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By Richard A. Epstein

Today, the momentum is growing for fundamentally restructuring the national residential mortgage market in the wake of the earlier collapse of the Federal National Mortgage Association (FNMA, or "Fannie Mae") and Federal Home Loan Mortgage Corporation (FHLMC, or "Freddie Mac). These two government-sponsored enterprises (GSEs)--so-called in recognition of their hybrid public/private nature--have long written large chunks of the residential home mortgage market, to the tune of trillions of dollars. The current legislative fixes now on the table include a bipartisan proposal from Tim Johnson and Mike Crapo, coupled with an earlier entry by Maxine Waters. The Johnson-Crapo proposal follows on earlier entries from Jeb Hensarling on the House side and Bob Corker on the Senate side. Each of these proposals seeks simultaneously to unwind the past and to redefine the future. To evaluate them requires understanding the historical linkage between past events and future prospects.

To begin, some background. In response to the brewing subprime mortgage crisis in 2008, Congress in late July of that year passed the Housing and Economic Recovery Act (HERA). That legislation, inter alia, created a new Federal Housing Finance Agency (FHFA), which on September 7, 2008 placed into a conservatorship both GSEs. These conservatorships were intended to keep both entities alive in order to facilitate their return to the private market. They were not receiverships whose object is the orderly liquidation of the two businesses. The basic plan called for an infusion of up to $200 billion in fresh cash into Fannie Mae and Freddie Mac under a Senior Preferred Stock Purchase Agreement (SPSPA) that gave the government warrants, exercisable at a nominal price, to acquire a 79.9 percent ownership stake in each enterprise. In exchange for that advance the senior preferred stock carried a 10 percent annual dividend payment, which went up to 12 percent if the GSEs delayed their dividend payments on the senior preferred.

The terms of that deal were radically altered in August 2012, when the United States, acting through the Treasury Department, imposed, through the Third Amendment to the 2008 SPSPA, a "net worth sweep" that entitled the government to 100 percent dividends on future earnings. That one bold stroke effectively made it impossible for the GSEs to repay their loans and rebuild their capital stock. Both the junior preferred stockholders and the common shareholders could under this agreement never receive a dime from either GSE, even after the entities returned to profitability. Assessing this gambit requires understanding two things: first, the relationship between the Third Amendment and the original 2008 SPSPA; and second, the relationship between the Third Amendment and efforts to revitalize the housing market. Both relationships are widely misunderstood today.

Prior Writings In July, 2013, I attacked the Third Amendment for its refusal to allow for any pay down of the $188 billion in advances made under the 2008 SPSPA. The government did so on the dubious ground that it could repudiate its obligations in the name of "taxpayer protection." At that time, the Third Amendment meant that some $59 billion in designated dividends should have been recharacterized first as a payment of accrued interest, and afterwards as a return of capital, which necessarily would reduce the interest payments going forward, and speed the path toward reprivatizing Fannie and Freddie. As I wrote then, "even if the 2008 transaction stands, the 2012 transaction should be nullified, and the private and common shares restored."

Thereafter in November, 2013, I attacked the position that the government took in its litigation with Washington Federal, where it sought by a variety of procedural devices to prevent the case from being heard. There is no question that many legal and factual obstacles stand in the path of any suit under the 2008 SPSPA, especially in comparison with the Third Amendment. But it hardly follows that those plaintiffs do not deserve their day in court, as the government has claimed by insisting that they do not have standing to bring this lawsuit.

Finally, in March of this year, I attacked the government position in the strongest possible terms in light of the recent revelations by Gretchen Morgenson's New York Times article, "The Untouchable Profits of Fannie Mae and Freddie Mac." As Morgenson revealed, the Treasury and FHFA had decided as early as December 2010 to block Fannie and Freddie shareholders from sharing in the profits of the newly revived entities.

The current attacks on the Fannie and Freddie shareholders have not in my view come to grips with the key implications of the 2008 SPSPA and its August 2012 Third Amendment. Hence this further commentary on the topic.

The 2008 SPSPA In 2008, the government explicitly decided to keep both Fannie and Freddie alive in a conservatorship, which it was allowed to do under HERA. That decision may well have made sense for a whole variety of reasons. Forcing both companies into premature liquidation could have further roiled the financial markets. Even if it did not, there was an ongoing dispute--a dispute that remains, and on which I take no position--as to whether the stock of Fannie and Freddie was totally worthless or whether the liquid assets of both companies would have allowed them to ride out the storm without going bankrupt. Indeed, even in liquidation, shareholders have the right to claim their residual equity in their shares, thus opening the door to extensive evidence on valuation--evidence that could be highly sensitive to the time that is chosen for liquidation.

Avoiding these issues made perfectly good sense, but the conservatorship itself presented a new round of issues on just how to value the contribution to equity made under the SPSPA. On this point, Senator Bob Corker thinks that Fannie and Freddie and their shareholders have no beef at all stating, "While I'm always glad when taxpayers see a return on investment, we can't forget that Fannie and Freddie wouldn't be earning one penny today without the government guaranteeing their transactions."

To this argument there are two replies. The first is that Fannie and Freddie may never had gotten into the mess if the United States had not insisted that it make high-risk loans to low- and moderate-income housing, first under the Housing and Community Development Act of 1992 (HCDA), as amended in 2007. In 1992, 30 percent of GSE loans were devoted to these programs. By 2007, that target had been raised to 55 percent. The conditions attached to the 1992 Act could be satisfied only in some financial Nirvana, for the legislation announced that Freddie and Freddie "have an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes, while maintaining a strong financial condition and a reasonable economic return . . . ." No one can do both simultaneously. It is a financial impossibility to increase the number of high-risk loans, without courting disaster in the event of a market downturn. Yet nothing in the Corker calculations takes this heavy obligation into account. Instead, he focuses exclusively on the government's implicit guarantee of Fannie and Freddie, later made explicit, which kept them afloat.

The deep danger in his approach is that it makes it impossible to determine the relationship between the heavy costs under the HCDA against the implicit government guarantee. But it is assuredly a wrong answer to count the implicit guarantee while ignoring the correlative duties that Congress imposed. In my view, a first-best world removes both of these requirements so that market-based housing becomes the norm. It might be said in response that without government intervention, the number of Americans that will own their own homes will decline. But that proposition is not the same as saying that the number of Americans with a roof over their head will decline. Instead it will lead to an increase in rental housing, which reduces radically the risk of major financial dislocations. Landlords run businesses and in general will not engage in the kind of borrowing and leasing that are likely to cause a financial disaster.

The second response in this instance is that the 2008 agreement is water over the dam. Before that agreement was entered into, the government had the option under HERA for the FHFA to close down Fannie and Freddie. But legal consequences follow once it takes the decision to go the other route. It is critical to remember that the shares of both companies traded in the market after the 2008 date marking the onset of the conservatorship, and the share prices in those transactions rested on the assumption that the Fannie and Freddie could not be stripped of future profits by government fiat. One cannot defend the Third Amendment in 2012 by announcing after the fact--and following and in the midst of active trading--that the 2008 SPSPA was, well, a mistake. That brazen approach gives the government two bites at the apple, and a free option to switch from one system to another with the benefit of hindsight after events have played themselves out. One might as well let gamblers place their bets in a horse race after the race has been run, and not before.

The Third Amendment The previous discussion sets up the analysis of the Third Amendment. In dealing with this issue, the government in its briefing in a shareholder lawsuit challenging the government's move took the strong position that the value of the government commitment in 2008 was "incalculably large," so that Fannie and Freddie shareholders had no expectation of being repaid. In and of itself, that statement is odd because in a financial situation it should always be possible to calculate the size of a bet, whether it be large or small.

