Saturday, October 6, 2007

And Justice For All?

I often hear comments from non-lawyers about decisions by courts, including The Supreme Court, such as “that result is so unfair, how could they do that?” and “what do they know about business anyway, they aren’t business people?” I find that, behind this question, there lurks a misconception about the nature of the issues The Supreme Court actually decides. I decided to address this question by making up a hypothetical case that will address some issues that may not be obvious at the onset to illustrate why judicial decisions sometimes seem at odds with carrying out our traditional notions of justice.

Imagine that you make loans for a living, and a friend asks you for a loan. Your friend tells you that he cannot borrow the money from other sources because they would condition a loan on his disclosing his plans to them, and he wants his plans to remain confidential. He does not want to tell you what he needs the money for. You decide to lend the money, but because you have no idea what it will be used for you will only do it if your friend agrees to pay you an exorbitant rate of interest, say two times the going rate. Your friend agrees and you lend him the money. You have no idea what he intends to use it for and your friend has never been in any legal trouble.

As it turns out your friend’s business idea was a pump-and-dump scheme, and he is very successful at defrauding investors. Unfortunately, he gets caught and sent to jail. The money he stole from investors is gone, having been spent on fast cars and expensive parties (many of which you attended). One day a large man greets you at your door and hands you a package of legal documents. You go directly to your lawyer (now also your best friend), who tells you that you are being sued by all of those investors who lost money on your friend’s scheme because they believe that if you had not loaned him the money they never would have been harmed. They claim you either knew, or should have known, that your friend was going to use the money to set up an illegal scheme, so you should be held to account. They also claim you did this because you profited from the scheme by charging such a high rate of interest. They are asking the court to award them damages equal to their losses of $100,000,000.

This case makes it all the way up to the Supreme Court. Both the Securities Exchange Commission (the “SEC”) and the Justice Department (“Justice”) file briefs with the Court letting the Court know how they feel about the case. The SEC is against you on this, but Justice believes you should not be held to account. (The following positions of these entities are HYPOTHETICAL!) What issues are raised that get you all the way to the Supreme Court and get the attention of the SEC and Justice?

The SEC has sided with the defrauded investors against you. Their position is that if you are not held to account, investors will be much more likely to be defrauded in the future because people like you will enable wrongdoers to operate. The cost to society of people being harmed in this way, they argue, goes way beyond the losses incurred by you if you are found liable for the investors' losses. The larger issue is that if this behavior continues, fewer people will invest in business and that will chill overall economic growth of the country because businesses will not be able to raise money in the capital markets. This far outweighs the cost to lenders of having to be more careful in making loans. They also argue that the cost to lenders of being more careful would be inconsequential. They point to the fact that this loan was very unusual in that the rate of interest was extremely high and almost all other lenders would have wanted to know what the proceeds of the loan were to be used for. The harm was due to the fact that you turned a blind eye and made a loan you shouldn’t have.

Justice, on the other hand, takes the position that if you are found liable for the illegal activity of your borrowers, nobody will be willing to make loans because they will be worried about the costs of such liability. At the least, investigating the use of funds you lend and taking other protective measures will increase the cost of operating and, therefore, raise the cost of borrowing. The lack of loans and/or higher cost of them would have a chilling effect on the economy because it would be more difficult for businesses to raise capital (sound familiar). Their position is that you cannot push the responsibility for wrongful acts to parties beyond the actor itself, and whatever resulting losses occur for people such as the defrauded investors in this case are more than offset by the benefit we get as a society from a smooth and unhampered banking system allocating funds to business investment.

As you can see, the implications go way beyond whether the investors in this case get some of their money back. There is a balancing act to be done among major issues affecting all of society. The reason these larger issues arise is that once the Court makes a decision in this case, it will become precedent (the law of the land) and will apply to all other cases like it that arise.

So what is the balancing act that the Court must do in my hypothetical? On the one hand, investors should be protected from the fraudulent acts of business participants even if it means businesses must be more careful. If investors are not protected, they will be unwilling to invest in businesses and that will hamper economic growth. This issue of investor protection was prevalent during the Great Depression and was the driving force behind the establishment of the SEC in the first place. On the other hand, if duties are imposed on businesses that relate to the acts of other businesses they interact with, it would cost more to do business because new procedures would be required and the cost of insurance, litigation, and damage awards to plaintiffs would rise (not to mention the cost to taxpayers of all of the additional lawsuits tying up the courts). This cost issue has many implications for society, including a chill on economic activity and our competitiveness as a country in this time of globalization. Is this the time to take another step toward investor protection or should we wait until the other major global economies begin imposing additional costs on their businesses to protect investors (or labor or the environment)?

If you think the Justices on the Supreme Court have an easy job, think again. This type of balancing act occurs all the time. For many of these questions there is no “right” answer, and getting “justice” for the harmed investors may not be the issue at all.

© October 6, 2007, Mark Palermo

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Anthony Curto said...

I agree there is a fine line that the Supreme Court has to balance the right answer and justice. But, there needs to be ethical standards for those who are willing to lend money,especially at above premium. Perhaps the purpose of this money was for anything illegal, if the lender doesn't care where the money is going, could it be funding terrorism? The lender should know what the money is being used to fund.

Dan said...

The Supreme Court as well as the chain of courts leading up to it have no business wrestling with ethical questions regarding the greater good of societies economy. Their charge is simple on paper, if more complicated in practice; they are to determine if an action or law is constitutional or unconstitutional, and not whether it is economically sound or economically not sound. If an action or law is deemed to be wrong for constitutional reasons but also prove to be economically unsound then the Justices’ ruling is clear. The reveres is also true.

In the event that the constitution does not hold the answer to the dilemma, in that it is not addressed at all in the constitution, then the Supreme Court should refuse to rule and turn the issue over to state legislation.