The topic of punitive damages has evoked great debate both in the field of law and within the economics profession. Various groups, especially those representing potential defendants, have claimed that such damages are often inappropriate and “out of control.” Such groups claim that the imposition of punitive damages often constitutes a violation of their right to due process. This chapter addresses the economics of punitive damages as they relate to corporations. The chapter explores the extent to which punitive damages serve the goals set forth in the law, and points out the various areas in which such damages may not serve the purposes of punitive damages as set forth by the law. In addition, it reviews some of the approaches plaintiffs use when making presentations to juries on punitive damages. This chapter focuses on the problems with some of these types of presentations and explores what can be done to address them.

Evolving Position of the U.S. Supreme Court on Punitive Damages

Punitive damages have a long history in the law. The doctrine of punitive damages can be traced back with certainty to English common law, although others have claimed that its roots begin even further back in history.¹ Punitive damages are a penalty that is applied in addition to compensatory damages when the defendant’s conduct is judged to be particularly reprehensible.² While they have a long history, courts have struggled to reach a consistent position on punitive damages; they have yet to arrive at one. However, recent Supreme Court decisions have taken major strides in that direction.

Punitive damages are designed to further the twin goals of punishment and deterrence. In 1991, the U.S. Supreme Court, in Pacific Mutual Life Insurance Co. v. Haslip, articulated these goals when it stated, “punitive damages are imposed for purposes of retribution and deterrence.”³ In later decisions, the Court consistently reaffirmed these purposes. For example, in Cooper Industries, Inc. v. Leatherman Tool Group, Inc., the Court stated, “Punitive damages may properly be imposed to further a State’s legitimate interests in punishing unlawful conduct and deterring its repetition.”⁴

In 1993, in TXO Production Corp. v. Alliance Resources Corp., the Court complicated matters by upholding a punitive damages award of $10 million with a compensatory damages amount of $19,000.⁵ In this case, punitive damages were 526 times what the compensatory damages were. Some concluded that the argument over the use of such a high ratio of punitive to compensatory damages as a violation of due process was a dead issue.⁶ However, the issue of the magnitude of the punitive/compensatory multiplier is complex, because in this case, the court also considered potential – not just actual – compensatory damages. Thus, the TXO decision was not an endorsement by the Supreme Court of such a high multiplier: It considered a denominator that was significantly higher.

In 1996, in BMW of North America v. Gore, the U.S. Supreme Court found that an award of $145 million in punitive damages and $1 million in compensatory damages violated the due process clause of the Fourteenth Amendment of the United States Constitution.⁷ In reaching its decision, the Gore Court named three factors or guideposts that courts should consider when reaching a decision on punitive damages:

1. The degree of reprehensibility of the defendant’s conduct
2. The disparity between the actual and potential harm
3. The disparity between a jury’s award of punitive damages and civil penalties imposed in other cases

In 2001, in Cooper Industries, Inc. v. Leatherman Tool Group, Inc., the Supreme Court stated that the due process clause prohibited the imposition of “grossly excessive or arbitrary punishments.”⁸ In this decision, the Court stated that a trial court’s application of the Gore guideposts was subject to de novo review.

On April 7, 2003, the Court more explicitly addressed the punitive multiplier as well as other factors taken into account when determining a punitive damages award. In State Farm Mutual Automobile Insurance Co. v. Campbell et al., the Court applied the Gore factors to a Utah case involving an insurer’s claims against their automobile insurance company.⁹ In going through the factors, the Court clarified how they apply to different lawsuits. The Campbell decision did not prescribe a specific multiplier, but it did state that “few awards exceeding a single digit ratio between punitive and compensatory damages will satisfy due process.” Indeed, the Court, in citing Haslip, did say “an award of more than four times the amount of compensatory damages might be close to the line of constitutional propriety.” The Court found this ratio to be “instructive.” Earlier the court in Gore also allowed for higher multiples when the injury was hard to detect or where the value of the injury and the related compensatory damages were unusually small. This decision set a precedent in that it was only the second time that the Supreme Court reduced a punitive damages award that was handed down by a jury.

The State Farm v. Campbell et al. decision addressed other areas that are quite relevant to the economics of punitive damages. Specifically, these include the inclusion of out‐of‐state factors as well as the potential bias in the introduction of net worth measures. The Court made this even clearer in 2007 in its decision in Philip Morris USA v. Williams. In Williams, the Court noted that in Campbell, it had already made clear that “where awards are sufficiently large,” one state may not impose its or its jury’s “public choice upon ‘neighboring states’ with different public policies.”¹⁰ After noted this, the Court went on to state: “the Due Process Clause forbids the use of a punitive damages award to punish a defendant for injury inflicted on strangers to the litigation.” Going further, the Court stated “a jury may not punish for harm to others.”

