March 14, 2004
From the desk of Mindles H. Dreck:Reasonable Doubts about Regulation
I submit to you that regulators of commerce in the United States are gradually:
- Subsidizing discovery for both public and private litigants
- Substituting subjective standards of fraud and misbehavior for specific guidelines
These trends will alter commercial and social activity in this country dramatically over the coming decades, although it is quite difficult to forecast the effects. I also believe that one's approach to these developments challenges the typical political boundaries of economic liberalism vs. 'progressive' statism or traditional conservatism vs. liberalism.
These pages have touched on many different developments relating to the tort bar and regulation, from my co-blogger's classic essays such as "Can We Sue Our Own Fat Asses Off?" and regulatory capture to my own comments on medical malpractice, financial institutions regulation, Sarbanes-Oxley and accounting disclosure. Unsurprisingly, my co-blogger and I have a similar aversion to many current regulatory developments, although we disagreed on the importance of expensing options.
In each case, there is a trade-off (or false dichotomy, some might say) between enforcement of behavioral standards through prescriptive guidelines/regulations or through the tort bar. Amidst our discussion of medical malpractice problems commenter Bernard Yomtov (if I remember correctly) asked why the growth in large medical settlements should bother privatization advocates like the Galt crew. The growing effectiveness of the tort bar in extracting large settlements, he avers, is merely privatizing regulation of medical care.
Bernard raised an interesting point - recent trends in financial regulation amount to giving up on the idea of strict prescriptive guidelines of behavior in favor of both subjective guidelines and creating a paper trail for litigators. Recent regulatory initiatives have focused on
- permanent retention and storage of internal and external email in non-alterable, third-party maintained media
- substantial, sworn disclosure of procedures and safeguards (via Sarbanes-Oxley, for instance)
- the identification of key individuals that should become the focus of any government or litigation action (via designation of key officers and departments, and the Sarbanes-Oxley mechanism of written representations)
- The adoption of subjective definitions of fraud and misrepresentation and disconnected remedies thereto.
- Continuous, subjective and coervice examination procedures
- The use of regulatory examinations to promote hiring practices and political correctness
I believe we can generalize from these developments that regulators, like the rest of us, are developing a post-modern cynicism about rule-writing. As with taxation and accounting guidelines, the more we attempt to make rules specific and comprehensive, the more opportunities for misbehavior and regulatory capture we seem to create.
Prosecution has recently focused on procedural matters or fraud in post-investigatory conduct than actual infractions. Martha Stewart was convicted for her conduct as the target of an investigation of insider trading, not insider trading itself. prosecutors elected not to bring charges on her trading after the investigation. Frank Quattrone was accused of destroying evidence and witness tampering. Quattrone faced no charges on the allegations of allocating hot stock offerings that made him an investigation target. But while the government was unable to successfully charge Quattrone or his employer, civil actions extracted a $100 million settlement from Quattrone's employer. Like the O.J. Simpson case, civil awards succeeded where criminal prosecution failed upon a higher standard of evidence.
Delegation to the tort bar, however, is neither entirely privatization nor problem-free. While tort lawyers themselves are not government employees, a trial verdict has the power of government behind it. It is not the market at work, it is a mechanism for enforcing explicit and implicit contracts. Regulators are forcing the private sector to modify its contracts and providing case preparation before the fact. This is truly a litigation subsidy. Some would suggest this merely levels the playing field between individual litigants and powerful institutional defendants. In some cases this is no doubt true, but not all. The class action lawsuit has certainly brought substantial means to the tort bar. In addition, the government can bring civil suit as well, and while the government may not dedicate as much money to trial, it certainly has other resources at its disposal. For instance, "regulatory blackmail" is common, where routine permits, licenses and filings unconnected to the complaints against a regulated entity are held up pending resolution of the matter (Infinity broadcasting complains that all its merger filings were delayed indefinitely while it was protesting an 'indecency' fine) It is far from clear that these legal subsidies aren't given to those with the deepest pockets or the greater power.
