Punitive damages and the free market: a law and economics perspective.

Six times in the last eight years, the U.S. Supreme Court has granted certiorari in cases where corporate defendants sought to challenge the constitutionality of state court awards of punitive damages.(1) This year's episode of the nearly perennial saga is BMW of North America, Inc. v. Gore.(2) Although that case will be argued next month, its notoriety precedes the Court's resolution of the questions presented by BMW's petition.

Gore was vilified this past spring by congressional proponents of "tort reform" limits on punitive damages. According to tort reform mythmakers, this case represents yet another outrageous example of large, excessive, "windfall" punitive damages awards - in this example, a punitive damages award of $4 million based on nothing more than a "slightly" bad paint job. The defects allegedly were so modest that they were not even noticed at the dine of purchase by the plaintiff/respondent, Dr. Ira Gore, and their effect on the value of the car (compensatory damages) was insignificant, a mere $4,000, or one-thousandth (or one-tenth of 1 percent) the size of the punitive damages award.

In sum, Gore stands, along with Liebeck v. McDonald's(3) (where a jury awarded a supposedly "careless old lady" a windfall" of $2.7 million in punitive damages for burns that were caused by spilled coffee - the judge reduced the award to $480,000, or triple the actual damages), for the proposition that awards of punitive damages are totally "out of control" and make no sense, particularly no economic sense.

Thus, tort reform advocates have argued - in the media,(4) in Congress,(5) and now in the Supreme Court - that windfall awards punish individual U.S. businesses unreasonably and unjustifiably. The tort reformers also argue implausibly and without evidence that excessive punitive damages awards ultimately harm U.S. competitiveness in the world marketplace.(6)

So goes the myth. The reality - as explained in an amicus brief filed with the Supreme Court in Gore by nine "law and economics" scholars in support of the plaintiff - is that punitive damages are an economically sensible way of deterring tortious conduct, particularly the kind of widespread consumer fraud exemplified by BMW's efforts to palm-off thousands of repainted cars with diminished value as new cars with undiminished value. For these reasons, punitive damages awards, far from being "bad for America," are in fact beneficial.

The myth that punitive damages are an economically irrational tool was not the sole fable dispelled by the law and economics amicus brief. The other myth is that law and economics is an irredeemably conservative, probusiness, anticonsumer school of thought, one that should be attacked when feasible and ignored when not, but under no circumstances considered suitable for the vindication of plaintiffs' rights.

Law and economics is the shorthand phrase used to describe a school of thought that has two aims: (1) to describe how the law has developed over the centuries (as reflecting, consciously or not, economic values and concerns) and (2) to prescribe and advocate how the law should evolve (to expressly and intentionally conform to economic values and concerns). Many, but not all, of the original exponents and theoreticians of law and economics have probusiness biases (for example, Richard Posner, formerly a professor at the University of Chicago Law School and currently the chief judge of the U.S. Court of Appeals for the Seventh Circuit).

Also, law and economics has been frequently and effectively invoked by advocates for corporate interests. Thus, many lawyers have long assumed that the entire school of thought is hopelessly infected by these biases. Many assume this theory offers nothing of value to the interests of workers, women, minorities, the poor, environmentalists, and, most pertinently, injured consumers.

Nothing could be further from the truth. Law and economics - if properly understood and applied - can be an enormously useful tool in the fight to preserve and extend the rights of these people and these groups. The usefulness of law and economics to "liberal," "public interest" concerns generally, and to tort victims specifically, is demonstrated in the amicus brief.

There, the law and economics scholars explain that BMW's "excessiveness" arguments are antithetical to the sound and universally accepted doctrine that punitive damages are awarded to punish a defendant for outrageous misconduct and to deter similar misconduct by the defendant and others. To fulfill their deterrent function, especially in cases involving intentional misconduct such as fraud, punitive damages should be calculated to equal or exceed the wrongdoer's expected profits.

