November 3, 1998
Rules Docket Clerk
Office of General Counsel, Room 10276
Department of Housing and Urban Development
451 Seventh Street, SW
Washington, DC 20410-0500
The Office of Advocacy is submitting these comments on the Regulatory Flexibility Act (RFA)(1) certification on the above-mentioned rulemaking. The Department of Housing and Urban Development (HUD), pursuant to the RFA, certified that the rule would not have "a significant impact on a substantial number of small entities." (2)The Office of Advocacy believes that this rulemaking has been incorrectly certified, since no factual basis has been provided to explain the agency’s certification and therefore, is not in compliance with the RFA. These comments summarize the certification errors and offer suggestions on how to address these RFA issues.
However, the Office of Advocacy also believes that this certification statement is a good start on the initial regulatory flexibility analysis required under the law, because HUD has produced substantial excellent economic analysis on its proposal. These comments provide assistance to HUD with the belief that only a modest amount of additional analysis, and subsequent publication of a request for comment on RFA issues, would be necessary to meet RFA requirements.
I. An IRFA Must Explain and Establish Certification Criteria
The published analysis fails to offer specific criteria (or a baseline) by which to judge whether its estimated regulatory costs are valid and will not impose a significant impact on a substantial number of small entities. While the impact analysis mentions the criteria used by the National Oceanic and Atmospheric Administration (NOAA), it does not identify or apply these criteria (or any other) to the analysis.
Under 5 USC 706 (§ 706 of the Administrative Procedures Act), the court will review HUD’s final rule to determine whether "the agency has articulated a rational connection between its factual judgment and its ultimate policy choice."(3) Under 5 USC 553, that "rational connection" must be presented in the statement of basis and purpose of the final rule.(4) That statement of basis and purpose must also respond to comments made about the "rational connection," comments that arise only when the regulatory agency provides notice of its reasoning to the public.(5) Thus, the proposed rule must also "articulate with reasonable clarity its reasons for decision, and identify the significance of the crucial facts."(6)
As discussed above, HUD made only passing reference in its "Impact Analysis" to criteria for assessing the significance of expected regulatory costs and offered no discussion of this critical RFA element in the public notice. Because of HUD’s brief reference to the NOAA "significant impact" criteria, the next several paragraphs discuss the NOAA criteria. Following immediately there after is a discussion of "significant impact criteria" the Office of Advocacy finds particularly useful when assessing the economic significance of a regulation on small entities.
(a) A decrease in annual gross revenues of more than 5 percent, for 20 percent or more of the affected small entities.
A gross revenue or "sales test" has meaning only in the context of net income (pre-tax profit). For some economic sectors, a 5 percent impact has almost no meaning at all. Physicians’ for example, earn net income (pre-tax profit) that is 35.2 percent of total income. Engineering and architectural services’ net income is 9.4 percent of total income and for them, a 5 percent decrease in gross revenues could cut profits in more than half. The agricultural services, forestry and fishing sector has an average net income of only 3.8 percent of gross revenues. As seen in the attached table, the net income of the housing sector within the corporate economy averages less than 3 percent overall and less than 5 percent for profitable entities.(7) On average, a 5 percent decrease in annual gross revenues would extinguish the profitability of this sector – a sector with only 59 percent of firms reporting a profit in the first place. The NOAA test does not reflect the realities in the housing market place,
(b) An increase in total costs of production of more than 5 percent as a result of an increase in compliance costs, for 20 percent or more of the affected small entities.
Once again, the 5 percent criterion must be compared with the overall profitability of the sector. In addition, agencies should examine a production cost increase in the context of effect on cash flow, thus predicting the cost impact on firms’ short-term solvency. As with the previous criterion, the measure does not reflect the realities in the housing market place.
(c) Compliance costs as a percent of sales for small entities that are at least 10 percent higher than compliance costs as a percentage of sales for large entities, for 20 percent or more of the affected small entities.
A recent study on the role and impact of small businesses in the American economy(8) indicates that the market place is not a nursery where small firms grow into large ones. Rather, the market place is a crucible within which small firms, and their owners, either fail or are hardened into competitive enterprises, some of which grow into large firms and some of which succeed as small firms. The rate of entry and exit varies significantly by market place (industrial or commercial sector). Economies of scale exist in almost every sector. The intent of the Regulatory Flexibility Act is to identify those rules imposing too great a barrier to entry into a market or causing too many exits from a market. As already noted, impact on profit can predict the likely effect on market exit. Compliance costs as a percent of revenues can do so only if set against an understanding of firm profitability. Comparison of relative cost impact for small and large entities has no significance unless small and large entities have similar profit rates (they usually don’t) and the costs are large in comparison with profits. This criterion has no discriminating value in the absence of a rationale for its use in a specific industry.