In response, I wrote, "the level of the Treasury commitment was not 'incalculably large': it was $188 billion, all of which will shortly be repaid." A detailed criticism of this statement was prepared by Larry Wall, of the Center for Financial Innovation and Stability of the Federal Reserve Bank of Atlanta. He graciously amended his account in response to some comments that I sent to him, so I shall examine the criticisms of my position only in his revised version.

Wall's first argument is that the $188 billion was not the only financial commitment; there was also the interest. I agree of course with that point, and thought that it was too obvious to say in that context. As should be evident from the discussion above, the government is entitled to recover that interest in full. The government surely took a larger risk at the earlier date. But by the time of the Third Amendment, which was the focus of my writing, the principal was on the road to being repaid, and all interest obligations were current.

Wall's second and more serious point relates to the obligations, if any, to absorb further losses in the portfolio, which could be a large sum, albeit one that was limited by the ability of the government not to make further advances if it chose not to. But however these residual risks of 2008 are calculated, they are not beyond calculation. Indeed, the applicable limits on how much the Treasury had to commit to this venture were twice raised. By the time the Third Amendment came about, no additional commitments would be needed, so that these contingent liabilities were not a serious factor in figuring out whether the Third Amendment was fair to the shareholders--which given its wholly one-sided nature it was not.

(Correction 4/21: Initially, it was stated that the applicable limits on how much the Federal Reserve had to commit were twice raised. It was in fact the U.S. Treasury not the Federal Reserve that guaranteed the obligations)

Wall's third point relates to the decision of the Treasury to take for nominal consideration an option to purchase 79.9 percent of the common stock. That option today would be worth billions of dollars if the Third Amendment had not been adopted. At this point two questions arise. The first is how we value that particular option as of 2008. Wall assigns to it a modest value, which is again disputable. To be sure, the odds that it would come into the money may have been low, but if the housing market did recover, as it did, chances are that it would be worth a substantial sum. The high rate of return is thus in tension with the low probability of its occurrence. Working out these numbers does not lead to the conclusion that the warrants should have been ignored in calculating the value of the government's stake.

More critically, once it is settled that the action is over the Third Amendment, all of Wall's calculations, as noted, are irrelevant. The proper time to evaluate the fairness of the Third Amendment is when it is made, not sooner. Indeed, ironically, the Third Amendment, if allowed to stand, wipes out the value of the government option to buy 79.9 of the common because Fannie and Freddie shareholders will never receive any payments either by way of dividend or liquidation ever. No analysis of the 2008 deal gives any insight into the Third Amendment.

Going Forward My last point is brief, but critical. There are all sorts of ways in which to reform the housing market, in order to avoid the mistakes of earlier periods. To do that, any workable reform, critically, would involve removing the deadly combination of an implicit government guarantee coupled with a mandate to make high-risk loans with small down-payments to low- and middle-income individuals who lack sufficient capacity to repay.

Unfortunately, the major reform proposals advanced to date, including most recently the Johnson-Crapo proposal, essentially double down on the old, failed model. The Johnson-Crapo bill is, I think, highly flawed. Its dangerous willingness to have the federal government guarantee about $5.2 trillion of mortgage debt is well-exposed in a recent Cato Institute Working Paper by Ike Brannon. Its dangerous similarity to recent health care reform is the centerpiece of James Glassman's pieces in the Weekly Standard, which characterizes the bill as the Obamacare of real estate. Here is not the place to go examine the Johnson-Crapo bill's complex structure and perverse incentives. Quite simply, the new bill repeats most of the old mistakes with Fannie and Freddie in the form of a new Federal Mortgage Insurance Corporation that has the same cross-subsidy to high-risk borrowers, now called "equitable access." Because the political pressures to service low- and middle-income groups will be as great now as they have ever been, it is an open question, at best, whether the new reforms will be able to prevent a slow decline in underwriting standards under the proposed new regime.

Complicating the uncertain prospects for Crapo-Johnson, and all future proposals, is the aftermath of the government's extraordinary actions under the Third Amendment. There is a tight connection between the past obligations to Fannie and Freddie and the creation of any new facility in which private parties are asked to risk capital, given the very real risk that private capital will stay away from facilities that are empowered to make foolish loans under federal oversight that will, almost inevitably, cave with time. The short answer is that if the Third Amendment holds up in court, private parties will in fact stay away in the future. There are just too many possibilities to wipe out private investment if the government has the power that it claims here and everywhere else. (If the executive branch can rewrite the ObamaCare legislation repeatedly, it can rewrite any legislation including regulation for the residential mortgage market.) Indeed, the situation is worse: even if the shareholder suits against the various government agencies prevail, private investors would rightly perceive an ongoing risk that they could be tied up for years in litigation brought to enforce their contractual rights. That grim prospect will certainly deter private participation in any new mortgage-loan facilities being contemplated.

What is clear is that the "protection of taxpayers" motif is bipartisan. Both parties see every reason to ignore contractual and constitutional obligations to Fannie and Freddie shareholders. What reason is there in this political climate to think that the Congressional leopard will lose its spots anytime soon? On all these issues, any defense of the Third Amendment, such as that offered by Larry Wall, only makes matters going forward worse.

Richard A. Epstein is the Laurence A. Tisch Professor of Law at the New York University School of Law the Peter and Kirsten Bedford Senior Fellow at Stanford University's Hoover Institution, and a Visiting Scholar with the Manhattan Institute's Center for Legal Policy. Professor Epstein works as an advisor to several hedge funds that have financial interests in the issues covered in this essay.

By Richard A. Epstein

On November 22, 2013, the Food and Drug Administration flexed its regulatory muscle by sending a warning letter to a genetic-testing company that goes under the stylish name of 23andme. The object of FDA scorn was a diagnostic kit that the tech company, backed by among others Google and Johnson & Johnson, sold to customers for $99. The kit contained an all-purpose saliva-based test that could give customers information about some 240 genetic traits, which relate to a wide range of genetic traits and disease conditions. The FDA warning letter chastised 23andme in no uncertain terms for being noncooperative and nonresponsive over a five-year period in supplying information that the FDA wanted to evaluate its product as a Type III device under the Medical Devices Act.

Legal Regulation of 23andme There is no doubt that the FDA is on solid legal ground. This case is not like the processes involved in Regenerative Sciences, LLC v. United States, where the FDA asserted that physicians' use of certain stem-cell procedures for joint disease involved the use of a drug that required FDA approval before it could be approved for use. In an earlier essay for the Manhattan Institute, I argued that this classification was in fact both legally incorrect and socially mischievous. In this case, the legal arguments are not available to 23andme because the current definition of "medical devices" covers not only those devices intended for use on the human body, but also those used for the diagnosis of disease. The Type III classification means that this device has to receive premarket approval from the FDA, which in turn requires that it be shown to be safe and effective for its intended use. Getting approval under this standard is arduous business, because any such approval must be for each of the tests separately. 240 tests thus require that number of approvals. The costs are prohibitive, and the delay enormous.

The FDA Warning Letter is significant both for what it says and for what it does not say. On the former, it details all the various steps that the FDA has taken in order to help shepherd 23andme through the FDA's processes, including the types of warning that the products should contain, and the various modifications that could be introduced in order to mitigate the risks of its use. It then notes that 23andme has done little to take advantage of the assistance offered to it. Indeed, worse, it has simply gone about its business selling the kits, without so much as a bow in the direction of the FDA.