Punitives and Consumer Fraud

Consumer fraud is especially trouble-some because it subverts the efficiency of the entire market system. In a well-functioning market populated by rational economic actors, voluntary market transactions produce outcomes in which both parties are better off, thus yielding an increase in total social welfare.

In cases such as Gore's, a seller's decision to withhold material information from the buyer means that there can be no assurance that the transaction will produce an increase in social welfare. In Gore's case, for example, his "new" but repainted BMW was, by virtue of that repainting alone, worth $4,000 less than he paid for it, and he testified that he would not have purchased the car at the full price had he known its true condition.

Punitive damages are especially important in cases of consumer fraud precisely because many consumers never learn that they have been defrauded. Consequently, most perpetrators of consumer fraud will escape even the possibility of sanction. Moreover, victims who detect frauds will often be deterred from suing by financial and other obstacles, including the typically overwhelming disparity between the relatively small amount of their loss and the anticipated cost of litigation.

Punitive damages for consumer fraud and other intentional wrongdoing serve two purposes: to punish the defendant for outrageous misconduct and to deter similar misconduct by the defendant or others. The deterrent function links a tangible threat of financial penalty for future misconduct with an intangible educational or "preference shaping" function of the punitive sanction as an indicator that certain actions are socially intolerable.

The imposition of punitive damages reveals an underlying economic logic to the common law prohibition of consumer fraud. The principle of providing truthful information is one of the defining aspects of a market system. To undermine that principle through consumer fraud is therefore to attack the very viability of the system. The common law embodies economic wisdom by meeting this attack with the possibility of punitive damages both to deter and to underscore the gravity of the threat.

There is another way of appreciating the economic logic of distinguishing intentional consumer fraud from less serious forms of sanctionable conduct. From an economic perspective, optimal deterrence of fraud differs dramatically from optimal deterrence of negligence. Assessment of damages for negligent misconduct raises concerns about overdeterrence as well as underdeterrence, because excessively high damages can induce actors without full information to spend too much on precautions or to avoid engaging in beneficial activity altogether.

By contrast, assessing compensatory and punitive damages for fraud or other intentional wrongdoing raises far less concern about overdeterrence, because the optimal level of this conduct is zero. The goal of the legal system is not to "optimize" the level of consumer fraud, but rather to eradicate it entirely. Indeed, as one conservative federal judge has noted, it is a misnomer to speak of "optimal" deterrence with respect to such intentional torts, because "the optimal amount of fraud is zero."(7)

In pursuit of this goal, punitive damages play a fundamental role, while compensatory damages often are of only secondary importance.(8) In assessing punitive damages for fraud or other intentional misconduct, there is far more risk of inefficiency from underdeterrence resulting from awards that are too low than there is of inefficiency from overdeterrence resulting from awards that are too high.

Achieving Optimal Deterrence

To achieve optimal deterrence, a punitive damages award requires consideration of two principal factors: (1) the probability that the wrongdoer might escape detection or punishment in other instances of the same misconduct in the future and (2) the magnitude of both the wrongdoer's actual gain and its expected profits from the misconduct.

The first factor to be weighed in determining the amount of punitive damages needed for optimal deterrence is the likelihood that the wrongdoer might escape detection and punishment. Under a regime of purely compensatory damages, a defendant like BMW would have m incentive to engage in fraudulent behavior and to withhold material information from potential customers, because it could expect to avoid liability in most or even all cases.

Defendants would lack incentive to engage in fraudulent behavior only if they knew that the liability system functioned perfectly, without error, so that all victims eventually were fully compensated for their losses. But perpetrators of consumer fraud often can expect to profit from their wrongdoing because of the likelihood that they will not be compelled to provide full compensation to all their victims or even any compensation to some victims.

