Disclosures of a Quantitative Nature

C. The Arbitrage Mechanism: Disclosures of a Qualitative Nature

IV. Our Proposed Regulatory Framework:
Substantive Aspects

A. The General Rationales for a Single Framework for
All ETFs

B. Functional Elements: Content of the Rules

C. Functional Elements: Scope and Nature of SEC
Discretion

V. Our Proposed Regulatory Framework:
Disclosure Aspects

A. The Single Regulatory Framework: Disclosure-Specific Considerations and the Correlative Functional
Element of ETF Self-Identification

B. Functional Elements: Quantitative Information
on Trading Price Frictions—Trading Day Deviations
from NAV and Bid-Ask Spreads

C. Functional Elements: Qualitative Information—an
MD&A-Style Approach to the Arbitrage Mechanism
and Related Matters

1. The Proposal and Its Basic Logic

2. The Contemplated MD&A-Style Information: Additional
Benefit and Cost Considerations

CONCLUSION

Appendix: Summary of June 2018 SEC Proposal

 



INTRODUCTION

The exchange-traded fund (ETF) is one of the key financial innovations of the modern era. The ETF, a new vehicle for collective investment, now stands alongside shares of individual companies, mutual funds, and hedge funds as one of the most important investments in the world. Seven of the ten most actively traded securities in the United States in 2016 were ETFs,[1] and the trading volume of shares in the SPDR S&P 500 ETF (SPY) exceeded the trading volume of shares in Apple, the world’s most valuable company.[2] Assets in U.S.-based ETFs multiplied more than 35-fold from year-end 2002 to July 30, 2018 (to $3.61 trillion), more than ten times the three-fold increase over that same period in the assets of mutual funds, the paradigmatic vehicle for collective investment.[3] As of September 30, 2017, each of the top fifteen holdings of Bridgewater Associates, the world’s largest hedge fund, was an ETF.[4] In January 2018, worldwide ETF assets reached $5 trillion.[5]

Individual ETFs and the process through which they evolve and through which new types of ETFs are invented, commercially introduced, and diffused in the marketplace together constitute a phenomenon that is not only financially significant, but also idiosyncratic in raising distinctive issues vital to investors and society.[6] ETFs offer a unique investment premise to both individual and institutional investors: what we here conceptualize as a nearly “frictionless,” often low-cost portal to a bewildering, continually expanding universe of plain vanilla and arcane asset classes, passive and active investment strategies, and long, short, and leveraged exposures.[7]

ETFs are nearly frictionless in the sense that, throughout the trading day, they offer almost instantaneous access to and exit from investment exposures at prices that closely reflect the value of the assets an ETF holds. But this frictionless exposure depends largely on the effectiveness of a novel, theory-driven device that we refer to as the “arbitrage mechanism.” We believe the arbitrage mechanism to be the ETF’s defining characteristic, because it is absent from the market microstructure of all other traded securities and from the ETF’s closest cousins, the mutual fund and the closed-end fund. The arbitrage mechanism’s effectiveness is essential to the integrity of ETF trading prices and the ETF’s core investment premise. And this mechanism has sometimes failed catastrophically, even with very large and simple ETFs.

Certain ETFs may pose heightened risks for investors and threaten to create negative externalities for financial markets. An ETF involving leveraged or leveraged inverse exposures or arcane, illiquid, or small asset classes might not only have a less effective arbitrage mechanism or unanticipated risk-return pattern, but also might disrupt asset prices in financial markets. An ETF offering straightforward long exposure to a small asset class may grow so large as to distort the market for that asset class, thus undermining not only the integrity of that market, but also the ETF’s ability to deliver on its investment premise. This appears to have occurred, for instance, with an ETF invested in junior gold mining stocks. Under certain circumstances, even plain vanilla investing strategies in which ETFs are playing an increasingly important role may, at least in the view of some observers, raise the possibility of material externalities. For example, if the overall assets of ETFs, mutual funds, and other market participants tracking the Standard & Poor’s (“S&P”) 500 Index grow large enough, a combination of the concentration in assets held, investor panic in the face of volatility, and expectations of easy exit might raise systemic risk concerns.

Despite the ETF phenomenon’s importance, it remains a regulatory and academic backwater. America has neither a dedicated system of ETF regulation, nor even a workable, comprehensive legal conception of what an ETF is. ETFs are subject to extensive regulation, but none of this regulation was developed with ETFs in mind. ETF regulation spills haphazardly from an odd mix of stock exchange listing rules and a motley group of statutes designed for older, fundamentally different products. The United States has almost no written rules that address the distinctive problems of ETFs directly, thus forcing ETFs to squeeze into regulatory cubbyholes intended for different vehicles like mutual funds, commodity pools, and even ordinary operating companies.[8] Appropriate ETF regulation is so lacking that the SEC has managed to hold it together mainly through a system of highly improvisatory, ad hoc administrative review generally applicable at the moment of each new fund’s proposed creation.

This regulatory state of affairs causes two basic types of problems: first, it introduces pathologies to the process of regulatory administration, and second, it fails to address the ETF phenomenon’s most distinctive characteristics. The pathologies of administrative process are almost inevitable given how ETF regulation is fragmented across a series of different statutes that impose disparate rules on functionally identical funds. Current ETF regulation is also excessively discretionary. Whether a proposed ETF can be introduced usually depends on the SEC granting the request of the ETF sponsor for ad hoc, individualized, exemptive relief and, sometimes, SEC approval of the individualized request of the listing exchange for a listing exchange rule change. In this process, the SEC’s professional staff engages in a substantive review of the proposed ETF and decides, with few meaningful statutory or administrative limits, whether to allow the fund to be introduced and, if so, what conditions the fund must comply with when in operation. This process is unfocused and sometimes opaque even to industry professionals, and the process inhibits innovation through its unpredictability, cumbersomeness, and complexity.

The current state of regulatory affairs also has the practical effect of grandfathering older ETF sponsors into more permissive rules than newer ones. Procrustean responses to proposed ETFs that offer leveraged or leveraged inverse exposures, for example, fail to deal with root issues and, in favoring certain older ETF sponsors, create unlevel playing fields. Some older ETF sponsors are able to introduce new ETFs through a relatively abbreviated process. In contrast, newer ETF sponsors may have to confront a more intensive substantive review.

Running beneath these problems is a failure to systematically recognize and respond to the ETF phenomenon’s unique characteristics. The most distinctive feature of the ETF is its arbitrage mechanism. The purpose of this mechanism is to help bring together the price at which an ETF’s shares trade on a stock exchange and the pro rata value of the fund’s underlying assets, which is known as its net asset value (NAV).[9] This parity between trading price and NAV is essential to an ETF’s unique role as a nearly frictionless, nearly universal, financial portal. The arbitrage mechanism poses risks, because it relies entirely on market incentives to lead certain “authorized participants” (APs) to enter into just the right transactions at just the right times with an ETF and traders in the secondary market so that the trading price of a share will be close to the share’s NAV.

ETF disclosure regulation, however, pays little attention to what we call “trading price frictions,” such as those related to ineffective arbitrage mechanisms or bid-ask spreads. An effective arbitrage mechanism is essential to the investment premise of the ETF; yet SEC disclosure rules deal badly with simple matters like the past performance of the arbitrage mechanism, raising a serious risk of investor complacency. Bid-ask spreads faced by investors whenever they buy or sell ETF shares on a stock exchange, which can be significant to returns from investing in ETFs, are outside the purview of SEC disclosure mandates. This is largely because most ETFs are subject to a longstanding system of financial disclosure largely designed for mutual fundsa financial product that has no such trading price frictions because, unlike ETFs, its shares do not trade.[10] Thus no arbitrage mechanisms or bid-ask spreads can exist in the mutual fund context. The disclosure system focuses on changes in NAV, certain operating expenses, and various sales loads and redemption fees, because these are the main concerns of mutual fund investors. But with ETFs, trading price frictions associated with the performance of the arbitrage mechanism and bid-ask spreads can be critical to investor decision-making.

The arbitrage mechanism sometimes has failed catastrophically in periods of market stress. On February 5, 2018, the shares of an arcane, “inverse volatility” ETF, with about two billion dollars in assets the prior trading day, closed at a trading price roughly eighteen times its NAV—and suffered a 96% drop in its NAV to boot.[11]

Even plain vanilla ETFs can experience deviations from NAV that are surprising in at least two ways. First, major deviations from NAV have occurred even in the ETFs that are least subject to such deviations. Early on August 24, 2015, major deviations from NAV occurred with respect to a number of large, well-established ETFs offering simple passive long exposure to broad portfolios of highly liquid domestic stocks. During the May 6, 2010 flash crash, the arbitrage mechanism of many ETFs invested in domestic equities “failed dramatically for approximately 20 minutes” to similar effect, in the words of one large ETF sponsor.

Second, although trading rules and other market structure factors can be important to the effectiveness of the arbitrage mechanism and must be continually monitored, ETF-specific factors can also matter. For instance, large, well-established ETFs subject to identical market structures could experience striking differences in deviations. Early on August 24, 2015, the country’s second-largest ETF—one tracking the S&P 500—traded markedly below its NAV while the country’s largest ETF—one also tracking the same index—traded at or slightly above its NAV. The two ETFs invested in nearly identical highly liquid shares of domestic companies in identical proportions and were subject to the same market structure and market conditions. Something specific to these ETFs must have mattered, be it in terms of differences in APs, arbitrage mechanisms, clienteles, or otherwise.

Yet the SEC’s mandatory disclosure regime for past performance did not require any of the ETFs suffering extraordinary deviations on August 24, 2015 to make either quantitative or qualitative disclosures about their occurrence. Nor did the regime require any such ETF to set out any analysis of possible reasons for the deviations it experienced.

As a result, the SEC’s system of required disclosures can contribute to investor complacency, if not misunderstanding. Using the SEC-mandated arbitrage mechanism performance scorecard, the country’s second-largest ETF properly and accurately reported a perfect “100.00” percent performance for a period that included August 24, 2015, despite the major deviation it suffered early that day. The key item of qualitative disclosure of past performance, the “Management’s Discussion of Fund Performance” (MDFP), was largely developed with mutual funds in mind, a product that has no arbitrage mechanism. The MDFP nowhere specifies discussion of the past performance of the arbitrage mechanism, and ETFs appear to have interpreted it as not requiring such a discussion.

ETF disclosure regulation also fails to properly respond to the model-based nature of the arbitrage mechanism, something especially surprising given the major model-related disruptions associated with the modern process of financial innovation.[12] The arbitrage mechanism and its effectiveness vary among ETFs, depending on, among other things, the assets an ETF holds. Irrespective of particulars, every arbitrage mechanism embodies a theoretical model hypothesizing the voluntary behavior of APs and other market participants in a variety of circumstances. Like all models, this model depends on assumptions and suffers from “model risk”—the risk that the model may be faulty. It is difficult to ascertain how realistic the assumptions are and how robust the model is to failures to satisfy the assumptions. Moreover, a model developed assuming a certain business, legal, and regulatory environment may work quite differently when the environment changes. These model-related uncertainties are especially large before an ETF actually starts trading and the model is tested and validated in the real world. The first few generations of investors in an ETF serve, in effect, as the participants in a clinical trial of safety and efficacy, not unlike the participants in trials required for new drugs by the Food & Drug Administration. These uncertainties magnify as ETFs grow more arcane or complicated.

ETF regulation has also suffered from academic neglect. The entire corpus of law review literature on ETFs comprises five articles.[13] All but one are from 2008 or earlier, and most focus on discrete, narrow aspects of ETF operations. One of the best of these articles thoughtfully analyzes the mechanics of an ETF and the ETF’s advantages and disadvantages relative to a mutual fund, but it stops short of describing and assessing the general structure of ETF regulation or offering a framework for new regulations as we do here.[14]

Thus this Article makes two basic contributions. The first is to be the only law review article to show the need for an overarching regulatory framework for ETFs. The second is to offer the outlines of such a framework.

Under our proposed framework, the arbitrage mechanism would be the organizing principle. Unlike the situation today, all collective investment vehicles utilizing the arbitrage mechanism would constitute an “ETF,” and thus, all types of ETFs, irrespective of the assets invested in, the strategies followed, or the exposures offered, would come under the same regulatory umbrella. The ETF would enjoy an independent legal status. ETFs, investors, and the public interest would be served by a unified framework attuned to the idiosyncrasies of the ETF phenomenon. This framework includes a streamlined, transparent, and primarily rules-based system for creating new ETFs that would allow most ETFs to avoid individualized SEC substantive review, while leaving the SEC enough discretion to adequately address the most troublesome new funds.

Importantly, we would not mark out funds for such close scrutiny on the basis of product type—for example, leveraged ETFs, bitcoin ETFs, and so forth. Such a cubbyhole-based approach is vulnerable to the financial innovation process and changing market dynamics. Instead, we rely on three circumstances that, today and in the foreseeable future, will be matters of high regulatory significance.

We also propose rules governing the disclosure and substantive operations of all ETFs. We suggest, for example, that certain substantive elements of the Investment Company Act of 1940 (“ICA”), which regulates most ETFs, should be extended to cover other ETFs that currently escape its application.

We propose disclosure requirements of a quantitative nature that would be granular enough to capture intraday breakdowns in the arbitrage process such as those that occurred on August 24, 2015. The essential historical information relating to intraday and at-the-close deviations from NAV would appear in traditional SEC disclosure documents and on the ETF’s public website. More granular historical information, if merited on cost-benefit grounds, would only be available on the ETF’s website in a downloadable form amenable to data analytics.

New disclosure requirements of a qualitative nature would consider the arbitrage mechanism as a key component of “performance” for the purposes of the MDFP. More generally, we suggest that all ETFs provide broader, more prospective information about the arbitrage mechanism and related structural engineering matters through an approach in the style of “Management’s Discussion and Analysis” (“MD&A”) requirements that comprehend the arbitrage mechanism’s model-related complexities. This discussion should provide both a particularized assessment of the effectiveness of a fund’s arbitrage mechanism and related engineering—including the implications of changes in the business, legal, or regulatory environment and the results of realworld testing—and outline the ETF’s efforts to monitor and improve the associated engineering.

Finally, if any truly significant deviations from NAV occur at any time during a trading day, we would require disclosures the next business day through a Form 8-K-style SEC filing to alert investors and through web disclosure. Trading price frictions also arise from bid-ask spreads. Steps should be taken to begin mandating an appropriate degree of public disclosure as to such spreads, at least in terms of information of a quantitative nature.

Collectively, these disclosure reforms should help inform investors and the SEC about possible trading price frictions associated with ETFs, facilitate sensible innovations in ETFs, encourage ETFs to improve their arbitrage mechanisms, and reduce systemic risk The reforms should also help facilitate SEC and industry initiatives relating to trading rules, other market structure matters, and additional factors associated with trading price frictions.

Part I of this Article summarizes the theory underlying the arbitrage mechanism and evidence as to patterns in the mechanism’s actual performance. Part II sets out and analyzes the current de facto structure of the process for introducing new ETFs. Part III sets out and analyzes current disclosure regimes applicable to ETFs. Part IV presents our proposal regarding regulation of a substantive nature. Part V presents our proposal for disclosure requirements.

On June 28, 2018, just prior to this Article’s scheduled publication in the July 2018 issue of this law review, the SEC issued a proposal to change the regulatory state of affairs as to certain ETFs. (We call this the “June 2018 SEC Proposal).[15] The June 2018 SEC Proposal, concurrent and prior statements by SEC Commissioners, and other published materials refer to drafts of this Article that had been posted in March 2018 on the Social Science Research Network (“SSRN”); this Article is largely as set forth in those and a subsequent draft.[16] This Article offers a brief descriptive summary of major aspects of the June 2018 SEC Proposal in the Appendix. However, we do not attempt to contrast that proposal with ours in either the Appendix or the main body of this Article. We will offer an analysis of the June 2018 SEC proposal and related matters in a forthcoming issue of this law review.

The SEC is to be commended for its proposal. Moving towards a more rules-based approach with respect to certain ETFs is a step in the right direction. We also welcome the SEC’s indicated openness to reconsidering the matter of better disclosures relating to the arbitrage mechanism and other distinctive aspects of ETFs, one of the core themes set forth in our Article. However, much more would need to be done to achieve a comprehensive regulatory framework for ETFs.

 

I.  The ETF’s Defining Characteristic: The Arbitrage Mechanism

A.  The Theory

The ETF’s central investment premise rests on its role as a unique, nearly frictionless portal to seemingly endless combinations of asset classes, investment strategies, and long, short, and inverse exposures. ETFs allow investors not only to enter and exit positions nearly instantaneously throughout the trading day, but, critically, to also do so at little cost—that is, at a trading price nearly equal to the NAV of the shares. Such a mechanism is absent from the market microstructure of other traded securities, such as stocks, and of mutual fund shares.[17] In our view, this novel, unique, and model-based device, which we refer to as the “arbitrage mechanism,” ought to be the starting point for a comprehensive framework for ETF regulation.

The arbitrage mechanism is a way of trying to help ensure that the price of an ETF on a stock exchange is approximately equal to the value of the assets that underlie the shares. The idea, to be more precise, is to help ensure that the fund’s stock market price is always nearly equal to the fund’s NAV, which is the value of the assets in the ETF’s portfolio, minus the net of liabilities, all divided by the number of shares outstanding.[18] An ETF investor would like to be able to count on the trading price being close to the NAV whenever she purchases or sells the ETF’s shares, irrespective of the usual tumult of the market forces of supply and demand. Much of the difficulty in designing ETF regulation comes from the variation in how closely the trading prices adhere to the NAV and the possibility of the arbitrage mechanism not meeting its objectives.

In a simple ETF that holds the constituent stocks of a domestic equity index, the arbitrage mechanism roughly works as follows: At the beginning of each day, a fund announces a list of securities in its portfolio, which is known as the “creation basket.”[19] Throughout the day, individual investors and market professionals (such as market makers and institutional investors) can invest or divest from exposure to this portfolio by buying and selling the shares of the ETF on a stock exchange. In addition, certain market professionals known as “authorized participants” (“APs”) can also create new shares of the fund or redeem existing ones by engaging in transactions directly with the fund. If an AP wants to create shares, the AP can assemble and deliver the various securities that make up the fund’s announced creation basket and then hand the securities over to the fund in exchange for a proportionate number of shares of the fund. An AP who wishes to create new shares of an S&P 500 index fund, for example, can deliver the proportionate number of the 500 stocks (give or take) that make up the fund’s portfolio.[20] Similarly, an AP can sell, or “redeem, a fund’s shares by buying the fund’s shares and giving them back to the fund in exchange for a proportionate number of the securities in a “redemption basket.” An AP who redeems shares of an S&P 500 fund, for example, will receive the proportionate basket of the 500 securities in the fund’s portfolio.[21] Note that these direct transactions with a fund usually only take place in very large blocks of shares, which are commonly known as “creation units” and “redemption units.” This restriction to large blocks avoids the costs of processing millions of tiny transactions and simplifies administration by ensuring that transactions happen in standard sizes.[22]

Note that not every investor can transact directly with a fund. Only a financial institution that has previously contracted with the fund to be an AP may do so.[23] APs are broker-dealers and clearing agents that have signed an authorized participant agreement with an ETF. Investors who are not APs may nevertheless be able to create or redeem shares by placing an appropriate order with an AP, because APs can create and redeem either for their own accounts or for those of their clients.[24]

APs are important because the creation and redemption transactions that they enter into with the ETF should have the effect of helping limit how much the fund’s trading price will deviate from the fund’s NAV.[25] While trading by market makers and other market participants can also serve to cause a general tendency for the trading price to gravitate to the NAV, the possibility of AP creations and redemptions tends to place both a floor and a ceiling on the stock exchange price of a fund’s shares. The arbitrage mechanism tends to set a floor, because if the trading price ever goes too low, APs will have the incentive to buy up shares on the exchange and redeem them from the fund in-kind at the NAV. If the NAV is $20.00, for example, and the price drops to $19.50, an investor can buy up shares on the stock exchange at $19.50 and then turn a 50cent profit by redeeming the shares from the fund for a basket of securities worth $20.00. The act of buying up the fund’s shares on the exchange will tend to drive the trading price of the shares back up until the NAV comes close to $20.00, making such arbitrage unprofitable. The arbitrage mechanism similarly serves as a ceiling on the stock market price, since if the price of shares rises too far above the NAV, an investor will buy up the basket of portfolio securities at a price equal to the NAV and use them to create new shares of the fund. The AP will then have the incentive to sell the new shares on the stock exchange, thereby driving the price back down until it gets close enough to the NAV that this arbitrage becomes unprofitable.

It is important to emphasize that an AP’s contracts with an ETF do not actually require the AP to create or redeem shares at any time.[26] An AP faces no fiduciary duty and no contractual obligation to create or redeem. The arbitrage mechanism assumes that an AP will create or redeem because it is acting out of financial incentive and a desire to profit from gaps between the trading price and the NAV.

It is also important to emphasize that the market microstructure of ETF shares is novel. The microstructure for other tradable securities, including shares in public companies, relies on market forces of supply and demand, with professional trading firms providing market liquidity, including firms designated as market makers by exchanges. In contrast, an ETF hopes that the voluntary, self-interested behavior of a specific group of firms—the APs for that ETF—can interact with such market forces whenever necessary in such a way as to help align the trading price with the NAV.

The arbitrage mechanism opens up a number of advantages over other types of investment funds. Unlike an open-end mutual fund, which may invest in similar assets and which also permits redemptions, the shares of an ETF trade on a stock exchange, allowing investors to buy and sell from each other at market-clearing prices in real time. A mutual fund, by contrast, does not list its shares on a stock exchange, effectively forcing investors, directly or through their brokerage accounts, to buy and sell only in direct transactions with the fund. And a mutual fund only processes these transactions once a day, often leaving investors to wait out market movements before they can buy or sell.[27] (On the other hand, with mutual funds, the ordinary investor can without question buy or sell precisely at the NAV while no ETF offers this certainty.) Additionally, because certain ETFs can transact in-kind, they offer significant tax advantages to investors, permitting funds to unload shares that have appreciated in value in direct, in-kind transactions with APs, thereby avoiding the need to realize taxable gains on those shares.[28]

This, then, is the simple architecture of how the arbitrage mechanism works. In practice, however, the arbitrage mechanism varies widely across ETFs, even among simple index funds. Some funds, for example, establish the creation basket at the beginning of the day using only a sample of the securities in the portfolio, while other funds establish the creation basket using pro rata portions of all of the securities in the portfolio.[29] Some funds transact entirely or almost entirely in their portfolio securities; some funds transact in a mix of cash and securities; other funds are cash-settled.[30]

The differences in the arbitrage mechanism become even greater for funds that hold assets such as derivatives or commodities. The United States Oil Fund LP (USO), for example, invests in oil futures contracts, rather than stocks.[31] Instead of asking APs to redeem and create shares by transacting in baskets of securities, the fund asks APs to transact exclusively in cash, creating complicated timing issues about how and when to calculate a NAV.[32] The iShares Gold Trust (IAU) dispenses with cash and asks its APs to deliver and receive physical bars of gold.[33] The trust has an elaborate set of procedures set up to process deposits and deliveries of gold, which must meet the specifications for weight, purity, and other characteristics as set forth in gold delivery rules of the London Bullion Market Association.[34]

As with simple stock index funds, similar commodities or derivatives funds can vary in their arbitrage mechanisms. IAU is the second-largest ETF invested to track the price of gold bullion after the SPDR Gold Trust (GLD).[35] The two funds would thus seem to be quite similar, but IAU issues and redeems in blocks of 50,000 IAU shares—which, as of January 13, 2018 were collectively worth about $643,000GLD redeems in blocks of 100,000 GLD shares—which, as of the same date, were worth about $12,696,000.[36]

Similarly, with IAU, redemption may be suspended only, “(1) during any period in which regular trading on NYSE Arca is suspended or restricted, or the exchange is closed, or (2) during any emergency as a result of which delivery, disposal or evaluation of gold is not reasonably practicable.[37] In contrast, with GLD, redemptions may be suspended under circumstances corresponding to (1) and (2), but also when the “[s]ponsor determines [it] to be necessary for the protection of the Shareholders.”[38]

Perhaps the most striking difference between the operation of the IAU and GLD arbitrage mechanism was an unexpected and evanescent one. On March 4, 2016, and for a short period thereafter, IAU’s arbitrage mechanism was literally not fully operative at the same time that GLD’s mechanism was functioning normally. That day, IAU announced that it had to temporarily suspend the creation of new shares until it could register additional shares with the SEC under the Securities Act of 1933 (“1933 Act”).[39]

B.  Patterns in Real World Performance

The available evidence suggests that the ETF arbitrage mechanism tends to perform reasonably well.[40] However, there appear to be two general exceptions.

First, the arbitrage mechanisms of ETFs involving less plain vanilla assets or strategies generally appear to be less effective. Second, in times of market stress, major breakdowns can occur even with respect to the arbitrage mechanisms of large ETFs offering straightforward long exposure to highly liquid domestic equities. Moreover, among such plain vanilla ETFs, the differences in the performance of the arbitrage mechanisms can be large and baffling.

In terms of overall arbitrage mechanism performance, ETFs generally do fairly well. Antti Petajisto undertook an empirical study of deviations between share prices and the respective NAVs of 1,670 ETFs in the period from January 2007 to December 2014.[41] Petajisto found that although the average deviation between trading price and NAV was only 6 basis points, the volatility of the deviation was 49 basis points, meaning that, with 95% probability, a fund is trading between -96 basis points and +96 basis points of its NAV, or within a 192 basis point band.[42]

Certain kinds of ETFs exhibited higher deviations. These included ETFs invested in less liquid U.S.-traded securities (such as municipal and high-yield bonds), international equities, and international bonds, with volatilities as high as 144 basis points, meaning a 95% confidence interval of almost 600 basis points.[43]

Markus Broman analyzed data with respect to a sample of 164 physically replicated ETFs traded in the United States that offer passive exposure only to U.S. equity indices for the period January 2006 to December 2012.[44] In looking at, among other things, differences between trading prices and the NAV, his basic conclusion was that “ETFs are generally efficiently priced.”[45] However, he did find that there was considerable variation among ETFs; that large ETFs did better than mid-sized ETFs; and that mid-sized ETFs did better than small ETFs.

ETF industry findings are broadly consistent with such patterns. For instance, in a letter to the SEC, BlackRock, the world’s largest asset manager,[46] briefly discussed its review of the premiums and discounts of nine ETFs from January 1, 2008 through July 21, 2015.[47]

It reported an average premium and discount of 0.01% and a standard deviation of 0.14% for SPY, the largest S&P 500 index fund. Funds holding municipal bonds and high-yield debt, and emerging market bonds had higher average premiums/discounts and standard deviations.

Second, when the market fails to operate as it ordinarily does, however, the arbitrage mechanism can perform much worse. Early evidence of the arbitrage mechanism’s fragility came during the so-called “flash crash” of May 6, 2010. That day, beginning shortly after 2:30 p.m., U.S. equity and futures markets fell over 5% within a few minutes. The rapid decline was followed by a similarly rapid recovery. This decline and rebound of prices in major market indexes and individual stocks was unprecedented in its speed and scope.[48]

ETFs were disproportionately affected during the May 6, 2010 flash crash. A total of 7,878 securities traded in the period from 2:40 p.m. to 3:00 p.m. Only 326 securities of individual companies experienced a price move of 60% or greater from the 2:40 p.m. price. In contrast, 227 of the 838 ETFs that traded in this period experienced such an extraordinary move.[49] It is highly implausible that these massive ETF stock price movements reflected real changes in the ETFs’ NAVs, since the prices of the ETFs’ portfolio assets were moving much less than the trading prices of the ETFs themselves.

Indeed, BlackRock stated unequivocally that during the 2010 flash crash, “the arbitrage mechanism of many ETFs failed dramatically for approximately 20 minutes,” in that ETF share prices fell dramatically compared to the current prices of the underlying holdings.[50] To illustrate this, BlackRock provided a graphic showing the intraday premium and discount performance of its own iShares Core S&P 500 ETF (IVV) relative to its intraday estimated fair value, a figure updated every fifteen seconds to reflect the most recent current prices in the underlying securities.[51] In BlackRock’s view, this twenty-minute failure “meant the secondary market liquidity on exchanges available to ETF holders effectively failed for this period of time.”[52]

More direct evidence of problems in times of market stress became available on another day of difficult trading: August 24, 2015. Trading was tumultuous that day. The Shanghai Composite Index had fallen 8.5%, and declines in European shares followed.[53]

The U.S. market open did not go smoothly. Most stocks listed on the New York Stock Exchange (NYSE) did not open immediately at 9:30 a.m. on the NYSE (though they were immediately open for trading at other exchanges and off-exchange venues).[54] At 9:35 a.m., the S&P 500 Index (SPX) reached its daily low of about 5% below its previous close, under the methodology prescribed by the S&P Dow Jones LLP (S&P DJI).[55] In contrast, all NASDAQ-100 (NDX) constituents (none of which were listed on the NYSE) did open at 9:30 a.m.[56] However, NDX opened at approximately an 8% decline and had declined nearly 10% by 9:32 a.m.[57]

Some major ETFs did far worse than the securities they held in their portfolios. Immediately after the 9:30 a.m. open, the trading price of IVV fell to its daily low of 20% below its previous close, even though its NAV had dropped only about 5%.[58] IVV was the second-largest ETF in the United States, a plain vanilla S&P 500 ETF advised by BlackRock. IVV appeared to continue trading at a substantial discount to its NAV until 9:43 a.m.[59]

During the trading day, 19.2% of non-leveraged ETFs experienced extreme price declines of 20% or more, while only 4.7% of shares of corporations experienced such declines.[60] The Vanguard Consumer Staples ETF (VDC) fell 32% at the open, while the corresponding index fell only 9%. In the first trading hour, one ETF fell as much as 46%. Ironically, the name of this ETF was the PowerShares S&P 500 Low Volatility ETF (SPLV).[61] At 9:31 a.m., the PowerShares QQQ Trust, Series 1 (“QQQ”), an ETF designed to track the NDX, reached its daily low of 17% below the previous close, even though its NAV dropped only about 9%—a difference of about 8%.[62] QQQ continued to trade at a substantial discount to its NAV until 9:37 a.m.[63]

Certain ETFs suffered nothing short of a breakdown in the arbitrage mechanism in early trading.[64] Arbitrage ceased temporarily on many ETFs because of a lack of information on gaps between the trading price and the NAV, anomalous single stock pricing, uncertainty around hedging because of fear of trades being cancelled, and delayed opens in many individual stocks.[65]

Two other issues from August 24, 2015 implicate the basic “nearly frictionless” investment premise of the ETF. First, substantial friction manifested itself not only in terms of gaps between trading prices and NAVs, but also in terms of the ability to instantaneously acquire, and exit from, the desired exposures. That day, only eight constituents of the S&P 500 and two constituents of the NDX suffered trading halts under the “Limit Up-Limit Down” system of the National Market System Plan to Address Extraordinary Market Volatility.[66] In contrast, 327 ETFs, representing 20% of all ETFs, suffered such trading halts.

Second, the friction experienced by any one ETF proved highly unpredictable, even as between seemingly identical ETFs subject to identical market structure rules. SPY and IVV were, respectively, the largest and second-largest ETFs in the United States. Both were plain vanilla ETFs, offering passive exposure to the performance of the S&P 500 Index, an index composed of 500 selected stocks from a cross section of industries that are among the most liquid in the world. Both ETFs were run by extremely large asset managers with deep, well-established expertise: SPY by State Street, the third-largest asset manager in the world, and IVV by BlackRock, the largest.[67]

Despite such similarities, identical market structure rules, and identical market conditions, the trading price frictions associated with the two ETFs varied considerably in the early minutes of market open. SPY’s trading price only departed somewhat from its NAV, but began tracking relatively closely at 9:38 a.m. And throughout this period, SPY traded at a premium to its NAV.[68][I]mmediately after 9:30 am,” IVV declined much more than its NAV and SPY and reached a discount of about 15%.[69] And IVV did not start closely tracking its NAV until 9:43 a.m.

The impact on investors of a breakdown in the arbitrage mechanism of the sort that occurred with some ETFs is difficult to exaggerate. Consider an investor who held shares in IVV for one year and then sold his shares at IVV immediately after the open on August 24, 2015 when IVV reached its daily low. When that investor bought IVV (at what was likely the then-prevailing NAV), the investor was essentially counting on obtaining the performance of the stocks in the SPX, less the impact of the ETF’s annual operating expenses. The reported expense ratio was 0.07%.[70] On Friday, August 22, 2014, the SPX opened at 1992.60, and at 9:35 a.m. on Monday, August 24, 2015, the SPX was about 1872,[71] a percentage drop of about 6%. When the investor sold near the open on August 24, 2015, he was expecting to have lost about 6% on his investment, that is, the change in the SPX and 0.07% due to the annual operating expenses.

Instead of losing about 6% of his assets, however, this investor would have lost about 21%.[72] This means that the performance of IVV’s arbitrage mechanism was more than two times more important than the performance of SPX. And the effect of this “drag”—this trading price friction—caused by this 15% arbitrage mechanism gap is about 200 times the drag caused by the 0.07% in annual expenses. (Of course, an investor who bought IVV immediately after the open on August 24, 2015 at the 15% discount to NAV and later sold IVV at or close to the NAV would have benefited from a real bargain.[73])

The arbitrage mechanism problems experienced by these plain vanilla ETFs on August 24, 2015 were bad, but they pale in comparison to those experienced by another ETF on Monday, February 5, 2018. That day, the SPX fell 4.1%, its largest drop in about six years,[74] and, not surprisingly, investors who were using ETFs and other products to bet on continued low volatility suffered. The ProShares Short VIX Short-Term Futures ETF (SVXY), an ETF with $1.89 billion in assets as of the Friday close,[75] was one such product. It pursued daily investment results corresponding to the simple, unleveraged, inverse (that is, -1X) of the performance of the S&P 500 VIX Short-Term Futures Index.[76]

Between the Friday close and the Monday close, the NAV of SVXY shares fell from $103.7288 to $3.9635—a fall of over 96%.[77] For at least some SVXY investors, a near-total loss in the NAV in one day must have been surprising. However, the harsh reality is that, as to this NAV drop, such SVXY investors had little to complain about. As ProShares stated, this “was consistent with its objective and reflected the changes in the level of its underlying index.”[78] Luckily, some investors did not have to find solace in this symmetry. The Harvard University endowment, for example, dodged the bullet entirely, having just disposed of its SVXY holdings the previous quarter.[79]

However, the performance of SVXY’s arbitrage mechanism that day is something that, presumably, was very surprising even to the most highly sophisticated investors. At the Monday close, the SVXY’s trading price was $71.82[80]—a figure 18 times that of SVXY’s NAV of $3.9635. Even by the standards of this arcane ETF, this deviation between the trading price and the NAV was an extraordinary outlier. For the twelve-month period ending February 16, 2018, SVXY’s median premium and discount from NAV was 0.02%.[81]

II.  The Existing Regulatory State of Affairs: Substantive Aspects

A.  Overview, with a Focus on Pathologies in Administrative Process

The existing regulation of ETFs was never consciously designed to meet the unique challenges these funds pose. American law contains no dedicated body of ETF regulation and not even a workable, comprehensive conception of what an ETF is. Instead, the regulation of ETFs has been cobbled together ad hoc from the statutes that regulate other kinds of investment vehicles, including ordinary mutual funds, commodity pools, and regular operating companies. These statutes were written long before the ETF’s emergence, and none of them regulates with an ETF’s distinctive characteristics in mind.

ETFs are dodecahedrons that have been crammed into a series of round, square, and triangular cubbyholes, and the fit has always been awkward. In this regard, ETFs are typical of financial innovations more generally, which regulators often cannot easily integrate into regulations designed for older financial products.[82]

The attempt to squeeze ETFs into existing cubbyholes has produced two types of problems in ETF regulation: first, pathologies in administrative process and second, failures to properly map regulation to the unique characteristics of the ETF phenomenon. The two problems are closely related. Nevertheless, we will largely deal with matters of administrative process in this Part II (with a focus on the introduction of new ETFs) and matters of mapping in Part III (in the context of disclosure requirements).

In terms of administrative process, there is first, an excess of fragmentation and second, an excess of discretion. Table 1 below illustrates these two basic problems.

ETF regulation is fragmented, because functionally similar ETFs are subject to different statutory regimes. ETFs all rely on an arbitrage mechanism, and this commonality tends to drive the significant features of all ETFs. Despite the importance of the arbitrage mechanism, regulation tends to ignore this commonality and instead divides ETFs based on the category of assets in which they invest. Depending on what an ETF invests in, it might be regulated as an investment company (that is, a mutual fund), a commodity pool, or a regular operating company, with very different consequences for each classification. Differences in assets yield differences in the regulation of the ETFs, for reasons that mostly do not make sense.

In addition to being fragmented, ETF regulation is also highly discretionary. Although some ETF regulation is codified in the form of stock exchange listing rules, the core of ETF regulation is an ad hoc process of individualized review that the SEC generally requires for every new ETF. Generally speaking, before a new ETF can be introduced, the SEC has the authority to assess it individually and demand—with no guidelines and no need for consistency or transparency—that the ETF agree to comply with any condition or requirement that the SEC sees fit. This extended review process—which differs for different kinds of ETFs and varies even across different divisions within the SEC—has no discernible principles and no discernible limits. It is opaque and difficult to understand, and it has the effect of grandfathering old ETF advisers into more permissive rules, such that older advisors can often introduce new funds on easier regulatory terms than newer advisors.

 

Table 1. Fragmentation and Discretion in ETF Regulation

B.  Fragmentation

The best way to understand the fragmentation of ETF regulation is to see it visually. Table 1 shows the sources of regulation for different types of ETFs. The rows in Table 1 show that the ETF universe can be divided into three different categories according to how they are classified: investment companies (“Investment Company ETFs”); commodity pools (“Commodity Pool ETFs”); or ordinary operating companies (“Operating Company ETFs”).

The reason regulation divides the ETF universe up in this way is that instead of focusing on all ETFs’ common reliance on the arbitrage mechanism, which is what should provide the center post for ETF regulation, current regulation focuses on the different kinds of assets that ETFs invest in. ETFs that are functionally similar in the way they operate and relate to investors are treated differently because of the differences in the assets they invest in.

By far the most common of the three categories of ETF is the Investment Company ETF.[83] Investment Company ETFs are subject mainly to regulation by the Investment Company Act of 1940 (“ICA”), which is the principal regulatory statute for ordinary mutual funds and other investment companies.[84] As we have noted, ETFs tend to be assigned to different regulatory categories based on the assets they invest in, and Investment Company ETFs are defined by their being invested in what are legally categorized as “securities.” The ICA says, roughly, that any company that is in the business of trading in securities or that devotes more than 40% of its assets to securities is an investment company to be regulated by the Act.[85] Thus, because most of the large index-based ETFs, such as SPY, invest in securities, they are regulated by the ICA, and they qualify under our rubric as Investment Company ETFs. The ICA includes several different categories of investment companies, and most ETFs qualify as “open-end management investment companies”—the same category that includes ordinary open-end mutual funds.[86] A few ETFs—most of which were started in the early days of the ETF industry—are classified as unit investment trusts” (“UITs”).[87]

Investment Company ETFs are subject to a number of regulations under the ICA, which are administered by the SEC. Unlike the other securities regulation statutes, the ICA does not just regulate disclosure—it also regulates substance. It limits how much money a fund can borrow, for example, and regulates the way they redeem their shares.[88] Note that although many funds regulated by the ICA are technically also subject to the 1933 Act and the Securities Exchange Act of 1934 (1934 Act), the ICA largely supplants the requirements of these two other statutes, mandating its own distinct forms of disclosure, which we will detail in Part III.

The next type of ETF is what we call a Commodity Pool ETF. Like an Investment Company ETF, a Commodity Pool ETF is defined by its assets, namely commodity futures, which are contracts for the future delivery of anything that counts as a “commodity” under the Commodity Exchange Act. Examples of Commodity Pool ETFs include USO,[89] which invests in contracts for the future delivery of oil, and the recently proposed ForceShares Daily 4X US Market Futures Long Fund,[90] which hopes to invest in contracts to pay the future return on the S&P 500 index.[91]

Because a Commodity Pool ETF invests in commodity futures, rather than securities, its main regulatory statute is not the ICA, but the Commodity Exchange Act.[92] The adviser of a Commodity Pool ETF must thus register as a commodity pool adviser with the Commodity Futures Trading Commission, the federal agency that administers the Commodity Exchange Act, and comply with the Commodity Exchange Act’s disclosure requirements.[93] The Commodity Exchange Act is not a Commodity Pool ETF’s only source of regulation, however, because a Commodity Pool ETF must also comply with the 1933 Act and the 1934 Act. Since the common stock that a Commodity Pool ETF issues to the public is a security, a Commodity Pool ETF must comply with the same securities regulations that apply to every other company that publicly issues securities. Indeed, as we shall discuss, for investors in a Commodity Pool ETF, the key source of information comes from the requirements of the 1933 and 1934 Acts, not from the Commodity Exchange Act. In addition, as we shall see, Commodity Pool ETFs face special regulation under stock exchange listing rules.

The final category of ETF is what we call an Operating Company ETF, not because such an ETF is actually an ordinary operating company like Apple or General Motors, but because of the way this category is regulated. Like other kinds of ETFs, an Operating Company ETF is defined by its assets, and it tends to invest in things other than securities and commodity futures. Examples include ETFs that invest in gold bullion, such as IAU or GLD, or the ETF that was proposed by the Winklevoss twins of Facebook fame that would have invested in bitcoins.[94] Operating Company ETFs are distinctive because they do not invest in securities or commodity futures and therefore are not subject to any special statutory regulation other than the 1933 Act and 1934 Act regimes that apply to all public operating companies. Even though these ETFs are collective investment vehicles and their reliance on the arbitrage mechanism profoundly affects the trading of their shares, Operating Company ETFs are basically no different under federal law from Apple and General Motors. Though, we will see in a moment that Operating Company ETFs face some special regulation under stock exchange listing rules, and this gives the SEC significant authority over them. But by statute, at least, Operating Company ETFs are run-of-the-mill public companies.

ETFs thus fall into several different regulatory regimes.[95] Statutes are not the only source of ETF regulation, however. Indeed, much more important than statutes are the rules imposed by stock exchanges. The great bulk of ETFs in the United States tend to list on the NYSE Arca, Cboe BATS Exchange,[96] and NASDAQ Intermarket stock exchanges. These exchanges have each developed detailed listing rules to govern the operations of the ETFs they list, and these rules have become a major source of ETF regulation.

The exchange listing rules came into being as part of the broader program of exchange-based private regulation envisioned by the 1934 Act. The 1934 Act empowers stock exchanges to develop rules to govern the operations, disclosure, and trading of the companies whose securities listed on the exchanges, and the rules governing ETFs flow out of this authority.[97] The rules are not entirely the products of the exchanges, however. The 1934 Act requires an exchange to obtain the approval of the SEC before the exchange can create or change a rule, and this veto right functionally gives the SEC the power to dictate what the rules will say. The SEC can not only reject an exchange’s proposed new rules; but also, it can force changes in an exchange’s existing rules by refusing to cooperate with the exchange on other matters. Thus, although the listing rules for ETFs vary across exchanges, they should all be understood as part of a single program of regulation directed, in essence, by the SEC. Indeed, at times the SEC has granted what it calls “class relief,” expressly setting out a set of policies applicable to all exchanges seeking to list ETFs of a given type.[98]

Despite the SEC’s central role in developing stock exchange listing rules, the rules set up for ETFs lack any coherent focus. None of NYSE Arca, NASDAQ Intermarket, and Cboe BATS Exchange have a single set of rules to regulate ETFs. Instead, just like the statutes that regulate ETFs, stock exchange listing rules tend to divide up ETFs by the kinds of assets they hold. Indeed, the exchanges divide up ETFs into an even finer set of categories than statutes do. NYSE Arca, for example, not only separates ETFs that invest in securities from other kinds of ETFs, but also breaks down ETFs that invest into securities into further subcategories based on whether they invest in debt or equity.[99] The NYSE Arca also pulls apart Operating Company ETFs into separate categories based on whether they invest in currency or tangible assets.[100]

There is a key difference between these stock exchange listing rules and the statutes that regulate ETFs, however, which is that the stock exchange listing rules often address the unique problems of the ETF arbitrage mechanism.[101] One common theme in the exchange listing rules, for example, is the diversification and liquidity of a fund’s portfolio.[102] Another common theme is the transparency with which the portfolio is disclosed.[103] Despite these common themes, however, the details of the rules can vary. The NYSE Arca, for example, imposes different liquidity requirements on the portfolios of index-based Investment Company ETFs and activelymanaged Investment Company ETFs.[104]

The net effect of this fragmentation across different regulatory statutes, rules, and exchanges is enormous, often resulting in unfair and incoherent differences in the legal obligations of otherwise similar ETFs. Contrast, for example, the regulatory obligations of the Van Eck Vectors Junior Gold Miners ETF, which invests in the stock of small gold mining companies, with GLD, which holds gold bullion. Both funds describe themselves as ETFs, and both rely on versions of the arbitrage mechanism to maintain the connection between their share prices and their NAVs. But because the Van Eck ETF holds securities, it is subject to the ICA and its many burdensome requirements, including, for example, the obligations to hire a chief compliance officer; to undergo regular inspections by the SEC; to comply with limits on borrowing and capital structure; to satisfy mechanical requirements for redemptions and securities sales; and to set up a board of directors and shareholder voting. In contrast, GLD faces none of these requirements, because GLD does not invest in securities.

These differences in regulatory obligations might make sense if they were connected to the differences in the two funds’ assets. To the extent that bars of gold and the common stock of gold mining companies pose different risks to investors, then of course the law should account for those differences, but that is not what the law is doing. Instead, the law draws distinctions based on ancient categories that have little correlation with modern investor needs. Though bars of gold and stock in gold mining companies are surely different, it is impossible to say what those differences have to do with, say, the need for a chief compliance officer, the value of regular inspections by the SEC, or the myriad of other ICA requirements. And if the need for a chief compliance officer or regular inspections has anything to do with the differences between gold bars and stock in gold mining companies, it is only by accident and not because Congress or any other rational policy designer foresaw it.

C.  Discretion

After fragmentation, the second major feature of the ETF administrative process is discretion. Although an ETF is subject to a host of statutes and rules, most of the regulation of ETFs comes from a process of ad hoc, individualized, discretionary review at the SEC. This individualized review process allows the SEC to impose requirements and conditions on every new ETF adviser. Many of these requirements and conditions have never been publicly announced or written down, and they have varied significantly over time, even for funds that are otherwise virtually identical. The SEC has a tremendous amount of discretion to impose novel requirements on any new ETF or ETF sponsor.

The details are somewhat complicated, but generally speaking, the SEC imposes this discretionary review on each new ETF in a slightly different way, depending on the nature of the ETF’s assets. For an Investment Company ETF, the source of the SEC’s discretionary review is the SEC’s statutory power to grant exemptions from certain provisions of the ICA. The ICA was drafted more than forty years before the first ETF came into being, so the ICA imposes a number of requirements that unintentionally prohibit the arbitrage mechanism at the heart of an ETF. For example, sections 2(a)(32) and 5(a)(1) of the ICA say that in an “open-end management investment company”—the category of investment company that includes ordinary mutual funds as well as most ETFs—shares of common stock must be redeemable at net asset value.[105] The SEC has interpreted this requirement to mean that every share must be individually redeemable by every shareholder.[106] This is a problem for ETFs, because ETFs generally only permit shares to be redeemed in large blocks and only by a small number of designated APs. Most shareholders thus cannot redeem directly, and even those who can are unable to redeem their shares one at a time. Hence, the arbitrage mechanism violates the ICA. Similarly, section 22 of the ICA regulates the distribution of shares of an open-end management investment company,[107] and the trading of ETF shares on a stock exchange may violate those regulations. In addition, ETFs tend to violate a number of other provisions of the ICA.[108]

The SEC’s solution to this problem has been to grant special exemptions to the Investment Company ETFs that apply for them. The SEC’s authority for these exemptions comes from section 6(c) of the ICA, which says:

The Commission, by rules and regulations upon its own motion, or by order upon application, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of this title or of any rule or regulation thereunder, if and to the extent that such exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title.[109]

In exchange for granting an exemption, however, the SEC imposes a number of requirements and conditions. Applicants often negotiate these conditions with the SEC privately and then memorialize the conditions in written applications that applicants later upload to the SEC’s website, where many of the applications become publicly available.[110] Sponsors that refuse to accept the SEC’s conditions may have their applications denied.[111]

This process of review is thus a major source of regulation for Investment Company ETFs. The SEC essentially uses it to invent new regulations, ad hoc, for each new fund sponsor. The ability to invent new regulations is valuable for all kinds of reasons—it is a power any regulator would love—but it is especially useful for ETFs, because statutory law has so little to say about the unique features of ETFs. The SEC thus leans heavily on the exemptive process to formulate legal requirements that address an ETF’s distinctive threats and risks.

One of the limitations of this ICA exemptive process, however, is that it does not reach Commodity Pool or Operating Company ETFs. Since only funds that trade in securities are subject to the ICA, only funds that trade in securities have to ask the SEC for exemptions from the ICA. The SEC thus cannot reach Commodity Pool or Operating Company ETFs through the ICA exemptive process, leaving these funds potentially free from the conditions and requirements that ICA exemptive orders apply to Investment Company ETFs.

Recognizing this problem, the SEC has found another source of authority to individually review Commodity Pool and Operating Company ETFs: stock exchange listing standards. Under the listing standards of the exchanges that list ETFs, every new Commodity Pool or Operating Company ETF has to be individually approved by the SEC before it can be listed on the exchange. The SEC achieves this outcome by leveraging a provision in the 1934 Act that requires all changes in stock exchange listing standards to be reviewed and approved by the SEC.[112] Thus, in order to give it a chance to review and impose conditions on every new Commodity Pool and Operating Company ETF, the SEC has required the exchanges to treat the listing of each one of these funds as a change in their listing standards, even if the fund complies with all of the requirements in an exchange’s listing standards.[113] Once the exchange applies for a special exemption to list a new Commodity Pool or Operating Company ETF, the SEC gets to decide whether to permit this technical change, and may impose additional requirements and conditions in exchange for its permission.[114]

It is worth nothing that Commodity Pool and Operating Company ETFs are not the only ETFs that have to ask the SEC for changes in stock exchange listing rules. Sometimes Investment Company ETFs have to apply as well. The stock exchanges have listing standards for Investment Company ETFs, just as they do for other types of ETFs, and in recent years the SEC has permitted the exchanges to make these standards “generic,” so that any Investment Company ETF that complies with the standards can list without any special approval for a rule change from the SEC.[115] Some Investment Company ETFs, however, do not satisfy the generic standards. These Investment Company ETFs thus have to ask the SEC for a rule change, much as Commodity Pool and Generic ETFs do. For an Investment Company ETF that complies with a stock exchange’s written listings standards, the SEC’s discretionary review thus focuses primarily on the fund’s application for an Investment Company Act exemption, rather than its listing on a stock exchange. If, however, an Investment Company ETF for some reason does not comply with an exchange’s listing rules, the SEC can demand the right to review and approve any necessary changes in the listing rules. When the SEC is not inclined to approve, it issues a notice and invites comments.[116]

The key fact about these two review processes—the ICA exemption and stock exchange listing rule change approval—is that they each give the SEC enormous discretion. The statutes that govern these two processes place almost no limits on what the SEC can do. For Investment Company ETFs, there is no statutory requirement that the SEC ever grant an application for exemption, no matter how meritorious the application might be. The SEC can refuse to grant an exemption from the ICA for any reason or no reason at all. And if the SEC does choose to grant an exemption, the SEC faces only the vaguest and most general of constraints. Section 6(c) of the ICA says that if the SEC wishes to give an exemption, it must determine merely that the exemption is “necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this subchapter.”[117]

For Commodity Pool and Operating Company ETFs, the SEC’s legal authority to review stock exchange listings is similarly broad. The requirements for a rule change application by a stock exchange appear in section 19(b) and rule 19b-4 of the 1934 Act.[118] Section 19(b)(2)(C)(i) says only that the SEC must approve a change in stock exchange rules if the change “is consistent with the requirements” of the 1934 Act.[119] But the 1934 Act does not provide any detailed requirements for stock exchange listing rules. At most, it provides only a set of vague exhortations that urge the SEC to make good policy.[120] The SEC thus has the effective authority to approve or disapprove a Commodity Pool or Operating Company ETF for almost any reason.

In theory, the SEC could choose to narrow its discretion by adopting formal, written rules that limit how it will carry its discretion out. Section 6(c) of the ICA, for example, says that the SEC could choose to grant exemptions “by rule or regulation,” rather than by individual application, but to date, the SEC has yet to adopt any official administrative rules that apply uniquely to ETFs.[121] Though the SEC proposed a set of rules in 2008, it never adopted them.[122] As noted in the Introduction, on June 28, 2018, the SEC proposed changes that would relate to one category of ETFs. The proposal is briefly summarized in the Appendix.

Of course, the SEC’s review of new ETFs has become somewhat standardized over time. Successful applications for review are available for public inspection on the SEC’s website, so the ETF industry has learned something about what the SEC requires. Most applications tend to be fairly routine, and the lawyers who draft them often begin by copying and pasting the applications of advisers already in business. A standard application contains a lengthy description of the sponsor’s plans and details for how it intends to operate its funds. These plans operate as restrictions on the sponsor later on, since the terms of the SEC’s exemptive order will inevitably require the sponsor to operate consistent with the plans described in its application.[123] In addition to this general description of a sponsor’s plans, the application will also contain a set of “express conditions,” which typically require, among many other things, that a fund be listed on a national stock exchange, that the fund not advertise itself as an ordinary mutual fund, and that the fund list the daily contents of its redemption/creation basket on its website.[124]

Despite the increasing standardization of conditions for ETFs that are allowed to list, the SEC nevertheless continues to make liberal use of its broad authority to refuse ETF listings. The SEC recently refused or substantially delayed the listings of a number of ETFs, including at least eleven proposed bitcoin-focused ETFs, a 4X leveraged S&P 500 ETF proposed by a company called ForceShares, and an actively managed ETF that would have kept portions of its portfolios secret.[125]

The details of how the SEC achieves and exercises all of this discretion can be a bit hard to follow, but their effect is important enough that they force us to contemplate a key question: Is all of this discretion a good idea? The main advantage is flexibility: the SEC can individually tailor the law to each new fund by designing the law ad hoc. If a fund pops up for the purpose of investing in some unusual category of assets like, say, bitcoin, the SEC can decide on a case-by-case basis what to permit and which conditions to impose. Regulation can be as flexible as the financial innovation that warrants it. And, of course, this individualized review nimbly avoids the legal and political burdens of the Administrative Procedure Act. Since the SEC can refuse an ETF’s application for any reason or no reason at all, there is no risk that skeptical judges on the D.C. Circuit will find the action “arbitrary and capricious,[126] unsupported by the requisite costs-benefit analysis, or otherwise troublesome.

But against these advantages we must weigh the brute fact that the individualized review process is not only cumbersome and complex, but also verges on the lawless. It allows the SEC to do more or less whatever it wants, for almost any reason. The regulation of ETFs—which are among the dynamic innovations in modern finance—is a kind of throwback to the very earliest state-level securities laws of the 1910s. Early state-level securities regulation operated as a system of “merit review,” in which government officials self-consciously screened securities offerings for their quality and promise. Rather than merely verifying compliance with a set of regulations, officials chose the securities that they deemed worthy and declared the rest illegal.[127]

This amount of SEC discretion produces serious problems. One is opacity. Although the SEC doubtless has internal policies for exercising its discretion, it is difficult to know what exactly those policies are because most of them are devised beyond the scope of public view. The SEC does not usually announce the policies it uses in reviewing an ETF’s application for exemption, and although successful applications are available for public review on the SEC’s web site, interviews suggest that ETF advisers may face individualized questioning and negotiations that never appear in the public record. ETF advisers often meet with SEC staff and present data and PowerPoint slides to address the staff’s concerns, but none of the details of these conversations make it into the brief and standardized final exemption applications that appear on the SEC’s website. If the SEC does make an objection to a feature of an ETF’s business plan, the adviser usually removes it without leaving any public record to show that the feature was ever disputed.[128] Likewise, when the SEC goes further and denies an exemptive application instead of merely requesting changes, this also tends to leave no public record, because staff members usually deliver the bad news in an unrecorded phone call or personal meeting, prompting the applicant to withdraw its application before the SEC can render an official public decision.[129] Thus, the contents of a failed application can usually only be guessed at or deduced through back-channel gossip with SEC staff and practicing lawyers. A related problem is that when lawyers parse the previously successful applications of existing ETF sponsors, they often find it impossible to distinguish between characteristics that are unique to a particular ETF and characteristics that the SEC intends to demand of all ETFs.

The opacity of the review process can baffle even seasoned industry players. In response to a recent request by the SEC for public comments on ETF regulation, what was then called the BATS stock exchange, a primary venue for ETF trading, complained specifically about the opacity of the review process. They noted that even though BATS had helped dozens of ETFs through the process of SEC review, BATS still often had little idea what the SEC would do in any given case.[130]

Indeed, differences among individual SEC staff members and between Divisions can dictate the outcomes at the SEC. BATS complained that the requirements varied depending on which individual SEC staff member received a fund’s application.[131] Further, different Divisions of the SEC clearly apply different policies on otherwise similar issues. Recall that ETFs can come into the SEC through two different channels—an ICA exemption or an exchange listing rule change. Crucially, these two channels flow through different Divisions of the SEC. Stock exchange listing standard changes go through the SEC’s Division of Trading and Markets, and applications for ICA exemptions go through the Division of Investment Management. As we will see in a moment when we consider a pair of funds that recently attempted to operate as commodity pools, the two Divisions applied very different standards, even to otherwise highly similar funds.[132]

A further problem is the delay and expense. Though the review process can be fairly simple for funds that closely resemble already established funds, the process can be extremely burdensome for innovative funds. For an ETF that requires a change in stock exchange listing rules in order to go public—which includes every new Commodity and Operating Company ETF and any new Investment Company ETF that does not satisfy existing stock exchange rules—the process for obtaining approval often takes more than a year.[133]

A final problem—perhaps the biggest problem of all—is that the SEC cannot update its policies without treating new fund advisers differently from old ones. In essence, the SEC has grandfathered older fund advisers into different—and usually more lenient—requirements than new funds. When the SEC reviews an ETF’s application for listing or exemption, the SEC only applies the policies it has in place at the time it does the review. If, however, the policies later change—if the SEC decides, for instance, to impose new conditions on a kind of ETF or get rid of old conditions—the SEC’s only way to implement the change is to apply it to new funds that the SEC reviews in the future. The SEC, in other words, has no way of changing the standards for older funds already in existence. Since the SEC has no written rules that apply to all ETFs, it has no way to change the rules for all ETFs. Whatever regulatory conditions appear in a fund’s initial application for exemption or stock exchange rule change go on to become the regulatory conditions that apply to the fund in perpetuity.

Though in theory the SEC could change the conditions of a fund’s operation after the SEC has approved the fund’s application by changing the terms of a fund’s exemption, in practice such changes are rare—we have never heard of one—and they would be impossible to implement on a large scale. There are more than a thousand ETFs in existence, and the SEC’s only way to change the standards for all of them would be to start an excruciatingly time-consuming process of individualized correspondence. The bottom line is that once an ETF survives individualized SEC review, the conditions of its operation are basically set in place forever unless the ETF later seeks and obtains a modification of such conditions.[134]

This risk of inconsistency between old and new funds has not stopped the SEC from changing its policies, however. Sometimes, the SEC loosens its restrictions. Prior to 2013, the SEC placed a number of restrictions on fund sponsors that used their own indices (rather than paying licensing fees to index providers like S&P). Fearful that sponsors might manipulate the indices they constructed, the SEC imposed various conditions to ameliorate what it be perceived to be conflicts of interest. In 2013, however, the SEC stopped imposing these conditions, announcing this change by issuing orders that eliminated the conditions to three different self-indexing fund sponsors on the same day.[135] Similarly, for many years the SEC refused to grant exemptions for actively managed ETFs, allowing ETFs to operate only if they constructed their portfolios according to indices. The SEC loosened the policy in 2008, allowing actively managed funds under certain conditions.[136]

When the SEC loosens its policies, existing advisers can apply for modifications to their exemptive letters, in the hope that they can attain some degree of fairness and uniformity.[137] Things can be more complicated when the SEC tightens its policies. Stock exchanges and ETF advisers have complained that the SEC’s requirements for approving new ETFs have generally grown more stringent over time, forcing new ETFs to operate under harsher requirements than old ETFs.[138]

A few key examples stand out. The first is the so-called “custom basket.” Since 2012, the SEC has required new ETF advisers to construct their creation and redemption baskets so that a basket consists of a pro rata cross section of the securities in the fund’s portfolio.[139] Prior to 2012, the SEC granted exemptions that allowed an adviser to construct creation and redemption baskets using only a subset of the securities in a fund’s portfolio.[140] The ability to construct customized baskets offers advantages for taxes and the functioning of the arbitrage mechanism. The advantages are especially pronounced in funds that hold illiquid assets, such as bond funds. If a bond fund holds hundreds of different bonds and an AP has to buy small quantities of each of them in order to create new shares of the fund, the AP will be much less likely to create shares than if the AP can purchase some smaller number of different bonds in large quantities.[141]

Another example involves derivatives. Between 2010 and 2012, the SEC refused to grant new exemption applications for funds that used derivatives—even as the SEC permitted existing funds to continue using derivatives unchecked.[142]

A third example concerns the ability of an adviser to operate an ETF in combination with an ordinary mutual fund. The only adviser that has the SEC’s permission to do this is Vanguard. In essence, Vanguard constructs ETFs by simply causing its existing mutual funds to issue share classes that trade on exchanges and can be redeemed during the trading day in large blocks as ETF shares. The same fund issues both mutual fund shares and ETF shares. Vanguard actively marketed this practice as a unique advantage of Vanguard funds. Vanguard’s web site explained that because of their ability to combine with ordinary mutual funds, “Vanguard ETFs are different from other ETFs.[143] Vanguard touted a variety of economies of scale and tax advantages for investors because of this system.[144]

When the SEC tightens its policies in this way, there is little that new advisers can do to level the playing field. Older advisers get the ability to continue operating under the older and more permissive policies, and they can even continue to create new funds under the exemptions granted under the old policies.

The clearest example of this unfortunate dynamic concerns leveraged and leveraged inverse funds. Leveraged funds generally try to return some multiple of the return on a specified index on a given day, so that a shareholder who buys shares in a 2X S&P 500 index fund, for example, will receive two times the daily return of the S&P 500 index, whether positive or negative. Leveraged inverse funds do the same, only with a negative multiple.

Prior to 2010, the SEC granted ICA exemptions to two leveraged and leveraged inverse fund advisers: ProShares and Direxion.[145] In 2010, however, the SEC announced a temporary moratorium on further exemptions to leveraged and leveraged inverse advisers.[146] The SEC announced this moratorium at the same time that it also announced the moratorium on exemptions for funds that used derivatives. Neither moratorium came with any explanation. The press release that announced the moratorium said merely that “we want to be sure our regulatory protections keep up with the increasing complexity of these instruments [that is, derivatives] and how they are used by fund managers.”[147] The press release offered no details on what the complexities were or how regulatory protections might change to address them.

Eventually, in 2012, the SEC lifted the moratorium for funds that used derivatives, but crucially, it kept the moratorium in place for leveraged and leveraged inverse funds. Hence, since 2010, the SEC has refused to approve any new exemptive orders for leveraged and leveraged inverse funds under the ICA. The SEC’s only explanation for maintaining the moratorium on these funds was a single, cryptic sentence given in a speech by the Director of the Division of Investment Management after the moratorium was lifted on derivatives: “Because of concerns regarding leveraged ETFs . . . we continue not to support new exemptive relief for such ETFs.”[148]

The effect of this moratorium has been to consolidate the market for leveraged and leveraged inverse funds into a de jure duopoly. Though the SEC refused to grant exemptions to new advisers, it kept in place the existing exemptions for ProShares and Direxion. Thus, as of the end of 2017, there were 121 leveraged equity ETFs listed for trading in the United States, and every one of them was sponsored by either ProShares or Direxion.[149]

This inconsistency between old and new advisers is made worse by a quirk of law that allows old advisers not only to continue operating old funds under old regulatory policies, but also to create new funds under old regulatory policies. Since 2000, the SEC’s exemptive orders under the ICA have covered not just the fund that was the subject of the initial order, but all new funds that the fund’s sponsor may create in the future, so long as the new funds comply with the terms of the original exemption.[150] Having received an exemption for one fund, a sponsor can use the exemption to obtain future exemptive relief for an unlimited number of new funds so long as the new funds comply with the terms of the original exemption.[151]

The ability to obtain future relief is useful because it guarantees older sponsors lighter regulation than newer sponsors. Many commentators agree that the SEC’s regulation of ETFs has grown stricter over time.[152] This increasing strictness treats new fund sponsors unfairly, because sponsors tend to use the exemption process to make regulation into a kind of one-way ratchet. If ever the SEC’s treatment of new sponsors grows lighter, existing sponsors can apply for an update to their exemptions to make sure they get the benefit of the lighter rules. But if the SEC’s treatment grows harsher, the existing sponsors do nothing, silently enjoying the benefit of their lighter treatment without ever applying for a change.

The value of old exemptions for creating new funds is glaringly evident in the experiences of ProShares and Direxion, the duopolistic leveraged fund advisers. While the SEC has ostensibly maintained a moratorium on the creation of new leveraged and leveraged inverse ETFs, ProShares and Direxion—which each received an exemption before the moratorium went in place—have been busily flooding the markets. Since the SEC’s moratorium on new leveraged fund advisers went into effect in 2010, Direxion’s new offerings include, among many others, a fund that offers three times the daily returns on an index of homebuilding companies (NAIL) and a leveraged inverse fund that offers negative three times the daily returns on an index of oil and gas producers (DRIP).[153]

The favoritism towards older advisers distorts the market not just for ETFs, but also for the advisers who run them. Older advisers are more attractive acquisition targets than newer advisers, because the age of an older adviser’s exemption makes the exemption a scarce and valuable resource.[154] Since an acquirer can use the old exemption to create an unlimited number of new funds that only need to comply with the terms of the original exemption, buying an older adviser can be like buying a beachhead for regulatory freedom.

D.  An Example: The ForceShares Funds

Fragmentation and discretion are evident in every aspect of ETF regulation, but are especially easy to see in the recent experience of an aspiring ETF advisor known as ForceShares. In the spring of 2017, ForceShares proposed to create two new ETFs, one that would achieve four times the daily return of the S&P 500 index and another that would achieve four times the inverse of the daily return on the S&P 500 index. ForceShares’s proposed funds would have been the first “leveraged” ETFs to achieve a leverage ratio above three.[155]

The most obvious way for ForceShares to operate these two funds would have been to invest the funds’ portfolios directly in the stock of S&P 500 companies and then achieve their desired leverage ratios through short sales and other simple devices to create the 4X leverage ratio. This is how other leveraged S&P 500 ETFs work,[156] and if ForceShares had operated its funds this way, its only innovation would have been to offer a slightly higher leverage ratio than its competitors—4X rather than 3X or 2X.

Running the fund this way was not an option for ForceShares, however, because the SEC had already announced its moratorium in 2010 on new exemptions for leveraged and leveraged inverse ETF advisers.[157] ForceShares sought an end-run around this barrier by exploiting the fragmentation of ETF regulation. Since the SEC had a moratorium on leveraged and leveraged inverse funds created under the ICA, ForceShares established its funds as commodity pools outside of the ICA.[158] By having the funds invest in futures contracts on the S&P 500, rather than the common stock of S&P 500 companies, ForceShares avoided owning securities in excess of the threshold that triggers the ICA—and thus sidestepped the ICA and the SEC’s moratorium on exemptions for leveraged and leveraged inverse funds under the ICA.[159] By sidestepping the ICA, ForceShares also avoided the prospective application of ICA Rule 18f-4, which the SEC had then proposed for adoption and which would have limited derivative usage by all Investment Company ETFs, mutual funds, and other open-end funds registered under the ICA.[160]

At first, ForceShares’ commodity pool strategy worked. Because the listing of a new Commodity Pool ETF technically amounts to a change in stock exchange listing standards, rather than a request for exemption from the ICA, the authority to review a new Commodity Pool ETF belonged to the SEC’s Divisions of Trading and Markets and Corporation Finance, rather than to its Division of Investment Management. Because the moratorium on new ICA exemptions for leveraged and leveraged inverse funds came from the Division of Investment Management, ForceShares neatly skirted the portion of the SEC staff that was hostile to leveraged and leveraged inverse ETFs. The staff of the Divisions of Trading and Markets and Corporation Finance thus issued an order approving the NYSE Arca’s rule change permitting ForceShares to list.[161] ForceShares had permission to go public.[162]

A few weeks later, however, ForceShares faced a reversal of fortunes. Overruling the SEC staff members who had approved ForceShares’ stock exchange listing, the SEC’s Commissioners issued an order staying the stock exchange standards change, pending the Commissioners’ further review.[163] The Commissioners never explained their logic, but presumably they were concerned about the same problems that originally motivated the Division of Investment Management to impose its moratorium on leveraged and leveraged inverse funds. As of this writing, ForceShares remains in this legal limbo.

The experience of ForceShares thus illustrates two key faults in the ETF administrative process. Most obviously, it shows the tremendous fragmentation within the process for introducing new ETFs. ForceShares’s decision to operate its funds as commodity pools, rather than investment companies, exploited divisions not only in statutes, but also in discretionary policies, stock exchange listing standards, and the internal bureaucracy of the SEC. ForceShares also shows the risks of the SEC’s reliance on discretion. The SEC’s discretion was not applied consistently even in the case of ForceShares itself, and the treatment of Forceshares was at odds with the SEC’s treatment of other advisers. Even as ForceShares was prohibited from taking its leveraged funds public, the two established leveraged fund advisers—ProShares and Direxion—continued to create new leveraged funds with little restriction.

III.  The Existing Regulatory State of Affairs: Disclosure Aspects

A.  Overview, with a Focus on Failures to Respond to Unique Characteristics of ETFs

Like the regulation of substantive matters, the regulation of disclosure in ETFs suffers from a “cubbyhole” problem. Current disclosure requirements for ETFs apply longstanding regulatory regimes intended for older, very different, financial products. Investment Company ETFs are thus subject to an ICA regime designed for mutual funds. Commodity Pool ETFs and Operating Company ETFs are largely subject to the 1933 Act and 1934 Act disclosure regime applicable to ordinary public companies.

But the market microstructures for mutual fund shares and public company shares lack any device analogous to the ETF’s arbitrage mechanism. For ETFs, the arbitrage mechanism is key to the core investment premise, to the integrity of trading prices, and to the regulatory challenges ETFs pose. Neither the mutual fund cubbyhole nor the ordinary public company cubbyhole inherently accommodate the ETF’s arbitrage mechanism.

The failures of the existing disclosure regime are best seen with Investment Company ETFs. These ETFs account for the bulk of the industry and are the only ETFs for which the SEC has attempted to develop any kind of ETF-specific disclosure requirements.[164] In particular, we focus on the predominant form of Investment Company ETF (the openend management company) and leave aside unit investment trusts.

For such Investment Company ETFs, the existing disclosure requirements fail to recognize either the significance of the arbitrage mechanism or the implications of the model-based nature of the arbitrage mechanism. Such requirements pay little attention to the past performance of the mechanism. We discuss disclosures of a quantitative nature in Section III.B and of a qualitative nature in Section III.C. We largely defer the analysis of how the current disclosure regime fails to properly respond to model-related complexities to Part V, in the context of discussing our proposed disclosure system.

The basic architecture of an Investment Company ETF’s disclosure requirements is somewhat convoluted, consisting of rules-based mandates relating to the disclosure documents of ETFs in general and conditions incorporated in the exemptive order for that ETF relating to that ETF’s website. Investment Company ETFs look to the Form N-1A adopted under the ICA for the form and content of key disclosure documents.[165] One set of public disclosure requirements flows from registration statement provisions of the 1933 Act’s section 5 and the ICA’s section 8(b). Here, the three most important documents are the (statutory) prospectus, Summary Prospectus, and the Statement of Additional Information (SAI). The statutory prospectus is intended only to “provide essential information” about the fund.[166] The Summary Prospectus is an even shorter document—containing what one would assume to be super-essential information—three or four pages consisting of the summary section of the statutory prospectus.[167] ETFs are given the option of providing the Summary Prospectus in place of the prospectus and typically elect to do so. The SAI, a document available on request, provides information that is not essential but which “some users” may find useful.[168] Few investors request copies of the prospectus or the SAI. Both the prospectus and SAI must be updated annually, and most fund groups routinely send copies of the new prospectus or the new Summary Prospectus each time it is updated.[169]

As a result of ICA section 30(e), shareholders also receive annual reports and semi-annual reports.[170] Besides the reports transmitted to shareholders, the fund must provide periodic reports, which are publicly available, to the SEC of their holdings and certain other matters.[171]

An Investment Company ETF is also subject to requirements pertaining to its publicly accessible website under the exemptive order specific to that ETF. Apart from requiring that the Prospectus and SAI be included on the websites, these orders vary from ETF to ETF but appear to focus on a small number of items of a quantitative nature largely consistent in nature with the quantitative items mandated by general Investment Company ETF disclosure rules.[172]

In short, for most Investment Company ETF investors, the two key documents are the prospectus (or, for the harried, the Summary Prospectus) and the annual report, both of which must be provided annually. An ETF’s website provides certain limited amounts of information of a quantitative nature.

Commodity Pool ETFs and Operating Company ETFs do not invest in “securities” to the requisite degree and are thus not subject to the normal ICA requirements pertaining to disclosure documents. Instead, these ETFs are largely subject to the 1933 Act registration statement and 1934 Act periodic disclosure requirements applicable to ordinary public companies.[173] Thus these ETFs, unlike Investment Company ETFs, meet prospectus requirements that flow from the Form S-3 Registration Statement and must file Form 10-Qs on a quarterly basis, Form 10-Ks on an annual basis, and Form 8-Ks on the occurrence of certain key events. The disclosures required of these ETFs are of the familiar variety seen in the 1933 Act and 1934 Act rules for ordinary public companies.

The arbitrage mechanism-related disclosures of non-Investment Company ETFs depart from those of Investment Company ETFs, and such disclosures are not consistent with each other. Non-Investment Company ETF disclosure documents are not subject to the ICA-based regime’s requirement to disclose certain information on the past performance of the arbitrage mechanism. For example, the United States Oil Fund (USO) , a Commodity Pool ETF, instead provides in the prospectus certain alternative measures of past performance.[174] IAU and GLD, both Operating Company ETFs, do provide certain information on the performance of their arbitrage mechanisms on their websites.[175] All three ETFs discuss risks flowing from the withdrawals of APs.[176] However, on the whole, all three ETFs, including the Blackrock-advised IAU, are less expansive in discussing the conditions necessary for arbitrage mechanism effectiveness than the Blackrock-advised IVV, an Investment Company ETF, whose disclosures will be discussed below.