The FDA Warning Letter and Its Possible Substitute The FDA then gives a list of the dangers that could follow from this action, which consists essentially of false positives and false negatives with respect to certain of its key components. The gist of this indictment is contained in the following paragraph:

For instance, if the BRCA-related risk assessment for breast or ovarian cancer reports a false positive, it could lead a patient to undergo prophylactic surgery, chemoprevention, intensive screening, or other morbidity-inducing actions, while a false negative could result in a failure to recognize an actual risk that may exist. Assessments for drug responses carry the risks that patients relying on such tests may begin to self-manage their treatments through dose changes or even abandon certain therapies depending on the outcome of the assessment. For example, false genotype results for your warfarin drug response test could have significant unreasonable risk of illness, injury, or death to the patient due to thrombosis or bleeding events that occur from treatment with a drug at a dose that does not provide the appropriately calibrated anticoagulant effect. These risks are typically mitigated by International Normalized Ratio (INR) management under a physician's care. The risk of serious injury or death is known to be high when patients are either non-compliant or not properly dosed; combined with the risk that a direct-to-consumer test result may be used by a patient to self-manage, serious concerns are raised if test results are not adequately understood by patients or if incorrect test results are reported.

The gist of the situation is that more information is a bad result because it could result in overconfident actions by patients who have the temerity to treat themselves without physician assistance, without ever asking whether some of these kits were sold to customers on the recommendation of their physicians. It is of course perfectly proper for any risk analysis to address the downside of certain course of action. But it is wholly incorrect for any risk analysis to ignore the benefits that could be derived from the 23andme kit. It takes little imagination to rewrite this letter to accentuate the positive. The FDA might try using my edited version:

For instance, if the BRCA-related risk assessment for breast or ovarian cancer reports a true positive, it could lead a patient to undergo much needed prophylactic surgery, chemoprevention, intensive screening, or other morbidity-reducing actions, while a true negative could result in the knowledge that no actual risk that may exist. Assessments for drug responses carry the benefit that patients relying on such tests may turn to a physician to control dose changes or even undertake certain therapies depending on the outcome of the assessment. For example, true genotype results for your warfarin drug response test could alleviate significant risks of illness, injury, or death to the patient due to thrombosis or bleeding events that occur by using doses appropriately calibrated anticoagulant effect. These risks are typically mitigated by International Normalized Ratio (INR) management under a physician's care. The risk of serious injury or death is known to be reduced when patients are well treated and properly dosed; combined with the benefit that a direct-to-consumer test result may be used by a patient to seek medical advice for proper treatment and explanation of the underlying disease.

The revised letter is every bit as true, if not more so, than the FDA's, rather different picture. In fact, a balanced appraisal, which the FDA never adopts, requires a blend of the two letters, by letting consumers know that the use of these tests could lead to bad results in some cases and good results in others. But in making this assessment it is critical to keep the dynamic element in mind. The forces of competition and the desire to increase sales will drive those companies who are in the market to improve their overall results. We can expect therefore over time that the correct results will be used. It is also the case that the FDA or anyone else could remind their customers that it is best to seek medical treatment for dangerous conditions because self-medication is a dangerous business--as if that were not known far and wide already.

Dealing With Two Kinds of Error
In light of these competing scenarios, the FDA should therefore have asked the question of the relative proportions of good and bad outcomes from the test. In dealing with this question, there is no reason whatsoever for it to stop with its list of hypothetical bad outcomes, without inquiring about the frequency and severity of bad outcomes. Some information on that question is of course available in this case, given that the kits in question have been marketed for over 5 years to about 475,000 customers, and it would be useful to know just how those patients fared over that time. Perhaps the FDA could devote some of its resources in this direction. That outcome is, however, not likely. In dealing with this issue, the FDA always wants to put the burden of proof on companies to show that their products are safe and effective, and will never look at field results that the companies present that tend to support that result. The proper procedure, however, is always to work in the opposite direction. The FDA should have to show by clear and convincing evidence that 23andme leads to the dangerous results that the FDA claims by surveying customers of the firm.

The reason for this proposed reallocation of the burden of proof is what it is in all these cases. Once the FDA keeps a product off the market, downstream actions by individual consumers and their physicians cannot undo its mistakes. But if the product is let on the market, patients and physicians need not use it if its risks outweigh its benefits. It would be a far more searing indictment of 23andme if customer complaints of false positives led physicians to discourage patients for relying on these treatments. But thus far, the physician complaints have all come at a distance from experts in the field who double down on the FDA warnings. Let them warn away, so long as they do not ban products, which given standard patterns of usage may do far more good than harm. All too often the FDA acts as though consumers are gullible and uninformed. It is time that Congress recognized that much of the danger to patient comes from the FDA. Its vaunted mission is "Protecting and Promoting Your Health." I for one wish it would quit trying to protect mine and that of other people who would like to control their own lives.

Richard A. Epstein is a professor of law at NYU Law School, a Senior Fellow at the Hoover Institution, a Senior Lecturer at the University of Chicago and a visiting scholar with the Manhattan Institute's Center for Legal Policy. His forthcoming book is "The Classical Liberal Constitution," from Harvard University Press.

By Richard A. Epstein

On Thursday, July 18, Texas Republican Congressman Jeb Hensarling will hold hearings on his "Protecting American Taxpayers & Homeowners Act." The PATH Act contains many forward looking proposals, on which I have no comment. But on this occasion, I want to focus on one key feature of the Act, which is only obliquely revealed by the statutory title. Mr. Hensarling shows great solicitude for American taxpayers and homeowners. But in a telling omission, he gives the back-of-the-hand treatment to the preferred and common shareholders of Fannie Mae and Freddie Mac, (commonly called Government Sponsored Entities or GSEs). In the interest of full disclosure, let me state for the record that I have advised several hedge funds on the merits of the PATH Act, and on the parallel bipartisan legislation that Tennessee Republican Senator Bob Corker called the Housing Finance Reform and Taxpayer Protection Act of 2013, both of which are designed to wind down the operations of Fannie and Freddie.

Liquidating Fannie and Freddie The source of my concern with Mr. Hensarling's proposed legislation involve sections 103 and 104 of the Act, which, according to its legislative summary provides for "Termination of Conservatorship," such that "Five years following the date of enactment mandates the appointment of the Federal Housing Finance Agency (FHFA) director to act as receiver for each Enterprise (i.e. Fannie Mae and Freddie Mac) and carry out receivership authority." Section 104 then provides for declining maximum amounts that GSEs shall be entitled to own over the five-year transitional period before these entities are liquidated.

In one sense, the demise of Fannie and Freddie should not be lamented, after the long and sorry history of massive government intervention in their internal affairs that created serious dislocations in the marketplace in 2008, including, most notably, the Congressional insistence in 2007 that Fannie and Freddie issue some $40 billion in subprime loans. As a result of these actions, both GSEs suffered major losses during the early part of 2008, not unlike those suffered by other private companies. The nature of these actions are outlined in a complaint attacking the various government actions filed in Washington Federal v. U.S. in June 2013.

Therein hangs the following tale, which leads to the Hensarling hearings. Although not widely known, both GSEs are as organized as corporations whose shares are privately owned and publicly traded. The independence of these corporations was effectively ended in July 2008 when Congress passed the Housing and Economic Recovery Act of 2008 (HERA), which forced both companies, while still solvent and flush with liquid assets that could be either sold or mortgaged, into a conservatorship that was overseen by an agent of the United States, FHFA. I have described much of the early operations of HERA in my Defining Ideas column Grand Theft Treasury. The title summarizes my deeply critical attitude toward this problem.