The problems of underdetection and underenforcement - and thus underdeterrence - are widespread in many classes of cases. Studies reveal that many injured people are intimidated by the legal system or are convinced that their injuries are too small to justify litigation costs, both financial and psychological. Accordingly, it has been estimated that only 3 percent of people involved in accidents not involving work or a motor vehicle ever make any liability claim, including those who make informal demands or file insurance claims.(9)

The U.S. Supreme Court has long emphasized that one of the traditional purposes of punitive damages is providing enhanced punishment to remedy the problem of underdeterrence caused by the failure of potential plaintiffs to sue to recover their compensable loss.(10)

The consumer fraud at issue in Gore provides a paradigmatic example of the need for punitive damages to counteract the risk of underdeterrence. There are three reasons.

1. Many victims of a fraudulent scheme may not realize that they have been duped. For example, Gore only accidentally discovered that his car had been repainted.

2. Although the total cost to society from a pattern of consumer fraud may be tremendous, the losses to individual victims often are too small to warrant the costs of litigation. For example, the jury awarded Gore only $4,000 in compensatory damages, far less than the anticipated cost of litigating the claim against a large corporation. The prospect of a substantial punitive damages award provides an essential incentive for fraud victims to bring suit, and thereby to fulfill their socially valuable role as private attorneys general.

3. In fraud cases it is likely that erroneous jury verdicts will favor defendants more often than plaintiffs. In other words, guilty defendants will escape liability more often than innocent ones will wrongly be forced to pay damages. This is so because of the difficulty of proving fraud's scienter element and because of the requirement in many jurisdictions that fraud's be proved by clear and convincing evidence rather than a mere preponderance of the evidence.(11)

The second overall factor to be considered in evaluating the amount of punitive damages necessary to achieve deterrence is the size of the wrongdoer's actual and potential profits. The reason is simple: An "economically rational" wrongdoer is unlikely to cease privately profitable but socially harmful activities unless it believes that it has more to lose than to gain. When each victim's out-of-pocket loss is small, it is predictable that the vast majority of victims win not sue. In consequence, a substantial punitive damages award may be required if the defendant and others are to be deterred from continuing the pattern of misconduct.(12) In cases of fraud and other situations where a defendant refuses to abide by accepted market mechanisms of exchange, punitive damages should be assessed with reference to all the profits from the defendant's wrongdoing. Economists recognize that punitive damages should be imposed to prevent selfish "strategic behavior" and to ensure that defendants negotiate m good faith rather than transact business through fraud, deceit, and other improper means." Punitive damages must at minimum be equal to the defendant's expected profits, because anything less would fail to deter defendants from circumventing legitimate methods of contractual exchange. In fact, the amount of punitive damages awarded for a discovered fraud should be sufficiently large to leave the perpetrator worse off than he would have been if he had behaved in an open and honest fashion. (14) It is impossible to "overdeter" attempts at contractual bypass; the optimal level is zero.

In this area, legal principles and practice dovetail with economic theory. Ironically, this point was stressed by BMW's current counsel of record in an amicus brief filed with the Supreme Court in support of the defendant/petitioner in TXO Production Corp. v. Alliance Resources Corp.

That brief repeatedly underscored that among the factors most relevant in fixing an appropriately sized punitive damages award is "the anticipated or actual gain to the defendant,"(15) alternatively phrased as "the actual or potential gain to the defendant."(16) "[T]he greater the anticipated gain from a tort, the greater the penalty needed to provide appropriate disincentives for its commission."(17)

In upholding a $10 million punitive damages award, the TXO plurality adopted identical reasoning, pointing to "the tremendous financial gains that TXO hoped to achieve" and "the amount of money potentially at stake."(18) Similarly, in Pacific Mutual Life Insurance Co. v. Haslip, the Court approved as a factor in imposing punitive damages "the profitability to the defendant of the wrongful conduct."(19)

To achieve optimal deterrence of an intentional tort, punitive damages must expose the wrongdoer to potential liability in an amount at least equal to the sum of the realized and expected profits from its misconduct, adjusted upward both to offset the wrongdoer's probability of escaping liability and to ensure that fraud is less profitable than honesty. Where consumer fraud is practiced on a nationwide scale on the basis of a unitary national policy, effective deterrence therefore demands that an award of punitive damages should not be limited to consideration of the damages inflicted on the individual plaintiff but must take into account the entire amount of the wrongdoer's actual and expected profits from its fraudulent practice.

