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A financial economic theory of punitive damages.

This Article provides a financial economic theory of punitive damages. The core problem, as the Supreme Court acknowledged in Exxon Shipping Co. v. Baker, is not the systemic amount of punitive damages in the tort system; rather, it is the risk of outlier outcomes. Low frequency, high severity awards are unpredictable, cause financial distress, and beget social cost. By focusing only on offsetting escaped liability, the standard law and economics theory fails to account for the core problem of variance. This Article provides a risk arbitrage analysis of the relationship between variance, litigation valuation, and optimal deterrence. Starting with settlement dynamics, it shows that punitive damages create problematic risk arbitrage opportunities, which systemically produce under- and overvaluation of cases. These effects yield inefficient pricing in the litigation system. Properly conceptualized and applied, punitive damages can mitigate risk arbitrage that skews actual results from the prescriptions of optimal liability and deterrence. The modern Supreme Court jurisprudence is flawed because it is overbroad. Single-digit multiplier caps underdeter defendants in most cases of ordinary liability because punitive damages do not sufficiently offset a defendant's risk arbitrage opportunity gained from a lower litigation risk exposure. When liability is catastrophic, however, punitive damages overdeter defendants, even with a single-digit ratio limit, because they impart the severe economic cost of financial distress in addition to the monetary cost of the judgment. These additional economic costs must be credited toward the calculus of cost internalization and optimal deterrence. Thus, a calibrated risk-based theory is needed to support legal limitations on punitive damages.

       A. From Constitutional Reformation to Legal Uncertainty
       B. Bursting the Myth and Identifying the Central Problem
       C. The Problem of Low Frequency, High Severity Awards
       A. Standard Law and Economics Theory
       B. Critique of the Standard Theory
       C. Toward a Complete Theory of Optimal Liability
       A. Corporations as Defendants
       B. Risk Arbitrage in Ordinary Cases
       C. Risk Arbitrage in Catastrophic Cases
       D. Case Studies of Texaco-Pennzoil and BP's Gulf Oil Spill
       A. Arbitrage and Efficient Pricing
       B. Mitigating Risk Arbitrage in Ordinary Cases
       C. Mitigating Risk Arbitrage in Catastrophic Cases
       D. The Role of Wealth and Administrative Issues


In the course of fundamentally reshaping the law on punitive damages, (1) the Supreme Court came to accept the rhetoric that punitive damages are "out of control." (2) This view justified constraining punitive damage awards under the Due Process Clause of the Constitution in two landmark cases. In BMW of North America, Inc. v. Gore, the Court held that a 500x multiple of punitive to compensatory damages was a "grossly excessive award" that violated substantive due process. (3) In State Farm Mutual Automobile Insurance Co. v. Campbell, the Court signaled that single-digit multipliers are more likely to satisfy due process. (4)

The move toward bright-line quantitative caps has been criticized as "theoretically bankrupt," (5) "harmful," (6) and "extremely crude." (7) The Court has well earned this criticism since it has not explained why single-digit multipliers satisfy constitutional or theoretical concerns aside from relying on an unfounded perception that punitive damages have spiraled out of control. The decisions in Gore and Campbell sought to reduce systemically the amount of punitive damages in the tort system by imposing quantitative caps as a disciplinary measure on state laws and by imposing standards governing the permissibility of punitive awards.

However, the suggestion that tort law redistributes excessive amounts of wealth is a Potemkin village. (8) In Exxon Shipping Co. v. Baker, the Supreme Court's latest decision on punitive damages, the Court finally rejected the fallacious premise behind its venture into the workings of state tort law: "A survey of the literature reveals that discretion to award punitive damages has not mass-produced runaway awards, and ... by most accounts the median ratio of punitive to compensatory awards has remained less than 1:1." (9) Bursting the myths advanced by tort reformists, (10) Baker concluded that the tort system has exercised "overall restraint." (11)

So what is the problem? According to Baker, the "real problem, it seems, is the stark unpredictability of punitive awards." (12) Although punitive damages are seldom awarded in tort cases and the median award is less than the median compensatory damages award, the variance in awards "is great, and the outlier cases subject defendants to punitive damages that dwarf the corresponding compensatories" (13) Variance is a measure of the spread of potential economic outcomes. (14) This spread is the essential quality of riskiness. (15) The greater the spread of potential outcomes, the greater the risk.

