The edict itself may seem a bit ridiculous — and the threat of pulling highway funds heavy-handed — but this use of federal funds to induce local compliance is likely permissible under existing case law. Courts would be unlikely to find the amount of money at stake to be large enough to create problems under NFIB v. Sebelius, and I don’t believe the restrictions imposed by the Highway Beautification Act are stringent enough to raise significant First Amendment concerns.
UPDATE: Marc Scribner explains why the threat to Times Square’s billboards is not the fault of the Obama administration or Transportation Department bureaucrats. Rather, it “is a classic example of Congress passing stupid laws, ordering regulators to implement them stupidly, and then forgetting about them until unintended consequences spring up down the line.” Added irony: NYC’s current transportation commissioner, Polly Trottenberg, was Transportation undersecretary for policy when one of the statutory provisions that now poses a threat to Times Square was passed.
SECOND UPDATE: The Federal Highway Administration (FHWA) has issued the following statement:
FHWA has been working with the New York State DOT and the New York City DOT for nearly a year to correct this unintentional consequence of extending the National Highway System (NHS). At no time has FHWA asked NYCDOT to remove the billboards from Times Square or threatened to withhold federal funds. FHWA and NYSDOT have discussed the possibility of removing the NHS designation from specific roadways, and FHWA stands ready to act if we receive that request from the state.