Nationwide Policy

In its brief to the Supreme Court, BMW proposed that the Court adopt a far-reaching new rule: that in determining the amount of punitive damages necessary to punish and deter a defendant's conduct, a state court be limited to considering only the defendant's transactions with citizens of that state or perhaps only the transaction with the individual plaintiff.(20) his approach makes no economic sense inasmuch as the rule would exacerbate the problem of underenforcement, which is especially acute in actions for consumer fraud, and thus would seriously erode the deterrent function of punitive damages awards.

Moreover, by keying damages to "what the defendant did to the plaintiff or plaintiffs in that case,"(21) BMW's proposal obfuscates the essential conceptual distinctiveness of punitive damages. Unlike compensatory damages, which refer conceptually to the victim's harm, punitive damages refer to the egregiousness and undesirability of the defendant's conduct. Put another way, the company's contention conveniently "forgets" that the purpose of punitive damages is not to compensate for the victim's loss but rather to deter the defendant's misconduct. Punitive damages are intended to deter wrongdoing and prevent future harm by providing economic compulsion to defendants to abandon unlawful or otherwise harmful policies. In BMW's case, the policy or practice at issue was formed and followed on a unitary, nationwide basis and pursued profits on the basis of a single, national market. It is economically unsound, therefore, to assess punitives based on an artificially small segment of the market, such as sales in a particular state or locale, let alone on the basis of a single victim or transaction. The company's proposition is especially startling considering that many of the automobiles involved in its fraud predictably will be used or resold in another state or locale.

BMW realized millions of dollars in gain from its nationwide policy. As the company acknowledged in its brief to the Court, its decision to conceal spoiled and refinished paint jobs from new car buyers and new car dealers was not made on a buyer-by-buyer, dealer-by-dealer, or even a state-by-state basis.(22) Nevertheless, it proposed that in determining the amount of punitive damages to punish and deter consumer fraud, state courts should be limited to consideration of transactions with citizens of the plaintiff's state, or perhaps only the transaction with the individual plaintiff.

BMW argued that the U.S. Constitution restricts punitive damages in this case to the transactions with the 14 Alabama residents, or possibly only with the plaintiff himself. But this would seriously erode the deterrent function of punitive damages when the defendant is engaging in nationwide misconduct. As noted above, for punitive damages to perform their deterrent function, they must force the defendant to bear the full amount of the expected gain from its fraudulent misconduct, adjusted upward both to reflect the likelihood of under-enforcement and to act as the "kicker" to ensure that fraud will be less profitable than honesty. The problem of underdeterrence would be exacerbated, though, if courts were precluded from taking into account all the defendant's ill-gotten gains. Under the rule proposed by BMW, adequate deterrence could not be achieved until punitive damages were awarded by courts in each state where its conduct was unlawful.

BMW's proposal flouts the conceptual distinction between compensatory damages, keyed to plaintiffs' harm, and punitive damages, keyed to defendants' misconduct. The company's proposal that punitive damages be calibrated to the harm suffered by any particular victim or group of victims is therefore conceptually incoherent.

The Supreme Court should allow state courts to assess punitive damages awards in fight of the pervasive but noncompensable damage inflicted on the market system by consumer fraud. Fraud can distort the price mechanism because the more it is known to exist in the marketplace, the more buyers will tend to discount the value of all products for which there is a perceived risk of fraud. Moreover, consumers facing the possibility of fraud will engage in unproductive and wasteful expenditures to discover fraud that could harm them.

Punitive damages for nationmide consumer fraud should be large enough to reflect economic damage done to the orderly workings of the market system through distortion of market information and disruption of faith in the market.(23) These damages arc not recoverable as compensatory damages by any particular victims. Hence, any proposed rule that would foreclose weighing noncompensable market harms caused by fraud in assessment of punitive damages should be rejected.