B.  The Arbitrage Mechanism: Disclosures of a Quantitative Nature

An effective arbitrage mechanism is essential to the integrity of the trading prices of an ETF and to the core investment premise of the ETF. Rooted in a mutual fund mindset, ICA disclosure requirements fail to recognize the significance of the arbitrage mechanism to ETF investors.

In this Section III.B, we illustrate the disconnect between the current disclosure regime and the central feature of ETFs by examining requirements pertaining to the historical performance of the arbitrage mechanism that are of a quantitative nature. Such quantitative disclosures are not only inadequate, but also exacerbate an existing problem of investor complacency regarding the basic investment premise of the ETF.

The main aspects of the ICA disclosure regime of a quantitative nature relate to the historical returns experienced by investors, shareholder transaction costs, and annual operating expenses. For historical returns, changes in the NAV are the metric. Shareholder transaction costs focus on “contractual” costs such as the sales load and the redemption fee. The annual operating expenses include on-going costs such as management fees.

Thus, for example, the Summary Prospectus requires that a fund provide a bar chart showing the fund’s annual total returns (that is, changes in the NAV) for each of the last ten calendar years (or for the life of the fund if less than ten years), along with corresponding numerical information.[177] Similarly, the annual report must include a NAV-based performance graph. In addition to the bar charts in the Summary Prospectus, the annual report requires a line graph that reflects the impact of shareholder transaction expenses.[178] The annual operating expenses are summarized in the form of what is commonly referred to as the “expense ratio” in the Summary Prospectus[179] and are reflected a different way in the annual and semi-annual reports.[180]

This NAV-centered metric of past performance and this information on shareholder transaction expenses like loads and redemption fees and on annual operating expenses do speak to the concerns of an investor in a mutual fund. In a mutual fund, investors always buy and sell shares directly with the fund at prices exactly equal to the NAV, apart from contractually-specified shareholder transaction expenses. And the expense ratio does represent the on-going “drag”—friction—on the investment performance.

This NAV-centered performance metric does not speak to the concerns of an ETF investor. Unlike a mutual fund investor, an ETF investor does not buy and redeem at the NAV. With ETFs, apart from APs, investors must buy and sell shares in the secondary market and thus are subject to trading price frictions, such as those associated with bid-ask spreads and ineffective arbitrage mechanisms. Mutual fund investors are not faced with such trading price frictions—mutual fund shares do not trade. We have already seen that for the unfortunate investor in IVV who sold on August 24, 2015, the performance of the arbitrage mechanism was two times more significant than the performance of the NAV.[181]

There are similar mutual fund mindset problems associated with the disclosures of shareholder transaction and annual operating expenses. Contractually specified sales loads and redemption fees simply do not arise in the ETF context.

For ETF investors, what may effectively be the biggest shareholder transaction costs are: (1) the possibility of paying too high a premium over NAV at purchase; (2) the possibility of selling at too large a discount to NAV; and (3) the impact of bid-ask spreads on purchase or sale of ETF shares. But these tradingprice frictions are, as we shall see, not subject to correspondingly fulsome disclosure requirements under either the general ICA disclosure rules or under ETF-specific exemptive orders.

Similarly, the ICA is fulsome on its disclosure requirements with respect to the expense ratio. But, as we have seen with that IVV investor, the 15% tradingprice friction caused by the arbitrage mechanism was about 200-fold the friction caused by the 0.07% in annual operating expenses.[182]

Differences in ETF expense ratios are material to shareholder costs, and the mandated disclosures in this regard are as well. One major reason why investors may choose IVV, the second-largest S&P 500 ETF, over SPY, the largest ETF is its expense ratio. IVV’s expense ratio, at 0.04% is 55% lower than SPY’s 0.0945%, with the result that, among other things, IVV’s “30-Day SEC Yield” as of March 31, 2018 was 1.84% versus SPY’s 1.80%.[183]

However, no mandated disclosures apply with respect to bid-ask spreads, despite the fact that spreads are also material to ETF shareholder costs, especially for active traders. Thus, SPY emphasizes that it is the largest S&P 500 ETF, in part, because of the consistently tight spreads between the bid and ask price, which translates into reduced trading costs for investors.[184] SPY has published a graph showing its spreads relative to IVV and the Vanguard S&P 500 ETF and states that it is “the only ETF traded at a penny-wide spread for 8 consecutive years, illustrating its unmatched resilience in varying market conditions.”[185]

In contrast to the omission of bid-ask spreads, the ICA regime does at least require some disclosures about the past performance of an ETF’s arbitrage mechanism. However, such rules are so inadequate that even the catastrophic breakdowns on August 24, 2015 were not required to be disclosed. Indeed, the SEC-prescribed methodology served to mask their occurrence.[186]

The ICA regime’s periodic reporting rules require one type of quantitative disclosure regarding the performance of an ETF’s arbitrage mechanism. Form N-1A requires that an ETF must provide, with respect to the most recently completed calendar year, and later quarters, either in the prospectus or on the ETF’s websitea table showing the number of days the [price at the close of trading] of the [f]und shares was greater than the [f]und’s net asset value and the number of days it was less than the [f]und’s net asset value (i.e., premium or discount).[187] The corresponding formulations in the exemptive orders vary in specificity and content, but none appear to require more than what is contemplated by Form N-1A.[188]

This requirement turned out to demand very little. Consider what the 2016 prospectus of IVV, issued after the August 24, 2015 debacle, disclosed by way of SEC mandate on the performance of the arbitrage mechanism for 2015 and the first two calendar quarters of 2016:[189] The table appeared as follows:

This information is accompanied by the requisite standard SEC warning that past performance cannot be used to predict future results.

The fund, in other words, disclosed that 100% of the time, its trading price was within half a percent of the NAV—even though at one point the fund’s trading price dropped fully 20% more than the fund’s NAV.

The reason the table ignores the massive divergence between the trading price and NAV on the morning of August 24 is that the table requires disclosure only of the gap between the trading price and the NAV at the close of trading. On August 24, the gap was largest early in the day, and it had dwindled to the 0.5% to -0.5% range by the close, hence the perfect 377 days out of 377 days record in the table.

Intraday performance of the arbitrage mechanism is not relevant under this methodology. Only performance at an instant in time—the close of trading—matters.

This SEC methodology masks intraday, catastrophic breakdowns from view and, in so doing, can sometimes result in glossing over the actual realities of arbitrage mechanism performance. Thus, an investor who diligently reads the 2016 IVV prospectus is presented with a table that is completely accurate with respect to such instants in time, but which in fact offers an unrealistically sunny view as to actual experience of most investors. After all, most trading in an ETF occurs during the course of the trading day, not at the close.

Indeed, performance at the close may especially poorly reflect the actual experience of well-counseled investors. Investors who heed the advice of major ETF sponsors would affirmatively avoid trading at the close. Vanguard advises ETF investors to “avoid trading at either the market open or close;” at the close, an ETF may have wider bid-ask spreads and prices may be more volatile.[190] Similarly, BlackRock advises ETF investors to “[c]onsider trading after the first, and before the last, 20 minutes of the trading day” as markets can be more volatile and there may be less liquidity at such times.[191]

This SEC approach may exacerbate what is likely an existing problem of investor complacency about the ETF’s basic investment premise. In 2013, a financial advisor who had put all of his clients’ money in ETFs stated, “I don’t think most people have any clue that the prices they’re paying or selling at can veer significantly from NAV.”[192] Even professional commentary intended to help investors on ETF investing does not appear to pay sufficient attention to arbitrage mechanism breakdowns. A thoughtful 2017 Wall Street Journal article on how, unlike in mutual funds, one needed to look beyond expense ratios when investing in ETFs did not mention the arbitrage mechanism issue.[193] Another article, originally published in October 2015, specifically recommended IVV as “the best core fund” for a portfolio, one of the reasons being that it had a “very low tracking error.”[194]

On October 8, 2016, the SEC adopted sweeping changes to investment company reporting requirements that will become effective over the period between mid-2018 and early 2020.[195] The attempt is ambitious, laudable, and much-needed. However, it includes no changes to the just-discussed measure of arbitrage mechanism performance.

C.  The Arbitrage Mechanism: Disclosures of a Qualitative Nature

The key item of disclosure of a qualitative nature relating to past performance of an Investment Company ETF is found in the MDFP required in the annual report. The MDFP is intended as the ICA-disclosure regime’s analogue to the managerial discussions of past performance required by the MD&A requirements found in 1933 Act and 1934 Act documents.[196] From the standpoint of disclosures pertaining to the arbitrage mechanism, there are two basic problems with the MDFP.

First, as with the quantitative disclosures of past performance just discussed, the MDFP has a mutual fund mindset. The MDFP appears to conceive of “performance” in terms of changes in the NAV. The MDFP is required to “[d]iscuss the factors that materially affected the [f]und’s performance” in the previous year, “by the [f]und’s investment advisor.”[197] Throughout the prospectus disclosure requirements, “performance” is conceived of as changes in the fund’s NAV, as adjusted for shareholder transaction costs and annual operating expenses. There is little indication that “performance” is meant to include the performance of the arbitrage mechanism.

ETFs do not construe the MDFP as requiring any discussion of the performance of the arbitrage mechanism. Neither the IVV annual report nor the IVV prospectus filed after the events of August 24, 2015 mentioned these events at all.[198] Similarly, neither the SPLV nor the VDC, which also experienced similar arbitrage mechanism failures, referred to August 24, 2015 in their annual reports or prospectuses.[199]

Second, more fundamentally, even if “performance” is interpreted more broadly, the usefulness of the MDFP as a guide to investors would still be limited. The reason is that, in the proposing release for the MDFP, the SEC explicitly rejected MD&A’s approach of requiring forward-looking information, such as a discussion of known trends, events, and uncertainties reasonably likely to have a material impact.[200] The SEC stated that the MDFP “is designed to assist investors in evaluating the past performance of the fund.”[201] In the adopting release, the SEC confirmed this by summarizing MDFP as follows: “the item requires funds to explain what happened during the previous fiscal year and why it happened.”[202] This requirement contemplates discussion only of those factors that had affected the fund’s performance in the previous year, with no discussion of factors that may affect future performance.[203]

The investor must look elsewhere to infer the advisor’s views as to the prospective performance of the mechanism. This is unlikely to be fruitful. In the “Risk/Return Summary” portion of the Summary Prospectus, the ETF is to “summarize the principal risks of investing in the [f]und, including the risks to which the [f]und’s portfolio as a whole is subject and the circumstances reasonably likely to affect adversely the [f]und’s net asset value, yield, and total return.[204]

Discussion of the risks associated with the fund’s investment strategies not among the fund’s “principal strategies” can be relegated to the Statement of Additional Information.[205]

No rules specifically address how risks associated with the arbitrage mechanism should be handled. The only requirement in this respect comes in the “Purchase and Sale of Fund Shares” section of the prospectus, where the ETF is merely to mention that the trading price of the ETF shares may be higher or lower than the NAV.[206] These summaries of risk do not contemplate discussions of specific factual events, such as the debacle of August 24, 2015, or the implications for the arbitrage mechanism’s effectiveness. Instead, for something like the arbitrage mechanism, these summaries only require brief discussions of its purpose and identification of the circumstances under which its effectiveness will be undermined.[207]

Changes in an ETF advisor’s views on the arbitrage mechanism are not required to be identified by the SEC disclosure requirements. In fact, an ETF advisors views are constantly evolving as the results of real world “testing” of their original hypotheses and assumptions occur and as changes in market conditions, trading rules, or other aspects of the business and regulatory environment force even previously valid theoretical models to be modified. BlackRock’s modeling with respect to the arbitrage mechanism did change after August 24, 2015.[208] But, given the MDFP’s approach, IVV was not required to disclose such modeling developments (although it did make some changes to its description of the associated risks).[209] The MDFP’s approach deprives investors of such expert views.

We return to these issues in Section V.C, where we suggest a more MD&A-like approach with respect to the arbitrage mechanism, including associated model-related complexities.

IV.  Our Proposed Regulatory Framework: Substantive Aspects

To solve the problems in existing ETF regulation, we encourage the SEC to create a single unified body of regulation that covers all ETFs and shifts a greater share of regulation away from discretionary review and toward written rules. This systematic approach to ETFs as a whole, rooted in the structural elements common to all ETFs, would largely displace the hodge-podge of regulatory regimes that vary widely across both different categories of ETFs and different ETFs within each category.

In Section IV.A, we set out the general rationales for a single framework as well as methods for implementing such a framework. To a significant extent, this analysis applies with respect to both the substantive and disclosure aspects of our proposal. As to the disclosure side, there are additional rationales for a single framework and additional implementation pathways and considerations. These disclosure-specific matters will be deferred to Part V.

In Sections IV.B and IV.C, we focus on the two key functional elements of our single framework’s substantive side.

We note that the SEC is now trying, and has tried in the past, to adopt new rules for Investment Company ETFs (but not other kinds of ETFs). The SEC proposed a set of rules in 2008, but the rules were never finalized amidst the demands of the global financial crisis.[210] The SEC also asked for general comments on ETFs in 2015, presumably with the intention of developing rules later on.[211] And on June 28, 2018, the SEC proposed certain changes relating to Investment Company ETFs, which changes are summarized in the Appendix.

A.  The General Rationales for a Single Framework for All ETFs

We contemplate a single framework for all ETFs. The treatment of Investment Company ETFs, Commodity Pool ETFs, and Operating Company ETFs would be unified.

The SEC would need to begin by adopting a definition that establishes the scope of the regulatory framework by clearly identifying what an ETF is. As we have seen, the regulation that applies to ETFs currently does not rely on a comprehensive conception of an ETF, and there is no single body of regulation that could even make use of such a definition. One consequence is that ETFs invested in different assets are subject to different regulation.

We would define an ETF—and thus circumscribe the universe of entities that would be subject to the new ETF rules—by focusing on the arbitrage mechanism. Specifically, we would define an ETF as a pooled investment vehicle that is publicly traded (on a stock exchange or otherwise) and that permits an investor to create and redeem shares in exchange for assets or a combination of assets and cash at values equal to the entity’s net asset value.[212]

The principal advantage of defining an ETF so broadly is that for the first time it would bring Commodity Pool and Operating Company ETFs under the same regulatory umbrella as Investment Company ETFs. Our definition would identify an ETF on the basis of structure—including public trading and the processing of creations and redemptions of shares at NAV—rather than on the basis of assets. Our aspiration to cover Commodity Pool and Operating Company ETFs in addition to Investment Company ETFs represents a major innovation over the SEC’s past and present rulemaking efforts in this area. The SEC’s 2008 proposal, Form N-CEN disclosure requirements relating to APs effective June 1, 2018, the forthcoming (2019) SEC requirements relating to certain liquidity risk requirements, and the June 2018 SEC Proposal, for example, all relate only to Investment Company ETFs.[213]

Equalizing the treatment of Investment Company and other kinds of ETFs is important to level the playing field and end the gamesmanship that allows Commodity Pool and Operating Company ETFs to avoid the restrictions on Investment Company ETFs and vice versa. It was the temptation for gamesmanship that led ForceShares, for example, to try to organize its funds as commodity pools in order to avoid the Division of Investment Management’s informal moratorium on approving new exemptions for leveraged Investment Company ETFs.[214] By organizing as a commodity pool rather than an investment company, ForceShares entered the SEC through a different division and obtained different and better treatment—until the Commissioners intervened. It is likely that any substantive restrictions the SEC places on new Investment Company ETFs by rule or informal policy could potentially be avoided by sponsors savvy enough to organize their funds as commodity pools.

 Therefore, we think that the SEC should self-consciously try to harmonize the treatment of Investment Company ETFs with other kinds of ETFs. It should treat all kinds of ETFs as a single regulatory space and develop a comprehensive approach that thoughtfully addresses all of them. To be clear, this does not necessarily mean that the SEC should treat all kinds of ETFs the same. The SEC might reasonably decide after careful study that different kinds of assets or different kinds of arbitrage mechanisms warrant different regulatory treatment. The SEC might choose to impose different requirements about portfolio transparency on an ETF that invests in oil futures and an ETF that invests in corporate bonds. But even if the SEC does choose to regulate different ETFs differently, it ought to do so self-consciously, as part of a single cohesive strategy that intentionally identifies differences and justifies each of them. If the SEC chooses, for instance, to permit custom redemption baskets for Investment Company ETFs, but not Commodity Pool ETFs, it should do so as part of a carefully thought-out strategy that pays due attention to both the similarities and differences between these vehicles.

 Such a unified strategy—even one that permits differences—would stand in contrast to the haphazard, ad hoc jumble of policies that prevails today. At present, both the similarities and the differences between Investment Company and non-Investment Company ETFs are the product of accident and history, rather than a cogent strategy. The SEC sometimes treats Investment Company and non-Investment Company ETFs similarly and sometimes treats them differently, but never does it design the similarities and differences as part of synoptic, unifying vision. The haphazard nature of the SEC’s approach was evident, for instance, in the experience of ForceShares, where the SEC first permitted a Commodity Pool ETF to circumvent the policies on Investment Company ETFs without realizing what had happened, then reversing itself a few days later without explaining why.[215]

 One way to harmonize the treatment of different ETFs is to adopt a single body of administrative rules. The SEC could adopt a set of formal rules under the Administrative Procedure Act and apply them to all ETFs. The SEC could accomplish this by combining its rulemaking authority under section 6(c) of the ICA (which covers exemptions to Investment Company ETFs) with its rulemaking authority under section 19(b) of the 1934 Act (which covers approval of stock exchange listing rule changes) to adopt a single rule that defines its scope broadly enough to cover everything.

 Another, less ambitious way to harmonize ETF regulation would be to develop an informal policy to be applied when reviewing stock exchange listing rule change applications for Commodity Pool and Ordinary Company ETFs. The SEC’s Division of Trading and Markets reviews these applications every time a new Commodity Pool or Ordinary Company ETF attempts to list. It might use this process to self-consciously harmonize its demands for Commodity Pool and Ordinary Company ETFs with any formal rules the SEC adopts for Investment Company ETFs. If the Commission decides not to approve leveraged Investment Company ETFs for ICA exemptions, for instance, it could announce a similar policy for reviewing stock exchange listing rule changes by Commodity Pool and Ordinary Company ETFs. This informal approach to harmonizing the treatment of different ETFs holds the appeal of possibly being more flexible than a more formal approach that addresses all kinds of ETFs in a single administrative rule and might make it easier to address differences and novel challenges as they arise.

One major challenge in harmonizing the treatment of Investment Company and other kinds of ETFs will be to consider which elements of the ICA to extend to non-Investment Company ETFs. The ICA and its implementing rules contain a host of regulations, none of which touch the ETF arbitrage mechanism, and the SEC should think about which of these to extend to non-Investment Company ETFs. Since 2003, for instance, the SEC has required every registered investment company to employ a Chief Compliance Officer and to give him or her responsibility for overseeing the legal compliance efforts of the fund and its adviser.[216] There is no good reason why Commodity Pool and Operating Company ETFs should not face this same requirement. Whatever differences these ETFs have with Investment Company ETFs, they surely do not concern the need for solid regulatory compliance. Section 17 of the ICA also has important rules on self-dealing and custody of assets, which might also apply in some fashion to Commodity Pool and Operating Company ETFs.[217] Self-dealing and custody pose problems in any investment fund that is dominated by an external advisor, a category which includes Commodity Pool and Operating Company ETFs.[218]

In recommending harmonized treatment, we are aware that the cleavage between securities and commodities regulation runs much deeper than ETFs and that the argument in favor of harmonization has been made much more broadly than we make it now.[219] We note, however, that because the SEC has placed itself in the position of individually reviewing every new Commodity Pool ETF, the SEC has an exceptional opportunity to harmonize this space. Because none of the relevant statutes in either securities or commodities regulation has anything at all to say about the distinctive features of ETFs, everything the SEC does in this space is invented by administrative regulation. Moreover, in its capacity as reviewer of stock exchange listing rule changes, the SEC is clearly the primary regulator of Commodity Pool ETFs, even if these vehicles are also formally regulated by the Commodities Exchange Act.

Ironically, one advantage of defining an ETF in terms of pooled investments with the creation/redemption arbitrage mechanism is the narrowness of this approach. This approach avoids extending our regulatory system to products commonly referred to as exchange-traded notes (“ETNs”)—at least as an initial matter. ETNs are in nature different from ETFs. First and foremost, ETNs are debt instruments and do not offer ownership interests in pooled investments. ETF investors have no credit exposure to the ETF sponsor while the fortunes of ETN investors depend ultimately on the ability of the ETN issuers to meet their contractual obligations. Second, the creation process associated with the arbitrage mechanism for ETNs works differently from the process associated with ETFs.[220]

Currently, however, the SEC often conflates ETFs and ETNs into a single unit for analysis—both being categorized as an exchange-traded product (“ETP”). This can serve to undermine the development of sensible policies and rules. As we saw in Section I.B, the SEC looked at the performance of all ETPs (both ETFs and ETNs) in assessing various arbitrage mechanism-related matters on August 24, 2015, even though the arbitrage mechanisms of ETFs and ETNs differ.

Our proposed rules would apply to existing ETFs as well as ETFs created in the future. Since the SEC’s system of ad hoc, fund-by-fund review has allowed old fund sponsors to operate under different rules from newer fund sponsors, any new system of regulation will have to cope with the fact that its changes will be felt unequally. Old sponsors that presently operate under lax requirements might feel the new rules more acutely than newer sponsors that presently operate under more burdensome requirements. One solution to this problem might be to apply the rules prospectively, enforcing them only against new funds created after the rules are adopted, regardless of the age of the funds’ sponsors and their exemptions. Another solution would be to apply the rules on the same terms to all funds, including funds already in existence when rules are adopted. Perhaps the difference in burdens of compliance could be dealt with by phasing the rules in gradually, thereby giving older sponsors time to figure out how to comply.

We acknowledge, however, the seriousness of the difficulty in applying the rules to existing funds. Some funds have attained such great size that liquidating them could potentially hurt current investors and the broader financial system, especially if there is no appropriate transition period. And given how delicate the arbitrage process can be sometimes, we fear that the announcement of a shutdown or major change in the way a fund does business could have unpredictable consequences for the trading prices of its shares. Should the Vanguard exemption be disallowed, absent some work-round with the IRS, there could be some tax consequences for existing ETF investors. Thus, though we favor applying the rules uniformly to all funds, regardless of the date of creation, we acknowledge the potential need for greater sensitivity.

We note the foregoing analysis, both with respect to the case for a single regulatory framework and pathways for implementation, generally applies not just to the regulation of substantive matters, but also to the regulation of disclosure matters. There are also disclosure-specific rationales and implementation considerations. We say more about such matters when we discuss our proposal for disclosure regulation in Part V.

We turn now to the functional elements of our proposal for regulation of substantive matters. We start by focusing on the content of the rules and then turn to the scope and nature of SEC discretion.

B.  Functional Elements: Content of the Rules

Our view that the new rules should apply to all ETFs rests on our conviction that the distinctive element of an ETF is its reliance on the arbitrage mechanism. The rules we propose thus focus on the arbitrage mechanism as the principal object of regulatory concern.

The SEC should develop rules that specify minimum criteria to be satisfied. The criteria should relate to portfolio transparency, asset liquidity, and the number and activity of APs. We briefly refer to the portfolio transparency and liquidity issues here in the context of ETFs generally, leaving aside the possible complications associated with ETFs that are actively managed.

Consistent with the SEC’s longstanding policy for granting exemptive orders to new Investment Company ETF applicants,[221] the contents of a fund’s redemption basket should have to be disclosed on a fund’s website every trading day prior to the commencement of trading. Also consistent with the SEC’s longstanding policy, such a rule should permit ETFs to announce their baskets at the beginning of the day and keep them fixed throughout the day, even if the fund changes its portfolio.[222] This permits an ETF to change its portfolio over the course of a day without allowing other traders to front-run the ETF’s trades. As will be discussed shortly, there are severe limitations to the accuracy of indicative intraday values currently being disseminated every fifteen seconds, and joint SEC-exchange-ETF industry efforts will be needed to address this and related problems.[223]

The portfolio of an ETF must also satisfy certain liquidity requirements. Liquidity is important to ensure that the fund and the arbitrageurs who create and redeem its stock can transact in the underlying portfolio assets with sufficient speed and convenience so they can keep the fund’s stock in line with its NAV. The exchanges already have liquidity rules in place and, beginning June 1, 2019, the SEC will require most Investment Company ETFs to adopt a written program reasonably designed to assess and manage their liquidity risk.[224] We believe that the SEC should continue further in this crucial area, including, among other things, extending the forthcoming requirements to Commodity Pool ETFs and Operating Company ETFs.

Yet a fundamental question arises, irrespective of the particulars of such arbitrage mechanism-related criteria. Why should the SEC be involved at all as to the effectiveness of the arbitrage mechanism? Here, we believe that the SEC should openly adopt a policy of unapologetic, but measured, paternalism. The SEC should focus not merely on giving investors information, but also on limiting the availability of products that appear likely to have serious problems in their arbitrage mechanisms.

The reason we believe in a modest degree of paternalism is that the pricing of an ETF’s shares does not necessarily reflect the risks of a poorly functioning arbitrage mechanism. If the arbitrage mechanism works as it should, then the stock price of an ETF will usually be approximately equal to the fund’s NAV. But a fund’s NAV is not a measure of a fund’s true expected value—it does not factor in risks related to fees, the potential for future breakdowns in the arbitrage mechanism, or anything else that is not an asset in a fund’s portfolio. This is because a fund’s NAV is merely a mechanical calculation that adds up the values of the assets in a fund’s portfolio.[225] One reaches the NAV by simply totaling up the value of the stocks, bonds, gold bars, or other portfolio assets and then subtracting the amount owed on any liabilities. If a fund holds stock in the S&P 500, then the only thing that affects the fund’s stock price will be fluctuations in the value of the S&P 500. Thus, the distinctive risk in an ETF—that the arbitrage process might fail at some point in the future—has little bearing on the trading price of an ETF today. Two ETFs with the same NAV will tend to trade at the same price today, even if one of the funds has a flawed arbitrage process that it is likely to break down next week.[226]

As a result, an unsophisticated investor cannot rely on the stock market to price the risk of a malfunctioning arbitrage mechanism. In this regard, an ETF stands in contrast to an ordinary company. In an ordinary company, an unsophisticated investor does not need to understand and price every risk effectively, because sophisticated investors will drive the market price to an appropriate level on their own. An investor does not need to know personally, for example, about the risks that Apple faces to the supply chain for its iPhones, because even if the unsophisticated investor does not understand these risks, many sophisticated investors will, and these sophisticated investors will buy and sell Apple’s common stock on the basis of this risk until the price of the stock settles at an appropriate level. This is why federal securities law has developed the so-called “fraud on the market” doctrine: even if an investor is not aware of a piece of information, she may nevertheless be said to have relied on it, because the information will inevitably influence the price at which an investor can buy or sell.

The unique, arbitrage mechanism-centered microstructure for the pricing of ETF shares creates a unique problem. The price of an ETF does not reflect every publicly disclosed risk that might affect the ETF’s value because certain kinds of risks are mechanically excluded from being reflected in the price.

To be sure, the market may eventually punish the advisors of an ETF with a poorly performing arbitrage process, when fund investors redeem, leaving a smaller base of money in the fund to generate the advisor’s fees. In this sense, even ETFs are subject to a certain kind of market competition that eventually rewards the good and punishes the bad. But this kind of competition operates much more slowly and much less directly than the kind of competition we ordinarily see in securities markets. In ordinary securities markets, the discovery of a new risk affects prices almost instantaneously; in ETF markets, it might take months or years. If, for example, a computer software company announced a major flaw in its key product, the price of the stock would drop immediately. If, by contrast, an ETF announced a major flaw in its arbitrage mechanism that might manifest sometime in the future, the fund’s NAV—and thus its market price—would not be affected. This ETF might lose investors eventually, but the investors might take a very long time to leave, and in the meantime many of them would overpay for an investment with unnecessary and unrewarding risks.

In addition to the foregoing matters, the rules might also address a number of technical issues in the ICA, such as the ability of registered investment companies to invest in shares of Investment Company ETFs, the need for broker-dealers to deliver prospectuses when selling Investment Company ETF shares, and the delay that ETFs often experience in settling redemptions when their portfolios include foreign securities.[227]

In addition to these written rules, the SEC should require regular review of funds and their arbitrage processes. The ICA currently subjects registered investment companies to regular examinations,[228] but this requirement does not currently extend to Commodity Pool or Operating Company ETFs. Moreover, the examination requirement does not require or assume that the SEC will review the operation of a fund’s arbitrage process. The rules should thus require every fund to be subject to periodic examination and should require every fund to report and explain to the SEC any significant deviations between its NAV and its exchange-trading prices, including intraday deviations. The proposed public disclosure requirements set out in Part V should be helpful to the SEC with respect to such matters.

C.  Functional Elements: Scope and Nature of SEC Discretion

Even after enacting the written rules of general applicability that we propose, the SEC should have the capacity both to add and remove requirements for individual funds. The SEC already has this power, since it can craft requirements ad hoc for every fund, and the adoption of written rules should substantially reduce both the frequency and extent of the SEC’s use of this discretion.

We believe such close substantive scrutiny should not flow from an ETF falling into identified product categories, but instead on the presence of any of three circumstances. Subjecting an ETF to such scrutiny based on it falling into a product category (for example, leveraged ETFs or bitcoin ETFs) is an example of a regulatory cubbyhole approach that has repeatedly proven inadequate in the face of modern process of financial innovation. Financial innovation will result in new product categories that would be untouched under such an approach, even if they pose greater regulatory concerns. A cubbyhole approach may also suffer from another kind of obsolescence: a product category we currently think deserves special scrutiny may not deserve such scrutiny with changing financial dynamics.

That is, such fund-specific SEC intervention should occur in three circumstances: (1) when the SEC has significant doubts about the effectiveness of an arbitrage mechanism or related structural engineering (broadly defined), irrespective of whether the arbitrage mechanism satisfies the criteria in the written rules; (2) when the riskiness or complexity of a proposed ETF could not be adequately addressed by investor “suitability” rules imposed on financial intermediaries and associated investor education efforts; and (3) when a proposed ETF or, in truly exceptional circumstances, an existing ETF creates significant negative externalities for financial markets or the financial system. Such intervention would occur only sparingly, and discretion would be cabined by certain principles and enumerated factors.

The first set of circumstancesthose pertaining to the arbitrage mechanism and related structural engineeringwould likely not apply to most types of ETFs. As discussed, the minimum transparency, liquidity, AP, and other requirements should be met by most proposed ETFs and should do an adequate job of ensuring a sufficiently effective arbitrage mechanism. However, a key feature of the ETF phenomenon is its role as a financial portal to an expanding universe of risk-return possibilities. Endless combinations of new asset classes, asset strategies, and forms of exposure are constantly arising through a robust innovation process. An eighteen-fold difference between an ETF’s trading price and its NAV, as occurred with the inverse volatility SVXY on February 5, 2018, is unimaginable with respect to an ETF offering straightforward passive exposure to the S&P 500. Innovations with respect to the arbitrage mechanism or related structural engineering may be necessary in ways not contemplated by the criteria established by the written rules.

Also, as discussed in Part V, arbitrage mechanisms and related structural engineering for both plain vanilla and innovative ETFs can be expected to change with more and more financial R&D, the continuing flow of real world “testing” results, and with changes in trading practices, trading rules, and other aspects of the business and regulatory environment. The SEC’s general written criteria may not reflect such new financial learning or the changes necessitated by a changing business and regulatory environment.

Another situation that may trigger SEC doubts about the effectiveness of an arbitrage mechanism and related structural engineering may involve the particular ETF sponsor. For instance, an ETF sponsor that does not have demonstrable expertise with respect to arbitrage mechanisms or the underlying assets in which the ETF invests should trigger SEC review.

The second set of circumstances relates to especially risky or complex ETFs that neither investor suitability rules nor investor education efforts effectively address. ETFs are the dominant collective investment vehicle for the riskiest and most arcane assets and strategies.[229] In Section I.B, we discussed the ninety-six percent drop in the NAV of SVXY on Monday, February 5, 2018. The NAV move that Monday was very sharp in absolute terms, but was consistent with SVXY’s stated goal of delivering the simple, unleveraged, inverse of the performance of the S&P 500 VIX Short-Term Futures Index. On Tuesday, the NAV changes were even sharper, but were even more startling given the stated objective of the ETF. The index decreased twenty-six percent on Tuesday, and thus, had SVXY again performed as intended, its NAV should have gone up by about twenty-six percent. Instead, SVXY increased 187 percent—an increase that was seven-fold higher than the expected increase.[230]

FINRA and SEC rules do require investment professionals to place clients only in “suitable” investments. FINRA Rule 2111 requires, for example, that broker-dealers and associated persons must “have a reasonable basis to believe that a recommended transaction or investment strategy . . . is suitable for the customer . . . .[231] However, there have been problems. In 2016, FINRA fined Oppenheimer & Co. Inc. for failing to reasonably supervise transactions in non-traditional ETFs, and in 2017, Morgan Stanley Smith Barney agreed to pay a penalty to settle SEC charges related to ETF investments it recommended to advisory clients.[232]

The mere fact that an ETF is especially risky or complex would be insufficient to justify SEC intervention on investor protection grounds under our system. Instead, intervention would occur only in those circumstances where the SEC has reasons to believe that suitability requirements and investor education efforts have not been or will not prove sufficiently effective.

We think this is the right way to address leveraged and leveraged inverse funds (apart from the possible applicability to certain of these funds of the arbitrage mechanism/structural engineering circumstance just discussed and the negative externalities circumstance to be discussed below). Recall that since 2010, the SEC has refused to grant new exemptions for leveraged ETF advisers, presumably, at least in part, on the belief that leveraged ETFs pose special risks to investors.[233] Perhaps rather than imposing such a blanket moratorium based on product category, the SEC and FINRA should think more carefully about whether suitability requirements or investor education efforts are or can be effective enough in addressing these funds, especially when the funds are unusually risky or complex. FINRA has, for instance, stated that though “it is not FINRA’s position that all leveraged and inverse ETFs are unsuitable for all retail customers,” firms that recommend such products “must carefully consider their suitability for each customer.”[234]

Our approach would address the de jure duopoly on leveraged and leveraged inverse ETFs enjoyed by the Direxion and ProShares advisory companies already discussed in Section II.C. Though one might reasonably debate whether leveraged and leveraged inverse funds (or certain subsets of such funds) should be allowed, no one can seriously argue that the public is well served by letting only two specific advisors create these types of funds. If certain leveraged and leveraged inverse funds should not be allowed, then letting these two advisors create these funds is doing harm. And if certain leveraged and leveraged inverse funds should be allowed, then investors ought to be able to reap the benefits of these funds through robust market competition among advisors. The SEC could plausibly rationalize the regulation of these funds either by prohibiting all advisers from creating them or permitting all advisers to create them. Either approach would be better than the status quo. Our approach would treat all sponsors proposing new leveraged or leveraged inverse funds the same way. (With respect to existing leveraged or leveraged inverse funds, as discussed earlier, there may be the need for special dispensation.)

ETFs involving bitcoins and other current privately-issued cryptocurrencies may trigger close review under both the risk and complexity circumstance and the arbitrage mechanism circumstance just discussed (as well as under the negative externalities circumstance to be discussed later in this Article). There is at least a possibility that bitcoins themselves (and thus bitcoin ETFs) may be fundamentally flawed from the standpoint of riskiness and complexity. For instance, do the nascent markets for bitcoins have elements of a Ponzi scheme or a tulip-like mania or, if they do not, are such markets nevertheless too susceptible to manipulation? While our approach to risky and complex ETFs contemplates how suitability rules and investor education may in certain circumstances be sufficient grounds for allowing the introduction of highly risky and complex ETFs, this pathway should be foreclosed to ETFs that are invested in assets that are fundamentally flawed. If bitcoins do not in fact suffer from such fundamental flaws and pass the risk and complexity test, there would still remain the question of whether bitcoins are amenable to the arbitrage mechanism of ETFs.

The third set of circumstances in which the SEC could intervene would be when an ETF may have significant negative externalities for financial markets or the financial system as a whole. In the Introduction and Section V.C.2, we refer to externalities when an ETF grows too large relative to an asset class and when too many ETFs track the same equity index.

One clear example involves the Van Eck Junior Gold Miners ETF. Because the ETF’s assets became too large relative to the market for junior gold mining stocks in the pertinent index, the ETF changed its threshold of allowable companies so as to allow the ETF to invest in larger producers not in the index.[235] According to a gold stock-oriented mutual fund manager, in advance of this change, market participants “indiscriminately” sold their junior gold mining stocks, causing “fresh volatility” and “depreciated prices.”[236] This was because market participants anticipated that the change would cause the Van Eck ETF to down-weight or divest altogether a number of the smaller constituents.

ETFs, such as those involving bitcoins, and inverse volatility strategies may trigger review not only under the arbitrage mechanism circumstance and riskiness and complexity circumstance discussed earlier, but also because of possible externality issues. Policy-makers worldwide have been worried about the possibility that bitcoins may contribute to systemic risk and how, in Treasury Secretary Steven Mnuchin’s words, “[w]e want to make sure that bad people cannot use these currencies to do bad things.”[237] The events of February 2018 have triggered public concerns over the possibility that inverse volatility strategies can disrupt the overall stock market.[238]

More broadly, the behavior of ETFs invested in less liquid assets in February 2018 is contributing to the International Monetary Fund’s growing unease over the potential impact of the fast growth of such ETFs on financial stability.[239] In particular, the IMF appears to suggest that these ETFs, in combination with a greater emphasis on passive investment strategies, may contribute to a contagion that extends to other asset classes. The IMF stated as follows:

As evidenced during the February [2018] episode of volatility in equity markets, the sensitivity of high-yield and emerging market bond ETFs to S&P 500 returns is higher than the sensitivity of their underlying indices to S&P 500 returns. This suggests that the rise in ETFs, particularly those investing in relatively illiquid assets, may increase contagion risk and possibly amplify price moves across asset markets during periods of stress. Greater investment in passive investment strategies, such as ETFs, may be related to the rise in cross-asset correlations during periods of stress, one of the main attributes of contagion. Benchmark-focused investors are more likely to be driven by common shocks than by the idiosyncratic fundamentals of assets they invest in.[240]

Determining the presence of the three circumstances and assessing their regulatory implications requires a highly interdisciplinary approach. That is, matters such as the likely effectiveness of a proposed ETF’s arbitrage mechanism or a proposed ETF’s possible negative externalities must involve lawyers working closely with other experts such as those with real world experience in financial markets and Ph.D.’s in economics, finance, and data analytics. Historically, the SEC has been dominated by, and known for, its outstanding lawyers. The first professional economists of the modern era did not arrive at the SEC until the 1970s.[241]

We believe that the modern SEC is up to these important, but challenging and unenviable tasks. It is perhaps emblematic that SEC Chairman Jay Clayton chose as Director of the Division of Trading and Markets someone who, Chairman Clayton emphasized, had “extensive markets experience” and “longstanding, active engagement with investors, financial services firms, exchanges, and the SEC.”[242] Brett Redfearn came from J.P. Morgan, where he was Global Head of Market Structure for the Corporate & Investment Bank.[243] The Division of Economic and Risk Analysis, the first new Division in thirty-seven years, was created in 2009 with the overarching goal of providing sophisticated, interdisciplinary analysis across the entire spectrum of SEC activities.[244] By the end of fiscal year 2017, this Division, the “think tank” home to most of the SEC’s Ph.D.’s, had grown to 157 full-time-equivalents, only slightly lower than the 182 full-time-equivalents at the Division of Investment Management.[245]

V.  Our Proposed Regulatory Framework: Disclosure Aspects

Our disclosure proposal centers on three concepts. First, like the regulation of substantive matters, the regulation of disclosure should apply universally to all types of ETFs, even if they are not regulated as investment companies. The rationales for a single regulatory framework apply to disclosure much as they do to substance. In fact, there are some additional rationales for harmonizing regulation in the domain of disclosure, and certain considerations may make implementation easier on the disclosure side. Section V.A discusses such matters as well as one functional element of our disclosure proposal that is a natural corollary to a single framework: every ETF should identify itself as an ETF in its name.

Second, every ETF should begin providing certain quantitative information on trading price frictions experienced by investors, whether the frictions arise from deviations from NAV or the simple matter of bid-ask spreads. Historical information on certain intraday and at-the-close deviations from NAV would be mandated, in traditional SEC disclosure documents and/or on the ETF’s website, depending on the nature of the information. Moreover, if extreme deviations from NAV occur at any point during a trading day, a next-day Form 8-K-type filing requirement and associated website disclosure would be triggered. Section V.B discusses the quantitative information elements to our proposal.

 Third, an ETF should be required to provide qualitative information offering the sponsor’s expert views on arbitrage mechanism-related trading price frictions and bid-ask spread-related trading price frictions as well the sponsor’s assessments of associated trends, events, and uncertainties. Such discussions would be in the spirit of what is widely considered to be the central disclosure item for ordinary public companies—the management’s discussion and analysis, or MD&A. In the ETF context, we would narrow the scope of the required discussion to trading price frictions. Section V.C discusses the qualitative information elements of our proposal and includes additional benefit and cost considerations associated with such qualitative elements.

A.  The Single Regulatory Framework: Disclosure-Specific Considerations and the Correlative Functional Element of ETF Self-Identification

Our proposal would extend to every ETFwhether Investment Company, Commodity Pool, or Operating Companythe same framework of mandatory disclosure for issues related to trading price frictions, including those related to the arbitrage mechanism. The basic reason is that the costs and benefits of disclosure related to trading price frictions do not depend on the assets an ETF invests in. Sections V.B and V.C, which set out the quantitative and qualitative elements of the proposal, offer more specific justifications and details about which disclosures we propose to require.

Consider first the primary goal of SEC mandatory disclosure: that investors have the basic information essential to their decision-making.[246] Every ETF has both an arbitrage mechanism (and deviations from NAV) and bid-ask spreads and, irrespective of the assets an ETF invests in, such characteristics can materially affect the risks and returns experienced by investors. Investor decision-making in all ETFs could thus benefit from information related to trading price frictions. This is especially so as to arbitrage mechanism-related information. As Section III.B showed, many ETF investors are unaware of how significant arbitrage mechanism-related matters can prove even with plain vanilla ETFs. The contemplated disclosure would alert them. And investors who are aware would finally have useful information that can be costly, difficult, or impossible for them to obtain on their own. The harmonization of disclosure across categories of ETFs would facilitate investor comparisons of ETFs in different categories.

A second longstanding goal of mandatory disclosure is at the level of managerial behavior: disclosure can reward managerial performance and deter managerial malfeasance. Under our disclosure proposal, many aspects of the past and prospective performance of an ETF’s arbitrage mechanism would be brought to the attention of the ETF’s investors for the first time. This would give the ETF sponsor greater incentives to try to improve the performance of the arbitrage mechanism, whether at the level of the arbitrage mechanism itself or at the level of the trading rules and other aspects of market structure. All ETFs, irrespective of assets invested in could benefit from appropriate managerial attention to such matters.

A third, more modern, goal is at the level of financial markets and society at large. In the context of ordinary public companies, a robust informational predicate is essential to an efficient market which, among other things, could promote the proper allocation of resources across companies and industries. In the context of ETFs, a greater understanding of the highly idiosyncratic risks flowing from an ETFs arbitrage mechanism could help investors make better informed allocations of portfolios across different kinds of investment vehicles. The additional information on the arbitrage mechanism and related market structure issues can also be helpful to both the SEC and the ETF industry in addressing trading rules and other market structure matters.

The costs side of our proposal’s justification also does not turn on the assets an ETF holds. There is little reason to expect that the costs of compliance with our disclosure proposal would vary materially across the different legal categories of ETFs. Indeed, irrespective of the assets an ETF holds, the ETF sponsor is likely to be well-situated to provide the contemplated information.

In sum, there are disclosure-specific rationales for a single regulatory framework for all ETFs that supplement the general rationales discussed in Part IV. Every investor in an ETF should be entitled to presume the same basic standards of regulatory protection.

But for this to occur, investors need to know whether the entity whose shares they have bought is an ETF. One functional element of our disclosure proposal flows directly from this: every ETF should incorporate the term “Exchange Traded Fund” in its name. Currently, ETFs are not required to do so. USO’s prospectus, for example, describes the fund as an exchangetraded fund, but the fund does not label itself an ETF in its name.[247]

Requiring a fund to directly mention its ETF status in its name would alert investors to the fact that the fund’s shares represent an ownership stakes in a pooled investment vehicle and that the vehicle has an arbitrage mechanism that seeks to tether the trading price of shares to the value of an underlying portfolio. In addition, this requirement, when combined with the baseline substantive and disclosure standards we advocate for all ETFs, should help investors because they can rely on the presence of an associated portfolio of investor protections.

 The SEC has the authority to create this new disclosure framework and require self-identification without requiring any statutory changes. Implementation of the disclosure side of our proposal is perhaps easier than the substantive side, because when it comes to disclosure, the SEC has even more levers to use. The SEC has comprehensive authority over Investment Company ETFs due to their coverage by the ICA. And the SEC also has authority over Commodity Pool and Operating Company ETFs. One reason is that these entities issue “securities” and therefore have to comply with many of the disclosure requirements under the 1933 and 1934 Acts. Another reason is that the SEC individually reviews the applications for changes in listing standards when these ETFs apply to list on stock exchanges. Ideally, such a new approach would be taken through applicable revisions in registration statement forms, periodic report forms (for example, the annual report for Investment Company ETFs and Form 10-K for other ETFs), and website disclosure requirements. An easier, more incremental alternative would to be to try to reflect such changes in an industry guide applicable to all ETFs.[248]

B.  Functional Elements: Quantitative Information on Trading Price FrictionsTrading Day Deviations from NAV and Bid-Ask Spreads

As we have seen, IVV suffered extraordinary departures from NAV on August 24, 2015. It is a sad commentary on the state of ETF disclosure requirements that for the period that included August 24, 2015, IVV was able to properly report a perfect 100.00% score (for coming within a band of
0.5% discount to NAV and +0.5% premium to NAV) using the SEC-mandated metric for the past performance of ETF arbitrage mechanisms.[249] This was solely due to the fact that the metric only looks at the difference between the trading price and the NAV at the close of trading. Had the SEC metric reflected extremes in intraday performance, the metric would have shown at least one striking outlier of about 15%, stemming from the results immediately after the 9:30 a.m. open on August 24, 2015. While simplicity and other reasons explain the SEC’s decision to look only at the close and not intraday performance, the result was an emphatically reassuring picture being presented to investors. As a result, an investor may have a misleading sense as to the true risks and returns of the ETF.

In addition, the shareholder transaction expensesbeing conceived in terms of the friction caused by contractual loads and redemption fees found only in the mutual fund contextignore the possibility of trading pricefrictions caused by contingent NAV premiums/discounts and ever-present bid-ask spreads incurred by ETF investors on purchase and sale.

First, we propose that the ETF not only provide the existing historical information reflecting various size categories of at-the-close deviations, but also provide historical information on the frequency with which various size categories of intraday deviations occurred. Only the most basic information should be set out through tables or charts in both traditional SEC disclosure documents and on the public websites of ETFs. As will be discussed, more granular information, if determined to make sense to mandate on benefit-cost grounds, cannot be captured by the graphs, tables, and other “depiction tools” on which traditional SEC disclosure documents must rely. Such “too complex to depict” information should, however, be made available on the ETF’s public website.

Reporting of intraday deviations depends, of course, on the ETF having information on such deviations. An ETF should be able to provide such information notwithstanding the severe limitations to so-called “intraday indicative values” and the high costs of more accurate alternatives. Some background on both intraday indicative values and other kinds of information will show why ETFs should be able to provide information on intraday deviations.

Exchange listing standards currently require ETFs to publicly disseminate during the trading day an intraday indicative value (“IIV”), “which is designed to provide investors with information on the value of the investments held” by the ETF.[250] Typically, the IIV is calculated and disseminated at least every fifteen seconds during the trading day and disseminated over the Consolidated Tape or via an exchange data feed.[251]

The IIV, however, is not necessarily a reliable proxy for intraday NAVs. Some ETFs are expressly allowed, for instance, to base the IIV on the current value of only certain assets in its portfolio, even if they may differ in composition of the overall portfolio.[252] Some ETFs are expressly allowed to calculate IIVs based on the current value of some, but not all, assets in its portfolio.[253] IIVs may sometimes rely on stale information, especially when certain assets are only traded overseas and the pertinent markets for those assets are closed. At a minimum, views diverge on the accuracy of the IIV. One major ETF sponsor has stated that the IIV “should closely approximate the net asset value (NAV) of an ETF throughout the trading day,”[254] In contrast, the SEC stated flatly that the IIV “may or may not be equal to the per-share value” of an ETF’s underlying portfolio.[255]

ETF advisers appear to rely on, and outside vendors to offer, alternatives that are believed to be more accurate.[256] But accurate, real-time information can be extremely expensive for an ETF sponsor.[257]

Our proposal for the ETF reporting of intraday deviations is practical because there is no need to rely either on crude IIVs or accurate, but costly, real-time information. Our proposal depends on the retrospective compilations of intraday deviations on a periodic basis. No real-time information is needed at all. Indeed, the historical information needed by an ETF sponsor to comply with our proposal would be completely stale from a trading standpoint and should be relatively inexpensive.

Of course, even with perfectly complete and accurate information, calculating the NAV can still be difficult as a purely conceptual matter. In Section I.B, for example, we how discussed how material gaps existed between the SPX (as calculated using the prescribed S&P DJI methodology) and the actual, real-time, market value of the constituent stocks until 9:42 a.m. on August 24, 2015. Sometimes, ETFs serve an important price discovery role.

More generally, a variety of circumstances exist in which the valuation methodologies used to compute NAV result in imperfect estimates of the fair value.[258] In all ETF disclosures relating to arbitrage mechanism performance proposed by this Article, we contemplate that the ETF would be free to provide commentary correcting naïve, incomplete, or mistaken understandings of NAV computation methodologies, the NAV concept itself, and the way intraday deviations are calculated.

Joint initiatives involving the SEC, ETF sponsors, stock exchanges, financial data providers, brokerages, and other market participants would be helpful in addressing some of the existing limitations of IIVs and in exploring more accurate, but cost-effective, alternatives for the purpose of the retrospective reporting of intraday deviations contemplated by this Article. Similarly, such joint efforts should try to resolve or, at least standardize, approaches to some of the complexities associated with NAV. Such initiatives with respect to IIVs, cost-effective alternatives, and NAVs should also involve efforts to better educate investors on the basics of these and related matters.

The essential information relating to intraday and at-the-close deviations from NAV should be included in appropriate tables, charts, and the like in traditional hard-copy SEC disclosure documents and, to increase accessibility, on the ETF’s public website. There is a possibility, however, that more granular information may turn out to make sense when a careful cost-benefit analysis is done.

However, the tables, graphs, and other “depiction tools” on which traditional SEC disclosure documents must rely may be incapable of capturing important aspects of this kind of information. This “depiction tools” roadblock and other issues create a “too complex to depict” problem for traditional SEC disclosure technology, as has manifested itself in other financial innovation-related contexts such as asset-backed securities and major banks heavily involved in complex derivatives.[259]

Some of the proffered solutions to this toocomplextodepict problem center on a new mode of information, one involving the transfer of “pure information” to investors. Thus, in our ETF context, the “pure information” of certain kinds of raw data on intraday deviations could be captured in a form that would be amenable to investors and third parties seeking to engage in sophisticated data analytics and downloadable from the ETF’s website.

Second, in the event there is an exceptional deviation that occurs at any time during the trading day, the ETF would need to publicly disclose this by the close of trading the next business day on a Form 8-K-style SEC filing and on the ETF’s public website. Both the SEC filing and the disclosure on the website are necessary. Normal Form 8-K’s alert investors in ordinary public companies to the occurrence of certain extraordinary events. This Form 8-K-style filing alerts investors in ETFs to the occurrence of an exceptional deviation. The placement of information on the ETF’s public website ensures wide and easy availability. A flat percentage trigger—say, 5% or over—applicable to all ETFs has the virtue of uniformity, but may be impractical because some arcane ETFs may thus be required to file a numbingly large number of such reports. The ETF sponsor would be encouraged, but not required, to provide a very brief, highly preliminary, assessment of reasons why the exceptional deviation occurred, both in its SEC filing and on the ETF’s website. And, as discussed, the ETF sponsor would be free to explain why it may believe that such deviations from NAV relate more to weaknesses or misunderstandings relating to NAV computations, the NAV concept itself, or how intraday deviations are calculated than with problems associated with its arbitrage mechanism.

Third, the data on the past performance of arbitrage mechanisms needs to be extended to ten years (or the life of the fund, if shorter). Currently, information is only required with respect to roughly one year or five years (in the annual report). As we have seen, past performance information with respect to changes in NAV are required for periods of ten years (or the life of the fund, if shorter).

We see no reason to use a different period for the past performance of arbitrage mechanisms. Just as performance of a fund can significantly vary from year to year, performance of the arbitrage mechanism can do so as well. Consider the average deviation in the iShares MSCI Emerging Markets ETF (EEM) for the period from September 2004 through September 2014. The average deviation on a daily basis was just 0.05%, but there was considerable variation: in late 2008, the worst daily deviations were -6.20% and +12.07 percent.[260] If this late 2008 performance were excluded, the worst daily deviations would be fractions of such numbers.

Fourth, there should be information on the most extreme performance outliers on a historical basis. Currently, following the bar chart in the Summary Prospectus, the fund must disclose the fund’s highest and lowest return (in NAV terms) for a quarter during the past ten years (or the life of fund, if shorter) covered by the chart.[261] Similarly, an ETF should be required to disclose the highest premium and lowest discount to NAV experienced at any time in the past ten years (or the life of the fund, if shorter).

Such arbitrage mechanism performance information should be helpful with respect to the shareholder transactionexpenses issue. In addition, prominent cautionary language about the possibility of contingent premium and discount expenses should accompany graphical presentations and narrative discussions of shareholder transaction expenses.

Fifth, the disclosures pertaining to shareholder transaction expenses should be accompanied by a warning about the possibility of “contingent” transaction costs flowing from NAV premiums and discounts. Trading price frictions always flow from bid-ask spreads. There should be quantitative disclosure of bid-ask spreads, such as mean bid-ask spreads and breakdowns of bid-ask spreads into size categories, perhaps with the use of tables, charts, or graphs.

C.  Functional Elements: Qualitative Informationan MD&A-Style Approach to the Arbitrage Mechanism and Related Matters

1.  The Proposal and Its Basic Logic

For investors in an ETF, assessments on an on-going basis as to what is known and unknown about the prospective effectiveness of that ETF’s arbitrage mechanism are critical to ascertaining an ETF’s overall risk and return characteristics. Such assessments are difficult to make, depending not only on expertise with respect to that ETF’s particular arbitrage mechanism and related structural engineering (including the modeling) and knowledge about the characteristics of that ETF’s clientele, but also on detailed information, some proprietary in nature, on diverse matters such as trading practices and prices, APs, market makers, and the current and prospective regulatory environment.

At its core, the mechanism is anchored in a model that predicts the completely voluntary behavior on the part of current and prospective APs as well as other market participants in both normal circumstances and times of market stress. Every such model relies on certain key business and legal assumptions. On the business side, the arbitrage mechanism assumes, for instance, that throughout the trading day, an informationally rich environment will allow APs to identify gaps between trading prices and the NAV; that enough APs are both able and willing to enter into the necessary transactions at the correct times and in the correct amounts; and that APs have shorting or other hedging tools available to allow them to achieve “riskless” arbitrage profits. On the legal side, the arbitrage mechanism assumes, for instance, that throughout the trading day, no exchange trading rules or other regulatory constraints will limit either the trading of the assets in which the ETF is invested or an AP’s shorting and other hedging transactions, and that the transactions can be executed with a high degree of legal certainty.

In the real world, one or more of these assumptions may not be satisfied. In times of market stress, an assumption of uninterrupted trading and the willingness and wherewithal of APs to engage in the necessary transactions can be heroic. Changes in the regulatory environment or in business practices, which may be especially likely during or after times of market stress, may render certain assumptions obsolete. Moreover, every theoretical model may suffer from model risk in the sense of being incomplete or wrong. The modelers may not realize, for instance, that certain additional assumptions are necessary in order for the mechanism to be effective. For the modelers, the real world “testing” that occurred on August 24, 2015 proved informative.

We believe that an ETF’s sponsor is uniquely situated to provide informed views an ongoing basis and would be able to do so without incurring undue costs. We also believe, critically, that most ETF shares are in the hands of investors who are sophisticated enough to appreciate the value of such views.

To accomplish the appropriate level of disclosure for Investment Company ETFs, we propose that “performance” for the purposes of the annual MDFP be conceived to include performance of the arbitrage mechanism, and that the discussion of the performance of this mechanism and related structural engineering (including modeling matters) in the MDFP meet requirements that are in the general spirit of the MD&A, not the MDFP.[262] For symmetry, with Commodity Pool and Operating Company ETFs, such reviews should be specifically required to be part of the MD&A disclosures that are mandatory in the annual Form 10-K.

The MD&A required in the Form 10-Q quarterly and Form 10-K annual reports[263] of public companies is not only the central risk-related disclosure item,[264] but also is widely considered the primary source of narrative disclosure that is reviewed, together with financial statements, for investment decisionmaking.[265] In the words of the SEC, the MD&A seeks to “give the investor an opportunity to look at the company through the eyes of management.”[266] Critically, corporations are not only required to provide historical information, but also offer management’s view as to the future. Speaking of MD&A requirements as a whole, the SEC stated that, “[the] requirements are intended to provide, in one section of a filing, material historical and prospective textual disclosure enabling investors and other users to assess the financial condition and results of operations of the registrant, with particular emphasis on the registrant’s prospects for the future.[267]

A company’s financial statements are historical in nature and show the company’s past performance. But the past is not necessarily prologue. The MD&A requirements help fill the gap. The MD&A requires disclosure of, for example, “known trends or any known demands, commitments, events or uncertainties” relating to any material change in the company’s liquidity and “known trends or uncertainties that have had or that the registrant reasonably expects will have a material . . . impact on net sales or revenues or income from continuing operations” with respect to risk-related matters, corporations must disclose known trends or uncertainties of various kinds.[268] More generally, the Regulation S-K Instructions mandate that the MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”[269]

This application of MD&A principles to the arbitrage mechanism and related structural engineering matters would consist of three basic components supplementing the MDFP in the Annual Report.

First, there would be a summary overview of the past performance of the arbitrage mechanism, comprehending intraday performance, including a brief discussion of how the past performance corresponded to prior expectations of the ETF sponsor.

This overview, which would for the firsttime result in an integrated discussion of the past performance of the ETF’s arbitrage mechanism, would be helpful in several ways. First, this overview requirement would create soft incentives for ETF managers to create more effective arbitrage mechanisms. Some money managers may be more talented than others. For instance, some ETF sponsors may be more adept at tracking a given benchmark” (as stated by BlackRock),[270] and there is every reason to believe that some ETF sponsors may be better at the modeling and structuring of arbitrage mechanisms than others. Such an overview requirement would give ETF sponsors with strong capabilities a convenient pathway for at least indirectly comparing their past performance and their expectations with those of competitors.

This overview would also alert ETF investors to possible differences among types of ETFs in terms of the effectiveness of the arbitrage mechanism. As we have seen in Section I.B, ETFs offering passive exposure to highly liquid domestic stocks tend to have more effective mechanisms than those investing in, say, high yield or municipal debt. Large ETFs might be better in this respect than small ETFs.

This benefit may be especially large for investors interested in ETFs that invest in more illiquid assets, more arcane strategies, and leveraged or leveraged inverse exposures. This relates to the role ETFs play in serving as a financial portal for both retail and institutional investors in an ever-expanding universe of risk-return possibilities. ETFs are the dominant collective investment vehicle for the riskiest strategies. Some of these arcane assets, strategies, and forms of exposure can pose unique difficulties for ETF arbitrage mechanisms. One ETF advisor, for instance, has noted such problems for bank loan ETFs, active ETFs, and leveraged and leveraged inverse ETFs.[271] Sometimes, a narrow asset class may make it difficult for an ETF in that class to operate.

Examples in the junior gold mining area, one involving an ETF intended to track an index and the other a 3X leveraged exposure, illustrate. As briefly discussed in Section IV.C in relation to another point, the Van Eck Junior Gold Miners ETF was intended to track an index of smaller gold mining stocks, the MVIS Global Junior Gold Miners Index. But the ETF grew so large ($5 billion) relative to the market capitalization of the index ($30 billion), that it caused concerns over Canadian takeover laws and U.S. Internal Revenue Service diversification requirements.[272] On March 31, 2017, none of the ETF’s top six holdings were among the top six components of the index.[273]

On April 13, 2017, the Direxion Daily Junior Gold Miners Index Bull 3X Shares Leveraged Exchange Traded Fund suspended daily creation orders due to the “limited availability of certain investments or financial instruments used” to provide the requisite exposure to an index of junior gold mining stocks.[274] This, Direxion stated, would cause the ETF’s shares to trade at a premium if demand exceeded supply during the period the creation units are limited.

Finally, this overview could help address a concern important to all ETF investors: at least in times of market stress, arbitrage mechanisms can not only perform badly, but also in bizarre, unpredictable ways. Thus, had our proposed requirement for an overview of the arbitrage mechanism been in place with respect to 2015, ETFs that suffered catastrophic failures in the arbitrage mechanism on August 24, 2015 would have been required to discuss these issues. As discussed in Section I.B, IVV and SPY, the two largest ETFs in the country, showed striking differences in deviations from NAV in early trading on August 24, 2015 even though they were both were invested in the same S&P 500 stocks in identical proportions. Informed ETF sponsor views on whether differences, if any, in the arbitrage mechanism, APs, clienteles, or other factors may help explain this puzzle would be highly useful, even to very sophisticated investors.

Second, an ETF advisor would offer its views on material events and uncertainties known to it that would cause reported performance of the arbitrage mechanism not to be necessarily indicative of future results. Consider, for instance, the situation where an ETF sponsor is aware that an active AP has decided to cease its arbitrage activities or is now no longer in a financial position to do so. The median number of active APs for ETFs in 2014 was four,[275] so unless other APs step in, this could have a material impact on the effectiveness of the arbitrage mechanism. (If the AP who has ceased its arbitrage activities is, in fact, primarily acting on behalf of its clients, then the AP’s withdrawal would have limited impact. The clients could presumably simply act through the remaining APs.) In fact, active APs have sometimes stepped away, including Citigroup and Knight Trading, with the impact depending on, among other things, the size of the ETF, the nature of the assets it invests in, and the number of APs remaining.[276]

Regulatory uncertainties could significantly affect the effectiveness of the arbitrage mechanism, in either direction. After the August 24, 2015 debacle, BlackRock, State Street Global Advisors, and others urged the SEC to adopt changes in “limit-up/limit-down” trading rulesrules related to the certainty of execution and such other matters as the procedures that should be followed after certain trading halts.[277] Absent such changes, the markets would be susceptible to another August 24 debacle “at any time.” Investors would benefit from ETF sponsor evaluation of the implications of a known regulatory change. In fact, changes in “limit-up/limit-down” trading rules and certain other aspects of the market structure have occurred, but at least one major ETF sponsor believes that more remains to be done.[278]

Third, the ETF advisor would discuss the circumstances in which the arbitrage mechanism can be expected to depart significantly from its past long-term performance and any significant changes in the advisor’s structural engineering, whether with respect to modeling or otherwise. The advisor should also seek to outline in broad terms what can be said in qualitative or quantitative terms about the impact of such circumstances or such engineering changes. Among the circumstances that should be discussed are high stress events involving changes in the liquidity or the prices of the assets in which the ETF is invested.

The August 24, 2015 real world “tests” caused ETF advisors to change their models. No doubt, extreme stress helped concentrate the minds of ETF advisors wonderfully.[279] But, in addition to that, realworld tests provide information on the validity of the modeling. This reflects a basic theme in modern financial innovation. There have been repeated instances involving the known and unknown limitations of theoretical models becoming manifest as realworld trading unfolds.[280]

The events of August 24, 2015 taught ETF advisors that their arbitrage mechanisms were more fragile than they had thought and that additional assumptions were necessary for such mechanisms to be effective. For instance, BlackRock, IVV’s advisor, stated in a house publication two months after the debacle that:

For many years, including most recently in our August 2015 letter to the SEC, we only included two categories – valuation clarity and access – that are necessary for an effective arbitrage mechanism. However, given the events of August 24, we felt it was important to acknowledge that certainty of execution, which was lacking for certain periods on that day, is also essential.[281]

2.  The Contemplated MD&A-Style Information: Additional Benefit and Cost Considerations

An ETF sponsor is uniquely situated to provide forward-looking assessments of the effectiveness of its ETF’s arbitrage mechanism. One reason is that an ETF advisor is usually responsible for designing the full particulars of the arbitrage mechanism used for its ETF. The variations in the arbitrage mechanism reflect careful engineering, attuned to the trading, regulatory, and other characteristics of the assets in which the ETF invests, the asset strategies it follows, and the forms of exposure it offers. The person who designed the mechanism is likely to be familiar with it.

Another reason why an ETF advisor tends to be well positioned to understand the effectiveness of the arbitrage mechanism is that advisors often become directly involved in seeking changes in trading rules or business practices that may directly affect the future performance of the arbitrage mechanism. After the flash crash of May 6, 2010, several regulatory reforms recommended by BlackRock and other market participants were implemented, including extending circuit breakers previously applied to individual stocks to a set of heavily traded ETFs.[282] Outside of the SEC itself, ETF advisors are best situated to assess the likelihood and impact of any such regulatory changes.

A third reason an advisor is well situated to discuss the arbitrage mechanism’s performance is that the advisor often has facts that are not available to others. For instance, until Form N-CEN requirements came into effect on June 1, 2018, no information needed to be provided publicly on the identity of APs by any ETF, including the dollar value of the shares each AP created and redeemed with the fund.[283] Today, although such Form N-CEN requirements with respect to APs apply to Investment Company ETFs, they do not apply to Commodity Pool ETFs or Operating Company ETFs. Even with such additional disclosure by Investment Company ETFs, only the fund has the expertise to make judgments as to the continued willingness or ability of existing APs to continue engaging in the arbitrage-based transactions or, if existing APs exit, the likelihood of new APs coming in.

The advisors may also have information on professional trading firms other than APs who monitor and trade the ETF’s shares. Such firms’ behavior can be an important factor in determining trading price parity with the NAV.

Naturally, the costs and benefits of adopting such a disclosure requirement must be considered, especially given the high bar that the D.C. Circuit has set for economic analysis in SEC rulemaking.[284] The costs should be fairly low. The ETF advisor likely already has the information, and, if not, the ETF advisor, as a matter of internal controls and reputation, would have the incentive to develop such information for reasons independent of any disclosure requirements. Such disclosures need not involve the loss of proprietary information. This is evidenced by the detailed discussions of arbitrage mechanisms in the public August and October 2015 BlackRock documents referred to earlier.

The most daunting “cost” may flow from the possibility of liability. Investment companies, including Investment Company ETFs, cannot avail themselves of the statutory safe harbor for forward-looking statements under the Private Securities Litigation Reform Act of 1995.[285] However, ETFs who provide well-grounded prospective information accompanied by appropriate cautionary language should be able to rely on the protections available with the judicially crafted “bespeaks caution” doctrine.[286] In other contexts, ETFs have not hesitated to offer what is clearly forward-looking information. For instance, IVV reported in its 2015 prospectus that it expects its “sampling indexing strategy” for tracking the S&P 500 will result in a divergence of the performance of the fund’s portfolio from the S&P 500 that, “over time, will not exceed 5%.”[287]

This is precisely the kind of “firm-specific” information that federal disclosure law has always emphasized and, as we have discussed, the ETF advisor is uniquely situated to provide this information.[288] Such firm-specific information would promote investor understanding of the true risks and returns associated with ETFs and thereby promote market efficiency.

Importantly, ETF investors are in a good position to comprehend and understand the value of the kind of nuanced MD&A-style analysis we contemplate. The current ICA disclosure requirements flow in large part from the perception that investors in mutual funds are not sophisticated and either incapable or uninterested in the kinds of disclosures more characteristic of the SEC.[289] The content of the ICA disclosure is circumscribed in ways inconsistent with standard 1933 Act and 1934 Act materials, as witnessed by the contrast between the MDFP and the MD&A. Most ETF shares (nearly 60%) are held by institutional investors, not retail investors, which is dramatically different from the situation with mutual funds.[290] In addition, the typical retail investor in ETFs is better off and more educated than retail investors in mutual funds and even retail investors in individual stocks. As of mid-2016, median household financial assets of ETF investors were nearly double that of mutual fund investors and somewhat higher than investors in individual stocks.[291]

The more sobering assessments of ETF risks and returns may be especially propitious from the standpoint of overall market efficiency. As discussed earlier, following the events in February 2018, the International Monetary Fund raised the possibility of how problems with ETFs invested in high yield and emerging market bonds, in tandem with the increase in passive investing, may result in result in contagion across asset classes.[292] Some respected Wall Street veterans have become increasingly concerned that what they perceive as a blind rush to ETFs in search of low-cost passive exposure market indexes such as the S&P 500 may be contributing to a general stock market bubble.[293] Concerns have also been raised about whether, because the percentages of certain popular blue chip stocks held by ETFs is so high, the presumptive liquidity of ETF shares may not be available in case of panic. Fuller investor understanding as to how the ETF portal may not prove frictionless may help curb possible irrational exuberance.

The benefits of an MD&A-style analysis of the arbitrage mechanism extend well beyond such ETF investor-specific or overall market efficiency gains. The focus should provide additional incentives for ETF advisors to seek to improve its performance. This may involve adopting changes to the arbitrage mechanism in light of new learning (including changing the nature of the relationship with APs and stock exchanges) or seeking changes in SEC trading rules or other aspects of the regulatory environment. This greater focus should also be helpful to the SEC in structuring its rules or practices of general application, as well as helping the SEC in terms of its discretionary review of requests to introduce new ETFs.

CONCLUSION

Individual ETFs and the underlying innovation process together constitute a modern phenomenon of vital importance to individual investors, institutional investors, and society. ETFs now account for the bulk of the most actively traded securities in the United States and a vigorous innovation process has made the ETF the key financial portal to an ever-expanding universe of asset classes, asset strategies, and forms of exposure.

This phenomenon, however, poses an array of highly distinctive risks and other concerns that have not been addressed. Many of these concerns relate to the defining characteristic of an ETF, the presence of a novel, unique, and model-based arbitrage mechanism.

The regulation of the ETF phenomenon is stuck in the past. There is no self-conscious body of ETF regulation, leaving the legal oversight in the first instance to a haphazard jumble of statutes that were never designed to deal with an ETF’s distinctive challenges. The United States is largely regulating ETFs as though they were mutual funds, commodity pools, or ordinary operating companies, even though in reality an ETF differs widely from these traditional financial products.

To date, the SEC’s main solution to the need for ETF-specific regulation has been to regulate by dictate. At the core of current substantive regulation is a process by which the SEC individually reviews each proposed ETF and decides, ad hoc, whether it should be allowed to do business. This individualized review has turned out to be immensely flexible, but it has also hobbled the ETF innovation process by creating a system that is opaque, unfocused, cumbersome, and incapable of fair and consistent updating or change. Current SEC disclosure regulation, rooted in a mutual fund mindset, fails to comprehend the arbitrage mechanism’s significance or its model-related complexities, and can mask major breakdowns in the mechanism.

A better system is needed, one that is crafted with the distinctive characteristics of the phenomenon in mind. Our proposal, which would require no new statutory authorization from Congress, is to unify ETF regulation with the adoption of a single body of written rules. On the substantive side, a single system of written rules would finally offer the ETF industry and its investors the transparency, consistency, and simplicity they require and free the SEC to focus on ETFs that raise special risks for their investors or for capital markets.

On the disclosure side, for the first time, investors would finally have, among other things, much-needed information about the performance of the arbitrage mechanism that defines the ETF and whose model-related complexities constitute a vital, little-understood, and evolving component in a true calculus of ETF risks and returns. The increased disclosure would also encourage ETF sponsors to improve their arbitrage mechanisms, help the SEC in its decision-making, and contribute to greater overall market efficiency.

ETFs are not the only pressing problem the SEC faces. But we believe that there are few, if any, subjects in financial regulation that are more important and for which the current rules are more outdated. ETFs have been a great success, but they also pose great risks. The time has come for a legal regime worthy of this phenomenon and its fascinating and complex new challenges.

 

Appendix: Summary of June 2018 SEC Proposal

On June 28, 2018, the SEC proposed changes that would govern the operation of most existing Investment Company ETFs and simplify the introduction of most new Investment Company ETFs.[294] The proposal appeared about three months after the first two drafts of this Article were posted on SSRN[295] and just before the final version of this Article went to the printer for publication in this July 2018 issue of this law review. We will analyze the proposal and related matters in a forthcoming issue of this law review.

In the interim, this Appendix offers a brief descriptive summary of major aspects of the rule at the centerpiece of the proposal, which the SEC is calling Rule 6c-11. We set forth the rule’s basic operation, the three major constraints on the scope of the rule, and various related substantive and disclosure requirements.

A.  The Basic Operation of the Rule

The rule would replace most of the individualized letters the SEC issued to exempt ETF sponsors from elements of the ICA. For covered Investment Company ETFs already in existence, the rule would revoke the individual exemptive letters that these ETFs and their sponsors had been relying on and replace the letters with the standardized exemption granted by the rule. The elements of the ICA for which exemptions would be granted by the rule substantially correspond to those for which exemptions have been granted by the old exemptive orders. In granting this standardized exemption, the rule aims to eliminate some of the inconsistencies among exemptive letters that now tilt the marketplace in favor of sponsors with older letters.

The standardized exemption under the new rule would extend to new Investment Company ETF sponsors as well as existing ones, so that these new sponsors would no longer need to seek letters granting individualized relief from the provisions of the ICA.[296] Thus, at least as to the ICA-related aspects of the new ETF creation process, the principal obligation that would be created by the new rule for most new Investment Company ETFs would be the various conditions the rule prescribes.

B.  The Scope of the Rule: Three Major Constraints

1.  Commodity Pool ETFs, Operating Company ETFs, and Investment Company ETFs Organized as Unit Investment Trusts

The rule does not cover all ETFs. Because the legal effect of the rule is merely to exempt certain Investment Company ETFs from having to comply with elements of the ICA, the rule does not affect, among other funds, ETFs that are not organized under the ICA. Thus, Commodity Pool and Operating Company ETFs would remain unaffected by the rule and would still be subject to the existing regulatory regimes.

In addition, the rule would exclude Investment Company ETFs organized as UITs. The UIT form was common in the earliest days of the ETF industry—SPY, the oldest and by far the largest ETF, is a UIT—but newer Investment Company ETFs are instead organized as open-end management investment companies. Like the other kinds of ETFs excluded from the rule, UITs could continue to operate and would remain subject to the same exemptive letters and regulatory regime as before the rule was proposed.

