How to Fix The Tort System

A real solution requires pragmatism, not politics. BusinessWeek's four-point plan would preserve the benefits and eliminate the excesses

This should be a triumphant moment for Thomas A. Gottschalk. As the executive vice-president for law and public policy at General Motors Corp. (GM ), he has devoted his long career to battling plaintiffs' lawyers. So you might think Gottschalk would be thrilled about the recently passed Class Action Fairness Act (CAFA), the biggest federal tort reform of his 62-year lifetime. Guess again. "CAFA will not eliminate many class actions," predicts the steely former litigator. "It was a modest procedural step."

That's the verdict of most of Gottschalk's longtime allies -- from the generals to the ground troops -- in America's tort war. They portray the U.S. legal system as a dire economic threat that jacks up the price of cars, drives obstetricians out of work, and effectively taxes all Americans' standard of living. Truly tackling these problems, many business leaders believe, requires a whole lot more than CAFA -- or anything else on Washington's agenda. In fact, they find inspiration overseas. Gottschalk, for example, wants to borrow an idea from Britain, where the losers of lawsuits pay for the winners' expenses. Other self-described tort reformers want to reduce the role of juries, whack big damage awards, and truly reshape American justice. "The whole tort reform debate in this country is pathetic," grouses Philip K. Howard, founder of the New York legal policy group Common Good.

That's about the only point that all sides agree on. Plaintiffs' lawyers, union leaders, and consumer advocates accuse Howard, Gottschalk & Co. of polluting the policy dialogue with bogus numbers and misleading anecdotes. They offer a radically different view of reality. Citing Vioxx, Enron, Firestone, WorldCom, and other recent scandals, the business community's opponents argue with equal passion that now is no time to be loosening the restraints on executive misbehavior by eviscerating the role of the courts. "Corporate America wants immunity from misdeeds through tort reform," charges Frederick M. Baron, ex-President of the Association of Trial Lawyers of America (ATLA).

Is either side right? How bad is the American legal system? What's the best way to fix it? These issues, for the first time in years, are squarely on the table. Now that CAFA is on the books, Bush wants to move on to medical malpractice litigation, the asbestos mess, and beyond. The stakes transcend the narrow-sounding issue of tort law -- the body of precedents governing personal injuries. The mislabeled "tort reform" debate also touches on antitrust, consumer protection, employment, environmental, and securities law. These all play a key role in determining the safety guidelines for cars, doctors, drugs, food, and construction sites. The cost-benefit choices we make in this arena influence the design of children's toys, the content of 10-Ks, how often office workers must view sexual harassment prevention videos, the amount of money given to asbestos victims, and countless other unique features of U.S. society.

Tort reform, then, is more than simply an economic policy debate. It's also about justice -- the ultimate values issue. How people feel about the subject directly depends on how they feel about things like individual responsibility and the public obligations of private companies. Do they attach more blame to McDonald's Corp. (MCD ) for making fattening hamburgers -- or to obese teenagers for eating them? "The debate is really about what kind of culture we want to have in America," says Cornell University law professor Douglas A. Kyser. "A lot of deep political issues get discussed through tort law language."

Problem is, much of the discussion has been distorted by hyperbole from both sides. Despite the alarmism from Corporate America, most of the big verdicts that become urban legends are reduced on appeal. Nor is there authoritative evidence that plaintiffs' lawyers are weighing down the economy. This is, in part, because there are no reliable aggregate data about the system. America's network of federal, state, and local tribunals is sprawling and undigitized. Nobody knows how many cases are filed each year or how they turn out -- especially since the vast majority are settled out of court. So any macroeconomic conclusions are speculative. When Bush claims that the annual "litigation tax" in America is $246 billion, it's a guess.

To the extent that reliable data do exist, they show no signs of broad systemic breakdown. The latest statistics from the Bureau of Economic Analysis indicate that legal services accounted for less than 1.5% of gross domestic product in 2003 -- a slightly lower share than in 1990. That means the legal industry has lagged the overall economy. Such slow growth suggests that lawyers are not reaping a bonanza from winning -- and defending -- big corporate cases. Moreover, the strong productivity gains in recent years undercut the argument that rapacious plaintiff lawyers are strangling growth.