In 2008, the court continued on its path of imposing restrictions on the ability of courts to impose punitive awards. In Exxon Shipping Company et al. Petitioners v. Grant Baker et al., the Court selected an even more restrictive compensatory to punitive multiple of 1:1 in this maritime lawsuit.¹¹ Specifically the court stated that a “punitive to compensatory ratio of 1:1 thus yields maximum punitive damages in that amount.” The court was clear that its ruling applied to maritime cases. The extent to which this will be extended to be considered more broadly in other types of lawsuits remains to be determined.

Frequency of Punitive Damages

Punitive damages are awarded relatively infrequently. It is well known that the majority of cases do not go to trial; however, of those that ultimately do, only a minority feature punitive damages. For example, Landes and Posner found that only 2% of product liability cases result in punitive damages.¹² Another study showed an even smaller percentage. In looking at certain localities, the Rand study found punitive damages occurred in only 1/10 of 1% in Cook County and even less in San Francisco.¹³ Rustad and Koenig could locate only 344 cases with punitive damages in 25 years of cases.¹⁴ Other studies show a somewhat higher incidence of punitive damages. For example, the American Bar Foundation study found punitive damages in 4.9% of all verdicts in its research sample.¹⁵ A study conducted by the Justice Department found a somewhat higher rate of 6%.¹⁶

As we have noted, in State Farm v. Campbell the Supreme Court put forward bounds on punitive damages, limiting them to single digits if not to the Haslip bounds of no more than four times compensatory damages. A 2004 study showed that blockbuster punitive awards – those greater than $100 million – may have been constrained by the disciplinary guidance of the State Farm decision.¹⁷ However, that same study of awards over the period 1989–2003 also showed that 64% of the blockbuster awards were imposed after 1996, which was the year of the BMW decision.

Eisenberg et al. probed the issue of the frequency of punitive damages more deeply. They pointed out that in many cases punitive damages are never sought by plaintiffs.(^*) Using a 2005 data set available from the Bureau of Justice Statistics they found that punitive damages were only sought in about 10% of tried cases that plaintiffs prevailed in. This low rate was often caused by state laws which restricted such recoveries. In cases where punitive damages were actually sought by plaintiff, they were awarded in 30% of plaintiff trial wins. They found that intentional tort cases accounted for 60% of such punitive awards.

Frequency of Punitive Damages and the Shadow Effect of Punitive Damages

A look at the relative frequency of punitive damages in verdicts might initially lead one to conclude incorrectly that because they are so infrequently awarded, they need not be a major source of concern. However, the threat of punitive damages studies lurks in far more cases than what would be indicated by the amount of such damage awards. Intimidated by the threat of punitive damages, defendants who fear a runaway punitive verdict often settle for a probability‐adjusted amount that includes their assessment of the likelihood of a punitive damages award. This is what is known as the shadow effect of punitive damages.

Defendants had long contended that the shadow effect was very significant. Few, however, were able to quantify it specifically. One attempt to do so was conducted by Koenig, who gathered insurance adjustor data and sought to determine what component of total settlements they allocated to punitive damages. He found that claims adjusters allocated a specific amount of total settlement values, 11%, to avoid claims of punitive damages.¹⁹ Eleven percent may seem relatively small, but when this amount is combined with the fact that the percent of cases that award punitive damages is also relatively small, the amount becomes quite significant.

Purposes of Punitive Damages

As discussed earlier, it is well accepted that the twin purposes of punitive damages are punishment and deterrence.²³ The Supreme Court, in its various recent decisions relating to punitive damages, such as Cooper Industries v. Leatherman and State Farm Mutual v. Campbell, has confirmed this. Punitive damages are “not compensation for injury. Instead, they are private fines levied by civil juries to punish reprehensible conduct and to deter its future occurrence.”²⁴ They are awarded for acts that are so extreme that the trier of the facts seeks additional penalties beyond compensatory damages. Punishment in the form of monetary penalties is not designed to compensate victims but is instead directed at the wrongdoer. These penalties seek to punish the defendant for its wrongful acts.

Deterrence can take two forms: specific and general deterrence.²⁵ Specific deterrence is designed to prevent the defendant from engaging in similar acts in the future. General deterrence is designed to prevent parties other than the defendant from pursuing similar acts. Of the two goals of punitive damages, there is some support in the literature for deterrence as the more important of the two goals.²⁶

Although one might think that it is desirable to take whatever measures are necessary to avoid all wrongful acts, economists believe that it is most efficient to pursue optimal deterrence and to avoid underdeterrence or overdeterrence. Overdeterrence occurs if resources devoted to deterrence are in excess of the value of the harm that was avoided. Underdeterrence occurs when insufficient resources are devoted to avoidance when comparing the value of the harm to the resources expended. Economists generally agree that there is an efficient level of deterrence and that either overdeterrence or underdeterrence is not desirable from a societal perspective. For companies producing socially desirable products, such as pharmaceutical companies, overdeterrence could mean that some products never get produced and marketed if a company believes that the potential litigation costs are too high. This could have serious adverse effects for consumers who would benefit from such products. Ironically, this overdeterrence can spill over to companies in other industries as they worry about being the target of suits that have affected others.