2.  Leveraged, Inverse, and Share Class Investment Company ETFs

The rule also excludes leveraged, inverse, and “share class” Investment Company ETFs.[297] Leveraged ETFs offer a multiple of the indices they track. Inverse ETFs offer the negative return (or a multiple of the negative return) of the indices they seek to track.[298] Share class ETFs are structured as share classes of pre-existing mutual funds that issue multiple classes of shares representing interests in the same portfolio.[299]

The only advisers with exemptive letters that permit leveraged or leveraged inverse ETFs are ProShares and Direxion. The only adviser with an exemptive letter that permits share class ETFs is Vanguard.[300] The rule would leave these sponsors’ exemptive orders in place.

The result is that some of the most significant inconsistencies in the status quo regulatory regime would remain untouched. ProShares, Direxion, and Vanguard would have the exclusive rights to continue operating their existing leveraged, leveraged inverse, and share class ETFs. ProShares and Direxion would also have the right to continue creating new leveraged funds and leveraged inverse funds.

3.  Stock Exchange Listing Standards

Because the rule only addresses elements of the ICA, it leaves undisturbed the many provisions that govern ETFs—including Investment Company ETFs—in the 1934 Act. As an example, it leaves stock exchange listing standards and the procedures for changing them in place. Many new ETFs require a change in stock exchange listing standards, including all Commodity Pool and Ordinary Company ETFs and Investment Company ETFs that fail to satisfy listing standards as previously adopted. Under the proposed rule, these ETFs and the exchanges on which they hope to list would still have to apply and wait for the SEC’s permission to change their listing standards.

C.  Conditions: Substantive Matters

After the scope, the second most important feature of the proposed rule is the set of conditions the rule imposes on funds that wish to rely on it. These conditions are the heart of the rule’s effort to regulate Investment Company ETFs. This Section C describes the conditions that relate to substantive matters (including disclosure requirements directed at APs and certain other market professionals) and Section D describes the conditions that relate to disclosure matters directed at investors.

The first set of substantive conditions concerns the issuance and redemption of shares. Funds may generally issue and redeem shares only in transactions with APs and may limit the issuance and redemption of shares only in certain circumstances.[301] A fund must list on a national securities exchange and, if delisted, would no longer be eligible to rely on the rule.[302]

A fund would have to disclose the contents of its portfolio on its website prior to the beginning of each trading day, but would not need to disclose subsequent changes in the portfolio over the course of the day.[303] The portfolio disclosure requirement applies to all funds, including both indexed and actively managed funds, and it requires a fund to disclose all of its investments, including cash, options, and short positions, in addition to securities.[304]

The rule would require a fund to disclose its creation and redemption baskets on its website prior to the start of each trading day.[305] Crucially, however, the rule would permit funds to construct their baskets on a customized basis.[306] In other words, all funds would now be able to construct creation and redemption baskets that do not reflect representative cross sections of their portfolios.[307] Currently, only certain older ETF sponsors have exemptive orders allowing them to construct customized baskets. Moreover, an ETF may use multiple different baskets for different APs. To protect against the risk that an AP might pressure a fund’s sponsors to construct custom baskets contrary to the interests of the fund or its shareholders, a fund must adopt detailed policies and procedures for constructing its custom baskets.

D.  Conditions: Disclosure Matters

Investment Company ETFs subject to the rule must meet certain investor-oriented disclosure requirements on their websites and in their registration statement Form N-1A’s.[308] In terms of content, the biggest changes concern three principal matters.

First, for the first time, large deviations between the trading price and the NAV of ETFs would trigger certain disclosures if the deviations occur at the close of trading.[309] If any ETF’s premium or discount was greater than 2% for more than seven consecutive trading days at the close of trading, that information must be posted on the fund’s website, along with a discussion of the factors that are reasonably believed to have materially contributed to the premium or discount. In addition, the proposal would supplement current requirements for quantitative information presented in tabular form concerning at-the-close deviations with some presentation in graphic form.[310]

Second, for deviations from NAV that occur during the trading day, the proposal imposes no disclosure requirements. The SEC considered such a requirement and chose not to include it in the proposal.[311]

Notably, however, the SEC indicated its openness to reconsidering this and other arbitrage mechanism-related disclosure issues as well as the overarching issue of whether the distinctive characteristics of ETFs merit a more systematic approach to disclosure. The SEC acknowledged that additional information regarding intraday deviations could help investors and requested comment on the possibility of adopting requirements relating to such deviations.[312] In addition, the SEC asked for comment on whether it should require regular disclosure of a qualitative nature relating to the performance of the ETF’s arbitrage mechanism.[313] More broadly, the SEC acknowledged that, unlike mutual funds, ETFs rely on the arbitrage mechanism, and asked for comment on whether a new registration form should be created specifically for ETFs.[314]

The SEC proposed to eliminate a requirement in existing exemptive orders that forced an ETF to widely disseminate its IIV, which is an intraday estimate of the NAV, generally at least once every fifteen seconds.[315] The effect of this change would be limited, at least initially, however, because exchange listing standards currently require a fund to disseminate its IIV, and the rule does not change these listing standards.

Third, for the first time, a fund would be required to disclose certain information on bid-ask spreads. On its website and in its prospectus, an ETF would need to provide the median bid-ask spread for the ETF’s most recent fiscal year.[316] An ETF would also have to include on its Form N-1A information that would, among things, serve to educate investors about what our Article refers to as the “trading price frictions” that are present with ETFs, but absent with mutual funds (for example, frictions from bid-ask spreads and premiums and discounts to NAV).[317]

 


[*]*. Copyright © 2018 by Henry T. C. Hu and John D. Morley. All rights reserved.

[†] .. Professor Hu holds the Allan Shivers Chair in the Law of Banking and Finance, University of Texas Law School. Professor Morley is Professor of Law, Yale Law School. We much appreciate the insights of SEC Commissioner Robert J. Jackson, Jr. and his colleagues (Robert Bishop, Caroline Crenshaw, Marc Francis, Satyam Khanna, and Jonathon Zytnick), Rochelle Antoniewicz, Brandon Becker, Alejandro Camacho, Andrew (Buddy) Donohue, Darrell Duffie, Kenneth Fang, Jane Heinrichs, William Hubbard, Bruce Kraus, Jerry Mashaw, Nicholas Parillo, George Raine, Amy Star, Josephine Tao, executives and counsel at a number of major ETF sponsors, the library assistance of Scott Vdoviak and Lei Zhang, and the research assistance of Mark Andriola, Michael Davis, Vaughn Miller, Alicia Vesely, and Georgiana Zehner. We are also grateful for comments received in connection with presentations, including at the 29th Annual Meeting of the American Law and Economics Association (May 12, 2018). Professor Hu served as the founding Director of the U.S. Securities and Exchange Commission’s Division of Economic and Risk Analysis (formerly called the Division of Risk, Strategy, and Financial Innovation) (2009–2011), and he and his colleagues were involved in certain matters discussed in this Article.

 [1]. Dani Burger, Stocks Are No Longer the Most Actively Traded Securities in Stock Markets, Bloomberg (Jan. 12, 2017, 9:57 AM), https://www.bloomberg.com/news/articles/2017-01-12/stock-exchanges-turn-into-etf-exchanges-as-passive-rules-all.

 [2]. Robin Wigglesworth, ETFs Are Eating the US Stock Market, Fin. Times (Jan. 24, 2017), https://www.ft.com/content/6dabad28-e19c-11e6-9645-c9357a75844a?mhq5j=e3.

 [3]. Specifically, from year-end 2002 to July 30, 2018, ETF assets increased from $102 billion to $3.61 trillion; while over the same period, mutual fund assets increased from $6.38 trillion to $19.24 trillion. Inv. Co. Institute, 2017 Investment Company Fact Book 9 (57th ed. 2017) [hereinafter ICI, 2017 Fact Book]; ETF Assets and Net Issuance August 2018, Inv. Co. Institute (Aug. 30, 2018), https://www.ici.org/etf_resources/research/etfs_07_18 [hereinafter, ICI, July 2018 ETF Assets]; Trends in Mutual Fund Investing July 2018, Inv. Co. Institute (Aug. 30, 2018), https://www.ici.org/research/stats/trends/ trends_07_18.

 [4]. See Bridgewater Assocs., LP, Form 13F Holdings Report (Form 13F) (Nov. 13, 2017). Cf. Nathan Reiff, What Are the Biggest Hedge Funds in the World, Investopedia (July 5, 2017), https://www.investopedia.com/news/what-are-biggest-hedge-funds-world (discussing Bridgewater’s size).

 [5]. Chris Flood, ETF Market Smashes Through $5tn Barrier After Record Month, Fin. Times (Feb. 11, 2018), https://www.ft.com/content/5cf7237e-0cdc-11e8-839d-41ca06376bf2.

 [6]. We use the term ETF for any pooled investment that trades publicly and offers certain parties the right to create and redeem shares through the arbitrage mechanism we describe in infra Section I.A. Cf. infra Section IV.A (distinguishing ETF thus defined from exchange-traded note (“ETN”) and exchange-traded product (“ETP”)). In the context of ETFs, we use the term “innovation process” to refer both to the way an individual ETF evolves and to the manner in which a new type of ETF is developed, introduced commercially, and diffused in the marketplace. This follows earlier applications to modern financial innovation of the Schumpeterian tradition of breaking down the process of technological change to invention, innovation, and diffusion. See Henry T. C. Hu, Swaps, the Modern Process of Financial Innovation and the Vulnerability of a Regulatory Paradigm, 138 U. Pa. L. Rev. 333, 337–40 (1989) [hereinafter Hu, Regulatory Paradigm]. We use the term “ETF phenomenon” to refer both to particular ETF products and to the underlying innovation process.

 [7]. There were 923 U.S.-listed ETFs at year-end 2010, 1,412 at year-end 2014, and 1,923 on July 31, 2018. ICI, 2017 Fact Book, supra note 3, at 59; ICI, July 2018 ETF Assets, supra note 3. Of course, many new ETFs do not represent new types of ETFs.

 [8]. This fundamental “cubbyhole” problem with respect to the regulation of financial innovations was first identified by the sources cited infra note 82 and, as suggested by the Sections of this Article referenced in that note, is a recurring theme with respect to the regulation of ETFs.

 [9]. We will discuss more specifically the concept of net asset value, and the complexities and ambiguities associated with this and related concepts, in Sections I.B and V.B.

 [10]. In contrast to an ETF, in which an investor normally buys or sells shares in the secondary market, in a mutual fund, the investor buys and “redeems” shares directly with the mutual fund itself, typically at the net asset value (“NAV”) of the mutual fund shares. As to the general operation of mutual funds, see, for example, John Morley, The Separation of Funds and Managers: A Theory of Investment Fund Structure and Regulation, 123 Yale L.J. 1228 (2013) [hereinafter Morley, Funds and Managers].

 [11]. See infra Sections I.B and IV.C (discussing the ProShares Short VIX Short-Term Futures ETF).

 [12]. The concept that certain structural factors would lead to modeling problems and related forms of misunderstanding with respect to financial innovations even at sophisticated financial institutions was first advanced in 1993. See generally Henry T. C. Hu, Misunderstood Derivatives: The Causes of Information Failure and the Promise of Regulatory Incrementalism, 102 Yale L.J. 1457, 1476–94 (1993) [hereinafter Hu, Misunderstood Derivatives]. Perhaps the two most dramatic recent illustrations of this concept both involved credit derivatives: the collapse of the American International Group (“AIG”) in 2008, one of the seminal events of the global financial crisis; and the JPMorgan Chase’s Chief Investment Officer debacle in 2012. See Henry T. C. Hu, Disclosure Universes and Modes of Information: Banks, Innovation, and Divergent Regulatory Questions, 31 Yale. J. Reg. 565, 623–36 (2014) (discussing JPMorgan Chase) [hereinafter Hu, Disclosure Universes]; Kara Scannell, At SEC, a Scholar Who Saw It Coming, Wall St. J. (Jan. 24, 2010), https://www.wsj.com/articles
/SB10001424052748703415804575023402762491286 (discussing AIG). See also discussion infra Section V.C.1 (discussing how the events of August 24, 2015 taught ETF advisors that additional assumptions were necessary for the arbitrage mechanisms to be effective).

 [13]. See generally William A. Birdthistle, The Fortunes and Foibles of Exchange-Traded Funds: A Positive Market Response to the Problems of Mutual Funds, 33 Del. J. Corp. L. 69 (2008) (describing ETFs and comparing them to mutual funds); Daniel J. Grimm, A Process of Natural Correction: Arbitrage and the Regulation of Exchange-Traded Funds Under the Investment Company Act, 11 U. Pa. J. Bus. L. 95 (2008) (discussing actively managed ETFs); Peter N. Hall, Bucking the Trend: The Unsupportability of Index Providers’ Imposition of Licensing Fees for Unlisted Trading of Exchange Traded Funds, 57 Vand. L. Rev. 1125 (2004) (discussing certain licensing fees); Thor McLaughlin, Eyes Wide Shut: Exchange Traded Funds, Index Arbitrage, and the Need for Change, 22 Rev. Banking & Fin. L. 597 (2008) (discussing how outsiders may game ETFs engaged in indexed investing); John Yoder & Bo J. Howell, Actively Managed ETFs: The Past, Present, and Future, 13 J. Bus. & Sec. L. 231 (2013) (discussing actively managed ETFs).

 [14]. See generally Birdthistle, supra note 13 (describing ETFs and comparing them to mutual funds).

 [15]. Exchange-Traded Funds, Securities Act Release No. 33-1051583, Fed. Reg. 37,332 (proposed July 31, 2018) (to be codified at 17 C.F.R. pts. 239, 270, 274), https://www.sec.gov/rules
/proposed/2018/33-10515.pdf [hereinafter June 2018 SEC Proposal].

 [16]. See, e.g., June 2018 SEC Proposal, supra note 15, at 113 n.291, 117 n.303, 176–77 nn.407–09 and accompanying text; Robert J. Jackson, Jr., Commissioner, SEC, Statement of Commissioner Robert J. Jackson, Jr. on Proposed Rules Regarding Exchange Traded Funds (June 28, 2018), https://www.sec.gov/news/public-statement/statement-jackson-exchange-traded-funds-062818; Hester M. Peirce, Commissioner, SEC, Looking at Funds Through the Right Glasses (Mar. 19, 2018), https://www.sec.gov/news/speech/peirce-looking-funds-through-right-glasses; Robert St. George, SEC Faces Call to Update ETF Regulations, Citiwire (Apr. 20, 2018), http://citywireusa.com/professional-buyer/news/sec-faces-call-to-update-etf-regulations/a1107444; Henry T. C. Hu, The $5tn ETF Market Balances Precariously on Outdated Rules, Fin. Times (Apr. 23, 2018), https://www.ft.com/content
/08cc83b8-38e0-11e8-b161-65936015ebc3 (op-ed based on March 18 draft of the Article). Cf. BlackRock, BlackRock Supports Discussion About the Future of ETF Regulation, iShares.com (Apr. 2018), https://www.ishares.com/us/insights/blackrock-supports-discussion-about-future-of-etf-regulation (statement on the foregoing April 23 op-ed and related matters). We posted two drafts of this Article on Social Science Research Network (“SSRN”) in March 2018 (one on March 9 and one on March 18) and posted a third draft on August 16, all at http://ssrn.com/abstract=3137918.

 [17]. Technically, uncollateralized debt obligations known as ETNs also have an arbitrage mechanism, but that mechanism operates differently from that of ETFs. See discussion infra Section IV.A.

 [18]. See infra note 40 (referring to Sections in this Article discussing ambiguities and complexities in the concept of NAV).

 [19]. Some funds also announce a separate list known as a “redemption” basket for use exclusively in redemptions. Current listing standards require beginning-of-day disclosure for actively managed ETFs, but not index-based ETFs. See, e.g., NYSE, Rules of the NYSE Arca, Inc. r. 8.600-E(d)(2)(B)(i) (2017) [hereinafter Rules of NYSE Arca]. Nevertheless, as a matter of practice, almost all index-based ETFs disclose their portfolios at the beginning of the day.

 [20]. An S&P 500 ETF, like an S&P 500 mutual fund, may not necessarily hold all 500 shares of the S&P 500 index. We are simplifying for clarity.

 [21]. Note that the shareholder may not receive the portfolio securities until the very end of the day when the redemption is processed. In the meantime, the shareholder is likely to hedge by short-selling the portfolio securities, in the expectation that the shareholder can close out the short sale later by delivering the securities once the redemption is processed. Request for Comment on Exchange-Traded Products, Exchange Act Release No. 75165, 80 Fed. Reg. 34,729, 34,733 (June 17, 2015) [hereinafter 2015 SEC Request for Comments].

 [22]. Evidence indicates that creation and redemption transactions tend to be small and rare relative to the size of most funds. Rochelle Antoniewicz & Jane Heinrichs, Understanding Exchange-Traded Funds: How ETFs Work, ICI Research Perspective, September 2014, at 10 fig.4.

 [23]. See, e.g., Fourth Amended and Restated Application for an Order Under Section 6(c) of the Investment Company Act of 1940 (Form 40-APP/A) at 13–14, In re Van Eck Assocs. Corp., No. 812-13605 (Oct. 7, 2010), https://www.sec.gov/Archives/edgar/data/869178/000093041310005013/c62957
_appa.htm.

 [24]. See, e.g., id.

 [25]. For an explanation of these incentives, see Richard A. Defusco et al., The Exchange Traded Funds’ Pricing Deviation: Analysis and Forecasts, 35 J. Econ. & Fin. 181 (2011).

 [26]. See, e.g., U.S. Oil Fund, LP, Registration Statement Under the Securities Act of 1933 (Form S-1) (Apr. 7, 2006) (“An authorized purchaser is under no obligation to create or redeem baskets, and an authorized purchaser is under no obligation to offer to the public units of any baskets it does create.”) [hereinafter U.S. Oil Fund 2006 Registration Statement].

 [27]. Mutual funds are not precluded from processing transactions more than once a day. From 1986 through 2006, mutual funds in the “Fidelity Select Portfolios” series offered hourly pricing. See Kathie O’Donnell, Fidelity to End Hourly Pricing on Select Funds, Inv. News (July 24, 2006, 12:01 AM), http://www.investmentnews.com/article/20060724/REG/607240754/fidelity-to-end-hourly-pricing-on-select-funds. The tendency to process transactions only once a day made mutual funds vulnerable to manipulation in the early 2000s. See Eric Zitzewitz, How Widespread Was Late Trading in Mutual Funds?, 96 Am. Econ. Rev. 284, 285–88 (2006).

 [28]. Jeffrey M. Colon, The Great ETF Tax Swindle: The Taxation of In-Kind Redemptions, 122 Penn. St. L. Rev. 1, 20–30 (2017).

 [29]. Charles Schwab & Co., Inc., Comment Letter on Exchange-Traded Products at 4–5 (Aug. 17, 2015), https://www.sec.gov/comments/s7-11-15/s71115-28.pdf [hereinafter Charles Schwab]. In a comment letter to the SEC, Charles Schwab & Co. examined three different fixed-income ETFs that each sought to track the Barclays U.S. Aggregate Bond Index on August 7, 2015 and discovered that one of them, which used the pro rata method, included 1,486 securities in its creation basket, even as the other two, which used the sampling method, included only sixty-four and fifty-six securities in their creation baskets, respectively. Id. at 4 n.10.

 [30]. See, e.g., Direxion Shares ETF Trust, Statement of Additional Information 87, 90 (Feb. 28, 2018) (specifying how, for certain bear ETFs, the creation units will only be sold for cash and how the redemption proceeds will consist solely of cash), http://direxioninvestments.onlineprospectus.net
/DirexionInvestments//DFEN/index.html?open=Statement%20of%20Additional%20Information.

 [31]. U.S. Oil Fund 2006 Registration Statement, supra note 26, at 33.

 [32]. Id.

 [33]. iShares Gold Tr., Registration Statement Under the Securities Act of 1933 (Form S-3) at 19 (Nov. 21, 2017) [hereinafter IAU 2017 Prospectus]. One of the authors (Hu) holds shares in the iShares Gold Trust (“IAU”).

 [34]. Id.

 [35]. In the past, one of the authors (Hu) has held shares in SPDR Gold Trust (“GLD”).

 [36]. See IAU 2017 Prospectus, supra note 33; SPDR Gold Tr., Registration Statement on Form S-3 Under the Securities Act of 1933 (Form S-3) 3 (May 8, 2017) [hereinafter GLD 2017 Prospectus].

 [37]. IAU 2017 Prospectus, supra note 33, at 20.

 [38]. GLD 2017 Prospectus, supra note 36, at 9.

 [39]. See Press Release, BlackRock, Issuance of New IAU (Gold Trust) Shares Temporarily Suspended; Existing Shares to Trade Normally for Retail and Institutional Investors on NYSE Arca and Other Venues (Mar. 4, 2016), https://www.businesswire.com/news/home/20160304005402/en/Issuance-IAU-Gold-Trust-Shares-Temporarily-Suspended.

 [40]. There are a number of theoretical and practical complexities associated with the NAV (and the related matter of intraday indicative values), including the fact that the NAV can depart from the intrinsic value of the shares. See, e.g., infra Section V.B. One of these complexities is discussed in this Section I.B because of its importance to understanding the performance of certain ETFs on August 24, 2015. Specifically, we discuss how, in early trading that day, the S&P 500 Index (using the prescribed methodology) likely reflected values of certain constituent stocks that were in excess of their actual market values.

 [41]. Antti Petajisto, Inefficiencies in the Pricing of Exchange-Traded Funds, Fin. Analysts J., First Quarter 2017, at 24, 26, 33.

 [42]. Id.

 [43]. Id. at 33.

 [44]. Markus S. Broman, Liquidity, Style Investing and Excess Comovement of Exchange-Traded Fund Returns, 30 J. Fin. Mkts. 27, 35 (2016).

 [45]. Id. at 37.

 [46]. See Largest ETFs: Top 100 ETFs by Assets, ETFdb.com, https://web.archive.org/web
/20150810122335/http://etfdb.com/compare/market-cap (last visited Aug. 28, 2018) (noting that assets under management were based on figures available on August 10, 2015); Towers Watson, The 500 Largest Asset Managers: The P&I/Towers Watson Global 500 Research and Ranking, Year End 2014, at 3 (2015), https://www.towerswatson.com/en-US/Insights/IC-Types/Survey-Research-Results/2015/11/The-worlds-500-largest-asset-managers-year-end-2014.

 [47]. BlackRock, Inc., Comment on Exchange-Traded Products, Release No. 75165; File No. S7-11-15 at 12–13, 27 Ex.5 (Aug. 11, 2015), https://www.blackrock.com/corporate/en-at/literature
/publication/sec-request-for-comment-exchange-traded-products-081115.pdf [hereinafter BlackRock, Aug. 11, 2015 Comment Letter].

 [48]. U.S. Commodity Futures Trading Comm’n & SEC, Preliminary Findings Regarding the Market Events of May 6, 2010, at 2 (2010).

 [49]. Id. at 29–30.

 [50]. Benjamin Golub et al., BlackRock Viewpoint, Exchange Traded Products: Overview, Benefits and Myths 3, 20 (2013) https://www.blackrock.com/corporate/en-pt/literature
/whitepaper/viewpoint-etps-overview-benefits-myths-062013.pdf.

 [51]. Id. at 20 fig. 3.7.2.

 [52]. Id. at 20.

 [53]. Corrie Driebusch, Markets Reel in Global Sell-Off—Wild Ride Leaves Investors Gasping, Wall St. J., Aug. 22, 2015, at A1.

 [54]. SEC Staff of the Office of Analytics and Research, Division of Trading and Markets, Research Note: Equity Market Volatility on August 24, 2015, at 15 (2015), https://www.sec.gov/marketstructure/research/equity_market_volatility.pdf [hereinafter SEC December 2015 Note].

 [55]. See id. at 3–4, 15.

 [56]. This 9:35 a.m. 5% figure is not a precise measure of the true decline in the value of the S&P 500 Index (“SPX”) constituent stocks. This is because the S&P Dow Jones LLP (“S&P DJI”) methodology for calculating the SPX generally uses the New York Stock Exchange (“NYSE”) closing price for the previous trading day for NYSE-listed constituents that had not opened on the NYSE itself (irrespective of whether trades were occurring elsewhere). At 9:35 a.m., only 38% of NYSE-listed stocks had opened on the NYSE. SEC December 2015 Note, supra note 54, at 3. Such SPX use of the previous day NYSE closing prices likely had the effect of SPX understating the extent of the decline in early trading. Thus, until 9:42 a.m., SPX remained substantially higher than it would have been had the constituent stocks calculated with reference to consolidated real-time trade prices. Id. at 3–4.

 [57]. Id. at 16.

 [58]. The 15% difference flows from comparing the 20% drop at the daily low of iShares Core S&P 500 ETF (“IVV”) (which occurred immediately after 9:30 a.m.), with the approximately 5% daily low of the SPX (which occurred at 9:35 a.m.). As an arithmetic matter, the actual difference between the IVV and SPX at 9:30 a.m. was greater than 15% (for example, since the daily low of SPX occurred at 9:35 a.m., the 9:30 a.m. SPX was necessarily higher). On the other hand, the methodology S&P DJI prescribes for calculating SPX in early trading uses stale prices with respect to NYSE-listed stocks that had not opened for trading. See supra note 56 (discussing how SPX remained substantially higher than the prices of the NAV of the constituent stocks calculated with reference to consolidated real-time trade prices). As a result, the 15% difference represents a rough approximation of the difference between the trading price of IVV and its NAV (based on consolidated real-time trade prices of S&P 500 constituent stocks). An early media report suggested that at the open, the trading price of IVV fell 26%, even though its NAV fell only 6%—a 20% difference. See Chris Dieterich, ETF Focus: Market Plunge Provides Harsh Lessons for Investors, Barron’s (Aug. 29, 2015), http://www.barrons.com/articles/market-plunge-provides-harsh-lessons-for-etf-investors-1440826630.

 [59]. As to this finding, the SEC used various measures proxying for the SPX. SEC December 2015 Note, supra note 54, at 5.

 [60]. The statistics cited above for non-leveraged ETFs (as we define the term) are the statistics reported for non-leveraged ETPs by the SEC. See SEC December 2015 Note, supra note 54, at 2, 80. We believe this is a good approximation even though the term ETPs can also include vehicles that we would not classify at ETFs, because the great bulk of ETPs were clearly ETFs. Id. at 9. See also infra Section IV.A (on distinctions between ETFs (as we define the term), ETNs, and ETPs). The SEC nowhere indicated that it had excluded inverse products from its calculations, even though it is likely that the SEC did so since the report nowhere discusses any product as having increased in value concurrent with decreases in stock prices.

 [61]. Chris Dieterich, The Great ETF Debacle Explained, Barron’s (Sept. 5, 2015), http://www.barrons.com/articles/the-great-etf-debacle-explained-1441434195.

 [62]. We calculated the 9% estimate for 9:31 a.m. by averaging the 8% 9:30 a.m. drop and the 10% 9:32 a.m. drop. SEC December 2015 Note, supra note 54, at 5, 16.

 [63]. Id. at 5.

 [64]. This is not to suggest that the NAV is always identical to the intrinsic value of an ETF’s assets. See, e.g., Charles Schwab, supra note 29; infra Section V.B. Cf. supra note 40 (discussing various complexities associated with NAV). See also supra notes 56 and 58 (discussing the S&P DJI methodology to calculate SPX resulted in many previous-day closing prices being used with respect to NYSE stocks that had not opened for trading on the NYSE, even though the stocks were trading in other venues).

 [65]. Barbara Novick et al., BlackRock, US Equity Market Structure: Lessons from August 24, at 2, 5 (2015), https://www.blackrock.com/corporate/en-au/literature/whitepaper/viewpoint-us-equity-market-structure-october-2015.pdf [hereinafter Novick, Market Structure]. 

 [66]. SEC December 2015 Note, supra note 54, at 4.

 [67]. See supra note 46 (discussing the rankings).

 [68]. SEC December 2015 Note, supra note 54, at 15.

 [69]. Id. at 16.

 [70]. This uses the ongoing expenses that investors pay each year as a percentage of the value of investments (all of which was accounted for by management fees). iShares Tr., Registration Statement Under the Securities Act of 1933 and/or Registration Statement Under the Investment Company Act of 1940 (Form N-1A) S-1 (Jul. 24, 2015) [hereinafter IVV 2015 Prospectus].

 [71]. This is based on comparing (1) the SPX price at the open on August 22, 2014 (1992.60) with (2) the SPX price at the close on August 21, 2015 (1970.89), then including a haircut of 5%. See S&P 500 Historical Data, Investing.com, https://www.investing.com/indices/us-spx-500-historical-data (last visited Aug. 28, 2018); SEC December 2015 Note, supra note 54, at 15 (SPX “reached its daily low of a little more than 5% at 9:35 [a.m.]”).

 [72]. This is based on comparing (1) the opening price of IVV on August 22, 2014 (200.67) with (2) the IVV price at the close on August 21, 2015 (198.79), then including a haircut of 20%. See iShares Core S&P 500 ETF (IVV): Historical Data, Yahoo! Finance, https://finance.yahoo.com/quote/IVV
/history?period1=1408683600&period2=1440392400&interval=1d&filter=history&frequency=1d (last visited Aug. 28, 2018) [hereinafter iShares Core S&P 500 ETF (IVV): Historical Data]; SEC December 2015 Note, supra note 54, at 16 (“[I]mmediately after 9:30 [a.m.], IVV reached a daily low of a more than 20% below its previous day’s close . . . .”).

 [73]. Technically, for ETF investors buying or selling ETFs in the secondary market, it is the variability between the NAV and the share price that can cause problems. That is, if the investor buys at a 15% discount to NAV and happens to sell at a 15% discount, there is no harm to the investor from such deviations from the NAV.

 [74]. Fred Imbert, Dow Plunges 1,175 Points in Wild Trading Session, S&P 500 Goes Negative for 2018, CNBC (Feb. 5, 2018, 5:06 PM), https://www.cnbc.com/2018/02/04/us-stocks-interest-rates-futures.html.

 [75]. See Short VIX Short-Term Futures ETF: NAV History, ProShares, http://www.proshares.com/funds/svxy.html (spreadsheet available under “NAV History”) (last visited July 31, 2018) [hereinafter ProShares SVXY NAV Spreadsheet] (spreadsheet available under “NAV History”).

 [76]. See id. Cf. infra note 230 (announcement of change in the investment objective on February 26, 2018).

 [77]. See ProShares SVXY NAV Spreadsheet, supra note 75.

 [78]. Gunjan Benarji, Short Volatility ETN to Liquidate, Wall St. J., Feb. 7, 2018, at B14.

 [79]. Michael McDonald & Luke Kawa, Harvard’s Endowment Cut ProShares Volatility Fund Before Rout, Bloomberg (Feb. 9, 2018, 1:44 PM), https://www.bloomberg.com/news/articles/2018-02-09/harvard-s-endowment-cut-proshares-volatility-fund-before-rout.

 [80]. See iShares Core S&P 500 ETF (IVV): Historical Data, supra note 72.

 [81]. See ProShares Short VIX Short-Term Futures ETF: Premium/Discount, ETF.com, http://www.etf.com/SVXY (last visited Aug. 28, 2018). ProShares’s own figures show that in the fourth quarter of 2017, the gap between at-the-close trading prices and NAVs was within 49.9% about two-thirds of the trading days. See Short VIX Short-Term Futures ETF: Premium/Discount Analysis Tool, ProShares, http://www.proshares.com/tools/premium_discount?ticker=svxy (last visited Aug. 28, 2018).

 [82]. The cubbyhole problem arises in many contexts with respect to the regulation of ETFs and appears in, for example, the Introduction, Sections II.A, II.B, II.D, III.A, IV.A, IV.C, and V.A This cubbyhole problem in modern financial innovation and associated informational issues for regulators as well as possible solutions were first advanced in the context of financial innovation and the capital adequacy cubbyholes used by international bank regulators in by Henry T. C. Hu. See Hu, Regulatory Paradigm, supra note 6, at 335–39, 392–412. See also Hu, Misunderstood Derivatives, supra note 12, at 1463, 1495–1508 (addressing the informational disadvantages regulators face as they integrate new financial products into regulatory structures developed for existing financial products); Henry T. C. Hu, New Financial Products, the Modern Process of Financial Innovation, and the Puzzle of Shareholder Welfare, 69 Tex. L. Rev. 1273, 1292–1300, 1311–12 (1991) (financial innovation and the “equity” and “debt” cubbyholes used by corporate law). Such works have influenced scholarship as to the design and administration of tax laws in the face of financial innovation. See, e.g., Jeff Strnad, Taxing New Financial Products: A Conceptual Framework, 46 Stan. L. Rev. 569, 570 n.2, 591 n.57, 605 n.110 (1994).

 [83]. Antoniewicz & Heinrichs, supra note 22, at 10 fig.4 (indicating the ETFs regulated as investment companies are more common than ETFs regulated as commodity pools or ordinary companies).

 [84]. 15 U.S.C. § 80a-1 (2012). For an introduction to the ICA and its purposes, see John Morley, Why Do Investment Funds Have Special Securities Regulation?, in The Elgar Handbook of Mutual Fund Regulation (William Birdthistle & John Morley eds., forthcoming 2018).

 [85]. Id. § 80a-3(a).

 [86]. Antoniewicz & Heinrichs, supra note 22, at 11.

 [87]. Id. Unit investment trusts (“UITs”) and open-end management investment companies differ in a few ways. A UIT, for example, is prohibited from having a board of directors, whereas an open-end management investment company is required to have one. 15 U.S.C. § 80a-4(2) (2012) (defining a UIT as an investment company that, inter alia, “does not have a board of directors”); 15 U.S.C. § 80a-16 (2012) (requiring a board of directors for other investment companies). For the most part, however, the differences between UITs and open-end management investment companies are not important for our purposes, and we leave aside discussion of UIT-specific regulatory matters.

 [88]. See, e.g., 15 U.S.C. § 80a-18(f) (2012) (regulating borrowing); Id. § 80a-22(e) (regulating the frequency of redemptions).

 [89]. U.S. Oil Fund, LP, Registration Statement Under the Securities Act of 1933 (Form S-1) passim (Jan. 19, 2007).

 [90]. Self-Regulatory Organizations; NYSE Arca, Inc.; Notice of Filing of Proposed Rule Change Relating to the Listing and Trading of Shares of the ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund Under Commentary .02 to NYSE Arca Equities Rule 8.200, Exchange Act Release No. 79201, 81 Fed. Reg. 76,977 (Oct. 31, 2016), https://www.sec.gov/rules/sro/nysearca/2016/34-79201.pdf [hereinafter Notice of Filing of Proposed Rule Change Relating to the Listing and Trading of Shares of the ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund Under Commentary .02 to NYSE Arca Equities Rule 8.200].

 [91]. Section 1 of the Commodity Exchange Act defines the word “commodity” to include any good or article. 7 U.S.C. § 1(a)(9) (2012). Note that although futures contracts on equity securities tend to be defined as securities, rather than commodities, futures contracts on indexes of equity securities are commodities. Section 2(a)(1) of the Securities Act of 1933, for example, defines the term “security” to include a future on a security but not a future on an index of securities. 15 U.S.C. § 77b(a)(1) (2012).

 [92]. 7 U.S.C. § 1 (2012).

 [93]. Id. §§ 6k, 6n.

 [94]. The SEC disapproved a proposed rule change pertaining to the Winklevoss bitcoin ETF on July 26, 2018 despite having previously granted a petition for review after the staff initially denied the stock exchange’s application for a rule change to permit the fund’s listing. BATS BZX Exch., Inc., Exchange Act Release No. 83723, 2018 WL 3596768 (July 26, 2018); BATS BZX Exch., Inc., Exchange Act Release No. 80511, 2017 WL 1491756 (Apr. 24, 2017) (order granting petition for review and scheduling filing of statements). Cf. infra note 237 (on status of proposed VanEck SolidX Bitcoin ETF and of nine other proposed bitcoin ETFs).

 [95]. The first ETF began operating in 1993. Antoniewicz & Heinrichs, supra note 22, at 6.

 [96]. BATS was recently acquired and is now a subsidiary of Cboe. John Detrixhe & Annie Massa, CBOE Agrees to Buy Market Operator Bats for $3.2 Billion, Bloomberg (Sept. 26, 2016) https://www.bloomberg.com/news/articles/2016-09-26/cboe-says-it-plans-to-buy-market-operator-bats-for-3-2-billion.

 [97]. 15 U.S.C. § 78s(b) (2012).

 [98]. See, e.g., Combination Exchange-Traded Funds, SEC No-Action Letter, 2007 WL 2011063 (June 27, 2007) (expanding class relief to ETFs that hold both equity and fixed-income securities); Class Relief for Fixed-Income Exchange-Traded Funds, SEC No-Action Letter, 2007 WL 1498768 (Apr. 9, 2007) (expanding class relief for index-based fixed-income ETFs); Class Relief for Exchange-Traded Index Funds, SEC No-Action Letter, 2006 WL 3455230 (Oct. 24, 2006) (expanding class relief for index-based ETFs that cannot meet one or more of the conditions in the 2001 class letter); Am. Stock Exch., SEC No-Action Letter, 2001 WL 940280 (Aug. 17, 2001).

 [99]. Rules of NYSE Arca, supra note 19, at r. 5.2-E(j)(3), cmts. 1, 2 (discussing ETFs investing in equities in the first comment and ETFs investing in debt in the second comment).

 [100]. Id. at r. 8.202-E, 8.201-E (discussing currency and tangible assets, respectively).

 [101]. For a general summary of stock exchange rules, see Kenneth Fang & Jane Heinrichs, Understanding the Regulation of Exchange-Traded Funds Under the Securities Exchange Act of 1934, Inv. Co. Institute 7–10 (2017), https://www.ici.org/pdf/ppr_17_etf_listing_standards.pdf.

 [102]. E.g., Cboe BZX Exchange, Inc., Rules of Cboe BZX Exchange, Inc. r. 14.11(c)(3)(A) (2018) (requiring minimum liquidity and diversification for components of an index used by an equity ETF) [hereinafter Rules of Cboe BZX Exchange]; Rules of the NYSE Arca, supra note 19, at r. 5.2-E(j)(3) (same).

 [103]. Rules of Cboe BZX Exchange, supra note 102, at r. 14.11(c)(3)(C) (requiring disclosure of intraday indicative value every 15 seconds); Rules of NYSE Arca, supra note 19, at r. 5.2-E(j)(3) cmt. .04(a) (requiring daily disclosure on a public web site of the portfolio holdings that will form the basis of a fund’s calculation of NAV).

 [104]. Rules of Cboe BZX Exchange, supra note 102, at r. 14.11(c)(3)(A) (requiring minimum liquidity and diversification for components of an index used by an equity ETF); Rules of NYSE Arca, supra note 19, at r. 5.2-E(j)(3) (same).

 [105].               15 U.S.C. §§ 80a-2(a)(32), 5(a)(1) (2012).

 [106].               The SEC’s position is implicit in the requests that ETF sponsors make to be exempted from sections 5(a)(1) and 2(a)(32) of the ICA. See, e.g., Index IQ ETF Trust, Investment Company Act Release No. 33163 (July 19, 2018) (notice) (“Because shares will not be individually redeemable, applicants request an exemption from section 5(a)(1) and section 2(a)(32) of the Act that would permit the Funds to register as open-end management investment companies and issue shares that are redeemable in Creation Units.”).

 [107]. 15 U.S.C. § 80a-22.

 [108]. ICA section 22(e) requires redemptions to be affected within seven days of demand. Id. § 80a-22(e). ETFs that invest in securities overseas are sometimes unable to satisfy this requirement because they cannot settle trades within seven days. Additionally, ICA section 17(a) limits transactions between a fund and its large shareholders (who, for technical reasons, may include authorized participants in an ETF). Id. § 80a-17(a).

 [109]. Id. § 80a-6(c).

 [110]. As a typical example, the SEC recently approved an application for exemption by the Northern Lights Fund Trust for a series of actively managed ETFs. Section 8 of the amended application contained a section titled “Express Conditions to this Application,” which listed eighteen different conditions the trust agreed to comply with in exchange for an exemption. The conditions included, among other things, a commitment to maintain a web site with daily information on the fund’s NAV and portfolio, a commitment not to call the fund a “mutual fund,” and various commitments designed to limit the influence of large traders who might hold the fund’s shares. N. Lights Fund Tr. & Toews Corp., Application for Exemption and Other Relief Filed Under the Investment Company Act of 1940 (Form 40-APP) 29–32 (June 26, 2017).

 [111]. See, e.g., Order Disapproving a Proposed Rule Change Relating to the Listing and Trading of Shares of the SolidX Bitcoin Trust Under NYSE Arca Equities Rule 8.201, Exchange Release No. 80319, 82 Fed. Reg. 16,247 (Apr. 3, 2017) [hereinafter SolidX Bitcoin Tr.]; Order Disapproving a Proposed Rule Change to BZX Rule 14.11(e)(4) to List and Trade Shares Issued by the Winklevoss Bitcoin Trust, Exchange Release No. 80206, 82 Fed. Reg. 14,076 (Mar. 16, 2017) [hereinafter Winklevoss Bitcoin Tr.]; Precidian ETFs Tr., Investment Company Act Release No. 31336, 110 SEC Docket 1226 (Nov. 14, 2014) (order permitting withdrawal of application) [hereinafter Precidian ETFs Tr.]. For the current status of the Winklevoss, SolidX, and nine other proposed bitcoin ETFs, see supra note 94 and infra note 237.

 [112]. 15 U.S.C. § 78s(b) (2012).

 [113]. Fang & Heinrichs, supra note 101, at 7–10.

 [114]. When a stock exchange applies for a rule change to list a new fund, the SEC issues a public notice, permitting both the fund and anyone else who might be interested to comment on the SEC’s decision. See, e.g., Notice of Filing of Proposed Rule Change Relating to the Listing and Trading of Shares of the ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund Under Commentary .02 to NYSE Arca Equities Rule 8.200, supra note 90.

 [115]. The SEC permitted automatic exchange listings for index-based Investment Company ETFs in 1998 and did the same for actively managed Investment Company ETFs in 2016. Amendment to Rule Filing Requirements for Self-Regulatory Organizations Regarding New Derivative Securities Products, 63 Fed. Reg. 70,952 (Dec. 22, 1998) (to be codified at 17 C.F.R. pts. 240 and 249). See, e.g., Self-Regulatory Organizations: The NASDAQ Stock Market LLC; Order Granting Approval of a Proposed Rule Change To Amend NASDAQ Rule 5735 To Adopt Generic Listing Standards For Managed Fund Shares, Exchange Act Release No. 78918, 2016 WL 5340200 (Sept. 23, 2016); Self-Regulatory Organizations: NYSE Arca, Inc.: Order Granting Approval of Proposed Rule Change, as Modified by Amendment No. 7 Thereto, Amending NYSE Arca Equities Rule 8.600 To Adopt Generic Listing Standards For Managed Fund Shares, Exchange Release No. 78397, 2016 WL 3151792 (July 22, 2016); Self-Regulatory Organizations: BATS Exchange, Inc.; Order Approving a Proposed Rule Change, as Modified by Amendment No. 6, To Amend BATS Rule 14.11(I) To Adopt Generic Listing Standards for Managed Fund Shares, Exchange Release No. 78396, 2016 WL 3970922 (July 22, 2016).

 [116]. Yet another potential source of discretionary review for all types of funds is the 1934 Act. ETFs of all types often violate certain provisions of the 1934 Act and rules promulgated thereunder, such as those governing credit on ETF shares, customer confirmation disclosures, and market manipulation. Fang & Heinrichs, supra note 101, at 10. For Investment Company ETFs, the SEC has limited some of its discretionary review authority by issuing class relief that covers all funds that meet certain requirements. See, e.g., WisdomTree Tr., SEC No-Action Letter, 2008 WL 2792544 (May 9, 2008). See also AdvisorShares Tr., SEC No-Action Letter, 2011 WL 2423998 (June 16, 2011) (class relief for ETFs of ETFs).

 [117]. 15 U.S.C. § 80-6(c) (2012).

 [118]. 1934 Act § 19(b), 15 U.S.C. § 78s(b) (2012). See also 17 C.F.R. § 240.19b-4 (2013).

 [119].               1934 Act § 19(b)(2)(C)(i), 15 U.S.C. § 78s(b) (2012).

 [120]. 1934 Act §§ 3(f), 6(b)(5), 11A(a)(1)(C)(iii), 15 U.S.C. §§ 78c(f), 78f(b)(5), 78k-1(a)(1)(C)(iii) (2012).

 [121]. 15 U.S.C. § 80-6(c) (2012).

 [122]. Exchange-Traded Funds, Securities Act Release No. 33-8901, 73 Fed. Reg. 14,618 (Mar. 18, 2008).

 [123]. Wells Fargo Exch.-Traded Funds Tr. et al., Investment Company Act Release No. 32869, 2017 WL 4803650 (Oct. 24, 2017) (issuing an exemption “on the basis of the information set forth in the application”).

 [124]. See, e.g., CBOE Vest Fin. LLC, Amended Application for an Order Under Section 6(c) of the Investment Company Act of 1940 (Form 40-APP/A) 27–29 (Oct. 19, 2017); Sigma Inv. Advisors, LLC, Fourth Amended and Restated Application for an Order Under 6(c) of the Investment Company Act of 1940 (Form 40-APP/A) 71 (June 13, 2013).

 [125]. Precidian ETFs Tr., supra note 111. As to the eleven proposed bitcoin ETFs, see supra note 94 and infra note 237.

 [126]. See generally Administrative Procedure Act, 5 U.S.C. § 706(2)(A) (2012) (“The reviewing court shall . . . hold unlawful and set aside agency action, findings, and conclusions found to be . . . arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”).

 [127]. See generally Daniel J. Morrissey, The Road Not Taken: Rethinking Securities Regulation and the Case for Merit Review, 44 U. Richmond L. Rev. 647 (2009) (arguing in favor of re-adopting merit review).

 [128]. Sometimes the feature might be discovered by comparing successive drafts of an application on the SEC’s web site, but some proposals never make it into any draft at all.

 [129]. E.g., Precidian ETFs Tr., supra note 111 (permitting withdrawal of application after an applicant apparently failed to receive the exemption).

 [130]. BATS Global Markets, Inc., Comment Letter on Exchange-Traded Products; Exchange Act Release No. 75165, File No. 87-11-15, at 2 (Jan. 14, 2016), http://cdn.batstrading.com/resources
/comment_letters/ETP-Comment-Letter-14-January-2016.pdf (“[T]he Commission staff has not published well-defined criteria related to its concerns associated with the approval of an ETP for listing.”).

 [131]. Id. (“[A]pplication of [the SEC’s] general principles . . . can often be subjective and BATS has experienced the application of different specific standards of review between different staff members and as between different ETPs that are nearly identical, making it difficult if not impossible to anticipate the issues that Commission staff may raise with respect to any particular ETP filing.”). BATS further complained that since the listing of a new ETF technically takes the form of a change in the rules of the exchange, BATS found itself in the awkward position of “being an intermediary in what can best be described as a negotiation between the Commission staff” and a fund. Id.

 [132]. See infra Section II.D.

 [133]. Fang & Heinrichs, supra note 101, at 8–9.

 [134]. The SEC does retain some capacity to change the terms for new funds by refusing to allow their registration statements to become effective. When a sponsor establishes its first fund, it generally organizes the fund as a Delaware statutory trust or Maryland Corporation and files a registration statement with the SEC on Form N-1A. The SEC staff can then review the registration statement and prevent it from becoming effective if it does not satisfy various legal requirements. When the sponsor later issues a new fund, it typically structures it as a new series of the existing Delaware statutory trust or Maryland corporation. BlackRock, for example, places most of its iShares-branded funds into a Delaware statutory trust or a Maryland corporation. One registration statement for a Delaware statutory trust included seventy-six iShares-branded funds; another registration statement for a Maryland corporation reflected thirty-seven such funds. iShares Tr., Registration Statement Under the Securities Act of 1933 and/or Under the Investment Company Act of 1940 (Form N-1A) 2–3 (Aug. 16, 2017) (listing seventy-six funds as series of the iShares Trust, a Delaware statutory trust); iShares, Inc., Registration Statement Under the Securities Act of 1933 and/or Under the Investment Company Act of 1940 (Form N-1A) 2–3 (Jan. 19, 2018) (listing thirty-seven funds as series of iShares, Inc., a Maryland corporation).

  By structuring a new fund as a series of an already existing trust, a sponsor avoids having to file a new registration statement on Form N-1A and can register the new fund by making a post-effective amendment to the existing Form N-1A under SEC Rule 485(a). 17 C.F.R. § 230.485(a) (2018). Rule 485(c)(1), however, allows the SEC to issue a stop order refusing to let the post-effective amendment become effective. In early 2018, for example, the SEC staff threatened to use a stop order to prevent existing sponsors from registering cryptocurrency funds as new series of existing entities. See, e.g., Dalia Blass, Director, Division of Investment Management, SEC, Staff Letter: Engaging on Fund Innovation and Cryptocurrency-Related Holdings (Jan. 18, 2018), https://www.sec.gov/divisions/investment
/noaction/2018/cryptocurrency-011818.htm. As to the current status of bitcoin ETFs, see supra note 94 and infra note 237.

 [135]. Guggenheim Funds Inv. Advisors, LLC, Investment Company Act Release No. 30560, 106 SEC Docket 2599 (June 14, 2013) (notice) and Guggenheim Funds Inv. Advisors, LLC et al., Investment Company Act Release No. 30598, 106 SEC Docket 3612 (July 10, 2013) (order); Sigma Inv. Advisors, LLC, Investment Company Act Release No. 30559, 106 SEC Docket 2588 (June 14, 2013) (notice) and Sigma Inv. Advisors, LLC, Investment Company Act Release No. 30597,106 SEC Docket 3612 (July 10, 2013) (order); Transparent Value Tr., Investment Company Act Release No. 30558, 106 SEC Docket 2576 (June 14, 2013) (notice) and Transparent Value Tr., Investment Company Act Release No. 30596, 106 SEC Docket 3611 (July 10, 2013) (order).

 [136]. WisdomTree Tr., Investment Company Act Release No. 28147, 92 SEC Docket 1672 (Feb. 6, 2008) (notice) [hereinafter WisdomTree Tr. (notice)] and WisdomTree Tr., Investment Company Act Release No. 28174, 92 SEC Docket 2090 (Feb. 27, 2008) (order) [hereinafter WisdomTree Tr. (order)]; Barclays Glob. Fund Advisors, Investment Company Act Release No. 28146, 92 SEC Docket 1668 (Feb. 6, 2008) (notice) and Barclays Glob. Fund Advisors, Investment Company Act Release No. 28173, 92 SEC Docket 2089 (Feb. 27, 2008) (order); Bear Stearns Asset Mgmt., Investment Company Act Release No. 28143, 92 SEC Docket 1659 (Feb. 5, 2008) (notice) and Bear Stearns Asset Mgmt., Investment Company Act Release No. 28172, 92 SEC Docket 2089 (Feb. 27, 2008) (order); PowerShares Capital Mgmt. LLC, Investment Company Act Release No. 28140, 92 SEC Docket 1648 (Feb. 1, 2008) (notice) and PowerShares Capital Mgmt. LLC, Investment Company Act Release No. 28171, 92 SEC Docket 2088 (Feb. 27, 2008) (order).

 [137]. For an explanation of the changes, see SEC Issues New Relief for Self-Indexing ETFs, Morgan Lewis (July 17, 2013), https://www.morganlewis.com/pubs/im_lf_secissuesnewreliefselfindexingetfs
_17july13 (urging self-indexing advisers to seek modified exemptions after the SEC began loosening restrictions for new self-indexing advisers).

 [138]. E.g., BATS Global Markets, Inc., supra note 130, at 2.

[I]nconsistent standards and treatment result in a competitive disadvantage to both issuers and exchanges as it relates to previously approved ETPs that are already listed and traded on another exchange because, in almost all instances, such previously approved ETPs were not subject to the same level of standards or restrictions applied by Commission staff to the newer ETP, restricting the ETPs ability to compete with nearly identical ETPs already in the market.

Id.

 [139]. Charles Schwab, supra note 29, at 4; Stacy L. Fuller et al., At the End of the Rainbow: A Custom Basket?, K&L Gates (Oct. 5, 2017), http://www.klgates.com/at-the-end-of-the-rainbow–a-custom-basket-10-05-2017.

 [140]. Id.

 [141]. Fuller, supra note 139.

 [142]. Press Release, U.S. Sec. & Exch. Comm’n, SEC Staff Evaluating the Use of Derivatives by Funds (Mar. 25, 2010), http://www.sec.gov/news/press/2010/2010-45.htm (announcing a moratorium on new exemptions for funds that “would make significant investments in derivatives”); Norm Champ, Director, Div. of Inv. Mgmt., SEC, Remarks to the ALI CLE 2012 Conference on Investment Adviser Regulation: Legal and Compliance Forum on Institutional Advisory Services (Dec. 6, 2012), https://www.sec.gov
/news/speech/2012-spch120612nchtm (announcing the lifting of the moratorium) [hereinafter Champ, Remarks].

 [143]. Stand-One and Share Class ETFs, What’s the Difference?, Vanguard https://advisors.vanguard.com/iwe/pdf/standAloneTrans.pdf (no longer available on website) (on file with the authors).

 [144]. Id.

 [145]. ProShares Tr., Investment Company Act Release No. 27609, 89 SEC Docket 2036 (Dec. 12, 2006) (notice) and ProShares Tr., Investment Company Act Release No. 27666, 89 SEC Docket 2448 (Jan. 18, 2007) (order); Rafferty Asset Mgmt., LLC, Investment Company Act Release No. 28379, 94 SEC Docket 316 (Sept. 12, 2008) (notice) and Rafferty Asset Mgmt., LLC, Investment Company Act Release No. 28434, 94 SEC Docket 1008 (Oct. 6, 2008) (order).

 [146]. Press Release, U.S. Sec. & Exch. Comm’n, supra note 142. The decision not to grant further exemptions for leveraged funds was announced at the same time as a decision not to grant further exemptions for funds that used derivatives. Id. In 2012, however, the SEC lifted the moratorium on funds that used derivatives even as it kept the moratorium in place for leveraged funds. Champ, Remarks, supra note 142. ForceShares noted the prohibition on leveraged ETFs in its correspondence with the SEC.

ForceShares LLC, Re: Comment on Proposed Rule Change to List and Trade Shares of the ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund Under Commentary .02 to NYSE Arca Equities Rule 8.200, 4 (June 13, 2017), https://www.sec.gov/comments
/sr-nysearca-2016-120/nysearca2016120-1801076-153684.pdf.

 [147]. Press Release, U.S. Sec. & Exch. Comm’n, supra note 142.

 [148]. Champ, Remarks, supra note 142.

 [149]. Leveraged ETF List, ETFdb, http://etfdb.com/type/equity/all/leveraged/#etfs&sort_name
=assets_under_management&sort_order=desc&page=6 (last visited Aug. 29, 2018).

 [150]. Exchange-Traded Funds, Securities Act Release No. 8901, 73 Fed. Reg. 14,618, at 8 fn.19 (Mar. 11, 2008) (citing Barclays Glob. Fund Advisors, Investment Company Act Release No. 24394, 65 Fed. Reg. 21,219 (Apr. 17, 2000) (notice) and Barclays Glob. Fund Advisors, Investment Company Act Release No. 24451, 72 SEC Docket 1082 (May 12, 2000) (order)).

 [151]. See, e.g., N. Lights Fund Tr. and Toews Corp., supra note 110, at 29 (“Applicants are requesting relief with respect to future series of the Trust or of other open-end management investment companies that currently exist or that may be created in the future and that are actively-managed exchange-traded funds (‘ETFs’) . . . .”).

 [152]. See supra note 138.

 [153]. Benzinga, Four New Leveraged ETFs Right for the Times, Nasdaq (Aug. 19, 2015, 1:20 PM), http://www.nasdaq.com/article/4-new-leveraged-etfs-right-for-the-times-cm510870.

 [154]. Crystal Kim, A Secret Ingredient in the Invesco ETF Deal, Barron’s, Oct. 2, 2017, at 15.

 [155]. Notice of Filing of Proposed Rule Change Relating to the Listing and Trading of Shares of the ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund, supra note 90; Jeff Cox, Controversial ETFs that Would Have Delivered Four Times the Market Hit a Snag, CNBC (May 18, 2017, 11:35 AM), https://cnb.cx/2vggcns. We should emphasize that we do not take a position on whether the ForceShares ETFs should be offered to the public.

 [156]. Antoniewicz & Heinrichs, supra note 22, at 6.

 [157]. Supra note 142 and accompanying text.

 [158]. Notice of Filing of Proposed Rule Change Relating to the Listing and Trading of Shares of the ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund, supra note 90.

 [159]. Although futures contracts on equity securities technically qualify as securities, rather than commodity futures, under the securities laws, ForceShares cleverly avoided this problem by investing in futures contracts on an index of equity securities—not contracts on the individual underlying securities. This worked because section 2(a)(1) of the Securities Act of 1933 (“1933 Act”) defines the term “security” to include a future on a security but not a future on an index of securities. 15 U.S.C. § 77b(a)(1) (2012).

  ForceShares also neatly avoided restrictions on leverage in registered investment companies. The listing rules of the NYSE Arca exchange (the exchange where ForceShares proposed to list) prohibit an index-based ETF from offering an inverse leverage ratio in excess of 300% if the fund is registered as an investment company. Rules of NYSE Arca, supra note 19, at r. 5.2(j)(3) cmt. .04. This would have been a problem for ForceShares, because ForceShares’s inverse fund aspired to a leverage ratio of 400%. ForceShares avoided the 300% restriction, however, because the restriction only applied to an investment company and not a commodity pool. (Note that ForceShares was proposing to list under NYSE Arca Rule 8.200.)

 [160]. Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 31933, 112 SEC Docket 6625 (Dec. 11, 2015). In its correspondence with the SEC, ForceShares cleverly pointed out that in the published Rule 18f-4 proposal, the SEC expressly invited any investment company that would violate the rule to register instead as a commodity pool. ForceShares LLC, supra note 146, at 3.

 [161]. Order Approving a Proposed Rule Change to List and Trade Shares of the ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund under Commentary .02 to NYSE Arca Equities Rule 8.200, Exchange Act Release No. 80579, 2017 WL 2535412 (May 2, 2017).

 [162]. The Division of Trading and Markets caused the SEC to issue a release requesting comments, with the effect that ForceShares’s application was set to automatically become effective. Notice of Filing of Proposed Rule Change Relating to the Listing and Trading of Shares of the ForceShares Daily 4X US Market Futures Long Fund and ForceShares Daily 4X US Market Futures Short Fund, supra note 90.

 [163]. Cox, supra note 155.

 [164]. This is true even with respect to the most recent SEC effort to strengthen disclosure requirements relating to ETFs and mutual funds, an effort centering on Forms N-PORT (to be regularly submitted beginning either by April 30, 2019 or April 30, 2020, depending on the size of the fund group) and N-CEN (to be regularly submitted as of June 1, 2018). Investment Company Reporting Modernization, Securities Act Release No. 10442, 82 Fed. Reg. 58,731 (Dec. 14, 2017) (delaying dates for submitting reports to April 20, 2019 and April 20, 2010) [hereinafter N-PORT Delay]; Investment Company Reporting Modernization, Securities Act Release No. 10231, 81 Fed. Reg. 81,870 (Oct. 13, 2016) (relating to Forms N-PORT and N-CEN) [hereinafter Investment Company Reporting Modernization]. See also infra note 283.

 [165]. Form N-1A, U.S. Sec. and Exch. Comm’n (Aug. 2017), https://www.sec.gov/files/formn-1a.pdf [hereinafter Form N-1A].

 [166]. Id. at v (discussing C(2)(a)).

 [167]. The option of using a Summary Prospectus to meet prospectus delivery requirements became available in 2009. See Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, Securities Act Release No. 8998, 74 Fed. Reg. 4,546, 4,573–74 (Jan. 26, 2009).

 [168]. Form N-1A, supra note 165, at v (discussing C(2)(b)).

 [169]. Michael Glazer, Prospectus Disclosure and Delivery Requirements, in 1 Mutual Funds and Exchange Traded Funds Regulation § 4.5.2(B) (Clifford E. Kirsch ed., 3d ed. 2011 & Supp. 10 2016).

 [170]. See Form N-1A, supra note 165, at 39–42, items 27(b)–(d) (annual and semi-annual report requirements). Id. at 39–45.

 [171]. Specifically, they are reports on Form N-Q and Form N-CSR. Form N-Q, U.S. Sec. and Exch. Comm’n (Aug. 2005), https://www.sec.gov/files/formn-q.pdf; Form N-CSR, U.S. Sec. and Exch. Comm’n (July 2018), https://www.sec.gov/files/formn-csr.pdf. Form N-Q is being superseded. See supra note 164 (discussing the adoption of Forms N-CEN and N-PORT).

 [172]. See, e.g., Fidelity Commonwealth Tr., Amended Application for an Order Under Section 6(c) of the Investment Company Act of 1940 (Form 40-APP/A) 19 (June 27, 2016) [hereinafter Fidelity Notice]; Fidelity Commonwealth Tr., Order Under Sections 6(c), 12(d)(1)(J), and 17(b) of the Investment Company Act of 1940, Investment Company Act Release No. 32191 (July 26, 2016); Barclays Global Fund Advisors, Notice of Application, Investment Company Act Release No. 28146, at 11 (Feb. 6, 2008) [hereinafter Barclays Notice]; Barclays Global Fund Advisors iShares Tr., Order Under Sections 6(c) and 17(b) of the Investment Company Act of 1940, Investment Company Act Release No. 28173 (Feb. 27, 2008); Claymore Exch.-Traded Fund Tr., Notice of Application, Investment Company Act Release No. 27469, 71 Fed. Reg. 51,869, 51,872 (Aug. 31, 2006) [hereinafter Claymore Notice], Claymore Exch.-Traded Fund Tr., Investment Company Act Release No. 27483 (Sept. 18, 2006).

 [173]. There are some minor variations. For instance, United States Oil Fund, LP is generally subject to the SEC’s 1933 Act and 1934 Act disclosure system, but its prospectus includes a one-page “Risk Disclosure Statement” mandated by the Commodity Futures Trading Commission. See U.S. Oil Fund, LP, Prospectus (Form 424B3) (Feb. 28, 2017) [hereinafter U.S. Oil 2017 Prospectus]. Also, this ETF has filed Form 8-Ks attaching the monthly account statements presented in the form of a Statement of Income (Loss) and a Statement of Changes in Net Asset Value as required pursuant to Rule 4.22 under the Commodities Exchange Act. See, e.g., U.S. Oil Fund, LP, Current Report (Form 8-K) (May 25, 2017).

 [174]. See U.S. Oil 2017 Prospectus, supra note 173, at 24.

 [175]. As to such IAU and GLD web disclosures, see iShares Gold Trust (IAU), iShares.com, https://www.ishares.com/us/products/239561/ishares-gold-trust-fund#premiumDiscountDialog (last visited Aug. 29, 2018) and SPDR Gold Shares (GLD), State Street Global Advisors SPDR https://us.spdrs.com/en/etf/spdr-gold-shares-GLD# (last visited Aug. 29, 2018). GLD, in addition, provides a graph in its Form 10-K that reflects the share price and NAV versus the gold price over the period November 18, 2004 to September 30, 2017. SPDR Gold Trust, Annual Report (Form 10-K) 38 (Nov. 28, 2017). In the interests of disclosure, one of the authors (Hu) holds shares in IAU and, in the past, has held shares in GLD.

 [176]. See IAU 2017 Prospectus, supra note 33, at 8–9; GLD 2017 Prospectus, supra note 36, at 9; U.S. Oil 2017 Prospectus, supra note 173, at 10.

 [177]. Form N-1A, supra note 165, at 7–8, item 4(b)(2).

 [178]. Id. at 41, item 27(b)(7)(ii).

 [179]. Id. at 2–5, item 3.

 [180]. Id. at 42–43, item 27(d)(1).

 [181]. One of the three exemptive orders examined with respect to disclosure contemplate performance information in the prospectus and annual report to not only be on the basis of NAV, but also in terms of the share price, while the other two exemptive orders do not add the general prospectus and annual report performance disclosure requirements. Compare Barclays Notice, supra note 172, at 11 (disclosure of cumulative total return and average annual total return “based on NAV and Bid/Ask Price”), with Fidelity Notice, supra note 172, at 19 and Claymore Notice, supra note 172, at 51,872.

 [182]. See supra Section I.B. (discussing the performance of IVV’s arbitrage mechanism on August 24, 2015).

 [183]. See iShares Core S&P 500 ETF: Fact Sheet as of 6/30/2018, iShares, https://www.ishares.com/us/literature/fact-sheet/ivv-ishares-core-s-p-500-etf-fund-fact-sheet-en-us.pdf (last visited Aug. 29, 2018); SPDR S&P 500 ETF, State Street Global Advisors SPDR, https://us.spdrs.com/en/etf/spdr-sp-500-etf-SPY (last visited Aug. 29, 2018).

 [184]. James E. Ross, ETF Insights: 3 Charts That Capture SPY’s Liquidity, SPDR Blog (Jan. 22, 2018), https://global.spdrs.com/blog/post/2018/jan/3-charts-that-capture-spys-liquidity.html.

 [185]. Id.

 [186]. It should be emphasized at the onset that the IVV disclosure documents referred to in our analysis below were well-written documents that complied fully with SEC requirements. Our analysis of informational gaps relates to the inadequacies of the existing SEC disclosure regime and is not meant to imply any improper act or omission by IVV or any other ETF.

 [187]. Form N-1A, supra note 165, at 14, item 11(g)(2). There is substantially the same requirement, but with data up to five years, for the annual report (again, with a website option). Id. at 41, item 27(b)(7)(iv).

 [188]. The verbal formulations vary in specificity and content. Compare Fidelity Notice, supra note 172, at 19 (having the website disclose the prior business day’s price and NAV at closing and a calculation of the premium and discount), with Barclays Notice, supra note 172, at 11 (requiring that the website, prospectus, and annual report include the prior business day’s premium and discount at closing; and a chart showing the frequency distribution, within appropriate ranges, of such premiums and discounts for each of the four previous calendar quarters) and Claymore Notice, supra note 172, at 11 (requiring that the website include updated daily information at the close and “information about the premiums and discounts at which the Fund Shares have traded”).

 [189]. iShares Tr., Registration Statement Under the Securities Act of 1933 and/or Under the Investment Company Act of 1940 (Form N-1A) 26 (Jul. 27, 2016) [hereinafter IVV 2016 Prospectus].

 [190]. Joel M. Dickson & James J. Rowley, Jr., “Best Practices” for ETF Trading: Seven Rules of the Road, Vanguard 1, 6 (2014), https://www.vanguard.com/pdf/ISGETF.pdf.

 [191]. BlackRock, Guide to Buying and Selling ETFs 1 (2017), https://www.ishares.com/us
/literature/brochure/guide-to-buying-and-selling-etfs-en-us.pdf.

 [192]. Christopher Condon & Margaret Collins, ‘Seduced’ ETF Investors Caught by Surprise as Prices Diverge, Futures Mag. (July 1, 2013) http://www.futuresmag.com/Wjw (quoting David Blain, a financial adviser who manages $75 million).

 [193]. Simon Constable, Four Reasons to Avoid the Lowest-Cost ETFs Unlike the Case for Mutual Funds, the Expense Ratio Isn’t the End and Be-All, Wall St. J., Oct. 9, 2017, at R5.

 [194]. Kent Thune, 7 Best iShares ETFs for Building Your Portfolio, InvestorPlace (Nov. 16, 2017, 6:03 AM), http://bit.ly/2mwSUYn. According to the InvestorPlace website, “[t]his article was originally published on Oct. 29, 2015, but we’re republishing it so our readers will continue to benefit from these still-solid iShares ETFs.”

 [195]. See Investment Company Reporting Modernization, supra note 164; N-PORT Delay, supra note 164. Cf. supra note 164 and accompanying text (on certain information as to APs being required on Form N-CEN beginning June 1, 2018 with respect to Investment Company ETFs).

 [196]. See, e.g., Disclosure and Analysis of Mutual Fund Performance Information; Portfolio Manager Disclosure, Securities Act Release No. 6850, 55 Fed. Reg. 1,460, 1,462 (Jan. 8, 1990) (proposed rule) [hereinafter MDFP Proposing Release]; Disclosure of Mutual Fund Performance and Portfolio Managers, Securities Act Release No. 6998, 58 Fed. Reg. 19,050, 8–12 (May 4, 1993) [hereinafter MDFP Adopting Release].

 [197]. Form N-1A, supra note 165, at 41, item 27(b)(7)(i).

 [198]. See iShares, 2015 Annual Report 6–7 (Mar. 31, 2016) (Management’s Discussion of Fund Performance); IVV 2016 Prospectus, supra note 189.

 [199]. See PowerShares, 2015 Annual Report to Shareholders (Oct. 31, 2015); PowerShares Exchange-Traded Fund Tr. II, Registration Statement: PowerShares S&P 500 Low Volatility Portfolio (Form N-1A) (Feb. 29, 2016); Vanguard U.S. Sector Index Funds, Annual Report (Aug. 31, 2015); Vanguard World Fund, Registration Statement: Vanguard Consumer Staples Index Fund (Form N-1A) (Dec. 22, 2015).

 [200]. MDFP Proposing Release, supra note 196, at 1,462.

 [201]. Id. (emphasis added).

 [202]. MDFP Adopting Release, supra note 196, at 10.

 [203]. Form N-1A, supra note 165, at 40, item 27(b)(7).

 [204]. Id. at 6–7, item 4(b)(1). See also id. at 11, item 9(c).

 [205]. Id. at 19, item 16(b).

 [206]. Id. at 10, item 6.

 [207]. See, e.g., IVV 2015 Prospectus, supra note 70 at S-3, 5.

 [208]. See infra Section V.C.

 [209]. Most notably, it added a sentence to the effect that APs may be less willing to create or redeem fund shares if there is, among other things, the lack of an active market for the underlying investments, which may contribute to the shares trading at a premium or discount. IVV 2016 Prospectus, supra note 189, at 6.

 [210]. Exchange-Traded Funds, Securities Act Release No. 8901, 73 Fed. Reg. 14,618 (Mar. 11, 2008).

 [211]. Request for Comment on Exchange-Traded Products, Exchange Release No. 75165, 80 Fed. Reg. 34,729 (June 17, 2015).

 [212]. We adapt this formulation from stock exchange listing standards. E.g., Rules of Cboe BZX Exchange, supra note 102, at r. 14.11(c)(1) (defining an “Index Fund Share” for index-based exchange-traded funds); Rules of NYSE Arca, supra note 19, at r. 8.200 (regulating “trust-issued receipts” that trade on an exchange and permit shareholders to redeem shares). Although there is no universal definition of an ETF in stock exchange listing standards, the various rules developed to apply to individual types of ETFs have been forced to identify the basic outlines of what an ETF is. 2015 SEC Request for Comments, supra note 21, at 34, 730–31.

 [213]. Exchange-Traded Funds, supra note 210, at 5 n.4 (noting the exclusion of Commodity Pool ETFs); infra note 224 (discussing forthcoming 2019 liquidity-related requirements excluding Commodity Pool ETFs and Operating Company ETFs); infra note 283 and accompanying text (noting how Form N-CEN does not cover Commodity Pool ETFs and Operating Company ETFs).

 [214]. Supra Section II.D.

 [215]. Supra Section II.D.

 [216]. 17 C.F.R. § 270.38a-1 (2004); Id. § 275.206(4)-7.

 [217]. 15 U.S.C. § 80a–17 (2012). For an example of how these rules might apply, see Exchange-Traded Funds, supra note 210, at 41.

 [218]. For an explanation of these issues, see generally Morley, Funds and Managers, supra note 10 (explaining the conflicts that can arise when a fund is distinct from its advisor).

 [219]. See, e.g., Roberta Romano, The Political Dynamics of Derivative Securities Regulation, 14 Yale J. on Reg. 279 (1997).

 [220].               For a more detailed discussion of differences between ETFs and ETNs, see, for example, Brian A. Johnson, Essays on Exchange Traded Notes (Summer 2016) (unpublished Ph.D. dissertation, University of California, Berkeley), at 5–8 (on file with author (Hu)).

 [221]. See, e.g., WisdomTree Tr. (notice), supra note 136; WisdomTree Tr. (order), supra note 136.

 [222]. WisdomTree Tr. (notice), supra note 136, at 7.

 [223]. See, e.g., Van Eck Assocs. Corp., Investment Company Act Release No. 27283, 71 Fed. Reg. 19,214, 19,215 (Apr. 7, 2006). Note that the SEC proposed similar rules in its 2008 proposal. Exchange-Traded Funds, supra note 210, at 27–28.

 [224]. See, e.g., Rules of Cboe BZX Exchange, supra note 102, at r. 14.11(liquidity requirements for fixed-income-linked Commodity Pool ETFs); Rules of NYSE Arca, supra note 19, at r. 5.2(j)(3) (liquidity requirement for index fund Investment Company ETFs funds).

  Beginning on June 1, 2019 or December 1, 2019 (depending on certain ETF size considerations), ETFs that are Investment Company ETFs (other than “In-Kind ETFs” as defined by the SEC) would be required by the SEC to adopt and implement said written liquidity risk management program. See Investment Company Institute Liquidity Risk Management Programs; Commission Guidance for In-Kind ETFs, Investment Company Act Release No. 33010, 83 Fed. Reg. 8,342, 8,343, 8343 n.2 (Feb. 27, 2018) (“[F]unds” in the release “includes open-end management companies, including exchange traded funds . . . that do not qualify as In-Kind ETFs . . . and excludes money market funds.”). Cf. Investment Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315, 81 Fed. Reg. 82142, 82,216–17 (Nov. 18, 2016) (stating that the SEC is defining an ETF as an “open-end management investment company (or series or class thereof), the shares of which are listed and traded on a national securities exchange, and that has formed and operates under an exemptive order under the [ICA] granted by the Commission or in reliance on an exemptive rule adopted by the Commission.”).

 [225]. For a complete explanation of this idea, see generally John Morley & Quinn Curtis, Taking Exit Rights Seriously: Why Governance and Fee Litigation Don’t Work in Mutual Funds, 120 Yale L.J. 84 (2010).

 [226]. Certain factors (unrelated to the arbitrage mechanism) could cause two ETFs with the same NAV to trade at somewhat different prices (or at different bid-ask spreads). For example, the shares of an ETF needing to make a (taxable) distribution would be less attractive to most investors than the shares of an otherwise identical ETF that does not need to do so. Depending on the efficiency of the market in the shares of these two ETFs, the respective share prices might reflect this. See E-mails from Andrew J. (Buddy) Donohue, Director, SEC Div. of Inv. Mgmt. (2006–10), to Henry T. C. Hu, Allan Shivers Chair in the Law of Banking and Fin., Univ. of Tex. Law Sch. (Apr. 30, 2018, 4:51 PM CST. and July 27, 2018, 2:40 PM CST) (on file with author (Hu)).