Does this mean there's no case against the tort system? Not at all. Just that the strongest evidence of plaintiffs' lawyer misconduct doesn't rest on broad economic data. Rather, the real crisis lies in the proliferation of specific types of bogus cases -- ones in which nobody has been injured, no malfeasance has occurred, or regulators have already taken care of the problem. Despite their claims of being selfless safety advocates, plaintiffs' attorneys in 2005 are analogous to chief executives in 1999: Most of the players are making an honest living. But an unacceptably high percentage of them are stretching the rules.

BusinessWeek's four-part solution to the problem is based on a set of pragmatic principles, with some parallels to those being used to clean up Corporate America. Like CEOs, lawyers should, first of all, be paid for performance. They shouldn't be allowed to take home multimillion-dollar paychecks if clients get pennies. Second, they shouldn't be able to cash in when they're merely piling on to government crackdowns. Third: When attorneys break the rules, the punishment should sting. These days, lawyers who file frivolous suits barely get their wrists slapped. These simple reforms would eliminate the most abusive cases while preserving the rights of victims. In the rare cases where they did not go far enough, such as asbestos, a far more radical change -- exiting the courts altogether -- may work better.

Surprisingly, the excesses in America's legal system grew out of the country's commitment to free markets and individualism. Modern tort law began with the unprecedented wave of injuries spawned by the Industrial Revolution. A century ago, when a worker lost his arm in a mill or a consumer got poisoned by canned food, he was generally out of luck, as were his dependents. Few people bought insurance back then, and the courts frowned on personal injury suits. The families of the young women who perished in New York's Triangle Shirtwaist Factory Building fire in 1911, to take one classic case, collected wrongful death payments of just $75 apiece -- despite rotten fire hoses, locked escape doors, and other signs of clear negligence.

Starting in the early decades of the 20th century, in piecemeal fashion, U.S. legislators and judges began tearing down the barriers that protected companies against lawsuits. Until 1916, for example, consumers could only sue the distributors that sold defective products, not the manufacturers. That changed when the wooden wheel on Donald C. MacPherson's 1910 Buick Runabout collapsed. In a landmark opinion, New York state court judge Benjamin Cardozo held that Buick Motor Co. owed a duty to the end user -- triggering the first of many big bangs in corporate liability. The progressives and New Dealers who championed the expansion of tort liability "wanted to create social insurance for the many misfortunes of life, including accidental injury, disability, and unemployment," says Robert W. Gordon, a professor at Yale Law School.

After World War II, tort law received a boost from economists -- something that would probably come as a surprise to many businesspeople today. A new generation of scholars such as Guido Calabresi and Richard A. Posner (both now federal judges) started writing law review articles packed with dense equations. They argued that the tort system should be more than simply a method of compensating the victims of misfortune. Instead, it should be a free-market tool for preventing accidents in the first place. In the real world, this usually meant hiking the liability on manufacturers, giving them a financial incentive to improve the safety of their products. The economic theory essentially held that the most socially efficient outcome would be achieved when the cost of the safety improvements matched the cost of being sued.

The result is one of those exceptional American institutions that sometimes causes the rest of the industrialized world to rub its eyes in wonder: A tort system that functions as both an insurance mechanism and as a form of decentralized regulation. Loud-mouthed, Lear-jetting, billboard-advertising plaintiffs' attorneys have been officially deputized to serve as private-sector adjuncts to the Securities & Exchange Commission (SEC), the Food & Drug Administration (FDA), the National Highway Traffic Safety Administration (NHTSA), and a wealth of other federal and state agencies. "Europeans would be extremely nervous with this kind of arrangement," observes Michael Greve, a German-born tort reform expert at the conservative American Enterprise Institute in Washington.