Compensatory Versus Punitive Damages

As we have noted above, the twin purposes of punitive damages are to accomplish deterrence and punishment. These are exemplary damages that are imposed in excess of compensatory damages. In developing a monetary value for compensatory damages, a jury seeks to make the plaintiff whole. While in theory there can be a demarcation between compensatory and punitive damages, it is questionable if a jury can effectively develop two separate and focused monetary amounts that can accomplish one goal without overlapping on the other one. This was pointed out by the Court in State Farm when it noted “The compensatory damages for the injury suffered here, moreover, likely were based upon a component which was duplicated by the punitive award.”²⁷

Particularly, when it is a significant amount, the compensatory award, while it should make the plaintiff whole, also serves as punishment for the defendant. This is because money is fungible and while we can give it different designations depending on the context of the activity, from the corporate payer’s point of view, it bears the same burden that any other cost would have.

Earlier we have noted the significance of the State Farm decision which indicated that there should be a relationship between the amount of a punitive award and the compensatory damages. Specifically, the Court frowned on multiples more than single digits. After that 2003 decision, many believed it would change the relationship between punitive and compensatory damages. However, Eisenberg and Heise, using four Civil Justice Survey data sets, found that the relationship between punitive and compensatory damages has not changed over time.(^*) In reaching that conclusion they did not find as significant an impact of the State Farm decision. They did, however, find a meaningful relationship between judge versus jury trials as a determining factor in the relationship. They assume that this is a function of the reasons that lead a plaintiff to pursue a jury trial versus a bench trial.

Criminal Penalties and Punitive Damages in Civil Lawsuits

Punitive damages in tort actions represent a dichotomy between private and public law.²⁸ The need for punishment in criminal actions is obvious. However, the introduction of punishment into civil actions, perhaps as a means of altering behavior, presents unique problems. One of the most fundamental of these is that criminal actions provide certain protections for criminal defendants that are lacking in civil proceedings. Among these protections is that provided by the Fifth Amendment of the U.S. Constitution, which implies that a defendant should not be exposed to multiple lawsuits for the same conduct. This is clear under criminal law but vague, if not confused, under civil law. In addition, a defendant could have been found not liable for punitive damages in one or more actions for the same conduct that a later jury finds worthy of a punitive award.

The other troubling aspect of using punitive damages in civil proceedings to inflict punishment on defendants is that such proceedings lack the safeguards normally provided to defendants in criminal proceedings. These include requiring proof beyond a reasonable doubt, the prevention of the aforementioned double jeopardy, and in federal courts as well as most state courts, the requirement of a unanimous verdict. Therefore, as far as punitive damages are concerned, a corporate defendant lacks the same legal protections as a private defendant even though it may be considered a “person” under the law.

Punishment of Corporations and Corporate Governance

There are very significant differences between the punishment of individuals and the punishment of corporations. When a trier of the facts concludes that an individual defendant needs to be punished, it is easy to focus on that defendant and to know that he or she will bear any penalty that is imposed. The situation is much less clear in the case of corporate defendants.²⁹ This is due to the nature of corporate organizations.

The ultimate owners of corporations are shareholders, who elect directors to serve as their fiduciaries and to oversee the management so as to maximize the value of their investment. These directors select managers who run the corporations on a day‐to‐day basis. Some managers also serve as directors; they are referred to as inside board members. As a result of recent scandals involving Enron, WorldCom, and Tyco, there has been pressure on outside board members to exercise closer scrutiny on their corporations.

Corporations group together various stakeholders toward some common economic activity. These stakeholders typically include equity and nonequity stakeholders. Equity stakeholders hold an ownership interest in the company. Nonequity stakeholders include employees, management, suppliers, communities, recipients of tax receipts, and possibly others, depending on the circumstances.

Spillover Effects and Punishment of Corporations

One of the problems with punishing a corporation is that the pain inflicted may be felt by those other than the wrongdoers. This is made possible by the doctrine of vicarious liability, whereby an employer can be found liable for acts of its employees. This is also known as the respondent superior rule. The concept of spillover effects is well known in microeconomics, especially in the field of public finance. Spillovers are what are referred to in microeconomics as externalities. These effects are defined as “[a] cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction. Sometimes called spillovers or neighborhood effects.”³⁰

It is difficult to isolate and punish the individual wrongdoers in a company. If one chooses to use the blunt tool of punitive damages, it is likely that innocent parties will bear the adverse effects of such an imprecise instrument. The guilty individuals, however, may have long departed the scene. The latter situation becomes particularly likely when the lawsuit reaches trial many years after the alleged acts. The tobacco and asbestos lawsuits present some examples of such scenarios. It is useful to focus on who the various stakeholders in a corporation are and see how they could be affected by a punitive award.

