We gave our policy views recently to the Solicitor General (who represents the Administration in front of the Supreme Court) on a case called Stoneridge Investment Partners v. Scientific-Atlanta. The core policy issue at stake is one of third party liability, and it’s an important element of an ongoing debate about litigation and whether the United States will continue to be the best place in the world to do business. Let’s look at an example.

Tom runs a business.

Richard is a banker. He makes a loan to Tom’s firm, which Tom uses to finance a business transaction.

Tom fraudulently misstates his accounting for this transaction, deceiving his shareholders. Richard knew nothing about Tom’s fraudulent behavior.

Tom gets caught. The Securities and Exchange Commission (SEC) goes after Tom.

Harry is a shareholder in Tom’s firm. After Tom is caught, Harry sues Tom’s firm. (Harry probably has help from some class action lawyers who are happy to help him sue, for a cut.)

Should Harry also be allowed to sue Richard’s bank? Should a third party (whether a banker, supplier, or other service provider) that does business with a firm be subject to lawsuits from that firm’s shareholders, if that firm behaves fraudulently? We think the right answer is no. Imposing liability would impose significant costs that we believe would harm the U.S. economy, and make doing business in the U.S. less attractive.

In the scenario above, if Richard’s bank were sued, a negotiation between the bank and Harry (or, more likely, between the bank and the class action lawyers who represent Harry) would probably ensue. The increased costs imposed on Richard’s bank would not only make the bank less profitable, but they would also raise financing costs for other firms. Higher financing costs reduce investment, deter innovation, and slow economic growth.

In addition, a third party will obviously know less about a firm’s books and operations than the firm’s executives and board of directors. Bankers, suppliers, and service providers are focused on running their own business, and not on supervising the business of their clients. Federal securities laws rightly impose the responsibility for corporate oversight of a company’s accounting and operations on that company’s executives and board, not third parties. It’s wasteful and inefficient to have multiple parties responsible for the same due diligence on one firm.

Finally, such a requirement would be unfair to firms that are good actors. The threat of litigation would force many good actors to pay to settle lawsuits for bad behavior on the part of another firm, something over which the good actor has no control. Spreading the costs of that litigation risk away from the bad actors also reduces the deterrent that exists today to discourage bad actors from behaving badly.

We think that current enforcement tools are strong enough both to deter bad behavior by Tom, and to compensate Harry for his losses. The SEC has criminal enforcement authority that it can and does use against Tom, and also against Richard and his bank if he facilitates Tom’s fraud. Harry can sue Tom. In addition, if Richard the banker also violates SEC laws, the “Fair Funds authority” created under the Sarbanes-Oxley Act gives the SEC the power to collect from Richard to repay Harry and the other defrauded shareholders.

So what’s the process? The SEC decided on a 3-2 vote to ask the Solicitor General (SG) to support the plaintiffs in Stoneridge. The Solicitor General requested the President’s policy view, and the President expressed a policy view (similar to that expressed above) that differs from the SEC’s. The President did not direct the Solicitor General as to which side the SG should take in the Stoneridge case. The SG also received views similar to the President’s from the Treasury Department, as well as from the (independent) Federal Reserve and the Office of the Comptroller of the Currency (an independent banking regulator).The SG decided Monday not to file a brief in support of the plaintiffs. He now has about four more weeks to decide whether to file a brief in support of the defendants.

The United States has the strongest economy and the most competitive financial markets in the world. But increased litigation risk is a serious problem now, and any increase in the costs of litigation risk can further damage our strong economic and financial system. We want a system in which good behavior is encouraged, bad behavior is deterred, most people are focused on producing the goods and services that make our economy grow, and the wasted costs of litigation are as small as possible.

Update: here’s the opinion, which went 4-3 our way. We’re pleased.