We understand the problems with civil suits, particularly jury trials. Juries tend to be sympathetic to anyone who suffers injury and generally weigh the specific costs of a jury award at the expense of its second-order effects. The insurance company can surely spare a few million for this unfortunate soul with breast cancer subsequent to a breast implant regardless of actual causative connections; one jury award can't possibly cause plant closings and slow innovation. Or so the reasoning seems to go.
I suspect we will trade one problem for another. If we increasingly rely on the pressures of potential civil litigation to alter behavior it may eventually rebound on the legal profession. I recently had a billing dispute with a securities lawyer. I referred to an email he had written some months before estimating charges for the assignment. He informed me that his firm's policy is to permanently destroy all email over three months old in order to protect the firm and its clients. Given the requirements for email retention in the financial industry (interpreting which his firm make's a pretty penny), I found this hysterically funny. Some time in the future, I suspect, objects of aggressive legal prosecution will prevail upon the authorities to invade privilege and subject the trial lawyers themselves to the same discovery subsidy that corporations suffer. So the keeper will become the kept. The only winners will be regulators looking for jobs.
No easy answers here (no unified Asymmetrical theory, if you will), but I can certainly speak anecdotally from recent experience that these new developments have a paralytic effect. It is incredibly difficult to recruit experienced outside board members and prohibitively expensive to buy them D&O insurance. Other experienced professionals are leaving their jobs rather than sign research reports, Sarbanes-Oxley filings on large entities or compliance certifications. Financial institutions and professional service E&O insurance prices are skyrocketing. The majority of technology budgets in the financial industry are focused on compliance with new regulation as opposed to innovation. The corporate sector is not far behind. It isn't just highly-ranked professionals or insurance and technology budgets. Simple open discourse is jeopardized. Institutions are beginning to govern intra-firm correspondence, or even investigative legal work product with an eye towards protecting themselves when this correspondence is made public. Critical expression must be oral and off-the-record, or it must be without substance. The ultimate effect is not just to disclose communication but to impede it. Without open, direct communication the firm stagnates. Writ large, these trends would seem to be a strong force for economic stagnation.
Posted by Mindles H. Dreck at March 14, 2004 1:29 PM | TrackBack | Technorati inbound linksThey are already contributing to policy stagnation. The very charged political effort to open all of the policy recommendations made to the White House through the energy policy task force is a case in point.
It is becoming far more difficult for policy makers at all levels to receive candid input, because of the possibility that that the input will later be used by others against the provider. Enterprise management will be far more likely to receive the "mushroom treatment", or to hear only what they are believed to "want to hear" in such an environment.
In some ways, the much heralded political "leak" has similar effects. Candid policy discussions can be made public with impunity by any participant who disagrees with the discussions, or with the conclusions or policy directions which result from them. This tends to reduce the munber of participants in these discussions and also to inhibit free input into the process.
Congress writes vague laws, encouraging regulators to "push to envelope". The courts then generally give the regulators latitude, encouraging further envelope pushing. The media then does its "berzerker" routine when later regulators try to take a step away from the edge. The history of the New Source Review process under the Clean Air Act is an interesting case in point.
This is a very, very important post. I'll try to comment further at my place.
And our firm doesn't purge e-mails that quickly, MHD, so if you're looking for alternative representation...
Yes, a very good and important post. My liberarianism has always presumed that less government regulation implied greater tort support. And that government regulation was, at least in part, a subtle subsidy to private industry.
Civil litigation is an economically inefficient method of regulation. Medical malpractice cases have not served to effectively police the ranks of physicians. Doctors continue to practice, even after being sued repeatedly. Worse, many specialties are becoming unavailable in the most litigious states because the cost of malpractice insurance is prohibitive. States have turned to caps on pain and suffering awards, and doctors have resorted to going without malpractice insurance. Health care already suffers from tremendous economic inefficiency. Employing civil courts as regulators only furthers this inefficiency.
These issues are discussed at length in Collapse of the Common Good, by Philip K. Howard. In the book, he reaches many of the same conclusions as our dear blogger does.