Shareholder Wealth Effects

Litigation‐related payments, like any other cost, lower profitability and reduce the pool of monies available for dividends, thereby impeding capital gains. For this reason, large litigation payments can lower stock values. Research studies have shown the impact that litigation has on stock prices.³³ This impact can be very significant. A good example of this was the 42% decline in the stock price of the Halliburton Company in response to a $30 million verdict in favor of five plaintiffs (see Exhibit 12.1).³⁴ This was one of many asbestos cases brought against the company.³⁵ Over the 25 years, the company had settled almost 200,000 asbestos claims, but these claims were usually settled for modest amounts. The market reacted to that recent verdict, as it marked a possible change in the asbestos litigation environment.

Securities firms have attempted to measure the magnitude of the large tobacco liabilities on Philip Morris Companies, Inc. By the end of 2002, Philip Morris USA, then the tobacco subsidiary of Altria, had been the object of 1,500 tobacco lawsuits.³⁶ Some of these suits were class actions and multiple‐plaintiff suits. For example, in West Virginia, the company was the object of a class action involving 1,250 plaintiffs. Analysts at Goldman Sachs issued a report in February 2001 in which they did a “sum of the parts” analysis. They computed the enterprise value of the company by applying multiples that would be relevant to the four industry segments that at that time composed the overall parent entity – Philip Morris Companies, Inc.³⁷ This study showed that the “litigation overhang” was equal to $91.5 billion.³⁸ That is, without the impending litigation liabilities, which are inherently difficult to measure with precision, the value of the equity of Philip Morris Companies, Inc. should have been equal to $200 billion. However, the value that the market placed on the equity was $108.7 billion. The analysts at Goldman Sachs attributed this very significant difference to the market’s allowance for the uncertain tobacco liabilities.³⁹

The Goldman Sachs analysis is but one of many examples of how stocks can be negatively affected by litigation liabilities. The relevance of these effects to punitive damages is that the imposition of a significant punitive award may cause stock prices to decline. As a result, shareholders may lose part or all of the value of their investments. Markets tend to anticipate relevant changes in economic conditions and are generally somewhat efficient with respect to the processing of relevant information.⁴⁰

While shareholders bear some of the costs of a punitive award, they are generally removed from the decision‐making process. As such, they are not in a good position to take actions to prevent such losses. Some assert that shareholders can use the corporate election process to try to bring about changes in management’s behavior. However, this is a very expensive and difficult process that is usually unsuccessful – even for shareholders holding sizable stock positions.⁴¹ Prior to reaching a decision on punitive damages, juries should be aware of the potential impact an award may have on shareholders. They should also know who these shareholders are and what responsibility, if any, they bore for the wrongful conduct. It is often the case that most of the shares are owned by large institutions managing shareholdings on behalf of many individuals, such as those who have entrusted their wealth to a pension fund management firm. For this reason, juries might feel differently about making an award that would hurt such shareholders. Later in this chapter we will return to the discussion of stock price effects.

Consumers

One other major affected group of stakeholders is consumers of the defendant’s products. This group may also feel the effects of a punitive damages award through a price adjustment. Prominent examples include the tobacco and pharmaceutical industries. One example is the increase in cigarette prices in response to the Master Settlement Agreement and its billion‐dollar payments.⁵³ In the pharmaceutical industry, research has also shown how drug prices are higher in a more active litigation environment.⁵⁴ Price increases brought on by litigation‐related costs are similar to per‐unit or excise taxes; microeconomic theory has shown this to be a form of regressive taxation. Taxes on tobacco and alcohol are considered very regressive taxes given the fact that the poor spend a relatively higher percent of their income on these goods compared to more wealthy people. Thus, for smokers who are not dissuaded from smoking due to the tax and who do not quit, these taxes are a heavy burden on them.⁵⁵ If punitive or other damage awards cause corporations to react by increasing prices, poorer consumers may bear a disproportionate burden relative to their income levels.

