The Institutional Dynamics of Transition Relief

Jonathan Masur & Jonathan Nash

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In this Article, we consider what type of institution should provide legal transition relief and analyze the form that it should take. These questions are of great importance because the issue of legal transition relief—whether and how an institution should compensate parties because a change in the law adversely affects them—arises any time a new legal regime would render illegal behavior that societal actors previously have engaged in legally. Relief from legal transitions can assume many forms. Transition relief may allow societal actors already engaging in the behavior in question to continue to do so (at least to some degree) on a going-forward basis, often called “grandfathering.” Or, it may offer them some form of monetary or other compensation for the loss of that ability. Transition relief can benefit—and, conversely, its absence can harm—producers, consumers, employees, and investors. To mention just two contemporary examples, both greenhouse gas regulation (at both the domestic and international levels) and efforts to rein in executive compensation at major financial corporations spark questions of transition relief.

For many years, the traditional law and economics literature advocated strongly against legal transition relief. Led most prominently by Louis Kaplow, scholars argued that we should treat legal transitions no differently from other types of transitions faced by societal actors, for which the government does not provide relief. Recent commentary, however, questions the scope of Kaplow’s claim. Scholars have pointed out that considerations of efficiency, incentives for socially desirable investments, governmental legitimacy, and fairness might justify legal transition relief.

Assuming then that transition relief is appropriate under at least some circumstances, we identify two centrally important questions for which scholars have yet to find satisfactory answers. First, while societal actors often hedge against transitions in technology and the economy by obtaining insurance in the private market, such a market does not exist with respect to legal transitions. We attempt to explain its puzzling absence. Second, commentators who advocate transition relief in limited circumstances do not confront the critical question of what institutional structure is best designed to ensure that transition relief is meted out only where justified and in an appropriately limited form. We suggest a framework for allocating authority over transition relief within the government.

First, there exists no meaningful market for regulatory insurance in the United States—not even a market for insurance against government takings (which would appear to be a much simpler endeavor). In attempting to explain this gap in the market, scholars have pinned the blame on a variety of the usual economic culprits: moral hazard, adverse selection, and the difficulty of finding uncorrelated risks. But we do not believe that these effects, or any combination of them, can explain the lack of a private market.

Moral hazard problems exist when an insured party engages in behavior—particularly as a consequence of purchasing insurance—that the insurer has not priced into the contract. So long as coverage is based upon a firm’s current business rather than hypothetical developments and new product lines, the insurer should be able to accurately price the firm’s behavior. A fixed-payment insurance contract that provided a lump-sum payout in the event of regulation, rather than one that protected a firm against its full losses, would protect the insurer against threats of moral hazard. Similarly, insurers would need to protect themselves against lobbying that increased the likelihood of regulation. Insurers should again be able to cure these moral hazard problems through contract. The parties simply could write regulatory insurance contracts to ban any lobbying activities by insured firms (and to force them to take no public position on relevant regulatory action). And it should not be difficult for insurers to monitor this type of activity. Thus, it seems unlikely that private insurance markets have failed to arise due to unavoidable moral hazard problems.

Several scholars have suggested that adverse selection problems are likely to plague systems designed to insure against takings or regulation. For instance, homeowners who know that they are more likely to be subject to takings will opt into insurance plans at higher rates. Like threats of moral hazard, however, adverse selection problems depend at their core on information asymmetries. If all relevant information is public, insurers can price contracts accurately, and higher-risk private parties who wish to opt in will be able to do so only at elevated rates. Information asymmetries may be present in the context of takings of real property, but they are unlikely to plague more general regulatory insurance. The key to the adverse selection problem for takings insurance is that both the vast majority of the relevant governmental action and the potential insured parties are local, while the principal insurers are not. It is this geographic and political divide that gives rise to the necessary informational asymmetries. The types of economic regulation that concern us here, by contrast, are rarely local; they are almost always created by state and federal governmental entities. There is negligible private information about these types of regulation (except the information held by the government actors themselves), and so regulated firms possess essentially no informational advantage over their putative insurers. Without such an asymmetry, there can be no problem of adverse selection.

Finally, state and national regulation can have potent and widespread effects, particularly if it comes from a populous, highly industrialized state such as California or New York. The difficulty in assembling a portfolio of truly uncorrelated risk positions in the face of such widespread single-event threats might be preventing a robust market for regulatory insurance from forming. We do not, however, believe that this is the case. Well-conceived regulatory insurance would cover only one (or a finite number) of the potential business risks to a firm. A potential insurer could select which of these many available risks it is willing to assume, knowing that any individual regulation would lead only to a partial decrease in firm value—not the complete destruction of the firm. In a competitive marketplace of multiple insurers, any given firm should be able to find one or more insurers willing to take on some slice of risk. Thus, a fear of correlated risks cannot account for the complete absence of a market for regulatory insurance.

