Entrepreneurs
Unmerited lawsuits are killing innovation, wasting capital
Looking for what to do next? Find out at the end of this article.
Risk is an element in every investment. However, as an investor, you want some assurances that companies in which you invest won’t be wiped out by lawsuits. Unfortunately, no such assurances are possible.
It’s not the ultra-wealthy who are hurt the most by the litigation explosion but the average American family. Half of all investors in the country are typical Americans who live next door and down the street.
Investors like stability. Lawsuits threaten that stability. A company burning through its resources and brainpower to defend itself in court – or to simply avoid litigation – will suffer from turmoil and uncertainty. Under those circumstances, shareholders often flee for more stable investments. If you don’t, you can put your investments in jeopardy.
The Pain Of Falling Share Value
The Pacific Research Institute reports that 177,000 annual tort cases against U.S. corporations reduce shareholder value by $684 billion a year. That’s 68 percent of a trillion dollars wiped out every year for Americans who invest in stocks, mutual funds, 401(k)s, IRAs and 529 plans for their children’s college educations.
“To put this into perspective using output terms, stockholder loss is equivalent to losing all U.S. supermarket sales for an entire year or the output of Florida each year,” the report says.
“If tort filings against publicly traded companies continue at the present rate and the equity loss per filing remains constant into perpetuity, the long-term wealth loss to U.S. stockholders will be $13.2 trillion. This number is likely an underestimate since both filings and losses per filing are trending upward.”
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One of those corporations hit particularly hard by excessive litigation is the drug maker Merck. More than 4,000 suits have been filed against Merck, maker of the pain reliever Vioxx. In August 2005, the first of those cases was resolved when a jury decided that Merck was liable for the death of a Texas man who was taking Vioxx. It awarded his widow $250 million.
But even before that trial began, the equities markets priced in the damage from the litigation. Merck’s shares plunged 41% in October 2004 after the drug was pulled off the shelves. Investors took a bath.
Not only did the shareholders lose a large part of their wealth, the Vioxx case will be in investors’ minds when they think about injecting capital in the next generation of pain killers.
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When Bayer was sued in Texas in 2003, its stock price lost 25 percent of its value in the first few days of a trial.
- Health maintenance organizations once lost $12 billion in stock value in a single day simply due to the threat of lawsuits.
Securities Litigation – Not Worth It For Investors
Plaintiffs’ lawyers file lawsuits against corporations on behalf of the corporation’s shareholders, yet the beneficiaries of securities class-action suits against corporations are not the members of the class - but the lawyers themselves.
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By all accounts, nearly all the money paid out as compensation in the form of judgments and settlements comes, one way or another, from investors themselves,” Georgetown law professor Donald C. Langevoort wrote in a study Capping Damages for Open-Market Securities Fraud. “Little if any of the sum is contributed by those who were the primary authors of the fraud; a recent study puts the figure at less than half of 1 percent.”
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Washington University finance professor Anjan V. Thakor found that simply filing a securities class action lawsuit will cause the defendant company’s share value to fall by, on average, 3.5 percent.
- A Manhattan Institute report said “Securities claims are thus often nothing more than a mechanism for transferring assets from one group of shareholders to another, with a 30 percent cut for” the plaintiffs’ lawyers who are looking for a big payout.
Escaping From A Judicial Hellhole
When states make changes to tort law, such as placing reasonable limits on damages that can be awarded by juries (no millions for spilling a hot beverage on yourself, like the woman who ended up with a lap full of McDonald’s coffee), they invite investment, which brings jobs and economic development.
Toyota, for instance, announced in February 2007 that it would build a $1.3 billion, 2,000-worker plant near Tupelo, Miss. Mississippi Gov. Haley Barbour is convinced that Toyota would not have made this investment in his state if it had not passed important tort reforms, placing limits on damages and types of actions brought by out-of-state claimants.
Toyota had initially declined to locate the plant in Mississippi, at one time a judicial hellhole, a court jurisdiction where businesses and consumers are treated shabbily and plaintiffs’ lawyers can be confident that sympathetic juries and judges will ensure that they would reap large rewards.
“For trial lawyers, this was the state you wanted to come to if you wanted to sue someone,” Barbour once told the Wall Street Journal.
But when legal reform was enacted in 2004, the car maker changed its mind, choosing Mississippi over about a dozen other states because of modest changes made to its civil justice system. Limits were placed on the amount of damages a jury can award so that plaintiffs and their attorneys can’t leave the courtroom with awards that are far out of proportion to the harm the plaintiffs have suffered and the work the lawyers put into the case. The legislation brought good-paying jobs to Mississippi and will increase the likelihood that other companies will see the state as an attractive place to locate in the future.
Chasing Away Entrepreneurs
Like conventional investors, entrepreneurs need a business environment that is not filled with legal traps. Entrepreneurs start news businesses and are the drivers behind initial public offerings – the process by which companies, often startup businesses, issue their stock to the public for the first time. Entrepreneurs and their capital are needed to expand companies and fund innovation.