The extent to which prices increase in response to cost increases by producers is determined by the price elasticity of demand for the products. With an inelastic demand, prices may increase with a comparatively smaller quantity decrease (see Exhibit 12.2a). With an elastic demand, the quantity demanded responds comparatively more (see Exhibit 12.2b). Various factors determine a product’s price elasticity including availability of substitutes, tastes and preferences, and the percent of an individual’s total budget the product constitutes.⁵⁶ The price elasticity of demand tends to be higher in the long run than in the short run.⁵⁷ In the case of cigarettes, various estimates of elasticities exist. One such estimate is that the short‐run price elasticity of demand is 0.4 and the long‐run price elasticity is 0.7 – both of which are in the inelastic range.⁵⁸ However, these estimates are drawn from a different time period in which prices were lower and quantity demanded was less elastic than it now appears to be. Other products, such as gasoline, generally considered in the media to have an inelastic demand still have higher elasticities in the long run. For example, gasoline may have a low –0.2% price elasticity of demand in the short run but may have a much higher value in the long run – such as in the –0.8% range.⁵⁹

Although the initial responsiveness was relatively sluggish, the cigarette industry does provide an informative showcase for how litigation‐related cost increases affect the quantity consumed and the market share of defendants in mass tort cases. Initially, presumably due to the inelastic nature of the demand for the product, while sales of cigarettes declined, some of the manufacturers were able to maintain profitability for a period of time through the price increases. However, many consumers of this industry’s products, who, on average, have somewhat lower incomes, did respond by switching to cheaper cigarettes from smaller manufacturers.⁶⁰ At the time the Master Settlement Agreement was signed, the major cigarette manufacturers commanded close to 100% of the market share. By 2002, the lesser‐known manufacturers accounted for 10% of the total U.S. cigarette market.

It is difficult for a jury to make a determination of the price effects and impact on consumers. Data on historical elasticities are not very helpful if prices change significantly and there is a new, more responsive or elastic part of the demand curve, assuming the curve does not shift due to other factors (see Exhibit 12.3). However, a jury may not be able to ignore the fact that when a company’s costs change, prices may increase in response. Punitive damages are a cost, and corporations have to address these changing costs and the potential impact this may have on prices. These price effects can bring about a change in quantity demanded (the extent of which will depend on the relevant price elasticity of demand), a factor that a jury may want to consider after hearing economic expert testimony.

Deterrence Theory and the Changing Litigation Environment

The role of the probability of detection and deterrence theory were analyzed at length by Polinsky and Shavell.⁶⁵ Their approach to computing a punitive penalty is not new and can actually be traced to Jeremy Bentham and the Utilitarians.⁶⁶ However, Polinsky and Shavell provide a clear framework for how, theoretically, the probability of detection could be incorporated into the process of determining a punitive award. Because from a societal perspective it is not optimal to have either too many or too few precautions, they reasoned that total damages should equal the harm caused. If the probability of being found liable, however, is less than 1, then there could be a need for punitive damages to make up for the shortfall between the value of the harm caused (H) and the expected damages (p)H, where p is the probability of being found liable. Using these calculations, they expressed a total damages multiplier and a punitive damages multiplier, as shown in Equation 12.1:

(12.1)

where:

• H = the harm caused
• p = the probability of being found liable
• D = the total damages

(12.2)

The probabilities of being detected and found liable may be different at the time the wrongful act was committed and at the trial. This lag can be many years. If a jury is attempting to assess the deterrence effects and utilizes a Polinsky‐Shavell type of probability analysis, it is useful to differentiate between ex‐ante and ex‐post probabilities. The ex‐ante probability is the probability of being found liable as of the time the act is committed. While a plaintiff may want to assert that this is the relevant probability (assuming that such plaintiffs choose to put forward such reasoning at trial), the ex‐post probability – the one that exists at the time a jury makes a decision – is the more relevant. This is due to the fact that deterrence is forward looking while punishment is backward looking.⁶⁷ To the extent that the litigation environment has changed during the period between the wrongful act and the trial date in a manner that increases this probability, the punitive damages multiplier declines. The advances made by the plaintiff’s bar, as evidenced by the spate of new asbestos cases and recent high‐profile pharmaceutical industry lawsuits, give weight to such a conclusion in certain litigation markets. An aggressive, organized, and well‐financed plaintiff’s bar stands ready to attack potentially liable deep‐pocketed defendants.⁶⁸ The latter may have had advantages in the past, such as being able to outspend plaintiffs; however, these advantages have declined and, in some cases, may not be relevant. This changing environment is underscored by the next quotation from an article about the increasing volume of lawsuits against pharmaceutical companies.

These days the battle between the drug companies is no longer one between corporate goliaths and individual advocates on a shoestring budget.

“We’ve got plenty of a war chest,” said J. Michael Papantonio, a lawyer in Pensacola, Fla., who is a leader in drug litigation. “It’s a different day out there. It’s not like they’re going to look across the table from us and say, ‘We’re going to dry you up.’”

Plaintiffs’ lawyers can now finance enormously complicated suits that require years of pre‐trial work and substantial scientific expertise, in the hope of a multi‐billion dollar payoff. Scores of firms collaborate on a case, with some responsible for finding claimants, others for managing the millions of documents that companies turn over, others for the written legal arguments, and still others for presenting the case to a jury. Some 60 firms have banded together, for example in the Baycol litigation.⁶⁹

The probability analysis makes for an interesting economics discussion, although some research implies it may be less relevant from a practical viewpoint. Using a sample of 500 jury‐eligible citizens, Professor W. Kip Viscuisi has shown that sample juries failed to properly apply probability‐based negligence rules.⁷⁰ This is not surprising because most juries do not have any exposure to probability theory.