 [227]. The SEC’s 2008 proposal addresses a number of these technical issues. E.g., Exchange-Traded Funds, supra note 210, at 44 (delays in delivering redemption proceeds), 49 (prospectus delivery requirement for broker dealers), 97 (investments by other investment companies in ETFs).

 [228]. 15 U.S.C. § 80a–30(b) (2012).

 [229]. A review of the ETF and mutual fund screener website of U.S. News & World Report showed forty-six mutual funds that were in the “trading-leveraged-equity” category, with total assets of $3.16 billion. In contrast, there were 101 ETFs in the same category, with total assets of $17.68 billion. (This was based on a review on August 22, 2017 of Best Mutual Fund Rankings: Trading—Leveraged Equity, U.S. News & World Report, https://money.usnews.com/funds/mutual-funds/rankings/trading-leveraged-equity.) Similarly, in the “trading-inverse-debt” category, there were only seven mutual funds, with total assets of $182 million versus nineteen ETFs with total assets of $3.46 billion. Id.

 [230]. See ProShares SVXY NAV Spreadsheet, supra note 75. At the Tuesday close, the gap between trading price and the NAV was still sizable, but the gap was far narrower than the Monday close. The Tuesday closing price was $12.24 while the NAV was $11.3792. Both SEC Chairman Jay Clayton and SEC Commissioner Kara Stein have expressed concerns over the nature of some ETFs now available to average investors. See, e.g., Benjamin Bain & Matt Robinson, VIX Funds Face Fresh Scrutiny from U.S. Regulators, Bloomberg (Feb. 23, 2018), https://www.bloomberg.com/news/articles/2018-02-23/vix-fund-blowups-spur-u-s-to-probe-if-misconduct-played-a-role.

  Three weeks after the “Vix-mageddon” of February 5, 2018, ProShare Capital Management announced that ProShares Short VIX Short-Term Futures ETF (“SVXY”) would change its investment objective to seek results (before fees and expenses) that correspond only to one-half of the inverse (-0.5X) of the S&P 500 VIX Short-Term Futures Index. Press Release, ProShare, ProShare Capital Management LLC Plans to Reduce Target Exposure on Two ETFs (Feb. 26, 2018), http://www.proshares.com/news
/proshare_capital_management_llc_plans_to_reduce_target_exposure_on_two_etfs.html.

 [231]. FINRA, FINRA Manual, at r. 2111 (2014).

 [232]. Morgan Stanley Smith Barney, LLC, Exchange Act Release No. 79794, 2017 WL 129913 (Feb. 14, 2017) (order instituting administrative and cease-and-desist proceedings); Press Release, FINRA, FINRA Sanctions Oppenheimer & Co. $2.9 Million for Unsuitable Sales of Non-Traditional ETFs and Related Supervisory Failures (June 8, 2016), https://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-million-unsuitable-sales-non-traditional-etfs.

 [233]. Supra note 14647 and accompanying text.

 [234]. Non-Traditional ETFs FAQ, FINRA, http://www.finra.org/industry/non-traditional-etf-faq (last visited Aug. 29, 2018).

 [235]. Frank Holmes, Small-Cap Mining Stocks, Big-Time Opportunity, U.S. Global Investors: Frank Talk (June 19, 2017), http://www.usfunds.com/investor-library/frank-talk/small-cap-mining-stocks-big-time-opportunity. We turn to another aspect of this ETF situation in infra Section IV.C.

 [236]. Id. Frank Holmes co-manages, among others, the U.S. Global Investors Gold and Precious Metals Fund. See U.S. Global Investors Gold and Precious Metals Fund, Morningstar, http://financials.morningstar.com/fund/management.html?t=USERX&region=usa&culture=en_US (last visited Aug. 29, 2018).

 [237]. Liz Moyer, Treasury Secretary Mnuchin Wants to Make Sure Bad People Cannot Use Bitcoin to Do Bad Things, CNBC (Jan. 16, 2018), https://www.cnbc.com/2018/01/12/mnuchin-wants-to-make-sure-bad-guys-cant-use-cryptocurrencies.html. See also Jeff Kluter, Can Bitcoin Threaten Market Stability?, Institutional Investor (Feb. 28, 2018), https://www.institutionalinvestor.com/article
/b17435bhd2bdgk/can-bitcoin-threaten-market-stability; Eric Lam, What the World’s Central Banks Are Saying About Bitcoin, Bloomberg (Jan. 28, 2018), https://www.bloomberg.com/news/articles/2017-12-15/what-the-world-s-central-banks-are-saying-about-cryptocurrencies.

  The SEC so far has not permitted the creation of a bitcoin ETF. On January 18, 2018, Dalia Blass, the Director of the Division of Investment Management, indicated that several questions had to be answered regarding cryptocurrencies before the SEC would let them be included in fund products. See Ari I. Weinberg, It’s Getting Harder to Bring an Exotic ETF to Market, Wall St. J., Mar. 5, 2018, at R7. Cf. Avi Salzman, The End of the Road for Bitcoin ETFs?, Barron’s (Jan. 10, 2018, 2:50 PM), https://www.barrons.com/articles/the-end-of-the-road-for-bitcoin-etfs-1515613827. On July 26, 2018, the SEC disapproved the proposed introduction of a bitcoin ETF by Cameron and Tyler Winklevoss. See supra note 94. On August 7, 2018, the SEC announced that it would delay its decision with respect to the proposed Van Eck SolidX Bitcoin ETF. See Cboe BZX Exch., Inc., Exchange Act Release No. 83792 (Aug. 7, 2018); Bitcoin Dealt a Blow After SEC Delays ETF Decision, Fin. Times (Aug. 8, 2018), https://www.ft.com/content/53311902-9ad1-11e8-ab77-f854c65a4465. On August 22, 2018, staff at the SEC rejected applications for nine separate bitcoin ETFs. At the time of this Article’s publication, however, the Commission was reviewing the staff’s decisions. See Rachel Evans & Lily Katz, Bitcoin ETFs Aren’t Coming Any Time Soon Thanks to the SEC, Bloomberg (Aug. 23, 2018), at https://www.bloomberg.com/news/articles/2018-08-23/bitcoin-etfs-won-t-be-coming-any-time-soon-thanks-to-the-sec.

 [238]. See. e.g., Bob Pisani, How Small, Exotic Volatility Trades Had Outsized Influence on the Market’s Free Fall, CNBC (Feb. 7, 2018, 3:43 PM), https://cnb.cx/2FX0NLz (asserting that the activities of the SVXY and related products in early February 2018 raise a question about whether these products introduce a systemic risk).

 [239]. Int’l Monetary Fund, Global Financial Stability Report April 2018: A Bumpy Road Ahead 19 (2018), https://www.imf.org/en/Publications/GFSR/Issues/2018/04/02/Global-Financial-Stability-Report-April-2018.

 [240]. Id.

 [241]. Henry T. C. Hu, Systemic Risk and Financial Innovation: Toward a “Unified” Approach, in Quantifying Systemic Risk 11, 23 (Joseph G. Haubrich & Andrew W. Lo eds., 2013), http://www.nber.org/chapters/c12053.pdf [hereinafter Hu, Unified Approach].

 [242]. Press Release, U.S. Sec. & Exch. Comm’n, SEC Names Brett Redfearn as Director of the Division of Trading and Markets (Oct. 18, 2017), https://www.sec.gov/news/press-release/2017-198.

 [243]. See Biography: Brett Redfearn, Director, Division of Trading and Markets, U.S. Sec. and Exch. Comm’n, https://www.sec.gov/biography/brett-redfearn (last visited Aug. 29, 2018).

 [244]. For a discussion of the role of this Division at the SEC and with respect to issues involving financial innovation and systemic risk, see, e.g., Hu, Unified Approach, supra note 241, at 23–26; Fingers in the Dike: What Regulators Should Do Now, Economist (Feb. 13, 2010), https://www.economist.com
/special-report/2010/02/11/fingers-in-the-dike (special report on financial risk). The original name for this Division was “Division of Risk, Strategy, and Financial Innovation.” Press Release, U.S. Sec. & Exch. Comm’n, SEC Renames Division Focusing on Economic and Risk Analysis (June 6, 2013), https://www.sec.gov/news/press-release/2013-2013-104htm.

 [245]. U.S. Sec. & Exch. Comm’n, Fiscal Year 2019 Congressional Budget Justification and Annual Performance Plan 15 (2018), https://www.sec.gov/reports-and-publications/budget-reports/secfy19congbudgjust.

 [246]. For a discussion of the longstanding goals of SEC-mandated disclosure in the context of ordinary companies, see, for example, Henry T. C. Hu, Efficient Markets and the Law: A Predictable Past and an Uncertain Future, 4 Ann. Rev. Fin. Econ. 179, 180–81, 200 (2012).

 [247]. U.S. Oil 2017 Prospectus, supra note 173, at 1–2.

 [248]. Cf., e.g., Guides for Statistical Disclosure by Bank Holding Companies, Securities Act Release No. 5735, 41 Fed. Reg. 39,007 (Sept. 14, 1976).

 [249]. See supra Section III.B.

 [250]. 2015 SEC Request for Comments, supra note 21, at 34,733.

 [251]. Id.

 [252]. Id.

 [253]. Id.

 [254]. Finding ProShare Intraday Values (IOPVS/IIVS), ProShares, http://www.proshares.com
/finding_proshares_intraday_values.html (last visited Aug. 29, 2018).

 [255]. 2015 SEC Request for Comments, supra note 21, at 34,733.

 [256]. See, e.g., Markit, Comment Letter on Exchange-Traded Products, at 2 (Aug. 17, 2015), https://www.sec.gov/comments/s7-11-15/s71115-17.pdf.

 [257]. This is based on an interview one of the authors (Hu) had with a major ETF sponsor in May 2018.

 [258]. See, e.g., Golub, supra note 50, at 14 (discussing circumstances such as when valuation methodologies used to compute NAV may suffer from price staleness associated with thinly traded securities, closed markets as can happen with international funds, and conventions); supra note 40 (referring to the theoretical and practical complexities associated with the NAV and the related matters associated with intraday indicative values).

 [259]. See, e.g., Hu, Disclosure Universes, supra note 12, at 575–83, 618–35, 639–50, 654–55 (discussing three “modes of information,” the rationale for the “transfer mode,” and how the GLD ETF provides “pure information” as to its gold bars); Henry T. C. Hu, Too Complex to Depict? Innovation, “Pure Information,” and the SEC Disclosure Paradigm, 90 Tex. L. Rev. 1601 (2012) (proposing a new conceptual framework for “information,” terminology such as “depiction tools,” and initial analysis of too complex to depict problems with, for example, asset-backed securities and too big to fail banks heavily involved in complex financial innovations).

 [260]. This is based on a review of Figure 3.3 in Ananth N. Madhavan, Exchange-Traded Funds and the New Dynamics of Investing 43 (2016).

 [261]. Form N-1A, supra note 165, at 8, item 4(b)(2)(ii).

 [262]. Regulation S-K, 17 C.F.R. § 229.303 (2018).

 [263]. Form 10-Q, U.S. Sec. and Exch. Comm’n, at 5, pt. I, item 2 (Apr. 2017), https://www.sec.gov/files/form10-q.pdf; Form 10-K, U.S. Sec. and Exch. Comm’n, at 9, pt. II, item 7 (Apr. 2017), https://www.sec.gov/files/form10-k.pdf. The MD&A is also required in registration statements. See, e.g., Form S-1, U.S. Sec. and Exch. Comm’n, at 5, pt. I, item 11(h) (Apr. 2017), https://www.sec.gov/files/forms-1.pdf.

 [264]. Hu, Disclosure Universes, supra note 12, at 593–96.

 [265]. See, e.g., Orie E. Barron et al., MD&A Quality as Measured by the SEC and Analysts’ Earnings Forecasts, 16 Contemp. Acct. Res. 75, 80 (1999) (“We focus on MD&A because a growing body of evidence suggests that the SEC and users of financial reports view MD&A as particularly important, despite the fact that MD&A is only a small part of each firm’s total disclosure.”); Carl W. Schneider, MD&A Disclosure, 22 Rev. Sec. & Commodities Reg. 149, 150 (1989) (characterizing MD&A as requiring “all material information, historical or prospective, that has impacted or might foreseeably impact on the financial affairs of the registrant”).

 [266]. Concept Release on Management’s Discussion and Analysis of Financial Condition and Operations, Securities Act Release No. 6711, 52 Fed. Reg. 13,715, 13,717 (Apr. 24, 1987).

 [267]. Management’s Discussion and Analysis of Financial Condition and Results of Operation, Certain Investment Company Disclosures, Securities Act Release No. 6835, 54 Fed. Reg. 22,427, 22,428 (May 24, 1989) (footnote omitted).

 [268]. See, e.g., 17 C.F.R. § 229.303(a)(1), (a)(3)(ii) (2018).

 [269]. Id. § 229.303, instruction 3 to para. 303(a).

 [270]. Golub, supra note 50, at 2.

 [271]. BlackRock, Aug. 11, 2015 Comment Letter, supra note 47, at 7.

 [272]. Sumit Roy, How an ETF Gets Too Big For Its Index, ETF.com (Apr. 10, 2017), http://www.etf.com/sections/features-and-news/how-etf-gets-too-big-its-index.

 [273]. See Ryan T. McIntyre, Method to Madness: Opportunity in a Volatile Time, Tocqueville Funds (Apr. 19, 2017), http://www.tocquevillefunds.com/insights/method-madness-opportunity-volatile-time (showing the top 10 holdings of the ETF and the MVIS Global Junior Gold Miners Index as of March 31, 2017 in Exhibit 1). On April 13, 2017, MVIS Index Solutions announced changes to its index, widening the criteria for inclusion. Luzi-Ann Javier, Danielle Bochove & Aoyon Ashraf, ‘Curse of Success’ Leads the Most Popular Mining ETF to Widen Its Holdings, Bloomberg (Apr. 13, 2017), https://www.bloomberg.com/news/articles/2017-04-13/vaneck-s-junior-gold-miner-etf-seen-rebalancing-as-assets-soar.

 [274]. Press Release, Direxion, Direxion Suspends Creation Units for Daily Junior Gold Minders Index Bull 3X Shares (Apr. 13, 2017), http://www.direxioninvestments.com/wp-content/uploads/2017
/04/Direxion-Suspends-Creation-Units-for-Daily-Junior-Gold-Miners-Index-Bull-3X-Shares.pdf.

 [275]. See Inv. Co. Inst., Comment Letter on Exchange-Traded Products (File No. S7-11-15) 16 (Aug. 17, 2017), https://www.sec.gov/comments/s7-11-15/s71115-22.pdf.

 [276]. Id. at 16–17 (discussion of withdrawal as APs by Knight Trading Group and Citigroup).

 [277]. BlackRock et al., Comment Letter on SEC Action to Address Market Structure Issues Related to August 24, 2015, at 1–3 (Mar. 10, 2016), https://www.sec.gov/comments/265-29/26529-60.pdf (comment letter from eighteen equity market participants, representing “asset managers, ETF providers, industry analysts, institutional and retail broker-dealers, and professional market makers and liquidity providers”).

 [278]. See, e.g., Paul Hughes, SEC Division of Economic and Risk Analysis, White Paper Series, The Effect of Amendment 10 of the “Limit Up-Limit Down” Pilot Plan (2017), https://www.sec.gov/files/dera_wp_the_effect_of_amendment_10_of_the_luld_plan.pdf; Barbara Novick et al., BlackRock, 2018 Case Study: ETF Trading in a High-Velocity Market 6 (2018), https://www.blackrock.com/corporate/literature/whitepaper/viewpoint-case-study-etf-trading-high-velocity-market-february-2018.pdf [hereinafter Novick, 2018 Case Study].

 [279]. “Depend upon it, sir, when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.” John Bartlett, Bartlett’s Familiar Quotations 310 (Geoffrey O’Brien ed., 18th. ed. 2014) (quoting Boswell, Life of Johnson, September 19, 1777).

 [280]. See generally Hedge Fund Operations: Hearing Before the H. Comm. on Banking and Fin. Serv., 105th Cong. 104–06, 279–82 (1998) (statement of Henry T. C. Hu) (comments on the 1998 collapse of Long Term Capital Management); Hearing to Review the Role of Credit Derivatives in the U.S. Economy: Hearing Before the H. Comm. on Agric., 110th Cong. 41–46 (2008) (statement of Henry T. C. Hu) (comments on the modeling-error related demise of the AIG in 2008); Hu, Misunderstood Derivatives, supra note 12 (suggesting systematic reasons for modeling and other problems in modern financial innovation; and offering reasons for such problems); Hu, Disclosure Universes, supra note 12, at 618–36 (on modeling and other problems relating the “London Whale” debacle at JPMorgan Chase in 2012).

 [281]. Novick, Market Structure, supra note 65, at 15 n.19.

 [282]. Golub, supra note 50, at 21.

 [283]. Investment Company Reporting Modernization, supra note 164, at 82,052 (describing item E.2 on Form N-CEN). Form N-CEN specifies that it applies to “registered investment companies.” Id. at 82,024 (General Instructions, at “A” and “C(1)”).

 [284]. The most notable such case is Businuess Roundtable v. Securities & Exchange Commission, 647 F.3d 1144, 1146 (D.C. Cir. 2011), where the D.C. Circuit struck down the SEC’s proxy access rule notwithstanding the Dodd-Frank Act’s affirmation of the agency’s authority. The SEC is mindful of the D.C. Circuit’s standards. See, e.g., U.S. Sec. & Exch. Comm’n, Division of Risk, Strategy, and Financial Innovation & Office of General Counsel, Current Guidance on Economic Analysis in SEC Rulemaking (2012) (memorandum to Staff of the Rulewriting Divisions and Offices); Michael S. Piwowar, Commissioner, U.S. Sec. & Exch. Comm’n, Remarks to the First Annual Conference on the Regulation of Financial Markets (May 16, 2014), https://www.sec.gov/news
/speech/2014-spch051614msp. In his first speech as Chairman of the SEC, Jay Clayton emphasized that “disclosure and materiality have been at the heart of the SEC’s regulatory approach for over eighty years” and the need for comprehensive analysis of benefits and costs of disclosure requirements. Jay Clayton, Chairman, U.S. Sec. & Exch. Comm’n, Remarks at the Economic Club of New York (July 12, 2017), https://www.sec.gov/news/speech/remarks-economic-club-new-york.

 [285]. See, e.g., 1934 Act, 15 U.S.C. §§ 77z-2(a), 77z-2(b)(2)(B) (2012).

 [286]. For a discussion on how the judicial bespeaks caution doctrine can be useful to companies that are excluded from protection under the statutory safe harbor, see, for example, Morris DeFeo, Jr., Amanda Paracuellos & Kelly Howard, When a Company’s Forward-Looking Statements Find No Safe Harbor: Bespeaks Caution Doctrine Provides Alternative Protection, Crowell & Moring LLP (2006) https://www.crowell.com/documents/DOCASSOCFKTYPE_ARTICLES_404.pdf.

 [287]. IVV 2015 Prospectus, supra note 70, at 1.

 [288]. A few judges have gone so far as to seemingly suggest that only firm-specific information is required under federal securities law. Most notably, Judge Frank Easterbrook has written that “[i]ssuers of securities must reveal firm-specific information. Investors combine this with public information to derive estimates about the securities’ value. It is pointless and costly to compel firms to reprint information already in the public domain.” Wielgos v. Commonwealth Edison Co., 892 F.2d 509, 517 (7th Cir. 1989).

 [289]. The last comprehensive reform of Form N-1A occurred in January 2009. A basic motivation for such changes was, in the words of then-SEC Chairman Christopher Cox, because too many mutual fund investors were not reading the prospectuses “because they were too complicated and too hard to understand.” Christopher Cox, Chairman, U.S. Sec. & Exch. Comm’n, Statement by SEC Chairman: Enhanced Disclosure for Mutual Fund Investors (Nov. 19, 2008), https://www.sec.gov/news
/speech/2008/spch111908cc.htm. The SEC’s Division of Investment Management has characterized Form N-1A as “intended to create a disclosure regime tailored to the unique needs of mutual fund investors” and the Form’s general instructions emphasize that it is “intended to elicit information for an average or typical investor who may not be sophisticated in legal or financial matters.” See Guidance Regarding Mutual Fund Enhanced Disclosure, U.S. Sec. & Exch. Comm’n 6 (June 2014) https://www.sec.gov/investment/im-guidance-2014-08.pdf (emphasis added); Form N-1A, supra note 165, at general instructions 3.C.1(b). While there are so-called “Plain English” requirements, there are no corresponding directives in 1933 Act registration statements and 1934 Act periodic reports that the disclosures be tailored to unsophisticated investors.

 [290]. According to a study by Deutsche Bank, institutional investors held 58.5% of U.S. ETFs as of the end of 2016. See Joe Rennison, Institutional Investors Boost Ownership of ETFs, Fin. Times (Apr. 13, 2017), https://www.ft.com/content/c70113ac-ab83-33ac-a624-d2d874533fb0. In contrast, with respect to equity, hybrid, and bond mutual funds, institutional ownership was only 7.8%, 4.1%, and 10.1%, respectively. ICI, 2017 Fact Book, supra note 3, at 229.

 [291]. ICI, 2017 Fact Book, supra note 3, at 72.

 [292]. See supra notes 239–40 and accompanying text.

 [293]. See, e.g., Howard Marks, There They Go Again . . . Again, Oaktree Capital (July 26, 2017), https://www.oaktreecapital.com/docs/default-source/memos/there-they-go-again-again.pdf (client memorandum written by Oaktree co-chairman Howard Marks). There are also respected Wall Street veterans with contrasting views. See, e.g., Novick, 2018 Case Study, supra note 278, at 4–5.

 [294]. See generally June 2018 SEC Proposal, supra note 15.

 [295]. See supra note 16 and accompanying text (discussing the March 2018 SSRN drafts and regulatory, industry, media, and other materials referring to such research and the subsequent August 16 SSRN draft).

 [296]. June 2018 SEC Proposal, supra note 15, at 143.

 [297]. The Proposal uses the term “leveraged ETFs” to refer to, in common parlance, both leveraged ETFs and inverse ETFs. See id. at 7 n.7; Proposed Investment Company Act Rule 6c-11(c)(4).

 [298]. June 2018 SEC Proposal, supra note 15, at 28–30.

 [299]. Id. at 137–39.

 [300]. See supra Section II.C for further discussion regarding these exemptions.

 [301]. June 2018 SEC Proposal, supra note 15, at 66–67; Proposed Investment Company Act Rule 6c-11(a).

 [302]. Id. at 70–72; Rule 6c-11(a).

 [303]. Id. at 76–87; Rule 6c-11(c)(1)(i)(A).

 [304]. Id. at 82–83; Rule 6c-11(c)(1)(i)(A).

 [305]. Id. at 88–107; Rule 6c-11(c)(1)(i)(B).

 [306]. Id. at 90, 105; Rule 6c-11(a), (c)(3).

 [307]. Id. at 90, 93, 105; Rule 6c-11(a) (defining “Custom basket.”).

 [308]. UTIs file Form N-8B-2 instead of Form N-1A. The June 2018 SEC Release contemplates changes to Form N-8B2 corresponding to changes in Form N-1A. Id. at 178–81.

 [309]. Id. at 119; Rule 6c-11(c)(1)(v).

 [310]. Id. at 116–19.

 [311]. Id. at 46–47.

 [312]. Id. at 113–14.

 [313]. Id. at 176–78.

 [314]. Id. at 176.

 [315]. Id. at 72–76.

 [316]. Id. at 114–16.

 [317]. Id. at 153–64.

Friendly Skies or Turbulent Skies: An Evaluation of the U.S. Airline Industry and Antitrust Concerns – Note by Kevin Kinder

From Volume 91, Number 5 (July 2018)
DOWNLOAD PDF


Friendly Skies or Turbulent Skies: An Evaluation of the U.S. Airline Industry and Antitrust Concerns

Kevin Kinder[*]

TABLE OF CONTENTS

INTRODUCTION

I. United States Commercial Aviation Background

A. Deregulation: Pushback and Taxi to Today’s U.S. Airline Industry

B. Cleared for Takeoff: A Twenty-First Century Merger Mania

C. Resulting Composition and Financial Picture of the Industry

D. Capacity Discipline: Corporate Catch-22

II. Legal Framework

A. Theoretical Basis for Consolidation and Existing Literature

B. Antitrust Statutes and Regulatory Regime

C. Foreign Airline Collaboration Models and Their Significance

1. Foreign Ownership Restrictions

2. Interline Agreements

3. Alliances

4. Joint Ventures

5. Antitrust Immunity

D. ATI Regulatory Scheme

1. Competitive Analysis

2. Public Interest Considerations

III. STRIKING THE RIGHT LEVEL AND MANNER OF ANTITRUST REGULATION

A. Constrain the “Public Interest” and Emphasize Predictability in Determining ATI

B. Periodic Reviews of Immunized Alliances that Minimize the Burden on Airlines

C. Increase DOJ Involvement in ATI Competitive Analysis

D. Knock Down Barriers to Entry, While Respecting the
Tenets of Deregulation and Free Competition

Conclusion

 

INTRODUCTION

Chances are any evening news coverage lately about the commercial airline industry in the United States was not positive. Indeed, 2017 was not a banner year for U.S. airlines on the public perception front, with numerous videos showcasing conflicts between airlines and passengers. No incident garnered the attention and ubiquitous condemnation from the public better than the violent removal of Dr. David Dao from United Express Flight 3411.[1] Videos of a bloodied Dr. Dao being dragged down the aisle like a rag doll as he cried for help and fellow passengers gasped in horror saturated news networks for weeks.

While United Airlines takes the cake for most viral incident of 2017, it was certainly not the only airline to face negative publicity. The NAACP warned African Americans that flying on American Airlines could subject them to disrespectful, discriminatory or unsafe conditions” after a pattern of disturbing incidents.[2] Delta Airlines faced a spring break fiasco after severe weather hit Atlanta and forced more than 3,500 flight cancellations over five days; the incident highlighted systemic flaws in Delta’s operations and ability to recover.[3] An electrical fire at the Atlanta airport in December again tested Delta’s preparedness in flight operations, luggage handling, passenger accommodations, and so forth as it was forced to cancel 1,400 flights.[4]

Notable incidents were not confined to legacy airlines. Shortly after the Dr. Dao incident, low-cost carrier (“LCC”) Southwest Airlines had police forcibly remove a passenger after she complained of allergies to dogs in the cabin.[5] JetBlue Airways’ “cakegate” incident drew headlines after a family was removed from a flight after a dispute over where to store their child’s birthday cake.[6] Alaska Airlines suffered a slew of cancellations after falling behind on hiring and training for a new aircraft in its fleet.[7] A Spirit Airlines pilot union dispute led to more than 300 flight cancellations and a violent brawl at the Fort Lauderdale Airport between customers and employees.[8] Ultra-low cost carriers (“ULCC”) Spirit, Frontier, and Allegiant occupied three of the four worst rankings in the American Customer Satisfaction Index.[9]

A common theme—one that is likely here to stay—in the above incidents is the presence of social media, with its ability to amplify incidents by transmitting news and images in real time. On any flight with the faintest whiff of an issue brewing there might suddenly be 200 aspiring Steven Spielbergs armed with camera phones ready to catch the next viral incident. News media outlets often compound the issues by running passenger-submitted content that only captures a snippet of the incident and failing to confirm facts. Facts, unfortunately, often take a back seat to the race to be first. For instance, the Dr. Dao incident did not actually involve any United Airlines employees as it occurred on a contracted United Express carrier, Republic Airline, and the forceful escalation was initiated by Chicago Department of Aviation officers.[10] Yet United Airlines was the focus of the pervasive news coverage and became the public villain. United did not help itself by borrowing from the “WhatNottoDoinaCorporateCrisis” playbook and issued a defensive, non-apologetic statement that effectively blamed “re-accommodat[ing]” Dr. Dao because of his “disruptive” and “belligerent” behavior.[11] After the public firestorm, congressional inquiries, and sinking share prices, United’s CEO, Oscar Munoz, put out a revised statement[12] and began a TV apology circuit. But, by the time Mr. Munoz sat down on Good Morning America,[13] it was too late. United was the clear public villain, representing everything wrong with air travel.

The public discord is understandable. To many, Dr. Dao’s treatment struck a nerve and perfectly epitomized the shortcomings of all U.S. passenger airlines.[14] Flying has become increasingly unpleasant for those unable or unwilling to fly in premium cabins. Passengers feel more like cattle in a metal tube squeezed into shrinking seats on crowded flights where airlines nickel and dime every conceivable charge. An oft-cited statistic is that, following a slew of mergers, the four largest airlines now control over 80% of the U.S. domestic air transportation market.[15] This consolidation is viewed as the engine behind the industry’s newfound ability to turn profits at passengers’ expense.[16] While including a catchy number without context or deeper analysis is effective in producing a mechanical reaction, it leaves open crucial questions that lead to better answers about the level of actual competition by airlines for passenger share in existing and new markets.

This Note attempts to answer some of these questions. It is clear that the failures listed above demonstrate operating flaws and areas for improvement. But with the number of passengers and flights already at an all-time high—U.S. airlines carry more than 928 million passengers annually on over 9.7 million regularly scheduled flights,[17] and the number of people flying is increasing faster than the overall population[18]—it is also clear that unfortunate passenger incidents are the exception, not the norm.

Recent antitrust decisions and policy initiatives by both the Department of Justice (“DOJ”) and Department of Transportation (“DOT”) have shaped the current U.S. airline landscape. The consolidation trend is not unique to the U.S. domestic air transportation market. The emergence of three global airline alliancestogether accounting for around 80% of air traffic across the transatlantic, transpacific, and Europe–Asia marketshas transformed the international air transportation market as well.[19] This Note evaluates the results of the DOJ’s antitrust approach to U.S. airline mergers and reconciles these results with the DOT’s “public interest” emphasis in determining airline applications for antitrust immunity (“ATI”). Given the current domestic market, it is likely that the remaining legacy carriers will leverage their respective global alliances and seek ATI with foreign airlines for continued network growth.

Part I of this Note tracks the tumultuous history of the U.S. airline industry from deregulation to its current health. Part II presents the legal framework, including U.S. antitrust laws, that govern domestic airline mergers and international ATI. Part III proposes practical solutions for the DOT to improve the ATI regulatory process and incubate open market competition, thereby better serving passengers and airlines by edging closer to deregulation.

I.  United States Commercial Aviation Background

A.  Deregulation: Pushback and Taxi to Today’s U.S. Airline Industry

At the outset of commercial aviation in the early twentieth century, there was little to no regulation by the U.S. government. Accidents were frequent, and aviation leaders viewed federal regulation as a key to bolstering public confidence by establishing safety standards.[20] To this end, President Coolidge signed the Air Commerce Act into law in 1926, which formed an Aeronautics Branch under the Department of Commerce and vested it with authority to promulgate regulations to ensure civil air safety.[21] The Aeronautics Branch set about making and enforcing flight safety rules, licensing pilots, ensuring airworthiness of aircraft, and establishing airways.[22] In 1926, the first regulations arrived in a forty-five page document titled “Air Commerce Regulations;” by stark contrast, today’s federal aviation regulations span over 3,600 pages in four volumes of the Code of Federal Regulations.[23]

The commercial aviation industry’s next major transformation came in 1938, when the United States government began regulating domestic interstate and foreign passenger air transportation.[24] The Civil Aeronautics Board (“CAB”) regulated air transportation as a public utility, exerting control over airline hubs, routes, schedules, and fares.[25] These economic regulations were crucial in managing the rapidly growing commercial airline industry; following World War II, the industrial complex and transition to the jet age revolutionized air travel and spiked demand. Airlines found solid footing and shed existing government support such as subsidies for carrying mail.[26] However, by the 1970s, bureaucratic inefficiencies,[27] hyperinflation, and oil supply shocks sparked concern over the continued viability of the U.S. airline industry.[28]

President Carter, therefore, signed the Airline Deregulation Act of 1978 (“ADA”) into law in October 1978.[29] It was intended “to encourage, develop, and attain an air transportation system which relies on competitive market forces to determine the quality, variety, and price of air services”[30] by relaxing and eventually terminating economic controls by the government.[31] Thus the modern U.S. airline industry was born—one that “relie[s] on competition among airlines to promote affordability, innovation, and service and quality improvements.”[32]

The initial foray into economic deregulation was mixed, at best. While it benefited passengers by reducing fares and expanding service and routes, many airlines struggled to adapt and survive under evolving industry dynamics.[33] A driving theory behind deregulation is that it lowers barriers to entry, which creates a more economically efficient market when coupled with competitive market forces. There were two periods when new airlines entered the market: immediately after deregulation (19781984) and the early 1990s.[34] But these sporadic bouts of entry were dwarfed by exits and consolidation.[35]

Years of sustained operating losses, job cuts, and periodic bankruptcies forced an intense consolidation that grounded many historical carriers.[36] In 1978, fifteen legacy airlines provided interstate and/or foreign air transportation; by 1988, just ten legacies remained and 168 airlines had failed or were absorbed.[37] The Reagan Administration’s laissez-faire approach was crucial in setting the industry down a path of consolidation—seventeen of eighteen proposed airline mergers between 1985 and 1988 were approved, increasing the market share of eight major airlines from 74.1% in 1983 to 91.7% in 1988.[38] From 1978 to 2005, twenty mergers involving a legacy airline had transpired.[39] However, industry mergers pale in comparison to bankruptcies. Over 190 airline bankruptcies/reorganizations were filed between 1979 and 2012.[40] Upstart airlines were not the only casualties—legacy airlines Delta, Northwest, United, American, US Airways, and Continental all filed for Chapter 11 bankruptcy.[41] Every remaining legacy airline has declared bankruptcy since 2000.[42]

While deregulation can be judged a success in expanding networks and departure frequency, increasing airline efficiency, and improving safety, financial instability at individual airlines has triggered industry volatility, employment losses, and service quality deteriorations.[43] A common response to these issues was increased consolidation, a trend that continues today.

B.  Cleared for Takeoff: A Twenty-First Century Merger Mania

Seven legacy carriers entered the new Millennium, down from fifteen at the deregulation mark.[44] By 2014, that number was reduced to three.[45] The first to fall was TWA in 2001, with American Airlines acquiring the remaining assets of the faltering carrier that had become a shell of its former iconic self.[46] This was a small foreshadowing of what was to come.

Entering 2005, six legacy carriers and nine total major carriers remained; the four largest carriers, in terms of passengers carried, accounted for 56% of domestic traffic.[47] A series of mergers quickly altered that composition. First, America West Airlines acquired US Airways in 2005, then Delta Airlines and Northwest Airlines merged in 2008, followed by the merger of United Airlines and Continental Airlines in 2010, the acquisition of AirTran Airways by Southwest Airlines in 2011, and lastly the American Airlines and US Airways merger in 2013,[48] which created the world’s largest airline.[49] The American-US Airways merger was initially hotly contested, but the eventual settlement caught many by surprise and caused many industry observers to express stern disagreement.[50] There was a strong sense that because the DOJ had approved a “super-Delta and a super-United,” it had no choice but to permit a “super-American” to act as a counterweight and restraint on the two.[51]

The result of these mergers is a highly concentrated U.S. airline industry, in both the aggregate and certain city-pair routes. The four largest U.S. airlines account for more than 80% of domestic passenger traffic.[52] A common criticism of consolidation is that it harms passengers as airlines, in tandem, match fare increases, impose new fees, reduce or eliminate service on certain routes, and downgrade amenities.[53] Stakeholders of the airlines, however, have cheered consolidation amidst steadily improving financial health. One airline executive referred to industry consolidation as the “New Holy Grail” given that “fewer and larger competitors” allow airlines to “reap the benefits,” such as reduced capacity and increased ancillary revenue.[54]

Most recently, Alaska Airlines merged with Virgin America, receiving DOJ approval in December 2016.[55] The resulting Alaska Airlines will hold just roughly 5% of the domestic passenger market.[56] Given the current market share of the legacies and Southwest, any future mergers will likely be similar mergers of smaller airlines positioning themselves to compete with the big four.

C.  Resulting Composition and Financial Picture of the Industry

Wall Street has viewed the airline industry mergers favorably. A 2014 Goldman Sachs report cheered the American-US Airways merger as a furtherance toward “dreams of oligopoly.”[57] The report envisioned that consolidation would continue to push the industry toward “lower competitive intensity” and greater “pricing power with customers due to reduced choice.”[58] The recent wave of mergers has helped airlines exercise better capacity control and set prices significantly above marginal cost relative to prior years.[59] Stock performance of the airlines reflect this newfound pricing power: American Airline’s stock increased more than 300% after its 2013 merger compared to a roughly 90% gain in the S&P 500 index across the same time.[60] American Airlines is not the only airline stock to take off. The recent industry-wide performance caught the eye of Warren Buffet and his Berkshire Hathaway invested more than $1.4 billion into the four largest U.S. airlines in 2016.[61]

What used to be an unattractive investment (industries in which every leading company has undergone bankruptcy usually do not inspire confidence) is no longer so amidst surging profits. U.S. airlines collectively hauled in profits of approximately $15.5 billion in 2017, marking the fifth consecutive year an after-tax net profit was produced as a group.[62] Strong profitability should continue in 2018; North American airlines are projected to record net profits of close to $16.4 billion.[63]

The price of jet fuel is a major factor in the recent profitability of U.S. airlines. However, many pundits question why record low fuel prices have not had a more direct impact on airfare. Senator Chuck Schumer (D-NY) called for an investigation, writing to the DOJ, “[i]t’s hard to understand, with jet fuel prices dropping by 40 percent since last year, why ticket prices haven’t followed.”[64] Indeed, after a sustained period of high fuel costs, jet fuel prices dipped nearly 70% between 2014 and 2016, while average airfares dropped 8.6%.[65] Airlines captured gains from cheaper fuelDelta projected $2 billion in savings on fuel costs alone in 2015, while Southwest was able to nearly cut its average price per gallon of fuel in half from the fourth quarter of 2014 to the first quarter of 2015.[66]

But expecting a direct relationship between fuel costs, albeit a major marginal cost, and airfares is naïve. So too is comparing U.S. airlines’ reaction to cheaper fuel with the reaction of European airlines. While fuel is a global commodity, U.S. airlines and European airlines make business decisions in distinctly different markets.[67] European airlines “[d]runk on the profit boost served up by cheap fuel” added capacity at a greater rate than passenger demand, causing fares to dip.[68] The European airline industry’s collective financial health lately pales in comparison to the United States—two European airlines, Monarch Airlines and AirBerlin, ceased operations in 2017, and a third, Alitalia, entered bankruptcy.[69] Granted, recent terrorist attacks and Brexit have not helped matters, but the remaining European airlines have had little choice but to scale back earnings expectations and slash ticket prices in an attempt to fill seats in a high capacity environment.[70]

As jet fuel prices continue to creep upwards, the responsiveness of U.S. airlines will be tested. Every cent that fuel per gallon increases equates to roughly $200 million in U.S. airline industry fuel expenses.[71] U.S. airlines are often hit harder by rising fuel costs compared to international airlines that are more aggressive in fuel hedging.[72] The recent consolidation has allowed the U.S. airline industry to mature to a level of sustainable adaptability while Europe lags behind. While European airlines flooded the market with seats in the wake of cheaper fuel, U.S. airlines were better disciplined in capacity; this difference was no doubt due in large part to consolidation and fewer U.S. airlines with sizeable market shares when compared to Europe.

D.  Capacity Discipline: Corporate Catch-22

A common feeling is that consolidation has allowed U.S. airlines to better exercise “capacity discipline,” a key term that became the crux of a DOJ investigation and class action lawsuits. Capacity discipline refers to “restraining growth or reducing established service.”[73] A large share of customer dissatisfaction with flying can reasonably be attributed to it. Load factor, the percentage of available seats filled with revenue passengers, has increased from around 70% in the early 2000s to nearly 85% in 2015.[74] When you mix in shrinking seats—average legroom has decreased two inches in the last decade[75]—with fuller flights and an increased chance of a middle seat neighbor, it is easy to understand the perception that flying is not what it used to be.

The U.S. airlines’ affinity for capacity control caught the eyes of federal lawmakers, regulators, and passengers alike. In June 2015, Senator Richard Blumenthal (D-CT) requested that the DOJ investigate capacity control as a form of collusion and anticompetitive behavior.[76] He referenced numerous public comments by airline executives committing their respective airline to continued “capacity discipline.”[77] For example, at the 2015 annual International Air Transport Association (“IATA”) conference, chief executives from Delta, Air Canada, and American Airlines all stressed the need for capacity discipline in their public remarks.[78] Similar comments were regularly made by executives on earnings calls and other communications with securities analysts.[79]

The DOJ opened an investigation in July 2015 into possible collusion between Delta, American, United, and Southwest to limit seats and artificially inflate fares.[80] The DOJ’s investigation posed an interesting question—“whether the airline executives have talked so much publicly about discipline to appease Wall Street’s profit demands, or whether there is any smoking gun showing that airline executives have colluded privately.”[81] Effectively, the DOJ inquired whether the level and persistence of stressing discipline could be interpreted “as thinly veiled invitations to restrict capacity increases to keep ticket prices high.”[82] In rare cases, explicit communication and collaboration are easy to prove. When collusion need[s] to be inferred from statements by executives to analysts, and other signaling,” it is exponentially more difficult because something beyond circumstantial evidence must be proven.[83] The DOJ investigation shifted toward a possible nexus between airline executives and Wall Street via dominant shareholders; DOJ investigators questioned whether airlines signaled or communicated strategy with competitors through mutual large shareholders as a proxy.[84] However, by January 2017, the DOJ effectively shuttered its investigation as it concluded that the airlines’ conduct did not cross the line of an antitrust violation.[85]

Shortly after the DOJ opened its investigation in 2015, numerous class action lawsuits were filed in federal district courts based on the same capacity and price fixing concerns of the DOJ investigation.[86] The multi-district litigation (“MDL”) survived a major hurdle in November 2016 when D.C. District Judge Colleen Kollar-Kotelly denied the airlines’ motion to dismiss, finding “that plaintiffs sufficiently set forth circumstantial evidence to demonstrate a plausible claim.”[87] The MDL is currently ongoing. Southwest Airlines reached a $15 million settlement in January 2018 followed by American Airlines in June 2018 for $45 million; Delta and United remain in litigation and have pushed discovery to January 2019—more than three years after the suits were originally filed.[88]

When airlines embrace capacity discipline, they find themselves at the center of a DOJ investigation and multiple class action suits. But airlines that resist capacity discipline do so at their own peril. For years, “Wall Street analysts have browbeat airline executives to either have discipline, or they will bust their recommendations on their stock.”[89] In 2015, Southwest CEO Gary Kelly announced capacity growth plans, but was forced to roll back these plans less than two months later after facing intense Wall Street backlash and coming under fire at the abovementioned IATA conference—this conference spurred the DOJ investigation.[90] More recently, United Airlines announced plans in January 2018 to raise capacity by 4% to 6% annually over three years.[91] Investors immediately swatted the plan, and United’s shares dipped 16% over the following three days.[92] The impact of United’s capacity growth plans was felt industry wide: Delta, American, and Southwest each saw share prices decline more than 7%, and collectively the combined market of the largest four airlines fell by 9.7% from $133 billion to $120.1 billion in the immediate aftermath of the announcement.[93]

Officers and directors of corporations owe a fiduciary duty only to the corporation itself and its shareholders.[94] Thus, officers at the largest U.S. airlines have found themselves in a corporate catch-22 between DOJ investigations and multi-district class action lawsuits on the one hand, and tumbling share prices and shareholder pressures on the other hand.

II.  Legal Framework

A.  Theoretical Basis for Consolidation and Existing Literature

Mergers and acquisitions (“M&A”) are external integration strategies in which legally and financially independent companies combine to form a larger entity.[95] Consolidation motives “include increasing revenues, improving management efficiency and capital investment performance, and eliminating a competitor from the market.[96]

Two main views exist for what drives airline M&A: (1) efficiency gains in the resulting airline or (2) market power gains. The first view involves the potential to reduce costs by enhancing the “hub-and-spoke” networks of legacy airlines, while the second view perceives an improved ability to raise passenger fares.[97] Some see financial and competitive pressures as the primary driver, i.e., a solution to increase profitability and financial stability. Another view is that airline consolidation is “necessary to minimize asset devaluation to prevent a domino effect, as most major US airlines are ‘too big to fail.’”[98]

At a basic level, the goal of M&A is to increase shareholder value.[99] A number of benefits are typically touted by airlines to gain regulatory approval and justify the merger to shareholders, including, but not limited to, “increase[d] . . . revenues by extending the airlines’ network, increase[ed] market share . . . higher fares on some routes, improv[ed] network connectivity, increas[ed] frequent flyer loyalty, [and] better aircraft utilization.”[100] In reality, however, receiving unanimous approval from all stakeholders is virtually impossible as shareholders, management, employees, customers, and governments harbor competing interests. M&A failure often results from a combination of factors, among them clashing company cultures, union resistance, or other operational difficulties.[101] Three major obstacles to airline mergers include: (1) workforce integration; (2) fleet integration; and (3) information technology integration.[102]

To regulators, the airline industry is, theoretically, inherently susceptible to coordinated behavior—a few large airlines dominate the industry, each transaction is small, and most pricing by competitors is transparent and readily accessible.[103] In evaluating mergers, much of the focus has been on existing network overlap, particularly non-stop routes. “The larger the degree of overlap between the networks of the two merging carriers, the larger is the potentially anti-competitive effect of the transaction. This ‘enforcement principle’ still guides the decisions of antitrust authorities on both sides of the Atlantic.”[104] Thus, market concentration is a key factor in the regulatory authorities’ antitrust analysis.

A measure of market concentration is the Herfindahl-Hirschman Index (“HHI”), calculated as the sum of the squared market shares of all firms in a market.[105] The DOJ considers markets “highly concentrated” when HHI exceeds 2,500.[106] A 2014 study found that [n]early 97 percent of city pair markets are highly concentrated and well over half have HHIs in excess of 4,000. Some of those city pairs involve small cities.[107] Yet nearly 90% of all passengers traveled on city-pairs with HHIs above 2,500, and about 40% of city pairs have HHIs in excess of 4,000 . . . [t]he average passenger flew on a city pair with HHI of 4,202.[108]

On the surface, these HHI figures support the argument that the U.S. airline industry has become too concentrated following the recent mergers. However, as with any single statistic, the HHI has its limitations and does not account for every variable of competition.

Academic literature examining airline mergers is mixed, at best. Maruna and Morrell’s investigation of eighteen mergers involving U.S. airlines between 1978 and 2005 found that only one merger could be judged a success.[109] Their review of existing literature suggested that between 50% to 80% of mergers failed to meet their stated goals.[110] A 2016 study judged the 2005 US Airways-America West merger “a success” as the emerging US Airways improved operations and cost controls, increased shareholder value, and developed long-term synergies.[111]

Post-merger studies often focus on routes in which both merging airlines previously competed, expecting any anti-competitive effects to occur most strongly on such routes.[112] Multiple studies of airline mergers prior to the recent wave beginning in 2005 generally found that the mergers resulted in loss of competition and higher fares.[113] Such effects were, surprisingly, not confined to overlap routes, but also routes in which one merged airline was only a potential competitor.[114] However, studies evaluating the recent legacy airline mergers are generally inconclusive as to the competitive impacts.[115] The 2008 Delta-Northwest merger received a healthy amount of academic attention, with most studies unable to discern any large effects other than small fare increases ranging from 1% to 4% on overlapping routes.[116] Research into the 2010 United-Continental merger is limited, but it has generally found the merger produced competitive results with reduced fares of 3% to 4% on some routes.[117] A study of the three recent legacy carrier mergers found them to be, as a whole, pro-competitive.[118] Across the three mergers, “overlap routes . . . experienced statistically significant output increases and statistically insignificant nominal fare decreases relative to non-overlap routes.”[119]

Thus, there is analytical support that the recent airline mergers and industry consolidation were not anticompetitive or bad for passengers. This Note does not seek to add to the voluminous record evaluating mergers (particularly in the domestic market) or question regulators for past decisions; rather, it seeks to explore the current regulatory approach and propose solutions for greater transparency and competition promotion moving forward.

B.  Antitrust Statutes and Regulatory Regime

The principal architect of deregulating the U.S. airline industry, Alfred E. Kahn, recognized that a deregulated industry would require vivid antitrust law enforcement to realize the potential benefits of competition it was intended to promote.[120] Two chief antitrust laws exist in the United States to protect consumers from lack of competition: the Sherman Act (1890)[121] and the Clayton Act (1914).[122] Section 1 of the Sherman Act declares “[e]very contract, combination . . . or conspiracy, in restraint of trade or commerce . . . to be illegal.[123] The Clayton Act focuses on specific types of conduct or transactions believed to threaten competition, such as mergers.[124] For example, § 7 prohibits mergers when “the effect of the acquisition may substantially lessen competition or tend to create a monopoly.”[125] The DOJ Antitrust Division and the Federal Trade Commission (“FTC”) are the primary enforcers; however, any state attorney general or individual alleging economic harm by a violation of the antitrust laws may also file suit.[126]

The Clayton Act lacks explicit definitions of prohibited activities; therefore, historical enforcement is determinative. The legislative history shows the drafters’ intent was to protect ‘competition, not competitors, and [Congress’s] desire to restrain mergers only to the extent that such combinations may tend to lessen competition.’”[127] This does not invite regulators “to thwart business efficiencies that may be achieved through the combination of two firms’ resources.”[128] Congress’ intent was to “cope with monopolistic tendencies in their incipiency and well before they have attained such effects as would justify a Sherman Act proceeding” by authorizing the review of activities that might “create, enhance, or facilitate the exercise of market power.”[129]

The Supreme Court’s approach in Brown Shoe Co. v. United States[130] set out the pattern used in modern antitrust jurisprudence:

There, the Court (1) defined the relevant product and geographic markets; (2) analyzed the probable effects of the merger by examining the market shares of the firms, the current concentration of the industry, the trend toward continued consolidation in the industry, and the statements and behavior of the individual firms; and (3) found a lack of mitigating factors that would provide procompetitive benefits from the merger.[131]

Effectively, any merger that increases market share or market concentration enough to “raise an inference” of illegality is presumed to be anticompetitive, and the merging entities carry the burden to “rebut the inherently anticompetitive tendency manifested by these percentages.”[132]

Judicial decisions concerning section 7 of the Clayton Act historically drove antitrust enforcement until the Hart-Scott-Rodino Antitrust Improvements Act of 1976[133] imposed new pre-merger notification requirements and signaled a shift of authority to enforcement agencies.[134] Prior to its passage, Merger Guidelines were drafted to assist in the movement from judicial interpretation toward agency law.[135] The Antitrust Division of the DOJ published the first Merger Guidelines in 1968 “to acquaint the business community, the legal profession, and other interested groups and individuals with the standards currently being applied.”[136] The Merger Guidelines have undergone multiple revisions as the rules guiding merger enforcement have developed;[137] The DOJ and FTC released their current version in 2010.[138] While the Merger Guidelines are not binding legal authority, their influence on the business community cannot be overstated, particularly in improving DOJ and FTC transparency.[139]

Turning to the U.S. airline industry, the DOJ Antitrust Division is responsible for reviewing airline mergers and acquisitions and enforcing controlling antitrust laws as a result of the ADA.[140] The ADA stipulated that approval of airline M&A would continue, but that jurisdiction would be transferred from the CAB (set to expire in 1984) to the DOJ.[141] However, the DOT filled this role from 1984 until the end of 1988 due to the Sunset Act of 1984,[142] modifying the deregulation transition.[143] The DOT’s authority expired, and since 1989, the DOJ has retained jurisdiction over applying the antitrust laws to airline M&A and other control relationships.[144] The DOT assists the DOJ by utilizing its expertise to advise and exert authority over slot controls and routes to remedy competitive concerns.[145]

Paradoxically, the authority to immunize foreign air services agreements between U.S. and foreign airlines from U.S. antitrust laws rests with the DOT.[146] This authority stems from the 1979 International Air Transportation Competition Act.[147] While the DOJ may submit comments during public comment periods, the DOT retains sole statutory authority to approve and immunize foreign air services agreements[148] from the same antitrust laws that the DOJ applies when evaluating domestic airline mergers and acquisitions. The DOJ, or DOT, has “no corresponding authority” to immunize domestic alliances between U.S. airlines.[149]

C.  Foreign Airline Collaboration Models and Their Significance

1.  Foreign Ownership Restrictions

Passengers today, particularly loyal and lucrative business travelers, demand seamless service from everywhere to anywhere in the world. Both U.S. and European legacy airlines have pursued business models reflecting such demands. However, few city-pairs generate enough daily demand to warrant non-stop service, and no airline could efficiently provide service with its own fleet to every destination their customers require.[150] Most businesses meet such global customer demands through cross-border mergers or the establishment of facilities abroad.[151]

Such a solution is not available for airlines; full cross-border airline mergers are restricted by long-standing government restrictions on foreign ownership and control of airlines by non-nationals.[152] Faced with these restrictions, airlines seek foreign airline partners and develop vast alliances to provide customers expanded network coverage and greater service options.[153] Global airline alliances, leveraging the “fundamentals of network economics and [the] global economy,” have prevailed as a next-best substitute[154] for airlines to realize the economic benefits of mergers and have become a dominant feature of the airline industry.[155]

Cooperation between foreign airlines first requires that “freedoms” be granted for airlines to serve foreign nations.[156] These freedoms, or rights to board and deplane passengers in a foreign country, are established in international commercial aviation agreements (bilateral or multilateral treaties between governments).[157] The terms vary as some “agreements may restrict the number of carriers that provide air service between the countries, the number of flights that they offer, and sometimes the fares that they charge for travel between the countries.”[158] The 1993 “Open Skies” agreement between the United States and Netherlands was crucial in spurring a liberalization of foreign air transportation access.[159] U.S. and Dutch airlines “no longer needed permission from either government to provide service, carry passengers, and offer particular fares between the [countries].”[160] This was just the beginning. In April 2008, the U.S.-E.U. Open Skies Agreement signaled a major culmination of the U.S. government’s push toward expanded foreign airline access.[161]

Despite providing for marked improvements in expanding access, the U.S.-E.U. agreement does not permit cabotage (the eighth and ninth “freedoms” of the air),[162] which is the right to transport passengers within the boundaries of another country, or relax foreign ownership restrictions on airlines.[163] Even the most liberal international aviation agreement in existence restricts airline operations and consolidation.[164] There are no indications these restrictions will be relaxed in the foreseeable future,[165] so cooperation among foreign airlines will continue to play a large role shaping the international air transportation market, particularly while foreign ownership and control restriction preclude higher levels of integration.

A broad spectrum of cooperation between airlines exists, ranging from arms-length interline agreements to full-fledged, highly-integrated joint ventures (“JVs”).[166] Within JVs, airlines participate on a revenue or profit-sharing basis and seek grants of ATI, the highest form of cooperation. The next section is a basic introduction to various levels of cooperation between foreign airlines. However, note that these levels are not absolute, so airlines are generally free to pursue unique and specific levels of cooperation.

2.  Interline Agreements

Simple interline agreements are at the lowest spectrum of the airline cooperation scale. When two or more airlines agree to a multilateral or bilateral agreement to accept other airlines’ passengers, travelers can then buy a single ticket itinerary with flights on two or more independent airlines.[167] An interline fare is typically less than the sum of available fares on the individual legs, resulting in a small pricing benefit and booking convenience for consumers.[168] But this arms-length level of cooperation does not approach the efficiencies and integration possible through consolidation, and the quality of the interline product may differ widely on different airlines or airports.[169] For example, travelers may face multiple check-ins, long distances between gates or terminal transfers, greater likelihood of lost luggage, and uncertainty over customer service responsibility for missed connections or related travel disruptions.[170]

3.  Alliances

Alliances depend upon agreements between airlines and can take a variety of forms. Alliance agreements typically begin as code share arrangements, with additional perks getting added over time.[171] Code share agreements are essentially enhanced marketing jointventures, whereby one airline sells and markets seats under its own designation on a flight operated independently by an alliance airline.[172] Alliances thus open new destinations and expand route networks for airlines without requiring additional aircraft.[173] Faced with foreign ownership rules and entry restrictions, airlines have increasingly joined one of three major global alliances—Star Alliance, SkyTeam, and OneWorld—to expand their route network in foreign nations.[174]

Alliance participants determine which international routes to include in the agreement. If the alliance partners are not competitors on a route, they can communicate about fares and other competitive matters without ATI.[175] If the allies are competitors on the same route, then the alliance agreement remains arms-length and the operating airline determines seat availability for the marketing partner, but each airline sets prices independently.[176] Further, alliances allow a flexibility that improves services and offers passengers a more seamless experience. Partner airlines may adjust flight schedules to coordinate connection schedules, benefit from better gate or terminal proximity, open lounge and club access with partners, and link frequent-flyer programs.[177] Airline alliances, in the absence of ATI, provide benefits to consumers relative to interline agreements by both improving networks and lowering fares through the economies of denser passenger flows.[178]

4.  Joint Ventures

A closer form of cooperation and integration between airlines is the joint venture (“JV”). Airlines agree to share revenue from JVs on specific international routes independent of which airline operates the flight.[179] JVs create an agreement that is “metal neutral” in the sense that the physical metal, or aircraft, involved in producing passenger revenue is irrelevant in determining the respective airline’s share of revenue, thereby erasing any incentive for opportunistic advantages in cooperating.[180] Metal neutrality is significant in capturing the possible pro-competitive efficiency gains from increased economies of scale.[181] Thus, under a metalneutral JV, the profits (or losses) are split equally amongst the carriers regardless even when Airline A’s flights are at capacity, but Airline B’s flights are empty. JVs are, in effect, mergers that apply to defined international routes.

5.  Antitrust Immunity

Airlines operating a revenue or profitsharing JV combined with a grant of ATI achieve the highest degree of cooperation.[182] As noted earlier, the DOT holds the statutory authority to immunize international air transportation agreements from U.S. antitrust laws.[183] However, the government of the foreign carrier’s country retains sole authority to immunize the agreement from its own antitrust laws; thus, JVs are often conditioned on receiving ATI approval from both governments. ATI effectively allows two airlines to operate as one on certain routes and jointly coordinate pricing, revenue sharing, flight schedules, marketing (such as aligning frequent flyer programs), sales, and any other competitively sensitive matters without concern that they violate antitrust laws.[184]

Some support ATI by pointing to benefits consistent with closer integration, while others criticize it as anti-competitive. Regulators are particularly concerned about consumer welfare on non-stop travel between partners’ hub cities, where overlapping services allow the trip to be taken on either airline.[185] Thus, the DOT has a longstanding policy precluding consideration of ATI until all elements of an Open Skies agreement are in place to ensure that un-aligned airlines may freely enter and compete.[186]

D.  ATI Regulatory Scheme

While jurisdiction over airline mergers was vested in the DOJ in 1988, the DOT retains exclusive authority to immunize international air transportation agreements from U.S. antitrust laws.[187] ATI applications are filed in a public docket and decided on by the Secretary of Transportation after a detailed competitive analysis.[188] Once an application is complete, the DOT allows a period of public comment and issues a written decision within six months.[189]

Applicant airlines have a high bar to meet. The DOT publicly recognizes that “the antitrust laws represent a fundamental national economic policy . . . that serves . . . travelers well” and that “immunity from [them] should be the exception, not the rule.”[190] Airlines’ applications for ATI are “strictly construed and strongly disfavored . . . to ensure that alliance partners maintain the ability and incentive to pass on the potential benefits . . . to consumers.”[191]

The DOT engages in a two-step review of air transportation agreements submitted for ATI involving both a competitive analysis and a public interest analysis.[192] First, the DOT evaluates whether approving ATI would be adverse to the public interest by “substantially [reducing] or [eliminating] competition.”[193] If the DOT makes that determination, it then decides whether ATI is nonetheless “necessary to meet a serious transportation need or to achieve important public benefits.”[194] If it makes that finding and the public benefits cannot be achieved by other “reasonably available” and “materially less anticompetitive” means, then the DOT must approve ATI pursuant to § 41309(b).[195]

Second, if the DOT concludes after its initial review that the application is not adverse to the public interest, § 41309(b) directs it to grant ATI.[196] The DOT next determines whether sufficient public benefits justify ATI under § 41308.[197] The DOT is authorized to exempt agreements from the antitrust laws “to the extent necessary to allow the [airlines] to proceed with the transaction specifically approved by the order,” provided that the public interest requires it.[198] In sum, the DOT must find that ATI would reduce or substantially eliminate competition and such harm would not be offset by consumer benefits generated by ATI to deny an application.

1.  Competitive Analysis

Because ATI results in similar commercial effects as a merger, the DOT conducts a full Clayton Act test just as when evaluating domestic airline mergers.[199] The Clayton Act test evaluates competitive implications and whether approval is likely to substantially reduce competition and “facilitate the exercise of market power.”[200] Applied to ATI applications, the DOT must determine whether approval would allow the immunized airlines “to profitably charge supra-competitive prices or reduce service or product quality below competitive levels.”[201] In determining this, the DOT evaluates: “(1) whether [ATI] would significantly increase market concentration; (2) whether [ATI] would cause potential competitive harm; and (3) whether new entry into the market would be timely, likely, and sufficient either to deter or to discipline the potential competitive harm.”[202]

The importance of defining relevant markets is not lost on enforcement agencies. The DOJ has stated that properly defining markets “could be ‘a central focus’ of the analysis and be outcome determinative.”[203] In the context of ATI requests, the DOT evaluates competitive effects at three market levels: (1) a broad network level; (2) a country-pair level; and (3) a city-pair level.[204] Because ATI diminishes competition on routes on which the airlines compete, ATI reviews have largely focused on the potential loss of competition in non-stop overlaps.[205]

Market power is “the ability to profitably raise prices above competitive levels (or reduce competition on dimensions such as [capacity]), for a significant period of time.”[206] Just as in DOJ domestic airline merger reviews, the HHI of impacted city-pairs is calculated to define the market concentration and quantify increased concentration attributable to ATI; any HHI increase of 200 points or more is presumed market power enhancing.[207] This presumption is rebuttable by airlines; Supreme Court doctrine allows parties to present evidence specific to itself or its industry to rebut statistical indicators of anticompetitive effects.[208] But rebutting statistical evidence with non-statistical defenses is difficult, often being rejected by courts.[209] While market concentration alone may not be determinative—as evidenced by the rebuttable presumptionit is influential in the analysis of other potential anticompetitive effects of ATI, such as unilateral and coordinated effects.[210]

The DOT must determine any unilateral effects of granting ATI. Unilateral effects stem from the “internalization of . . . competition” between the airlines.[211] Therefore, this determination is highly dependent on the level of competition between the airlines at the time of application and whether the respective airlines’ services can be considered close substitutes.[212]

Coordinated effects, on the other hand, consider potential impacts of ATI on how firms compete in the relevant market(s).[213] A reduction in competitors may diminish competition by encouraging coordinated interaction among fewer competing airlines. Evaluating coordinated effects is largely an offshoot of game theory, as it involves decisions by multiple airlines in which certain conduct is profitable for each of them, but only as a result of cooperative reactions by the others.[214] The DOT may also consider external factors such as infrastructure or slot constraints that act as barriers to open entry or potentially exacerbate competitive harm.

2.  Public Interest Considerations

The consideration of public benefits and mitigating factors in determining ATI is largely where the DOT’s approach diverges from the DOJ’s approach in reviewing mergers. Congress has enumerated numerous factors that the DOT may consider in its public interest evaluation, including “the availability of a variety of air service, maximum reliance on market forces, the avoidance of unreasonable industry concentration, and opportunities for the expansion of international services.”[215] While § 41308 imposes a more stringent test that ATI be “required by” the public interest, the DOT has proffered several forms of public benefits to justify approval, including reductions in double marginalization, cost and operational efficiencies, expanded networks, improved coordination and services, increased capacity, and aligned frequent flyer benefits.[216]

The expansion of international air services has undoubtedly emerged as the dominant public interest factor permitting ATI despite a competitive analysis indicating rejection, and the DOT recognizes U.S. foreign policy goals as a key public benefit.[217] Since the early 1990s, the DOT and the State Department have used ATI as an incentive and bargaining chip to induce foreign nations to enter into Open Skies agreements with the United States.[218] For instance, the first ATI grant in 1993 was a result of the U.S.-Netherlands Open Skies agreement. Recently, the DOT approved ATI proposals by both United-All Nippon Airways and American-Japan Airlines, conditioning approval on the U.S.Japan Open Skies Aviation Agreement being signed.[219] The State Department and DOT effort has succeeded as the United States currently has more than 120 open-skies partners.[220]

Occasionally, public interest considerations beyond Open Skies prove instrumental. The 2005 SkyTeam ATI application was denied because the DOT determined it was not required by the public interest given that “the carriers had not shown they could effectively reconcile” differing business practices to achieve commonality within the alliance.[221] In 2009, in the midst of a global recession and struggling airlines, the DOT approved a Star Alliance ATI request because it “[would] help Continental and the other participants manage cyclical changes in the industry to preserve existing services, with a view toward increasing capacity and enhancing competition between carriers and alliances.”[222] The DOT has justified airlines’ insistence of not proceeding with an agreement without ATI as a public benefit.[223] Lastly, OneWorld’s 2010 ATI application was approved because a OneWorld immunized JV was needed to “provide a third global network [to] better discipline the fares and services offered by the Star and SkyTeam alliances,” reasoning that “this too is a public benefit.”[224] Recall that this “competitive counterweight” line of reasoning was instrumental in the DOJ’s approval of the American-U.S. Air merger. [225]

III.  STRIKING THE RIGHT LEVEL AND MANNER OF ANTITRUST REGULATION

The 1993 Open Skies Agreement between the United States and Netherlands opened a new industry order of cooperation among foreign airlines. Northwest Airlines and KLM immediately created an alliance and eventually expanded it into a JV.[226] United Airlines seized on the newfound expansion opportunities and launched the Star Alliance in 1996; American Airlines followed suit in 1999, creating the OneWorld Alliance, and Delta finished the alliance trifecta with its SkyTeam Alliance in 2000.[227] The DOT’s willingness to approve ATI is a significant development; more than twenty-eight international alliance agreements were granted ATI by the DOT after 1993, contributing to the formation of four vast, transatlantic JVs.[228]

The proliferation of foreign air services agreements is not confined to the lucrative transatlantic market. The United States and Japan completed an Open Skies agreement in 2010, signaling a countervailing shift toward greater liberalization in the transpacific air market.[229] Since then, American Airlines-Japan Airlines, Delta-Virgin Australia, United-Air New Zealand, and United-ANA created transpacific JVs with ATI.[230] As airlines across the globe increase cooperation with foreign counterparts, international travel demand has steadily increased. Each year, over 80 million U.S. residents travel abroad.[231] Global air passenger demand increased 7.6% in 2017 compared to 2016, above the ten year average annual growth rate of 5.5%.[232] International passenger traffic increased 7.9% in 2017, slightly edging domestic traffic which increased 7%; in sum, more than 4 billion passengers took to the skies in 2017, with the Asia-Pacific and Latin America regions capturing the highest year-to-year demand gains.[233]

While U.S. airlines were undergoing a merger-fueled movement toward greater concentration that left four airlines accounting for nearly 85% of the domestic market (up from 65% in 2010),[234] a similar battle opened on the international front. Nearly every major airline worldwide has joined one of the three global alliances: (1) Star Alliance consists of twenty-eight carriers;[235] (2) SkyTeam consists of twenty carriers;[236] and (3) OneWorld consists of thirteen carriers.[237] Immunized alliances operated 41% of transatlantic capacity in 2000; by 2015, that share increased to 86%.[238] During that time, HHI increased 1,592 points, a 155% increase.[239] Since 2015, the number of independent, non-aligned transatlantic airlines has decreased, leaving four transatlantic JVs in control of more than 90% of U.S.-E.U. traffic.[240] Similarly, the three global alliances provide over 80% of capacity in both the U.S.-Asia Pacific and E.U.-Asia Pacific markets,[241] and both shares are set to rise given the relative novelty of Open Skies agreements with Asian nations. Given this backdrop, it is no surprise that ATI applications are controversial and frequently spur regulatory disputes.[242] Two recent DOT decisions fueled the flames and left interested parties pondering whether they signal a DOT policy shift or are simply anomalies.

In November 2016, the DOT tentatively blocked American Airlines and Qantas Airwayss JV application for ATI finding that the JV, which would control around 60% of the U.S.-Australia market if approved, would “substantially reduce competition and consumer choice, without producing sufficient countervailing public benefits.”[243] The DOT did not believe that there would be greater capacity growth under the JV than what it expected would happen without it; thus, it found that many of the public benefits presented by an AmericanQantas JV could be achieved through materially less anticompetitive cooperation such as codesharing.[244] American and Qantas’ application invited challenges from LCC competitors over certain “exclusivity” provisions in the joint business agreement.[245] Lastly, JetBlue Airways highlighted that American Airlines was seeking ATI, a prerequisite of which is an active Open Skies agreement, while embroiled in a nasty industry dispute concerning Open Skies and the big three Middle Eastern carriers (ME3),[246] which could have impacted the DOT’s decision.

Less than a month later, the DOT approved Delta and Aeromexico’s application for an immunized JV; however, it imposed multiple conditions to address competition concerns. The DOT found that “the non-transparent slot allocation regime and infrastructure constraints at Mexico City’s Benito Juarez International Airport (MEX),” coupled with Delta and Aeromexico’s control of nearly 50% of the MEX slots, were unique constraints on the public realizing the benefits of the JV.[247] To remedy the airlines’ entrenched share at MEX and John. F. Kennedy International Airport (“JFK”) and to address the difficulty of new entrant airlines to acquire slots, the DOT conditioned approval on Delta and Aeromexico divesting twenty-four MEX slots and six JFK slots.[248] In a surprising development, the DOT also limited its ATI grant to five years.[249] After JetBlue and Hawaiian Airlines called for a three-year limit, the DOT determined a five-year limit and a de novo application to extend ATI was required by the public interest so interested parties could evaluate the effects of the slot divestures and proposals by the Mexican government to improve MEX slot allocation procedures.[250] Lastly, the DOT required Delta and Aeromexico to remove “certain anticompetitive,” or exclusivity, provisions from their JV agreement.[251]

Moving forward, the need for a clear and transparent approach to ATI by the DOT on international air travel cannot be overstated. With mergers involving U.S. legacy airlines likely off the table for the foreseeable future, these legacy airlines will continue to expand their respective alliances and favor ATI (the closest substitute to a merger facing foreign ownership restrictions) to expand their global network and capture maximum integration efficiencies. United Airlines is exploring an immunized JV with Air Canada following a shift in Canadian laws.[252] American Airlines and Qantas have reapplied for ATI with an improved application,[253] hoping for a better result under the Trump administration. The following subsections will explore practical regulatory and systematic reforms available to ensure “friendly skies” for both airlines and passengers alike. The key is a transparent and consistent approach by the DOT that allows robust free market forces (for which deregulation paved the way) to better regulate and ensure continued competition.

A.  Constrain the “Public Interest” and Emphasize Predictability in Determining ATI

The DOT justified its initial ATI approvals in the 1990s largely on the public interest factor that Congress provided it, finding that passengers would benefit from network efficiencies and increased competition “by allowing airlines with small market shares to combine their networks and become more effective in competing against larger airlines.”[254] In doing so, the DOT seemingly disregarded a fundamental principle of antitrust law—it exists to protect competition, not competitors—in its ATI approach. Indeed somewhere along the line, the public interest consideration has merged with an omnipresent “industry interest” review. And the DOT continues to tout “the benefits of creating alliances that could compete against one another, rather than against individual airlines” in granting ATI.[255]

Even after the DOT established a “heightened public benefits standard[],” which effectively required applicants to propose a metal-neutral JV for ATI approval,[256] its emphasis on competitors remained. But the recent American-Qantas and Delta-Aeromexico proceedings illustrate that how the DOT considers competitor-to-competitor effects as a public interest is anything but consistent. The DOT rejected American and Qantas’ ATI bid after it previously granted Delta-Virgin Australia and United-Air New Zealand immunity in the same U.S.-Australia market. Yet shortly after this rejection, the DOT approved ATI for Delta and Aeromexico finding it to be “required by the public interest because the proposed JV would provide . . . a third network competitor [to] the current first and second largest competitors.”[257] Interested parties, particularly airlines eying future immunized JVs, are left squinting to find the DOT’s rationale or distinction between these applications. When one compares the novelty of the U.S.-Mexico Open Skies agreement and the infrastructure/slot issues at MEX[258] to the established U.S.-Australia Open Skies agreement that led to two transpacific immunized JVs without similar concerns of barriers to entry, American Airlines and Qantas have to be left wondering how a third network in the U.S.-Australia market differs from a third network in the U.S.-Mexico network.

At the heart of its public benefits analysis, the DOT must consider “international comity and foreign policy considerations.”[259] A determinative factor in virtually every ATI approval has either been expanding the DOT and State Department’s Open Skies push or threats by airlines that they would not finalize a proposed deal without ATI.[260] Assertions of public benefits and threats of withholding agreements without immunity have accompanied airlines’ applications since the beginning.[261] It is precisely the DOT’s job to independently evaluate the anticompetitive effects and public benefits of an application and ferret out false claims or threats made by applicants from truth. Instead, the DOT’s public interest methodology has been critiqued as “nothing more than ‘copy and paste’” in accepting applicants’ claims as its justification for approval.[262] The consistent acceptance by the DOT of applicants’ claims, despite objections by the DOJ and other affected parties, has raised suggestions that the DOT is a “captured agency.”[263]

The DOT’s emphasis on expanding Open Skies should be a textbook example of foreign policy considerations. Open Skies agreements carry enormous potential to promote competition and liberalize air travel by removing barriers to entry in foreign airspace. However, when large legacy airlines hold prominent seats at the table consummating such agreements,[264] or the DOT links Open Skies to ATI with signatories’ national airlines,[265] Open Skies agreements can quickly turn to be protectionist and anticompetitive in their implementation.

The public interest is not served by entrenching incumbent national airlines’ positions and insulating them from robust competition. The three U.S. legacy carriers neither desire nor require government protection; instead, they have routinely demonstrated a willingness to compete with other legacies and LCC/ULCCs in the domestic U.S. market. There is no reason to expect anything different in the international market. Ample room exists for the DOT to reign in its public interest approach and emphasize that ATI applicants present verifiable benefits to passengers while still fulfilling its “foremost international aviation goal . . . [of] opening international markets to the forces of competition.”[266] In construing the public interest narrowly and, by default, placing greater emphasis on the competitive analysis, industry participants should experience a more transparent and uniform approach toward ATI applications. The DOT’s ability to clean up its public interest approach and improve the predictability of its evaluations would reduce the likelihood of a repeat of the two above-referenced ATI decisions—in which American and Delta highlighted the exact same public benefits of ATI as virtually every application, but American was denied while Delta was approved despite more troubling competition concerns in its applicable market. Such an approach by the DOT would provide airlines efficiency and cost improvements when evaluating whether a potential application might receive immunity. Lastly, a narrower public interest approach improves the chances that the DOT, crucially, keeps passenger welfare at the forefront of its evaluations and adheres to the fundamental principle of antitrust to protect competition, not competitors.