What do they do in Germany, Belgium, or France when sport-utility vehicles roll over? For starters, the victim's medical expenses are covered by nationalized health care. And lost wages are largely picked up by employers or the government. So nobody needs to go to court to be made whole -- and punitive damages aren't allowed. It's basically a no-fault system that renders plaintiffs' lawyers irrelevant, eliminating most of the expensive features of the U.S. adversarial system, such as pretrial discovery.

That probably sounds great to many in Corporate America. But built into the Western European system is an even greater degree of regulation. Instead of offloading responsibilities to plaintiffs' lawyers, bureaucrats and administrative judges do all the work. "You can substitute for tort law by having more extensive social insurance and relying on regulators to a greater extent," says Mark Geistfeld, an expert in comparative jurisprudence at New York University School of Law. "But it's not like the cost disappears; it just becomes part of the tax base."

That's why comparisons between the U.S. and other countries are misleading. Britain, Germany, and Japan all have fewer lawyers per capita than America -- a fact critics of the U.S. love to cite. But these countries don't ask their attorneys to engage in business regulation, and they have more restricted notions of individual rights. As a result, tort changes that call for importing a big idea from overseas miss the larger context. Making courtroom losers pay their opponents' legal expenses only works in Britain because it is part of a larger whole that also includes nationalized health insurance.

Throwing out big chunks of the U.S. system, therefore, isn't a grand solution. Sure, it's theoretically possible to eliminate punitive damages or adopt other European-style reforms without bringing aboard their entire social safety net. But it almost certainly wouldn't end there. One way or another, the American public will demand that the Firestones and Enrons of the world be held accountable for tire blow-outs and financial blowups. Radical reductions in corporate liability would undercut the accountability of genuinely bad actors. It wouldn't take long before the public would cry out for more regulation. This is one reason why the AEI's Greve thinks it could be foolhardy for medical-device makers to lobby for broad legal immunity for products approved by the FDA. "As soon as the agency made a mistake and 14 people died, there would be hysteria, and the whole approval process would be shut down," he predicts. "You need a sensible mix of public and private enforcement."

The right way to reform the U.S. tort system is not to put most plaintiffs' lawyers on the streets but to ensure that they do a better job at their two key roles: compensating victims and deterring corporate wrongdoing. The crisis is not that ambulance chasers are wrecking the economy, but that too many entrepreneurial personal-injury attorneys have found illegitimate ways to earn money. Tort reformers aren't directly attacking this problem. Instead of cracking down on exploitative lawyers, the critics often try to solve the problem by punishing their clients. For instance, the White House's main idea for reducing the cost of medical malpractice litigation is to place an arbitrary $250,000 ceiling on pain-and-suffering recoveries, which would hurt the most severely injured malpractice victims, such as those blinded or paralyzed. That would also shortchange blue-collar workers, the elderly, and others who couldn't receive big compensation for lost earnings.

This is the wrong approach. The big mistake of the last century was not excessive compassion. The fact that America offers the most compensation worldwide for intangible emotional injuries is a tribute to the country's best humanitarian impulses. In retrospect, the thing that the legal theorists overlooked was that tort law would become a big business. Invited to become private corporate cops, way too many plaintiffs' attorneys crashed the party. The challenge now is to weed out the parasites without compromising fundamental values. Here's how:

1. Pay for Performance

This fix would eliminate a big chunk of the most abusive cases. The main target would be cases like a 1996 false advertising suit against Intel Corp. (INTC ), which awarded 500,000 people the right to claim a $50 discount off a new microprocessor. Only 150, or 0.0003%, took advantage of the offer. The plaintiffs' lawyers, meanwhile, walked off with nearly $1.5 million. Hundreds of similar tales could be told. The Intel case highlights the single most scandalous thing about the American tort system: the low percentage of people who truly benefit from class actions. The problem is not confined to the notorious episodes, like Intel, in which people are awarded coupons. Many alleged "victims" don't even bother to collect hard cash. A still unpublished study by James D. Cox and Randall S. Thomas, professors from Duke University and Vanderbilt University law schools, indicates that even sophisticated institutional investors claim less than 30% of the money they could get from securities-fraud class actions.