Deterrence and Regulatory Processes

Earlier discussions have shown that using punitive damages to try to achieve deterrence means using a very imprecise tool. Doing so may have significant adverse effects with little assurance that the guilty parties will feel the effects of the punishment. However, a jury may want assurance that deterrence will be accomplished so that similar acts do not occur in the future. Juries need to look at the regulatory processes that are in effect in the industry and determine if these processes address the need for deterrence. Some industries have strong deterrence measures in place. For example, as a result of the Master Settlement Agreement, the marketing activities of the tobacco industry are overseen by the National Association of Attorneys General (NAAG). This body meets regularly, has a specific tobacco committee, and is empowered to take aggressive legal actions. Juries wanting to deter one of the major tobacco companies from engaging in improper marketing activities should consider that NAAG is better able to prevent such actions. A jury may hope that an additional monetary penalty for an act that occurred many years before, on top of the billions of dollars in payments that this industry has made and will continue to make through the Master Settlement Agreement, would better accomplish this. However, NAAG is but one of several regulatory bodies that exert regulatory pressures on the tobacco industry.

Some industries are closely regulated; others are not. The insurance industry in the United States, which has been the target of many lawsuits, is an example of a closely regulated industry. Insurance companies must be authorized to do business in each state in which they market insurance. State insurance regulators are empowered to restrict the ability of an insurance company to do business if it fails to adhere to that state’s insurance requirements.⁷³ Regulatory processes work much better than attempted deterrence through the court system. An example is the high number of vanishing premium lawsuits that have been brought against life insurance companies.⁷⁴ These suits allege that life insurance companies did not properly inform purchasers of insurance that premiums for certain types of insurance policies could possibly not vanish if investment gains in the value of the policy were insufficient. By the time many of these lawsuits went to trial, the problem (to the extent that the problem ever did exist, an issue that is disputed by defendants) was already dealt with by the regulators of the industry. The National Association of Insurance Commissioners issues model regulations that are subsequently adopted by the various state insurance regulators. In this case, a specific model regulation was put forward to regulate the representations that insurance company salespeople could make. This is an example of how regulators can very directly identify the problem and construct a specific regulatory solution to eliminate it. When such regulatory structures are in place, jurors can have confidence that a process is in place that can better deal with the problem than they can. When there is a long time lag between the alleged wrongful acts and the trial, a jury may be able to look back and see that deterrence has already been achieved.

Each industry is different. In light of the fact that regulators may be able to accomplish deterrence effectively, juries should be made aware of what regulatory processes exist and how effective they can be in achieving deterrence. Once the regulatory‐deterrence context has been established, a jury can try to determine if punitive damages will accomplish additional deterrence.

Typical Financial Measures Used in the Determination of Punitive Damages

Many states allow juries to consider the wealth of the defendant when determining the magnitude of a punitive award. For example, the punitive damages statute of the State of Texas decrees that a jury can consider the net worth of the defendant. However, states vary in the extent to which they rely on net worth in setting punitive damage awards. While many punitive damages statutes discuss net worth, the simplistic application of net worth often is of little value to a jury, and at times it actually can be very misleading. Many states explicitly allow a consideration of net worth in the determination of punitive damages. Some states, such as Nevada and Missouri, only allow net worth to be considered in a second punitive phase. In this way, the magnitude of the defendant’s wealth does not provide the jury with an opportunity to engage in income redistribution to aid an injured plaintiff, even if the deep‐pocketed defendant is not culpable. What is clear, however, is that if net worth is introduced, defendants need to make sure that the jury is also given additional financial information so as to better understand what this measure actually represents.

In State Farm Mutual Automobile Insurance Co. v. Campbell et al., the U.S. Supreme Court addressed the inclusion of the net worth of State Farm in the determination of punitive damages. The Court had already expressed concerns in BMW v. Gore when it stated that the wealth of the defendant “provides an open‐ended basis for inflating awards when the defendant is wealthy (Justice Breyer concurring).” The Campbell court also expressed reservations about the use of evidence on a defendant’s wealth when it stated:

reference to its assets (which, of course, are what other insured parties in Utah and other States must rely upon for payment of claims) had little to do with the actual harm sustained by the Campbells. The wealth of the defendant cannot justify an otherwise unconstitutional punitive damages award.⁷⁹

In addressing the plaintiff’s attempts to introduce the wealth of the defendant, the Supreme Court expressed clear concerns that the wealth of a large defendant could bias the jury and possibly result in an award that bore little relationship to the actual harm caused. That is, if the wealth of a defendant is allowed to be a factor for the jury to consider, then the punitive/compensatory multiple could be far higher for a rich defendant than for a poorer one. The Supreme Court in Campbell was concerned about multiples greater than single digits. The only role for net worth, then, is in the determination of whether the defendant can pay a specific punitive award that the jury has already decided on rather than as a factor that the jury would consider as part of the punitive award calculus. The problem with including net worth, even in this more limited role, is that it may not necessarily provide useful information on what a defendant can actually pay.

