No Law

In his inaugural address, President George W. Bush followed many of his predecessors in defining freedom as the highest American political value. What was less noticed was that he also made an important qualification, that freedom must be "sustained by the rule of law" if it is to grow and survive. While he did not have time for it in that speech, he had previously set as one of his major goals for his second term the reform of our civil law. For, America cannot be a light to the world if it does not adhere to its own ideals.

Why is the rule of law so important? The World Bank has been trying for years to understand what brings prosperity to nations, relying on the incontestable logic that one cannot improve world conditions unless one knows what leads to success. After analyzing forty years of data from just about every existing nation, its main study found that having a sound rule of law was the number one prerequisite for prosperity.

In their study, rule of law explained almost sixty percent of why economies grow, while the second best factor, the amount of commercial trade, explained only about ten percent and the amount of education in a nation explained merely half of that. Government spending as a percentage of the economy was very strongly negatively related to economic growth and the amount of democracy in countries had a smaller but still negative effect. It seems socialism does not work and that if the people will not let law restrain them, they will use their majority to vote for things that do not promote prosperity.

It is interesting that the philosopher who most influenced American ideas about society and government, John Locke, made rule of law the defining characteristic of a sound government. While better known for his defense of freedom, property and separation of powers, he believed all of these depended on law. His first requirement for government was "an established, settled, known law, received and allowed by common consent to be the standard of right and wrong and the common measure to decide all controversies between them," which was devised by a representative legislature that "neither must or can transfer the power of making laws to anybody else." It is "to govern by promulgated, established laws, not to be varied in particular cases but to have one rule for rich and poor, the favorite at court and the countryman at plow."

This understanding was incorporated into American law and was the basis for its worldwide rise to freedom, prosperity and predominance. But it came under stress with the rise of the welfare state after the 1930s Depression. First, Congress did "transfer the power of making laws" to professional bureaucracies, political executives and judges in its haste to expand welfare and regulate business, changing law from "established, settled" principles set under "common consent" to being made by experts. Second, such laws becoming so numerous, remote and not publicly debated were no longer "promulgated" to nor "known" by most people. Finally, as administrative discretion became more accepted, they were "varied in particular cases" to advantage one more sympathetic interest over another less popular one or to punish those who could not be found guilty of disobeying established laws but seemed deserving of punishment anyway.

In recent years, the decline has become precipitous. Just this year, the authoritative Heritage Foundation/Wall Street Journal "Index of Economic Freedom" study, which includes many measures of rule of law, had found that the United States for the first time dropped out of the top ten countries on these measures. That is why the president made legal reform, and especially tort reform, one of his top priorities. Even a Washington Post columnist, Sebastian Mallaby, agreed: "The tort system is an abomination." It is "unpredictable." Relying upon the results of the best study of it by the consulting firm, Tillinghast-Towers-Perrin, updated since 1985, it is estimated that for 2003 the tort system cost $246 billion, or $845 in higher costs for goods, services and medical care per year for each American. The "shocking thing" is that less than half of the funds went to the injured plaintiffs and more than half of that went to emotional distress rather than economic compensation for actual and potential losses. An incredible 54 percent went to administration, with 33 percent going directly to the lawyers.

The greatest problem is that "the location of the trial, the composition of the jury and the depth of the defendant's pockets--not just the size of the injury" determines what defendants receive. It is this "haphazard nature of the tort payouts that undermines the potential salutary effect on corporate behavior" that is the larger point of a civil justice system. Court settlements are meant to compensate for injuries to individuals and affected parties--the greater the injury, the greater the payout supposedly--but the social benefit is that companies adjust their behavior to avoid future injuries to employees and/or customers as a means to escape the resulting damage awards, relying simply on their own self interest. If settlements are haphazard rather than based on "known standards" or hit the richest party nearby even if not at fault, however, companies or medical doctors do not know how to change their procedures to avoid additional injuries and suits in the future.

The problems with the law go well beyond torts to fraud generally. The crash of the stock market and related company failures in 2000-1 left many investors and employees in a particularly bitter mood, looking for scapegoats rather than at normal business fluctuations. The collapse of the Houston energy trader Enron in 2001 provided a convenient opportunity for government prosecutors. Enron was fast and loose with contracts and undoubtedly engaged in fraud. Prosecutors won plea agreements from its chief financial officer, who apparently was the guilty mastermind behind the scheme, and his wife (who was assistant treasurer) by threatening a longer sentence for the spouse than the one-year term she received. The chief executive officer and the lead accountant have also been charged, even though the main issue for the higher-ups is the mushy area of "conspiracy" to hide the fraud rather than the fraud itself, as was the case for poor Martha Stewart too.

Charging these officials apparently was not enough for the prosecutors. The chairman of Enron, Kenneth L. Lay, was better known, more smooth and richer so made a better target even though he had left the company to the CEO and only returned when problems appeared. John C. Coffee, Jr., a Columbia University law professor, says Lay was "a distant, hands-off manager who had resigned and come back" and was unlikely to have known the details of the fraud. Lay apparently did tell stockholders and employees that the company was doing better than it was and encouraged purchasing stock, stating that he was doing so himself. He had sold much stock earlier also but the Wall Street Journal estimates that he and his directors lost an incredible $250 million on their sales of stock. Most experts predict Lay should be acquitted but he will have spent four or more years in doubt and million of dollars to the lawyers, while the government loses nothing but the taxpayers money.