B.  Periodic Reviews of Immunized Alliances that Minimize the Burden on Airlines

Independent, non-aligned U.S. airlines have played an increasingly active role in recent DOT public dockets evaluating ATI applications. A consistent and vehement belief of such airlines is that approvals of immunity not be in perpetuity, but instead come with time constraints. Particularly, Southwest, JetBlue, and Hawaiian have argued for three to five-year time limitations on any new grants of ATI[267] and called for de novo reviews of existing immunized alliances.[268] Calls for periodic reviews of ATI is not a novel argument; multiple advocates have pushed for some form of mandatory review mechanism. In 2009, a House Bill by Rep. James L. Oberstar proposed to sunset ATI approvals after three years.[269] While his exact proposal may not have left the ground, it is past due for the DOT to implement a revised policy of periodic ATI reviews that reflects the present competitive dynamics of both the domestic and international markets, which have seen an unprecedented move toward greater consolidation.

The DOT’s recent five-year time limit imposed on Delta and Aeromexico was the first of its kind, yet the DOT recognizes its authority “to alter or amend its grant of ATI at any time if [it] believes a change in competitive circumstances has occurred.”[270] But the DOT’s regulations covering reviews of ATI were codified in 1985,[271] eight years before the DOT approved a single ATI application or realized the foreign policy implications of ATI in expanding Open Skies. Under § 303.06 of the DOT’s regulations, the DOT “may initiate a proceeding to review any [ATI] previously conferred . . . [and] may terminate or modify such immunity if the [DOT] finds . . . that the previously conferred immunity is not consistent with the provisions of section 414.”[272] Thus, while the DOT explicitly acknowledges its authority to amend or revoke ATI at any time, its actions reflect otherwise. In rejecting a request by JetBlue and Hawaiian to institute a de novo review of Delta and Korean Air’s ATI grant after they sought to implement a JV (fifteen years after initial ATI approval), the DOT again recognized its authority to undertake reviews at any time, but held that for it to do so “JetBlue and Hawaiian must show that a new proceeding is necessary . . . either because the existing process for reviewing the agreements is flawed or because there is a substantial basis to revisit the grant of [ATI].” [273] While the DOT may occasionally give lip service to the notion that immunity from antitrust laws is an exception, not the rule,[274] its actions fly in the face of that notion when it rejects calls for periodic review of ATI and shifts the burden of proof from those enjoying ATI to those challenging it.

At a basic level, it is difficult to accept that on the one hand the DOT categorizes ATI as an exception to the norm and only appropriate when the public interest requires it, but on the other hand approves ATI in perpetuity without an adequate regime of ex post review in place. Critics of the DOT’s current approach claim that after the initial public benefits review, ATI approval “is virtually permanent and the [airlines] are left unchecked to stifle innovation and competition in the market through coordinated pricing, scheduling, and operation functionalities, to the detriment of the travelling public.”[275] They argue that periodic reviews of five years or less in a public docket “will increase public transparency and ensure that immunized alliances remain beneficial and in the public interest, as defined not only by the immunized [airlines], but also by the public to whom they purport to bring benefits.”[276] Additionally, some studies have claimed that the pricing efficiencies and passenger benefits generated by alliances relative to interlining has not required ATI to capture such benefits.[277]

Opponents of instituting duration limits on ATI are primarily legacy airlines with portfolios of active immunized agreements. This is predictable given that any policy changes will have the largest impact on their global network strategies. They argue that a policy of ATI term limits would have a chilling effect on investment in joint operations and expanding route networks as airlines would be hesitant to make long-term investments, reducing the likelihood of reaching the level of cooperation that offers the greatest level of passenger benefits.[278] The effects of such a policy reduces the incentive to cooperate fully and creates uncertainty that diminishes consumer benefits and runs counter to the purpose of Open Skies agreements.[279] Additionally, factoring in the time constraints involved with the public docket and application process, a 3-5 year limit “would place the [DOT] and [airlines] in a state of perpetual re-application and re-review.”[280]

An optimal and practical policy that the DOT could adopt is to conduct a de novo review in a public docket of every active immunized agreement once every ten years (in the absence of unique competitive concern such as the slot/infrastructure issues at MEX). Such a policy would permit the DOT to regularly assess market conditions and verify that airlines are meeting the proposed public benefits that drove the DOT to approve their applications, while granting immunized airlines a longer horizon to entice full cooperation and investment with aligned foreign airlines and avoiding a perpetual administrative counterweight to international expansion. Current DOT regulations permit adopting such a policy via an informal, but clearly defined, case-by-case approach, thereby avoiding the difficulties of formal rulemaking or Congressional reengineering.[281] Additionally, this approach would allow the DOT to evaluate its projected docket volumes and work directly with airlines to set application and review timelines that minimize administrative burdens and facilitate quick reviews. For example, an airline may voluntarily agree to do its review after nine years if it would lead to quicker turnaround times and the DOT agrees to permit it eleven years of ATI, if approved.

It is clear that effective international JVs require significant long-term investment and advance work to facilitate optimal division of resources between airlines and maximum public benefits. The proposed policy attempts to weigh this against the reality that the DOT’s past and current approach does not grant verified and actual passenger benefits a seat at the ATI table. While it would impose a new burden on U.S. legacy airlines operating with numerous grants of ATI, it should not be considered an undue burden. These airlines already comply with numerous recurring DOT obligations such as continuing fitness reviews and renewal of certificates.[282] Further, “the vast majority of the United States’ aviation partners authorize alliances for limited periods including . . . Australia, the European Union, New Zealand and South Korea.”[283] Thus, network airlines are experienced in structuring alliances or JVs with ATI with advanced knowledge of an eventual requirement to re-apply. Lastly, airlines’ claims that ATI time limits will temper investments may carry an element of application gamesmanship with them. For example, despite teeing off on the DOT in accepting the DOT’s slot divestitures and five-year ATI limit, Delta invested more than $620 million to acquire a 49% equity stake in Aeromexico and consummated their U.S.-Mexico transborder JV.[284]

A tangential issue to ATI limits is the public release of annual ATI reports prepared by immunized airlines for DOT review. DOT has required ATI recipients to prepare annual reports on the implementation of alliance agreements and benefits resulting from ATI.[285] JetBlue has called for the public release of these reports, arguing that it “will increase transparency and promote a more robust understanding of the public benefits, if any, that are produced by . . . ATI.”[286] It claimed that both the procedural process and the substantive components are a mystery and that it was denied access to redacted versions of such annual reports.[287]

Delta responded to JetBlue’s request by highlighting that there are multiple types of reports prepared by airlines and sent to the DOT that are kept confidential that would seemingly fall under JetBlue’s push to increase transparency.[288] The DOT has sided with the airlines that prepare these annual ATI reports largely over concerns that requiring public disclosure could potentially inhibit competition and diminish airlines’ “candor with the [DOT].”[289]

The DOT’s hesitation to publicize immunized airlines’ annual reports is reasonably related to concerns with the free flow of information required to determine whether alliances are providing public benefits on a continual basis. Therefore, this Note does not suggest any changes to the DOT’s current annual review policy. Instead, the proposed periodic review and time limitations on ATI grants should adequately remedy the transparency concerns that JetBlue raises while respecting an airline’s right to confidential trade secrets and candor with the DOT.

There is no disputing the incredible difficulty antitrust regulators face in evaluating potential mergers and ATI requests. Using current and past information to project future competitive implications of corporate activities (in a constantly evolving competitive landscape) is certainly an art rather than science. To expect clairvoyance or perfection from regulatory agencies would indicate a complete lack of reality. The DOJ is tasked with the unenviable job of having to get it right on the first try in evaluating domestic airline mergers. A merged airline cannot simply be unwound ten years later if it is not delivering the expected consumer benefits. This is not the case with the DOT and its ATI role. Rather, the flexibility of ATI to account for evolving competitive landscapes of international markets is a tremendous safeguard and positive byproduct of the restrictions on foreign mergers. While there are valid concerns against imposing a firm time limit and periodic public reviews of immunized alliances, these concerns do not outweigh the DOT’s primary responsibility to promote competition to its primary constituent, the flying public, in fulfilling its antitrust responsibilities given to it by Congress. A reasonable and practical solution to balancing these interests is to establish a periodic ten-year ATI review.

C.  Increase DOJ Involvement in ATI Competitive Analysis

As previously detailed, following deregulation, the DOJ was given authority to evaluate U.S. domestic airline M&A while the DOT retained ATI authority.[290] During the short span in which the DOT held authority for both functions, it faced criticism over its performance with aviation-related antitrust issues and itself favored the transfer of M&A authority to the DOJ.[291] Since the division of antitrust roles in 1989, there have been periodic spats between the agencies and continued questions over the DOT’s fitness to perform its antitrust functions.

Given this backdrop, it is rather surprising that the DOT has often exhibited a proclivity to ignore the DOJ’s antitrust expertise. Although the DOT states that it “initially confer[s] with [the DOJ], given its experience [with] the antitrust laws,”[292] rhetoric between the two, at times, reasonably suggests otherwise. Concerns have been raised that the DOT does not give “sufficient consideration” to the impacts of ATI “on the competitive structure of the domestic airline industry.”[293] The DOT and DOJ publicly disputed the evidentiary standards used by the DOT in approving the Star Alliance-Continental (2009) and OneWorld-British Airways (2010) ATI applications. The DOJ charged that DOT’s review process was a complete abandonment of evidentiary standards because it rubber stamped the applicants’ unsubstantiated public benefits claims; some agreed with the DOJ and characterized the DOT’s “public benefits methodology [as] literally nothing more than ‘copy and paste.’”[294] The DOT claimed the DOJ attacks were “an inappropriate interference with [its] aviation policy and bilateral negotiation prerogatives.”[295]

Calls for increased DOJ involvement or even complete transfer of authority are not new. In 1998, the Transportation Research Board (“TRB”), under the Congressional direction to study government actions promoting airline industry competition, recommended that Congress shift ATI review to the DOJ; the TRB had concerns over the DOT’s policy linking consummation of Open Skies to ATI with signatories’ national airlines.[296] Others argue that the DOT is a “captured agency” as it frequently underestimates the potential anticompetitive effects of ATI because it favors the concerns of the largest shareholders of the industry it regulates.[297] Proposed solutions to the captured agency issue include retaining the initial ATI review with DOT given “its role in crafting U.S. global aviation policy,” but transferring authority to the DOJ for subsequent reviews and reapplications.[298]

This Note does not advocate for either approach. While there may be valid agency capture concerns over comingling regulatory and industry policy roles, the DOT’s authority over tangential matters such as airport slots and route certificates, expertise in the airline industry, and past successes working with the State Department to expand Open Skies make it the best agency to regulate ATI moving forward. That said, there is ample room for improvement in the ATI regulatory process. An increased role by the DOJ would facilitate many improvements. DOJ has demonstrated a tremendous ability to work with the Securities & Exchange Commission (“SEC”) and international regulators to effectively enforce the Foreign Corrupt Practices Act.[299] There is no reason that the DOT cannot similarly leverage the DOJ’s antitrust expertise in its quantitative competitive analysis of ATI applications and continuous monitoring obligations. Finally, given the interplay between the competitive situation in domestic and international markets, increased coordination will ensure that sufficient consideration is given to ATI impacts on both markets.

D.  Knock Down Barriers to Entry, While Respecting the Tenets of Deregulation and Free Competition

With most industries, high market concentration indicates an industry ripe for new entrants. The airline industry, however, contains numerous industry-specific barriers, including takeoff and landing slots (particularly at commercially-coveted airports), airport terminal/gate access, and the tremendous capital required to acquire aircraft and initiate services.[300] Additionally, the hub-and-spoke networks of legacy airlines effectively serve as operational barriers.[301] Collectively, these barriers inhibit the formation of new airlines and often create enormous difficulties for existing airlines to enter specific markets. The U.S. government should prioritize efforts to minimize barriers to entry and promote robust industry competition. However, in trying to spur competition, the government often finds itself potentially crossing a line of government intervention that deregulation was intended to leave behind in lieu of free market competition. This section steps beyond antitrust law and explores potential systematic and philosophical reforms to spur further innovation and competition in the U.S. airline industry.

Overhauling U.S. aviation infrastructure has tremendous potential to generate real economic benefits and fresh competition. The United States’ antiquated aviation infrastructure and policies carry costly effects. U.S. airports are increasingly congested as growing travel demands strain airports’ ability to keep up—72% of U.S. air passenger traffic flows through the thirty busiest airports and delays cost passengers and airlines billions annually.[302] President Trump touted improving U.S. transportation infrastructure, including U.S. airports which he referred to as “bottom of the rung” internationally, as a key policy agenda; he pushed for an investment of over $1 trillion in U.S. infrastructure improvements through public-private financing and tax incentives shortly after being elected.[303] Improving airport infrastructure is arguably just as important as easing air traffic congestion. For example, airlines without historical control of terminal space or gates at Los Angeles International (“LAX”) find lack of real estate is a huge barrier to entering or expanding service at LAX;[304] while LAX may not have the slot constraints or air space issues that the New York City airports do, the lagging infrastructure has the same practical effect in limiting the number of airlines and flights that can serve LAX. Expanding and improving U.S. airports will provide opportunities for those airlines without historical real estate holdings to enter or expand at airports that are currently space constrained.

Lastly, moving forward, the DOT should be cautious of pushing policies that position it to pick “winner and loser” airlines or overstep its regulatory authority abroad and disrupt international comity. Its approach toward “exclusivity clauses” in alliance or JV agreements applying for ATI presents a powder keg of issues moving forward. Hawaiian Airlines recently requested that the DOT require Qantas to codeshare on routes in Australia with other U.S. airlines on the same terms and availability that American Airlines would receive via their JV (thereby requiring ongoing price regulation and monitoring by the DOT).[305] While the request became moot after the DOT denied American and Qantas’ ATI bid, it offers an interesting case study. The DOT and State Department’s Open Skies objective has been to open and liberalize air travel between the U.S. and other countries; to entertain forcing foreign airlines to codeshare with U.S. airlines on flights entirely within a foreign country would seemingly undermine the entire notion of Open Skies and international comity. The DOT should be extremely hesitant to intervene in the contractual relations of private airlines, especially when foreign airlines are involved, and any DOT action may invite a reciprocal response by foreign regulators.

The DOT’s MEX slot divesture approach in granting Delta and Aeromexico ATI is also troubling and should not set a precedent moving forward. The DOT limited eligibility for the divested MEX slots to LCCs only and deemed Interjet, a Mexican LCC, ineligible because it was the second largest airline at MEX.[306] It reasoned that LCCs have the largest competitive impact in disciplining fares and that restricting slots to just LCCs would limit the total number divested.[307] The rationale behind the DOT’s decision is arguably sound; there is continued support for a “Southwest Effect”lower airfares on routes with a Southwest or other LCC/ULCC presence.[308] But its decision produced negative outcomes. The DOT should not be in the business of picking winners and losers by completely shutting out a segment of airlineslegaciesfrom even stepping to the plate and making their case. While the 80% market share of the four largest U.S. airlines is often tossed around, it fails to capture competitive realities. Legacy airlines have demonstrated a willingness to compete against both fellow legacies, by encroaching into entrenched hubs and growing nonstop service to more destinations,[309] and LCCs, by expanding product offerings such as the introduction of “basic economy” fares to reach even the most price-conscious of passengers.[310]

The MEX slot divesture also concerns matters of international comity. Interjet has challenged the DOT’s slot divestiture process in the D.C. Circuit as “arbitrary and capricious” and questioned whether the DOT “exceeded its statutory authority” in allocating slots at an airport outside the United States.[311] Moving forward, the DOT should refrain from taking similar actions that can be construed, at a minimum, as regulatory fiat, or, worse, as encroaching on the sovereignty of Open Skies agreement partners. JetBlue’s experience in trying to receive slots at MEX illustrates the “opaque [and] confusing” process: JetBlue was awarded only commercially undesirable slots before 5:00 a.m. and after 10:00 p.m.[312] Rather than unilaterally engineer a solution that arbitrarily excluded U.S. and Mexican airlines from the process, the DOT should have shared its slot concerns with the Mexican aviation authority and the MEX airport authority in order to come to a consensus for slot divestitures together that would permit ATI approval. Offering assistance in bringing the MEX slot allocation system in line with the IATA World Slot Guidelines, while touting the benefits that JetBlue and other U.S. airlines bring to communities would also be more effective than a divestiture power grab. Going forward, a DOT mentality that respects international comity and robust market competition will incentivize all airlines and generate the greatest public benefit.

Conclusion

Under many metrics, U.S. airlines are serving passengers at record levels. Foremost, U.S. commercial aviation has never been safer; 2017 marked the eighth straight year of zero U.S. airline passenger fatalities.[313] Average ticket prices are at historic lows, and increases in fares are considerably behind increases in disposable income, CPI, and jet fuel prices this century.[314] Airlines are aggressively competing and expanding into competitor hubs, while improving flight operations; in 2017, fewer flights were cancelled, on-time arrival rate increased, and airlines lost fewer bags and bumped fewer passengers.[315] However, viral incidents such as United’s removal of Dr. Dao and the large domestic market share of the four biggest U.S. airlines contribute to the public’s negative perception of air travel. The data paint a different picture. Ugly on-board incidents are the exception, and all U.S. airlines have demonstrated an impressive flexibility to quickly adopt policies that reduce the likelihood of repeating such incidents. United adopted ten policy changes in response to the Dr. Dao incident, including reducing overbooking and increasing gate agent flexibility to reach voluntary seat denials, which other U.S. airlines also adopted.[316]

There will always be room for improvement, but high market concentration in the U.S. domestic airline market has not caused disastrous anticompetitive results. That said, there is no guarantee that similar results will occur as international markets become more concentrated. International air travel involves unique barriersas the slot situation at MEX exemplifiesand significant costs to acquire aircraft and establish operations abroad. Open Skies and ATI have enormous potential to open international markets and improve travel for U.S. passengers. However, ATI is also an extraordinary tool of regulatory relief that requires adequate safeguards. The DOT can better serve airlines and passengers alike by clarifying public interest considerations, periodically reviewing ATI approvals, and increasing DOJ involvement.

 


[*] *. Senior Submissions Editor, Southern California Law Review, Volume 91; J.D. 2018, University of Southern California Gould School of Law; B.A. Political Science and Economics 2015, Emory University. I am forever thankful to my dad for his twenty-eight years of service as an Air Force pilot and for instilling in me a passion for aviation from a young age. A special thank you to Rob Land for sparking my interest in airline antitrust immunity and encouraging this Note. Lastly, I am extremely grateful to Katie Schmidt, Karen Blevins, and Christopher Phillips for their outstanding feedback and editing efforts.

 [1]. Michael Goldstein, Biggest Travel Story of 2017: The Bumping and Beating of Dr. David Dao, Forbes (Dec. 20, 2017, 9:13 PM), https://www.forbes.com/sites/michaelgoldstein/2017/12/20/biggest-travel-story-of-2017-the-bumping-and-beating-of-doctor-david-dao/#b43cd2cf61fc.

 [2]. Hugo Martin & Joseph Serna, Passenger Mix-Up on Flight to Japan Caps a Year of Airline Foul-Ups, L.A. Times (Dec. 27, 2017, 4:50 PM), http://lat.ms/2Fkp01C.

 [3]. Jon Ostrower, Delta’s Meltdown: What Went Wrong, CNN (Apr. 10, 2017, 5:51 PM), http://cnnmon.ie/2oEJrwy. See also Scott McCartney, The Best and Worst U.S. Airlines of 2017, Wall St. J. (Jan. 10, 2018, 9:33 AM), http://on.wsj.com/2FQLuoL (reporting overloaded telephone lines prevented Delta pilots and flight attendants from calling in for new assignments).

 [4]. Bart Jansen, Delta: Atlanta Airport Power Outage Cost $25M to $50M in Income, USA Today (Jan. 3, 2018, 11:49 AM), https://usat.ly/2tcSUQN.

 [5]. David Koenig, Police Drag Woman Off Southwest Airlines Flight, Chi. Trib. (Sept. 28, 2017, 3:00 AM), http://trib.in/2Fbmr2E.

 [6]. Amy B. Wang, Passenger Says JetBlue Booted His Family from Flight Over a Birthday Cake, Wash. Post (May 14, 2017), http://wapo.st/2FiEbZo.

 [7]. McCartney, supra note 3 (noting that most of the operational shorthandedness was with Alaska’s subsidiary, Horizon Air).

 [8]. Amy B. Wang & Luz Lazo, Federal Court Orders Spirit Pilots Back to Work After Chaos at Fort Lauderdale Airport, Wash. Post (May 9, 2017), http://wapo.st/2oF3DhQ.

 [9]. Kathryn Vasel, America’s Least Favorite Airline (Hint: It’s Not United), CNN (Apr. 25, 2017, 12:13 PM), http://cnnmon.ie/2FclbMY.

 [10]. Benjamin Zhang, ‘Infuriated’ United Pilots Union Slams Cops for Forcibly Dragging Passenger from Plane, Bus. Insider (Apr. 13, 2017, 6:22 PM), http://read.bi/2GYcNNl. The four Chicago Department of Aviation officers involved in the incident were suspended immediately, and two were subsequently fired. Maya Salam, Security Officers Fired for United Airlines Dragging Episode, N.Y. Times (Oct. 17, 2017) https://nyti.ms/2kXopKv. A Chicago directive later stripped Chicago Airport Security Officers of their “police” label. Id.

 [11]. Tracey Lien, Before Apologizing on Tuesday, United Tried Two Unsuccessful Tactics to Quell Its Public Relations Crisis, L.A. Times (Apr. 11, 2017, 11:20 AM), http://lat.ms/2oYhLVt. See also Erin McCann, United’s Apologies: A Timeline, N.Y. Times (Apr. 14, 2017), http://nyti.ms/2um2OeG.

 [12]. Lien, supra note 11.

 [13]. Michael Edison Hayden & Erin Dooley, United CEO Feels ‘Shame,’ Passenger Will Be Compensated, ABC News (Apr. 12, 2017), http://abcn.ws/2o6tkpj.

 [14]. Goldstein, supra note 1.

 [15]. Trefis Team, How M&A Has Driven the Consolidation of the US Airline Industry Over the Last Decade?, Forbes: Great Speculations (May 4, 2016, 8:34 AM), http://bit.ly/2oG127C.

 [16]. See Christopher Drew, Airlines Under Justice Dept. Investigation Over Possible Collusion, N.Y. Times (July 1, 2015), http://nyti.ms/1dyF91l.

 [17]. Airlines Carried Record Number of Passengers in 2016, CBS News (Mar. 27, 2017), http://cbsn.ws/2FSvrGU. See also Air Traffic by the Numbers, Fed. Aviation Admin. (Nov. 14, 2017), https://www.faa.gov/air_traffic/by_the_numbers.

 [18]. Karl Russell, Why We Feel So Squeezed When We Fly, N.Y. Times (May 2, 2017), https://nyti.ms/2pv5cOa.

 [19]. Brian Pearce & Gary Doernhoefer, The Economic Benefits of Airline Alliances and Joint Ventures, Int’l Air Transp. Ass’n (Nov. 28, 2011), https://www.iata.org/whatwedo/Documents
/economics/Economics%20of%20JVs_Jan2012L.pdf.

 [20]. A Brief History of the FAA, Fed. Aviation Admin. (Jan. 4, 2017), https://www.faa.gov
/about/history/brief_history.

 [21]. Air Commerce Act, Pub. L. No. 69-254, 44 Stat. 568 (1926).

 [22]. Id.

 [23]. Dennis Parks, The First Regulations, Gen. Aviation News (Oct. 23, 2011), https://generalaviationnews.com/2011/10/23/the-first-regulations.

 [24]. Civil Aeronautics Authority Act of 1938, Pub. L. No. 75-706, 52 Stat. 973.

 [25]. See id.

 [26]. Post-War Revival and Regulation, Smithsonian Nat’l Air & Space Museum, http://s.si.edu/2FevJXI (last visited July 30, 2018).

 [27]. See Con’l Air Lines, Inc. v. Civil Aeronautics Bd., 519 F.2d 944, 959–60 (D.C. Cir. 1975) (ordering the Civil Aeronautics Board to approve Continental Airline’s outstanding application of eight years to begin service between Denver and San Diego).

 [28]. See Justin Elliott, The American Way, ProPublica (Oct. 11, 2016), https://www.propublica.org/article/airline-consolidation-democratic-lobbying-antitrust. See also John F. Stover, American Railroads 234 (2d ed. 1997) (examining the Penn Central Railroad collapse and its domino effect causing concern that air transport could follow the nation’s troubled railroads).

 [29]. Airline Deregulation Act of 1978, Pub. L. No. 95-504, 92 Stat. 1705.

 [30]. Id.

 [31]. Jagdish N. Sheth et al., Deregulation and Competition: Lessons from the Airline Industry 31 (2007) (“CAB’s authority over routes that an airline could serve was to terminate by December 31, 1981, and regulation of fares that airlines could charge was to cease by January 1, 1983.”).

 [32]. Amended Complaint ¶ 1, United States v. US Airways Group., Inc., 38 F. Supp. 3d 69 (D.D.C. 2014) (No. 13-cv-1236-CKK) [hereinafter Amended Complaint].

 [33]. See Wilfred S. Manuela Jr. et al., The U.S. Airways Group: A Post-Merger Analysis, 56 J. Air Transp. Mgmt. 138, 139 (2016).

 [34]. Dennis W. Carlton et al., Are Legacy Airline Mergers Pro- or Anti-Competitive? Evidence from Recent U.S. Airline Mergers, Int’l J. Indus. Org. 1, 4 (2018), https://doi.org/10.1016/j.ijindorg
.2017.12.002.

 [35]. Id. at 4–5.

 [36]. Drew, supra note 16.

 [37]. Sheth et al., supra note 31, at 57–60.

 [38]. Id. at 57–58, 65.

 [39]. Manuela Jr. et al., supra note 33, at 139 (finding that only one merger could be judged successful in improving financial and operating performance).

 [40]. Id.

 [41]. Id. at 138–39, 141. See also Carlton et al., supra note 34, at 4–5.

 [42]. American Airlines filed most recently in 2011. Jiajun Liang, What Are the Effects of Mergers in the U.S. Airline Industry? An Econometric Analysis on Delta-Northwest Merger, 3 Macalester Rev. no. 1, art. 2, 2013, at 1.

 [43]. Manuela Jr. et al., supra note 33, at 139.

 [44]. See U.S. Airline Mergers and Acquisitions, Airlines for Am., http://airlines.org/dataset/u-s-airline-mergers-and-acquisitions (last visited July 30, 2018).

 [45]. Fiona Scott Morton et al., Benefits of Preserving Consumers’ Ability to Compare Airline Fares 34 (2015), http://3rxg9qea18zhtl6s2u8jammft-wpengine.netdna-ssl.com/wp-content
/uploads/2015/05/CRA.TravelTech.Study_.pdf.

 [46]. Elaine X. Grant, TWA—Death of a Legend, St. Louis Mag. (July 28, 2006, 12:00 AM), https://www.stlmag.com/TWA-Death-Of-A-Legend.

 [47]. See Morton et al., supra note 45, at 35.

 [48]. Id.

 [49]. Chris Dimarco, US Airways Defends American Airlines Merger, Inside Counsel (Sept. 12, 2013), http://web3.insidecounsel.com/2013/09/12/us-airways-defends-american-airlines-merger.

 [50]. A.W., Why Did the Obama Administration Change Its Mind on the American Airlines-US Airways Merger?, Economist: Gulliver (Oct. 15, 2016), https://www.economist.com/blogs/gulliver
/2016/10/connected; James B. Stewart, Baffling About-Face in American-US Airways Merger, N.Y. Times (Nov. 15, 2013), http://nyti.ms/2thoSet.

 [51]. Jad Mouawad & Christopher Drew, Justice Dept. Clears Merger of 2 Airlines, N.Y. Times, (Nov. 12, 2013), http://nyti.ms/2oHKBHU.

 [52]. Trefis Team, supra note 15.

 [53]. See Amended Complaint, supra note 32, ¶¶ 1–10.

 [54]. Id. at ¶¶ 34–35.

 [55]. Ben Mutzabaugh, Justice Dept. OKs Alaska Airlines-Virgin America Merger, USA Today (Dec. 6, 2016, 2:14 PM), https://usat.ly/2I31EMB.

 [56]. Winnie Sun, What the Virgin-Alaska Air Merger Means for Millennials and Investors Alike, Forbes (Apr. 5, 2016, 4:14 PM), http://bit.ly/2D0qzwC.

 [57]. Elliott, supra note 28.

 [58]. Id.

 [59]. James B. Stewart, ‘Discipline’ for Airlines, Pain for Fliers, N.Y. Times (June 11, 2015), http://nyti.ms/1QPNKtp.

 [60]. See id.

 [61]. Doug Cameron & Nicole Friedman, Warren Buffett’s Berkshire Hathaway Discloses New Investments in Airlines, Wall St. J. (Nov. 14, 2016, 9:57 PM), http://on.wsj.com/2fzTRHP.

 [62]. 2017 Annual and 4th Quarter U.S. Airline Financial Data, Bureau Transp. Stat. https://www.bts.gov/newsroom/2017-annual-and-4th-quarter-us-airline-financial-data (last visited July 30, 2018).

 [63]. IATA Reveals 2018 Financial Forecast, Int’l Air Transp. Ass’n (Dec. 5, 2017), http://airlines.iata.org/news/iata-reveals-2018-financial-forecast.

 [64]. Drew, supra note 16.

 [65]. A.W., supra note 50.

 [66]. Drew, supra note 16.

 [67]. This Note cannot go into detail on Europe, but it is plain to see that the European airline industry has felt a large impact from the growth of ULCCs Ryanair and EasyJet. EBIT margins for European airlines were just 5.3% and 5.6% in 2015 and 2016, while North American carriers were 14.7% and 15.4% in 2015 and 2016, respectively. Chris Bryant, Europe’s Airlines are Drunk on Cheap Fuel, Bloomberg (Oct. 6, 2016, 4:45 AM), https://bloom.bg/2dW6OLP. But see Airlines for Am., U.S. Airline Industry Review: Allocating Capital to Benefit Customers, Employees and Investors 16 (2018) [hereinafter Airlines for America] (finding that U.S. airlines’ average pre-tax profit margin between 2010 and 2017 was 6.5%, while the average U.S. corporation margin was 16.7%).

 [68]. Bryant, supra note 67.

 [69]. Annabel Fenwick Elliott, Thousands to Be Refused Refunds as Europe’s 10th Biggest Airline Ceases Trading, Telegraph (Oct. 10, 2017, 2:57 PM), https://www.telegraph.co.uk/travel/news/air-berlin-to-stop-flights-by-end-of-october.

 [70]. Robert Wall, European Airlines Fly into Trouble, Wall St. J. (July 21, 2016), http://on.wsj.com/2D1sHEh.

 [71]. Airlines for America, supra note 67, at 17.

 [72]. See, e.g., David Reid, U.S. Airlines to Scoop Almost Half of Global Profit in 2018, CNBC (Dec. 5, 2017), https://www.cnbc.com/2017/12/05/us-airlines-to-scoop-almost-half-of-global-profit-in-2018.html.

 [73]. Amended Complaint, supra note 32, ¶ 59.

 [74]. Karl Russell, Why We Feel So Squeezed When We Fly, N.Y. Times (May 2, 2017), http://nyti.ms/2pv5cOa.

 [75]. Id.

 [76]. E.g., Jad Mouawad, Senator Urges Inquiry into Airline Behavior, N.Y. Times (June 17, 2015), https://nyti.ms/1eoLoWK.

 [77]. Id.

 [78]. Stewart, supra note 59.

 [79]. See, e.g., Drew, supra note 16.

 [80]. Brent Kendall & Susan Carey, Obama Antitrust Enforcers Won’t Bring Action in Airline Probe, Wall St. J. (Jan. 11, 2017, 5:33 AM), https://www.wsj.com/articles/obama-antitrust-enforcers-wont-bring-action-in-airline-probe-1484130781; Ryan Strong, DOJ Antitrust Investigation: Is It Time For Airline Discipline?, Colum. Bus. L. Rev. Online (Oct. 8, 2015) https://cblr.columbia.edu/doj-antitrust-investigation-is-it-time-for-airline-discipline.

 [81]. Drew, supra note 16.

 [82]. Stewart, supra note 59.

 [83]. Scott Mayerowitz et al., Government Seeks Evidence that Airlines Illegally Worked Together, but Will the Case Fly?, U.S. News (July 3, 2015, 9:28 AM), http://bit.ly/2FfOgae. Perhaps no investigation was more open and shut than the DOJ investigation of Robert Crandall.

In 1982, Robert Crandall . . . who would become CEO of American Airlines, expressed his anger about . . . fare wars in a phone call with Howard Putnam, CEO of Braniff Airways. Putnam . . . asked Crandall if he had a suggestion to deal with the problem. Crandall told him to raise his fares and he’d follow suit. Specifically, Crandall replied: “Yes. I have a               suggestion for you. Raise your goddamn fares 20 percent. I’ll raise mine the next morning.”               He said: “You’ll make more money and I will too.” The Justice Department sued and the case               was settled for little more than an agreement by Crandall to keep a written record of all of his               contact with other airline executives for two years.

Id.

 [84]. Steven Davidoff Solomon, Rise of Institutional Investors Raises Questions of Collusion, N.Y. Times (Apr. 12, 2016), https://nyti.ms/2Gx2fJe. See also José Azar, Martin C. Schmalz & Isabel Tecu, Anti-Competitive Effects of Common Ownership, 73 J. Fin. 4. at 5, 12, 18 (2018) (finding that when common ownership is taken into account, HHI figures are ten times larger than what the DOJ considers “presumed likely to enhance market power,” and that airfares are 3% to 7% percent higher for airlines that are commonly owned by the same major stockholders).

 [85]. Kendall & Carey, supra note 80.

 [86]. Id.

 [87]. In re Domestic Airline Travel Antitrust Litig., 221 F. Supp. 3d 46, 60 (D.D.C. 2016).

 [88]. Andrew M. Harris & Mary Schlangenstein, American Airlines Agrees to Pay $45 Million to Settle Fare Collusion Lawsuit, Bloomberg (June 15, 2018), https://www.bloomberg.com/news/articles
/2018-06-15/american-agrees-to-pay-45-million-to-settle-fare-collusion-suit; Chuck Stanley, Airline Antitrust MDL Discovery Deadline Pushed to 2019, Law360 (Feb. 12, 2018), http://bit.ly/2tk9VbC.

 [89]. Drew, supra note 16.

 [90]. Id.

       [91].     Shawn Tully, Why United’s Big Expansion Plans Made Investors Freak Out, Fortune (Jan. 26, 2018), http://fortune.com/2018/01/26/united-airlines-stock-capacity.

       [92].     Id.

 [93]. Id.

 [94]. See, e.g., Arnold v. Soc’y for Sav. Bancorp, Inc., 678 A.2d 533, 539 (Del. 1996).

 [95]. Manuela Jr. et al., supra note 33, at 139.

 [96]. Id.

 [97]. Id.

 [98]. Id.

 [99]. Id. at 140.

Despite anticipated gains at the time of the announcement, market returns to the acquiring firm after the acquisition including return on assets (ROA), return on equity (ROE), and return on sales, are generally a zero-sum game and the expected synergies from the merger . . . are not realized by acquiring firms, indicating that acquisitions have no significant effect or even have a slightly negative effect on an acquiring firm’s financial performance in the post-announcement period.

 [100]. Id.

 [101]. Id.

 [102]. Id. at 140–41.

 [103]. Amended Complaint, supra note 32, ¶ 41.

 [104]. Kai Hüschelrath & Kathrin Müller, Airline Networks, Mergers, and Consumer Welfare, 48 J. Transp. Econ. & Pol’y 385, 386 (2014).

 [105]. Morton et al., supra note 45, at 33–35.

 [106]. U.S. Dep’t of Justice & Fed. Trade Comm’n, Horizontal Merger Guidelines 19 (2010) [hereinafter Horizontal Merger Guidelines], https://www.ftc.gov/sites/default/files/attachments
/merger-review/100819hmg.pdf.

     [107].     Morton et al., supra note 45, § 36 (referring to domestic U.S. city pairs).

 [108]. Id.

 [109]. Max Maruna & Peter Morrell, Mergers: After the Honeymoon, FlightGlobal (July 29, 2010), https://www.flightglobal.com/news/articles/mergers-after-the-honeymoon-345465.

 [110]. Id.

 [111]. Manuela Jr. et al., supra note 33, at 148–49.

 [112]. See, e.g., Carlton et al., supra note 34, at 2–4, 29.

 [113]. Id. at 3–4.

 [114]. See John Kwoka & Evgenia Shumilkina, The Price Effect of Eliminating Potential Competition: Evidence from an Airline Merger, 58 J. Indus. Econ. 767, 782 (2010) (finding that the US Airways and Piedmont merger resulted in higher fares on routes in which Piedmont was only a potential entrant).

 [115]. Carlton et al., supra note 34, at 3–4.

 [116]. Id. at 4.

 [117]. Id.

 [118]. See id. at 2.

 [119]. Id. at 3.

 [120]. See Nancy L. Rose, After Airline Deregulation and Alfred E. Kahn, 102 Am. Econ. Rev.: Papers & Proc. 376, 379 (2012) (finding that Kahn did not intend nor advocate for deregulation to mean “laissez-faire” and that he attributed the industry’s early struggles and industry concentration to “a ‘lamentable failure of the administration to enforce the policies of the antitrust laws—to disallow a single merger or to press for divestiture of the computerized reservation systems or attack a single case of predation.’”) (citation omitted).

 [121]. Sherman Act, 26 Stat. 209 (1890).

 [122]. Clayton Act, 38 Stat. 730 (1914).

 [123]. Sherman Act, ch. 647, § 1, 26 Stat. 209 (codified as amended at 15 U.S.C. § 1 (2018)).

 [124]. Volodymyr Bilotkach & Kai Hüschelrath, Antitrust Immunity for Airline Alliances, 7 J. Competition L. & Econ. 335, 358 (2011).

 [125]. Clayton Act, ch. 323, § 7, 38 Stat. 731 (codified as amended at 15 U.S.C. § 18 (2018)).

 [126]. Bilotkach & Hüschelrath, supra note 124, at 358.

 [127]. Catherine A. Peterman, The Future of Airline Mergers After the US Airways and American Airlines Merger, 79 J. Air L. & Com. 781, 783–84 (2014) (emphasis added).

 [128]. Am. Bar Ass’n Section of Antitrust Law, Mergers and Acquisitions: Understanding the Antitrust Issues 1 (3d ed. 2008).

 [129]. Peterman, supra note 127, at 784.

 [130]. See Brown Shoe Co. v. United States, 370 U.S. 294, 325–32, 336, 343–46 (1962).

 [131]. Peterman, supra note 127, at 785.

 [132]. Id. (citation omitted).

 [133]. 15 U.S.C. § 18a (2018) (establishing that proposed mergers that exceed a certain size cannot be legally consummated until expiration of the thirty-day waiting period after making the pre-merger filings or waiver by the reviewing agency).

 [134]. Peterman, supra note 127, at 785–86.

 [135]. Id. at 786.

 [136]. Id. (citation omitted).

 [137]. Id.

 [138]. See Horizontal Merger Guidelines, supra note 106.

 [139]. See Peterman, supra note 127, at 786–87.

 [140]. Bilotkach & Hüschelrath, supra note 124, at 359.

 [141]. William E. O’Connor, An Introduction to Airline Economics 41 (6th ed. 2001).

 [142]. Sunset Act of 1984, Pub. L. No. 98-443, 98 Stat. 1703 (1984).

 [143]. O’Connor, supra note 141, at 41–42.

 [144]. Id. at 42. See also Charles N.W. Schlangen, Differing Views of Competition: Antitrust Review of International Airline Alliances, 2000 U. Chi. Legal F. 413, 437 (2000) (“Although DOJ was slated to oversee mergers and other domestic aviation-related antitrust issues beginning in 1989, Senator Metzenbaum . . . was so dissatisfied with DOT’s performance that he introduced a bill to accelerate the transfer to the fall of 1987. It is telling that both DOT and DOJ favored the transfer.”).

 [145]. U.S. Department of Transportation Notice of Practice Regarding Proposed Airline Mergers and Acquisitions, No. 80,011, 80 Fed. Reg. 2468–69 (proposed Jan. 16, 2015).

 [146]. Bilotkach & Hüschelrath, supra note 124, at 359.

 [147]. International Air Transportation Competition Act of 1979, Pub. L. No. 96-192, 94 Stat. 35 (1980).

 [148]. 49 U.S.C. §§ 41308–41309 (2018).

 [149]. William Gillespie & Oliver M. Richard, Antitrust Immunity and International Airline Alliances 5, 5 n.10 (Econ. Analysis Group, Discussion Paper No. 11-1, Feb. 2011), https://www.justice.gov/atr
/antitrust-immunity-and-international-airline-alliances.

U.S. airlines may merge. They may also request from the antitrust agencies a business review on joint venture proposals. There was an exception on immunity grants within the U.S after the U.S. Congress passed the Aviation and Transportation Security Act of 2001 in response to the terrorist attacks of 09/11/2001. The Act, which has since expired, included a provision that allowed DOT to grant antitrust immunity to carriers in States with “extraordinary” air transportation needs. This provision only applied to intra-state routes. Under this Act, DOT temporarily granted antitrust immunity to Aloha Airlines and Hawaiian Airlines in inter-island routes in Hawaii in the period from 12/2002 to 10/2003 . . . [W]ith antitrust immunity the carriers made significant capacity reductions and not only did fares rise sharply (by 35% to 41%) but they also remained high well past the expiration of immunity.

 [150]. Pearce & Doernhoefer, supra note 19, at 3.

 [151]. Id. at 4 (arguing that “[i]n open markets firms locate themselves and their services where consumers demand them, constrained only by competition law or regulations such as health and safety”). This is the strategy pursued by telecom, banking, media, and other industries. Id.

 [152]. Id.

 [153]. Eur. Comm’n & U.S. Dep’t of Transp., Transatlantic Airline Alliances: Competitive Issues and Regulatory Approaches 3 (2010) [hereinafter Transatlantic Airline Alliances].

 [154]. Id. at 3.

 [155]. Bilotkach & Hüschelrath, supra note 124, at 360 (noting “the impossibility of worldwide airline networks operated by a single airline, and the impossibility to coordinate (and therefore rationalize) operations by way of merging two companies”).

 [156]. Pearce & Doernhoefer, supra note 19, at 4.

 [157]. Gillespie & Richard, supra note 149, at 2.

 [158]. Id. at 2–3.

 [159]. Id. at 3.

 [160]. Id.

 [161]. Id.

 [162]. See Freedoms of the Air, Int’l Civ. Aviation Org., https://www.icao.int/Pages
/freedomsAir.aspx (last visited July 31, 2018).

 [163]. Gillespie & Richard, supra note 149, at 3.

 [164]. See id.

 [165]. Transatlantic Airline Alliances, supra note 153, at 13.

 [166]. Id. at 5.

 [167]. Pearce & Doernhoefer, supra note 19, at 4.

 [168]. Id.

 [169]. Id. at 4–5.

 [170]. Id. at 5.

 [171]. Id.

 [172]. Id. at 2, 5.

 [173]. Gillespie & Richard, supra note 149, at 3.

 [174]. Id. at 1.

 [175]. Id. at 3.

 [176]. Id. (noting that sales revenue goes to the operating carrier and the marketing carrier receives a booking fee to cover handling costs).

 [177]. Pearce & Doernhoefer, supra note 19, at 5.

 [178]. Id. See also Gillespie & Richard, supra note 149, at 13–16, 20.

 [179]. Pearce & Doernhoefer, supra note 19, at 1–2.

 [180]. Id.

 [181]. Id. at 1, 6.

 [182]. Transatlantic Airline Alliances, supra note 153, at 5.

 [183]. Supra Section II.B.

 [184]. See Gillespie & Richard, supra note 149, at 1. See also Order to Show Cause at 4, Am. Airlines, Inc., DOT-OST-2015-0129 (Dep’t of Transp. Nov. 18, 2016) [hereinafter AA-QF Show Cause Order].

 [185]. Pearce & Doernhoefer, supra note 19, at 2.

 [186]. Order to Show Cause at 7, Delta Air Lines, Inc., DOT-OST-2015-0070 (Dep’t of Transp. Nov. 4, 2016) [hereinafter DL-AM Show Cause Order].

 [187]. 49 U.S.C. §§ 41308–41309 (2018).

 [188]. See 14 C.F.R. § 303 (2018).

 [189]. 49 U.S.C. § 41710 (2018).

 [190]. Order to Show Cause at 33, Alitalia-Linee Aeree Italiane-S.p.A., DOT-OST-2004-19214 (Dep’t of Transp. Dec. 22, 2005) (emphasis added).

 [191]. Answer of Hawaiian Airlines, Inc. at 4, Am. Airlines, Inc., DOT-OST-2015-0129 (Dep’t. of Transp. Feb 22, 2016) (citation omitted).

 [192]. See 49 U.S.C. §§ 41308-41309 (2018).

 [193]. Id. § 41309(b)(1).

 [194]. Id. § 41309(b)(1)(A).

 [195]. Id. § 41309(b)(1)(B).

 [196]. Id. § 41309(b).

 [197]. Id. § 41308.

 [198]. Id. § 41308(b).

 [199]. Hubert Horan, Double Marginalization and the Counter-Revolution Against Liberal Airline Competition, 37 Transp. L.J. 251, 254 (2010).

 [200]. DL-AM Show Cause Order, supra note 186, at 9.

 [201]. Id.

 [202]. Id.

 [203]. Peterman, supra note 127, at 788–89 (citation omitted).

 [204]. Order to Show Cause at 6–10, Delta Air Lines, Inc., DOT-OST-2015-0070 (Dep’t of Transp. Nov. 4, 2016).

 [205]. Gillespie & Richard, supra note 149, at 1–2.

 [206]. Id. at 7.

 [207]. Peterman, supra note 127, at 789.

 [208]. See United States v. Gen. Dynamics, 415 U.S. 486, 506–08 (1974).

 [209]. Peterman, supra note 127, at 790.

 [210]. Id.

 [211]. Id.

 [212]. Id.

 [213]. Id. at 791.

 [214]. Id.

 [215]. Transatlantic Airline Alliances, supra note 153, at 14 (citation omitted).

 [216]. DL-AM Show Cause Order, supra note 186, at 18.

 [217]. Gillespie & Richard, supra note 149, at 18.

 [218]. Bilotkach & Hüschelrath, supra note 124, at 360. See also Am. Bar Ass’n, Antitrust Law Developments 1486 n.1425 (6th ed. 2007) (“The DOT has defined an open skies agreement as containing, among other things, open entry on all routes, unrestricted capacity and frequency on all routes, unrestricted route and traffic rights, and open code-sharing opportunities.”).

 [219]. Gillespie & Richard, supra note 149, at 19 n.44.

 [220]. U.S. Dept. of State, Fact Sheet: Open Skies Partnerships: Expanding the Benefits of Freer Commercial Aviation (July 5, 2017), https://www.state.gov/e/eb/rls/fs/2017/267131.htm.

 [221]. Gillespie & Richard, supra note 149, at 19 (citation omitted).

 [222]. Id. (citation omitted).

 [223]. Transatlantic Airline Alliances, supra note 153, at 13.

 [224]. Gillespie & Richard, supra note 149, at 19 (citation omitted).

 [225]. See supra text accompanying notes 4851.

 [226]. Gillespie & Richard, supra note 149, at 18–19.

 [227]. See Transatlantic Airline Alliances, supra note 153, at 6.

 [228]. See U.S. Dep’t of Transp., Airline Alliances Operating with Antitrust Immunity (Jan. 3, 2018), http://bit.ly/2Hh62q0 (OneWorld Transatlantic, SkyTeam II, Delta-Virgin Atlantic-Air France-KLM-Alitalia, and Star Alliance).

 [229]. See Gillespie & Richard, supra note 149, at 19 n.44.

 [230]. See U.S. Dep’t of Transp., supra note 228.

 [231]. Katherine LaGrave, A Record 80 Million Americans Traveled Abroad Last Year, Condé Nast Traveler (Nov. 7, 2017) https://www.cntraveler.com/story/a-record-80-million-americans-traveled-abroad-last-year.

 [232]. Press Release, Int’l Air Transp. Ass’n, 2017 Marked by Strong Passenger Demand, Record Load Factor (Feb. 1, 2018), http://www.iata.org/pressroom/pr/Pages/2018-02-01-01.aspx.

 [233]. Id.

 [234]. Trefis Team, supra note 15.

     [235].     Star Alliance Member Airlines, Star Alliance, http://www.staralliance.com/en/member-airlines (last visited Aug. 13, 2018).

     [236].     SkyTeam Airline Alliance, SkyTeam, https://www.skyteam.com/en/about (last visited Aug. 13, 2018).

 [237]. Introduction to Oneworld—An Alliance of the World’s Leading Airlines Working as One, OneWorld, https://www.oneworld.com/news-information/oneworld-fact-sheets/introduction-to-oneworld (last visited Aug. 13, 2018).

 [238]. Answer of Hawaiian Airlines, Inc., supra note 191, at 13.

 [239]. Id. at 15­–16.

 [240]. Answer of JetBlue Airways Corporation at 49–50, Delta Air Lines, Inc., DOT-OST-2015-0070 (Dep’t of Transp. July 6, 2016) [hereinafter JBLU Answer] (noting that Aer Lingus was acquired by IAG and that US Airways merged with American Airlines).

 [241]. Pearce & Doernhoefer, supra note 19, at 1.

 [242]. Id. at 2.

 [243]. AA-QF Show Cause Order, supra note 184, at 2.

 [244]. Id.

 [245]. See, e.g., Answer of Hawaiian Airlines, Inc., supra note 191, at 85­–87.

 [246]. Reply of JetBlue Airways Corporation at 2, Am. Airlines, Inc., DOT-OST-2015-0129 (Dep’t of Transp. Mar. 2, 2016). See generally P’Ship for Open & Fair Skies, Restoring Open Skies: The Need to Address Subsidized Competition from State-Owned Airlines in Qatar and the UAE (2015) (charging the ME3 with receiving over $40 billion in improper government subsidies and distorting markets rather than driving new demand).

 [247]. DL-AM Show Cause Order, supra note 186, at 1.

 [248]. Id. at 2 (requiring that all slots be turned over to LCCs to boost competition).

 [249]. Id.

 [250]. Id. at 27.

 [251]. Id. at 2.

 [252]. Frederic Tomesco, Air Canada Hopes to Resuscitate Cross-Border Venture with United, Bloomberg (June 27, 2017, 1:43 PM), https://bloom.bg/2Hiw5Ns (noting that the Canada-U.S. bilateral market is the busiest in the world and that the two airlines collectively control 57% of the market).

 [253]. See generally Joint Application of American Airlines and Qantas Airways for Approval of and Antitrust Immunity for Proposed Joint Business Agreement, Am. Airlines, Inc., DOT-OST-2018-0030 (Dep’t of Transp. Feb. 26, 2018) (emphasizing the impact in the wake of the initial rejection on both AA & QA with regards to the U.S.-Australia market).

 [254]. Bilotkach & Hüschelrath, supra note 124, at 361 (citation omitted).

 [255]. Id. (citation omitted).

 [256]. JBLU Answer, supra note 240, at 47 n.98.

 [257]. DL-AM Show Cause Order, supra note 186, at 2.

 [258]. See Final Order at 3–6, Delta Airlines, Inc., DOT-OST-2015-0070 (Dep’t of Transp. Dec. 14, 2016) [hereinafter DL-AM Final Order] (responding to concerns of Hawaiian Airlines as to whether the U.S.-Mexico air services agreement contains the requisite elements of an Open Skies Agreement and of JetBlue as to the non-transparent slot allocation and infrastructure limitations at MEX).

 [259]. 49 U.S.C. § 41309(b)(1)(A) (2012) (providing the statute’s only stated considerations).

 [260]. Am. Bar Ass’n, supra note 218, at 1487.

 [261]. See Schlangen, supra note 144, at 439.

 [262]. Horan, supra note 199, at 256.

 [263]. Schlangen, supra note 144, at 439–40.

 [264]. See Horan, supra note 199, at 260, 284–85.

 [265]. Schlangen, supra note 144, at 443.

 [266]. Id. at 445 (citation omitted).

 [267]. See, e.g., DL-AM Final Order, supra note 258, at 3–6.

 [268]. See Motion of JetBlue Airways Corporation to Institute an Antitrust Immunity Review Proceeding at 4, Delta Air Lines, Inc., DOT-OST-2002-11842 (Dep’t of Transp. July 28, 2017).

 [269]. H.R. 831, 111th Cong. § 1(e) (2009).

 [270]. DL-AM Final Order, supra note 258, at 27.

 [271]. See Implementation of the Civil Aeronautics Board Sunset Act of 1984: Transfer of Antitrust Authority Under Sections 408, 409, 412 and 414 of the Federal Aviation Act of 1958 from the Civil Aeronautics Board to the Department of Transportation, 50 Fed. Reg. 31134 (July 31, 1985) (codified at 14 C.F.R. pts. 251, 261, 287, 291, 296, 298, 299, 303 & 380).

 [272]. 14 C.F.R. § 303.06 (2018) (Section 414 refers to the Federal Aviation Act of 1958).

 [273]. Order at 3, Delta Air Lines, Inc., DOT-OST-2002-11842 (Dep’t of Transp. Nov. 17, 2017).

 [274]. Peterman, supra note 127, at 790–91.

 [275]. Motion of JetBlue Airways Corporation to Require Submission of Additional Documents and Data at 4–5, Delta Air Lines, Inc., DOT-OST 2015-0070 (Dep’t of Transp. July 2, 2015).

 [276]. Comments of JetBlue Airways Corporation at 9, Delta Air Lines, Inc., DOT-OST-2015-0070 (Dep’t of Transp. Nov. 18, 2016) [hereinafter JBLU Comments].

 [277]. See, e.g., Gillespie & Richard, supra note 149, at 20. See also Bilotkach & Hüschelrath, supra note 124, at 348–49; JBLU Answer, supra note 240, at 47–48 n.98 (noting the benefits of JetBlue’s many codeshare agreements without ATI).

 [278]. Joint Applicants’ Reply to Answer of Hawaiian Airlines, Inc. at 28, Am. Airlines, Inc., DOT-OST-2015-0129 (Dep’t of Transp. Mar. 2, 2016) [hereinafter Joint Applicants’ Reply].

 [279]. Reply of the Joint Applicants at 14, Delta Air Lines, Inc., DOT-OST-2015-0070 (Dep’t of Transp. July 15, 2016) [hereinafter Reply of the Joint Applicants].

 [280]. Joint Applicants’ Reply, supra note 278, at 29.

 [281]. JBLU Comments, supra note 276, at 8. See also 14 C.F.R. § 377.10 (2018) (permitting licenses to continue to have effect during DOT review or action and allowing DOT to apply § 377 to immunized alliances in the interim until re-approval).

 [282]. DL-AM Final Order, supra note 258, at 27.

 [283]. JBLU Answer, supra note 240, at 48.

 [284]. Morgan Durrant, Delta Successfully Completes Cash Tender Offer for Additional Shares of Grupo Aeroméxico, Delta: News Hub (Mar. 13, 2017, 8:30 AM), http://bit.ly/2IcsmT6. See also AA-QF Show Cause Order, supra note 184, at 3 (noting that American and Qantas launched new routes and codeshare arrangements between the U.S. and Australia/New Zealand without a grant of ATI).

 [285]. DL-AM Show Cause Order, supra note 186, at 28.

 [286]. JBLU Answer, supra note 240, at 52.

 [287]. Id. at 51–52.

 [288]. Reply of the Joint Applicants, supra note 279, at 59.

 [289]. DL-AM Show Cause Order, supra note 186, at 29.

 [290]. See supra Section II.B.

 [291]. Schlangen, supra note 144, at 437.

 [292]. Order to Show Cause at 19, United Air Lines, Inc., OST-96-1116-20 (Dep’t of Transp. May 9, 1996).

 [293]. Bilotkach & Hüschelrath, supra note 124, at 361.

 [294]. Horan, supra note 199, at 256.

 [295]. Id. at 253.

 [296]. Schlangen, supra 144, at 443.

 [297]. Id. at 438–40.

 [298]. Id. at 443–45.

 [299]. See John F. Libby & Jacqueline C. Wolff, The FCPA in 2016: DOJ and SEC Focus on International Cooperation and Investigation of Individuals, Lexology (Jan. 21, 2016), https://bit.ly/2GLy8wU.

 [300]. See Morton et al., supra note 45, at 40.

 [301]. Id.

 [302]. Robert Puentes, Aviation Needs a Makeover, U.S. News (Jan. 19, 2017, 8:00 AM), https://www.usnews.com/opinion/economic-intelligence/articles/2017-01-19/americas-aviation-industry-needs-a-makeover.

 [303]. Michael Laris, After Assailing ‘Obsolete’ Airports and Transportation System, Trump Tells Airline Executives He’s Here to Help, Wash. Post (Feb. 9, 2017), http://wapo.st/2DdrdXr.

 [304]. See Ted Reed, When the Olympics Are Ready for Los Angeles, Will LAX be Ready for the Olympics?, Forbes (Sept. 15, 2017, 11:00 AM), http://bit.ly/2oW33wq.

 [305]. See Answer of Hawaiian Airlines, Inc., supra note 191, at 84–87.

 [306]. DL-AM Show Cause Order, supra note 186, at 24–25.

 [307]. Id. at 21.

 [308]. See Alan R. Beckenstein & Brian M. Campbell, Public Benefits and Private Success: The Southwest Effect Revisited 27–28 (Darden Bus. Sch., Working Paper No. 206, 2017).

 [309]. Daniel M. Kasper & Darin Lee, Compass Lexecon, An Assessment of Competition and Consumer Choice in Today’s U.S. Airline Industry 22–25 (2017), http://bit.ly/2Fo77zO.

 [310]. Bart Jansen, Airlines Gauge Success of Basic Economy by How Many Passengers Avoid It, USA Today (Oct. 26, 2017), https://usat.ly/2lkfgvz.

 [311]. Final Brief of Petitioner at 2, ABC Aerolineas, S.A. de C.V. v. U.S. Dep’t of Transp., No. 17-1056 (D.C. Cir. Sept. 1, 2017).

 [312]. JBLU Answer, supra note 240, at 12–14.

 [313]. Bart Jansen, Airline Safety Best on Record in 2017: Trump Claims Credit, but Experts Cite Years of Efforts, USA Today (Jan. 2, 2018, 5:36 PM), https://usat.ly/2qjapNx.

 [314]. Airlines for America, supra, note 67, at 5–7, 9.

 [315]. McCartney, supra note 3.

 [316]. Hugo Martin & Lauren Raab, United Airlines Reaches ‘Amicable’ Settlement with Passenger Dragged from a Plane, L.A. Times (Apr. 27, 2017, 4:20 PM), http://www.latimes.com/business/la-fi-united-david-dao-20170427-story.html.

An Impossible Standard: The California Parole Board Process for Inmates with Cognitive Impairments – Note by Amber Heron

From Volume 91, Number 5 (July 2018)
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An Impossible Standard: The California Parole Board Process for Inmates with Cognitive Impairments

Amber Heron[*]

TABLE OF CONTENTS

INTRODUCTION

I. LAWS GOVERNING CALIFORNIA PAROLE HEARINGS

A. Background Information

B. Determinate and Indeterminate Sentences

C. Parole Suitability

D. Information Examined Prior to a Parole Hearing

E. Parole Hearing

F. Appeal of Parole Decision

G. California’s Parole Laws Disadvantage Inmates
with Cognitive Impairments

II. INDIVIDUALS WITH DEVELOPMENTAL DISABILITIES
IN CALIFORNIA PRISONS

A. Statistics Concerning Inmates with Disabilities

B. CDCR’s Definition of a Developmental Disability

C. The Americans with Disabilities Act

1. Armstrong v. Wilson

2. Armstrong v. Schwarzenegger

3. Clark v. California

III. ARGUMENT

A. Factors Considered in Parole Suitability Hearings

1. Comprehensive Risk Assessment

2. Rule Violations

3. Programming

4. Insight

5. The Board’s Discretion

B. Additional External Factors Affecting Parole
Suitability Hearings

1. CDCR’s Narrow Definition of a Developmental Disability

2. Learning Disorders

3. TABE Assessment

4. Unconstitutional Denial of Liberty Without Due Process

IV. RECOMmENDATIONS FOR THE CALIFORNIA PAROLE PROCESS WITH REGARD TO Prisoners WITH
COGNITIVE IMPAIRMENTS

A. Expanded Definition of Developmentally Disabled

B. Increased Commissioner and Correctional Officer
Training

C. Less Emphasis on Insight

D. Providing Psychological Evaluations and
Psychologist Testimony at Parole Proceedings

E. Amending Rule Violation Write-Ups

F. Fair Weight Given to TABE Scores

CONCLUSION

 

INTRODUCTION

How can one be expected to demonstrate something they are incapable of, and what if that something meant the difference between freedom and remaining in prison? Thousands of inmates in California face this issue, and many are kept incarcerated for life without any recognition of their cognitive capabilities.

Take Maria’s story,[1] for example; she is a client I became familiar with as a student working in the University of Southern California Gould School of Law’s (“USC”) Post-Conviction Justice Project (“PCJP”).[2] Maria had extensive cognitive impairments that went undiscovered while incarcerated in a California prison for nearly three decades. Because of this, Maria was denied parole an astounding six times with the parole board citing lack of insight each time. Maria’s continued denials persisted despite state-issued psychological evaluations concluding that her intellectual functioning was minimal.

Unfortunately, Maria’s predicament is not uncommon. There are several similarly situated inmates who are unable to effectively advocate for themselves due to their cognitive impairments, yet they are not provided with necessary accommodations. As a result, individuals are denied parole even though they do not pose a current danger to society. This culminates in the gravest deprivation of liberty without due process—denial of their freedom. [3]

In 2015, only 17% of California inmates were found suitable for parole.[4] In 2016, it dropped slightly to 16%.[5] The chances of release are even less for incarcerated individuals with cognitive impairments. This Note will provide an outline of the California parole process and explore the ways by which people with cognitive impairments[6] are disadvantaged by the current system.

First, this Note will explain the basic process of parole hearings in California and how an inmate may be found suitable for parole. Next, I will outline the current requirements that must be met for a person to be considered disabled in California’s prisons and discuss some of the groundbreaking California cases regarding inmates with disabilities. In order to provide proper context, I discuss the disabled population in prison, however, the primary focus of this Note is on the portion of California inmates that are not encompassed under the California Department of Corrections and Rehabilitation’s (“CDCR”) definition of developmentally disabled (“DD”).

Ultimately, this Note argues that California’s current parole system is legally impermissible due to the overlooked disadvantages it creates for inmates with cognitive impairments who do not fall within CDCR’s definition of disabled. As a result of CDCR’s exclusionary and limiting definition of a cognitive disability, numerous inmates are left with no access to accommodations that could help mitigate the unfairness their impairments present. Among the impairments inmates face are processing disorders, low cognitive functioning, and minimal formal education. Individuals who face impairments form a large population of potentially non-violent individuals who could be found suitable for parole, but because they have some cognitive limitation(s) that inhibit them from reaching the parole board’s specific standard, they cannot, and likely may never, meet the rigid suitability standards.

This Note argues that reform must come from re-envisioning the manner in which the parole process is administered and by applying a truly individualized approach. To be clear, the legal standard of current dangerousness is not at issue; it is the process by which the parole board determines a given inmate’s current danger that needs reform. Although many have evaluated the intersection between the DD population and the criminal justice system—including, for example, the often-unfair treatment and lack of opportunities at parole hearings for DD inmates[7]—few have studied inmates that fall into a “grey area.” That is, individuals who do not fall within the DD classification, but who cannot successfully meet the requirements of parole without a more personalized assessment.

I will advocate for a system that better identifies inmates that may not qualify as DD by the CDCR standard but still have limitations that preclude them from effectively self-advocating. For individuals who are identified, I argue that reasonable accommodations must be provided. In addition, I recommend the following changes: (1) increasing commissioner and correctional officer training for CDCR staff; (2) placing less emphasis on insight during a parole hearing; (3) providing a psychologist who can testify at each inmate’s parole proceeding; and (4) giving greater weight to an inmate’s score on their test for basic adult education (“TABE”). Although the parole board is required to assess each inmate’s suitability for parole on a “case-by-case”[8] basis, this current system does not adequately account for an individual’s cognitive impairments.

In sum, to remedy this impermissible system that results in discriminatory parole denials because of an individual’s cognitive impairment, inmates must be assessed at their ability-level and the formal, rigid standards currently in place must be changed.

I.  LAWS GOVERNING CALIFORNIA PAROLE HEARINGS

A.  Background Information

CDCR is the entity responsible for operating the California state prison and parole systems.[9] Upon completion of a prison sentence—either from the expiration of a determinate sentence or as a result of a parole suitability finding—an individual is “released to either state supervised parole or county-level supervision” pursuant to the California Penal Code.[10] Typically, individuals who commit more serious or violent crimes are released into state parole custody, and the less violent offenders receive county supervision.[11] As of January 31, 2018, CDCR had 129,557 individuals in its custody.[12] Of that number, 117,427 were housed and living in institutions.[13]

B.  Determinate and Indeterminate Sentences

In California, most offenders are sentenced to a specified amount of time under the Determinate Sentencing Law (“DSL”).[14] This means that after an individual serves the imposed timefor example, seven yearshe or she is released from prison on parole. Sometimes, an individual with a determinate sentence will become eligible for a parole suitability hearing prior to their scheduled release date.[15]

If an individual does not receive a determinate sentence, they are likely to receive an indeterminate sentence pursuant to the Indeterminate Sentencing Law (“ISL”).[16] An indeterminate sentence will be a term of life, with the possibility of parole, such as fifteen-years-to-life or twenty-five-years-to-life. These individuals are more commonly referred to as “lifers.” An individual serving a life term with the possibility of parole cannot be released from prison until the Board of Parole Hearings (“BPH”) determines they are ready to be reintegrated back into society.[17]

This Note primarily focuses on inmates serving indeterminate sentences because inmates with determinate sentences rarely face a parole board. In 2013, there were approximately 32,000 inmates in California serving life sentences with the possibility of parole and an additional 3,200 inmates sentenced to life without the possibility of parole.[18] As of April 2013, California had more than “three times as many lifers” as any other state.[19]

C.  Parole Suitability

A life-term inmate must serve a certain statutory period before becoming eligible for a parole suitability hearing.[20] When an inmate becomes eligible for parole, BPH administers a parole hearing.[21] BPH then makes a legal determination concerning whether an inmate poses a “current, unreasonable risk of danger to the public.”[22] The language of California Penal Code section 3041 is unambiguous when it states that the parole board, or panel, “shall grant parole to an inmate unless . . . consideration of the public safety requires a more lengthy period of incarceration.”[23] This mandatory language is what creates a “constitutionally protected liberty interest” in parole.[24] Despite this “statutory mandate,” an indeterminately sentenced California inmate is granted parole “less than 1 percent” of the time at their initial suitability hearing and “roughly 18 percent” overall.[25]

A panel consisting of two individuals—a presiding commissioner and a deputy commissioner (collectively, “the Board”)[26]—will together consider “[a]ll relevant, reliable information” to make a parole suitability determination.[27] Commissioners are appointed to three year terms by the governor of California, subject to confirmation by the state senate.[28] California has fourteen Governor appointed commissioners.

Title 15 of the California Code of Regulations (“CCR”) sets out a list of factors to be considered in determining an inmate’s suitability for release on parole, although it is not exhaustive.[29] The Board is tasked with balancing these suitability and unsuitability factors.

There are nine enumerated factors that indicate circumstances tending to show suitability: (1) no juvenile record; (2) stable social history; (3) signs of remorse; (4) motivation for crime; (5) battered woman syndrome; (6) lack of criminal history; (7) age; (8) ability to understand and plan for the future; and (9) institutional behavior.[30] Additionally, and with much significance, the California Supreme Court held that “insight bears more immediately on the . . . present risk to public safety” of an inmate, in comparison to other suitability factors considered.[31]

Factors weighing toward unsuitability are: (1) the commitment offenseparticularly if the prisoner committed the offense in an especially heinous, atrocious or cruel manner;[32] (2) previous record of violence; (3) unstable social history; (4) sadistic sexual offense; (5) psychological factors; and (6) poor institutional behavior.[33]

These factors, taken in their entirety, determine the outcome of a parole hearing. Further, the California Supreme Court held, with regard to parole decisions, that whether an inmate is found suitable and thus released on parole, or instead given a threetofifteenyear set-off depends on the Board’s nearly unlimited discretion.[34] Given this wide range of discretion, coupled with virtually unlimited unsuitability factors, the possibility of being released on parole is slim.[35]

For individuals with cognitive impairments, moreover, the odds of being granted parole are even worse.[36] For example, inmates with cognitive impairments can face particular difficulties with demonstrating insight because insight-based questions often require the articulation of abstract ideas, an ability that inmates with developmental disabilities may not possess. In addition, certain cognitive disabilities significantly affect subjective emotional cues, making expressions of remorse more challenging.

Ultimately, being found suitable for parole is not only dependent on how effectively an inmate can verbally communicate and articulately respond to multi-faceted questions at an actual hearing, but also on their behavior in prison and even their record prior to incarceration.[37]

D.  Information Examined Prior to a Parole Hearing

Before a parole hearing, the Board receives an inmate’s central file (“C-File”), results of the inmate’s Comprehensive Risk Assessment (commonly referred to as psych evals), all rule violations in prison, vocational and educational certificates, letters supporting and opposing parole, and victim-impact statements.[38] In addition to written statements, the victims and victims’ families are permitted to attend and speak at the parole hearing.[39]

Marsy’s law is responsible for a wide expansion of victims’ rights.[40] In particular, Marsy’s law allows victims or representatives of victims to make statements at an inmate’s parole hearing, in which they “reasonably express their views concerning the prisoner, including . . . the effect of the crimes on the victim’s family, and the prisoner’s suitability for parole.”[41] Some argue that the presence of victims at parole hearings increases the chance of receiving a denial.[42]

E.  Parole Hearing

The parole hearing itself is normally several hours long, occurs onsite where the individual prisoner is incarcerated, and is typically administered by the Board asking the inmate several questions.[43]

Parole hearings traditionally follow a similar structure, in which the inmate is asked about his or her life in chronological order.[44] The inmate’s childhood, adolescence and, if applicable, adulthood are discussed. After that, the commitment offense is discussed, often at great length. The commitment offense, a static factor that cannot be changed despite the passage of time, can prove challenging for inmates, especially those with heinous or violent crimes.[45] Thereafter, the inmate’s time while incarcerated is discussed, including both negative factors, such as rule violations, and positive factors, such as programming and certificates that document good behavior.[46] Lastly, parole and relapse prevention plans are discussed.

All inmates are entitled to legal counsel at their parole hearing.[47] California is required to provide counsel for inmates who want representation, but otherwise do not have an attorney. The state, however, only compensates parole-appointed attorneys a “maximum $400 per case.”[48]

In addition to the two commissioners, the inmate, and his or her attorney (if the inmate elected to have one present), a District Attorney from the prosecuting county of the controlling offense can be present to ask clarifying questions as well as to make a statement about the inmate’s suitability for parole.[49] Almost always, the District Attorney opposes the inmates release on parole.

After an hourslong hearing is conducted, the commissioner and deputy commissioner privately deliberate to make a parole determination.[50] In rare cases, a hearing may be continued, but almost always an inmate will either be found suitable for parole, known as receiving a grant, or the inmate will be denied parole.[51] If the inmate is found unsuitable for parole, the Board “shall schedule the next hearing . . . [f]ifteen years after,” unless “clear and convincing” evidence exists to schedule the next hearing in either ten, seven or three years.[52] Thus, the default denial of parole in California results in a fifteen year set-off, which itself indicates the gravity of parole hearings.[53] Prior to the passage of Marsy’s Law in 2008,[54] the governing statute presumed a set-off of only one year and allowed commissioners to set a maximum denial of five years.[55]

After the Board issues its decision on the day of the hearing, BPH has 120 days to review and finalize the decision.[56] Once the Board’s decision has been finalized, the presiding California governor has thirty days to review the decision.[57] For homicide offenses, the governor may “affirm, modify, or reverse” the Board based on the same factors the Board considers.[58] In every other case, the Governor is “limited to remanding the case back to the Board for reconsideration.”[59]

F.  Appeal of Parole Decision

In the event of a denial or grant reversal by the Governor, an inmate may file a habeas corpus petition in a California state court to challenge the denial.[60] As determined by the California Supreme Court, the decision to grant or deny parole is “subject to a limited judicial review to determine only whether the decision is supported by ‘some evidence.’”[61]

The “some evidence” standard has been widely contested but consistently reaffirmed by California courts.[62] In accordance with California’s Constitution and statutes, the executive branch is vested with the decision to grant parole to an inmate in CDCR’s custody.[63] The California Supreme Court stated in In re Shaputis that “[i]t is the job of a reviewing court” to apply the “deferential ‘some evidence’” standard to the parole determination.”[64] Justice Corrigan acknowledged that the court may be skeptical of the stated reasons of the Board for a parole denial; however, “considerations of judicial restraint and comity between the executive and judicial branches counsel against including mere suspicions in the court’s opinion.”[65] As a result of this deferential standard, parole denials are commonly upheld.

G.   California’s Parole Laws Disadvantage Inmates with Cognitive Impairments

The stringent requirements of the California parole board process disadvantage inmates with cognitive impairments both prior to and during their parole hearings. As it currently stands, the parole process demands certain abilities. A parole hearing moves quickly with several abstract, complicated questions asked in an unforgiving manner. Processing disorders, minimal education, and the inability to retain or recite information can each jeopardize an inmate’s possibility of being found suitable for parole. Because of the inflexible structure and immutable demands placed on inmates at parole hearings, it ultimately amounts to a process that systematically disadvantages inmates with cognitive impairments.

II.  INDIVIDUALS WITH DEVELOPMENTAL DISABILITIES IN CALIFORNIA PRISONS

A.  Statistics Concerning Inmates with Disabilities

The Bureau of Justice’s statistics state that “1 in 5 prison inmates have a serious mental illness.”[66] In addition, the Bureau states that individuals in federal prisons are almost three times as likely to report having a disability as the nonincarcerated population.[67] Among the most common inmate-reported impairments are Down syndrome, autism, dementia, intellectual disabilities, and learning disorders . . . .”[68] The most commonly reported impairments nationwide were impairments with learning, with 23% of all state inmates saying that they struggled with learning.[69] Improper testing for disabilities and a lack of self-reporting also affects these statistics.[70] These statistics indicate that individuals in prison are more likely to be suffering from some sort of mental disorder than the non-incarcerated population.[71] In addition, further distortion of these numbers occurs due to a lack of self-reporting and when, in most instances, the [developmentally disabled] inmate is not identified, and so is mainstreamed with the general . . . prison population.”[72]

In addition, the statistics are influenced because inmates may be hesitant to admit to having a cognitive impairment, fearing the stigmatization that comes with such an admission. Given the choice, many inmates would prefer to avoid being labeled as disabled, or seen as different, even if it means sacrificing the possibility of being successful at a future parole hearing. This is especially true for inmates who do not formally meet CDCR’s DD definition. In such cases, an inmate who admitted having an impairment may face stigmatization, yet, under current law, no additional assistance would be provided to this inmate.