Net Worth

Net worth is the difference between the value of a company’s assets and liabilities on its balance sheet.⁸⁰ One of the problems with using net worth is that the balance sheet is not designed to serve as a guide for juries to assess punitive damages. The assets on a balance sheet include both tangible and intangible assets. Among the intangible assets on a company’s balance sheet is goodwill. Goodwill is created in acquisitions and is an accountant’s way of dealing with the difference in the value of a previously acquired company’s assets and the total purchase price of the company. Goodwill and other intangible assets cannot be used to pay a fine. Yet since various courts allow net worth to be considered, these assets are part of what courts have said juries can look to when determining the magnitude of a punitive award.

One solution to the problem of intangibles embodied in the net worth of some companies is to substitute tangible net worth. This measure removes intangible assets from total assets prior to deducting total liabilities. It still is not without its own drawbacks, but for the purposes of considering the wealth of a defendant that could possibly be used to pay a punitive award, it is more appropriate than total net worth. The difference between total net worth and tangible net worth can be significant. For example, Table 12.1 shows that in 2018, Pfizer, Inc. had a total, unadjusted net worth of $63.8 billion, while its goodwill was $53.4 billion or 84% of net worth. In addition, other intangible assets were $35.3 billion. If these amounts were deducted from total unadjusted net worth to try to arrive at some measure of tangible net worth, the resulting value would be a negative value.

It is generally assumed that the goal of using punitive damages is not to put the defendant out of business. Indeed, the Fifth Circuit in Jackson v. Johns Manville Sales Corp. expressed concerns that punitive damages could result in the destruction of the corporate defendant.⁸¹ Including the full value of a company’s assets fails to consider the uses of those assets and their role in the maintenance of the company’s viability. A company needs to maintain a certain level of liquid assets to maintain its solvency. Other assets, such as illiquid equipment and real estate, may be necessary to maintain the operations and continuity of the business. For example, Bristol Meyers Squibb’s property, plant, and equipment equal approximately $5.321 billion – almost half of unadjusted total shareholder equity.

The Supreme Court, in State Farm v. Campbell el al., expressed clear reservations about the use of net worth when it stated that “the presentation of evidence of a defendant’s net worth creates the potential that juries will use their verdicts to express biases against big businesses, particularly those without strong local presences.”⁸² More fundamentally, net worth is simply not designed to be a gauge by which a jury determines punitive damages. However, as flawed as it is, other measures sometimes used by plaintiffs are even worse. One such measure is market capitalization.

Market Capitalization

Market capitalization is the product of a company’s stock price and its total shares outstanding. Sometimes this value is used by plaintiffs as an alternative to net worth. One of the appealing features it has for plaintiffs over net worth is that it may be significantly higher. As an example, Table 12.2 shows the value of the net worth of the companies that are included in the Dow Jones Industrial Average. At the time the data were assembled for the table, market capitalization was 279.93% higher than net worth as of December 2002. The reason for this difference is that assets are not recorded on a company’s balance sheet at market values. Unfortunately, as far as the determination of punitive damages is concerned, this measure is even more flawed than net worth.

The most fundamental flaw of using market capitalization as a gauge in determining punitive damages is that it is not an asset of the corporation and it does not represent an asset that a company can use to pay an award. Market capitalization represents the value of the total outstanding equity of a public company at a moment in time. It represents a claim that equity holders have against the future gains of the company. Shareholders may not have any responsibility for, or any knowledge of, the acts that are the subject of the litigation. Using market capitalization as part of the punitive damages decision‐making process raises serious questions of fairness. Moreover, since the company is not in a position to use these assets to pay a punitive award, the market capitalization becomes totally inappropriate.

Another flaw of market capitalization as a measure is that it is not stable. While total shares outstanding are often relatively stable, market capitalization varies with the movement in share prices. The significant variability of share prices is well known. The relevance of this to punitive damages is that if a punitive award is based on an unstable measure of wealth, there could be widely varying amounts of punitive damages depending on what the market capitalization is at the time the measure is presented to the jury. This is shown in Table 12.3, which illustrates that the market capitalization of Johnson & Johnson fell over $39 billion after Reuters reported that the company could have known that its baby powder was cancer causing.⁸³ The decline was dramatic even though the company, a highly respected corporation, vehemently denied that it hid any information regarding the safety of its talc products.