In September 2008, the FHFA, as conservator of these GSEs, entered into a deal with the United States Treasury to organize a bailout of these still solvent entities. First, FHFA issued to the Treasury a new 10 percent perpetual senior preferred stock for which Fannie and Freddie over time received in exchange about $187 billion in fresh capital. As part of the deal, the Treasury received warrants to purchase 79.9 percent of the common stock at a nominal price of $0.00001, effectively wiping out most of its value. The now junior preferred stock remained on the books but had sharply diminished value. Clearly, the net benefits from this initial bailout were set by the Treasury, which exercised its power to buy into these GSEs at prices highly favorable to itself. At no point did the former directors of either GSE have any say on the terms of the deal. Essentially, the United States was on both sides of the transaction in a clear breach of the standard rule that all self-dealing transactions must be scrutinized to determine whether the shareholders' conservator provide them with fair value.

The Dubious 2012 Amendments to the 2008 Agreement Fast forward now to August 2012, at the start of the housing market recovery. At this time, FHFA and the Treasury entered into their Third Amendment to the 2008 Agreement which provided that "all positive net income each quarter will be swept to the Treasury." It is important to understand the unprecedented magnitude of this Amendment. At the time, Fannie and Freddie had returned to profitability and were thus able to pay both the interest on the Treasury's senior preferred stock and return some of the $187 billion that the Treasury had contributed to the both GSEs. This Third Amendment in effect stripped all the cash out of these companies and gave it to the United States as a "dividend" on its investment, with no reduction in principal.

Any sensible person would instantly realize that the unilateral variation in terms was not done to aid the private shareholders of Fannie and Freddie, but was intended to transfer all their wealth to the government whose crude contractual "amendment" violates the first principle of contract law: A and B may never enter into a contract that binds C without C's consent. What is truly amazing is the spin that Mr. Hensarling puts on this so-called Amendment in a document described blandly as PATH Act Questions & Answers:

Some are arguing that Fannie and Freddie have begun paying a financial benefit to taxpayers. While it's true that both companies had positive net income for the last three quarters of 2012 and have made $65.2 billion in dividend payments, these statistics don't give a complete picture of their financial situation. It is important to note that under the GSEs' contact with the federal government, these dividend payments cannot be used to offset prior Treasury draw, so that regardless of how much is paid out in dividends, the GSEs still owe taxpayers $187 billion in bailout funds borrowed And since their contracts with the federal government state that all positive net income each quarter will be swept into the Treasury as a dividend payment, in their current state the GSEs will never be able to repay that debt to the taxpayers.
His "complete picture" of the financial deal is replete with half truths. It would help if Mr. Hensarling noted that he was speaking of the August 2012 Third Amended Agreement, which was signed only by two government operatives, then acting director Edward J. DeMarco of FHFA and Timothy Geithner, then Treasury Secretary. "Their contracts" with the federal government are not "their" contracts. They are just "contracts" that the government has entered into itself. The simple point here is that neither government agency represented the GSEs's shareholders who assets were stripped bare by government actions. Of course, the companies cannot pay back the debt because the government has seized all the assets that would allow that result to happen.

The Four Lawsuits It is no surprise that this highhanded action has attracted four major lawsuits in recent weeks. In addition to the Washington Mutual case, plaintiffs filed suits in Fairholme Funds, Inc. v. FHFA, (with Charles Cooper as lead counsel), Perry v. Lew(with Ted Olson as lead counsel) and Cacciapelle v. U.S., (with David Boies as lead counsel), attacking these sweetheart agreements and administrative shortcuts.Taken as a unit, these four lawsuits highlight three fatal flaws of the corrupt government deal of August 2012.

The first involves the blatant breach of the FHFA's duty of loyalty to the GSE shareholders, for whose sole benefit this arrangement was imposed. No fiduciary, government or private, may engage in collusive self-dealing that results in a huge one-sided giveaway of all corporate assets. FHFA is not exempt from this bedrock rule. Second, the Treasury's major abuse involves its conscious disregard of the explicit protections for GSEs built into Section 1117 of HERA. For starters, that section gives the Treasury only "temporary authority to purchase obligations and securities" up to December 31, 2009. That authority certainly did not allow the Treasury to engineer its one-sided 2012 sweep, except on the absurd premise that the statutory authorization to "buy" before 2010 implicitly authorizes outright government expropriation of GSE assets after 2009.

To be sure, the Treasury's temporary authority instructs it to "protect the taxpayer," and so it should be. But the phrase must be read in context. This instruction is meant to prevent the GSEs from ripping off the U.S. with one-sided deals. By no stretch of the imagination does that phrase authorize the U.S., in the name of taxpayers, to rip off GSE shareholders. Explicitly, HERA's statutory mandate only invites the Treasury to determine such financial matters as the maturity and risk of these notes, with the eye to making deals that allow for "the orderly resumption of private market funding or capital market access." However, the Treasury has not uttered a single syllable to explain why it's necessary to wipe out GSE shareholders by sleight of hand when ample funds are available to repay, with interest, the full $187 billion advance to these GSEs. Its brief public comment to date has echoed the point that it advanced $187 billion to Fannie, as it were, to maintain the solvency of both GSEs and protect the broader economy. The Treasury's email said "We fully believe our actions have been lawful and appropriate," without of course referring to the details of the Third Amended agreement. The normal tradition of judicial deference to administrative decision only applies to cases where there was reasoned elaboration before the government. It does not attach to imperial actions that are taken without public notice or comment or reasoned explanations.

Third, by stripping the GSEs of their assets by these verbal machinations, the Treasury and FHFA have taken the property of the shareholders--the corporate assets--without paying a dime in constitutionally required compensation. Remember, both Fannie and Freddie were solvent at the time of the August 2008 takeover, notwithstanding their previous run of losses. If the United States is allowed by fiat to throw solvent firms into government receivership, the Treasury's tortured logic would routinely allow the government to force any profitable corporation into receivership, thereafter to force a one-sided renegotiation of contracts that offers it huge dividends on nonexistent investments.

This logic holds even on the dubious assumption that that the GSEs got fair value for their perpetual 10 percent preferred stock. If so, proper accounting procedure requires the Treasury to first credit distributions to its 10 percent interest on the unpaid balance, using the remainder to pay down principal. By rough calculations, about $50 billion of the money paid to the Treasury should have paid down the debt, which would then decline from about $187 billion to approximately $137 billion. In effect, the desired remedy only requires courts to take the unexceptional position that the government cannot escape all of its fiduciary, statutory and constitutional obligations by re-labeling a return of capital as a dividend.

Ominous Long Term Implications The availability of a simple account fix to government overreaching lays bare the inexcusable workings of the Treasury's one-sided deals. Ironically, Mr. Hensarling's conscious effort to undermine property rights works at cross-purposes with his larger, laudable objective of trying to rid housing markets of their past, massive irregularities in order to encourage more private investment. What private fund will invest in projects when their cash can be siphoned off by dubious contractual liberties and administrative shortcuts that make a mockery of the rule of law? Why force hedge fund investors to bear losses created by a government money grab that wipes out all of the shareholders' legitimate anticipated returns? Prompt action is needed to stop Mr. Hensarling before his populist express gives us a rerun of the Chrysler and General Motors political bankruptcies about which I have written elsewhere. But if courts don't invalidate the government's contractual gimmicks and administrative shortcuts, this is exactly what will happen.