B.  CDCR’s Definition of a Developmental Disability

As defined by CDCR, an individual is considered to have a DD if the disability “originates before an individual attains the age of 18, continuesor can be expected to continue­—indefinitely, and constitutes a substantial handicap for that individual.”[73] The disabilities noted include cerebral palsy, epilepsy, and autism. In addition, an individual is considered to have a developmental disability if they have “disabling conditions found to be closely related to mental retardation . . . .[74]

The Clark Remedial Plan[75] states that criteria for inclusion in the Developmental Disability Program (“DDP”) are: (1) [l]ow cognitive functioning (usually IQ of 75 or below); and (2) [c]oncurrent deficits or impairments in adaptive functioning.”[76] Both elements must be met to qualify as a DD individual under CDCR’s standard.[77] Being classified for inclusion in the DDP is pertinent to whether a person has access to the treatment and accommodations that may be necessary for an eventual parole suitability finding.

During intake, CDCR assesses all inmates for potential inclusion in the DDP.[78] Certain characteristics that may present in an individual with developmental disabilities include concrete reasoning, limited or below agelevel communication skills, a short attention span, and difficulty retaining information. In addition, people with developmental disabilities may exhibit noncompliant behavior and struggle to understand the consequences of their actions.[79]

C.  The Americans with Disabilities Act

The Americans with Disabilities Act (“ADA”) was signed into law on July 26, 1990 with the intent to protect the rights of individuals with disabilities from pervasive discrimination.[80] The rights afforded in the ADA extend to state prisoners.[81] In accordance with the ADA, along with the Rehabilitation Act of 1973, an institutional staff member is required to meet with an inmate to identify “any disability-related accommodations needed for the [parole] proceeding.”[82] The findings and requests by the inmate are memorialized in BPH’s 1073 form, which is titled a “Notice and Request for Assistance at Parole Proceeding.”[83]

Despite the mechanisms currently in place to help account for an individual’s disability, CDCR and BPH have faced notable class action suits challenging the notion that proper accommodations exist and are enforced.[84] The most note-worthy cases of this kind are Armstrong v. Wilson,[85] Armstrong v. Schwarzenegger[86], and Clark v. California.[87] These cases are discussed in further detail in the Sections that follow.[88]

1.  Armstrong v. Wilson

In Armstrong v. Wilson, the court stated that the ADA does apply to state correctional facilities.[89] The ADA plainly states: [N]o qualified individual with a disability shall, by reason of such disability, be excluded from participation in or be denied the benefits of the services, programs, or activities of a public entity, or be subjected to discrimination by any public entity.”[90] Thus, California prisons must abide by the provisions in the ADA.[91] Two years after the decision in Armstrong v. Wilson, the Supreme Court ended ongoing circuit splits on this issue by holding in Pennsylvania Department of Corrections v. Yeskey that “the plain text of Title II of the ADA unambiguously extends to state prison inmates.”[92]

2.  Armstrong v. Schwarzenegger

On June 29, 1994, inmates with disabilities filed suit against CDCR and the Board of Prison Terms (“BPT”),[93] alleging that they were being deprived of their required accommodations due to their disabilities.[94] Initially, this class action suit did not include individuals with developmental disabilities, but was amended in January 1999 to include them.[95] The parties agreed to bifurcate the proceedings into two separate litigations—one involving CDCR and another with BPT. CDCR entered into a settlement agreement premised on a finding of the Armstrong court that the ADA and Rehabilitation Act of 1973 extend to prisons—as noted above, the court ruled in Armstrong v. Wilson that both statutes apply to state prisons.[96]

The claims against BPT were litigated in a bench trial beginning in April 1999.[97] Included in the plaintiffs’ evidence were stories about a deaf prisoner being “unable to communicate with a sign language interpreter because he was shackled” and a “blind inmate left without assistance to read complicated written materials.”[98] In March 2001, the court issued a permanent injunction ordering California to comply with the ADA and the Rehabilitation Act of 1973.

After an appeal by the State in November 2001, the court entered a Revised Permanent Injunction on February 11, 2002.[99] The injunction required the State to:

create and maintain a system for tracking prisoners and parolees with disabilities, take reasonable steps to identify prisoners and parolees with disabilities prior to parole proceedings, and provide reasonable accommodations to prisoners and parolees with disabilities at all parole proceedings, including parole revocations and revocation extensions, life prisoner hearings, mentally disordered offender proceedings, and sexually violent predator proceedings.[100]

After failing to comply fully with the injunction, the plaintiffs sought and were awarded an enforcement motion against BPT on May 30, 2006.[101]

In January 2007, a separate injunction was issued after a finding that “despite extensive monitoring of CDCR Institutions,” the state of California was “continuing to severely violate the rights of prisoners with disabilities.”[102]

3.  Clark v. California

On April 22, 1996, two inmates incarcerated in California with developmental disabilities filed a class action lawsuit citing discrimination due to their disabilities.[103] In 1998, prior to the start of trial, the two parties negotiated an interim agreement.[104] As a result of this negotiation, the Clark Remedial Plan (“CRP”) was issued on March 1, 2002.[105] This plan details the DDP in California prisons.[106] It includes policies pertaining to the “identification, appropriate classification, housing, protection and nondiscrimination of inmates/parolees with developmental disabilities.”[107]

In July 2009, the defendants—the state of California, California Governor, CDCR, and prison officials—filed a motion to “terminate the Settlement Agreement & Order,” known as the CRP, arguing that continued relief was no longer necessary.[108] The court denied the State’s motion for relief and granted, in part, the prisoners’ motion for further relief.[109]

III.  ARGUMENT

In California, there exists only one mechanism—a parole hearing—for an inmate to demonstrate that they no longer pose a current danger to society and thus should be granted parole.[110] This current system for determining if parole should be granted or denied is dependent not only on whether an inmate possesses the necessary factors supporting parole, but also on their ability to clearly articulate these factors.[111] Given many inmates low cognitive abilitieswhether labeled as disabled by CDCR standards or notit is much more difficult for these individuals to clearly interpret and process questions asked at their Comprehensive Risk Assessment and their parole hearing and to articulate answers to questions about insight and remorse. From the parole hearing structure, to a lack of accommodations, to sub-par training for commissioners and correctional officers, the current California parole system is impermissible and ultimately unconstitutional for individuals with cognitive impairments.[112]

There are numerous studies which indicate that inmates who are developmentally disabled will be “unlikely to be able to follow general prison rules, participate in work or treatment programs,” and face “a higher risk of victimization than higher-functioning inmates.”[113] Further, “[t]heir failure to comply with the prison routine” and difficulty or inability “to read and to understand prison rules and to advocate effectively for themselves, contributes to them more often being denied parole.”[114] In fact, research demonstrates that “inmates with mental retardation tend to serve longer sentences because of their higher frequency of infractions in prison and have greater difficulty securing parole.”[115]

From these research results about inmates who are recognized as DD, we can infer that individuals with cognitive impairments that are undiagnosed are just as likely to experience these issues, ultimately resulting in a parole denial. Because the Board does not adjust its suitability standard for inmates with cognitive impairments, individuals with cognitive impairments may end up staying in prison for far longer, resulting in arguably unconstitutional sentences. To remedy this, commissioners at parole hearings should not only be required to consider an inmate’s level of cognitive functioning, but also be mandated to run parole hearings in accordance with the inmate’s ability-level.[116]

A.  Factors Considered in Parole Suitability Hearings

Below is a list of factors, though not exhaustive, that are considered during a parole suitability hearing. These statutorily mandated factors tend to disadvantage individuals with cognitive impairments because each of them requires some level of advanced processing and communication ability.

1.  Comprehensive Risk Assessment

Prior to a parole suitability hearing, the Forensic Assessment Division of BPH issues a Comprehensive Risk Assessment to all inmates.[117] The purpose of the risk assessment is to help identify an inmate’s “potential for future violence and protective factors that could minimize his or her risk if  released to the community.”[118] When performing the evaluation on the inmate, the assessment may include inquiries into the inmate’s “commitment offense, institutional programming, past and present mental state, and analysis of static and dynamic risk factors” as well as “emotions and attitudes, and perceptions and attributions.”[119] The inmate can receive a “final risk ratings of low, moderate, or high risk for violence . . . .”[120] Assessments are administered every five years.[121] For a realistic chance at parole, an inmate should receive a “low” score on their risk assessment. Anything higher gives the Board greater discretion to deny parole.[122]

Pursuant to CDCR’s rules, an inmate is unable to appeal the results of their Comprehensive Risk Assessment.[123] The inmate, along with his or her attorney, can, however, contest the findings of the assessment at their parole hearing.[124] The hearing panel, at its discretion, will determine how heavily to weigh the Comprehensive Risk Assessment.[125] In practice, the commissioners often place substantial weight on the findings contained within the Comprehensive Risk Assessment.

The susceptibilities of the Comprehensive Risk Assessments should be examined more closely, given how heavily the Board relies upon such assessments. The atmosphere, pressure, nervousness, and potential confusion of questions being asked can lead an inmate to present poorly. It is administered in prison, and the inmate goes into the assessment with an acute awareness of the implications of the score they receive. Thus, before the assessment even begins, there is heightened pressure on the inmate. These external factors can be especially damaging to those who have undiagnosed cognitive impairments.

2.  Rule Violations

For the primary purpose of safety—for the correctional officers, other employees, and fellow inmates—prison policies are very strict.[126] The majority of inmate rule violations occur and are documented as either a custodial counseling chrono, also known as a “128,” or a more serious rule violation report, referred to as a “115.”[127]

Violations that constitute a 128 include: “[p]ossession of contraband other than controlled substances,” “[m]isuse of food,” “[o]ut-of-bounds presenting no threat to facility security,” “[m]isuse of telephone privileges,” “[m]ail or visiting violations,” “[f]ailure to meet work or program expectations,” “[l]ate for or absent without authorization from a work or program assignment,” “[u]se of vulgar or obscene language,” and “[f]ailure to comply with departmental grooming standards.”[128]

An inmate may receive a 115, a more serious write-up, for “[t]he use or threat of force or violence against another person,” “[a] breach of or hazard to facility security, “serious disruption of facility operations,” “introduction, use, or possession of controlled substances or alcohol,” “[p]ossession of dangerous contraband,” and “[a]ny felony offense.”[129] The high demands placed on inmates may make it very difficult to avoid receiving disciplinary citations despite an inmate’s best effort to do so.

The extensive list of rules inmates must follow at all times while incarcerated exists for purposes of efficiency, management, and promoting safety.[130] For inmates with cognitive impairments, non-adherence to obscure and sometimes unknown rules that result in rule violation write-ups can be exceptionally detrimental at a parole hearing. Navigating the prison system requires a level of savviness that many DD inmates simply do not possess.

At a parole hearing, any rule violation received while incarcerated will be discussed.[131] In addition, the Board will critically assess more recent rule violations and write-ups from the year leading up to the hearing—so these can be especially damaging.[132] Rule violations are heavily relied upon as a basis for denying parole.[133]

For inmates classified as having a developmental disability or a documented mental health disorder, a slightly modified procedure is followed.[134] If, at the time of a citation “the inmates behavior was so strongly influenced by symptoms of mental illness or developmental disability/cognitive or adaptive functioning deficits,” the mental health staff can recommend that the rule violation be documented in an “alternate manner.”[135] After review by the correctional officer captain, he or she can choose to ignore the recommendation and still give a write-up or can decide to place a memorandum in the inmate’s file documenting the reason not to issue the 128 or 115.[136] Ultimately, however, a record will exist discussing the incident and may be inquired into at a parole suitability hearing.

Despite this specific regulation aimed to help the DD prisoner population better navigate the system and prevent unfair violations, the inmate must still be able to discuss the rule violations they receive, along with any similar incidents, in an articulate and insightful manner at a parole hearing. Not only must the prisoner admit to their improper conduct, but they must also explain the motivations behind such behavior. People with cognitive impairments are expected to answer these questions despite the fact that their ability to process and communicate is often compromised as defined by their disability.[137]

3.  Programming

During an individual’s parole suitability hearing, a part of the hearing is dedicated to assessing the programming they have engaged in while incarcerated.[138] The Board will look for programming relevant to a problem an inmate may have had prior to incarceration, especially if the inmate’s commitment offense was related to the problem. For example, if an inmate’s offense was gang-related, the inmate will almost certainly need to have programmed with Criminal Gangs Anonymous (“CGA”) or a similar gang-prevention program. In addition, inmates with addiction issues will likely need programming with Narcotics Anonymous (“NA”) or Alcoholics Anonymous (“AA”). Inmates will often be asked to recite the twelve-steps at their hearing and discuss how each step has helped with their sobriety.[139] The ability to retain and recite the steps and to explain how each step impacted an inmate’s sobriety may simply be beyond the ability-level of inmates with certain cognitive impairments. Therefore, recognizing an inmate’s limitations is essential for purposes of a fair proceeding.

In addition, access to programs can be limitedespecially for males at higher-level security prisons—and knowing which programs to take can be hard—especially for someone with cognitive impairments. Even if an inmate successfully participates in programs, they must also be able to precisely detail what they learned and how it changed their internal thinking. For an inmate who functions at a lower cognitive level, this specific type of articulation may be unachievable. The Board, however, does not account for that inability.

4.  Insight

Insight is defined as “the power or act of seeing into a situation,[140] or “[t]he capacity to gain an accurate and deep understanding of someone or something.”[141] The concept of “insight” has increasingly influenced California jurisprudence concerning prisoners’ parole hearings.

For example, in 2008, the California Supreme Court issued its opinion in In re Lawrence, which affirmed a California Court of Appeal’s finding that the Governor’s reversal of a parole grant was improper. In its decision, the Court relied heavily on the inmate’s insight, stating that upon incarceration she “lacked emotional insight;” however, over time, she gained “substantial insight” in relation to “both the behavior that led to the murder and her own responsibility for the crime.[142] Since then, the Board has focused immensely on insight at parole hearings.[143] A lack of insight is one of the most common reasons cited supporting the Board’s denial of parole.[144] As predicted, a denial or reversal by the Governor due to “lack of insight” has been substantially litigated.[145] The success of these petitions, however, has been limited given the “some evidence” standard used by courts to challenge Board denials.[146]

As stated by the California Supreme Court, expressions of insight and remorse will vary from prisoner to prisoner and . . . there is no special formula for a prisoner to articulate in order to communicate that he or she has gained insight into, and formed a commitment to ending, a previous pattern of violent behavior.”[147] Lack of insight supports a parole denial when it is rationally indicative of the central issue of an inmate’s current dangerousness when considered in light of the full record.[148]

Courts have recognized the obstacles faced by inmates accused of a lack of insight, since the assertion of a lack of insight can be “shorthand for subjective perceptions based on intuition or undefined criteria that are impossible to refute.”[149] There is also the concern that insight has become the “new talisman” for denying parole.[150] When an inmate is denied his or her constitutional right for parole based on a lack of insight, the Board must find a “factually identifiable deficiency in perception and understanding” of the criminal conduct or its causes that is probative of current dangerousness.[151]

When . . . undisputed evidence shows that the inmate has acknowledged the material aspects of his or her conduct and offense, shown an understanding of its causes, and demonstrated remorse, the Governor’s [or Board’s] mere refusal to accept such evidence is not itself a rational or sufficient basis upon which to conclude that the inmate lacks insight, let alone that he or she remains currently dangerous.[152]

For example, in In re Denham, petitioner was denied parole based on a lack of insight because the Board speculated that he played a larger part in the commitment offense than he testified to.[153] The court concluded that “the Board cite[d] no evidence establishing that Denham’s participation in the crime was anything other than what he described at the 2010 parole hearing.”[154] Thus, the Court concluded that the Board reached its conclusion through improper speculation.[155]

The Court also held in In re Twinn that the Governor’s parole reversal violated due process because the Governor failed to establish a rational nexus between the prisoner’s alleged lack of insight and his current dangerousness.[156] Twinn was imprisoned after being convicted of second-degree murder.[157] Twinn had consistently denied his intention to kill the victim and clearly expressed remorse and accepted responsibility for his actions.[158] The Court reversed the governor’s denial, stating there was no “rational nexus” between Twinn’s description of his role in the murder and current danger to public safetyespecially when taking into account Twinn’s remorse, acceptance of responsibility, and good behavior.[159]

Though California courts, in some cases, have recognized that a “lack of insight” has become a prevalent reason for denying parole,[160] the courts’ very deferential “some evidence” standard for review of Board (and Governor) decisions leaves courts with limited ability to address any issues stemming from the Board using this reason.[161] Extensive focus geared towards the “proper” demonstration of insight poses particular issues for inmates with certain cognitive disorders. Further, this heightened emphasis on insight is particularly odd given that “insight” is not even listed as either a suitability or unsuitability factor in the statute.[162] Courts nonetheless have “accepted the presence or absence of insight as a relevant factor within the Board’s authority,” even going as far as to qualify it as a “significant factor.[163] This immense focus on an advanced concept like insight proves to be particularly damaging to individuals who cannot function or think at a highly abstract level.

5.  The Board’s Discretion

Further, and perhaps most significant, is the power granted to commissioners to make parole suitability determinations.[164] The law, both statutorily and as interpreted by courts, affords commissioners extensive discretion to grant or deny parole.[165] The Board is tasked with assessing an inmate’s suitability on a case-by-case basis attempting to “balance . . . the interests of the inmate and of the public.”[166] With this broad discretion, commissioners are equipped with numerous bases on which to deny parole. For individuals who cannot conform to the Board’s precise expectations, a parole denial is a hearing’s most likely result.

An individual’s cognitive abilities are essential to processing and communicating information.[167] Therefore, prior to and during a parole hearing, an individual with impaired cognition will have a harder time than an individual without a cognitive disability to follow prison rules, excel in recommended or required programming, and communicate insight to the Board, thus, resulting in a higher likelihood of parole denial.[168]

B.  Additional External Factors Affecting Parole Suitability Hearings

There are several external factors that, although not often captured during a parole proceeding, have significant implications for receiving a grant. Many of these factors begin far before an individual enters CDCR’s custody. They can start as early as birth, or during childhood, when an individual with a disability is improperly diagnosed or not diagnosed at all. In addition, impairments can develop or worsen if an individual is granted limited access to education. In CDCR custody, cognitive impairments that were not addressed prior to a prisoner’s incarceration may continue to go unacknowledged, leading to challenges in prison that are similar to those the individual experienced outside of prison. Ultimately, this lowers that individual’s chance at parole.

1.  CDCR’s Narrow Definition of a Developmental Disability

CDCR’s determination of whether an individual falls within the DDP has far reaching implications. As currently written, CDCR’s narrow definition of a DD fails to encompass many inmates affected with impairments.

The Center for Disease Control (“CDC”) defines developmental disabilities as “a group of conditions due to an impairment in physical, learning, language, or behavior areas. These conditions begin during the developmental period, may impact day-to-day functioning, and usually last throughout a person’s lifetime.”[169] CDCR has a similar, but arguably stricter, definition.[170] Although there are still claims made by inmates with recognized developmental disabilities regarding unmet necessary accommodations, the arguably more difficult challenge lies with the thousands of inmates who do not fall within CDCR’s strict definition of DD, but have cognitive processing disorders or other intellectual impairments.

CDCR has several regulations designed to assist inmates who are included in the DDP.[171] For example, at a parole hearing of a person who falls within the DDP, staff assistance will be provided.[172] The assistance is usually a DDP counselor who does not provide legal advice, but can assist an inmate in understanding and participating in the parole hearing process.[173] However, inmates who have impairments but do not fall within CDCR’s DDP, such as an individual with a learning disorder, do not receive extra assistance at their parole hearing.[174]

Understandably, CDCR does not want to differentiate between inmates in the non-disabled group. For efficiency purposes, as well as cost concerns, treating all non-disabled inmates alike is alluring to prison officials. The problem, however, is that this practice is unjust and unreasonable. For example, cognitive impairments that preclude an inmate from effective, abstract thinking do not necessarily make them a current danger (the legal standard), yet time and again, an inmate in this position will be denied parole for “lack of insight.”[175]

At the crux of my argument lies a fundamental concept that the disability community commonly tries to convey—impairments, challenges, and disabilities are on a spectrum and cannot be defined or captured in a single definition easily.[176] The convenience of a bright-line definition for who qualifies as DD is understandably appealing to CDCR, but those who fall outside the bright-line definition, yet still possess cognitive impairments, must be provided a way in which their limitations will be identified, acknowledged, and considered during incarceration and at their parole hearing.

2.  Learning Disorders

An example of the impact of CDCR’s limiting definition of a DD individual is demonstrated through its treatment of people with learning disorders. CDCR defines a learning disorder as “a cognitive disorder that affects the ability of persons with normal intellect to learn academic and social information.”[177] Examples of learning disorders include dyslexia and dyscalculia. CDCR does not test for learning disorders, but instead, an inmate may be considered to have one if they have a TABE score that is under 4.0.[178]

At a parole hearing for an inmate with a learning disorder, the only advocate is the inmate’s lawyer (inmates are entitled to have a lawyer present). No other assistance is provided to help mitigate the struggles that this individual could face.[179] CDCR states in all caps on their website that, “THE ATTORNEY IS THE BEST ACCOMODATION” for inmates with cognitive impairments.[180] Lawyers, however, are not professionally trained to best accommodate individuals with impairments and, as such, likely do not possess the required skills to properly address these unique challenges.

3.  TABE Assessment

Another factor that is not statutorily mandated to be considered, and thus is often overlooked, is an inmate’s TABE score. Pursuant to the California Penal Code, all individuals housed in CDCR custody are issued a TABE after being placed in state custody.[181] The TABE is a diagnostic assessment that helps to determine an individual’s ability in English, math, and reading.[182] The TABE is used by CDCR, as well as other public service agencies, to help guide its determinations for what educational programs are needed for a given individual.[183]

CDCR divides its adult basic education (“ABE”) classes into three levels: ABE I classes are for individuals who score between zero and 3.9 on the reading portion, ABE II is for inmates who fall between 4.0 and 6.9 on the reading portion, and ABE III is for inmates who score between 7.0 and 8.9 in reading.[184] The California Penal Code states that the “department shall offer academic programming throughout an inmate’s incarceration that shall focus on increasing the reading ability of an inmate to at least a 9th grade level.”[185]

4.  Unconstitutional Denial of Liberty Without Due Process

There are several problems with CDCR’s approach to the segment of inmate population that does not qualify as developmentally disabled, but nonetheless has impairments. For one, a lawyer, though required by law to represent their client to the best of their ability,[186] may be simply unfamiliar with the inmate’s impairments and not able to best accommodate them. Further, a parole hearing is not an official judicial proceeding, and thus, inmates are not afforded the same rights they would have in a court of law.[187] Inmates are expected and required to speak on their own behalf with little intervention from their attorneys.[188] Individuals who have cognitive impairments may not be able to adequately respond or engage at a parole hearing. As a result, a large segment of the prison population may be in need of supplemental resources even though they are not classified as DD.

Because there exists a wide array of cognitive impairments that inmates face and often those impairments are not formally acknowledged, many inmates who do not pose a current danger to society will remain in prison after attaining parole eligibility. This is a denies the inmates their due process rights.

IV.  RECOMmENDATIONS FOR THE CALIFORNIA PAROLE PROCESS WITH REGARD TO Prisoners WITH COGNITIVE IMPAIRMENTS

People with cognitive impairments, especially those that are undiagnosed or not properly and thoroughly addressed, get in trouble more often in prison and have higher Comprehensive Risk Assessment scores. They also do not articulate insight and remorse as eloquently as non-disabled individuals. Because of this, and because the Board does not adjust its suitability standard for inmates with cognitive impairments, those individuals who no longer pose a danger to society may end up staying in prison for longer, ultimately resulting in unconstitutional sentences.[189]

A.  Expanded Definition of Developmentally Disabled

CDCR’s current definition of developmentally disabled is extremely limiting.[190] I recommend expanding the definition to include those individuals who have cognitive impairments and are currently excluded. The DD population by its nature is extremely diverse. A more inclusive definition could help certain individuals receive the accommodations they require. While I respect the need to have a bright-line definition for administrative purposes, I think a more encompassing definition will capture some of the currently excluded inmates with little increase in administrative burden.

B.  Increased Commissioner and Correctional Officer Training

Though CDCR, by definition, is a department that is supposed to focus on corrections and rehabilitation, its correctional officers and commissioners are inadequately trained to serve and promote the prisons’ rehabilitative functions. Currently, all of the commissioners and deputy commissioners that conduct parole hearings must, “[w]ithin 60 days of appointment and annually thereafter undergo a minimum of 40 hours of training in . . . educational, vocational, mental health, medical, substance abuse, psychotherapeutic counseling, and sex offender treatment programs.”[191] Although the training includes a portion on mental health, it does not focus specifically on developmental disabilities or the many nuances of the DD population. Further, forty hours of training per year is woefully inadequate to cover the numerous topics that are particularly pertinent to the prison population.

Similar to parole commissioners, the “corrections staff usually have little training on disability issues.”[192] The lack of professional training for correctional officers is arguably more damaging than the lack of training for commissioners because an inmate must first succeed in rehabilitating while incarcerated before having an opportunity to be successful at their parole hearing.

“California falls far behind some other states” in regard to rehabilitation.[193] In a study conducted by the University of California, Irvine that focused on the MR/DD population in prison, researchers found “virtually no specialized rehabilitation or substance abuse programs . . . in jail, or in prison[,] [that could] meet the unique needs of offenders with retardation.”[194] In the few jurisdictions that have special corrections programs for the DD, they have been shown to lead to “increased social functioning and reduced recidivism rates, while at the same time reducing corrections costs.”[195]

There needs to be more training of both correctional officers and commissioners, especially in the realm of cognitive impairments, because it affects a large segment of the prison population. The trainings need to increase knowledge and sensitivity to these issues as well as provide instruction on how to best interact, encourage, and rehabilitate individuals struggling with cognitive impairments. This would give inmates a fair chance to rehabilitate and demonstrate to the commissioners at their parole hearings that they are no longer a current danger to society. It is essential to expand awareness and give training tools to commissioners and CDCR employees.

C.  Less Emphasis on Insight

After In re Lawrence, the Board’s focus on insight has increased substantially and has become one of the most important factors used to determine if parole will be granted.[196] Because insight is not a statutorily mandated factor and because it requires the ability to process ideas abstractly—in a way certain inmates are incapable of doing—the Board should focus less on insight, or at a minimum, be willing to accept a wider range of ways in which it can be demonstrated.

D.  Providing Psychological Evaluations and Psychologist Testimony at Parole Proceedings

Another remedy that may improve California’s current parole system is to allow testimony of a mental health professional at all parole hearings. As of now, the inmates Comprehensive Risk Assessment is the only documentation that addresses this. However, the ultimate goal of the psychologist who administers the risk assessment is not identifying disabilities; rather, it is to determine how much of a public safety risk the inmate poses. Thus, the assessment likely underrepresents, or does not address at all, an inmate’s disabilities. Having a mental health professional attend all parole hearings could provide the commissioners with information on an inmate’s cognitive ability and add a necessary safeguard that the system is currently lacking.

E.  Amending Rule Violation Write-Ups

Furthermore, I propose extending the amended procedure for administrating rule violations for inmates in the DDP to inmates who have cognitive impairments, but do not fall within CDCR’s stringent definition of a having a disability. This would allow individuals who function at a low cognitive level, or who have processing disorders, to explain their actions more fully. If someone, for example, cannot understand a rule, they should not be punished for it.[197]

F.  Fair Weight Given to TABE Scores

Further, more weight and analysis should be given to an inmate’s TABE score at their parole hearing. This could better inform the commissioners of an inmate’s cognitive ability level. More importantly, there should be different rules for the hearing based on how the inmate scored on the TABE. If an inmate has a TABE score of under 4.0, the commissioners should be required to ask different questions and run the parole hearing in a different way than when interacting with an inmate whose score is above 9.0. Expecting an individual to perform beyond their ability results in an unfair parole proceeding.

CONCLUSION

Ultimately, the way the California parole board treats people with cognitive impairments is arguably illegal. Though the Clark Remedial Plan was intended to prevent some of the criminal justice system’s abuses against people with cognitive disabilities, it has failed on a multitude of fronts.

CDCR’s rigid and narrow definition of a developmental disability is too limiting. As a result, it excludes the large segment of the incarcerated population with cognitive impairments. This disadvantages that specific population both prior to and during their parole hearings because they are unable to meet the requirements of parole suitability. This system is impermissible and must be changed as it results in the continued incarceration of people who do not pose a current danger to society.

 

 


[*] *. Senior Submissions Editor, Southern California Law Review, Volume 91; J.D. 2018, University of Southern California Gould School of Law; B.A. Political Science 2011, University of Washington, Seattle. I would like to thank Professor Heidi Rummel for valuable guidance and feedback on earlier drafts of this note. In addition, I would like to thank the staff and editors of the Southern California Law Review for their excellent work.

 [1]. Maria’s name and some facts have been changed to protect her identity and maintain confidentiality. Maria is the inspiration behind my note.

 [2]. PCJP is a clinical program that represents male and female prisoners incarcerated in California state prisons. Among its clients, PCJP represents parole-eligible inmates serving indeterminate life sentences and juveniles sentenced to life without the possibility of parole.

 [3]. See U.S. Const. amends. V, XIV.

 [4]. See Cal. Dep’t of Corr. and Rehab., Parole Suitability Hearings 1 (2015), http://www.cdcr.ca.gov/BOPH/docs/Parole-Suitability-Hearings-updated-9.29.pdf (“In 2015, the Board held 5,300 parole suitability hearings and granted parole to 906 inmates.”).

 [5]. Jazmine Ulloa, More California Inmates Are Getting a Second Chance as Parole Board Enters New Era of Discretion, L.A. Times (July 27, 2017), http://www.latimes.com/politics/la-pol-ca-parole-board-proposition-57-20170727-htmlstory.html. These statistics indicate that the likelihood of being found suitable for parole in California still remains quite low; however, it is significantly better than the past. In 2007, “less than 2%” of inmates were found suitable for parole. Id.

 [6]. For purposes of this Note, I use the language “cognitive impairments” to differentiate between individuals who are formally identified as developmentally disabled in California prisons and those individuals who are not encompassed within that bright-line definition. The Center for Disease Control (“CDC”) defines an individual with a “cognitive impairment” as “a person [who] has trouble remembering, learning new things, concentrating, or making decisions that affect their everyday life.” Ctr. for Disease Control, A Cognitive Impairment: A Call for Action, Now! 1 (2011), https://www.cdc.gov/aging/pdf/cognitive_impairment/cogimp_poilicy_final.pdf. Much thought was given to the sensitivity surrounding the usage of the word “impairments,” and the term is intended only to be construed as the actual definition from the CDC.

 [7]. See generally Joan Petersilia, Doing Justice? The Criminal Justice System and Offenders with Developmental Disabilities (2000) (discussing the “frequent victimiz[ation]” of inmates with developmental disabilities in the California parole process).

 [8]. In re Powell, 755 P.2d 881, 886 (Cal. 1988).

 [9]. See generally Cal. Dep’t of Corrections and Rehabilitation, CA.Gov, http://www.cdcr.ca.gov (last visited Aug. 20, 2018).

 [10]. Sentencing, Incarceration, & Parole of Offenders, Cal. Dep’t of Corrections and Rehabilitation, http://www.cdcr.ca.gov/victim_services/sentencing.html (last visited Aug. 20, 2018).

 [11]. Id.

 [12]. Cal. Dep’t of Corr. and Rehab: Div. of Internal Oversight and Research, Monthly Report of Population as of Midnight January 31, 2018, 1 (2018), https://www.cdcr.ca.gov/Reports_Research/Offender_Information_Services_Branch/Monthly/TPOP1A/TPOP1Ad1801.pdf.

 [13]. Id.

 [14]. See Sentencing, Incarceration, & Parole of Offenders, supra note 10.

 [15]. Id.

 [16]. Id.

 [17]. Id.

 [18]. Keith Wattley, Insight into California’s Life Sentences, 25 Fed. Sent’g Rep. 271, 271 (2013).

 [19]. Id.

 [20]. Lifer Parole Process, Cal. Bd. of Parole Hearings, http://www.cdcr.ca.gov/BOPH
/lifer_parole_process.html (last visited Aug. 20, 2018).

 [21]. Parole Suitability Hearings, supra note 4.

 [22]. Lifer Parole Process, supra note 20.

 [23]. Cal. Penal Code § 3041(b)(1) (West 2018) (emphasis added).

 [24]. See Board of Pardons v. Allen, 482 U.S. 369, 374 (1987). See also Swarthout v. Cooke, 562 U.S. 216, 218 (2011).

 [25]. Wattley, supra note 18, at 272.

 [26]. Lifer Parole Process, supra note 20.

 [27]. Cal. Code Regs. tit. 15, § 2281 (West 2018).

 [28]. Cal. Gov’t Code § 12838.4 (West 2018).

 [29]. Cal. Code Regs. tit. 15, § 2402 (West 2018).

 [30]. Id.

 [31]. In re Shaputis, 265 P.3d 253, 271 (Cal. 2011).

 [32]. Cal. Code Regs. tit. 15, § 2402 (West 2018). This can be a particularly challenging factor for individuals who have committed violent crimes. Many have argued and litigated that a murder, for example, may always be considered “heinous” or “atrocious” and thus it provides the Board with an ability to deny parole on grounds that do not have a “rational nexus” to an inmate’s current dangerousness.

 [33]. Id.

 [34]. In re Rosenkrantz, 59 P.3d 174, 203 (Cal. 2002).

 [35]. Parole Suitability Hearings, supra note 4.

 [36]. See generally Petersilia, supra note 7.

 [37]. Cal. Code Regs. tit. 15, § 2281(c)(5)–(6) (West 2018).

 [38]. Robert Weisberg et al., Stan. Crim. Just. Ctr., Life in Limbo: An Examination of Parole Release for Prisoners Serving Life Sentences with the Possibility of Parole in California 7 (2011).

 [39]. Cal. Penal Code § 3043 (West 2018).

 [40]. See David R. Friedman & Jackie M. Robinson, Note, Rebutting the Presumption: An Empirical Analysis of Parole Deferrals Under Marsy’s Law, 66 Stan. L. Rev. 173, 198 (2014). Marsy’s law was enacted after Ms. Marsalee (Marsy) Nicholas was murdered by her ex-boyfriend. A week after Marsy was killed, Marsy’s mother and brother encountered Marsy’s ex, the accused murderer in a grocery store. Marsy’s family was not informed that he had been released on bail. Because of the bill’s passage, courts now must consider the “safety of victims and families when setting bail and release conditions.” See About Marsy’s Law: Justice with Compassion, Marsy’s Law, https://marsyslaw.us/about-marsys-law (last visited Aug. 20, 2018). In addition, family members are legally entitled to attend all bail hearings, pleas, sentencing and parole hearings. Id.

 [41]. Victim’s Bill of Rights Act of 2008: Marsy’s Law, Cal. Bd. of Parole Hearings, http://www.cdcr.ca.gov/BOPH/marsys_law.html (last visited Aug. 20, 2018).

 [42]. See Weisberg et al., supra note 38, at 20.

 [43]. Id. at 22.

 [44]. See id. at 7–8. See also Cal. Dep’t of Corr. and Rehab., Parole Suitability Proceeding Handbook: Information for Victims and Their Families 8–9 (2016).

 [45]. Cal. Code Regs. tit. 15, § 2402 (West 2018).

 [46]. See Weisberg et al., supra note 38, at 7–9.

 [47]. Lifer Parole Process, supra note 20.

 [48]. Beth Caldwell, Creating Meaningful Opportunities for Release: Graham, Miller and California’s Youth Offender Parole Hearings, 40 N.Y.U. Rev. L. & Soc. Change 245, 267 (2016). To competently prepare for a parole hearing, an attorney will need to spend much more than $400 worth of time. Preparation should include reviewing the inmate’s entire C-File which can be hundreds to thousands of pages long, as well as other pertinent documentation such as childhood and medical records. In addition, the lawyer should visit the client multiple times to moot and prepare for the difficult questioning at the hearing.

 [49]. Lifer Parole Process, supra note 20.

 [50]. See Parole Suitability Proceeding Handbook, supra note 44, at 9.

 [51]. Parole Suitability Hearings, supra note 4.

 [52]. Cal. Penal Code § 3041.5 (West 2018).

 [53]. Id.

 [54]. Victims’ Bill of Rights Act of 2008: Marsy’s Law, Cal. Const. art. I, § 28.

 [55]. Friedman & Robinson, supra note 40, at 180.

 [56]. Lifer Parole Process, supra note 20.

 [57]. Cal. Penal Code § 3041.2 (West 2018).

 [58]. Friedman & Robinson, supra note 40, at 181.

 [59]. Id.

 [60]. U.S. Const. art. I, § 9, cl. 2. California inmates have a right to file a federal habeas corpus petition challenging their parole denial. Swarthout v. Cooke, 562 U.S. 216, 219–22 (2011) (“[T]he responsibility for ensuring that the constitutionally adequate procedures governing California’s parole system are properly applied rests with California courts.”).

 [61]. In re Rosenkrantz, 59 P.3d 174, 183 (Cal. 2002).

 [62]. In re Shaputis, 265 P.3d 253, 264–68 (Cal. 2011). See also In re Lawrence, 190 P.3d 535, 538–39 (Cal. 2008); In re Rosenkrantz, 59 P.3d at 183.

 [63]. In re Shaputis, 265 P.3d at 264–68.

 [64]. Id. at 270–71.

 [65]. Id.

 [66]. Rebecca Vallas, Disabled Behind Bars: The Mass Incarceration of People with Disabilities in America’s Jails and Prisons, Ctr. for Am. Progress (July 18, 2016, 12:01 AM), https://www.americanprogress.org/issues/criminal-justice/reports/2016/07/18/141447/disabled-behind-bars.

 [67]. Id.

 [68]. Id.

 [69]. Laura M. Maruschak, Medical Problems of Prisoners, Bureau of Just. Stat. (last revised Aug. 20, 2018), https://www.bjs.gov/content/pub/html/mpp/mpp.cfm.

 [70]. See id.

 [71]. See, e.g., Vallas, supra note 66.

 [72]. See Petersilia, supra note 7, at 46.

 [73]. See Cal. Dep’t of Corr., Clark v. California: Remedial Plan 1–2 (2002), https://www.cdcr.ca.gov/BOPH/docs/ADA-Resources/CLARK%20Remedial%20Plan.pdf.

 [74]. Id.

 [75]. Sentencing, Incarceration, & Parole of Offenders, supra note 10. See infra Section III.A.

 [76]. See Clark v. California: Remedial Plan 1, supra note 73, at 2.

 [77]. Id.

 [78]. See Katie Riley et al., ADA Overview—Inmates with Disabilities 19 (2013), https://www.cdcr.ca.gov/BOPH/docs/Attorney_Orientation/PP%20-%20Inmates%20with
%20Disabilities%20-%206%20slides.pdf.

 [79]. Id.

 [80]. 42 U.S.C. § 12101–12213 (2012).

 [81]. Id. § 12131 (defining “public entity” as “any department, agency, special purpose district, or other instrumentality of a State or States or local government” and thus reaching states’ correctional facilities).

 [82]. Resources for Persons with Disabilities, Cal. Bd. of Parole Hearings, http://www.cdcr.ca.gov/BOPH/Attorney_Resources/ADA_Resources.html (last visited Aug. 20, 2018).

 [83]. Id.

 [84]. See id.

 [85]. Armstrong v. Wilson, 942 F. Supp. 1252, 1258 (N.D. Cal. 1996), aff’d, 124 F.3d 1019, 1021 (9th Cir. 1997).

 [86]. Armstrong v. Schwarzenegger, 622 F.3d 1058, 1063 (9th Cir. 2010). This case began when Schwarzenegger’s predecessor was in office, Governor Davis, and has continued since Schwarzenegger left office, under Governor Brown.

 [87]. Clark v. California, 739 F. Supp. 2d 1168, 1173 (N.D. Cal. 2010).

 [88]. See infra Sections II.C.1–3

 [89]. Wilson, 942 F. Supp. at 1258.

 [90]. Title II of the Americans with Disabilities Act, 42 U.S.C. § 12132 (2012) (emphasis added).

 [91]. See Wilson, 942 F. Supp. at 1258.

 [92]. Pennsylvania Dep’t of Corr. v. Yeskey, 524 U.S. 206, 213 (1998).

 [93]. In July 2005, the Board of Parole Hearings (“BPH”) replaced the Board of Prison Terms (“BPT”) as the agency responsible for determining whether and when lifers are released on parole. See S.B. 737 (Cal. 2005) (enacted) (adding California Government Code section 12838.4, eliminating the Board of Prison Terms, and creating the Board of Parole Hearings, which are now under the umbrella of the CDCR).

 [94]. See Armstrong v. Schwarzenegger, 622 F.3d 1058, 1062 (9th Cir. 2010) (“More than a decade and a half ago, disabled prisoners and parolees brought this action against the California officials with responsibility over the corrections system and parole proceedings.”); Armstrong v. Davis, 275 F.3d 849, 854–55 (9th Cir. 2001). See also Case Profile: Armstrong v. Schwarzenegger, C.R. Litig. Clearinghouse, http://www.clearinghouse.net/detail.php?id=572.

 [95]. Case Profile: Armstrong v. Schwarzenegger, supra note 94. 

 [96]. Armstrong v. Wilson, 942 F. Supp. 1252, 1258–59 (N.D. Cal. 1996).

 [97]. Case Profile: Armstrong v. Schwarzenegger, supra note 94.

 [98]. Id.

 [99]. Id.

 [100]. See id. See also Stipulation and Order on Revised Injunction, Armstrong v. Davis, 275 F.3d 849 (9th Cir. 2001), enforced sub nom. Armstrong v. Schwarzenegger, 622 F.3d 1058 (9th Cir. 2010).

 [101]. Case Profile: Armstrong v. Schwarzenegger, supra note 94.

 [102]. Id.

 [103]. See Clark v. State, No. C96-1486-FMS, 1996 U.S. Dist. LEXIS 21630, at *2–5 (N.D. Cal. Oct. 1, 1996), aff’d, 123 F.3d 1267 (9th Cir. 1997). See also Case Profile: Clark v. Wilson, C.R. Litig. Clearinghouse, https://www.clearinghouse.net/detail.php?id=576.

 [104]. Case Profile: Clark v. Wilson, supra note 103.

 [105]. Sentencing, Incarceration, & Parole of Offenders, supra note 10.

 [106]. Case Profile: Clark v. Wilson, supra note 103.

 [107]. Id.

 [108]. See Clark v. California, 739 F. Supp. 2d 1168, 1174 (N.D. Cal. 2010).

 [109]. See id. at 1173.

 [110]. Cal. Penal Code § 3041(b)(1) (West 2018).

 [111]. See supra Part I.

 [112]. Procedural due process requires a fair process which typically includes an unbiased decision-maker and notice of the government’s actions before a person may be deprived of their life, liberty or property. See, e.g., Fuentes v. Shevin, 407 U.S. 67, 80–81 (1972). See also U.S. Const. amends. V, XIV. If an individual, due to cognitive impairments, is incapable of conforming to parole board standards, the hearing itself does nothing to ensure that due process is being afforded. Inmates remain incarcerated solely as a result of their disability.

 [113]. Petersilia, supra note 7, at 46.

 [114]. Id. at 29.

 [115]. Id.

 [116]. The parole board has always been tasked with ascertaining an inmate’s potential current danger on an individualized basis. “In determining whether or not an inmate is suitable or unsuitable for parole, ‘[t]he relevant determination for the Board . . . is, and always has been, an individualized assessment of the continuing danger and risk to public safety posed by the inmate.’” In re Lewis, 91 Cal. Rptr. 3d 72, 82–83 (Ct. App. 2009) (quoting In re Lawrence, 190 P.3d 535, 564  (Cal. 2008)). However, the individualized assessment is simply concerned with the inmate’s current danger and not their cognitive-ability level which could impact how they are able to demonstrate their rehabilitation.

 [117]. Forensic Assessment Division, Cal. Bd. of Parole Hearings, http://www.cdcr.ca.gov
/BOPH/fad.html (last visited Aug. 20, 2018).

 [118]. Id.

 [119]. Id.

 [120]. Board of Parole Hearings’ Revised Final Statement of Reasons 15 CCR § 2240, Cal. Bd. of Parole Hearings 23 (2012), https://www.cdcr.ca.gov/boph/docs/revised_final_statement
_reasons_original.pdf [hereinafter Final Statement of Reasons].

 [121]. Cal. Code Regs. Tit. 15 § 2240(b) (West 2018).

 [122]. See Cal. Pen, Code § 3041(b)(1) (West 2018). The higher the risk assessment score the better able the Board is to find that “consideration of the public safety requires a lengthier period of incarceration for this individual.” Id.

 [123]. Final Statement of Reasons, supra note 120, at 4.

 [124]. Id. at 4.

 [125]. Id. at 26.

 [126]. See, e.g., Cal. Code Regs. tit. 15 § 3270 (West 2018).

 [127]. Id. § 3312 (a)(2)–(3).

 [128]. Id. § 3314.

 [129]. Id.

 [130]. Id.

 [131]. Weisberg et al., supra note 38, at 5.

 [132]. Cal. Code Regs. tit. 15 §§ 2281 (c)(5)-(6). (West 2018).

 [133]. Id.

 [134]. Cal. Code Regs. tit. 15 § 3317.1 (West 2018).

 [135]. Id.

 [136]. Id.

 [137]. Facts About Developmental Disabilities, Ctrs. for Disease Control & Prevention, https://www.cdc.gov/ncbddd/developmentaldisabilities/facts.html#ref (last visited Aug. 20, 2018).

 [138]. Cal. Pen. Code § 3043 (West 2018).

 [139]. About the Narcotics Anonymous (NA) 12-Step Recovery Program, Recovery.org (Aug. 13, 2018), https://www.recovery.org/topics/about-the-narcotics-anonymous-na-12-step-recovery-program.

 [140]. Insight, Merriam-Webster Dictionary (11th ed. 2016).

 [141]. Insight, Oxford Dictionary (3d ed. 2011).

 [142]. See In re Lawrence, 190 P.3d 535, 541, 563 (Cal. 2008). See also In re Shaputis, 190 P.3d 573, 584–85 (Cal. 2008).

 [143]. Wattley, supra note 18, at 273.

 [144]. Shaputis, 190 P.3d at 584. See Wattley, supra note 18, at 273. When parole is denied, there are typically multiple reasons cited. “Within 20 days following any decision denying parole, the board shall send the inmate a written statement setting forth the reason or reasons for denying parole, and suggest activities in which he or she might participate that will benefit him or her while he or she is incarcerated.” Cal. Pen. Code § 3041.5 (b)(2) (West 2018).

 [145]. In re Ryner, 126 Cal. Rptr. 3d 380, 392 (Ct. App. 2011). See In re Rodriguez, 122 Cal. Rptr. 3d 691, 699–700 (Ct. App. 2011).

 [146]. In re Rosenkrantz, 59 P.3d 174, 182–83 (Cal. 2002).

 [147]. Shaputis, 44 P.3d at 584–85 n.18.

 [148]. Id. See also Rodriguez, 122 Cal. Rptr. at 702–03; In re Twinn, 118 Cal. Rptr. 3d 399, 417–18 (Ct. App. 2010).

 [149]. Ryner, 126 Cal. Rptr. 3d at 391.

 [150]. Id. at 390. See also In re Shippman, 110 Cal. Rptr. 326, 354 (Ct. App. 2010) (Pollack, J., dissenting).

 [151]. Ryner, 126 Cal. Rptr. 3d at 392.

 [152]. Id.

 [153]. In re Denham, 150 Cal. Rptr. 3d 177, 187–88 (Ct. App. 2012).

 [154]. Id. at 188.

 [155]. Id.

 [156]. In re Twinn, 118 Cal. Rptr. 3d 399, 415 (Ct. App. 2010).

 [157]. Id. at 402–03.

 [158]. Id. at 414.

 [159]. Id. at 417–18.

 [160]. See, e.g., In re Ryner 126 Cal. Rptr. 3d 380, 390 (Ct. App. 2011).

 [161]. In re Rosenkrantz, 59 P.3d 174, 183–84 (Cal. 2002).

 [162]. Cal. Code Regs. tit. 15 § 2402 (West 2018).

 [163]. Wattley, supra note 18, at 273.

 [164]. See In re Powell, 755 P.2d 881, 885–86 (Cal. 1988).

 [165]. Id.

 [166]. Id.

 [167]. Alice Medalia & Hadine Revheim, Dealing with Cognitive Dysfunction Associated with Psychiatric Disabilities, N.Y. Off. of Mental Health, https://www.omh.ny.gov/omhweb/cogdys
_manual/cogdyshndbk.htm (last visited Aug. 20, 2018).

 [168]. Petersilia, supra note 7, at 61.

 [169]. Ctrs. for Disease Control & Prevention, supra note 137.

 [170]. See supra Section III.B.

 [171]. See, e.g., Riley et al., supra note 78, at 19.

 [172]. Id. at 23.

 [173]. Id.

 [174]. Id.

 [175]. See generally In re Shaputis, 190 P.3d 573 (Cal. 2011); In re Lawrence, 190 P.3d 535 (Cal. 2008).

 [176]. See, e.g., Ctrs. for Disease Control & Prevention, supra note 137 (Developmental disabilities are a group of conditions due to an impairment in physical, learning, language, or behavior areas.”).

 [177]. Riley et al., supra note 78, at 23.

 [178]. Id. A TABE score reflects grade level skills achievement. A TABE score of under 4.0 would indicate an individual is performing below a fourth-grade level in the tested subject.

 [179]. Id.

 [180]. Id. at 25.

 [181]. Adult Basic Education (ABE) I, II, and III, Cal. Dep’t of Corr. & Rehab., http://www.cdcr.ca.gov/rehabilitation/ABE.html (last visited Aug. 20, 2018).

 [182]. TABE Test, Study Guide Zone, https://www.studyguidezone.com/tabetest.htm (last visited Aug. 20, 2018).

 [183]. Id.

 [184]. Adult Basic Education (ABE) I, II, and III, supra note 181.

 [185]. Cal. Pen. Code § 2053.1 (West 2018).

 [186]. See generally Model Rules of Prof’l Conduct r. 1.3 (Am. Bar. Ass’n 2016).

 [187]. 3 Witkin, Cal. Crim. L, & Punishment § 731 (4th ed. 2012). See also In re Lugo, 80 Cal. Rptr. 3d 521, 533 (Ct. App. 2008) (“By its nature, the determination whether a prisoner should be released on parole is generally regarded as an executive branch decision. The decision, and the discretion implicit in it, are expressly committed to the executive branch.”).

 [188]. Witkin, supra note 187.

 [189]. Wattley, supra note 18, at 271. See also Swarthout v. Cooke, 562 U.S. 216, 219–20 (2011); Bd. of Pardons v. Allen, 482 U.S. 369, 373–81 (1987).

 [190]. See Clark v. California: Remedial Plan 1, supra note 73, at 1–2.

 [191]. Cal. Penal Code § 5075.6(b)(1) (West 2018).

 [192]. Petersilia, supra note 7, at 61.

 [193]. Id.

 [194]. Id.

 [195]. Id.

 [196]. See Wattley, supra note 18, at 273.

 [197]. Petersilia, supra note 7, at 29.

Volume 91, Number 4 (May 2018)

Volume 91, Number 4 (May 2018)

The Health Insurer Nudge – Article by Wendy Netter Epstein

From Volume 91, Number 4 (May 2018)
DOWNLOAD PDF


 

The Health Insurer Nudge

Wendy Netter Epstein[*]

Lawmakers are looking for Affordable Care Act savings in the wrong place. Removing sick people from risk pools or reducing health plan benefits—the focus of lawmakers’ attention—would harm vulnerable populations. Instead, reform should target the $210 billion worth of unnecessary care prescribed by doctors, consented to by patients, and paid for by insurers.

 This Article unravels the mystery of why the insurance market has failed to excise this waste on its own. A toxic combination of mismatched legal incentives, market failures, and industry norms means that the insurance market cannot solve the problem absent intervention.

But this intervention could be a simple nudge: steering decisionmakers away from unnecessary care, while protecting the autonomy of doctors and patients. Insurers should require, by contract, that providers receive an automated warning before ordering commonly overused interventions. Such computer-driven nudges have been effective in other contexts and would reduce premiums without harming those most in need of help. Because insurers lack appropriate incentives to nudge, the law must mandate them.

TABLE OF CONTENTS

Introduction

I. The Problem: High Rates of Unnecessary and Ineffective Health Care

A. Rising Premium Rates in Health Care and the Unnecessary Care Cause

B. High Rates of Unnecessary Care Increases Premiums and Harms Patients

1. Overutilization

2. Misconsumption

3. The Harm of Unnecessary Care

C. The Actors That Contribute to High Rates of Unnecessary Care

1. Doctors

2. Patients

II. Rational Insurers Should Screen for Unnecessary Care, But Laws, Markets, and Norms Get in
the Way

A. History of Insurer Approaches to Coverage Decisions

1. Deference to Physicians (Early Years–1970s)

2. A Move to Insurer-Driven Reimbursement Decisions (1970s–1990s)

3. The Pendulum Swings (Mostly) Back to Physician-Driven Reimbursement (1990s–Present)

B. Why Payors Often Reimburse for Unnecessary Care

1. Difficulty and Administrative Cost in Identifying
Unnecessary Care

2. Legal Constraints and Desire to Avoid Negative Publicity

3. Insurers Just Raise Premiums Instead

4. Physician and Patient Autonomy

III. Between Autonomy and Death Panels: The Need for a Nudge

A. The Autonomy Value is Important but Dangerous if Unalloyed

B. The Promise of Nudge

1. Types of Nudges

2. Criticism of Nudges

IV. Nudging Away Unnecessary Care

A. The Proposed Solution: A Warning Nudge

1. The Data on Which to Base Warnings

2. Why Warning Nudges Would Be Effective

B. The Need to Mandate This Nudge

C. Addressing Challenges and Suggestions for Further
Study

1. A Paternalistic Approach

2. Concerns About Data

3. Obtaining Buy-In from Providers

4. IT Resistance and Alert Fatigue

5. Cost of Compliance

6. Patients Ultimately Make Care Decisions

Conclusion

 

Introduction

In the current health reform debate, policymakers are looking for ways to lower both premiums and overall health insurance costs. Discussions have largely centered on options like reducing coverage or removing sick people from risk pools.[1] These approaches, however, would severely harm vulnerable segments of the population.[2] Policymakers should instead focus on ways to reduce unnecessary care.

Health care spending in the United States is bloated by payments for expensive treatments that are unnecessary and ineffective.[3] Arthroscopic knee surgery for osteoarthritis works no better than a placebo surgery, and yet it continues to be routinely performed.[4] Pre-operative chest X-rays are often ordered for patients with no symptoms of heart or lung disease, even though they are unlikely to yield useful information.[5] MRI’s for uncomplicated headaches are on the rise, despite guidelines recommending they not be used.[6] And the list goes on.[7]

The United States significantly outspends all other industrialized nations in health care, yet does worse in most measures of quality.[8] Unnecessary care is a big part of the problem.[9] By some estimates, spending on unnecessary care accounts for as much as 30% of total health care spending—on the order of $750 billion per year, with $210 billion of that spent on unnecessary services.[10] An Institute of Medicine report made the sobering analogy that if the price of milk had grown as quickly since 1945 as the cost of unnecessary health care, a gallon of milk would [now] cost $48.[11] Spending on unnecessary care raises systemic costs, ultimately raising insurance premiums and pricing some patients out of the market. It can also harm patients who are exposed to unnecessary radiation, complications, infections, and emotional harm.[12]

Unnecessary care is consumed because doctors prescribe it, patients consent to it, and payors pay for it. The role of doctors and patients in creating this problem has received considerable attention in the literature.[13] Economic incentives, cultural norms, and legal incentives stemming from the medical malpractice system cause doctors to over-test, over-prescribe, and over-treat.[14] Patient decision-making is also subject to informational deficits and cognitive biases that lead many to err on the side of more treatment—doing something feels better than doing nothing.[15] Furthermore, moral hazard makes patients inefficiently price sensitive,[16] and lack of price transparency impedes patient ability to take cost into account in making decisions.[17] Significant efforts are underway to address these patient and physician-centric problems, although they are not without challenges.[18]

But what is particularly perplexing is why insurance companies and government payors are reimbursing for high-cost, unnecessary care. Of all the actors in the complicated web that is health care, insurance companies would seem best situated to act as a check on patients and doctors. A rational, profit-maximizing insurance company—or even a nonprofit one—should be motivated to refuse reimbursement for unnecessary care that fails to improve patient health and might even harm it. Insurers able to reduce claims costs would increase profit margins or at least be able to reduce premiums. But while insurers occasionally refuse coverage, particularly for so-called “experimental” procedures, the vast majority of the time, they defer decisions on the medical necessity of treatment to physicians.[19]

There are reasons that insurers do so, grounded in norms, imperfect markets, and laws.[20] For one, it can be hard to identify with requisite certainty which expensive procedures are likely to be ineffective.[21] And the possibility of error in these determinations could have dire consequences. Consider, for example, the insurer that refuses to pay for a certain cancer treatment that, it later learns, would have saved the patient’s life. Private insurers, for a variety of reasons, tend to follow the lead of Medicare in coverage decisions.[22] Insurers also might lack adequate incentives to incur the administrative costs of a stricter medical necessity review, particularly when insurers can instead raise premiums in an imperfectly competitive market.[23] And in some cases, state statutes and common law require insurers to defer to doctors on the medical necessity of care.[24]

But perhaps the biggest hurdle is the norm of patient and physician autonomy. Health Maintenance Organizations (HMOs) were strongly criticized when their utilization reviews were said to infringe on patient and physician autonomy in making medical decisions.[25] The predominant arguments were that each patient is different, medicine is more of an art than a science, and doctors employed by insurance companies should not be able to override the decision of a doctor who has actually examined the patient.[26] The autonomy argument is still commonly made today—often in the form that a patient’s right to self-determination is particularly strong in health care where patients are charged with making very personal decisions that affect their own bodies.[27]

But while patient and physician autonomy are important, patients and physicians do not operate in a vacuum. When patients and physicians choose unnecessary care, and that care is reimbursed by a private or government payor, the decision has repercussions beyond the patient’s individual well-being.  Other members of the risk pool bear the reimbursement cost.[28]

And there are other considerations. Since the original outcry against HMO utilization reviews, data has improved. While there are circumstances in which the individual patient’s knowledge is particularly important, much can be learned from the data that apply across broad categories. We can now identify some common tests and procedures that are over-used and the circumstances in which such overuse is particularly likely. Over time, we will be able to identify more circumstances and make these determinations more personalized.[29] There are many organizations—private and governmental—gathering this data.[30] And while there is still a tremendous amount of work to be done, all indications are that progress will continue.

Also, the challenge of addressing overuse of health services by changing patient and doctor behavior persists. De-biasing decisionmakers is difficult, transparency is slow in the making, and changing payment incentives can have perverse effects.[31] Consider, as well, that we now better appreciate how slow medical practice is to adapt to new evidence. One study found that it takes, on average, seventeen years for custom and practice in medicine to catch up with the evidence, meaning that the majority of doctors continue to adhere to outofdate practices long after the evidence mandates change.[32] Custom and practice-based medical malpractice law, therefore, also does little to stem the tide of unnecessary care.[33]

The time has therefore come to revisit the role of payors in addressing the unnecessary care problem. Payors cannot be tasked with making reimbursement decisions absent input from physicians. There are too many land mines, including that insurer financial motivations can prompt denial of reimbursement for profit maximization reasons, rather than for the betterment of patient health.[34] Yet individual circumstances and doctor intuition still matter. Political headwinds against “death panels” are too strong to contemplate payor power absent a role for doctors and patients. Neither can unabated physician and patient autonomy in decision-making carry the day. Payment decisions not only affect individuals, but impose costs on society writ large.

The problem begs for a middle path—a way to steer decisionmakers away from unnecessary care while still protecting the right to choose.[35] Insurers motivated by reducing claims costs should require the implementation of a nudge: an automated warning to providers when they try to order a test that is known to be overused or a treatment that evidence suggests will be ineffective. Essentially, the insurer should require the provider’s ordering system prompt the doctor with a warning saying, “are you sure you want to prescribe this test?” There is preliminary evidence that such nudges can move the needle in significant ways.

There are hurdles to consider. Caution should be exercised about the quality of the data on which nudges are based. Building the necessary information technology (“IT”) capacity would be costly. Providers might become conditioned to these warnings and begin to ignore them or might resent the additional administrative step of having to click through another screen. But perhaps the most important hurdle is that payors are inadequately incentivized to implement these nudges on their own. Regulators therefore need to mandate such a system.

Part I of this Article starts by describing the problem of unnecessary care, the actors who cause it, even if inadvertently, and its consequences. Attempts to address the problem by changing patient and physician behaviors are well-intended but so far have not yielded enough positive change. Notably, far too little attention has been paid to payors’ roles in the unnecessary care problem.

Part II takes up the issue of payors specifically and addresses why they now do little to screen for unnecessary care. It explores the evolution in payor approaches to coverage determinations, from complete respect for physician autonomy to more active insurer decision-making and back again, and concludes by exploring payor incentives. A combination of imperfect markets, laws backing physician autonomy, and industry norms explain why the market has not corrected the unnecessary care problem on its own.

Part III makes the normative argument that unalloyed respect for physician and patient autonomy is dangerous. On the other hand, failure to guard autonomy entirely is equally problematic. Such situations are ripe for nudges. In order to move decision-making away from the problematic poles between which the industry has vacillated over its history, and given the imperfect functioning of insurance markets, this Part suggests that a nudge may be required.

Finally, Part IV sets out the proposed solution—an automated warning to providers when they try to order care that is likely to be unnecessary. Studies of warning-type nudges give reason for optimism that this transparent and autonomy-respecting regime can be successful, although Part IV also explores the challenges to its success.

I.  The Problem: High Rates of Unnecessary and Ineffective Health Care

The Affordable Care Act (“ACA”) has been shrouded in controversy—both political and legal—since its passage in 2010. Heated debates about the individual mandate,[36] Medicaid expansion,[37] and religious objections to coverage of contraceptives[38] have dominated the conversation. Although these debates continue, the rhetoric on repealing and replacing the ACA has centered of late on a very practical problem: high premium rates.

A.  Rising Premium Rates in Health Care and the Unnecessary Care Cause

Premiums rates have risen significantly over the past decade.[39] Rising premiums were an important theme in the 2016 presidential election. Then-candidate Donald Trump pressed his case for doing away with the ACA with particular fervor following the release of a government report in October 2016 that detailed rate hikes. In one of the presidential debates, he stated: “[O]ne thing we have to do, repeal and replace the disaster known as Obamacare. [I]t’s destroying our country . . . . [T]he premiums are going up 60, 70, 80%.”[40] The issue of high premium rates was, by many accounts, salient with voters.[41]

After the election, President Trump and other Republican leaders continued to press the point, emphasizing the need to lower premiums as a key reason to repeal and replace the ACA.[42] In fact, premiums do generally seem to be on the rise, although increases have been highly variable nationwide.[43] On average, premiums for individual policies purchased on the Exchanges rose about 25% in 2017.[44] For those who obtain their policies through employers, premiums increased by a more modest amount, but still went up faster than wages.[45]

There is some debate about just how problematic increasing premium rates are. The premium increases largely track the 2009 Congressional Budget Office estimates for premium rates at the time the ACA was passed.[46] And despite increasing premiums, about 85% of enrollees through the Exchanges receive premium tax credits, which lower their premiums to 10% of their income.[47] Even so, someone has to pay when premium rates go up.[48] For the most part, that health care costs are too high and that health reform should focus on bringing down costs generally and premiums specifically are rare points on which liberals and conservatives in the health care debate agree—even if they disagree on how to go about it.[49]

There are many reasons why health insurance premiums have gone up under the ACA.[50] Recent attention, particularly among Republicans, has focused on two such reasons: the requirement of more robust coverage and the expense in covering sicker insureds.[51] The ACA requires that plans cover “essential health benefits,” which include ten core categories of health care services.[52] Plans providing broader coverage are raising premiums to cover the additional claims costs.[53] The ACA also prevents plans from experience rating, which means charging sicker patients higher rates. Because plans are prohibited from excluding patients with pre-existing conditions and cannot charge them more, premiums have also gone up.[54]

But fixing either of these problems is difficult and requires making troubling trade-offs. For instance, Republican plans to replace the ACA have contemplated allowing insurers to offer skimpier coverage or permitting insurers to charge sicker people higher premiums.[55] Whether these results are palatable turns on difficult value judgments, but for many, these approaches are inscrutable and impossible to justify because of their negative impact on vulnerable populations like the sick and the poor.[56]

Yet there is another important contributor to high premium rates that is well-documented, but has largely eluded policymaker focus in the repeal and replace debate: the fact that premiums are hugely bloated by unnecessary care.[57] Fixing this problem would implicate far fewer value judgments. If it were possible to reduce premiums by cutting back on unnecessary care, it would be hard to imagine many objections.[58] And policymakers might not have to submit to skimping on benefits or failing to cover sick people to decrease premiums. The next section describes the problem of unnecessary care and how it impacts insurance rates.

B.  High Rates of Unnecessary Care Increases Premiums and Harms Patients

The term “unnecessary health care”[59] describes the provision of “services which show no demonstrable benefit to patients.”[60] Unnecessary care includes both “overutilization”—too much care that does not improve patient health[61]—and “misconsumption”—the wrong choice of care when a different choice (or even doing nothing) would lead to better outcomes.[62] Taken together, overutilization and misconsumption have dire consequences for both the cost of health care and patient well-being.

1.  Overutilization

There are many examples of overutilization of care, but perhaps the most prominent are the overuse of imaging, diagnostic tests, and antimicrobials (including antibiotics).[63]

Imaging studies, such as magnetic resonance imaging (MRI), ultrasound imaging, computed tomography (CT) scans, and conventional X-rays, create visual representations of the body’s inside for clinical analysis.[64] Advances in imaging techniques have greatly enhanced the ability of physicians to diagnose a wide variety of ailments.[65] But imaging can be both expensive[66] and harmful to patients, and many studies have now determined imaging to be markedly overused.[67] For instance, X-rays for uncomplicated lower back pain, CT scans for sinusitis, and MRI scans for uncomplicated headaches, are all commonly performed but often not clinically indicated.[68] A 2016 University of Michigan study found that nearly 60% of the advanced imaging “performed for more than 29,000 Michigan women diagnosed with early breast cancer between 2008 and 2014 could not be medically justified based on retrospective record review.[69] One report estimates that 2050% of all high-tech imaging is unnecessary.[70]

Laboratory tests are similarly overused—by some estimates on the order of 6070% more than necessary.[71] These tests do not contribute towards management of patients.[72] Consider as a particularly illuminating example the documented overuse of BRCA-1 genetic tests in patients for whom such testing was not clinically indicated.[73] Although the BRCA-1 tests have come down in price following the Supreme Court’s holding in Association for Molecular Pathology v. Myriad Genetics that isolated DNA sequences are not patentable,[74] the Myriad test at one point cost $3,000.[75]

Finally, the prescription of antimicrobials (which includes antibiotics and antifungals) when medically inappropriate is an important example of overutilization.[76] In 2016, the Centers for Disease Control and Prevention released a study in collaboration with other medical experts that found that at least 30% of antibiotics prescribed in the United States are unnecessary.[77] Overuse includes the prescription of antibiotics for conditions caused by viruses that do not respond to antibiotics.[78]

2.  Misconsumption

In addition to overutilization, much care is also misconsumed in the United States. Misconsumption is essentially inappropriate treatment that medical guidelines do not support, but that doctors nonetheless perform.[79] Misconsumption often comes from treatments that became popular absent evidence of efficacy—and maybe even became the standard of care—but were later determined to generally not be effective. While some misconsumption naturally ends over time once evidence of ineffectiveness becomes widely known, much still persists. Often misconsumption continues for many years after dispositive evidence that the procedure is ineffective.[80] In other words, the standard of care is very slow to conform to evidence.[81]

Consider the case of knee arthroscopy for osteoarthritis, where a fiberoptic endoscope and surgical instruments are inserted into the knee to smooth rough surfaces and repair tears in the cartilage and meniscus.[82] A review of past gold standard studies clearly shows that the procedure is not beneficial to osteoarthritis patients, yet doctors continue to perform it.[83]

There are many other procedures that fall in a similar category: spinal fusion surgeries for low back pain on worn out discs,[84] vertebroplasty for osteoporotic vertebral fractures,[85] placement of coronary stents in patients with nonacute indications,[86] laparoscopic uterine nerve ablation for chronic pelvic pain,[87] and removal of healthy ovaries during a hysterectomy.[88] Radical mastectomy was the standard of care for breast cancer for decades and continues to be in wide use even after a randomized trial revealed that it was no better at protecting women from cancer than more conservative techniques.[89]

3.  The Harm of Unnecessary Care

Rates of both overutilization and misconsumption in the United States are disturbingly high. The United States spends approximately 17% of gross domestic product (GDP) on health care services—the highest percentage by a wide margin of any industrialized nation.[90] According to the Institute of Medicine, the provision of unnecessary care accounted for more than 8% of health care spending in the United States in 2009 ($210 billion out of $2.6 trillion).[91] The Congressional Budget Office warns that the costs associated with unnecessary care are significant and growing.[92] Studies of Medicare specifically have led to similar conclusions. One well-known study of Medicare claims found large regional variations in Medicare spending, with enrollees in higherspending regions receiving more care than those in lowerspending regions.[93] Yet health outcomes and satisfaction with care were no greater in the higher utilization regions than in the low utilization regions.[94]

As National Institutes of Health bioethicist Ezekiel Emanuel and Stanford economist Victor Fuchs concluded in their 2008 article, The Perfect Storm of Overutilization, unnecessary care[95] is the most important contributor to high health care costs in the United States.[96] This cost is problematic both because of the financial impact and the potential harm unnecessary care causes patients.

First, consider basic economics. When insured patients receive unnecessary care, they generate claims costs that must be paid by the insurer. Insurers, and the actuaries that work for them, analyze claims costs in setting premium rates. When claims costs increase, insurers respond by raising premiums to cover the costs.[97] As premiums increase, poorer insureds in the individual market who pay premiums out of pocket become uninsured as they can no longer afford the premiums.[98] Poor, uninsured individuals who do not qualify for Medicaid cannot access care except through charity and in emergency rooms.[99] That care becomes more costly than before the care became emergent.[100] And it likely results in debt, which is recovered only through government funds or hospitals raising overall rates.[101] The bottom line is that increasing premiums has a domino effect that not only negatively impacts individuals who have to pay more to cover insurance premiums, but also increases the number of uninsureds with all of the consequences that follow.

The Affordable Care Act attempted to address the problem by subsidizing premiums for poorer individuals through tax credits.[102] As premiums increase, individuals receive larger subsidies so that the percentage of their income they must pay to cover premiums is fixed. But while the tax credits may indeed prevent people from becoming uninsured, rising premium rates means the government must pay ever-increasing rates to subsidize insurance for these individuals.[103]

High rates of unnecessary care also result in premium increases for employer group insurance plans.[104] In response to increasing premiums, employers must either pass a higher percentage of costs onto employees[105] or they must make other sacrifices to try to reduce costs, such as by narrowing networks, increasing deductibles and copays, or choosing less robust coverage plans. Alternately, employers may pay employees less to account for larger employer shares of health insurance premiums.[106]

And it is not just private insurance that is affected. High rates of unnecessary care increase government spending under Medicare and Medicaid, too. The Congressional Budget Office has found that higher per beneficiary spending spurred by unnecessary testing and procedures is a clear driver of rising Medicare expenses.[107]

Second, patients are harmed in non-economic ways by unnecessary care. The delivery of care inherently involves risk and may lead to complications. Patients who needlessly receive medical interventions are subject to health care-associated infections, . . . post-operative complications such as blood clots, and other harms.[108] A recent report suggests that medical errors might be the third most common cause of death in the United States.[109] Unnecessary care increases a patient’s risk of being subject to medical errors.

Further, exposure to excess radiation from unnecessary imaging can be dangerous. One study estimates that excess radiation from overuse of CT and MRI scans causes 1.5%–2% of all cancers.[110] Unnecessary diagnostic testing can also lead to overdiagnosisthat is, the diagnosis of a person with a condition that will not cause harm or would otherwise have remained irrelevant.[111]

Problems from overuse of antimicrobials are also significant, putting patients at needless risk for allergic reactions and other side effects. The overuse of antibiotics drives antibiotic resistance, endangering patients who actually require antibiotics to treat bacterial infections.[112]

Given this parade of horribles, the logical question is how we have ended up with such tremendous levels of unnecessary care being consumed in American health care.

C.  The Actors That Contribute to High Rates of Unnecessary Care

High rates of unnecessary care are not attributable to a single actor. Most of the scholarly focus to date has been on the contribution of patients and doctors to the problem. In their famous 2008 article, Drs. Emanuel and Fuchs described how doctor and patient incentives lead to the “perfect storm of ‘more’” care.[113]

1.  Doctors

Doctors’ contributions to unnecessary care are well-documented in the literature and therefore only briefly described here. They include the fee-for-service reimbursement system, the perceived need to practice defensive medicine, and the training and culture of physician-delivered care.

First, doctors are typically paid based on the services they provide. The more tests and procedures ordered and performed, the higher their compensation.[114] A doctor therefore has a financial incentive to do more, not less.

Second, the medical malpractice liability regime encourages doctors to practice “defensive medicine,” where doctors order more diagnostic tests and perform more medical procedures to protect them from later being sued for not doing enough.[115] In a Pennsylvania study, 92% of the 824 physicians surveyed reported ordering imaging tests and diagnostic measures for assurance against malpractice liability.[116]

Finally, cultural norms spur unnecessary care. Doctors are instilled with a commitment to leave no stone unturned on behalf of their patients and to put patient health above financial considerations.[117] At the same time, there are no approved standards of care. What physicians learn in medical school becomes their standard practice, and it can be difficult to uproot learned practices despite new evidence.[118] It can also be difficult for physicians to keep abreast of new evidence.[119] Further, incentive to conduct high quality studies of effectiveness is lacking given that payment is based on standard practice, not evidence, and there is typically little opportunity to monetize research findings.[120]

Given how slow medical practice is to adapt to new evidence,[121] custom and practice-based medical malpractice law also does little to stem the tide of unnecessary care. The FDA regulates pharmaceuticals for efficacy, if imperfectly,[122] but only the laws of medical malpractice and informed consentand the market if it were properly functioningserve as a check on the provision of ineffective medical services.

