The double whammy: regulation beats litigation. Unfortunately, CEOs must contend with both.

Modern CEOs spend much time fending off the dual threats that regulation and litigation pose to their companies. It is tempting for CEOs to place these two problems in separate compartments on the grounds that regulation calls for one sort of response and litigation quite another.

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Regulation seeks to intervene to stop any harm before it occurs. Accordingly, it typically works through an expensive, complex and time-consuming administrative process that relies on expert reports, hearings, rulemaking, licenses and inspections. Its sanctions usually involve pulling permits to keep or remove products from the market, augmented by relatively minor fines.

Litigation takes an opposite tack. Courts never promulgate rules and standards before the fact. Rarely do they seek to enjoin the manufacture or sale of particular products. Rather, the whole process is driven by plaintiffs lawyers intent on getting judges and juries to award hefty damages for individual or class harms. In virtually all cases of serious exposure today, it is not possible to contract out from tort liability to suit. The rules of the game are set by the courts. Those who enter the market have to play by them.

These differences in approach matter. The Food and Drug Administration can keep or pull drugs from the market, or the Environmental Protection Agency can shut down a plant. The judicial system, in contrast, allows thousands of people to sue for personal injuries or refunds for drugs allowed into the market, or substantial damages for thousands of victims of toxic torts. The potential verdicts are vastly larger than any administrative fine.

The Case for (Bad) Regulation

Most CEOs grudgingly recognize that regulation and litigation form an indispensable and inescapable feature of modern business life. It is hard to imagine a sensible world, for example, wholly devoid of pollution controls. But on a wide range of issues, dealing with such matters as securities and products markets, many CEOs believe that neither form of regulation is necessary, so long as competitive markets are allowed to seek out the best mix of prices and products. Unfortunately, the modern temper of the time often demands some form of regulation.

In many industries, that imperative boils down to an unappetizing choice between bad regulation and bad litigation. Which should be chosen? It is not possible to give a uniform answer to this question that covers all cases. But it is possible to set a strong presumption to which, I believe, most CEOs already gravitate: Bad regulation is preferable to bad litigation.

Two reasons drive this choice. First, regulatory requirements are known in advance, which prevents the nasty surprises that come from an onslaught of consumer class actions or personal injury suits. Most important, administrative fines are far easier to price than jury verdicts that vary enormously. Under current law, the same dispute could result in any outcome, from no liability to full liability for both compensatory and punitive damages. The legal cost-benefit formulas are that pliable.

Second, regulation works in the world of the possible, not the world of the imagination. When the federal government regulates automotive safety, it does so in advance of any production. Therefore, it has to acknowledge that particular standards that look sensible in isolation make no sense when considered in tandem. No matter how great the regulatory zeal, no administrator can pile on major safety requirements that add endless pounds and dollars to a vehicle that still has to run and be sold.

All tradeoffs are made long before any particular accident occurs. In contrast, individual juries are not constrained by any consistency requirement. Each jury looks at its particular accident and may endorse one change that with hindsight may have prevented this loss. However, juries don't have to ask what would happen if manufacturers had to incorporate all jury-driven design changes simultaneously--those cars could add a ton in weight and not move at all. Controlling costs, weeding out inconsistencies and ending uncertainty all point in the direction of regulation.

The Double Whammy

So here's the rub. All too often the American legal system does not choose between regulation and litigation. Instead, it routinely allows two bites at the apple. First, direct regulation establishes standards for key products such as cars and pharmaceuticals. Then the courts treat these standards as mere minimums that juries are invited to top. Juries can impose liability on auto manufacturers for design features that were explicitly approved by regulators under the National Traffic and Motor Vehicle Safety Act. Drug companies can be held liable on the grounds that FDA-approved warnings are inadequate for the needs of physicians and patients.

The current regime offers the worst of both worlds. The FDA is not lax in dealing with drug warnings. Quite the opposite, its real problem stems from its own institutional incentives. When the FDA lets a bad drug reach the market, an angry Congress threatens to limit its power. When the FDA keeps a good drug off the market, no one tallies the deaths and injuries attributable to the delay. Anonymous harms travel uncounted under the regulatory radar. In consequence, approvals come too slowly and stern warnings often frighten off patients who could benefit from drug therapy. Yet courts treat those stiff warnings as mere legal minimums. Accordingly, judges invite juries to rectify the supposed dangers of agency slack by awarding large damages on the grounds that injured patients were entitled to still stronger warnings. But the boom is lowered only after a lengthy trial about the effectiveness that some alternative warning might have had. The litigation system that compounds the danger of FDA delay is powerless to correct it. There are no lawsuits for drugs that don't make it to the market.

Seeking a Cure

Unfortunately, there's no easy fix to this double whammy. For 50 years, the state courts, which control these issues, made it crystal clear that product sellers could not ask individual consumers to waive suits for personal injury by any disclaimer, no matter how sensible or conspicuous. Next, state courts soundly rebuffed the suggestion that complying with all regulation on design or warnings provided a complete defense against design or warning suits, respectively. A product seller or service provider may bring that perfect compliance to the attention of a jury, which is free to disregard it.

Recently, this multibillion-dollar battleground has switched to the federal arena in connection with the vexed issue of federal preemption. In our constitutional system, "preemption" means that federal law ranks supreme: The lowliest federal regulation trumps the loftiest state rule. Accordingly, an explicit federal statute can block all state person-al injury actions for products and services that meet all federal standards. However, these explicit cases are relative rarities. Hence the real battle is over the muddier question of implied preemption, which often boils down to whether the state liability rule is inconsistent with the federal regime. Cases of outright contradiction are relatively straightforward, but also uncommon. More frequently, cases involve the more nebulous notions of whether federal regulation occupies the entire field or frustrates the enforcement of the federal system.

The FDA Initiative

These arcane disputes have huge ramifications. For example, last year the FDA, tired of seeing its rulings constantly belittled in court, publicly reversed course by announcing that its warnings should be treated as adequate in all state law personal injury cases. If upheld, its change of heart would block almost all personal injury and death suits stemming from drug use, for virtually no pharmaceuticals today are improperly fabricated.

But will the ruling stand up? That issue is complicated because the Supreme Court gives deference to federal agencies in interpreting their own statutes. The proposition sounds innocent enough, but it raises CEO-like issues. Give agencies that kind of power, and the lobbyists of every stripe will swarm down on agency personnel to open or shut that preemption gate. These activities continue throughout litigation to curry favor with the Office of the Solicitor General in order to sway the Supreme Court in its many preemption cases. Yet all such outcomes are provisional, for either way the losers petition Congress to reverse any outcome in the agencies or courts.

No longer do major personal injury litigations focus on freakish accidents with little consequences for the bottom line. Modern design and warning cases present standard fact patterns that can make or break major corporations. The arcane issues of federal preemption may sound like "lawyer talk" for CEOs, but they lie at the focal point of all modern mass litigation. Beware, and beef up accordingly.

Richard A. Epstein ([e-mail]) is a professor of law at the University of Chicago and a senior fellow at the Hoover Institution. His latest book is Overdose: How Government Regulation Stifles Pharmaceutical Innovation.