The core problem is not a systemic amount of punitive damages resulting in dramatic redistribution of wealth through the tort system. Rather, the problem is that "punitive damages are a substantial source of variance in the tort system--something that, in turn, increases the uncertainty over the ultimate parameters of the defendant's liability." (16) Such awards are like lightning: they rarely strike but when they do, the consequences are severe. The small but very real risk of an excessive award has significant ripple effects on the entire tort and civil dispute systems. The core problem in punitive damages is one of risk and uncertainty.

Scholarship on punitive damages has been copious and rich in both theoretical and empirical insights. (17) As evinced by its influence on the Supreme Court, the empirical scholarship has shed light on facts and dispelled misconceptions about punitive damages. On the theory side, the inquiry has focused on the purpose of punitive damages. Courts have consistently asserted that punitive damages serve the twin goals of "retribution and deterring harmful conduct." (18) Scholars have advanced a broad array of theories principally coalescing around these two basic ideas. (19) Law and economics theory has led the way in establishing a coherent view of deterrence. (20) The theory has garnered a "remarkable consensus" among a wide range of scholars that deterrence is a central goal of punitive damages. (21)

The standard law and economics theory argues that punitive damages should be imposed on defendants who would otherwise escape liability through undetected wrongful acts. (22) This concept yields an elegant formula for calculating punitive damages: punitive damages should equal the harm multiplied by the reciprocal of the injurer's chance of being found liable for wrongful activities. (23) Based on this theory, punitive damages should provide a level of liability sufficient to achieve full cost internalization and optimal deterrence. Despite the elegance of the idea, the standard law and economics theory fails to account for the central problem of punitive damages identified by the Supreme Court and other scholars--the relationship between the risk associated with high variance outcomes and the theory of punitive damages. On this issue, the Court has suggested that it would be open to accepting variance as a desirable effect if variance promoted an "optimal level of penalty and deterrence," but there is neither empirical evidence nor theory explaining the role of variance or how it should be used. (24) This Article provides a theory of variance.

Consistent with law and economics thought, the premise of this Article is that tort law should deter wrongful conduct by imposing an optimal level of liability. However, undetected wrongful conduct, the key point of the standard law and economics model, is not the principal problem. The essential problem concerns the relationship between the riskiness of punitive damages and the deterrence effect of punitive damages. A complete theory requires a financial economic analysis to determine the effect of risk on the valuation of uncertain future cash flows (25)--in the legal and dispute resolution contexts, the effect of risk on the valuation of disputed legal rights. Yet no scholar has undertaken a financial economic analysis of punitive damages.

A nascent but growing body of scholarship has applied principles of financial economics to model the civil litigation system. (26) This work suggests that civil litigation for money damages, such as tort cases, fundamentally boils down to assigning financial values to a disputed right, analogous to how rights to uncertain future cash flows associated with securities instruments and capital assets are valued in the financial markets. (27) Commenting on the recent insights provided by a finance perspective, Professor Richard Nagareda has observed that finance-based models of litigation behavior complement the cognitive psychology models of the civil justice system:

Risk matters not just in the sense of whether a given party faces a potential gain or loss in the endgame of litigation. From a finance-based standpoint, risk also matters in the sense that a given party might stand to bear or to impose risk itself in the form of variance. (28)

Risk is important to an understanding of the litigation and tort systems, and a theory of punitive damages should account for it. Drawing on recent insights from the finance perspective of litigation, this Article advances an alternative deterrence-based theory.

Viewed from this perspective, the modern Supreme Court reformation of punitive damages is wrong. With optimal deterrence as one normative end, the prescriptions in Gore and Campbell are overbroad, underdeterring in some circumstances and overdeterring in others. Central to this thesis is the problem of settlement. Punitive damages affect not only the small class of cases most likely to be candidates for punitive awards, but they also have significant ripple effects on the settlement side of the tort system. These ripple effects are not visible through analysis of case law. Although scholars have suggested a "shadow effect" on settlement, (29) with some suggesting that punitive damages increase settlement values, (30) no scholar has advanced an economic theory that integrates settlement into the calculus of optimal deterrence.