I don't agree with all of the text, but it's not a bad read...
Glad to see that Mindles has been let free from his cage once again! And a nice post, too.
Today's events (see Spain) have already been depressing enough, and now to consider this as well! Good post, unfortunately.....
I am a registered representative, that is only one of the designations I carry, and only so that I can sell variable products as an insurance agent. Recently in discussion with my broker/dealer's chief compliance officer he said that they may have to start capturing and saving all email from the reps address of record. I would estimate that something less than 1% of email traffic through that address even tangentially touches on securites. It seems ludicrous for all those to be saved just in case I am accused of misconduct, and further it seems like a huge invasion of privacy. Of course the solution is simple, but it none the less rankles.
No easy answers here (no unified Asymmetrical theory, if you will), but I can certainly speak anecdotally from recent experience that these new developments have a paralytic effect.
Anecdotally seems to be the biggest problem with this topic. In NJ there was a 'doctors strike' in support of a bill to cap malpractice rewards at $1M, in order to control the cost of malpractice insurance. I searched very hard to find any hard numbers on how many awards there were for over $1M. It was almost impossible to find any hard numbers but it appears that only a handful of cases reached such amounts. Why spend so much energy for such a reform when its advocates can't even tell if it would impact a serious number of cases.
I did find a lot of evidence that malpractice companies did little screening of doctors. Many of them are privately held corporations that are not required to release public financial data. They can claim its the legal system driving up awards but can selectively release the data that supports that claim. What really floored me was that I found articles that stated insurance companies do not keep track of doctors' records! A doctor that has been successfully before gets the same premiums as a doctor who has not.
This is in sharp contrast to the auto industry which seems to data mine every last scrap of information to fine tune their rates.
This has lead me to conclude that this topic is full of people with agendas and self interest of various soughts. This means that much of the information we receive is ancedotal or calculated by dubious assumptions (I squint my eyes whenever I read an assertion that something 'costs' this much to comply with every year).
I'll end my triad against ancedotal evidence with a piece of ancedotal evidence. A week or two ago I noticed a full page add in the Wall Street Journal for 'legal reform'. Naturally it was short on specifics but long on long-winded assertions such as 'Lack of legal reform costs jobs'. One piece of data it presented was the claim that frivious lawsuits cost every American $809 per year. Immediately I looked at the footnotes and what did I see? They basically took the sum of all lawsuits together and divided by the number of Americans. The number is valid if you considered every lawsuit to be frivious.
Just because it can't be googled easily doesn't mean it doesn't exist. Voluminous data exists in mandated statutory filings every year and the data is most certainly available. Thomson/Sheshunoff will sell it all to you for about $21k per year
Here is a presentation given at the casualty actuarial society in 2002. The page linked (13) shows median awards and settlements rising to about $800k and $650k, respectively in 1999. You might also be interested in some data on so-called mega awards compiled by HHS. These huge awards have the affect of pushing up settlement values by the simple math of Value at risk (if you increase the probability, even a tiny bit, of a huge award, the expected value of the claim is increased - hence the logic of capping).
There are plenty of interested parties pushing dubious aggregations of data (I would not include either the Casualty Actuary community or HHS in that), but there is more than sufficient data to show trends in the economics of this crappy business.
WRT Mindles's comments about big settlements and VAR, I think there's some confusion, in the public debate about insurance premiums and payouts, between the concepts of average and marginal payout. The average insurance payout in a particular type of case may be small, but the existence of just a few very large payouts, even for other types of cases, is enough to increase significantly the risk faced by insurers, and hence the premiums they must charge. The payout distribution is analogous to the price distribution for a security, where increased variability increases the value of options written on that security, and sometimes even on other securities. These have been difficult points to convey in my occasional discussions of tort reform with a couple of lawyer friends. Part of the cause of the problem here, as in other public-policy controversies, is that students may graduate from schools of law and journalism without receiving any serious instruction in how markets set prices.
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