Richard A. Epstein is a professor of law at NYU Law School, a Senior Fellow at the Hoover Institution, a Senior Lecturer at the University of Chicago and a visiting scholar with the Manhattan Institute's Center for Legal Policy. His forthcoming book is "The Classical Liberal Constitution," from Harvard University Press in 2013. He has consulted for several hedge funds not involved in the ongoing litigation on the issues discussed in this Op-Ed.

by Richard Epstein

The Supreme Court's five-to-four decision in favor of the landowners in Koontz v. St. Johns River Water Management District counts as a victory of sorts for the property rights movement. The case involved an all-too common exercise of state permit power. Koontz had applied for a permit to develop some 3.7 acres of his waterfront property and for that privilege he was prepared to offer the state a conservation easement that would make it impossible for him to develop the remaining 11 acres of that parcel. The official reply was that the permit would be denied unless Koontz acceded to one of two conditions. By the first, he had to agree to cut down the site development to one-acre and to make other costly modifications to his project. By the second, the District requested that he hire, for an uncertain sum, contractors to replace culverts or fill in ditches on other parts of the land. Koontz balked; the District stuck to its guns, and nothing happened. In his subsequent law suit, Koontz claimed that the exactions imposed by the District offended the various tests for an appropriate nexus between the permit and condition that had been developed in the important Supreme Court cases of Nollan v. California Coastal Commission (1987) and Dolan v. City of Tigard (1994).

Harms v. Benefits One unfortunate aspect about this case was that Koontz, bending to the current legal realities, had been prepared in his application to deed over some portion of his land to the Water District to get the permit in the first place. But the antecedent question is why he should be required to make any such concession in the first place. In dealing with this issue, Dolan put the right framework on the question by insisting that the condition in question be linked to either a benefit that the state provided or to a harm that the developer's project would create--in that instance additional runoff into public waters.

The implicit subtext of the Koontz application was that the failure to mitigate so-called environmental damage counts as a harm which the Water District is entitled to redress without compensation. But there is no reason why that should be the case. In dealing with the harm/benefit distinction in other private law contexts, it is clear that the operative distinction runs as follows. The defendant engages in harm to the world when he pollutes it. The state demands a benefit from the landowner such as insisting that the land be used as a nature preserve. It ties the English language into impossible knots to say that the defendant harms any plaintiff to whom he does not supply a benefit. That would mean that all landowners harm their neighbors by refusing to allow them to graze their cattle in the fields or to bed down at night on the front lawn. And it would mean that every person in the world has conferred a benefit on all individuals whom they do not summarily execute or rob. It is only if the terms "harm" and "benefit" are placed within a coherent framework of preexisting property rights that they can be used in a coherent sense that makes legal intervention the exception for a targeted case, not a universal imperative in any case where any landowner attempts any development at all.

Second Best Solutions The implicit failure to address the systematic failure in this branch of takings law necessarily limits the utility of this opinion to second-class status. But within that constraint, the good news about the case is that Justice Alito's majority opinion in significant part commanded the support of the four liberal members of the Court for whom Justice Kagan wrote in dissent. More concretely, both sides agreed that the issue of exactions did not go away simply because the permit was denied. In early cases, the permit was granted subject to conditions that proved intolerable, and Justice Alito was manifestly right to conclude that the constitutional guarantees could not be circumvented by the practice of not granting the permit unless the applicant agrees to certain conditions, rather than granting the permit subject to those same conditions. Terminological niceties should not be decisive in takings cases, any more than they are with any other constitutional right.

The two sides of the Court split, however, on the second question before the Court, which was whether the exaction doctrine applied to cash exactions instead of those that were made in kind. The point really matters because, as Justice Alito rightly stressed, if the cash alternatives escape constitutional scrutiny there is a royal road for circumvention of the basic command that the government cannot hold up a particular project in order to fund development projects, such as the ditches and culverts here, that should be funded from general revenues. Justice Kagan's dissent is that we cannot go into this dangerous territory lest we destabilize the current law that gives the state virtual carte blanche on how it imposes real estate and other taxes needed for public development.

Unfortunately, she is wrong for two interrelated reasons. First, the distinction is all too easy to draw in this particular case. A general real estate tax is imposed on all parcels of land based on value in order to fund common improvements from which the community at large benefits. This particular exaction is imposed on a single parcel of land at the time of its possible development and thus singles out one owner for excessive burdens from which it gets no special return benefits. Allowing this form of abuse to take place with cash exactions is a royal road to constitutional evasions.

Second, Justice Kagan is wrong to think that the entire field of real estate taxation should be subject to no constitutional constraints at all. But why? The ideal of any government exaction is to encourage socially beneficial transactions that cannot be achieved through voluntary means because of the large number of parties whose participation is necessary to allow the collective scheme to succeed. A system of real estate taxes that hit an entire community only to provide benefits to one fraction of it fails that test just as much as this special exaction. There is no reason to keep the exaction/taxation line alive, and every reason to abandon a position that Justice Alito too easily accepts, that taxes and fees are normally outside the scope of the takings.

Unfinished Business The difficult portion of the Alito opinion is simply this: because it does not take a robust critique of all exactions, it falters in the remedy stage of the case. At the very least, a landowner who is held up in this fashion should recover damages for economic losses attributable to what is temporary taking of land given that no development could take place. Going forward, the correct response is to treat the Water District actions as a total taking of the land if it is not prepared to rescind its order. At that point, the correct thing to do is to order the state to take title to the entire parcel, paying its full market value if the development could have gone forward without committing a common law nuisance. The key point to note here is that in any sensible system of water and land management, this case is so far from the tipping point that it should never have reached the Supreme Court at all, under any sensible application of the Dolan decision. Remanding the case for further proceedings in Florida courts has the unfortunate but predictable consequence of extending this saga into the yet another tier in Dante's Inferno. A clearer understanding of first principles could have brought much needed coherence to this area of law.

Richard A. Epstein is the Laurence A Tisch Professor Law at New York University, the Peter and Kirsten Senior Fellow at The Hoover Institution, and the James Parker Hall Distinguished Service Professor of Law and senior lecturer at the University of Chicago, as well as a visiting scholar with the Manhattan Institute's Center for Legal Policy.

Richard Epstein

It is widely agreed that housing markets are a mess. The run-up in prices before 2006 was fueled in large measure by a cheap money policy that allowed individuals to overbid on real estate and then mortgage the properties to the hilt. Once the house of cards came tumbling down, many of the mortgages went into default. In other cases owners kept up their mortgage payments on "underwater" property--where the amount of the lien exceeded the market value of the property.

The risks involved in these cases were all systematic, which means that the problems were not confined to the personal circumstances of this or that buyer. Systematic solutions are needed, and unfortunately, since 2008, the policies chosen have only perpetuated the difficulties. The root of the difficulty lies in the treatment of foreclosure remedies.

The traditional legal attitude on this point was clear: foreclosure was strict, delays were not tolerated. The lender had to prove nonpayment of the loan, at which point, he was entitled to reclaim possession of the property. He was also entitled to renegotiate the terms of the loan, if he were left better off by the extension than by foreclosure. The only role for the legal system was to make sure that these contracts and contract modifications were enforced to the letter.

The logic behind this position is simple. Once a borrower falls behind in his payments, and knows that foreclosure looms in the future, two motives dominate. First, don't make any payments on the mortgage because eventually you won't be able to keep it anyhow. Second, don't perform any maintenance on the property above and beyond the minimum. To maintain your property when defaulting on your mortgage is to be a sap, and to make expenditures that will only help your creditor.

Strict foreclosure forces the defaulting owner out onto the street. That is all to the good: of course, these people will need housing, but they will purchase some at far lower cost, or, more likely, return to the rental market, which demands less by way of capital. The unit then can be resold by the bank at its market value, where new buyers can afford the smaller mortgage, and make a larger down payment that will tend to stabilize the situation. After some hiccups, the situation would become far more stable.