This Article advances an arbitrage theory of the relationship among variance, punitive damages, and settlement. (31) In financial markets, arbitrage is the process of making an abnormal profit by buying assets in one market and selling them in another, or vice versa, to profit from an unjustified price difference. (32) Sustained or systematic arbitrage opportunities evince inefficiencies in market pricing. As used here, the term "arbitrage" connotes the concept that a class of litigants can systematically enjoy advantages during settlement due to consistent, predictable, and recurring circumstances, resulting in aggregate settlement values that deviate from expected judicial outcomes. While in an individual case a party's unique advantage is understood in the lexicon of bargaining as "leverage," (33) arbitrage is a more apt term here because it communicates the idea of prices deviating from intrinsic values across the tort system and accordingly affecting the system's efficiency.

This Article shows that risk imposes significant economic costs that are borne by both parties to a litigation under different circumstances. Financial economics tell us that risk has a price. Investors must be paid to bear risk; the greater the risk, the more they must be compensated. (34) The nature of litigation requires that parties be risk bearers, and their exposure to litigation risks is different depending on whether the risk is ordinary or severe. In most circumstances where the potential liability is ordinary, a corporate defendant has a lower exposure to litigation risk than an individual plaintiff and thus enjoys a systemic risk arbitrage opportunity resulting from repeated valuational concessions at settlement by plaintiffs under a set of recurring conditions. (35) This settlement effect tends to undervalue cases from the perspective of optimal liability. However, when a corporate defendant is exposed to catastrophic risk--low frequency, high severity awards--the risk arbitrage flips to a systematic advantage for plaintiffs. The defendant will pay a risk premium to eliminate the risk through settlement. This settlement effect tends to overvalue cases. Unlike the standard law and economics theory of punitive damages, which focuses on using punitive damages to correct escaped liability, this Article argues that optimal deterrence is best achieved by using punitive damages to mitigate these mutual risk arbitrage opportunities. This Article provides a financial model of these effects per principles of corporate finance valuation, premium underwriting, and capital budgeting. When the principal defendants at issue are corporations, a theory of punitive damages must account for the implications on corporate finance and risk transfer.

This analysis yields simple prescriptive rules for regulating punitive damages: (1) when punitive damages do not threaten financial distress, (36) there should be no regulation of punitive damages outside of traditional, preexisting state law protections against excess and abuse; (2) the cap on punitive damages should not be some arbitrary cap based on a numeric ratio, but it should instead be a function of the defendant's wealth such that punitive damages are limited to the point at which the defendant would experience financial distress. For the vast majority of tort cases, financial distress is not an issue, and in these cases the pre-Gore jurisprudence best promotes optimal deterrence. Even a minute probabilistic threat of high multiple and/or dollar value awards tends to offset a corporate defendant's risk arbitrage in settlement; accordingly, not capping punitive damages increases settlement values, achieving valuations closer to expected judicial outcomes. However, the economic costs associated with the financial distress generally impart greater social cost than any adverse incentives arising from inadequate liability assessment due to escaped liability. (37) The limit of punitive damages can be defined as the maximum imposable residual liability net of compensatory damages and the financial economic costs on the firm associated with the litigation risk.

This Article is organized into five Parts. Pan I provides an overview of the law and frames the central problem in this area of law. Part II summarizes the standard law and economics theory of punitive damages and then critiques this theory from the perspective of achieving optimal deterrence. Part III provides a financial economic model of how parties settle cases and shows why plaintiffs and defendants have different risk arbitrage opportunities during settlement depending on the circumstances and the nature of the risks each party confronts. Part IV argues that optimal deterrence is achieved only when the prices of legal actions are efficient and there are no arbitrage opportunities at settlement. It then relates this principle to the proper rules for regulating punitive damages. Lastly, Part V applies the theory of variance and risk arbitrage advanced here to reassess the Supreme Court's reformation of punitive damages.
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Title Annotation:Introduction, p.33-40
Author:Rhee, Robert J.
Publication:Michigan Law Review
Date:Oct 1, 2012
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