(d) Capital costs of compliance that represent significant portions of capital available to small entities, considering internal cash flow and external financing capabilities.
Both cash flow and financing potential offer strong indicators of impact on an industrial sector. The guideline properly leaves ambiguous the size of costs necessary to impose a "significant impact." HUD did not apply this measure to their rule, but if they had, they should have defined what constituted a significant portion of cash flow and an unacceptable level of debt, based on facts developed for the housing industry.
(e) Two percent of small business entities affected being forced to cease business operations.
As discussed under the third criterion, small businesses exit the market all the time. Only an analysis of the market exit rate could determine whether a two- percent increase in market exit would constitute a significant increase. Properly done, this analysis should identify the normal market lifetime of small entities and whether the proposed rule would significantly shortened that lifetime.
In addition, HUD should apply a firm closure model; reflecting common business analysis practices, rather than apply the method most recently used by a NOAA agency. That agency applied a criterion that a firm would exit the market if its revenues decreased by 50 percent. Considering that one of the richest sectors (physicians) only have net income of 35 percent of revenues, the 50 percent value seems extraordinary. Based on the less than 3 percent net income rate for the corporate housing sector, HUD might use a value much smaller than that used by the NOAA agency.
HUD must go beyond a description of the costs its regulation will impose. It must explain how it applied logic to those facts to reach its decision.(9) HUD must specify and examine the criteria used to measure the significance of cost impacts on small entities, and explain why these criteria measure cost significance. These costs then must be presented in comparison with the criteria in order to illustrate whether the proposed rule meets or fails to meet the criteria. Without this final step, the criteria become irrelevant, and could be viewed as an arbitrary set of standards. Additionally, HUD’s failure to complete all three steps described above opens the agency to legal liability under the APA.
II. An IRFA Must Describe Small Entities Subject to the Rulemaking
HUD’s Small Business Impact Analysis offers a detailed examination of the number and type of housing units affected by its proposed regulations; however, except for public housing, HUD fails to discuss the number of small entities affected by its rule. The agency also fails to offer any description of small entities potentially affected by the rule that a commenter might use to understand the salutary potential of regulatory alternatives. This effectively leaves 75 percent of all unit ownership unexamined by the agency.
Despite the lack of data in the underlying analytical document, HUD does offer a count of the national total number of small entities potentially affected by the proposed rule. This single summary number does not offer a description of potentially affected small entities, especially in the context of the various regulatory requirements or with regard to the economic and financial status of those entities. The RFA requires that this information be included in the IRFA and, without this information, the published analysis is in violation of the statute.
The published analysis is should be revised to elicit substantive comments concerning regulatory flexibility. Advocacy notes that HUD, despite the stringency of the statute, has requested information from stakeholders concerning regulatory flexibility issues, and that this regulation is extremely important from a public policy standpoint.
However, if HUD determined, as it should, that the rule would impose a significant economic impact on a substantial number of small entities, preparation of an adequate initial regulatory flexibility analysis need neither be resource intensive nor time consuming, and the Office of Advocacy is willing to meet with the agency to discuss how this can be done.
If there are any questions regarding these comments, please do not hesitate to call Mr. Damon Dozier, the Assistant Advocate for Environmental Policy, who can be reached at (202) 205-6936, or Dr. David W. Schnare, Senior Advisor on Regulatory Analysis, who can be reached at (202) 205-7176.
Sincerely,
Jere W. Glover
Chief Counsel for Advocacy
cc: Art Fraas, OMB
ENDNOTES
1. Pub. L. No. 96-354, 94 Stat. 1164 (codified at 5 USC § 601)
2. 5 USC § 605(b)
3. Center for Auto Safety v. FHA, 956 F.2d 309, 313 (D.C. Cir. 1992).
4. Crowley’s Yacht Yard, Inc. v. Pena, 863 F.Supp. 18, 21 (D.D.C. 1994).
5. American Medical Ass’n v. Reno, 57 F3d 1129, 1132-33 (D.C. Cir. 1995).
6. Greater Boston Television v. FCC, 444 F.2d 841, 851 (D.C. Cir. 1970).
7. U.S. IRS, Statistics of Income Report, Total Assets, Trade or Business Income and Deductions, Portfolio Income, Rental Income, and Total Net Income, by Industrial Groups – 1995, All Partnerships, (1997).
8. Office of Advocacy, Office of Economic Research, The New American Evolution: The Role and Impact of Small Firms, 1998.
9. See, Crowley’s Yacht Yard at 21.