Attempts have been made, and continue to be made, to mitigate these problems. Payment reforms attempt to encourage doctors to reduce costs while maintaining quality—to give doctors an incentive to avoid low-value care.[123] And tort reform attempts to lessen the perceived need to practice defensive medicine.[124] But these solutions, at least as of yet, have not significantly stemmed the tide of unnecessary care.[125]

2.  Patients

Doctors are not alone in contributing to the unnecessary care problem. Patients must consent to the care they receive.[126] While some patients are merely susceptible to their physician’s suggestions, others drive the provision of unnecessary care, convincing their doctors to agree to their desired care.[127]

For one, patients are subject to a number of cognitive biases that cause them to insist on extra tests or prescriptions.[128] There is a cultural preference for “more,” particularly when it comes to technological solutions.[129]

Adding to this, the nature of insurance creates moral hazard, where patients lack adequate financial incentive to refuse unnecessary care.[130] Patients’ monthly premiums are a sunk cost, and they spend little out-of-pocket (at least historically) for the care they consume.[131]

Lack of price transparency further exacerbates the situation.[132] Patients who might be deterred from overuse by the cost of tests and procedures are not motivated to turn down care because they do not have insight into cost at the time of decision-making.

As with physician incentives, efforts have been made to address patient incentives—to improve patient decision-making so that it does not contribute to waste of health care resources. For instance, there has been a big push in the last decade to de-bias patient decision-making and encourage rational choice.[133] Efforts have been made to address moral hazard by giving patients more skin in the game through consumer-driven health care. As a supplement to these efforts, policymakers have tried to make costs more transparent. These policy initiatives attempt to stem the tide of unnecessary care.[134] But just as with efforts to address physician biases, these patient-centric efforts have, so far, not made a big impact.

What is obviously missing from this story is a discussion of payors who currently reimburse the unnecessary care that is being consumed. The next Part explores why payors tend to be complicit in the storm of unnecessary care, despite what would appear to be contrary incentives.

II.  Rational Insurers Should Screen for Unnecessary Care, But Laws, Markets, and Norms Get in the Way

While physician and patient incentives to increase unnecessary care are well-documented, it is perplexing why insurance companies[135] are paying for high-cost, unnecessary care. Of all of the actors in the complicated health care web, insurance companies seem best situated to act as a check on patients and doctors. A rational, profit-maximizing insurance company—or even a nonprofit one[136]—should be motivated to refuse reimbursement for unnecessary care to lower claims costs.

This Part details how insurance companies have approached coverage determinations over time. It then addresses the various counterintuitive reasons—grounded in market failures, legal incentives, and industry norms—that insurers today often reimburse for unnecessary care.

A.  History of Insurer Approaches to Coverage Decisions

Private health insurance is governed by what essentially amounts to a three-party contract. Patients agree to pay insurance companies fixed monthly premiums, and these premiums entitle patients to coverage, which means the insurer makes payments to cover the patient’s care. Providers are reimbursed for the care they provide (either directly or indirectly) by these insurer payments.[137]

Insurance contracts are necessarily incomplete.[138] With perfect information, an insurer could specify by contract what it is agreeing to reimburse for. But typically, the parties do not know at the time of contracting what type of care the patient will need or what an appropriate treatment for the patient will be.[139] Insurance contracts address this problem in two general ways. First, they define broad categories of care that are either covered or excluded.[140] For instance, emergency room visits might be covered, but experimental treatments or cosmetic procedures excluded. Second, within those categories for which a policy provides coverage, the insurer agrees to reimburse only for tests and procedures deemed “medically necessary.”[141] This approach to defining coverage is intended as a work-around for the incomplete contracts problem.[142]

Over time, approaches to determining the bounds of reimbursement have evolved, from an early period marked by deference to physician decision-making on matters of medical necessity, to insurer attempts to more actively manage the reimbursement process, and then back again to a mostly physician-centered approach.[143]

1.  Deference to Physicians (Early Years–1970s)

Although the term “medically necessary” is vague, it initially mattered little. Prior to the mid-twentieth century, medicine was dominated by physician paternalism.[144] Physicians made medical decisions on behalf of patients, and insurance companies reimbursed for the care provided without question.[145] Use of the term “medical necessity” in contracts was really a delegation to one party—the doctor—to make decisions about what care was required.

The few court cases that emerged from this period are consistent with the norm of deference to physician decision-making. For instance, in the 1966 case Mount Sinai Hospital v. Zorek, a patient’s physician sought to hospitalize a patient to treat her obesity.[146] In a move that was rare for the time, the insurer objected to paying for the hospitalization.[147] The court concluded that the insurer must defer to the treating physician and pay for the treatment prescribed.[148] The court reasoned that “[o]nly the treating physician can determine what the appropriate treatment should be for any given condition. Any other standard would involve intolerable second-guessing . . . .[149]

However, by the early 1970s, the tide started to turn, as the United States faced the first real crisis of rapidly expanding health care costs.[150] With doctors paid on a fee-for-service basis, and patients largely insulated from cost by their insurers, demand and reimbursement for services rose quickly.[151] In response, policymakers turned to managed care to contain costs.[152] With it came new approaches to insurer reimbursement that were less deferential to physicians.

2.  A Move to Insurer-Driven Reimbursement Decisions (1970s–1990s)

Although managed care was first introduced after World War I, it gained popularity as a delivery model in the 1970s and 1980s. Managed care organizations (MCOs) were designed primarily to manage cost and utilization.[153] Their ascendancy eroded physician power in driving reimbursement decisions.[154]

One of the key ways that MCOs attempted to rein in costs was by more stringently reviewing utilization of health care resources—by both prospective and retrospective review of claims.[155] Prospective review required physicians to justify the medical necessity of the prescribed service or procedure to the insurer before the service was delivered.[156] It usually took the form of requiring pre-approval or prior authorization.[157] The idea was to weed out unnecessary care before it occurred.

With retrospective review of claims, insurers reviewed requests for reimbursement after care had already been delivered, refusing requests the insurer deemed unnecessary.[158] The purpose of retrospective review was to uncover provider practice problems and deter physicians from delivering high-cost, unnecessary care.[159]

The overall result was that insurers during this period routinely refused to reimburse for care they deemed unnecessary. Particularly for patients covered by MCOs, the provision of health care services was heavily influenced by insurer decisions, not just clinical decisions.[160]

Physicians and patients did not accept this new reality without resistance. Physicians abhorred the administrative burdens MCOs imposed.[161] And they argued that insurers should not be able to substitute their judgment for a physician’s expertise. They noted that each patient has individual needs and circumstances that cannot be properly appreciated by an insurance company.[162] Much of medicine is based on intuition, not hard science, hence there was often no legitimate basis on which insurers could make decisions.[163] Physicians also criticized utilization review because it lacked transparency.[164] Patients were similarly angered, primarily by their inability to obtain the care that their doctors told them they needed.[165]

But perhaps the strongest argument against insurer-driven reimbursement decisions was that insurers had a perverse incentive to ration care.[166] Motivated by controlling costs and generating profits, insurers’ reasons for declining coverage, commonly believed to be based on cost containment and not medical appropriateness, were inherently suspect.[167]

Courts prevented insurers from entirely taking the reins in decision-making during this period, continuing in many cases to define medical necessity with reference to physician judgment.[168] But by most accounts, it was the political failure of insurer-driven reimbursement decisions that doomed the approach.[169] By the late 1990s, the pendulum had swung back, at least mostly, to deference to physician decision-making.

3.  The Pendulum Swings (Mostly) Back to Physician-Driven Reimbursement (1990s–Present)

Today, private (and public) insurers are mostly punting to doctors on questions of medical necessity.[170] Insurers do still have processes for deciding whether to cover new technologies.[171] And most readers have probably had some experience with insurers refusing to pay or requiring that certain steps be taken before reimbursing for treatment. But it is not common for insurers (or the government) to evaluate the effectiveness of interventions that are already in common use—even if sound evidence suggests that the intervention is ineffective.[172] Without overwhelming evidence of harm, it is uncommon for an insurer to refuse reimbursement.[173]

The reasons for this are complicated. In response to the backlash against utilization review, laws have made it more difficult for insurers to take on physician decision-making, administrative processes have been put in place to make it easier to challenge insurer decision-making, and other realities have resulted in insurers taking a back seat to physicians and patients in assessing the necessity of care for reimbursement purposes.

B.  Why Payors Often Reimburse for Unnecessary Care

Rational insurers should be motivated to screen and refuse to pay for unnecessary care. Why don’t they? This section explores the legal, cultural, and market-based reasons.

1.  Difficulty and Administrative Cost in Identifying Unnecessary Care

It can be difficult and therefore costly for insurers to administratively identify unnecessary care. Unlike with pharmaceuticals,[174] no agency approves the effectiveness of medical procedures before they become the standard of care. Nor does any agency review continued effectiveness.[175] One of the major arguments against evidence-based medicine has always been that much of medical practice is not based strictly in science.[176]

Relatedly, differences in individual patients, detectable by the treating physician, can be hard for an insurance company to identify. These differences may make care necessary for one patient, but not another.

For these reasons, “putting a great deal of effort into identifying and eliminating unnecessary care is likely to increase rather than decrease administrative costs.”[177] If administrative costs in identifying unnecessary care are higher than insurers’ savings in rejecting reimbursement for unnecessary care, that would explain why insurers now mostly defer to physician decision-making.[178]

Given this background, perhaps it is not surprising that there is a strong industry norm of private insurers simply following Medicare’s coverage decisions.[179] The advantage is that Medicare bears the administrative cost of determining when care should be reimbursed and when it should not.[180] The disadvantage—which is a significant one—is that Medicare’s process is flawed and not designed to identify unnecessary care.[181] Rather, Medicare tends to consider whether to cover new technologies and procedures, infrequently revisiting decisions already made, despite developments in the evidence of effectiveness. Or at least, Medicare is very slow to update its coverage decisions.[182]

Following Medicare decisions, however, also has the advantage—at least perceived to be so by private insurers—of insulating them from liability.[183] The next Section discusses the legal regime that deters insurers from more actively policing unnecessary care.

2.  Legal Constraints and Desire to Avoid Negative Publicity

There are a number of legal constraints that insurers face in reviewing patient and physician decision-making about care. First, states responded to the political failure of utilization review by building up a large statutory and regulatory apparatus to monitor the actions of insurance companies. Some states require plans to use a specified definition of medical necessity and require insurers to defer to the judgment of physicians.[184] For example, in Louisiana, medical necessity is defined to include “health care services . . . that are considered by most physicians . . . to be the standard of care.”[185] In states that do not mandate a definition of medical necessity, many still require plans to submit their proposed definitions to state regulators for approval.[186]

Other restrictions on insurers are also in common use. The majority of states restrict insurer use of pre-authorization procedures[187] and the time that plans take when making prospective medical necessity determinations[188] and dictate the information that must be provided in denial letters.[189]

Perhaps the most impactful change, though, has been the increase in legislatively-mandated review processes, both internal and external, for medical necessity denials. These processes are intended to give insureds better recourse.[190] Internal reviews generally involve review by a plan physician who was not involved in the initial denial and then review by an internal committee.[191] Once internal processes are exhausted, insureds may be entitled to external review.[192]

This growth in regulation was based on the need to address real abuses of the utilization review process, as described above. But it also impacts insurers’ abilities to screen for unnecessary care and adds significant cost to insurers that refuse reimbursement for unnecessary care if their decisions are challenged.

Second, insurers are also deterred from more aggressively screening for unnecessary care by the cost of litigation. When an insurer rejects a reimbursement request on the basis that the care is not medically necessary, it can be sued for breach of contract. Then, in subsequent litigation, insurers face hurdles. Many courts still interpret “medical necessity” to be congruent with physician judgment and standard of care (and not necessarily evidence).[193] Also, ambiguities in insurance contracts are construed in favor of the insured.[194] The conventional wisdom is that courts tend to be sympathetic to plaintiffs seeking access to care they would not be able to afford absent coverage.[195] Indeed, there have been a number of high profile cases where insurers have been ordered to pay for care even where evidence of effectiveness was lacking.[196]

More recently, some scholars have expressed skepticism that medical necessity litigation is as one-sided in favor of insureds as previously thought.[197] But regardless of insurer success in these lawsuits, they provide an additional cost that deters insurers from attempting to screen for unnecessary care.

Insurers may face other liability, as well. In addition to contract suits, insurers can be sued in tort for bad faith performance of their duties to insureds.[198] And insurers have been sued—and held liable—under state insurance law.[199]

Even if insurers win when they are sued, they incur costs—both financial and often reputational, as well. “[I]nsurers are acutely aware that a well-publicized dispute over an inappropriately denied claim might cause them to lose the next renewal of their contract.”[200]

For all of these reasons, insurers are deterred from a more aggressive review of unnecessary care. But there is yet another consideration, which is that insurers have other, more foolproof ways of generating profits.

3.  Insurers Just Raise Premiums Instead

Maximizing profits[201] requires either reducing costs or increasing revenues (or even better, doing both). Where reducing costs is difficult, insurers may turn to the other option. Notably, they can increase revenues by raising premiums. Insurers frequently choose this option. Premiums have been steadily increasing over the last decade, while costs for unnecessary care have been on the rise.[202]

There should be both regulatory and market-driven checks on insurers’ abilities to raise premiums. Neither, however, seem to have significantly stemmed the tide of rate increases.

First, a competitive market should constrain insurer ability to raise premiums. Theoretically, if insurers raise rates higher than competitors, consumers would purchase plans from the competitors and revenues might actually decrease rather than increase.[203] Although advocates of the private health insurance system often assume that competition will drive down prices, empirical evidence supporting this theory is scant.[204] Rather, there is a growing body of evidence that health insurance markets are not perfectly—or even adequately—competitive.[205] Insurers wield their market power, permitting them to raise premiums without significant competitive consequence.[206]

Market concentration has exacerbated these problems.[207] Studies evaluating the effect of consolidation on pricing have found that consolidation leads to premium increases.[208] By recent measure, the top five largest insurers hold 83% of the market.[209] It seemed the so-called “big five” might even further consolidate down to three before antitrust challenges ultimately ended Aetna’s attempt to acquire Humana[210] and Anthem’s purchase of Cigna.[211] But even with five, market competition has not served as a strong check on insurers’ abilities to raise premiums.

Second, regulation might limit premium increases. Depending on the state, an insurer might need to obtain prior approval of rates from the department of insurance.[212] But in other states, insurers might only be subject to “file and use” requirements, meaning they must file their rates, but the rates need not be approved,[213] or the requirement of providing an actuarial certificate attesting that their rates are in compliance with state law.[214] The ACA has brought some increased regulatory scrutiny to insurer premiums,[215] requiring that large rate increases be evaluated to ensure they are based on valid cost assumptions.[216]

But regardless of these constraints, it is a job of regulators to keep insurance companies solvent. So if costs increase, premium increases are typically considered justified and are approved.[217] Nothing about the rate approval process scrutinizes whether insurers have made efforts to contain costs.[218] Therefore, while there is considerable regulation governing rate increases, it has not significantly impacted insurers’ abilities to raise rates.[219]

And where raising prices is prohibitive, insurers have made other business decisions to protect profits that are also viewed as more desirable than policing unnecessary care. For instance, insurers have simply withdrawn from non-profitable individual markets.[220] They have increased focus on administering employer ERISA plans where the employer bears the risk and the insurer is just paid a fee.[221] Or insurers have moved into other areas entirely, such as providing direct medical services.[222]

The final reason why insurers seem loathe to screen for unnecessary care involves the strong norms of physician and patient autonomy.

4.  Physician and Patient Autonomy

Particularly in matters concerning health, autonomy or self-rule is considered to be of great importance[223]—both to patients and physicians.[224] One physician describes, in a commonly held view, how autonomy in health care would ideally function:Everyone in society should have access to needed health care . . . . Only the physician and the patient should decide how to respond to a given medical condition. And someone should reimburse providers of health care at reasonable rates.[225]

Patient autonomy and physician autonomy mean different things and have different justifications. Patient autonomy means the right to self-determination—to make personal decisions about what happens to one’s own body.[226] It is specifically to be valued for deontological reasons.[227] Even if patients choose poorly, pure autonomy dictates that they should nonetheless be permitted to make the choice.[228]

Respecting patient autonomy is also said to further individual well-being.[229] Only the patient truly understands her goals and preferences; therefore, the patient is best-suited to make health care decisions.[230] And a patient is deserving of autonomy, so the argument goes, because the decisions are highly personal, affecting only the individual.

The theoretical basis for physician autonomy differs. Physician autonomy is a type of professional autonomy. A professional—someone who has “special power and prestige”[231]—develops a special competence.[232] In medicine specifically, physician autonomy means the freedom to make decisions on the basis of professional judgment and specialized knowledge.[233] Physician autonomy is colloquially synonymous with clinical freedom[234] and is highly valued by physicians.[235]

Both patients and physicians have been vocal about how insurers should defer to their autonomy.[236] Indeed the need to respect patient and physician autonomy was made particularly clear following the backlash against HMOs.

But even now, insurers face pressure from patients, physicians, and the organizations that represent their interests when they refuse to reimburse for care insurers deem unnecessary.[237] Take, for example, the story of Blue Cross and Blue Shield of North Carolina’s 2010 attempt to limit reimbursement for spinal fusion surgery under specific circumstances. Its proposal was backed by significant research indicating that spinal fusion surgery was ineffective in the circumstances under which it intended to refuse reimbursement,[238] but the American Association of Neurological Surgeons and the North Carolina Spine Society complained loudly. While they argued about the well-being of their patients, perhaps most importantly, they called the insurer’s decision an “intrusion into the physician-patient relationship . . . .”[239] Unsurprisingly, the insurer backed down.[240]

This is just one example to highlight the power, politically and culturally, that professional and personal autonomy arguments have.[241] These strong norms deter insurers from actively screening for unnecessary care. The autonomy value has a special moral importance in health care.[242]

Therefore, although it might seem that a rational insurer should serve as a check on patient and physician decision-making to screen out unnecessary care, important impediments exist to insurers fulfilling that role.[243] The normative question of whether or not insurers’ failure to play the part is the right result remains unanswered. The next Part argues that although insurers cannot topple autonomy rights, there is a role for them to play.

III.  Between Autonomy and Death Panels: The Need for a Nudge

Policymakers and industry experts agree that reducing unnecessary care is highly desirable. This care does not help patients—and may even harm them—and adds huge, unnecessary cost to the delivery of health care. Although the goal is uncontroversial, there is little consensus on what role, if any, insurers (and regulators) might play in effectuating change. The next Sections argue that while the importance of protecting patient and physician autonomy forecloses insurer-driven decision-making, patient and physician autonomy should not be unfettered. There is a crucial role for insurers (and ultimately providers) to play in cabining unnecessary care. These are precisely the circumstances—where autonomy must be respected, but decision-making is problematic—that call for a nudge.

A.  The Autonomy Value is Important but Dangerous if Unalloyed

There are many reasons to value patient autonomy, including both deontological and welfarist reasons. Patients should have the right to make very personal decisions concerning their own bodies.

And there are equally good reasons to respect providers’ professional autonomy, not the least of which is that professional autonomy is a key component of physician career satisfaction, which in turn is significantly associated with quality of patient care.[244] Professional autonomy motivates physicians and ensures that their expertise can be brought to bear on offering the best patient care.[245]

But arguments that this autonomy should be unfettered—an ideal of complete clinical autonomy for physicians and decision-making autonomy for patients, without concern for resources—are highly flawed.[246] The importance of autonomy cannot mean that there is no role for insurers or regulators in care decisions.[247]

First, when left entirely to their own devices, patients and physicians do not always make decisions that ultimately result in the best care.[248] Both patients and physicians suffer from a number of systematic decision-making biases that often prevent them from choosing treatment options that most improve well-being.[249] For instance, patients suffer from affective forecasting errors that lead to systematic mispredictions about how they will adapt to certain medical conditions, and they can be prone to commission bias, where doing something seems to be a better choice than doing nothing.[250] These biases and others likely contribute to the overtreatment and mistreatment problems discussed in Part I.[251]

Physician decision-making, too, is subject to biases and likely exacerbates these patient problems. Perhaps most prominently, physicians tend to be overly optimistic, believing that negative events are less likely to occur at their hands than those of others.[252] Physician financial incentives further skew care choices away from the ones that would be best for patients.[253]

Second, the autonomy value is predicated on the assumption that individual decisions do not negatively impact other members of society. That assumption is wrong.[254] Rather, the decision to consume unnecessary care ultimately increases premiums.[255] The evidence is convincing: spending is at least 30% higher than it should be—raising rates for all insureds.[256] Where an individual’s exercise of autonomy negatively impacts the rights of others in the community to exercise their own autonomy rights, the case for unalloyed autonomy is significantly weakened.[257]

The importance of autonomy does not dictate the system currently in place, where physician and patient demands for medical treatment are answered largely without question.[258] At the same time, physician and patient autonomy cannot be ignored and replaced with insurer decision-making motivated by reducing cost.[259] This was the failed experiment of the 1980s and 1990s.

Given these constraints, nudges bear consideration. A nudge holds the potential to steer decisionmakers, while still protecting autonomy.

B.  The Promise of Nudge

When it is important to protect decisional autonomy, but the exercise of autonomy alone results in suboptimal decision-making, the situation may be ripe for a nudge. “Libertarian paternalism”[260] refers to a regulatory system that “steer[s] people’s choices in directions that will improve the choosers’ own welfare” without choosing for them.[261]Nudges” are the methods implemented to steer people toward better decision-making.[262]

In Richard Thaler and Cass Sunstein’s original conception, a nudge was defined as that which “alters people’s behavior in a predictable way without . . . significantly changing their economic incentives.”[263] Nudges encourage people to choose in one way, but leave open the possibility of making a different choice—like a GPS that steers you in one direction, but lets you go a different way.[264]

Lawmakers and policymakers[265] are increasingly focusing on nudges because they can be effective without being coercive.[266] For instance, Great Britain changed the default on corporate pension plans to automatically enroll employees, while allowing opt-out.[267] The change resulted in significantly increased savings for retirement. [268] In many studies, nudges compare favorably to more traditional interventions like financial incentives, sometimes having a larger desired impact than more expensive and coercive tools.[269]

The term “nudge” describes a diverse set of potential interventions. The next section discusses the different forms that nudges can take.

1.  Types of Nudges

Perhaps the most well-known nudge is changing a default rule.[270] For instance, changing a regime from one that requires opting in to one of automatic enrollment with the right to opt out encourages enrollment, while protecting autonomy.[271] Policy defaults have been employed to encourage individuals with large mortgages to escrow funds for their taxes and insurance[272] and to nudge voters to vote by automatically registering citizens, but providing information on how to decline registration.[273]

Nudges, however, are not just changes to default rules. Other examples include moving healthy snacks to higher shelves than unhealthy ones,[274] redesigning a physician’s electronic prescribing pad to make it easier for the physician to prescribe generic medication and more onerous to prescribe a brand name drug,[275] and informing customers about their neighbor’s lower electricity usage to encourage energy conservation.[276] A vast literature has developed in the last two decades that explores nudges intended “to make people healthier, wealthier, and happier.”[277]

A warning is another particular type of nudge.[278] Consider, for example, the surgeon general’s warnings that are mandated to appear on cigarette packages, informing individuals that smoking causes lung cancer.[279] Credit card bills warn about the dangers in only making the minimum payment.[280] In general, warnings are intended to trigger an individual’s attention. As Sunstein has noted, “attention is a scarce resource, and warnings are attentive to that fact.”[281]

Warnings serve a number of purposes. In the most basic sense, they are informational.[282] They might inform a consumer of information necessary to make a decision that the consumer did not previously possess.

Warnings also serve to remind. Even if a decisionmaker might have previously known the information, she might not draw on the information in the moment of making the decision. Or because decisionmakers use judgment heuristics—essentially mental shortcuts—in making decisions, warnings can counteract incorrect or inaccurate recall.[283] For instance, warnings can work to counteract human tendency to be overly optimistic, in addition to other biases.[284]

Ultimately, the purpose of a warning is to influence behavior.[285] However, warnings have the advantage of being fully transparent,[286] and they do not impact personal autonomy. People are entirely free to ignore the warning if they choose.[287] Perhaps for this reason, warnings have been popular with both policymakers and with the individuals that they impact.[288]

Although warnings are not foolproof, there is ample empirical support for their effectiveness.[289] For example, consider a study of a warning nudge used to encourage students to make healthier selections in their school lunches. There, a computerized ordering system based on the U.S. Department of Agriculture MyPlate recommendations was used to encourage students to make healthier lunch choices. The study found that the treatment group subject to the nudge made significantly healthier food selections than the students who were not nudged.[290]

Not all warnings are successful, but a large and growing body of literature has explored the conditions under which warnings are most likely to result in the desired behavior. The next Section explores this literature and the challenges to the use of nudges more generally.

2.  Criticism of Nudges

There are some general criticisms of the use of nudges.[291] While less paternalistic than flat out regulation, nudges can still be coercive. If one believes that government should never intervene in an individual’s sovereign life,[292] then nudging is an unwanted intrusion. One critic of nudging has described nudges as “state incursions into the sphere of liberty.”[293]

For instance, the government might want to try to reduce obesity by drawing attention to the calories in fast food.[294] If one believes that the choice to be obese is one that a free individual in a free society should be able to make—and that an individual should not be forced to know how many calories they are consuming—then mandatory calorie labeling may be an unwanted governmental intrusion.

Nudging is also criticized when the goals behind its use are controversial. Put another way, the choice architect that puts in place the nudge is making certain decisions about what behavior is desirable. That choice might reflect a value judgment about which people disagree. Or it might be based on data that is imperfect or subject to interpretation.

Finally, not all nudges actually work, in the sense of accomplishing the behavior change that they intend. And although nudges are intended to be low cost, they are often not costless. There is the risk that nudging’s costs exceed its benefits in some circumstances.

Although these objections bear consideration, they are not insurmountable. Nudges do involve a degree of manipulation, but then so do essentially all decisions. It is difficult to avoid all aspects of paternalism in presenting choices. As to concerns about deciding which way to nudge, these are valid, but less problematic when the nudge is transparent.[295] If the government is the choice architect and people do not like the direction the government is nudging, they can make their opinions known by voting. If done right, nudges are transparent and preserve autonomy, muting concerns about infringement on liberty.[296] However, nudges are problematic if they are costly or do not work, which is why the gathering of good empirical data is crucial.

The use of warnings to nudge raises some additional concerns. Because warning nudges are perhaps the least coercive of all nudges, the biggest question is whether or not they work to influence choice.[297] On this question, the literature is robust. Scholars have identified the following crucial factors in determining the success of warning nudges: (i) noticeability, (ii) temporal and spatial proximity, (iii) the requirement of physical interaction with the warning, (iv) the use of concrete directions, (v) and the cost associated with warning compliance.[298]

First, warnings are likely to be most effective where they are conspicuous and brief.[299] Few people actively look for warnings. If the warning is not read by the decisionmaker, it cannot have the desired effect.[300]

Second, temporal and spatial proximity are important to warning compliance. For instance, in one study, a warning that a file cabinet would tip if the top cabinet were filled before the bottom cabinet was placed on the packing box and in various places inside the top cabinet.[301] When the warning was just on the packing box, it was viewed, read, and complied with at significantly lower rates than when it was placed inside the cabinet. Further, when the warning was placed on a cardboard bridge that had to be physically removed to fill the top drawer, compliance levels were even higher than when the warning was simply placed inside the cabinet.[302] Results from other studies are consistent: compliance is highest when the warning is delivered in both physical and temporal proximity to the task and when the decisionmaker must physically interact with it in some way.[303] Given these parameters, technology provides particularly good opportunities to deliver effective warnings at a low cost.[304]

Third, warnings are more likely to be effective if accompanied by concrete directions for the individual reading it, such as you can do X and Y to lower your risk.[305] In one study, people who used water-repellent sealer were given different labels to determine whether compliance is dependent upon the explicitness of warnings and instructions.[306] The results indicated that “procedurally explicit precautions included in the directions substantially increased reading rates from 4% to 78% and compliance rates from 10% to 65%.”[307]

Lastly, to the extent that decisionmakers view the decision of whether or not to comply with a warning through the lens of a cost-benefit analysis, then the cost of complying with a warning is particularly important and can influence warning effectiveness.[308] Compliance cost may take many forms. There may be financial costs associated with warning compliance, or there may be costs in terms of time, convenience, or emotional toll.[309] For instance, a smoker may choose to ignore the surgeon general’s warning because the costs of recovering from addiction are higher than the cost of good health—at least in that individual’s estimation. Biases can skew cost-benefit analyses.[310] In particular, the optimism bias, which causes people to discount the risk of experiencing a negative event, can be impactful. But in general, studies confirm that the lower the costs of complying with the warning, the more likely that the warning will be effective.[311]

Warnings are not perfect. Users can choose to ignore them. Plenty of people still smoke despite surgeon general’s warnings. And many still only make the minimum payment on their credit card bills. Warnings cannot always counteract other, potentially stronger forces motivating decisions. But nonetheless, there is reason to be optimistic that a properly designed warning that accounts for these challenges could effectively reduce unnecessary care. The next Part presents the proposal.

IV.  Nudging Away Unnecessary Care

The fundamental challenge with reducing unnecessary care is that there is a spectrum from patient and physician autonomy on one end to insurer decision-making on the other, where both poles are problematic, and no path to a middle ground has been identified. Complete autonomy for patients and doctors results in health care decisions being made by those with no real incentive to stop harmful overuse. But too much control by insurers means that both non-beneficial and beneficial care may be rationed.

In Crossing the Quality Chasm, the Institute of Medicine delivered the directive that, “IT must play a central role in the redesign of the health care system if a substantial improvement in health care quality is to be achieved during the coming decade.”[312] In keeping with that sentiment, the way to reduce unnecessary care, but protect patient and physician autonomy, is by employing a computerized nudge. Providers should receive an automated warning before their orders for commonly overused interventions are placed, dissuading unnecessary care without the use of inflexible, autonomy-reducing methods. In a perfect world, insurers would require this nudge in their contracts with providers. However, because a toxic combination of mismatched legal incentives, market failures, and industry norms prevents that from happening, the government will have to mandate it.

A.  The Proposed Solution: A Warning Nudge

The health care industry is notoriously behind in its adoption of technology.[313] Yet recent years have been marked by a digital transformation of medicine.[314] Use of health IT systems and electronic health records is now widespread and growing.[315] By the end of 2017, approximately 90% of office-based physicians nationwide will be using electronic health records.[316] The vast majority of hospitals and most outpatient practices now use some form of Computerized Provider Order Entry (CPOE) system, which allows providers to order tests, procedures, consultations, and prescribe medications electronically.[317] Most communications between providers and insurers now also occur electronically, with use of electronic prior authorization procedures notably on the rise. These systems are far from perfect, often scoring low on usability and interoperability.[318] Lawmakers and policymakers are continuing to explore ways to improve the state of health IT.[319] But this technology proliferation can be deployed to effectively nudge.

Systems could be programmed so that a computerized warning pops up when a provider places an order (or submits a pre-authorization) for a test or procedure that is likely to be unnecessary.[320] The warning would prompt the provider with a question that essentially asks if she is sure about the order given evidence that the test or procedure is often overutilized or misconsumed. The warning should link to additional sources of information that supply the warning’s scientific basis to the provider. And where appropriate, the warning should also suggest an alternate intervention.

For instance, when a provider enters an order for an X-ray for uncomplicated lower back pain, a CT scan for sinusitis, or an MRI for an uncomplicated headache—all of which have been identified as commonly overused tests[321]—the warning would pop up. Similarly, to address misconsumption, a warning could pop up when a provider tries to schedule (or seeks pre-authorization for) a spinal fusion surgery for a worn out disc or laparoscopic uterine nerve ablation for chronic pelvic pain.[322] The provider could proceed as planned if the provider believes that it is in the best interests of the patient to do so, but this nudge requires the provider to click “Yes, I’m sure” for the order to process.[323] Although the warning would not deter all unnecessary care, there is reason to believe it could be effective.

There is precedent for such a system already in place. Clinical decision support systems (CDSSs) are designed to help providers make care recommendations to their patients.  Early CDSS systems were used in prescribing medications, attempting to prevent medication errors by screening for drug doses, allergies, and drug interactions. CDSSs now go beyond a focus on medications and often employ alerts and warnings relevant to broader issues of patient care.[324] Some insurer systems are also screening for red flags of unnecessary care, typically as a part of their electronic pre-authorization practices[325]—although the purpose of these reviews is ultimately to decide whether or not to grant pre-authorization. Providers cannot override denials.[326]

CDSSs, however, are not yet in widespread use[327] and, as currently implemented, are both overinclusive and under-inclusive. CDSSs, particularly as employed for e-prescribing, have been criticized for the abundance of alerts that pop up when providers try to enter orders, many of which are not useful.[328] And even where CDSSs are deployed, they are still mostly used for prescribing and not for other types of orders and interventions. There is also concern about the quality of the data on which these systems are programmed.[329] The next Section takes up the data issue specifically.

1.  The Data on Which to Base Warnings

Perhaps one of the biggest questions about any computerized warning system concerns the underlying data. Who decides which orders draw warnings and how?[330] This Section makes a suggestion, but also provides alternatives worth considering.

The first, and probably best option, is to tie the warnings to the already established Choosing Wisely campaign. In 2012, the American Board of Internal Medicine Foundation, Consumer Reports, and nine medical specialty societies launched the campaign.[331] Its purpose was to promote quality, evidence-based care that was “truly necessary.”[332] Specifically, it tasked medical societies with preparing lists of five tests or procedures in their clinical domains that are performed too often.[333] The initial set of lists was well-received, and the campaign has grown from there, with more than seventy societies now involved.[334] The Robert Wood Johnson Foundation has provided considerable funding to aid its efforts, awarding grants in 2013 and 2015.[335]

To give an example of how the campaign works, the American College of Radiology (“ACR”)a nonprofit, professional medical society whose members are radiologists, nuclear medicine physicians, and medical physicists[336]generated its list of five recommendations to reduce unnecessary care in radiology, one of which states simply: “Don’t do imaging for uncomplicated headache.”[337] To support the recommendation, ACR provides citation to a list of academic sources.[338] This guidance could easily be converted to a computerized warning, such that a provider entering an order for imaging for an uncomplicated headache would get a pop-up discouraging (but not preventing) the order.

The Choosing Wisely lists have been well-received, but on their own have not had a particularly robust effect on unnecessary care. One study found that following the release of the guidelines, use of imaging for headaches and cardiology both declined, but other services on the “unnecessary” lists actually saw increases in use.[339] Merely establishing guidelines does not seem to be enough to effect practice patterns.

Using professional societies more generally—and the Choosing Wisely lists specifically—as the basis for computerized warnings, however, offers a number of advantages. The lists are driven by the providers practicing in their respective specialties. They are simple to translate to warnings and are not so numerous as to overwhelm. They do not contain “close calls,” but rather focus on the big-ticket sources of overuse. They also establish a national standard, which might even be helpful to physicians in malpractice litigation[340] and could promote uniformity in approach.[341]

In terms of challenges, however, the Choosing Wisely lists may reflect and perpetuate physician biases in care given that it is the providers themselves generating the lists. If the project gets into more controversial territory, it might be hard to reach consensus. There would need to be a structure for updating the lists over time, and the project’s funding is driven by private grants, which may not sustain it over the long term.

There are other options for sourcing the data. Government-driven processes have the advantage of solving the funding problem and ensuring a singular national approach. Any government process would need to win the buyin of the provider community, though, and would need to overcome the traditional hurdles of bureaucracy and difficulty in ensuring quick responses to changes in evidence. A government-driven process would likely meet great resistance from the current Congress and administration.[342]

Another option is a government-private partnership. The Advancing Clinical Decision Support project, led by the RAND Corporation, Massachusetts-based Partners HealthCare, and Harvard Medical School and funded by the U.S. Office of the National Coordinator for Health Information Technology is an example already underway. The overall goal of the project is to address barriers to adopting CDSSs. Partnerships such as this could be tasked with vetting data for the warning nudges.[343]

Finally, there are a number of dispersed private endeavors engaged in evaluating scientific evidence, typically with a focus on new medical technologies.[344] These endeavors are driven by health plans, but usually include representation from a wider community of industry actors, such as academics, physicians, and representatives from medical associations.[345]

Ultimately, the goal would be to use sound scientific data that is consensus-driven, with significant buy-in from the providers that the data seeks to influence. Where clear data is lacking, a warning would not be used. There are plenty of areas, however, where unnecessary care data is robust; efforts should start there. Over time, the warnings should be personalized as effectively as possible to individual patient circumstances. Although there is much work to be done, the trend is moving strongly in that direction.[346]

2.  Why Warning Nudges Would Be Effective

Warning messages based on Choosing Wisely lists or other comparable data could effectively reduce unnecessary care. The warnings utilize most, if not all, of the best practices scholars have identified for securing warning compliance and do not significantly impact physician autonomy, which is perhaps the biggest concern in any effort to reduce unnecessary care.

First, the warnings would disseminate valuable, targeted information. The timing and mode of delivery ensures that providers will draw on relevant information at the time of deciding on care. The warnings would be designed to force physical interaction because the provider will have to click to “answer” it.[347] Where possible, the warnings would also provide a concrete suggestion of what the provider should do instead of the original order.[348]  Importantly, the warnings would be limited and targeted because the Choosing Wisely lists are limited and targeted, addressing a major source of provider ire with current CDSS systems that over-warn and prompt warning fatigue.

Second, although designed to prompt compliance, the warnings would not impact professional autonomy. Ultimately, providers still decide whether or not to place the order. Providers often fight the use of evidence-based medicine to the extent it impacts their abilities to take account of differences between individual patients and does not respect their professional intuition.[349] The warning system addresses those arguments by nudging providers away from care that is likely unnecessary, while avoiding a more coercive approach.

Early studies provide further basis for optimism that unnecessary care warnings can be effective. Los Angeles-based Cedars-Sinai Health System built 180 Choosing Wisely recommendations into its electronic health records . . . .”[350] For instance, because sedative drugs are not supposed to be used by the elderly, it built in a warning for new orders of benzodiazepine for patients over age 65. The health system saw a 40% decrease in use after implementing the warning message.[351] New York-based Crystal Run Healthcare experimented with something similar, programming into its system pop-up alerts based on four of the Choosing Wisely recommendations from the American Academy of Family Physicians. It led to decreases in annual EKGs, MRIs for low back pain, and bone density screening. [352]

More generally, there is ample evidence that warnings built into computerized provider order entry systems can improve the quality and efficiency of care. In Scotland, the addition of computerized, educational reminder messages was associated with a reduction of more than 20% in test ordering.[353] Another study found increased adherence to radiology test guidelines and a decrease in radiology utilization.[354] There are also many studies of medication alerts that have been shown to be effective in reducing unnecessary and even harmful prescriptions.[355] For instance, in one study, physicians who received computerized alerts about a drug’s potential adverse effects were significantly less likely to prescribe the medication.[356] Many other systematic reviews have found that computerized decision support tools in general can deter low-value care.[357]

Given the promising nature of this approach, it might be surprising that it has not gained significant traction. The next Section explains why the government will need to mandate the nudge.

B.  The Need to Mandate This Nudge

Insurers would be best situated to require unnecessary care warnings because providers lack sufficient incentive to adopt such technology. While some health systems have experimented with implementing these warnings unprompted by insurers, it is unlikely that these systems will proliferate if left to providers. After all, despite the beginning of payment reform, providers are still largely paid on a fee-for-service basis, giving them the financial incentive to order more care, not less. Providers must pay to implement the technology, and while providers may have incentive to improve quality—which should mean reducing harmful unnecessary care—it is hard to see much effort originating from health systems or provider groups absent other forces at play.[358]

Insurers, however, could require by contract an unnecessary care warning system. Private insurers and providers routinely enter into contracts that govern provider “in network” status and dictate reimbursement rates, among other provisions. There is nothing that prevents insurers—especially because most possess a dominant negotiating position over providers[359]—from simply requiring by contract that providerordering systems include warnings of unnecessary care.

Flaws in decision-making caused by market failures and counterproductive legal incentives have, however, gotten in the way.[360] The most prominent flaw being that it is easier to raise premiums in an imperfectly competitive, ineffectively regulated market, than to undertake systematic efforts to reduce unnecessary care that involve incurring transaction costs.[361] For this reason, the nudge will not happen unless it is mandated.

It is not uncommon for nudges to require regulation.[362] For instance, in an effort to reduce obesity, lawmakers required the labeling of nutrition information on restaurant menus.[363] Other so-called “informational nudges” have also been regulated,[364] such as laws pertaining to credit card disclosures, insurance choice, and fuel economy, to name a few.[365]

And insurance contracts are already subject to a host of other mandates.[366] In the name of consumer protection and public health, laws require coverage of essential health benefits, among other services or benefits for which insurers must provide coverage, including coverage for particular types of providers and coverage for certain groups like adopted children and domestic partners.[367]

Mandates generally are not without controversy. They infringe on the parties’ freedom of contract.[368] And there is concern that insurance mandates increase premiums,[369] but if the system works as designed, a mandate requiring unnecessary warnings should actually decrease premiums by reducing costly unnecessary care. Any additional cost that the specific mandate contemplated in this Article provokes should be covered by the anticipated savings.[370]

Lawmakers might also avoid the insurance contract and instead go directly to the source by requiring that providers implement these warning systems. This direct regulation might be conducted through amendments to HIPAA or perhaps through the meaningful use requirements. But insurers are still the actors most motivated to reduce unnecessary care, despite the challenges, and it makes the most sense to give them a crucial role to play, particularly in monitoring for compliance. Although insurers might not have the incentives to require a warning nudge system in the first place, once it is in place, they will have an incentive to see it work effectively.

C.  Addressing Challenges and Suggestions for Further Study

Although the warning nudge has the potential to substantially reduce unnecessary care and drive down insurance premiums, it is not without its challenges.

1.  A Paternalistic Approach

The most commonly levied argument against nudging is that it is paternalistic and manipulative, even if it might be less overtly coercive than other forms of regulation.[371] The argument against automated warnings, then, is perhaps obvious—they are an attempt to change behavior and do not respect the autonomy of doctor and patient decision-making.

It is true that the whole purpose of the warning system would be to influence decision-making and change behaviors. But while there is a degree of paternalism, any coercion is minimal. After all, doctors and patients are ultimately free to make their own decisions absent repercussion. Common alternatives, such as tying compensation to the likely effectiveness of treatment, are far more coercive.

In general, health care interactions already contain all sorts of attempts to influence. Doctor treatment recommendations in particular have been shown to highly influence the choices that patients make about their care.[372] Framing effects in health care are, to a large degree, unavoidable. And if that is the case, the arguments for at least framing in the “right” direction are strong.

2.  Concerns About Data

But what is the “right” direction? Perhaps the biggest stumbling block to the nudge solution is still the data. As scholars have noted, “[d]espite widespread concerns that many patients receive biomedical interventions that have little or no evidence about their safety and therapeutic effectiveness, what ‘effective’ means and how to measure it are contested questions.”[373] Indeed much of medical practice is the result of tradition and collective experience, not the rigorous and systematic study of medical interventions.[374] And the individual skill of a provider or individual patient characteristics can often be highly relevant to outcomes.[375]

Yet while it is undoubtedly true that definitive clinical information about effectiveness is often lacking and individual circumstances may often be important, this need not be paralyzing. More studies need to be done, but additional resources are being directed at learning more about the effectiveness of a wide-range of treatments. And scholars and policymakers have good ideas about how to incentivize more useful clinical research.[376]

It is clear that evidence of overuse and misuse currently exists. It would be short-sighted to ignore that data—that campaigns like Choosing Wisely have studied—and take no action while waiting for more comprehensive data to emerge. Even if data is imperfect, the warning nudge accounts for personalized decision-making by not requiring compliance. Providers may still disagree. This is a key advantage over other proposed solutions. For instance, one idea that has started to gain traction is for insurers to tier reimbursement or cost-sharing rates to evidence of effectiveness. This is promising, but the concern about infringement on physician judgment is an important stumbling block to this more aggressive nudge.[377]

The fact that evidence of effectiveness (or ineffectiveness) is lacking for many interventions is not necessarily a bad thing for a nascent alert system. From a cognitive perspective, it may be beneficial to focus on a smaller number of (high impact) warnings. Too many warnings may be counterproductive.

3.  Obtaining Buy-In from Providers

Another challenge concerns potential provider resistance to a warning system. Providers as a group are fiercely protective of their professional autonomy. This has translated into some general resistance to the concept of evidence-based medicine, which is perceived as a slight to professional judgment and intuition.[378]

But there is evidence that physicians can be influenced by computerized warning systems,[379] and a number of reasons exist to believe that provider buy-in can be obtained in this context. First, if the warnings are driven by the work of professional associations, of which providers are members, they are more likely to credit the warnings and pay attention. Second, warnings are much less coercive and have a far less serious impact on professional autonomy than other methods of reducing unnecessary care, like utilization reviews or even value-based insurance design.[380] Third, physicians desiring to limit their practice of defensive medicine might feel empowered by the national standards.[381] A good warning system should actually reduce liability that stems from unnecessary care that causes harm.

4.  IT Resistance and Alert Fatigue

A related challenge to obtaining provider buy in concerns provider resistance to IT. One survey found that doctors in the United States were less likely to believe that health IT can improve care than in other countries.[382] Physicians are often suspicious that technology will lead to the industrialization of medicine and complain that IT adoption has increased their administrative burdens, giving them less time to focus on important patient care.[383] Studies indicate that physicians are reluctant to support an IT that interferes with their traditional work routines.”[384] Notably, for this alert to be effective, it must be communicated at a time when it can influence the doctor’s care recommendations, which may involve changes to work routines. Many doctors currently don’t access an order entry system until after a course of care has been agreed to with the patient.[385]

Alert fatigue—the idea that with too many (unhelpful) alerts, providers will stop paying attention—is also a concern.[386] Some particularly troubling reviews have found very high alert override rates, particularly where alerts are pervasive and important alerts are buried in a sea of unimportant ones.[387]

It is therefore particularly important to design a warning system that does not overwhelm. Better to use discrete lists, like the ones from Choosing Wisely’s campaign, that might under-deter unnecessary care than to risk undermining the entire enterprise by adding too many unwieldy alerts.

It is also important to test for unintended consequences. For instance, it is possible that physicians might react negatively to the alerts and increase unnecessary care rather than reduce it. This reaction seems unlikely, particularly when coupled with payment reform and the fact that these alerts would be driven by peers. But with any new nudges, experimentation is prudent to test for any potentially negative consequences.[388]

On the other hand, if the nudge is not strong enough, insurers can be utilized to encourage compliance—another advantage of involving insurers. For instance, an insurer could either tier reimbursement rates such that the care it wishes to deter is reimbursed at a lower rate or could tier co-pays to try to directly impact patient decision-making.[389] There are downsides to this, particularly that this more coercive use of financial incentives requires an even higher confidence in the data and more negatively impacts patient and physician autonomy.[390] But it is an option that could be deployed if provider resistance to the warnings proves too strong.

5.  Cost of Compliance

Another crucial consideration is the cost of provider compliance.[391] The administrative burden discussed in the prior Section is one such cost. Presumably that cost could be minimized by systemic efficiencies and targeted use of warnings. But there is another relevant provider cost—the revenue providers will lose from delivering less care (or care with lower rates of reimbursement) in a fee-for-service system.

This is an important cost. One could imagine a rational physician who is warned that a spinal fusion surgery is likely unnecessary, but discounts that warning because he stands to earn a significant amount from performing the surgery. In a world where the warnings are easily ignored and the reimbursement rates from unnecessary care are substantial, warnings may not be particularly effective.

Here, there are at least two answers. First, the payment reform movement might be helpful. If providers are paid based on patient outcomes and cost savings, rather than on a fee-for-service basis, this problem becomes much less significant.[392] Although there has been a big trend away from fee-for-service, a few politicians have expressed skepticism of payment reform.  The future is unclear.

Second, cultural forces (and pressures) are not to be underestimated and might play a more important role in physician decision-making than rote financial concerns. If these warnings are generated by professional associations of which the provider is a member and effectively change the standard of care, it might override reimbursement concerns. This is particularly true if the warnings cause the standard of care to more quickly align with the evidence.

6.  Patients Ultimately Make Care Decisions

Finally, although the nudge is directed at physician practices, it is actually patients who ultimately make care decisions. Informed consent doctrine requires that a physician explain treatment options and attendant risks and benefits, so that the patient can properly decide on care.[393] Therefore, reducing unnecessary care will not be accomplished by directing efforts at providers alone.

That being said, if the care is truly unnecessary, the physician is not legally required to give the patient the option to choose it.[394] And as a practical matter, physicians are highly influential in care decisions and often hold the ability to align patient perceptions about appropriate care with their own.[395] Most patients are not as medically literate as their doctors. Some patients would actually prefer to have the physician decide their care, or at least strongly steer them in the right direction.[396] To the extent that physicians today acquiesce to patient demands for unnecessary care more often than they should, the warning system might give the physician more confidence to persuade the patient otherwise.

At bottom, all of these potential challenges could be better assessed with more empirical testing of the concept. Responses to nudges are notoriously unpredictable. But given the magnitude of the unnecessary care problem and the fundamental flaws in the other approaches, now is the time to try.[397]

Conclusion

High premiums have become the central focus of recent debates over the U.S. healthcare system’s future. Solutions like reducing benefits or kicking sick people out of risk pools would have dire consequences. There is a better target—the unnecessary care that accounts for 30% of health care costs.

The problem is well-documented. Patients and providers lack adequate incentive to address it. Insurers would seem best situated to act as a check because a rational insurer should want to reduce claims costs. But insurer experiments with refusing to reimburse for unnecessary care were political failures. And because of problematic legal incentives, market failures, and cultural norms, insurers have taken a back seat to patients and physicians in recent years.

The problem calls for a nudge—a way to respect patient and physician autonomy, but to discourage unnecessary care. A computerized warning, based on the professional consensus of medical associations, could be particularly impactful and should be implemented and tested. In a perfect world, insurers would just require providers they contract with to implement the warnings. But in this case, the government will likely have to intervene.

 


[*] *. Visiting Associate Professor, University of Chicago Law School; Professor, DePaul University College of Law; Faculty Director, Mary and Michael Jaharis Health Law Institute. I would like to thank John Bronsteen, Christopher Buccafusco, Anthony Casey, Emily Cauble, I. Glenn Cohen, Max Helveston, Andrew Gold, Gregory Mark, Jonathan Masur, Frank Pasquale, Govind Persad, Nicholson Price, Jessica Roberts, Christopher Robertson, Zoë Robinson, Rachel Sachs, Ana Santos Rutschman, Ameet Sarpatwari, Nadia Sawicki, and Nicolas Terry. I also thank the attendees and listeners of the University of Chicago Faculty Workshop, the DePaul University Faculty Workshop, the Chicago Health Law Professors Workshop, and the Week in Health Law Podcast for insightful comments.

 [1]. See Gisele Grayson, Alyson Hurt & Alison Kodjak, CHART: Who Wins, Who Loses with Senate Health Care Bill, NPR: Policy-ish (June 22, 2017, 3:59 PM), http://www.npr.org/sections/health-shots/2017/06/22/533942041/who-wins-who-loses-with-senate-health-care-bill.

 [2]. Dylan Matthews, These Are All the People the Senate Health Care Bill Will Hurt, Vox (June 26, 2017, 5:11 PM), https://www.vox.com/2017/6/22/15855262/senate-health-bill-victims-hurts-medicaid-poor (discussing effect of Senate health care bill on vulnerable parties).

 [3]. The Cost of Health Care: How Much is Waste?, Nat’l Acad. Press, http://resources.nationalacademies.org/widgets/vsrt/healthcare-waste.html (last visited May 6, 2018). See also Carrie H. Colla et al., Choosing Wisely: Prevalence and Correlates of Low-Value Health Care Services in the United States, 30 J. Gen. Internal Med. 221, 221–22 (2015) (“Elimination of low-value services as a cost control strategy has much economic appeal because it would improve quality while reducing costs.”).

 [4]. J. Bruce Moseley et al., A Controlled Trial of Arthroscopic Surgery for Osteoarthritis of the Knee, 347 New Eng. J. Med. 81, 85 (2002).

 [5]. Tanner J. Caverly et al., Editorial, Too Much Medicine Happens Too Often: The Teachable Moment and a Call for Manuscripts from Clinical Trainees, 174 JAMA Internal Med. 8, 9 (2014); Meredith A. Niess & Allan Prochazka, Preoperative Chest X-Rays: A Teachable Moment, 174 JAMA Internal Med. 12, 12 (2014) (“Exposing a patient to multiple, additional studies prolongs surgical delay, increases exposure to radiation, prolongs and exacerbates underlying anxiety, and increases the likelihood of additional incidentalomas.”); Chest X-Rays Before Surgery, Choosing Wisely, http://www.choosingwisely.org/patient-resources/chest-x-rays-before-surgery (last visited May 6, 2018).

 [6]. Brian C. Callaghan et al., Headaches and Neuroimaging: High Utilization and Costs Despite Guidelines, 174 JAMA Internal Med. 819, 820 (2014) (explaining that neuroimaging for headaches generates nearly $1 billion in annual costs despite recommendations against the practice).

 [7]. See infra Section I.B. Tremendous amounts of ineffective drugs are also prescribed and reimbursed. This problem raises considerations beyond the scope of this Article, which focuses on unnecessary medical services and largely brackets, for now, the issue of pharmaceuticals. For a discussion of the pharmaceutical over-prescription issue, see Rebecca S. Eisenberg & W. Nicholson Price, II, Promoting Healthcare Innovation on the Demand Side, 4 J.L. & Biosci. 3, 3–7 (2017) and Rachel E. Sachs, Commentary, Promoting Demand-Side Innovation: Prizes for Payers, 4 J.L. & Biosci. 391, 391–93 (2017).

 [8]. 155 Cong. Rec. S11,132 (daily ed. Nov. 5, 2009) (statement of Sen. Hagan) (noting that the United States spends “the most per capita of all industrialized nations,” but has “higher infant mortality and lower life expectancy”); David Squires & Chloe Anderson, U.S. Health Care from a Global Perspective: Spending, Use of Services, Prices, and Health in 13 Countries, Commonwealth Fund: Issue Briefs (Oct. 8, 2015), http://www.commonwealthfund.org/publications/issue-briefs/2015/oct/ushealthcarefromaglobalperspective. See also Adam Candeub, Contract, Warranty, and the Patient Protection and Affordable Care Act, 46 Wake Forest L. Rev. 45, 51 (2011) (“There is little to no data linking total health care expenditures with positive health care outcomes . . . .”).

 [9]. Ezekiel J. Emanuel & Victor R. Fuchs, Commentary, The Perfect Storm of Overutilization, 299 JAMA 2789, 2789 (2008) (“The most important contributor to the high cost of US health care, however, is overutilization.”).

 [10]. See Grayson, supra note 1 and accompanying text.

 [11]. Comm. on the Learning Health Care System in Am., Inst. of Med., Best Care at Lower Cost: The Path to Continuously Learning Health Care in America 99–100 (Mark Smith et al. eds., 2013) (ebook).

 [12]. See Diane Armao, Richard C. Semelka & Jorge Elias, Jr., Radiology’s Ethical Responsibility for Healthcare Reform: Tempering the Overutilization of Medical Imaging and Trimming Down a Heavyweight, 35 J. Magnetic Resonance Imaging 512, 516 (2012); Najlla Nassery et al., Opinion, Systematic Overuse of Healthcare Services: A Conceptual Model, 13 Applied Health Econ. & Health Pol’y 1, 1–2 (2015).

 [13]. See infra Sections I.C.1–2.

 [14]. David A. Hyman & Charles Silver, You Get What You Pay For: Result-Based Compensation for Health Care, 58 Wash. & Lee. L. Rev. 1427, 1443 (2001); Jessica Mantel, Spending Medicare’s Dollars Wisely: Taking Aim at Hospitals’ Cultures of Overtreatment, 49 U. Mich. J.L. Reform 121, 132–33 (2015) (explaining that fee-for-service encourages doctors to recommend costly interventions); Richard S. Saver, Health Care Reform’s Wild Card: The Uncertain Effectiveness of Comparative Effectiveness Research, 159 U. Pa. L. Rev. 2147, 2174 (2011) (“Financial incentives powerfully guide physician behavior . . . above and beyond technical appeals to clinical judgment.”). See also Arnold S. Relman, Commentary, Doctors as the Key to Health Care Reform, 361 New Eng. J. Med. 1225, 1225–27 (2009) (arguing for physician compensation independent of medical decisions).

 [15]. Timothy Stoltzfus Jost, The American Difference in Health Care Costs: Is There a Problem? Is Medical Necessity the Solution?, 43 St. Louis. U. L.J. 1, 15 (1999); Shannon Brownlee, Vikas Saini & Christine Cassel, When Less Is More: Issues of Overuse in Health Care, Health Aff. Blog (Apr. 25, 2014), https://www.healthaffairs.org/do/10.1377/hblog20140425.038647/full (“Patients often believe implicitly that there’s always one more test, one more treatment to try, and that their doctor would never recommend a procedure or a stay in the ICU that was not in their best interest.”).

 [16]. Jerry L. Mashaw & Theodore R. Marmor, Conceptualizing, Estimating, and Reforming Fraud, Waste, and Abuse in Healthcare Spending, 11 Yale J. on Reg. 455, 458 (1994) (“The reliance on third-party payments to finance medical care strengthens patients’ own bias towards using whatever methods are available when their health is at stake.”).

 [17]. Wendy Netter Epstein, Price Transparency and Incomplete Contracts in Health Care, 67 Emory L.J. 1, 3 (2017) [hereinafter Epstein, Price Transparency] (“Patients suffer from both an imbalance of information and an imbalance of power.”); Erin C. Fuse Brown, Irrational Hospital Pricing, 14 Hous. J. Health L. & Pol’y 11, 16 (2014); Mark A. Hall & Carl E. Schneider, Patients as Consumers: Courts, Contracts, and the New Medical Marketplace, 106 Mich. L. Rev. 643, 653–56 (2008) (discussing physicians’ failure to disclose prices).

 [18]. See Epstein, Price Transparency, supra note 17, at 51–58; Erin C. Fuse Brown, Resurrecting Health Care Rate Regulation, 67 Hastings L.J. 85, 104–06 (2015) (discussing price transparency shortcomings in solving market failure). See generally Wendy Netter Epstein, Revisiting Incentive-Based Contracts, 17 Yale J. Health Pol’y L. & Ethics 1 (2017) (discussing challenges with value-based compensation for providers).

 [19]. Katherine Baicker, Amitabh Chandra & Jonathan S. Skinner, Saving Money or Just Saving Lives? Improving the Productivity of US Health Care Spending, 4 Ann. Rev. Econ. 33, 38 (2012) (discussing why insurers pay for services deemed medically necessary by physicians); Mark A. Hall & Gerard F. Anderson, Health Insurers’ Assessment of Medical Necessity, 140 U. Pa. L. Rev. 1637, 1644–51 (1992) (discussing case law that led private insurers to defer to physicians’ decisions).

 [20]. See generally Elisabeth Rosenthal, An American Sickness: How Healthcare Became Big Business and How You Can Take It Back (2017) (discussing factors causing American healthcare system to become expensive and inefficient).

 [21]. See discussion infra at Section II.B.1.

 [22].               See generally Jeffrey Clemens & Joshua D. Gottlieb, In the Shadow of a Giant: Medicare’s Influence on Private Physician Payments (Nat’l Bureau of Econ. Research, Working Paper No. 19503, 2013) (showing private medical care pricing tracks Medicare pricing and discussing factors that contribute to Medicare’s influence in certain markets).

 [23]. See infra Section II.B.3 (discussing that imperfect markets and ineffective regulatory efforts permit insurers to raise premiums).

 [24]. See infra Section II.B.2.

 [25]. Suzanne M. Grosso, Rethinking Malpractice Liability and ERISA Preemption in the Age of Managed Care, 9 Stan. L. & Pol’y Rev. 433, 435 (1998) (describing how utilization review violates provider autonomy).

 [26]. Id.

 [27]. See, e.g., Nadia N. Sawicki, Modernizing Informed Consent: Expanding the Boundaries of Materiality, 2016 U. Ill. L. Rev. 821, 827 (2016) (“The doctrine of informed consent is grounded in the ethical principle of patient autonomy.”); Peter H. Schuck, Rethinking Informed Consent, 103 Yale L.J. 899, 924 (1994); Erin Sheley, Rethinking Injury: The Case of Informed Consent, 2015 BYU L. Rev. 63, 68 (2015).

 [28]. See infra Section I.B.3.

 [29]. See, e.g., Alexander M. Capron & Donna Spruijt-Metz, Behavioral Economics in the Physician-Patient Relationship: A Possible Role for Mobile Devices and Small Data, in Nudging Health: Health Law and Behavioral Economics 233, 234 (I. Glenn Cohen, Holly Fernandez Lynch & Christopher T. Robertson eds., 2016).

 [30]. See infra Section IV.A.1.

 [31]. See supra notes 1415 and accompanying text.

 [32]. E. Andrew Balas & Suzanne A. Boren, Managing Clinical Knowledge for Health Care Improvement, in 2000 Yearbook of Med. Informatics 65, 66.

 [33]. See Sara Rosenbaum et al., Commentary, Who Should Determine When Health Care Is Medically Necessary?, 340 New Eng. J. Med. 229, 230 (1999) (“[F]or more than 200 years, the courts in malpractice cases have turned to clinical practices for evidence of when and under what circumstances medical care should be considered medically necessary, and insurers therefore have relied on the prevailing clinical standards of care.”).

 [34]. See Christopher Robertson, The Split Benefit: The Painless Way to Put Skin Back in the Health Care Game, 98 Cornell L. Rev. 921, 937 (2013).

 [35]. Richard H. Thaler & Cass R. Sunstein, Libertarian Paternalism, 93 Am. Econ. Rev. 175, 178–79 (2003). See also Cass R. Sunstein & Richard H. Thaler, Libertarian Paternalism Is Not an Oxymoron, 70 U. Chi. L. Rev. 1159, 1161–62 (2003).

 [36]. See Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519, 548–61, 570 (2012) (finding the individual mandate to be a constitutional exercise of congressional taxing authority, but not a proper use of Congress’s Commerce Clause or Necessary and Proper Clause powers); Akhil Reed Amar, Opinion, Constitutional Objections to Obamacare Don’t Hold Up, L.A. Times (Jan. 20, 2010), http://articles.latimes.com/2010/jan/20/opinion/la-oe-amar20-2010jan20. The individual mandate, however, was subsequently repealed as a part of tax reform efforts. Louise Radnofsky, The New Tax Law: The Individual Health-Insurance Mandate, Wall St. J. (Feb. 13, 2018, 12:09 PM), https://www.wsj.com/articles/the-new-tax-law-the-individual-health-insurance-mandate-1518541795.

 [37]. See Nat’l Fed’n of Indep. Bus., 567 U.S. at 585 (mandatory Medicaid expansion violated Congress’s Spending Clause authority); Sara Rosenbaum, Commentary, Medicaid and National Health Care Reform, 361 New Eng. J. Med. 2009, 2009–12 (2009) (discussing the controversy over Medicaid expansion).

 [38]. Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751, 2759 (2014); Douglas Nejaime & Reva B. Siegel, Conscience Wars: Complicity-Based Conscience Claims in Religion and Politics, 124 Yale L.J. 2516, 2518 (2015).

 [39]. See Health Care and the 2008 Elections, Henry J. Kaiser Fam. Found. 2 (Oct. 2008), https://kaiserfamilyfoundation.files.wordpress.com/2013/01/7828.pdf; Henry J. Kaiser Fam. Found. & Health Res. Educ. Trust, Employer Health Benefits Survey: 2016 Annual Survey, 24–25 (Sept. 2016).

 [40]. The Third Presidential Debate: Hillary Clinton and Donald Trump, YouTube (Oct. 19, 2016), https://youtu.be/smkyorC5qwc. See also Rachana Pradhan, Trump Misleads on Obamacare Premiums Increases, Politico (Oct. 19, 2016, 10:53 PM), http://www.politico.com/blogs/2016-presidential-debate-fact-check/2016/10/trump-misleads-on-obamacare-premium-increases-230052.

 [41]. In one survey, between 57–62% of voters in the 2016 Presidential Election said that “the cost of health insurance premiums” was “very important” to their vote for President. Ashley Kirzinger et al., Kaiser Health Tracking Poll: September 2016, Henry J. Kaiser Fam. Found. (Sept. 29, 2016), https://kaiserf.am/2j7E3Px. See also Olga Khazan, How Obamacare Helped Trump, Atlantic (Nov. 9, 2016), https://www.theatlantic.com/health/archive/2016/11/how-obamacare-helped-trump/507113/. Other prominent Republicans adopted the same focus. See, e.g., Abby Goodnough, Increase in Health Act Premiums May Affect Arizona Vote, N.Y. Times (Oct. 29, 2016), https://nyti.ms/2jOFiou (discussing Senator McCain’s opposition to Obamacare on basis of increasing premiums); Jon Greenberg, Sen. Ted Cruz Says Premiums Have Gone “Up and Up and Up” for “Virtually Every Person”, Politifact (Oct. 17, 2013, 5:19 PM), http://www.politifact.com/truth-o-meter/statements/2013/oct/17/ted-cruz/sen-ted-cruz-says-premiums-have-gone-virtually-eve.

 [42]. Drew Altman, Obamacare Debate: Where GOP Governors Stand on Repeal and Replace, Henry J. Kaiser Fam. Found. (Jan. 10, 2017), http://www.kff.org/health-reform
/perspective/obamacare-debate-where-gop-governors-stand-on-repeal-and-replace; Margot Sanger-Katz, No Magic in How G.O.P. Plan Lowers Premiums: It Pushes Out Older People, N.Y. Times: The Upshot (Mar. 14, 2017), https://nyti.ms/2nj1Xf5; President Donald Trump (@realDonaldTrump) (Apr. 24, 2017, 10:18 AM), https://twitter.com/realDonaldTrump/status/856557986474491904 (“If our healthcare plan is approved, you will see . . . premiums will start tumbling down.”).

 [43]. See Cynthia Cox et al., 2017 Premium Changes and Insurer Participation in the Affordable Care Act’s Health Insurance Marketplaces, Henry J. Kaiser Fam. Found. (Nov. 1, 2016), https://kaiserf.am/2zIR5wW; Reed Abelson & Margo Sanger-Katz, A Quick Guide to Rising Obamacare Rates, N.Y. Times: The Upshot (Oct. 25, 2016), https://nyti.ms/2k4Jr4r.

 [44]. Brad Tuttle, 8 States Where Obamacare Rates Are Rising by at Least 30%, Money (Oct. 18, 2016), http://time.com/money/4535394/obamacare-plan-premium-price-increases-2017-states; Off. of the Assistant Sec’y for Planning and Evaluation, ASPE Research Brief: Health Plan Choice and Premiums in the 2017 Health Insurance Marketplace 5 (2016).

 [45]. See Sy Mukherjee, Here’s How Much Your Health Insurance Premiums Could Go Up Next Year, Fortune (Aug. 10, 2016), http://fortune.com/2016/08/10/employer-health-premiums-rise.

 [46]. Larry Levitt et al., How ACA Marketplace Premiums Measure Up to Expectations, Henry J. Kaiser Fam. Found. (Aug. 1, 2016), https://kaiserf.am/2GY4ULB; Editorial, Affordable Care Act Premium Increases Are a Fixable Problem, N.Y. Times (Oct. 25, 2016), https://nyti.ms/2jE1t0m.

 [47]. Dan Mangan, Obamacare Deductibles Are on the Rise for 2017, Along with Monthly Premiums, CNBC (Oct. 26, 2016, 3:19 PM), https://cnb.cx/2GgHn4F.

 [48]. Abelson & Sanger-Katz, supra note 43.

 [49]. Barack Obama, United States Health Care Reform Progress to Date and Next Steps, 316 JAMA 525, 529 (2016) (conceding that ACA adjustments will be needed in light of premiums); Alan Rappeport & Margot Sanger-Katz, Hillary Clinton Takes a Step to the Left on Health Care, N.Y. Times (May 10, 2016), https://nyti.ms/2nnv268 (describing Clinton’s preference for a public option). See also Altman, supra note 42; Goodnough, supra note 41; Greenberg, supra note 41; Khazan, supra note 41; Kirzinger, supra note 41; Trump, supra note 42.

 [50]. See, e.g., Abelson & Sanger-Katz, supra note 43.

 [51]. Id.

 [52]. 42 U.S.C. § 18022(b) (2012) (essential health benefits include “(A) Ambulatory patient services. (B) Emergency services. (C) Hospitalization. (D) Maternity and newborn care. (E) Mental health and substance use disorder services, including behavioral health treatment. (F) Prescription drugs. (G) Rehabilitative and habilitative services and devices. (H) Laboratory services. (I) Preventive and wellness services and chronic disease management. (J) Pediatric services, including oral and vision care.”).

 [53]. Cong. Budget Off., Pub. No. 3102, Key Issues in Analyzing Major Health Insurance Proposals 59 (Dec. 2008), https://www.cbo.gov/sites/default/files/110th-congress-2007-2008/reports
/12-18-keyissues.pdf (“The more comprehensive the insurance coverage, the higher the premium would be.”). This claim is not without controversy. Some mandates have been shown to lower premiums. See, e.g., Tracey A. LaPierre et al., Estimating the Impact of State Health Insurance Mandates on Premium Costs in the Individual Market, J. Ins. Reg. 3, 31 (Mar. 1, 2009) (noting that if patients forego care, they can require more expensive care later).

 [54]. The individual mandate was supposed to account for this by drawing healthier people into the risk pool. The mandate, however, has been repealed. Radnofsky, supra note 36.

 [55]. Alison Kodjak, New GOP Health Proposal Could Ditch Protections for People Who Are Sick, NPR (Apr. 20, 2017), http://www.npr.org/sections/health-shots/2017/04/20/524881039/new-gop-health-proposal-could-ditch-protections-for-people-who-are-sick.

 [56]. See Julia Zorthian, Just 21% of Voters Approve of the New GOP Health Care Plan, TIME (May 11, 2017), http://time.com/4775979/ahca-health-care-republican-support-quinnipiac-poll. These methods are also unlikely to succeed in lowering premiums for some segments of the population. See Cong. Budget Off. Cost Estimate: American Health Care Act 3 (Mar. 13, 2017), https://www.cbo.gov/system/files/115th-congress-2017-2018/costestimate/americanhealthcareact.pdf.

 [57]. Aaron L. Schwartz et. al, Measuring Low-Value Care in Medicare, 174 JAMA Internal Med. 1067, 1068 (2014) (explaining why Medicare paying for unnecessary care).

 [58]. See Agnès Couffinhal & Karolina Socha-Dietrich, Ineffective Spending and Waste in Health Care Systems: Framework and Findings, in Tackling Wasteful Spending on Health 17, 19 (2017) (“In other words, cutting ineffective spending and waste can produce significant savings–a strategic move for policy makers.”); Donald M. Berwick & Andrew D. Hackbarth, Eliminating Waste in US Health Care, 307 JAMA 1513, 1513–16 (2012). Although most scholars agree that reducing unnecessary care will drive down premiums, one concern is that volume reduction may be offset with higher prices. See, e.g., Jost, supra note 15, at 17. Insurer market power, however, mutes this concern.

 [59]. The term “wasteful care” is also used in the literature, although it typically also includes administrative waste and fraud and abuse. See, e.g., Jules Delaune & Wendy Everett, Waste and Inefficiency in the U.S. Health Care System: Clinical Care: A Comprehensive Analysis in Support of System-Wide Improvements, New Eng. Healthcare Inst. (Feb. 2008), http://media.washingtonpost.com/wp-srv/nation/pdf/healthreport_092909.pdf.

 [60]. Einer Elhauge, The Limited Regulatory Potential of Medical Technology Assessment, 82 Va. L. Rev. 1525, 1531 (1996) (describing care as “harmful if it provides a lower benefit to the individual patient than other care options (including no care) and unnecessary if it provides no benefit improvement over less (or no) care”). For purposes of this Article, unnecessary care describes only care that does not improve health outcomes. The term does not mean to include care that is inefficient in an economic sense because another intervention might be more cost effective. Whereas unnecessary care does not provide clinical benefit to the patient, “low-value” care might provide some clinical benefit, just at a higher cost than other options. It would be worthwhile to consider how to reduce low value care in future work, but this Article does not take up that question.

 [61]. See, e.g., Emanuel & Fuchs, supra note 9; Ezekiel J. Emanuel & Victor R. Fuchs, Response, Health Care Overutilization in the United States, 300 JAMA 2250, 2251 (2008).

 [62]. Martin Hensher et al., “Too Much Medicine:” Insights and Explanations from Economic Theory and Research, 176 Soc. Sci. & Med. 77, 82 (2017).

 [63]. Berwick & Hackbarth, supra note 58, at 1513–16. See Elizabeth McGlynn et al., The Quality of Health Care Delivered to Adults in the United States, 348 N. Eng. J. Med. 2635 (2003) (finding that, on average, patients receive the recommended treatment for their conditions only slightly more than 50% of the time).

 [64]. Medical Imaging Modalities, Med. Imaging & Tech. Alliance, http://www.medicalimaging.org/about-mita/medical-imaging-primer/ (last visited May 7, 2018).

 [65]. See John K. Iglehart, The New Era of Medical Imaging—Progress and Pitfalls, 354 N. Eng. J. Med. 2822, 2822–23 (2006).

 [66]. See Jost, supra note 15, at 9.

 [67]. Vijay M. Rao & David C. Levin, The Overuse of Diagnostic Imaging and the Choosing Wisely Initiative, 157 Annals Internal Med. 574, 574–75 (2012) (“[I]nappropriate imaging unnecessarily exposes patients to excessive radiation, inconvenience, and actual harms . . . .”).

 [68]. B. Rehani, Commentary, Imaging Overutilisation: Is Enough Being Done Globally?, 7 Biomed. Imaging & Intervention J., Jan.–Mar. 2011, at 1–2 (discussing overuse of diagnostic imaging, such as X-rays and CT scans); Bryn Nelson, Medical Care Overuse Causes Waste, Harm in Healthcare, Hospitalist (June 2015), https://www.the-hospitalist.org/hospitalist/article/122392
/medical-care-overuse-causes-waste-harm-healthcare; Peter Ubel, Who Received More Wasteful Care: Medicaid Enrollees or People with Private Insurance, Forbes (May 31, 2017, 7:37 AM), https://www.forbes.com/sites/peterubel/2017/05/31/who-receives-more-wasteful-care-medicaid-enrollees-or-people-with-private-insurance.

 [69]. Press Release, Univ. of Mich. Rogel Cancer Ctr., Study Suggests Many Women with Early Breast Cancer Receive Unnecessary Imaging Test, (Feb. 23, 2016), http://www.mcancer.org
/news/archive/study-suggests-many-women-early-breast-cancer-receive-unnecessary-imaging-tests.