Unfortunately our policy makers thought they had a better idea. Their first imperative was to keep the borrower in possession by delays and formalities, ignoring all these serious externalities. That policy has now failed, so other bad ideas have been put forward. At the federal government level, a Home Affordable Modification Program (HAMP) has been put into place on the ground that pressuring lenders to defer foreclosure will improve the situation. Instead it threw good public dollars after bad, prolonging the agony.

Now we have another equally bad proposal to intervene in the mortgage market. Recent pieces in the New York Times by Joe Nocera and Robert Schiller, have eagerly embraced an idea put forward by Cornell University Law Professor Robert C. Hockett. In an incredibly tedious and self-important article, Hockett suggests that local government agencies use eminent domain power to condemn mortgages that are underwater but not yet in default--at reduced prices (what Nocera calls "steep but fair discount")--and then let some municipal authority refinance the loans and resell them in bundles for a profit to the agencies in question. Naturally such a scheme would require a middle man, and a fat fee. Mortgage Resolution Partners (whom Hockett advises) is happy to play that role.

The idea has already been rightly panned by the Wall Street Journal. But the entire proposal needs still further consideration. First off, Hockett and his group insist that there is a huge collective action problem that prevents the rationalization of mortgage matters. And there is. It is called local government regulations that have blocked the foreclosure measures set out above. Handle those and the externalities to which they refer disappear. No longer do we have owners neglecting property or clogging the courts with endless motions.

Next, note that this whole proposal seeks to create something out of nothing, and like all such schemes, necessarily fails. The initial argument in favor of this position is that the state can condemn for public use a mortgage, just like it can condemn any other property. The current definitions of public use are so broad, that the transfer of money from one pocket to another might now qualify, which is hardly a ringing endorsement of why this ploy should be adopted.

The just compensation requirement here is a lot stiffer, and the right question to ask is just where the increase in social value comes that justifies all the financial sleight-of-hand that goes on. And here there is only one way to make the numbers work, which is to rob the current mortgage holder blind.

The key question to ask is this: why do people whose property is underwater not walk away from the property? The answer is that the subjective value of the home to them exceeds the value of the mortgage, even if the mortgage exceeds the sale price of the property. If therefore the mortgage is not in default, there is a good chance that it will stay out of default for some time to come. At that point, using a valuation process that compares mortgage amount to market value systematically undervalues the mortgages and forces the groups that hold these mortgages to part with them for a fraction of their value. The government in other words cherry picks the portfolio with a free option to take mortgages for less than their intended worth.

The scheme is, moreover, subject to all sorts of political corruption, for once borrowers know of the system, they can collude with the so-called middlemen to have their mortgages on the list. After all, what borrower is against paying less. So this turns out to be nothing more than a fancy con game, in which two parties use the power of eminent domain to pillage a third. The idea has been proposed for the City of San Bernardino, which is itself bankrupt. If this system is allowed to go forward, it too will be bankrupt--morally as well as financially.

Richard A. Epstein is the Laurence A Tisch Professor Law at New York University, the Peter and Kirsten Senior Fellow at The Hoover Institution, and the James Parker Hall Distinguished Service Professor of Law and senior lecturer at the University of Chicago, as well as a visiting scholar with the Manhattan Institute's Center for Legal Policy.

Ted Frank

Published on 01/25/12

Last week, several Internet sites protested against two bills, the Stop Online Piracy Act and Protect IP Act, that would take a heavy-handed approach to preventing copyright infringement.

Though the movement was led by left-leaning technology sites, the SOPA/PIPA kerfuffle has the potential to demonstrate why conservative principles are important.

The problem with SOPA and PIPA was their broad scope. The bills went beyond primary infringers to impose criminal penalties on search engines and service providers that linked to infringing domain names.

The threatened censorship of the Internet -- hundreds of innocent sites could be blocked because of alleged infringement by a single blog -- led many sites to go "dark" for a day to protest SOPA's drastic consequences.

It was certainly amusing to watch thousands of teenagers take to Twitter to complain, profanely, that in the absence of Wikipedia and other sites, they had no place to go to plagiarize their homework assignments.

But, more importantly, several senators and representatives, including a number of former supporters of the legislation, announced their opposition.

Hollywood, which has predicted catastrophic consequences from piracy since the now-obsolete VCR became commonplace decades ago, is outraged and continues to support the legislation -- but it now seems clear that SOPA and PIPA will not become law without substantial modifications.

In the meantime, some observations:

First, we should be thankful: Legislative "gridlock" is a feature, not a bug, of our constitutional system. We often see parties in power complain how hard it is to get legislation passed, but the number of bottlenecks in the system means that legislation is considerably less likely to pass without consensus.

Without these bottlenecks, special interests would find it far easier to ram through bad legislation like SOPA. The deliberate pace of legislation gave time for Internet opponents to mobilize.

Second, both bills demonstrate the problem of overcriminalization. All too often, a special interest asks Congress to "fix" a problem by threatening to send more people to prison.

When criminal law goes beyond punishing intentional, violent and fraudulent behavior to ensnare innocent business people guilty only of running afoul of complex and technical regulations, the chilling effect on free enterprise and job creation can be tremendous.

Bloggers had fun pointing out the number of instances where SOPA supporters were violating the proposed law, but millions of Americans already unknowingly violate hundreds of other laws on the books.

When everyone is a criminal, federal prosecutors have the awesome power to pick and choose who will have their lives ruined. The possibility of politically motivated prosecutions is a severe danger to liberty.

Third, Congress passes bills all the time without knowing what's in them, each time with dramatic unintended consequences. Bloggers were outraged at a congressional hearing where committee members had no clue about the damage SOPA was going to do to the Internet.

Further, they seemed to care very little about the effect of their ignorance. But this ignorance extends far beyond the Internet. Limited-government conservatives oppose bad legislation like Dodd-Frank and Obamacare because of the unintended consequences and adverse effects of government meddling in the market.

Finally, the successful opposition to SOPA demonstrates the importance of corporate free speech. It has become trendy on the left to assert after Citizens United that corporations are not people, and thus have no free-speech rights; there's even a constitutional amendment to that effect pending.

One wonders how far that argument goes: Do corporations have no Third Amendment rights, either, allowing the government to quarter troops at the Ritz? Corporate free speech made a decisive difference in the SOPA/PIPA debate. The media, generally SOPA supporters, were unwilling to cover the issue until corporations like Google and Wikipedia forced them to pay attention. The Left should re-evaluate its attempt to limit political speech.

The near-catastrophic passage of SOPA demonstrates the power of limited-government principles. Conservatives should use it as a teaching moment.

By Walter Olson

Reprinted from the Wall Street Journal, September 24, 2005

Sometimes it takes a good lawyer to get an insurance company to pay up on the promises it made. But if you want insurers to pay billions on promises they never made—risks they were at pains to avoid underwriting, never collected premiums for, and never set aside reserves against—then a pair of very special lawyers, Jim Hood and Dickie Scruggs, are at your service.

In case you're arriving late, insurance pros worldwide stood transfixed last week at the news that Mr. Hood, the elected attorney general of Mississippi, and his ally Mr. Scruggs, the Pascagoula wheeler-dealer known for his role in the $246 billion tobacco litigation, were suing to invalidate—as "unconscionable" and contrary to public policy—the standard flood exclusion in every Magnolia State homeowner's contract. Assuming ordinary readings of policy language, the early estimates have insurers on the hook for a record $40-$60 billion in Katrina payouts. Knock out the flood exclusions and that exposure will increase by many billions more—scores of billions if the principle gets applied in Louisiana.