The problem is that, according to another law professor, Robert Weisberg of Stanford University: "It's hard to remember a major fraud case that went to a jury trial and led to an acquittal." Prosecutors are threatening Lay's wife Linda with prosecution because she sold stocks before he did and made money. As a result of such tactics against his spouse, Lay just might settle. It is difficult for juries to understand the technical accounting evidence (often not understood by CEOs either) and, of course, a company chairman and the CEO must have "conspired" (means breathe together or agree together) on something and he is rich and unsympathetic anyway. The chief executive officer of failed Tyco, L. Dennis Kozowski, was lucky to find a hung jury but he spent $2 million on a birthday party and who could sympathize with that when the jury comes to vote in the second trial that prosecutors have now set? In all of these cases, the government prosecutors settle with the defendants on whom they have the most proof of guilt in return for testimony against the more rich and famous. While it is strange to make a deal with the most obviously guilty party first, presumably their testimony bears great weight with a jury that could never comprehend a million dollar party.

The latest chief executive to face the wrath of the prosecutors is Bernard Ebbers of WorldCom. A Washington Post investigative report on several such business executives finds that the government's "best evidence" against him is the admittedly guilty company chief financial officer who has made a deal with prosecutors to say Ebbers told him to fix the books. Witnesses like this are seen as a "tutor" who can lead juries, according to Fordham University law professor, Daniel Richman. Ebbers did not use e-mail and there is no written evidence but that probably will not make much difference in a "his word against yours" courtroom world of a little guy (and his more invisible rich lawyer) against a rich, pushy CEO, regardless of the truth. Richard Scrushy of HealthSouth is next on the list. Martha Stewart can tell him and the others that juries will convict on conspiracy on the word of a guilty defendant who has made a deal.

In fact the Department of Justice Corporate Fraud Task Force, under Deputy Attorney General James B. Comey, has filed some 900 cases (60 against top corporate officers) and has won 500 pleas and a few convictions. The Securities and Exchange Commission has filed 600 civil enforcement actions, in both cases going well beyond the Congressional Sarbanes-Oxley Act of 2002, relying heavily on conspiracy and other such broad charges. State Attorneys General such as Elliott Spitzer of New York have been aggressive too. The U.S. Chamber of Commerce has called for a reevaluation of the aggressiveness of the task force, saying it is reaching too broadly and is affecting U.S. productivity.

Mr. Spitzer's special target has been the mutual funds business, which in the wake of the stock market bust, found sympathy with modest investors and affected employees. While he unearthed some fraud, the major effect was to embarrass Chairman William Donaldson of the SEC to keep up with him by proposing new regulations requiring 75 percent of mutual fund directors, including the chairman, to be "independent" of the firm. Unfortunately, 80 percent of chairman and half of the directors of U.S. firms fail this test and solving it may cost as much as $20,000 per stockholder. Obviously, most firms are innocent but they will have to pay this extra-legal penalty anyway. Indeed, although it was sponsored by the industry, one study shows that companies with independent boards have worse investment performance. While Sen. Judd Gregg has passed legislation to require a justification by the SEC, Congress has otherwise left matters to its bureaucracy.

More recently, ten former WorldCom directors reached tentative settlement of a class action suit by paying over $18 million each from their own pockets--without being able to use directors' insurance--representing one-fifth of their collective net worth. A few days later, ten former Enron directors agreed to pay $13 million each of their own money to settle a shareholder suit. The settlements were made in spite of a federal judge ruling that there were no grounds to seek redress from the Enron directors on fraud or insider-trading charges. None of the directors were shown to have participated in or knew about the frauds involved in the cases. But they were easy targets, including the wife of a former U.S. Senator.

This certainly looks like a legal system with no common, settled rules. Since even insurance cannot protect, it is financially risky to become a mere director and one faces prison for making poor decisions as a CEO. This must affect the risks businessmen will be willing to take and, therefore, affect business profitability and worker prosperity. Tort reform and a changed attitude about fair rules and enforcement generally are critical to avoid suppressing risk-taking among American business executives. This lack of fair rules is what has kept most of the World Bank countries from achieving economic success and just might help explain why the U.S. is falling behind.

Mallaby presents a sound list of tort reforms that should inform the Bush proposals. Rather than second-guessing company behavior years afterward when knowledge has changed, there should be a short statute of limitations on when claims can be filed. Asbestos manufacturers could not have known the dangers of their product, which was approved by all regulators at the time, so how can future companies change behavior based on what they do not know? He supports a schedule of awards for different types of injury (perhaps a range) to assure no one gets an advantage and that all receive something fair. Given the costs, standards need to be set to limit grounds for suit and disclosure laws on product safety can avoid many of the problems in the first place. And reform works. States that have passed tort reform reduced spending for hospital heart patients by 4 percent, according to one study, without adversely affecting patient health.

In defining business property rules, Congress must take rule making back from bureaucracies like the SEC and set a few knowable standards based on common consent and understanding that apply equally to all. Task forces with pre-defined targets must be abolished and allow prosecutors to enforce all law with equal scrutiny. Fraud should be rooted out, not mere conspiracy. And fraud must be real--how can a CEO puffing up his business be considered fraud? It should not be criminal to make a poor business judgment. Rather than pleas, those who are most guilty should get the most prosecutor resources and longest sentences, not the one who will garner the most media attention. Extorting pleas by threatening wives is probably not the most edifying approach for those who are supposed to be representing the dignity of the law.

It is not a concern for business or even for its future success in driving the economy that is the principal problem. As important as is prosperity, it is secondary to the law. If law is unpredictable and unknowable beforehand, it creates disorder, breeds disrespect and cannot be obeyed, so that all law and order is undermined. The survival of a rule of law is much more important for it is the foundation, as Mr. Bush reminded us, for our government based on popular consent and our very freedom.

Donald Devine, Editor.

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