 [70]. Rao & Levin, supra note 67, at 574 (“20% to 50% of all ‘high-tech’ imaging provide[s] no useful information and may be unnecessary.”).

 [71]. E.g., Martina Montagnana & Giuseppe Lippi, Editorial, Overusing Laboratory Tests: More Advantages or Drawbacks, J. Laboratory & Precision Med. (July 12, 2017), http://jlpm.amegroups.com/article/view/3701/4403.

 [72]. Id.

 [73]. Della Brown White et al., Too Many Referrals of Low-Risk Women for BRCA1/2 Genetic Services by Family Physicians, 17 Cancer Epidemiology Biomarkers & Prevention 2980, 2980 (2008).

 [74]. See Ass’n for Molecular Pathology v. Myriad Genetics, Inc., 133 S. Ct. 2107, 2111 (2013).

 [75]. White, supra note 73, at 2980.

 [76]. Although this Article mostly focuses on the overuse of medical services, largely bracketing the issue of pharmaceutical overuse, see supra notes 46, the over-prescription of antimicrobials bears consideration and could be stemmed by the nudge suggested in Part IV, see infra Part IV. See also C. Lee Ventola, The Antibiotic Resistance Crisis: Part 1: Causes and Threats, 40 Pharmacy & Therapeutics 277, 277–83 (2015) (describing that although most commonly considered overutilization, antibiotic overuse could just as easily be seen as an example of misconsumption).

 [77]. Katherine E. Fleming-Dutra et al., Prevalence of Inappropriate Antibiotic Prescriptions Among U.S. Ambulatory Care Visits, 2010–2011, 315 JAMA 1864, 1869 (2016).

 [78]. See Antibiotic Prescribing and Use in Doctor’s Offices, Ctrs. For Disease Control and Prevention, https://www.cdc.gov/antibiotic-use/community/about/should-know.html (last updated Jan. 9, 2018).

 [79]. See Christina J. Charlesworth et al., Comparison of Low-Value Care in Medicaid vs Commercially Insured Populations, 176 JAMA Internal Med. 998, 999 (2016) (examining the pervasiveness of low-value, unnecessary care).

 [80]. E.g., Aaron E. Carroll, Heart Stents Are Useless for Most Stable Patients. They’re Still Widely Used., N.Y. Times (Feb. 12, 2018), https://nyti.ms/2BoJ0h6; Eric Patashnik, Why American Doctors Keep Doing Expensive Procedures that Don’t Work, Vox (Feb. 14, 2018, 10:06 AM), https://www.vox.com/the-big-idea/2017/12/28/16823266/medical-treatments-evidence-based-expensive
-cost-stents.

 [81]. E. Andrew Balas, Editorial, Information Systems Can Prevent Errors and Improve Quality, 8 J. Am. Med. Informatics Ass’n 398, 399 (2001) (“Studies show that it takes an average of 17 years to implement clinical research results in daily practice, a remarkably slow and inefficient process.”).

 [82]. David T. Felson, Arthroscopy as a Treatment for Knee Osteoarthritis, 24 Best Pract. & Res. Clinical Rheumatology 47, 47–48 (2010).

 [83]. See Jeffrey Katz et al., The Role of Arthroscopy in the Management of Knee Osteoarthritis, 28 Best Pract. & Res. Clinical Rheumatology 143, 151–55 (2014); Anne Mounsey & Bernard Ewigman, Arthroscopic Surgery for Knee Osteoarthritis? Just Say No, 58 J. Fam. Pract. 143, 143–45 (2009).

 [84]. See Roger Chou et al., Interventional Therapies, Surgery and Interdisciplinary Rehabilitation for Low Back Pain: An Evidence-Based Clinical Practice Guideline from the American Pain Society, 34 Spine, 1066, 1066–77 (2009); Robert Langreth, Why You Should Never Get Fusion Surgery for Plain Back Pain, Forbes (Jan. 10, 2011, 8:44 AM), https://www.forbes.com/sites/robertlangreth
/2011/01/10/why-you-should-never-get-fusion-surgery-for-plain-back-pain.

 [85]. Rachelle Buchbinder et al., Percutaneous Vertebroplasty for Osteoporotic Vertebral Compression Fractures, Cochrane Database of Systematic Revs. (Apr. 4, 2018).

 [86]. Rasha Al-Lamee, Percutaneous Coronary Intervention in Stable Angina (ORBITA): A Double-Blind, Randomised Controlled Trial, 391 Lancet 31, 31 (2018); Anahad O’Connor, Heart Stents Still Overused, Experts Say, N.Y. Times: Well (Aug. 15. 2013, 6:00 AM), http://well.blogs.nytimes.com
/2013/08/15/heart-stents-continue-to-be-overused.

 [87]. See Jane Daniels et al., Laparoscopic Uterosacral Nerve Ablation for Alleviating Chronic Pelvic Pain: A Randomized Controlled Trial, 302 JAMA 955, 959–60 (2009).

 [88]. See Stephen J. Duckett et al., Identifying and Acting on Potentially Inappropriate Care, 203 Med. J. Aust. 183, 183 (2015); C.A. Larson, Prophylactic Bilateral Ophorectomy at Time of Hysterectomy for Women at Low Risk: ACOG Revises Practice Guidelines for Ovarian Cancer Screening in Low-Risk Women, 21 Current Oncology, 9, 9–12 (2014).

 [89]. A fair amount of medical care that is the standard of care may in fact be ineffective. See Lindi H. VanderWalde & Stephen B. Edge, Decisions Shared or Otherwise: The Ongoing Evolution of Local Therapy for Breast Cancer, 32 J. Clinical Oncology 873, 873­–74 (2014).

 [90]. See Bradley Sawyer & Cynthia Cox, How Does Health Spending in the U.S. Compare to Other Countries?, Peterson-Kaiser: Health System Tracker (Feb. 13, 2018), https://www.healthsystemtracker.org/chart-collection/health-spending-u-s-compare-countries/#item-start. By comparison, Germany spends 11.2% of its GDP on health, Canada spends 10.4%, and Japan spends 10.2%. Id.

 [91]. See Sarah Kliff, We Spend $750 Billion on Unnecessary Health Care. Two Charts Explain Why., Wash. Post: Wonkblog (Sept. 7, 2012), https://www.washingtonpost.com/news/wonk/wp/2012
/09/07/we-spend-750-billion-on-unnecessary-health-care-two-charts-explain-why; Annie Lowrey, Study of U.S. Health Care System Finds Both Waste and Opportunity to Improve, N.Y. Times (Sept. 11, 2012), https://nyti.ms/2tR4FY4.

 [92]. Cong. Budget Off., Pub. No. 4933, The 2014 Long-Term Budget Outlook 35–36 (2014), http://www.cbo.gov/sites/default/files/cbofiles/attachments/45471-Long-TermBudgetOutlook_7-29.pdf.

 [93]. See Elliott S. Fisher et al., The Implications of Regional Variations in Medicare Spending. Part 2: Health Outcomes and Satisfaction with Care, 138 Annals Internal Med. 288, 288 (2003).

 [94]. Id. (“Medicare enrollees in higher-spending regions receive more care than those in lower-spending regions but do not have better health outcomes or satisfaction with care.”). See also Aaron L. Schwartz et al., Measuring Low-Value Care in Medicare, 174 JAMA Internal Med. 1067, 1071–73 (2014).

 [95]. Emanuel and Fuchs use the term “overutilization,” but they employ it in a broader sense than this Article. Emanuel & Fuchs, supra note 9, at 2789 (“Overutilization can take 2 forms: higher volumes, such as more office visits, hospitalizations, tests, procedures, and prescriptions than are appropriate or more costly specialists, tests, procedures, and prescriptions than are appropriate.”).

 [96]. Id.

 [97]. See M.S., Are Health Insurers Making Huge Profits?, Economist: Democracy in America (May 5, 2010), http://www.economist.com/blogs/democracyinamerica/2010/03/insurance_costs_and
_health-care_reform.

 [98]. The Affordable Care Act’s premium tax credits are intended to address this problem by lowering monthly premiums for those whose income falls between 100–400% of the Federal Poverty Level. Internal Revenue Serv., Eligibility for the Premium Tax Credit, https://www.irs.gov
/affordable-care-act/individuals-and-families/eligibility-for-the-premium-tax-credit (last updated Feb. 8, 2018).

 [99]. See Rachel Garfield & Anthony Damico, The Coverage Gap: Uninsured Poor Adults in States that Do Not Expand Medicaid, Henry J. Kaiser Fam. Found. (Nov. 1, 2017), http://www.kff.org
/uninsured/issue-brief/the-coverage-gap-uninsured-poor-adults-in-states-that-do-not-expand-medicaid.

 [100]. See Key Facts about the Uninsured Population, Henry J. Kaiser Fam. Found. (Nov. 29, 2017), http://www.kff.org/uninsured/fact-sheet/key-facts-about-the-uninsured-population.

 [101]. See Spending on Health Care For Uninsured Americans: How Much, and Who Pays?, in Comm. on Consequences of Unins., Hidden Costs, Value Lost: Uninsurance in America 38–61 (2003) (ebook).

 [102]. See 26 U.S.C. § 36B(b) (2016). The ACA also provides for cost-sharing reduction subsidies. See, e.g., 42 U.S.C. §§ 18051(d)(3)(A)(i) (2016); id. § 18071(c)(3)(B); id. § 18082(c)(3); Press Release, Ctrs. for Medicare & Medicaid Servs., March 31, 2016 Effectuated Enrollment Snapshot (June 30, 2016), https://www.cms.gov/newsroom/mediareleasedatabase/fact-sheets/2016-fact-sheets-items/2016-06-30.html (noting that in 2016, 85% of people who purchased insurance through the Health Insurance Marketplace received a tax credit).

 [103]. See Abelson & Sanger-Katz, supra note 43.

 [104]. Rachel Dolan, Health Policy Brief: High-Deductible Health Plans, Health Aff. (Feb. 4, 2016), http://healthaffairs.org/healthpolicybriefs/brief_pdfs/healthpolicybrief_152.pdf.

 [105]. See Katherine Baicker & Jonathan Skinner, Health Care Spending Growth and the Future of U.S. Tax Rates, in 25 Tax Pol’y & Econ. 39, 42–43 (Jeffrey Brown ed., 2011) (most evidence suggests that in the long run workers bear the costs of the higher premiums).

 [106]. Baicker et al., supra note 19, at 37 n.4.

 [107]. See Cong. Budget Off., Pub. No. 3085, The Long-Term Outlook for Health Care Spending 15 (Nov. 2007), https://www.cbo.gov/sites/default/files/110th-congress-2007-2008/reports
/11-13-lt-health.pdf (finding the majority of rising Medicare expenditures can be attributed to higher spending per beneficiary).

 [108]. Couffinhal & Socha-Dietrich, supra note 58, at 22.

 [109]. Martin A. Makary & Michael Daniel, Medical Error—The Third Leading Cause of Death in the US, 353 British Med. J. 2139, 2139 (2016).

 [110]. David J. Brenner & Eric J. Hall, Computed Tomography—An Increasing Source of Radiation Exposure, 357 New Eng. J. Med. 2277, 2282 (2007).

 [111]. E.L.M. Ho, Editorial, Overuse, Overdose, Overdiagnosis . . . Overreaction?, 6 Biomed. Imaging & Intervention J., July–Sept. 2010, at 1; To Screen or Not to Screen: The Risks of Over-Imaging and Testing, Univ. of Mich. Inst. for Healthcare Pol’y & Innovation (Oct. 13, 2016), http://ihpi.umich.edu/news/screen-or-not-screen-risks-over-imaging-testing.

 [112]. Press Release, Ctrs. for Disease Control and Prevention, CDC: 1 in 3 Antibiotic Prescriptions Unnecessary (May 3, 2016), https://www.cdc.gov/media/releases/2016/p0503-unnecessary-prescriptions
.html.

 [113]. Emanuel & Fuchs, supra note 9, at 2789–91.

 [114]. See Gardiner Harris, Doctor Faces Suits Over Cardiac Stents, N.Y. Times (Dec. 5, 2010), http://www.nytimes.com/2010/12/06/health/06stent.html.

 [115]. Couffinhal & Socha-Dietrich, supra note 58, at 24 (“The rise of defensive medicine, driven mainly by fear of missing a low-probability diagnosis and fear of litigation, can also fuel overtreatment, notably the ordering of unnecessary tests.”).

 [116]. David Studdert et al., Defensive Medicine Among High-Risk Specialist Physicians in a Volatile Malpractice Environment, 293 JAMA 2609, 2609 (2005). See also Benjamin R. Roman et al., Association of Attitudes Regarding Overuse of Inpatient Laboratory Testing with Health Care Provider Type, 177 JAMA Internal Med. 1205, 1205 (2017); M. Sonal Sekhar, Letter to Editor, Defensive Medicine: A Bane to Healthcare, 3 Annals Med. & Health Sci. Res. 295, 295 (2013). But see Baicker et al., supra note 19, at 50 (discussing a study finding the magnitude of defensive medicine is low).

 [117]. See generally Atul Gawande, The Cost Conundrum—What a Texas Town Can Teach Us About Health Care, New Yorker (June 1, 2009), http://www.newyorker.com/magazine/2009/06/01 (noting that McAllen, Texas provided a chief example of the overuse of medical services).

 [118]. Patashnik, supra note 80. See also Elhauge, supra note 60, at 1537 (noting that professional groups do not effectively police unnecessary medical practices).

 [119]. Lynda Chin & Greg Satell, How Physicians Can Keep Up with the Knowledge Explosion in Medicine, Harv. Bus. Rev. (Dec. 19, 2016), https://hbr.org/2016/12/how-physicians-can-keep-up-with-the-knowledge-explosion-in-medicine; Patashnik, supra note 80.

 [120]. Eisenberg & Price, supra note 7, at 1–7. See also Couffinhal & Socha-Dietrich, supra note 58, at 24 (“Discrepancies between how care should be delivered as prescribed by guidelines and how care is delivered in practice can be driven by knowledge deficits, cognitive bias, or resistance to changing traditional practice, despite evidence that an old practice is outdated.”).

 [121]. See Balas & Boren, supra note 32, at 65–66.

 [122]. There is a prevalence of drugs prescribed for off-label uses not approved by the FDA. Randall S. Stafford, Regulating Off-Label Drug Use—Rethinking the Role of the FDA, 358 New Eng. J. Med 1427, 1427–29 (2008).

 [123]. Couffinhal & Socha-Dietrich, supra note 58, at 26 (noting that traditional fee-for-service payment drives the prevalence of low-value care).

 [124]. But it is not clear that it has the desired effect. See, e.g., Hal Scherz & Wayne Oliver, Commentary, Defensive Medicine: A Cure Worse Than the Disease, Forbes: Capital Flows (Aug. 27, 2013, 10:52 AM), https://www.forbes.com/sites/realspin/2013/08/27/defensive-medicine-a-cure-worse-than-the-disease (noting that where tort reform has been enacted, no decline in the amount of defensive medicine has been found).

 [125]. See Alan Rosenberg et al., Early Trends Among Seven Recommendations from the Choosing Wisely Campaign, 175 JAMA Internal Med. 1913, 1914 (2015) (examining an alternative solution to reducing overuse and waste in the U.S. health care system in light of past solutions failure to mitigate the issue).

 [126]. E.g., Canterbury v. Spence, 464 F.2d 772, 782 (D.C. Cir. 1972).

 [127]. Eric G. Campbell et al., Professionalism in Medicine: Results of a National Survey of Physicians, 147 Annals Internal Med. 795, 799–800 (2007) (finding 36% of the physicians surveyed would accommodate a patient who badly wanted a test, even if the physician knew it was unnecessary).

 [128]. Couffinhal & Socha-Dietrich, supra note 58, at 24–26 (“Patients’ requests for additional treatments are another important driver of low-value care. In the patient’s mind, ‘doing nothing’ ordoing less’ may be indistinguishable from doing harm.”).

 [129]. See Katherine Hobson, Cost of Medicine: Are High-Tech Medical Devices and Treatments Always Worth It?, U.S. News (July 10, 2009, 8:00 AM), http://health.usnews.com/health-news/best-hospitals/articles/2009/07/10/cost-of-medicine-are-high-tech-medical-devices-and-treatments-always-worth-it.

 [130]. Robertson, supra note 34, at 939 (describing moral hazard).

 [131]. See id. at 939–40.

 [132]. See generally Epstein, Price Transparency, supra note 17 (exploring the problems that lack of price transparency cause in the health care marketplace and providing a potential solution to this problem).

 [133]. See Wendy Netter Epstein, Nudging Patient Decision-Making, 92 Wash. L. Rev. 1255, 1288–92 (2017) [hereinafter Epstein, Nudging Patient] (discussing limitations of efforts to de-bias patient decision-making).

 [134]. See, e.g., John C. Robinson & Paul B. Ginsburg, Consumer-Driven Health Care: Promise and Performance, 28 Health Aff. 272, 272, 278­–79 (2009).

 [135]. Although most of this Article’s analysis focuses on private insurers, many of the same arguments can be made about government payors, which have similar motivation to reduce claims costs.

 [136]. For-profit insurers enhance shareholder value by maximizing profit, but even nonprofit insurers must be concerned about claims costs relative to revenue. See, e.g., Robert Weisman, Health Insurers Make Less in 2013, Boston Globe (Feb. 28, 2014), https://www.bostonglobe.com/business
/2014/02/28/compensation-net-income-down-largest-massachusetts-health-insurance-companies
/xHIc03wLzB50zKxmBYvr7K/story.html (noting total compensation of $1.9 million for the chief executive at the nonprofit insurer Harvard Pilgrim Health Care).

 [137]. Aaron E. Carroll, Medicaid Gives the Poor a Reason to Say No Thanks, N.Y. Times: The Upshot (Sept. 22, 2014), https://nyti.ms/2lMGw26. Government programs like Medicare and Medicaid are similar, with the exception that the government is the payor rather than the insurance company, and some patients may not pay monthly premiums. Id.

 [138]. John V. Jacobi, Tara Adams Ragone & Kate Greenwood, Health Insurer Market Behavior After the Affordable Care Act: Assessing the Need for Monitoring, Targeted Enforcement, and Regulatory Reform, 120 Penn St. L. Rev. 109, 130 (2015) [hereinafter Jacobi et al., Health Insurer Market Behavior] (explaining that “the infinite complexity of human medical conditions” make it impossible to contractually cover every possible procedure); Rosenbaum, supra note 33, at 231 (noting that “no amount of effort could produce a contract that specified all [covered procedures]”).

 [139]. See Russell Korobkin, The Efficiency of Managed Care “Patient Protection” Laws: Incomplete Contracts, Bounded Rationality, and Market Failure, 85 Cornell L. Rev. 1, 29 (1999) (noting contracts are incomplete in part because of “the fast pace of change in medical technology and knowledge”).

 [140]. See Alan M. Garber, Evidence-Based Coverage Policy, 20 Health Aff. 62, 64 (2001).

 [141]. Id. at 65 (describing medical necessity provision in federal employees’ health plan). Private insurance plans have similar provisions. Id. Medicare is also bound by a similar provision in the Social Security Act. Id. at 64.

 [142]. Linda A. Bergthold, Medical Necessity: Do We Need It? 14 Health Aff. 180, 181–82 (1995) (describing the emergence of medical necessity provisions in the 1940s to ensure payment for providers).

 [143]. Id. at 181–83.

 [144]. See Marsha Garrison & Carl E. Schneider, The Law of Bioethics: Individual Autonomy and Social Regulation 41 (2003).

 [145]. Bergthold, supra note 142, at 182 (“[I]nsurers accepted the decisions of physicians about what was medically necessary without much question.”); Jost, supra note 15, at 1; Jessica Mantel, A Defense of Physicians’ Gatekeeping Role: Balancing Patients’ Needs with Society’s Interests, 42 Pepp. L. Rev. 633, 636–38 (2015); Rosenbaum, supra note 33, at 229 (“From the 1950s through the late 1970s, physicians’ medical opinions largely dictated coverage and were rarely challenged by insurers.”).

 [146]. Mt. Sinai Hosp. v. Zorek, 271 N.Y.S.2d 1012, 1014 (Civ. Ct. 1966).

 [147]. Id.

 [148]. Id. at 1016, 1019.

 [149]. Id. at 1016.

 [150]. See Aaron C. Catlin & Cathy A. Cowan, History of Health Spending in the United States, 1960–2013, 11–14 (2015), https://www.cms.gov/Research-Statistics-Data-and-Systems
/Statistics-Trends-and-Reports/NationalHealthExpendData/Downloads/HistoricalNHEPaper.pdf.

 [151]. See Catlin & Cowan, supra note 150, at 11–14; Baicker, supra note 19, at 38; Peter D. Jacobson et al., Defining and Implementing Medical Necessity in Washington State and Oregon, 34 Inquiry 143, 152 (1997).

 [152]. See Health Maintenance Organization Act of 1973, 42 U.S.C. § 300e (2012).

 [153]. David Villar Patton, Note, Achieving Managed Care Accountability by Ending the ERISA Preemption Defense, 59 Ohio St. L.J. 1423, 1426 (1998) (describing MCO mechanisms to reduce healthcare costs and discourage unnecessary care).

 [154]. Id. at 1428. See also Mantel, supra note 145, at 638.

 [155]. See Michael A. Dowell, Avoiding HMO Liability for Utilization Review, 23 U. Tol. L. Rev. 117, 117 (1991) (describing purpose of utilization review as assuring payment is made only for medically necessary services); John V. Jacobi, Tara Adams Ragone & Kate Greenwood, The Sentinel Project: The ACA’s Marketplace Reforms and Access to Care, Seton Hall L. Ctr. for Health & Pharm. L. & Pol’y, Sept. 8, 2014, at 1, 24 [hereinafter Jacobi et al., Sentinel Project] (defining prospective and retrospective review).

 [156]. See Jacobi et al., Sentinel Project, supra note 155, at 24.

 [157]. See id.

 [158]. Id.

 [159]. See Robertson, supra note 34, at 935–36.

 [160]. Rosenbaum, supra note 33, at 229 (“The line between clinical decisions about necessary medical care and decisions about insurance coverage is particularly blurred in managed-care plans.”).

 [161]. See Meghan O’Rourke, Doctors Tell All—and It’s Bad, Atlantic (Nov. 2014), https://www.theatlantic.com/magazine/archive/2014/11/doctors-tell-all-and-its-bad/380785.

 [162]. Rosenbaum, supra note 33, at 230 (explaining the importance of accounting for individual variation).

 [163]. See Richard A. Epstein, The Erosion of Individual Autonomy in Medical Decisionmaking: Of the FDA and IRBs, 96 Geo L.J. 559, 572 (2008) [hereinafter Epstein, Erosion of Individual Autonomy] (“[W]hat physicians do daily is to extrapolate from known to unknown situations by making intelligent guesses.”); Rosenbaum, supra note 33, at 231.

 [164]. Rosenbaum, supra note 33, at 231 (noting utilization reviews are often based on “unpublished, proprietary, and unreviewed data”). Another concern is that the burden caused by utilization review might deter some beneficial care. See Jost, supra note 15, at 16.

 [165]. See Alain Enthoven, The Donald C. Ozmun and Donald B. Ozmun and Family Lecture in Management at the Mayo Clinic: Managed Care: What Went Wrong? Can It Be Fixed? (Nov. 1, 1999), in Insights by Stan. Bus., http://stanford.io/1mb4jHf.

 [166]. See Robertson, supra note 34, at 937.

 [167]. Elhauge, supra note 60, at 1550 (“Worse, insurers have a financial incentive to deny care even when the benefits exceed the costs.”); Robertson, supra note 34, at 936 (“Still, the insurer’s ability to ration is, and should be, severely limited.”).

 [168]. See, e.g., Adams v. Blue Cross/Blue Shield of Md., 757 F. Supp. 661, 669 (D. Md. 1991) (defining “accepted medical practice” as standards adopted by the Maryland oncological community); Sarchett v. Blue Shield of Cal., 729 P.2d 267, 270–71 (Cal. 1987) (defining “medical necessity” with reference to physician judgment on treatment of illness or injury); Hall & Anderson, supra note 19, at 1645. But, this is not true for all cases. See Bergthold, supra note 142, at 185 (noting courts’ inconsistency in deferring to physician authority).

 [169]. Managed care and utilization reviews still exist today, but in a less impactful way than during insurer-driven reimbursement years. Kathryn E. Flynn, Maureen A. Smith & Margaret K. Davis, From Physician to Consumer: The Effectiveness of Strategies to Manage Health Care Utilization, 59 Med. Care Res. & Rev. 455, 455 (2002) (noting utilization reviews are unpopular).

 [170]. See, e.g., Christopher T. Robertson, The Presumption Against Expensive Health Care Consumption, 49 Tulsa L. Rev. 627, 628 (2014) (“These public and private insurers have largely punted on the rationing imperative, and now pay for all sorts of high-cost treatments with little or no proven efficacy, and without any serious concern for cost-effectiveness as such.”); William M. Sage, Managed Care’s Crimea: Medical Necessity, Therapeutic Benefit, and the Goals of Administrative Process in Health Insurance, 53 Duke L.J. 597, 606–07 (2003) (“Recently, many health plans have beaten a hasty and well-publicized retreat from preauthorization, and have even offered relatively generous support for care in clinical trials that was previously excluded as ‘investigational.’”).

 [171]. Am. Acad. of Actuaries, Issue Brief: Health Insurance Coverage and Reimbursement Decisions 2 (Sept. 2008), http://www.actuary.org/pdf/health/comparative.pdf (describing the services of technology assessment organizations, in-house insurer assessments, and federally funded assessment centers typically housed at universities).

 [172]. See, e.g., Eisenberg & Price, supra note 7, at 17–18.

 [173]. See Austin Frakt, Blue Shield of California Just Did Something Unusual, Incidental Economist (Aug. 29, 2013, 4:08 PM), http://theincidentaleconomist.com/wordpress/blue-shield-of-california-just-did-something-unusual (quoting Steven Pearson, president of the Institute for Clinical and Economic Review, that “[i]t is exceedingly rare for health plans to remove coverage for any service that they have previously covered unless there is striking new evidence of safety problems or other unanticipated harms.”). But see Austin Frakt, JAMA Forum: Pushback Against Covering Proton Beam Therapy, news@JAMA (Sept. 4, 2013) [hereinafter Frakt, Pushback], https://newsatjama
.jama.com/2013/09/04/jama-forum-pushback-against-covering-proton-beam-therapy (describing how several insurers have stopped covering proton beam therapy for early stage prostate cancer).

 [174]. Although even for pharmaceuticals that have supposedly been approved by the FDA as safe and effective, it can be difficult to identify unnecessary care, particularly because the FDA approves drugs on imperfect information and the prescription of drugs for off-label uses—by definition not approved by the FDA—is prevalent. See Stafford, supra note 122, at 1427–29.

 [175]. Professional regulation and the tort liability system are intended to ensure that safe and effective care is being delivered, but do an insufficient job, particularly given their grounding in custom, not evidence.

 [176]. See Epstein, Erosion of Individual Autonomy, supra note 163, at 571–72. Further, there is insufficient incentive for this evidence to be developed because agency approval is not required and there is no carrot of patent exclusivity.

 [177]. Jost, supra note 15, at 17.

 [178]. But rates of unnecessary care are so high, it is doubtful that administrative expenses in identifying it could be higher. See Part IV for a suggestion of a low-cost nudge to deter unnecessary care.

 [179]. Baicker, supra note 19, at 48 (“[P]rivate insurance coverage is heavily influenced by the norms driven by Medicare coverage . . . .”). It is important to note that Medicare’s coverage decisions cannot take the cost of care into account. Sean R. Tunis, Editorial, Why Medicare Has not Established Criteria for Coverage Decisions, 350 New Eng. J. Med. 2196, 2197 (2004).

 [180]. And by following Medicare’s decisions, insurers might insulate themselves from potential liability. See infra Section II.B.2.

 [181]. See Katharine Cooper Wulff, Franklin G. Miller & Steven D. Pearson, Can Coverage Be Rescinded When Negative Trial Results Threaten a Popular Procedure? The Ongoing Saga of Vertebroplasty, 30 Health Aff. 2269, 2273 (2011) (describing how, despite evidence, private insurers wait for Medicare decisions).

 [182]. See Medicare Program; Revised Process for Making Medicare National Coverage Determinations, 68 Fed. Reg. 55,634 (Sept. 26, 2003) (detailing Medicare procedures for making National Coverage Determinations).

 [183]. See Baicker, supra note 19, at 41 (noting that private insurers following Medicare decisions “avoid litigation in which their patients claim that insurers are withholding valuable care”).

 [184]. Ctr. for Health Pol’y, Stan. Univ., State-by-State Compendium of Medical Necessity Regulation: Survey of State Managed Care Regulators 8 (2001), http://www.hcfo.org/files/hcfo/stanford.pdf (noting that, as of 2001, 11 states had laws specifying a standard definition of medical necessity that plans are required to use). See also Baicker, supra note 18, at 38; Nat’l Acad. for State Health Pol’y, Medical Necessity (Dec. 18, 2013), http://www.nashp.org/medical-necessity (state-by-state list of legislation regarding medical necessity).

 [185]. La. Admin. Code tit. 50, § 1101(A) (2017). For an example of another state’s similar definition, see Ariz. Admin. Code § R9-22-101 (2017). Not only are insurers required to reimburse for care when custom deviates from the evidence, but also physicians are insulated from tort liability when they adhere to the standard of care. Rosenbaum, supra note 33, at 230.

 [186]. See Ctr. for Health Pol’y, Stan. Univ., supra note 184, at 12; Elhauge, supra note 60, at 1555–56 (describing power of state insurance commissioners). See also Med. Doctor Provider Class Plan Determination Report, No. 90-11109-BC (Mich. Dep’t of Licensing & Reg., Ins. Bureau Aug. 5, 1991) (appeal) (mandating Blue Cross Blue Shield of Michigan yield determination of medical necessity to the treating physician). There is other pressure to accept physician decisions about standard of care. See, e.g., Sage, supra note 170, at 597–98 (describing case law “allowing individual plaintiffs to sue managed care health plans in state court alleging that faulty decision making caused physical harm”).

 [187]. See Ctr. for Health Pol’y, Stan. Univ., supra note 184, at 37.

 [188]. Id. at 40.

 [189]. Id. at 9. Mandates also require insurers to cover certain categories of care. See infra notes 366–70 and accompanying text. See also Robertson, supra note 34, at 938 (“State and federal governments have imposed over two thousand mandates on insurance providers, requiring them to cover particular treatments.”).

 [190]. See Jacobi et al., Health Insurer Market Behavior, supra note 138, at 132–33.

 [191]. Id.

 [192]. Id. See also Sage, supra note 170, at 597 (noting that ERISA plans are not exempt).

 [193]. See Jacobi et al., Health Insurer Market Behavior, supra note 138, at 130; Robertson, supra note 34, at 937.

 [194]. Robertson, supra note 34, at 937–38; Elhauge, supra note 60, at 1553–54 (noting that courts construe any contractual ambiguity against the insurer, applying also to ERISA plans).

 [195]. Robertson, supra note 34, at 937–38 (noting that insurers consistently lose these cases in court); Sage, supra note 170, at 610–11 (“The conventional wisdom about medical necessity litigation is that judges disregard contractual language in order to allow sympathetic plaintiffs access to potentially lifesaving therapies . . . .”).

 [196]. See Bailey v. Blue Cross & Blue Shield of Va., 67 F.3d 53, 55 (4th Cir. 1995) (affirming summary judgment for the plaintiff despite insurance policy specifically excluding coverage); Elhauge, supra note 60, at 1554; Sage, supra note 170, at 610–11. These denials were based on the experimental nature of the procedure, not its medical necessity, but the analysis was similar.

 [197]. See, e.g., Peter D. Jacobson, Elizabeth Selvin & Scott D. Pomfret, The Role of the Courts in Shaping Health Policy: An Empirical Analysis, 29 J.L. Med. & Ethics 278, 285 (2001). See also Sage, supra note 170, at 612 (noting that ERISA also keeps many disputes out of court because plaintiffs’ lawyers can’t make money on the suits).

 [198]. Robert H. Jerry, II & Douglas R. Richmond, Understanding Insurance Law 156 (5th ed. 2012) (“[I]nsurers can be held liable in tort for bad faith performance of their duties to insureds.”).

 [199]. Elhauge, supra note 60, at 1549–51. The corporate practice of medicine doctrine also prevents insurers from directing the practice of medicine. See Ani B. Satz, Fragmentation After Health Care Reform, 15 Hous. J. Health L. & Pol’y 173, 203 (2015).

 [200]. Hall & Anderson, supra note 19, at 1672.

 [201]. For discussion of implication for nonprofit insurers, see supra note 136.

 [202]. Robert Harrow, Why Health Insurance Prices Will Continue to Rise in 2016 and Beyond, Forbes (Jan. 14, 2016, 9:52 AM), https://www.forbes.com/sites/robertharrow/2016/01/14/why-health-insurance-prices-will-continue-to-rise-in-2016-and-beyond (“The knee-jerk reaction to increased operating costs has been to ‘adjust premiums’—in other words, increasing prices.”); Ctr. For Consumer Info. & Ins. Oversight, Fighting Unreasonable Health Insurance Premium Increases, Ctrs. for Medicare & Medicaid Servs., https://www.cms.gov/CCIIO/Resources/Fact-Sheets-and-FAQs
/ratereview05192011a.html (last updated Nov. 16, 2011) (noting rapid rise of premiums).

 [203]. Ctr. For Consumer Info. & Ins. Oversight, supra note 202.

 [204]. See, e.g., Leemore S. Dafny, Are Health Insurance Markets Competitive?, 100 Am. Econ. Rev. 1399, 1400, 1426 (2010) (noting minimal empirical evidence for competitive private insurance market).

 [205]. Id. (finding that local health insurance markets are not perfectly competitive).

 [206]. Id. at 1427 (finding that “health insurers are exercising market power in an increasing number of geographic markets”).

 [207]. Id.

 [208]. See, e.g., Leemore S. Dafny, Evaluating the Impact of Health Insurance Industry Consolidation: Learning from Experience, 33 Commonwealth Fund: Issue Brief, Nov. 2015, at 5 (collecting evidence).

 [209]. Health Insurance Industry Consolidation: What Do We Know from the Past, Is It Relevant in Light of the ACA, and What Should We Ask: Before the Subcomm. on Antitrust, Competition Policy & Consumer Rights of the S. Comm. on the Judiciary, 114th Cong. 5 (2015) (testimony of Leemore S. Dafny, Ph.D., Director of Health Enterprise Management, Kellogg School of Management, Northwestern University).

 [210]. Rebecca Hersher, Aetna and Humana Call off Merger After Court Decision, NPR (Feb. 14, 2017, 11:41 AM), http://www.npr.org/sections/thetwo-way/2017/02/14/515167491/aetna-and-humana-call-off-merger-after-court-decision.

 [211]. Mara Lee, Anthem Terminates Cigna Merger Agreement, Mod. Healthcare (May 12, 2017), http://www.modernhealthcare.com/article/20170512/NEWS/170519940.

 [212]. Rate Review Processes in the Individual and Small Group Markets, Henry J. Kaiser Fam. Found., https://www.kff.org/health-reform/state-indicator/rate-review-program-effectiveness (last updated Apr. 8, 2016) (state-by-state requirements).

 [213]. Henry J. Kaiser Family Found., Rate Review: Spotlight on State Efforts to Make Health Insurance More Affordable 4 (2010), https://kaiserfamilyfoundation.files.wordpress.com
/2013/01/8122.pdf.

 [214]. Id.

 [215]. Ctr. For Consumer Info. & Ins. Oversight, Review of Insurance Rates, Ctrs. for Medicare & Medicaid Servs., https://www.cms.gov/CCIIO/Programs-and-Initiatives/Health-Insurance-Market-Reforms/Review-of-Insurance-Rates.html (last visited May 8, 2018).

 [216]. Health Insurance Issuer Rate Increase: Disclosure and Review Requirements, 45 C.F.R. § 154.200–.230 (2018) (describing the criteria CMS will use when evaluating whether a rate increase is unreasonable). See also Dafny, supra note 204, at 6–7 (describing the ACA provision on medical loss ratios).

 [217]. State Approval of Health Insurance Rate Increases, Nat’l Conf. St. Legislatures (Sept. 18, 2016), http://www.ncsl.org/research/health/health-insurance-rate-approval-disapproval.aspx (describing that to be approved, rate increases must be proportional to benefits offered and not arbitrary).

 [218]. See generally Scott E. Harrington & Janet Weiner, Deciphering the Data: Health Insurance Rates and Rate Review 1–5 (2014), https://ldi.upenn.edu/sites/default/files/pdf
/health%20insurance%20rate%20and%20review.pdf.

 [219]. Ctr. For Consumer Info. & Ins. Oversight, supra note 215 (“Many times, insurance companies have been able to raise rates without explaining their actions to regulators or the public or justifying the reasons for their high premiums.”).

 [220]. Harrow, supra note 202 (Aetna pulling out of some state exchanges).

 [221]. See J. Craig Anderson, More Companies Self-Insure Workers to Avoid Rising Health Care Premiums, Portland Press Herald (Aug. 8, 2017), https://www.pressherald.com/2017/08/08/more-companies-self-insure-workers-to-avoid-rising-health-care-premiums.

 [222]. For example, in January 2017, UnitedHealth Group announced its purchase of Surgical Care Affiliates, an outpatient surgery chain, to begin providing direct medical services. Jeff Sommer, Gripes About Obamacare Aside, Health Insurers Are in a Profit Spiral, N.Y. Times (Mar. 18, 2017), https://nyti.ms/2me4jeX.

 [223]. See Tom L. Beauchamp & James F. Childress, Principles of Biomedical Ethics 12–13 (6th ed. 2009); John Stuart Mill, On Liberty 52 (Edward Alexander ed., Broadview Press 1999) (1859); Edmund D. Pellegrino, Patient and Physician Autonomy: Conflicting Rights and Obligations in the Physician-Patient Relationship, 10 J. Contemp. Health L. & Pol’y 47, 47 (1994); Schuck, supra note 27, at 924.

 [224]. Gillian Matthews, Clinical Freedom, 8 J. Med. Ethics 150, 150 (1982) (“[F]rom earliest days [medicine] has been concerned with the protection of freedom—both of the patient and the physician.”).

 [225]. Uwe E. Reinhardt, U.S. Health Care Costs Part VI: At What Price Physician Autonomy?, N.Y. Times: Economix (Dec. 26, 2008, 10:07 AM), https://economix.blogs.nytimes.com/2008/12/26
/us-healthcare-costs-part-vi-at-what-price-physician-autonomy.

 [226]. See Sawicki, supra note 27, at 827.

 [227]. See Barbara Secker, The Appearance of Kant’s Deontology in Contemporary Kantianism: Concepts of Patient Autonomy in Bioethics, 24 J. Med. & Phil. 43, 44 (1999).

 [228]. Schuck, supra note 27, at 924–26. This same argument is made in support of the medical marijuana and right-to-try movements. See, e.g., Julie Turkewitz, Patients Seek ‘Right to Try’ New Drugs, N.Y. Times (Jan. 10, 2015), https://nyti.ms/2jYDo43.

 [229]. Evanthia Sakellari, Patient’s Autonomy and Informed Consent, ICUs & Nursing Web J. Jan.–Mar. 2003, at 2.

 [230]. Id. at 4–5. See also Lawrence O. Gostin, Informed Consent, Cultural Sensitivity, and Respect for Persons, 274 JAMA 844, 844–45 (1995). But see Epstein, Nudging Patient, supra note 133, at 1274–88 (discussing flaws in patient decision-making).

 [231]. Magali Sarfatti Larson, The Rise of Professionalism: A Sociological Analysis x (1977).

 [232]. Id. at 208–10. See also Matthews, supra note 224, at 151 (describing the characteristics that define a professional).

 [233]. See Anne-Marie Barry & Chris Yuill, Understanding the Sociology of Health: An Introduction 35 (2nd ed. 2008); Zhiping Walter & Melissa Succi Lopez, Physician Acceptance of Information Technologies: Role of Perceived Threat to Professional Autonomy, 46 Decision Support Sys. 206, 207 (2008).

 [234]. Although paternalism once dominated health care, the law of informed consent makes a physician’s clinical autonomy subject to patient consent. See supra notes 126, 133, 225.

 [235]. “A survey of physicians found that 68% agreed or strongly agreed that clinical freedom was essential to the practice of medicine and physicians should fight against any constraints upon it.” Walter & Lopez, supra note 233, at 208. See also L. Cooke & M. Hutchinson, Doctors’ Professional Values: Results from a Cohort Study of United Kingdom Medical Graduates, 35 Med. Educ. 735, 735–40 (2001).

 [236]. See Matthews, supra note 224, at 152–53.

 [237]. See Frakt, Pushback, supra note 174.

 [238]. Donald H. Taylor, Jr., Balancing the Budget Is A Progressive Priority 53–55 (2012); Donald H. Taylor, Jr., Will BCBS of California’s Proton Beam Therapy Decision Stick?, freeforall (Aug. 29, 2013), https://donaldhtaylorjr.wordpress.com/2013/08/29/will-bcbs-of-californias-proton-beam-therapy-decision-stick.

 [239]. Taylor, supra note 238, at 54 (quoting Dr. John Wilson, a neurosurgeon at Wake Forest University).

 [240]. Id. at 55 (noting that the policy was revoked only six weeks after announcing it).

 [241]. David C. Beyer & Najeeb Mohideen, The Role of Physicians and Medical Organizations in the Development, Analysis, and Implementation of Health Care Policy, 18 Seminars Radiation Oncology 186, 187–88 (2008) (discussing the role of the AMA and physician specialty associations in influencing health policy).

 [242]. See Mantel, supra note 145, at 637–38; William M. Sage, Should the Patient Conquer?, 45 Wake Forest L. Rev. 1505, 1505 (2010) (“[N]early all progressive impulses among American health lawyers and policy makers over the past half century have sought to liberate and empower the patient.”).

 [243]. Robertson, supra note 34, at 939 (“Due to these pressures, ‘insurers have largely abandoned direct attempts to limit coverage for most medical procedures and instead have adopted a pass-through attitude toward medical spending.’”).

 [244]. Jeffrey J. Stoddard et al., Managed Care, Professional Autonomy, and Income: Effects on Physician Career Satisfaction, 16 J. Gen. Internal Med. 675, 675, 680–82 (2001).

 [245]. The use of the term “autonomy” might be confusing in that physicians cannot make decisions absent patient informed consent. And to be sure, physician and patient autonomy may conflict, which is the subject of much scholarly discussion. See, e.g., Pellegrino, supra note 223, at 58. The relevant issue for current purposes, however, is how patient and physician autonomy should interact with the role of insurers.

 [246]. See Reinhardt, supra note 225 (doubting that physician autonomy serves society well).

 [247]. See id. (arguing against complete autonomy for physicians and patients).

 [248]. See Epstein, Nudging Patient, supra note 133, at 1256, 1268–69.

 [249]. See George Loewenstein, Projection Bias in Medical Decision Making, 25 Med. Decision Making 96, 100, 103–04 (2005); Michael L. Kelly, Commentary, Ethics Case: Risk Perception, Bias, and the Role of the Patient-Doctor Relationship in Decision Making about Cerebral Aneurysm Surgery, 17 AMA J. Ethics 6, 7 (2015) (“[C]ognitive biases and decision-making heuristics strongly influence decision making for both patients and physicians.”) (footnotes omitted).

 [250]. Epstein, Nudging Patient, supra note 133, at 1283–85.

 [251]. See id.

 [252]. See Prognosis in Advanced Cancer 25–26 (Paul Glare & Nicholas A. Christakis eds., 2008).

 [253]. Sita Slavov, How Your Doctor Is Driving Up Health Care Costs, U.S. News (Aug. 22, 2013, 9:00 AM), https://www.usnews.com/opinion/blogs/economic-intelligence/2013/08/22/how-financial-incentives-for-doctors-drive-up-health-care-costs.

 [254]. See Mantel, supra note 145, at 664 (noting that the exercise of autonomy crowds out other goods and services).

 [255]. See supra Section I.B.3.

 [256]. Reflections on Variations, Dartmouth Atlas of Health Care, http://www.dartmouthatlas.org/keyissues/issue.aspx?con=1338 (last visited May 8, 2018). See also Reinhardt, supra note 225 (“[O]verall per-capita Medicare spending could probably be reduced by at least 30[%] without harming patients . . . .”).

 [257]. See Mantel, supra note 145, at 663–64.

 [258]. See id.; Elhauge, supra note 60, at 1531–33.

 [259]. It is tempting to argue that laws entirely deferring to physician decision-making are flawed and must be replaced, but they exist as a response to the negative impact of insurer-driven decision-making. Because the right answer is neither complete patient/physician autonomy nor complete insurer-power, getting rid of the laws would not fix the problem. See infra Part IV (proposing a nudge solution).

 [260]. Richard H. Thaler & Cass R. Sunstein, Libertarian Paternalism, 93 Am. Econ. Rev. 175, 175 (2003) (coining the term “Libertarian Paternalism”).

 [261]. Cass R. Sunstein & Richard H. Thaler, Libertarian Paternalism Is Not an Oxymoron, 70 U. Chi. L. Rev. 1159, 1161–62 (2003).

 [262]. Richard H. Thaler & Cass R. Sunstein, Nudge: Improving Decisions About Health, Wealth and Happiness 4–6 (2008) [hereinafter Thaler & Sunstein, Nudge: Improving Decisions].

 [263]. Id. See also Daniel M. Hausman & Brynn Welch, Debate: To Nudge or Not to Nudge, 18 J. Pol. Phil. 123, 126 (2010).

 [264]. Thaler & Sunstein, Nudge: Improving Decisions, supra note 262, at 4–6; Hausman & Welch, supra note 263, at 126; Cass R. Sunstein, Nudging: A Very Short Guide, 37 J. Consumer Pol’y 583, 584 (2014) [hereinafter Sunstein, Nudging: A Very Short Guide] (discussing the GPS analogy). See also Christopher T. Robertson, I. Glenn Cohen & Holly Fernandez Lynch, Introduction, in Nudging Health, supra note 29, at 7.

 [265]. See generally Shlomo Benartzi et al., Should Governments Invest More in Nudging?, 28 Psychol. Sci. 1041 (2017) (arguing for the greater use of nudges).

 [266]. Sunstein, Nudging: A Very Short Guide, supra note 264, at 584 (discussing the United Kingdom’s Behavioural Insights Team and the United States’ White House Social and Behavioral Sciences Team).

 [267]. See Nudge Nudge, Think Think. The Use of Behavioural Economics in Public Policy Shows Promise, Economist: Free Exchange (Mar. 24, 2012), http://www.economist.com/node/21551032.

 [268]. See William G. Gale & David C. John, State Sponsored Retirement Savings Plans: New Approaches to Boost Retirement Plan Coverage 16–17 (Pension Research Council, Wharton School, Working Paper No. WP2017-12, 2017), https://pensionresearchcouncil.wharton.upenn.edu/wp-content
/uploads/2017/09/WP-2017-12-John-Gale.pdf.

 [269]. See Benartzi, supra note 265, at 1051.

 [270]. Thaler & Sunstein, Nudge: Improving Decisions, supra note 262, at 108–09.

 [271]. Richard H. Thaler & Shlomo Benartzi, The Behavioral Economics of Retirement Savings Behavior 2 (AARP Pub. Pol’y Inst., Issue Paper No. 2007-02, 2007), https://assets.aarp.org
/rgcenter/econ/2007_02_savings.pdf.

 [272]. See 12 C.F.R. § 226.35(b)(3) (2017).

 [273]. See Or. Rev. Stat. § 247.017 (2017); Cass R. Sunstein, The Ethics of Influence: Government in the Age of Behavioral Science 14 (2016) (discussing Oregon’s automatic voter registration system).

 [274]. See, e.g., Ellen van Kleef, Kai Otten & Hans C.M. van Trijp, Healthy Snacks at the Checkout Counter: A Lab and Field Study on the Impact of Shelf Arrangement and Assortment Structure on Consumer Choices, 12 BMC Pub. Health 1071, 1071 (2012).

 [275]. See Christopher T. Robertson, I. Glenn Cohen & Holly Fernandez Lynch, Introduction, in Nudging Health, supra note 29, at 6.

 [276]. P. Wesley Schultz et al., The Constructive, Destructive, and Reconstructive Power of Social Norms, 18 Psychol. Sci. 429, 432–33 (2007).

 [277]. Cass R. Sunstein, Simpler: The Future of Government 9 (2013). See generally Thaler & Sunstein, Nudge: Improving Decisions, supra note 262 (discussing how “choice architecture” can nudge people in beneficial directions).

 [278]. Cass R. Sunstein, Do People Like Nudges? 1 (Dig. Access to Scholarship at Harvard, Working Paper No. 16147874, 2015), http://nrs.harvard.edu/urn-3:HUL.InstRepos:16147874 [hereinafter Sunstein, Do People Like Nudges?].

 [279]. See generally Family Smoking Prevention and Tobacco Control Act, Pub. L. 111–31, 123 Stat. 1776 (codified as amended in scattered sections of 21 U.S.C.).

 [280]. See Cass R. Sunstein, The Ethics of Nudging, 32 Yale J. Reg. 413, 415 (2015).

 [281]. Sunstein, Nudging: A Very Short Guide, supra note 264, at 586. See also Behavioural Insights Team, Behaviour Change and Energy Use 18–22 (2011), https://www.gov.uk
/government/uploads/system/uploads/attachment_data/file/60536/behaviour-change-and-energy-use.pdf (describing ways of influencing consumers’ energy usage patterns by influencing their behavior through disclosure of personalized comparative usage information). There is some disagreement about whether warnings are properly categorized as nudges. If the goal of a warning is to stimulate conscious decision-making, it should be contrasted with nudges that influence decision-making by “exploiting [individuals’] cognitive and emotional limitations” and aim to make decisions more automatic. Robert Baldwin, From Regulation to Behaviour Change: Giving Nudge the Third Degree, 77 Mod. L. Rev. 831, 834–35 (2014) (describing the argument but noting that many policy-makers have followed Thaler and Sunstein’s broader definition of nudge to include warnings).

 [282]. See Lawrence O. Gostin, Daniel Hougendobler & Anna E. Roberts, American Public Health Law, in Oxford Handbook of U.S. Health Law 943 (I. Glenn Cohen et al. eds., 2017); Sunstein, Do People Like Nudges?, supra note 278, at 1.

 [283]. Thaler & Sunstein, Nudge: Improving Decisions, supra note 262, at 23.

 [284]. Id; Sunstein, Do People Like Nudges?, supra note 278, at 8.

 [285]. Warnings can have an emotional effect on decisionmakers. See, e.g., Cass R. Sunstein, Why Nudge? The Politics of Libertarian Paternalism 59 (2014) (ebook) [hereinafter Sunstein, Why Nudge?]. See also Robert Lepenies & Magdalena Malecka, The Institutional Consequences of Nudging—Nudges, Politics, and the Law, 6 Rev. Phil. & Psychol. 427, 430 n.9 (2015) (describing how consumers “do not react to laws, but—non-cognitively—to a nudge”).

 [286]. See Sunstein, Do People Like Nudges?, supra note 278, at 15.

 [287]. Cass R. Sunstein, Opinion, There’s a Backlash Against Nudging—but It Was Never Meant to Solve Every Problem, Guardian (Apr. 24, 2014, 2:30 PM), https://www.theguardian.com
/commentisfree/2014/apr/24/nudge-backlash-free-society-dignity-coercion.

 [288]. See, e.g., Sunstein, Do People Like Nudges?, supra note 278, at 4 (finding strong support for various warning nudges in studies).

 [289]. See, e.g., Kenneth R. Laughery & Michael S. Wogalter, Designing Effective Warnings, 2 Revs. Human Factors & Ergonomics 241, 241–42 (2006) (surveying literature). But see James Nonnemaker et al., Experimental Study of Graphic Cigarette Warning Labels 4-1–4-3 (2010) (finding limited impact, if any, from cigarette warnings).

 [290]. Gabrielle F. Miller et al., The Effects of Pre-Ordering and Behavioral Nudges on National School Lunch Program Participants’ Food Item Selection, 55 J. Econ. Psychol. 4, 13 (2016) (finding that nudged students selected significantly more fruits, vegetables and low-fat milk than non-nudged groups).

 [291]. Lepenies & Magdalena, supra note 285, at 428 (discussing critiques of nudges for being intrusive and exploiting human weakness).

 [292]. See Mill, supra note 223, at 112–13.

 [293]. Heidi M. Hurd, Fudging Nudging: Why “Libertarian Paternalism” is the Contradiction It Claims It’s Not, 14 Geo. J.L. & Pub. Pol’y 703, 703 (2016).

 [294]. See, e.g., Kamila M. Kiszko et al., The Influence of Calorie Labeling on Food Orders and Consumption: A Review of the Literature, 39 J. Community Health 1248, 1248 (2014).

 [295]. It is possible that transparency might decrease the effectiveness of the nudge, which is yet another reason for experimentation. But there is at least some evidence that nudges can be both transparent and effective. See, e.g., Hendrik Bruns et al., Can Nudges Be Transparent and Yet Effective?, 69 J. Econ. Psychol. (forthcoming Dec. 2018).

 [296]. Cass R. Sunstein, Nudges Do Not Undermine Human Agency, 38 J. Consumer Pol’y 207, 210 (2015) (noting that desirable nudges can promote both autonomy and welfare). See Sunstein, Why Nudge, supra note 285, at 143 (objections to paternalistic approaches are muted if they “impose small costs, or no material costs, on those who seek to go their own way”).

 [297]. Laughery & Wogalter, supra note 289, at 242.

 [298]. Id. at 249–58.

 [299]. Id. at 242 (“Generally, a warning must capture attention; that is, it must be noticed and encoded.”).

 [300]. Id. at 253.

 [301]. Judy Edworthy & Austin Adams, Warning Design: A Research Perspective 42–43 (1996).

 [302]. Id.

 [303]. See generally J. Paul Frantz & Timothy P. Rhoades, A Task-Analytic Approach to the Temporal and Spatial Placement of Product Warnings, 35 Human Factors 719 (1993) (discussing how to create effective warnings that consider a person’s cognitive and behavioral activities during product use).

 [304]. Laughery & Wogalter, supra note 289, at 260.

 [305]. Barbara Sattler, Bruce Lippy & Tyrone G Jordan, Hazard Communications: A Review of the Science Underpinning the Art of Communication for Health and Safety 8 (1997), https://www.osha.gov/dsg/hazcom/hc2inf2.html.

 [306]. J. Paul Frantz, Effect of Location and Procedural Explicitness on User Processing of and Compliance with Product Warnings, 36 Human Factors 532, 532 (1994).

 [307]. Id.

 [308]. David M. DeJoy, Attitudes and Beliefs, in Warnings and Risk Communication 197–98 (Michael S. Wogalter et al., eds., 2005) (ebook).

 [309]. Id.

 [310]. Although cost-benefit analysis may also suffer from “incommensurability” in this context. See, e.g., Matthew Adler, Incommensurability and Cost-Benefit Analysis, 146 U. Pa. L. Rev. 1371, 1376 (1998); Cass R. Sunstein, Incommensurability and Valuation in Law, 92 Mich. L. Rev. 779, 796 (1994) (“Incommensurability occurs when the relevant goods cannot be aligned along a single metric without doing violence to our considered judgments about how these goods are best characterized.”) (emphasis omitted).

 [311]. Dejoy, supra note 308, at 197–98; Laughery & Wogalter, supra note 289, at 257–58.

 [312]. Comm. on Quality of Health Care in Am., Inst. of Med., Crossing the Quality Chasm: A New Health System for the 21st Century 165 (2001). See also Nicolas P. Terry, Meaningful Adoption: What We Know or Think We Know About the Financing, Effectiveness, Quality, and Safety of Electronic Medical Records, 34 J.L. Med. 7, 10 (2013).

 [313]. Robert Pearl, 5 Things Preventing Technology Adoption in Health Care, Forbes, (Sept. 11, 2014, 1:25 PM) https://www.forbes.com/sites/robertpearl/2014/09/11/5-things-preventing-technology-adoption-in-health-care.

 [314]. See generally Robert Wachter, The Digital Doctor: Hope, Hype, and Harm at the Dawn of Medicine’s Computer Age (2015) (exploring how technology has changed the practice of medicine). The regulations responsible, at least in part, for spurring this transformation are Title IV of Division B and Title XIII of Division A, known together as the Health Information Technology for Economic and Clinical Health Act (“HITECH Act”). 42 U.S.C. §§ 300jj–300jj-52 (2016); id. §§ 17921–17953.

 [315]. EHR Adoption Rates: 20 Must-See Stats, Practice Fusion (Mar. 1, 2017) [hereinafter EHR Adoption Rates: 20 Must-See Stats], http://www.practicefusion.com/blog/ehr-adoption-rates; Off. of the Nat’l Coordinator for Health Info. Tech., Office-based Physician Electronic Health Record Adoption, HealthIT.gov (Dec. 2016), https://dashboard.healthit.gov/quickstats/pages/physician-ehr-adoption-trends.php; Data and Program Reports: EHR Incentive Programs, Ctrs. for Medicare & Medicaid Servs., https://www.cms.gov/Regulations-and-Guidance/Legislation/EHRIncentivePrograms/DataAnd
Reports.html (last modified Apr. 25, 2018, 10:59 AM). But see Stephanie O. Zandieh et al., Challenges to EHR Implementation in Electronic-Versus Paper-Based Office Practices, 23 J. Gen. Internal Med. 755, 755 (2008).

 [316]. EHR Adoption Rates: 20 Must-See Stats, supra note 315.

 [317]. Agency for Healthcare Res. & Quality, Patient Safety Primer: Computerized Provider Order Entry, Patient Safety Network, https://psnet.ahrq.gov/primers/primer/6/computerized-provider-order-entry (last updated June 2017); Jason M. Baron & Anand S. Dighe, Computerized Provider Order Entry in the Clinical Laboratory, 2 J. Pathology Informatics, Aug. 2011, http://www.jpathinformatics.org/text.asp?2011/2/1/35/83740.

 [318]. See, e.g., Bryan Cleveland, Using the Law to Correct the Market: The Electronic Health Record (EHR) Incentives Program, 29 Harv. J.L. & Tech. 291, 307 (2015).

 [319]. See id. at 307–08.

 [320]. Computerized warnings require adoption of health IT systems. While there are still providers using paper-based systems, adoption of health IT systems is widespread. Stephen T. Mennemeyer et al., Impact of the HITECH Act on Physicians’ Adoption of Electronic Health Records, 23 J. Am. Med. Informatics Ass’n 375, 375 (2016).

 [321]. See supra Section I.B.

 [322]. Id.

 [323]. A provider might even be asked to justify overriding the warning, but given the strength of the autonomy value and the administrative burden, it does not seem prudent for the nudge to be taken that far.

 [324]. Agency for Healthcare Res. & Quality, Glossary: Clinical Decision Support System (CDSS), Patient Safety Network, https://psnet.ahrq.gov/glossary/clinicaldecisionsupportsystem (last visited May 8, 2018).

 [325]. Traditional Medicare does not utilize pre-authorization procedures. Its use by private insurers depends on the particular plan.

 [326]. These systems that reject coverage based on certain data, rather than simply warning the physician are highly criticized by physicians (and patients) for failing to account for individual patient circumstances and overriding physician professional judgment.

 [327]. Colene Byrne et al., Advancing Clinical Decision Support: Key Lessons in Clinical Decision Support Implementation 1 (2011), https://www.healthit.gov/sites/default/files
/acds-lessons-in-cds-implementation-deliverablev2.pdf.

 [328]. Ben-Tzion Karsh, Agency for Healthcare Res. & Quality, AHRQ Pub. No. 09-0054-EF, Clinical Practice Improvement and Redesign: How Change in Workflow Can Be Supported by Clinical Decision Support (2009), https://healthit.ahrq.gov/key-topics/clinical-decision-support/clinical-practice-improvement-and-redesign-how-change-workflow-can-be-supported-clinical-decision.

 [329]. Byrne et al., supra note 327, at 1–2 (documenting challenges facing CDSS).

 [330]. Garber, supra note 140, at 67 (“The most crucial—and controversial—question for evidence-based coverage policy concerns the adequacy of evidence. What standards must the body of evidence meet to support a decision to offer coverage?”).

 [331]. Daniel Wolfson et al., Engaging Physicians and Consumers in Conversations About Treatment Overuse and Waste: A Short History of the Choosing Wisely Campaign, 89 Acad. Med. 990, 990 (2014). See also Choosing Wisely, http://www.choosingwisely.org (last visited May 8, 2018).

 [332]. Wolfson et al., supra note 331, at 991.

 [333]. Id. at 990.

 [334]. See Choosing Wisely: Partnering with Patients to Make Better Choices on Using Health Care Services, Me. Health Mgmt. Coalition (Oct. 10, 2013), https://www.mainequalitycounts.org
/image_upload/Choosing%20Wisely%20Presentation%20from%20Kellie_Kathy_Betty.pdf; Special Society Partners, Choosing Wisely, http://www.choosingwisely.org/our-mission/specialty-society-partners (last visited May 8, 2018).

 [335]. Wolfson et al., supra note 331, at 994; Press Release, Robert Wood Johnson Found., $4.2 Million Grant Program to Support Health Care Organization Implementation of Choosing Wisely Recommendations (Jan. 8, 2015), https://www.rwjf.org/en/library/articles-and-news/2015/01/new–4-2-million-grant-program-to-support-health-care-organizati.html.

 [336]. See About ACR, Am. C. of Radiology, https://www.acr.org/About-ACR (last visited May 8, 2018).

 [337]. Am. Coll. of Radiology, Don’t Do Imaging for Uncomplicated Headache, Choosing Wisely (Apr. 4, 2012), http://www.choosingwisely.org/clinician-lists/american-college-radiology-imaging-for-uncomplicated-headache.

 [338]. Id.

 [339]. See Rosenberg et al., supra note 125, at 1913.

 [340]. See M. Susan Ridgely & Michael D. Greenberg, Too Many Alerts, Too Much Liability: Sorting Through the Malpractice Implications of Drug-Drug Interaction Clinical Decision Support, 5 St. Louis U. J. Health L. & Pol’y 257, 280 (2012) (“Given that the law in most states now recognizes a national (as opposed to local) standard of care, having a group of appropriate national professional societies involved in ratifying a national DDI list should have the effect of ‘moving the goal posts’ even faster. Malpractice liability will continue to be judged based on negligence, and by comparison with professional standards of care, so moving the goal posts in terms of the standard of care seems like a reasonable strategy to employ.”).

 [341]. See id. at 279–80 (noting that use of professional organizations has the benefit of creating a single nationwide standard and engaging relevant expertise).

 [342]. Although other countries do have government-funded national panels. See Ross Koppel, The Marginal Utility of Marginal Guidance: Commentary on Too Many Alerts, Too Much Liability: Sorting Through the Malpractice Implications of Drug-Drug Interaction Clinical Decision Support by M. Susan Ridgely and Michael D. Greenberg, 5 St. Louis U. J. Health L. & Pol’y 311, 316 (2012).

 [343]. See Advancing Clinical Decision Support, Rand Corp., https://www.rand.org/health/projects
/clinical-decision-support.html, (last visited May 8, 2018); Ridgely & Greenberg, supra note 340, at 280.

 [344]. See, e.g., Press Release, Blue Cross Blue Shield Ass’n, Blue Cross and Blue Shield Association Releases ‘Investing in America’s Health’ (Jan. 29, 2014), https://www.bcbs.com/news/press-releases
/blue-cross-and-blue-shield-association-releases-investing-americas-health (describing the Technology Evaluation Center).

 [345]. There are also groups involved in what is termed “academic detailing”—university-based or non-commercial groups without ties to industry that educate providers with a goal of encouraging adherence to medical evidence from randomized controlled trials. These groups might also be a source of relevant data. See Michael A. Fischer & Jerry Avorn, Academic Detailing Can Play a Key Role in Assessing and Implementing Comparative Effectiveness Research Findings, 31 Health Aff. 2206, 2206–10 (2012). See also Garber, supra note 140, at 65–66 (describing the Canadian Task Force on the Periodic Health Examination, the U.S. Preventive Services Task Force, and the U.S. Agency for Healthcare Research and Quality).

 [346]. Paul Keckley, Medical Necessity and Unnecessary Care, Health Care Blog (Jan. 29, 2015), http://thehealthcareblog.com/blog/2015/01/29/medical-necessity-and-unnecessary-care (“The data and sophisticated analytic tools upon which determinations of medical necessity and unnecessary care are increasingly available. Defaults that ‘my patients are different’ and ‘we don’t have the data’ will fall on deaf ears.”).

 [347]. A concern remains, however, of automatic click through rather than processing of information.

 [348]. See, e.g., Peter Davey et al., Interventions to Improve Antibiotic Prescribing Practices for Hospital Inpatients, Cochrane Database of Systematic Revs., Apr. 30, 2013, at 1, 2, http://onlinelibrary.wiley.com/enhanced/exportCitation/doi/10.1002/14651858.CD003543.pub3; Linda Court Salisbury, Minimum Payment Warnings and Information Disclosure Effects on Consumer Debt Repayment Decisions, 3 J. Pub. Pol’y & Mktg. 49, 57–62 (2014) (finding that an information nudge greatly increased proportion of consumers choosing three-year payment amount).

 [349]. Howard I. Kushner, Evidence-Based Medicine and the Physician-Patient Dyad, 14 Permanente J. 64, 64 (2010).

 [350]. Mary Brophy Marcus, Do You Really Need That MRI?, CBS News (Dec. 16, 2015, 12:44 PM), http://www.cbsnews.com/news/do-you-really-need-that-mri.

 [351]. Id.

 [352]. Choosing Wisely at Crystal Run Healthcare, Choosing Wisely (Aug. 7, 2014), http://www.choosingwisely.org/resources/updates-from-the-field/choosing-wisely-at-crystal-run-healthcare.

 [353]. Ruth E. Thomas et al., Effect of Enhanced Feedback and Brief Educational Reminder Messages on Laboratory Test Requesting in Primary Care: A Cluster Randomised Trial, 367 Lancet 1990, 1990–96 (2006).

 [354]. Andrew Georgiou et al., The Impact of Computerized Provider Order Entry Systems on Medical-Imaging Services: A Systematic Review, 18 J. Am. Med. Informatics Ass’n 335, 339 (2011) (reporting that electronic reminders promoted adherence to ordering guidelines and can reduce unnecessary and inappropriate testing).

 [355]. See, e.g., Davey et al., supra note 348, at 2 (“[I]nterventions to increase effective prescribing can improve clinical outcome.”).

 [356]. Kevin M. Terrell et al., Computerized Decision Support to Reduce Potentially Inappropriate Prescribing to Older Emergency Department Patients: A Randomized, Controlled Trial, 57 J. Am. Geriatric Soc’y 1388, 1390–91, 1393 (2009) (finding that the electronic decision support system reduced the amount of emergency room discharges that resulted in a potentially inappropriate prescription). But see Section IV.C.3 for a discussion of how such systems can also be ineffective.

 [357]. See, e.g., Andrew Georgiou et al., The Impact of Computerized Physician Order Entry Systems on Pathology Services: A Systematic Review, 76 Int’l J. Med. Informatics 514, 523 (2007) (reviewing four studies that found CPOE use resulted in improved compliance with guidelines); David F. Lobach, Electronically Distributed, Computer-Generated, Individualized Feedback Enhances the Use of a Computerized Practice Guideline, J. Am. Med. Informatics Ass’n Ann. Fall Symp. 1996, at 493, 496 (1996) (finding increased compliance with guidelines without high maintenance expenses).

 [358]. See supra Section I.C.1 for a discussion of provider incentives.

 [359]. See Roger Fontes, Negotiating Contracts with Insurance Companies, MD Mag. (Aug. 16, 2013), http://www.mdmag.com/physicians-money-digest/practice-management/negotiating-contracts-with-insurance-companies-fontes (“[I]nsurance companies have the more dominant negotiating position in most circumstances.”).

 [360]. See supra Section II.B.

 [361]. See id.

 [362]. See Donald Marron, Obama’s Nudge Brigade: White House Embraces Behavioral Sciences to Improve Government, Forbes: Business in the Beltway (Sept. 16, 2015, 3:32 PM), https://www.forbes.com/sites/beltway/2015/09/16/obama-nudge-government. See generally Behav. Insights Team, http://www.behaviouralinsights.co.uk (last visited May 8, 2018).

 [363]. See Saurabh Bhargava & George Loewenstein, Behavioral Economics and Public Policy 102: Beyond Nudging, 105 Am. Econ. Rev.: Papers & Proc. 396, 397 (2015).

 [364]. See Brigitte C. Madrian, Applying Insights from Behavioral Economics to Policy Design, 6 Ann. Rev. Econ. 663, 664–68 (2014) (discussing various policy tools that have been used to influence consumer behavior).

 [365]. See Bhargava & Loewenstein, supra note 363, at 397.

 [366]. See Jacobi et al., Health Insurer Market Behavior, supra note 138, at 114–28 (discussing federal and state efforts to regulate insurance contracts and how these efforts have shifted after the ACA).

 [367]. See id. Most of the conditions that government currently places on insurer contracts are related to coverage decisions that are exclusively within the control of the insurer. This type of legal mandate would therefore be somewhat of a departure from other requirements.

 [368]. Jacobi et al., Sentinel Project, supra note 155, at 11.

 [369]. Id.

 [370]. A mandate does make the “nudge” a requirement, which is a bit of an odd formulation. Despite a heavy hand in requiring the warning system, however, the providers themselves are still more nudged than shoved because they may opt out of the warning’s advice.

 [371]. See, e.g., Hurd, supra note 293, at 703, 734.

 [372].                                                                       See, e.g., Terrie R. Fried, Shared Decision Making—Finding the Sweet Spot, 374 New Eng. J. Med. 104, 104 (2016).

 [373]. Karen J. Maschke & Michael K. Gusmano, Evidence and Access to Biomedical Interventions: The Case of Stem Cell Treatments, 41 J. Health Pol., Pol’y & L. 917, 918 (2016). See also Mantel, supra note 145, at 694 (“Like government regulators, insurers simply cannot develop timely, detailed rules for the full range of treatment decisions given the breadth of the medical landscape, the lack of definitive clinical information, and constantly evolving medical knowledge.”).

 [374]. See Ridgely & Greenberg, supra note 340, at 258 (discussing the challenge of “developing clinical practice guidelines that can be readily and unambiguously translated into a computable form”).

 [375]. See Koppel, supra note 342, at 314–15.

 [376]. See, e.g., Eisenberg & Price, supra note 7, at 39–48 (discussing current regulatory efforts and areas for improved regulation to spur clinical research); Sachs, supra note 7, at 392–96 (discussing additional areas to incentivize insurers to participate in clinical research). See also Baicker et al., supra note 19, at 51 (suggesting government subsidization of clinical effectiveness research).

 [377]. See Clark C. Havighurst, Health Care Choices: Private Contracts as Instruments of Health Reform 117–37 (1995); Michael E. Chernew et al., Value-Based Insurance Design, 26 Health Aff. 195, 198 (2007); Austin Frakt, Health Plans that Nudge Patients to do the Right Thing, N.Y. Times: The Upshot (July 10, 2017), https://nyti.ms/2u03ARI (explaining that a value-based insurance design is an option currently being explored).

 [378]. E.g., Marshall B. Kapp, Getting Physicians and Patients to Choose Wisely: Does the Law Help or Hurt?, 46 U. Tol. L. Rev. 529, 533–34 (2015).

 [379]. See Davey et al., supra note 348, at 2–4 (finding that stewardship programs can decrease antibiotic prescription rates); Gilad J. Kuperman et al., Medication-Related Clinical Decision Support in Computerized Order Entry Systems: A Review, 14 J. Am. Med. Informatics Ass’n 29, 29 (2007).

 [380]. See Baicker et al., supra note 19, at 49–50; Eisenberg & Price, supra note 7, at 29. Indeed, it is possible to make the nudge even stronger by, for instance, requiring that providers justify to insurers their decisions to ignore a warning prompt. A more coercive approach seems likely to hinder provider buy-in, but different regimes merit testing for effectiveness.

 [381]. A malpractice “safe harbor” might also be employed for providers who change their practices based on the warnings. See Ridgely & Greenberg, supra note 340, at 262 (suggesting a “safe harbor” to aid adoption of drug-drug interaction protocols).

 [382]. Press Release, Accenture, Doctors Agree on Top Healthcare IT Benefits, But Generational Divide Exists, According to Accenture Eight-Country Survey (Jan. 10, 2012), https://newsroom.accenture.com/subjects/research-surveys/doctors-agree-on-top-healthcare-it-benefits-but-generational-divide-exists-according-to-accenture-eight-country-survey.htm.

 [383]. See Terry, supra note 312, at 12–13; Walter & Lopez, supra note 233, at 208, 212–13.

 [384]. Walter & Lopez, supra note 233, at 207.

 [385]. Even if a doctor may not be timely influenced by an alert of unnecessary care for a current patient, at the very least, the alert may influence the care of future patients.

 [386]. See Ridgely & Greenberg, supra note 340, at 258.

 [387]. Koppel, supra note 342, at 314 (“[P]roviders quickly become enraged at the constant (but irrelevant) reminders associated with many of the medication orders they enter.”); Ridgely & Greenberg, supra note 340, at 258, 261 (“CDS systems ‘generate excessive number[s] of alerts, many of which are clinically unhelpful.’”); Sarah Patricia Slight et al., A Cross-Sectional Observational Study of High Override Rates of Drug Allergy Alerts in Inpatient and Outpatient Settings, and Opportunities for Improvement, 26 BMJ Quality & Safety 217, 223–24 (2017).

 [388]. For this reason, it might even be worth considering state-level regulation (or even more localized implementation), first, to allow experimentation on a smaller-scale.

 [389]. See Eisenberg & Price, supra note 7, at 29.

 [390]. Id. at 48.

 [391]. This assumes a cost already born to implement the IT-based warning system in the first place.

 [392]. See Epstein, Price Transparency, supra note 17, at 24–29 (discussing the promise of incentive-based compensation, but encouraging targeted implementation that takes account of the need to innovate and motivate).

 [393]. See Epstein, Nudging Patient, supra note 133, at 1266–74 (describing informed consent doctrine).

 [394]. Id. at 1271.

 [395]. Id. at 1305. See also Katherine Berry et al., Influence of Information Framing on Patient Decisions to Treat Actinic Keratosis, 153 JAMA Dermatology 421, 421, 424–25 (2017) (finding patient decisions significantly affected by physician wording).

 [396]. See Cass R. Sunstein, Choosing Not to Choose: Understanding the Value of Choice 107 (2015).

 [397]. See Austin B. Frakt & Nicolas Bagley, Why It’s So Hard for Insurers to Compete Over Technology, news@JAMA: JAMA Forum (July 5, 2017), https://newsatjama.jama.com/2017/07/05
/jama-forum-why-its-so-hard-for-insurers-to-compete-over-technology (discussing other options and hurdles to success).