Wouldn't that bust some otherwise solvent insurers? Sure, but Mr. Scruggs—a key donor to many politicians and judges in his state, as well as brother-in-law of former Sen. Majority Leader Trent Lott—isn't worrying. "I'd rather see an insurance company go broke than the tens of thousands of my friends and neighbors in Mississippi, Alabama, and Louisiana go bankrupt," BestWeek has him saying.

There are some genuine, knotty issues that will arise in resolving Katrina coverage. Ambiguous policy language, unsettled issues of state law, situations in which a structure was damaged first by wind and then by floodwater—all will fuel litigation by policyholders, some of it meritorious. But that's quite a different question from whether clear and long-standing contract language should be tossed in the wastebin.

The flood exclusions, Mr. Hood asserts, were hidden "in the fine print" of coastal residents' policies. If so, it was some of the most publicized fine print in history. "Homeowner's insurance doesn't cover flood damage"—blares the warning on one of the federal government's own consumer-affairs Web sites. In fact, the well-known exclusion dates back decades and has been generally respected by courts.

"Unconscionable"? Contrary to "public policy"? The exclusion prevails in all 50 states, including those states—Mississippi is one—where regulators must okay the offering of new standard policies. Mississippi's insurance authorities, like their counterparts elsewhere, had green-lighted the flood exclusion, amid little controversy.

Then there's the federally sponsored flood insurance program, which exists in large part because storm surge perils in hurricane country are considered too severe to insure commercially at politically palatable rates. For years, insurance agents and the government have urged property owners to buy that added coverage. But why should they bother, if the Hood/Scruggs arguments are to be taken seriously? Can't their ordinary homeowners' policies just be redefined retroactively as covering the risk?

Criticized in the past for his close ties to the state's powerful trial lawyers, Mr. Hood has often been at odds with Republican Gov. Haley Barbour (with whom he is not obliged to coordinate his activities). In a way, Mr. Hood is simply taking to an extreme the failings of that familiar category of public official, the grandstanding state attorney general. Every element is there: the headline-chasing, the demonization of unpopular businesses, the cozy relationship with private attorneys suing those same businesses, the posturing about being on the "people's" side at the expense of any coherent or defensible legal principle.

It's hardly a coincidence that it was Mr. Hood's predecessor, Mike Moore, who, in league with Mr. Scruggs, dreamed up the disgraceful $246 billion state tobacco/Medicaid caper. Back then, some businesspeople seemed to imagine cigarette makers were going to be the first and last targets of the emerging AG/trial-lawyer axis. They weren't.

Insurance spokespeople ordinarily issue muted responses when politicians attack, but not this time. "You cannot have a capitalist economy where contracts are ignored," noted Robert Hartwig of the Insurance Information Institute, who said Mr. Hood's lawsuit is "an affront to the Constitution and sets a horrendous precedent." So, can't State Farm, Allstate and others cite Article I, Section 10 of the U.S. Constitution, which provides that "No state shall. . . pass any. . . law impairing the obligation of contracts"? Unfortunately, the Supreme Court in Blaisdell, a 1934 New Deal case, gave states free rein to nullify contracts so long as "the legislation is addressed to a legitimate end and the measures taken are reasonable and appropriate to that end." If you think that guts the originally intended protection, maybe you're part of that "Constitution in exile" movement we keep being warned about.

Should the Hood-Scruggs theory be taken seriously, the bankrupting of some insurers and the diversion of money from insureds in other states will only be the start. The wider problem would be that both reinsurers and primary insurers are likely to head for the hills rather than underwrite future conventional policies in Mississippi, or indeed any jurisdiction judged capable of electing a Hood to high office. At a minimum, they're likely to demand a steep premium to compensate for legal risk.

Alarmist? Mississippi insurance commissioner George Dale is already worried that as panicked insurers pull out of the state, first-time customers—such as construction contractors moving into the area—will be among the earliest casualties: "Contractors got to have insurance; they can't build without insurance."

We've had the natural disaster. Let's hope it's not followed by legal disaster.

Mr. Olson is a senior fellow at the Manhattan Institute and author of The Rule of Lawyers (St. Martin's, 2003).

By Ramesh Ponnuru

Ramesh Ponnuru and the National Review have graciously allowed us to reprint his article "Social Injustice," which discusses the inroads trial lawyers are making with the political right, through socially conservative populists among their midst. We've also been allowed to attach an exchange in the letters-to-the-editor section of the magazine, in response to the column (download PDF).

The website for the Center for a Just Society, a new social-conservative group in Washington, has a lot of the items you would expect to see: denunciations of embryonic-stem-cell research; calls for an end to the filibustering of Bush's judicial nominees. The quality of the writing at is a cut above what you would find from most social-conservative organizations, and the range of issues is slightly wider. The Center attempts to bring "Judeo-Christian perspectives" to bear on topics that social conservatives have traditionally ignored. Thus it makes a moral case for Social Security reform. What most sets the Center's website apart from the sites of other conservative organizations, however, is what it has to say about tort reform. Or, rather, "tort 'reform.'"

In one of the statements on its website, the Center writes: "[T]here is a widespread effort underway to take away our right to a trial by jury. Those pushing this wrong-headed agenda claim that it will reduce the costs of healthcare and eliminate 'frivolous lawsuits.' . . . [T]ruth be told, the agenda behind the agenda [emphasis in original] has less to do with lowering the cost of healthcare and eliminating frivolous suits and more to do with immunizing wrongdoers from the consequences of their behavior."

This perspective reflects the views of the Center's chairman, Ken Connor. He is best known as a social-conservative leader. He was president of the Family Research Council, and he represented Florida governor Jeb Bush in the Terri Schiavo case. (The Center was in the thick of the Schiavo fight as soon as it set up shop, back in March.) But he has also had a long career as a trial lawyer suing nursing homes for what he calls "elder abuse."

The Center is in its infancy. It does not even have an office yet. Its advocacy of tort reform has not received much attention. The most impact it has had came when Focus on the Family, James Dobson's much larger and more influential conservative organization, publicized its description of the Republicans' medical-liability reform bill as an attack on the sanctity of life. But the Center may represent an emerging trend. There are some signs that social conservatives and the trial bar may be making common cause—which means that on litigation reform, the social and economic Right may be headed for a split. Whether that split occurs will depend on whether the social Right can see through the misleading slogans of the trial bar.


In the weeks between Justice Sandra Day O'Connor's announcement that she will retire from the Supreme Court and President Bush's nomination of John Roberts to replace her, there were reports of tensions between Bush's social-conservative and business supporters. Social conservatives didn't want a new justice in O'Connor's mold. They were fond of originalist jurists such as federal appeals-court judge Michael Luttig. Business lobbies worried, however, that Luttig was less likely than O'Connor to impose limits on punitive damages in lawsuits against corporations.

Harry Reid, the leader of the Senate Democrats, seemed to pick up on this tension. He said that several Republican senators would make fine replacements for O'Connor: Mike Crapo of Idaho, Mike DeWine of Ohio, Lindsey Graham of South Carolina, and Mel Martinez of Florida. His list omitted two Republican senators who had more frequently been mentioned as possible nominees to the Court: Jon Kyl of Arizona and John Cornyn of Texas. When asked about the omission of Cornyn, Reid said that he had already listed his picks. All six of the senators have socially conservative voting records. Walter Olson, the author of several of the most important books making the case for tort reform, spotted the distinction among them: Kyl and Cornyn have taken the lead on tort reform, while the other four have often voted with the plaintiffs' bar against most of their Republican colleagues. Crapo, Graham, and Martinez are, indeed, former trial lawyers.

In the end, however, Bush ignored Reid's advice. By choosing Roberts, he was able to mollify both business and social conservatives. Neither constituency knows that he will vote with it, but each has some reason to think that he might. The conservative coalition did not split.

