The American business model part 3: the role of lawyers

Every society should be subject to the rule of law. This is not the same as rule by lawyers. In its worship of law, the United States is both an example and a warning.

In Russia, the rule of law has come to mean protection of property rights. This is understandable, since private property was illegal in the Soviet Union. The most urgent requirement of a private business system is secure title to property. Without it, businesses cannot borrow, because they can offer no security for loans; investors will not buy businesses unless they are sure that they will own them. For the Peruvian economist Herman De Soto, title to property is the key to economic growth.

Property rights have to be secure both against the state and against other private individuals. In Russia, there is a big problem because, when the Soviet system broke down, a great deal of state property was privately acquired in a legal vacuum. This is sure to be one of the main issues in the forthcoming trial of Mikhail Khodorkovsky.

The recent cases brought by the US Security and Exchange Commission against leading mutual funds concern violation of property rights. The charge is that the managers of the funds knowingly traded the money entrusted to them in ways which were either illegal or contrary to their prospectuses. Leading companies like Putnams and Bank of America (CHECK) have had to pay out hundreds of millions of dollars in fines and restitution to investors.

So far, so good. But in the United States the law has been unleashed against business in much more aggressive ways, through the explosion of product-liability litigation. The most spectacular example was in 1998 when the US tobacco industry agreed to pay out a staggering $246bn.-about half of Russia’s national income – as compensation to state governments for the costs that cigarette smoking had imposed on the public health care system. In this, and many other cases –ranging from asbestos to breast-implants and scalding coffee –the law is now being used to tax away private property rights in a way which could never be achieved by the political process. It does this by sanctioning the obnoxious principle of retroactive law – punishment for past actions which were legal at the time – by turning buyers of products into passive victims rather than active choosers, and by an uncritical attitude to the ‘junk science’ on which many of the claims for compensation are based.

Two special features of the American legal tradition have enabled this to happen. The first is the class action lawsuit: a device for allowing many litigants to press the same claim at once. It was the extension of class action lawsuits to personal injury litigation which has brought about the explosion of claims. Lawyers could calculate how many people had bought a product said to be defective, and bring a class action suit on their behalf, independent of their consent, or of harm actually suffered. For example, in 1999 Toshiba paid $2.1bn to settle a class-action suit over a flaw in five million of its popular lap top computers, which the vast majority of users had never noticed.

The second special feature is contingency payment. Lawyers are allowed to get paid not by fees, but by sharing in damages awarded to their clients. This gives them an incentive to litigate on behalf of as many people as possible to boost the total settlement. In the tobacco lawsuit, lawyers fees were said to have been over $20bn, creating a new class of legal billionaires.

Product liability litigation is often the result of corrupt deals between private laws firms and state attorney generals eager to get re-elected by espousing populist causes. Russia should heed America on the rule of law, but make sure it does not lead to the rule of lawyers.