The high cost of out-of-control litigation, however, has made America a less attractive place to take a company public. Entrepreneurs are denied wealth-creating opportunities.
- “The U.S. securities markets are on the way to losing their pre-eminence.” Philip K. Howard wrote in the New York Sun in February 2007. “That’s the conclusion reached by two recent reports, one indirectly sponsored by Treasury Secretary (Henry) Paulson and the other by Mayor (Michael) Bloomberg and Sen. Chuck Schumer. The facts are indeed alarming — the American share of global initial public offerings declined to 5% from 50% in the last five years.
“Foreign companies are being scared away in part, both reports conclude, by soaring costs of American law.”
- "Why roll the legal dice in America when legal systems in Britain and elsewhere focus on punishing the individual wrongdoer, not shooting everyone in sight?” Howard continued in the same New York Sun op-ed.
“We should have seen it coming. Over 20 years ago the dean of Harvard Law School, Derek Bok, observed that ‘Foreign businessmen express amazement at a system . . . that exposes the entrepreneur to legal challenge so easily and on so many different fronts, a system that lends itself so readily to harassment, obstruction, and delay.’ ”
- “We went public after opening our fourth store because we needed the capital to open more stores. Going public and entrepreneurship were the keys to our success. If you’re a public company today, you have to be surrounded with lawyers and you can’t make a decision without a lawyer on one side of you and an accountant on the other side,” The Home Depot co-founder Bernie Marcus told Investor’s Business Daily in January 2006.
“I’m concerned for the next generation of entrepreneurs whose creativity, risk-taking and innovation are stifled by the current legal and regulatory climate. Will they be able to create the next Home Depot? I worry about this.”
The explosion of lawsuits has caused entrepreneurs to discount initial public offerings of stock. Studies have found that some issuers underprice the stock because they expect to encounter litigation costs if share prices fall too low after the initial purchase. These up-front costs are incurred simply to avoid future litigation costs.
Killing Innovation
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The threat of being sued is a significant disincentive for inventors who want to bring new products to the market. Sylvia Hsieh, a Santa Clara, Calif., attorney writing in USA Today in 2006 said that “An average patent case will cost between $3 million and $10 million, and take two to three years to litigate.”
- The threat of excessive litigation is so pervasive that U.S. companies lose more than $367 billion each year in potential sales because investors hold back their capital from research and development projects.
Until lawmakers put realistic caps on the damages that a jury can award and take the incentives out of filing abusive and frivolous lawsuits, investors and entrepreneurs will continue to lose wealth. Plaintiffs who have been truly harmed should be compensated for their losses. But that shouldn’t include heavy losses for those who had no part in harming the plaintiffs.
Now For a Dose of Financial Facts
In the big picture, lawsuit liability costs now exceed $865.37 billion a year. This figure represents more money than the unprecedented 2008 U.S. federal bailout – more money than the cost of the wars in Iraq and Afghanistan on an annual basis – and more money than the Gross Domestic Product of the majority of nations in the industrialized world.
According to Pacific Research Institute, which has conducted multiple econometric studies on the cost of the American civil liability system, more than half the amount spent on liability lawsuits each year is excessive. The U.S. spends approximately 2.2 % of Gross Domestic Product on direct tort liability costs, while most advanced economies spend .9 %. So, compared to our economic competitors, the U.S. spends 59 % more on excessive liability costs. That’s the equivalent of a 13 % tax on annual income in the U.S – income that supports retired Americans and Americans on fixed incomes.
Additional costs can be measured not only in dollars, but also in availability of medical services, jobs lost or outsourced, and critical innovations either stalled or foregone altogether.
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The annual loss to U.S. stockholders due to liability lawsuits is $684 billion – the equivalent of all U.S. supermarket sales for a year, or the entire economic output of the State of Florida.
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Drawing on data from the Institutes of Medicine, 114,000 people would be alive today if not for excessive tort liability in medical services during the past two decades.
- The so-called “tort tax” on an American family of 4 is $9,827.
Now What Do We Do?
Foundation for Fair Civil Justice (FFCJ) exists to bring empowering programs and education to American entrepreneurs and investors.
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Please take the time to sign up for our Fairness Matters e-newsletter, which will bring you news items right to your email that tell the ongoing story about the need for legal reform by clicking here. We don’t share your email address with anyone – that’s important to us.
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Learn more about the bread-and-butter, common sense need for legal reform and how lawsuit abuse affects you as a entrepreneur and investor by listening to our “Let’s Be Fair” radio commentaries, hosted by FFCJ Senior Fellow Bob Dorigo Jones by clicking here.
Bob is a bestselling author and founder of the nationally profiled “Wacky Warning Label Contest,” which annually picks the wackiest warning labels on products to underscore the absurd lengths to which American business has to go in response to the threat of lawsuits.
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