Finally, to perform their "preference-shaping" educational function, punitive damages should reflect the entire degree of the defendant's culpability, taking into account all harm to the actual and potential victims of the defendant's policy. Thus, in this case the Supreme Court of Alabama correctly took into account the nationwide scope of BMW's nondisclosure policy in assessing the "reprehensibility of the defendant's conduct."(24)

Underdeterrence of consumer fraud is already a serious problem because of the unlikelihood of victim discovery of fraud, the financial and other barriers to bringing suit, and the likelihood of erroneous prodefendant verdicts. Whenever a plaintiff has surmounted these obstacles and has prevailed in a claim for punitive damages, the trial court should have the power to award punitive damages in an amount sufficient to deter future intentional misconduct by the defendant and others. Accordingly, state courts should continue to be permitted to award punitive damages based on all the defendant's ill-gotten gains, not just those obtained from residents of the plaintiff's home state.

This was the argument of Citizen Action and several law professors in the Gore amicus brief.(25) The brief provides a useful example of how law and economics analysis can fortify a plaintiff's case through detailed attention to public interest concerns. It is not, however, only at the level of a Supreme Court case that this analysis is useful. Counsel at trial and lower appellate levels need to recognize and even anticipate use of law and economics analysis in their opponents' strategies and in judicial thinking. Skill at comprehending and crafting law and economics arguments greatly enhances the litigator's arsenal.

For too long, business defendants' interests have dominated the applications of law and economics principles in the world of law practice. The time to change that trend is now.