Rather, we believe that the major impediment to a private market for legal transition insurance is the chore of pricing. In comparison to typical accidents, significant regulatory acts occur extremely infrequently, usually numbering just below one thousand per year nationally. Even this description overstates their quantity in the same way that a reporting of all fires, floods, automobile accidents, and illnesses would overstate the effective number of insurance claims (and thus the number of useful data points) in a given year. Each federal agency issues no more than a handful of regulations each year, and thus any given regulatory field is altered only rarely. Without a broader pool of data to draw upon, an insurance firm cannot reliably estimate the hazards presented by any given regulation. In addition, unlike traffic accidents or house fires, regulatory acts are effectively one-off, nonstochastic events. An individual fitting a given demographic profile in 2005 is, for the most part, equally likely to have an automobile accident as a similarly situated individual in 2006; what variation exists is captured by the easily obtainable demographic information that insurers collect. Accordingly, data from 2005 are useful in predicting 2006 outcomes, data from 2004 are useful in predicting both 2005 and 2006, and so on. The likelihood of a particular regulation, on the other hand, depends upon a wide variety of factors, the impact of which is often unobservable or unpredictable. A shift in agency leadership or political priorities, a transfer of governmental power, a change in membership or chairmanship on a key committee, or even new developments in science or technology (or even culture) can affect the probability of any given regulation in any particular field in unforeseeable ways.

Worse still, regulation in one period is not necessarily a good proxy for regulation in another period. The fact that the EPA has acted once to regulate the level of arsenic in drinking water has ambiguous effects on the likelihood that the agency will act again, either to raise or lower allowable levels. It may indicate that a similarly situated EPA will tighten the arsenic standard; it may lead the EPA to learn that the current level of protection is needlessly high and prompt a relaxation of those limits; or it may simply indicate that the EPA already has selected a near-optimal level of regulation and that the status quo is likely to persist. Based on available quantitative data alone, an outside observer has almost no capacity to select among these possibilities. Even the meaning of potential explanatory variables can change over time, and often rapidly. Democrats in Georgia in 1972 were very different than Democrats in Georgia in 1992, who were in turn very different than Democrats in Georgia in 2006.

These pricing difficulties imply that government efforts to foster a private market in insurance will be ultimately unsuccessful; the informational difficulties are too great, and the government lacks a means of surmounting them. In addition, even more exotic options such as information markets and regulatory derivatives will not serve as workable substitutes. The same pricing problems that inhibit private insurance will prevent firms from investing in regulatory derivatives in quantities necessary to make them a useful hedge.

In the absence of a private market for transition relief, government-provided relief remains a viable option. The key to our solution is the disaggregation of transition relief into various steps and the allocation of individual duties based on institutional competency. We proceed in three stages. First, we unbundle the various steps that compose transition relief, and we explain how the decisions or decisionmaking involved in some of those steps differ from those involved in other steps (and from decisions and decisionmaking in the ordinary regulatory context). Some decisions regarding transition relief are more akin to plenary lawmaking. These decisions affect numerous societal actors and draw their resolution from broad societal values. Here, one might think of the broad decision of whether transition relief is warranted in the first instance. Other decisions are more in the nature of applications of an existing legal structure to particular private actors. Numerous issues that arise in transition relief settings are highly technocratic (as opposed to value-laden) in this sense: for instance, whether a modification of an existing building should subject the structure to regulation as if it were new construction; whether a transaction was consummated before or after the advent of a new legal regime; and how to allocate limited funds or grandfathering rights.

Second, consider the role of expertise in making these narrow, technocratic decisions. To be sure, expertise in the particular area of law at issue is of some value. But that kind of expertise is often exceeded in value by more general expertise in meting out transition relief. Questions that arise in these decisions transcend particular areas of law. The question of whether a modification should be treated as a new construction arises in environmental law, land use law, and disabilities law, to name just a few areas. The question of whether a transaction should be deemed consummated before or after a legal change takes effect arises in tax law and bankruptcy law. And the question of how to distribute limited funds or grandfathering rights arises in environmental law and natural resources law. This strongly suggests that a single government agency could accumulate considerable relevant expertise were it charged with handling such transition relief decisions across various legal specialties.

Finally, we observe that private actors will naturally be willing to invest money and time to obtain transition relief, and government actors will face an incentive to mete it out in return for private benefits. A government actor that is charged with distributing transition relief—even in accordance with some set legal scheme—likely will enjoy some discretion in making those decisions. The less that a government body is subject to lobbying by outside influences, the less it will fall prey to private rent-seeking in the allocation of transition relief. Accordingly, we conclude that an independent agency might be best situated to make some decisions related to the provision and application of transition relief.

Acknowledgments:

Copyright © 2010 NYU Law Review.

Jonathan Masur is a professor at the University of Chicago Law School.

Jonathan Nash is a professor at Emory University Law School.


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