At least, it hasn't yet. But that list of senators who used to be trial lawyers suggests one of the reasons that tensions will persist: There are socially conservative trial lawyers. The profession abounds with politically talented, rich, and influential people. While conservatives have not tended to regard the courts as instruments of social change—as much of the tort bar reflexively does—there are bound to be some outliers. With the Republicans in charge of Washington and threatening the livelihoods of trial lawyers, it stands to reason that the latter would, as the lobbyists say, "reach out" to the Republican party. Connor recently spoke at a convention of the Association of Trial Lawyers of America urging the group to do just that. He says he was received "extraordinarily well."

Connor argues that while some Republicans—the "bluebloods" at the "apex" of the party—have an economic interest in fighting trial lawyers, the "blue collars" at the "base" of the party are against trial lawyers only because the trial lawyers have allied themselves with the Democrats. If the trial lawyers end that alliance, he thinks, common ground could be found.


Connor's organization argues that the tort system is valuable because it holds corporate wrongdoers accountable. It thus affirms the value of responsibility and, when injuries or fatalities result from corporate misconduct, the sanctity of human life. In certain respects, this claim is obviously true. But tort reformers are not composed exclusively of corporate wrongdoers, their flacks, and their dupes. As Olson puts it, "Much of the popular success of the litigation-reform side has come precisely from people's feelings that the outcomes of litigation don't track our moral sentiments very closely, and seem to track them less well over time."

Take nursing-home litigation. Until 2001, Connor's native Florida had a "resident's rights" law that allowed plaintiffs to recover damages from nursing homes without proving negligence. Nursing homes were often sued over bedsores—even though they are hard to avoid for invalid patients. Ted Frank, who runs the American Enterprise Institute's Liability Project, points out that "Christopher Reeve, who had the finest medical care money can buy, died from a bedsore infection." And the nursing homes faced a Catch-22: They were not allowed to restrain patients who suffered from dementia, but were liable if those patients hurt themselves in a fall. Frank concedes that some lawsuits involved "really substandard care," but says that too many attempted to "hold companies responsible for things they had nothing to do with."

The law forced many nursing-home companies into bankruptcy, causing a shortage. By 1998, one out of every four Medicaid dollars spent on nursing homes in the state was going to pay liability costs. Connor's partner, Jim Wilkes, the lead attorney on most of Connor's nursing-home cases, spent more than a million dollars trying to block limits on liability. The Florida chapter of AARP actually supported the 2001 reform, perhaps swayed by the thought that elderly Floridians needed nursing homes more than the trial lawyers needed the money.

Or take asbestos litigation, which has done more to reward wrongdoing than to punish it. Asbestos claims have soared in recent years even as the incidence of asbestos-related diseases has declined. Lester Brickman, a professor at the Cardozo School of Law, credibly alleges that the explanation is that 80 to 90 percent of recent claims are fraudulent. Lawyers have coached witnesses to make false testimony and get false diagnoses, and then sued companies that played the most minor of roles in the asbestos industry. Not all trial lawyers are, of course, guilty of these tactics. Many trial lawyers, especially those who represent clients whom asbestos actually made ill, are appalled by the false claims. But it is hard to avoid the conclusion that the system has strayed rather far from holding wrongdoers accountable.

The Center for a Just Society is certainly right to say that not everything that travels under the name of tort reform deserves support. It argues, correctly, that federal tort reform can trample on state prerogatives. If a state has lawsuit laws that lead doctors to leave it, it ought to be the responsibility of the state's voters and politicians to change those laws. On the other hand, frivolous product-liability lawsuits can't be avoided by skipping the border. No state can shield a drugmaker or medical-device manufacturer located in its jurisdiction from abusive lawsuits filed in other states. In such cases, it's up to the federal government to protect interstate commerce by restraining the states. The Republicans' medical-liability bill should be amended so that it touches only interstate commerce. But the trial lawyers, and the Center, oppose the whole thing.


The Center opposes the bill on the theory that it is "pro-abortion" because it provides immunity to the makers of RU-486 (the "abortion cocktail"), and prescribing doctors, from lawsuits by the families of women who die as a result of the drug. But this immunity is partial. What the bill says is that if a product or treatment complies with federal regulations, the people who made the product or supervised the treatment can't be sued for punitive damages if something goes wrong. They can be sued for compensatory damages, including damages for causing pain and suffering. But if they're compliant with FDA regulations, for example, the courts shouldn't punish them. The makers of RU-486 already enjoy some legal immunities thanks to Bill Clinton. But even if they didn't, the Center's argument would be faulty. Just as conservatives would not favor raising corporate-tax rates in order to drive companies involved in abortion out of business, they should not oppose efforts to improve the legal environment for corporations because they might help companies involved in abortion.

John Edwards illustrates the bankruptcy of the "pro-life" case for pro-plaintiff medical-malpractice laws. Suing obstetricians for causing cerebral palsy by failing to do C-sections was one of his most profitable lines of litigation. He has boasted about how he swayed jurors by assuming the voice of an unborn child pleading for help. But the evidence strongly suggests that cerebral palsy is usually genetic in origin, and almost never the result of a botched delivery. (One piece of evidence: C-sections have grown more common over the last few decades, while the incidence of cerebral palsy has stayed the same.) Lawsuits, and the resulting malpractice-insurance premiums, have driven obstetricians away from some areas.

In a forthcoming paper for the Journal of Legal Studies, law professor Jonathan Klick and economist Thomas Stratmann provide reasons to believe that such lawsuits result in infant deaths. Specifically, they find that caps on punitive damages in medical-malpractice lawsuits bring infant-mortality rates down. More doctors practice in states that adopt them. The health benefits flow primarily to black infants in rural areas. Klick thinks that federal legislation might have a positive effect on infant mortality, too (although he is careful to note that he does not endorse the legislation). The study undermines the claim that medical-malpractice reform is anti-life.

When John Kerry picked Edwards as his running mate and Republicans attacked the latter for being a trial lawyer, Connor rushed to his defense. But if Connor is concerned about the bad name trial lawyers have in some circles, perhaps he should have blamed lawyers such as Edwards rather than their critics. Connor says, "Trial lawyers should be viewed as stewards of the civil justice system." They will not be viewed that way, however, if a sizable number of them are not acting as such.

The right to a jury trial, meanwhile, isn't nearly as threatened as the Center—and the tort bar—would have you believe. There are, it is true, some proposals floating around to handle medical-malpractice cases through the kind of administrative compensation schemes that long ago took over workers' compensation. But legislated caps on damages aren't an affront to the jury system, any more than are statutes blocking juries in criminal trials from imposing life sentences for shoplifting (to borrow a comparison from Olson). The historical value of the jury was as a brake on the power of the courts. Their role has not been to enable the courts to take actions that the legislature refuses to authorize.

The issues involved in tort reform are complicated, and people can disagree about them in good faith. The Center for a Just Society might well lead social conservatives to make a contribution to this debate (among others). Connor says that the Center will come out for making the losing party pay for civil litigation—a potentially far-reaching reform. If the Center does that, it will be hard for anyone to argue that it is merely a front for the trial lawyers.

But social conservatives ought to keep in mind that the current system features, and even encourages, all kinds of squalid behavior. Lawsuits are filed as fishing expeditions. Firms that have not done anything wrong are targeted because of their deep pockets. Simple fraud is more than occasionally perpetrated through the courts. All of these are forms of bearing false witness. And "Judeo-Christian perspectives" on that have not been positive.



Rafael Mangual
Project Manager,
Legal Policy

Manhattan Institute

Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.