(1) See Bankers Life & Cas. Co. v. Crenshaw, 486 U.S. 71 (1988); Browning-Ferris Indus. v. Kelco Disposal, Inc., 492 U.S. 257 (1989); Pacific Mut. Life Ins. Co. v. Haslip, 499 U.S. 1 (1991); TXO Prod. Corp. v. Alliance Resources Corp., 113 S. Ct. 2711 (1993); Honda Motor Corp. v. Oberg, 114 S. Ct. 2331 (1994). (2) 646 So.2d 619 (Ala. 1994), cert. granted, 115 S. Ct. 932 (1995) (No. 94-896). (3) Liebeck v. McDonald's Restaurants, P.T.S., Inc., No. CV-93-02419 (N.M., Bernalillo County Dist. Ct. Aug. 17,1994). (4) See, eg., Joan Biskupic, The Case of the $4 Million BMW, WASH. POST, May 29,1995, at A-4. (5) See, eg., Senator Orrin Hatch, Statement in Support of S.672, the Civil Justice Reform Act of 1995 (Apr. 4,1995); 141 CONG. REC. S5874, S5901 (May 1, 1995) (statement of Sen. Cohen). (6) See, eg., Brief Amicus Curiae of the U.S. Chamber of Commerce in support of Petitioner BMW, Brief Amicus Curiae of the National Association of Manufacturers in support of Petitioner BMW; Brief Amicus Curiae of the American Tort Reform Association in support of Petitioner BMW; Brief Amicus Curiae of the Products Liability Advisory Council in support of Petitioner BMW; Brief Amicus Curiae of the Washington Legal Foundation in support of Petitioner BMW; Brief Amicus Curiae of the Pharmaceutical Research and Manufacturers of America in support of Petitioner BMW; and Brief Amicus Curiae Richard Blatt et al. in support of Petitioner BMW. These briefs were filed in Gore, cert.granted, 115 S. Ct. 932 (No. 94-896). (7) Ackerman v. Schwartz, 947 F.2d 841, 846-47 (7th Cir. 1991) (Easterbrook, J.). (8) See generally David D. Haddock et al., An Ordinary Economic Rationale for Extraordinary Legal Sanctions, 78 CAL. L. REV. 1, 25 (1990). See also Mark F. Grady, Punitive Damages and Subjective States of Mind: A Positive Economic Theory, 40 ALA. L. REV. 1197, 1217-19 (1984) (distinguishing inadvertent negligence from deliberate negligence - the intentional omission of known precautions or the engagement in willful or wanton action - which may warrant punitive damages). (9) DEBORAH HENSLER, COMPENSATION FOR ACCIDENTAL INJURIES IN THE U.S. 120 (RAND 1991). A Harvard University study concluded that only 1 out of every 7.5 hospital patients who are injured due to medical negligence file medical malpractice claims, and only half of these ultimately recover. Thus, "the legal system is paying just 1 malpractice claim for every 15 torts inflicted in hospitals." Gene Koretz, A Malpractice Conundrum: Actually, Too Few Claims Are Filed, BUS. WK, Mar. 27,1995, at 28. See also PAUL WEILER, MEDICAL MALPRACTICE ON TRIAL (1991). (10) See, eg., Missouri Pac. Ry. v. Humes, 115 U.S. 512, 523 (1885) ("The injury actually received is often so small that in many cases no effort would be made by the sufferer to obtain redress, if the private interest were not supported by the imposition of punitive damages."). See also David Owen, Punitive Damages in Products Liability Litigation, 74 MICH. L. REV. 1257, 1285 (1976) (deterrent effect depends in part on defendant's "perception of the likelihood of his being identified and punished"); Note, Punitive Damages and the Reasonable Relation Rule: A Study in Frustration of purpose, 9 PAC. L.J. 823, 841-42 (1978) ("Nowhere is the potential for a result contrary to the Purpose of punitive damages greater than in the area of consumer actions. This is an area in which the claim of an individual is most likely to be so small in comparison to the cost of litigation as not to warrant court action."); WILLIAM M. LANDES & RICHARD A. POSNER, THE ECONOMIC STRUCTURE OF TORT LAW 160-61 (1987). (11) See generally VINCENT R. JOHNSON & ALAN GUNN, STUDIES IN AMERICAN TORT LAW 843 (1994). (12) RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 220 (4th ed. 1992) ("The extra something [in punitive damages] should be the difference between the victim's loss and the injurer's gain, and then some.") (emphasis added). (13) Haddock et al., supra note 8, at 13-19. (14) Id. at 18-19. (15) Brief Amici Curiae of the American Tort Reform Association et al. at 3, TXO Prod. Corp., 113 S. Ct. 2711. (16) Id. at 12. (17) Id. at 16. (18) TXO Prod. Corp., 113 S. Ct. 2711, 2722 (plurality opinion). (19) 499 U.S. 1, 22. (20) Petitioner's Brief at 10-11, 14, 50, Gore, cert. granted, 115 S. Ct. 932 (No. 94-896). (21) Id. at 50. (22) Id. at 22 n.8. (23) Indeed, the punitive damages award in this case produced the desired effect: Shortly after the award was rendered, BMW announced that it was abandoning its nondisclosure policy and pledged to reveal all defects, large and small. (24) Gore, 646 So. 2d 619, 625. (25) Copies of this brief and the other briefs filed by the parties and their respective amici are available from Ned Miltenberg at [phone], ext. 281; fax [phone]. Mark M. Hager is a Professor at the Washington College of Law, American University. He served as co-counsel, along with Jeff L. Lewin, Professor of Law at Widener University, on the law and economics amicus brief filed by seven other law and economics scholars in BMW of North America, Inc. v. Gore, which will be argued before the U.S. Supreme Court in October. Ned Miltenberg is ATLA Associate General Counsel for Constitutional Litigation. Professor Hager wishes to acknowledge the contributions made to the Gore brief by Professors Jennifer Arlen, USC; Kenneth G. Dua-Schmidt, Unity of Wisconsin; Mark F. Grady, David D. Haddock, Northwestern University; Jeffrey L Harrison, Unity of Florida; Robin Paul Malloy, Syracuse University; Fred S. McChesney, Emory University; and Thomas Ulen, University of Illinois.