April 4 (Bloomberg) -- Banks and their lawyers have found a surprisingly effective way to stymie financial reform: Kill new rules in the courts. It’s a strategy that may cripple regulators, undermine the legitimacy of the judicial system and ultimately come back to haunt the banks.

Litigators working for the financial industry have been scoring some important victories, using the courts to block rules required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Notably, the U.S. Court of Appeals for the D.C. Circuit struck down a Securities and Exchange Commission rule that would have given shareholders more say in the selection of corporate directors, on the grounds that the regulation lacked adequate cost-benefit analysis. A lower court struck down a Commodity Futures Trading Commission rule imposing position limits on traders because of supposedly ambiguous wording.

The courts are likely to keep playing an outsized role in financial regulation. This is bad news for those seeking reform. There are three reasons the courts are going to be stacked in favor of industry, making them particularly useful for lobbyists who want to weaken Dodd-Frank.

First, an asymmetry exists in the types of claims that courts will accept. As David Arkush, an attorney at Washington-based law firm Gupta Beck PLLC, put it: “Businesses nearly always have standing to challenge rules that affect them. But if you’re someone who benefits from a rule and thinks it should be stronger, it’s much harder to get into court.” That’s a much less reform-friendly balance than the rule-making process, which requires regulators to read and weigh comments from all sides equally.

Blunt Weapon

Second, litigation is a blunt and unpredictable weapon with the power to gut whole sections of financial reform, as opposed to merely watering them down. It’s very hard for regulators to anticipate exactly what parts of their rules lawyers will challenge, and how the courts will react.

Judges are simply showing up at the end of a long process and giving a thumbs-up or a thumbs-down ruling, with little clarity or guidance to influence policy makers and no institutional back and forth. As opposed to lobbying, which aims to change legislation at the margin, court challenges block laws completely. There may never be position limits for commodity derivatives, and the SEC has shelved proxy access.

Third, the threat of litigation has a chilling effect that individual lobbying successes do not. It puts pressure on regulators to take more time writing the rules, to make them longer and more complicated, and to tilt them in favor of industry so that it won’t sue. The potential for courts to take issue with specific word choices, or to set unpredictable requirements for cost-benefit analysis, hang like a sword of Damocles over the whole rulemaking process.

In a recent Washington Monthly article, the journalist Haley Edwards describes how litigation risk tips the balance of power at regulatory agencies toward those who want less aggressive reforms, even to the point of paralysis. A single director showing doubts, or a single negative cost-benefit report, can significantly increase the risk that a rule won’t survive the unpredictable challenges of the courts.

For those, conservative and otherwise, who believe greater transparency will lead to improved government, this is ultimately damaging. Consider the approach to cost-benefit analysis. Instead of setting clear parameters for how such analyses should be done, the banks’ litigators are using cost-benefit as a veto point to threaten regulators. This prevents a more open and honest dialogue about the approach’s strengths and weaknesses.

Politically Charged

As Michael Livermore of the Institute for Policy Integrity, a group that favors cost-benefit analysis, argues: “the fact that cost-benefit analysis is brought in by the courts for financial reform in a way that is contentious, unclear, without a lot of guidance, and in a politically charged way, entrenches views on opposite sides of the debate.”

How can balance be restored? For one, President Barack Obama should put more focus on appointing judges to vacant positions. This would help correct an ideological tilt to the right that has made the courts particularly receptive to Dodd-Frank challenges. Obama didn’t nominate someone for the several vacancies on the District of Columbia Circuit Court until September 2010. That candidate, Caitlin Halligan, asked for her name to be withdrawn from consideration last month after even more Senate obstruction and filibusters.

So, one means to that end would be rewriting the filibuster rule, which has allowed senators to block Obama’s appointments. It is paradoxical that Senator Harry Reid, who worked so hard to pass financial reform, could see much of it undone by his lack of action in fixing the filibuster.

Ideally, the financial industry and the judiciary should recognize that killing Dodd-Frank in court isn’t in their best interests in the long term. By politicizing the courts and subverting the will of Congress, they are undermining the rule of law. By striking down rules wholesale, they are subverting the process of compromise -- an approach that could lead to even more draconian regulations on Wall Street.

Regulators, for their part, should push forward as best they can. If they write tough rules justified with as many arguments as they can muster, perhaps the courts will back down. The resulting regulations will probably be longer and more complicated, but such is the hand that the authors have been dealt.

Finally, conservatives should make the case for their own version of financial reform, instead of playing the role of spoiler. Just as with the Affordable Care Act, rooting for the courts to save them from having to offer something constructive is the wrong approach. It will lead the party to become more disconnected from popular policies and more interested in the anti-democratic impulse to recreate an activist court. This is a losing strategy, even if it is paying dividends right now.

(Mike Konczal is a fellow at the Roosevelt Institute. His blog, Rortybomb, was named by Time magazine as one of the 25 best financial blogs. E-mail him and follow him on Twitter. The opinions expressed are his own.)

To contact the writer of this article: Mike Konczal at rortybomb@gmail.com

To contact the editor responsible for this article: Mark Whitehouse at mwhitehouse1@bloomberg.net