It's no mystery why this happens. Defendants want to keep redemption rates low -- and many plaintiffs' lawyers don't care. Their fees are set when deals are signed and pegged to a high theoretical number of claimants. Judges, meanwhile, are way too busy to bird-dog settled disputes. This distorted set of incentives produces unintelligible award notices buried deep in newspapers, burdensome forms to fill out, and short claim periods.

Solution: Reverse the economics of class-action settlements. Plaintiffs' lawyers should be paid after victims collect their money -- not before. This would have two benefits. First, it would make them more aggressive about getting the word out to class members. Second, and more important, it would filter out a high percentage of the system's silliest claims. One of the main reasons people don't bother to collect class-action benefits is that they don't perceive any injury in the first place. And if people don't think they've been hurt, it's often a strong sign that the case isn't worth bringing.

A little-noticed provision of the recent Class Action Fairness Act instituted this pay-for-performance rule for coupon settlements, which account for approximately 10% of all class settlements. The reform now needs to be extended to the much broader world of cases in which people get cash or goods in kind -- like toasters or tires.

An equally important move would target cases that require almost no work. Consider the dozens of suits filed against Christie's International PLC and Sotheby's Holdings Inc. (BID ) for price-fixing in 2000. Because the U.S. Justice Dept. dug out plentiful evidence of a joint conspiracy to prop up the sales commissions that the two premier auction houses charged clients, the private filings were slam dunks. While the plaintiffs' lawyers helped distribute money to victims, they did not deserve their typical 33% share of the take. So U.S. District Judge Lewis A. Kaplan of Manhattan came up with a creative plan: forcing plaintiffs' lawyers to bid for the job in a reverse auction. The firm that promised to give the biggest sum to the victims won. This is one of the best ways ever devised to ensure that the tort system effectively fulfills its compensation function. More judges should follow Kaplan's lead.

2. Penalties That Sting

The Christie's-Sotheby's story raises a point often overlooked: The players in the best position to resolve the problem are often judges, not legislators. Judges can figure out when attorneys in their courtrooms are acting in bad faith. In contrast, politicians can only police the system from afar by rewriting laws, which always produces unintended consequences.

One fix: Give judges stronger tools to punish renegade lawyers. Before 1993, it was mandatory for judges to impose sanctions such as public censures, fines, or orders to pay for the other side's legal expenses on lawyers who filed frivolous lawsuits. Then the Civil Rules Advisory Committee (CRAC), an obscure branch of the courts, made penalties optional. This needs to be reversed, either by the CRAC or by Congress.

Simply rewriting the rules only solves part of this problem, though. An equally important step is for judges to rise to the challenge and use their disciplinary powers. For too long, a cozy, protect-the-guild mentality has protected exploitative attorneys from serious punishment. So the cost of filing baseless harassment lawsuits has never approached the rewards of cashing in on them. The tough regime should apply on both sides of the bar. Judges have also been far too relaxed about punishing defense attorneys who destroy documents -- a tactic that's every bit as serious as filing frivolous cases.

3. Curb the Duplication

The third reform targets one of Corporate America's biggest complaints: duplicative litigation. This problem arises in a wide variety of settings. Think of the lawsuits involving cigarettes, Vioxx, or the Windows operating system. The companies at the center of the storms -- Philip Morris (now Altria Group (MO )), Merck (MRK ), and Microsoft, (MSFT ) respectively -- each faced administrative inquiries, individual cases, and class actions filed by private lawyers, state attorneys general, and federal regulators.

The U.S. system encourages this type of overlapping enforcement -- and it's O.K. if every player contributes something unique to the ultimate solution. But that isn't always the case. After the National Highway Traffic Safety Administration announced that it was investigating alleged suspension problems with Dodge Durango trucks, plaintiffs' lawyers filed five class actions asking the company to recall the vehicles. Chrysler voluntarily agreed to do so -- and then had to spend money fighting tort lawyers claiming credit for the move. Three of the cases have been dismissed.

