Beyond Tort Reform

The U.S. securities markets are on the way to losing their pre-eminence. That's the conclusion reached by two recent reports, one indirectly sponsored by Treasury Secretary Paulson and the other by Mayor Bloomberg and Senator Chuck Schumer. The facts are indeed alarming — the American share of global initial public offerings declined to 5% from 50% in the last five years.

Foreign companies are being scared away in part, both reports conclude, by soaring costs of American law. The highwater mark for securities lawsuits was reached in 2005, with over $9 billion in class action settlements. The zeal of American prosecutors in corporate scandals is also of a different order of magnitude. In 2004, government fines in America totalled $4.74 billion, over 100 times more than in Britain, which had a total of $40.48 million. Sarbanes-Oxley, the federal law that imposes higher accountability standards on corporate boards, has almost tripled auditing costs for small public companies.

But competitiveness is a complex phenomenon, critics correctly observe. Yes, New York is losing its luster, but globalization is inevitable in securities markets. Moreover, the "litigation tax," while large for companies that pay it, is only a drop in the bucket in international markets.

What's largely missing in this debate is the critical role of trust in the law. Perhaps the most chilling parts of the Bloomberg-Schumer report are the surveys of foreign business leaders who suggest, overwhelmingly, that they no longer trust American law. For most of the last century, trust in American commercial and securities law was one of our greatest competitive advantages. Investors flocked to our markets because securities laws guaranteed transparency and honesty. American contract law was the gold standard for world business, in part because of a long tradition of judges rigidly applying guidelines of liability and damages. Economist Douglass North received a Nobel prize in part for his work on the vital role of legal stability in economic prosperity.

An "essential element of the concept of justice," legal philosopher H.L.A. Hart observed, "is the principle of treating like cases alike." That's why law is the foundation of freedom — people know where they stand. They can act freely instead of looking over their shoulders all day long.

But that trust has now capsized. Companies are afraid that if a few employees out of thousands do something wrong — even if not material to the bottom line — the company faces the prospect of ruin. An indictment, not a conviction, could put a company out of business. Why roll the legal dice in America when legal systems in Britain and elsewhere focus on punishing the individual wrongdoer, not shooting everyone in sight?

We should have seen it coming. Over 20 years ago the dean of Harvard Law School, Derek Bok, observed that "Foreign businessmen express amazement at a system … that exposes the entrepreneur to legal challenge so easily and on so many different fronts, a system that lends itself so readily to harassment, obstruction, and delay."

In those 20 years, foreign investors have witnessed litigation that actually destroyed industries. The tragedy of asbestos, which cries out for a legislative compensation plan, was instead handled by class action litigation that, to date, has driven over 70 companies into bankruptcy — irrespective of whether there was any causal link between the company and the victims.

Sarbanes-Oxley is a mixed blessing, improving oversight of management by corporate boards, but also exposing executives to personal liability for procedural errors. Business people tend to rely on their instincts of right and wrong based on their general understanding of law. If they might be personally liable for a problem with internal controls in a remote subsidiary, they may do business elsewhere.

The premise of American law in recent decades is that there can never be too much accountability. If some litigation and fear of prosecution for wrongdoing are good, then why not open the gates? But a sword of Damocles approach to justice drives business away and makes those who stay so paranoid that they cannot effectively operate. Corporate board meetings have become an exercise in water torture, a slow drip of formal reports designed not to uncover truth but to cover everyone's backsides.

It's impossible to measure how much distrust of law has contributed to declining competitiveness. But the evidence is all around us. Just talk with foreign business leaders. The main victims of this trend, however, are employees and their pension plans. Drying up of markets means that countless people lose job opportunities and that innovation moves offshore.

Trust, once lost, is hard to regain. Tort reforms limiting damages don't get close to the heart of the problem. American justice has a deeper flaw — it no longer reliably distinguishes right from wrong. Instead, decisions are made on an ad hoc basis, jury by jury, without predictable boundaries.

What's needed is not merely more tort reform, but also a fundamental shift in goals, toward balance and predictability. Only then can we rebuild the trust in law that used to be one of America's greatest competitive assets.

Mr. Howard, a lawyer, is a partner at Covington & Burling and chairman of Common Good, a nonpartisan legal reform group, cgood.org.