Corporate America's preferred solution to the duplication problem is so-called preemption -- getting Congress to declare that agency approval of, say, a particular drug blocks subsequent private litigation. That would be fine if agencies had perfect foresight. But as the Vioxx episode proves, they don't. "When you preempt, you make a decision about future cases for all time," says D. Bruce Hoffman, formerly deputy director of the Bureau of Competition at the Federal Trade Commission and now in private practice. Winning preemption "should be a very steep hill [for companies] to climb."

A better solution is a package of more modest reforms. The first one would be eliminating punitive damages for injuries caused by products that have been approved by regulators. The long and involved process of winning over the FDA or NHTSA should, at a minimum, insulate managers from claims that they deserve huge financial penalties for wantonly disregarding the public good (unless executives lied to bureaucrats). A second idea is giving judges explicit authority to reject class actions that duplicate ongoing regulatory initiatives. That will require a mechanism for ensuring that judges find out whether an agency is reviewing issues raised in class actions -- something that's missing now. The committee that sets rules for civil litigation, or Congress, needs to fix these problems.

4. Exiting the Tort System

These three changes would solve many of the tort system's genuine problems, but not all of them. There are rare issues that need to be removed from the courts -- with all of their elaborate procedural rules -- and directed into specialized administrative tribunals. One of them, clearly, is asbestos. Aggressive plaintiffs' lawyers are overloading the judiciary with thousands of dubious cases that don't even involve sick people. Congress' plan to create a trust fund to handle this problem makes sense.

Asbestos is the easy case. The tougher one is medical malpractice. Evidence of massive systemic malfunction is starting to accumulate. Only about 2% of the people who are genuinely injured even bother to file lawsuits, according to most studies. When people do go to court, only 40% of every dollar spent on litigation goes to victims. Then there's the spreading damage to doctors. For some specialists, medical malpractice premiums can eat up between 20% and 50% of annual income. That's why neurosurgeons are avoiding trauma cases and orthopedic surgeons are eliminating emergency room calls.

The steady drumbeat of problems has prompted many physicians, lawyers, and politicians to support the idea of special health courts. They would have dedicated judges, a panel of neutral experts, and medically trained staff. Because pretrial discovery would be limited, the cost of filing cases would decline. The theory is that this would induce more injured people to make claims, and that they would get their money faster.

But there's a big trade-off -- no emotional or punitive damages. To ensure consistency, health court awards would be based on a European-style damages schedule. In Britain, for example, damages paid for quadriplegia range from $311,000 to $387,000, depending on a patient's residual movement, depression, pain, and age. What's more, victims won't get to tell their story to a jury. That worries consumer advocates, who fear that the health-care industry would find a way to control these courts. "The jury is the only unit of government that is nonpartisan and not elected. It doesn't have to answer to anybody," says Barry Boughton, a lawyer with Public Citizen.

That's a powerful objection. Before reengineering American justice, we should get more information about the problem and experiment with some modest steps. One would be giving juries considering emotional damages guidance about what other juries have done in similar cases. Studies have shown that this would cut down on the unpredictable verdicts that torment doctors and insurers. Another step: publicizing data on how often doctors have been sued for malpractice or disciplined by their states' medical boards.

These moves do not go as far as advocates like Common Good's Howard would like. But they surpass anything on the table. There is, ultimately, no perfect way to balance the interests of everybody who has a stake in the medical malpractice debate -- or any of the other broad issues subsumed under the tort reform banner. Any rule changes that protect doctors or drugmakers, by definition, would limit the rights of some victims. The guiding principle for tort reform should be to target bad lawsuits as narrowly as possible. That's the only way to balance the enormous values at stake.

Corrections and Clarifications In "How to fix the tort system" (Cover Story, Mar. 14), we miscalculated the percentage of eligible people who took advantage of a class-action judgment against Intel Corp. (INTC ): 150 of 500,000 is 0.03% (not 0.0003%).

By Mike France

With Lorraine Woellert in Washington and Michael J. Mandel in New York

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