Still another flaw of market capitalization is that the market reacts to news and tries to anticipate the outcome of relevant events. Assume that an award was made that was somehow based on market capitalization as a measure of the defendant’s wealth. Between the time when the punitive verdict was announced and the time that the company had to make a payment, the market would react to the news of the verdict (if it had not already anticipated it). The stock price would fall in relation to the magnitude of the verdict.

An example of this occurred in May of 2019 when a verdict was announced about a jury award of over $2 billion dollars for a California couple who were allegedly exposed to the herbicide Roundup, which the plaintiffs claimed caused cancer. The Northern California jury awarded $55 million in compensatory damages and $2 billion in punitive damages. That verdict marked the straight loss of Bayer in Roundup cases. The market value of Bayer stock fell as Bayer faced 13,400 more Roundup claims (see Exhibit 12.4).⁸⁴ However, in July 2019 that verdict was reduced by the court to $87 million.⁸⁵

Once the news of an adverse punitive verdict reaches the market, the declining stock price means that the value of the company’s market capitalization would be significantly lower on the date that the company has to make the payment than what it was when the jury reached its verdict. The market would try to adjust the value of the stock to reflect the losses associated with the payments. Insofar as market capitalizations were to somehow reflect an ability to make the punitive payment (which they do not), this ability would be reduced by the market’s reaction to the impending payment.

Still another problem with market capitalization occurs when the defendant is a subsidiary. A subsidiary of a public company may not have a separate stock price. Such a company pays dividends “upstream” to a parent company. It may not have outstanding shares traded in the marketplace, however, and thus does not have a market capitalization. Citing the market capitalization of the parent company may be irrelevant. In cases such as this, market capitalization is not a viable measure to consider, assuming that it is otherwise appropriate (which it is not).

Last, given that the U.S. Supreme Court in State Farm v. Campbell et al. expressed its concern about the bias‐related effects that net worth could have in the award determination process, it would seem that market capitalization, a measure that is often a multiple of net worth, would be even more problematic in the court’s view.

Uncertain Litigation Environment

Another interesting aspect of the litigation market is that companies often are not good at predicting what the volume and outcome of future lawsuits will be. Companies that are the targets of multiple lawsuits or serial tort suits often take charges and acknowledge liabilities based on their best estimates of the magnitude of the litigation‐related exposure. Such liabilities are referred to as contingent liabilities, and accounting rules require that they be accrued when they are highly probable and estimable.⁹² Some firms have indeed attempted to apply sophisticated statistical analysis to calculate litigation reserves.⁹³ While one assumes that these statements represent companies’ best estimates, the number and outcome of current and future cases are often quite uncertain. This became particularly true in the 1990s and early 2000s when the volume of certain types of cases grew dramatically. A remarkable example is the asbestos lawsuits.⁹⁴ The defendants in these suits, companies that at some point in time had an affiliation with asbestos manufacturers, thought these suits were behind them. A settlement was entered into on January 15, 1993, that was supposed to include a future claim against the entity founded by the asbestos defendants – the Center for Claims Resolution.⁹⁵ In 1997, however, the U.S. Supreme Court decided that the settlement did not meet the requirements for class certification under the Federal Rule of Civil Procedure 23. Many previously healthy companies were forced to file for Chapter 11 bankruptcy due to the sheer volume of these cases. Table 12.4 shows a few of the major companies that filed Chapter 11, some of which are leading names in American industry.

The asbestos defendants thought that they had the litigation problem contained through the Georgine settlement; they did not. The uncertainty of litigation is underscored by the dramatic reversals that this litigation took, ultimately forcing otherwise viable companies into bankruptcy. For companies facing mass tort lawsuits, the outstanding volume of litigation and the potential impact this may have on the health of the company should be considered in the determination of punitive damage amounts.

An example of the difficulties involved in predicting the impact of potential litigation exposure on the financial well‐being of a corporation is found in Owens Corning Fiberglas Corporation v. Roy Malone et al. In this case, the Supreme Court of Texas agreed with the trial court and the court of appeals in concluding that a punitive award would not have an adverse effect on the financial health of Owens Corning (OCF). The court stated:

The trial court considered OCF’s “enough is enough” evidence from the post‐trial hearing and determined that OCF’s financial position is not so precarious that further punitive damages awards against it should be disallowed. We agree. The evidence is that OCF is a solvent, healthy company. In 1993, shortly before this case was tried, OCF reported to its shareholders that “at the end of 1991, our company was valued by the market at $932 million; 12 months later, the market value of the company was in excess of $1.5 billion, an increase of 60%!” Moreover, in March, 1993 OCF reported to the SEC that “the additional uninsured and unreserved costs which may arise out of pending personal injury and property damages asbestos claims and additional similar claims filed in the future will not have a materially adverse effect on the Company’s financial position.” We cannot say that the prior paid punitive damage awards against OCF, combined with the punitive damage awards here, have exceeded the goals of punishment and deterrence.⁹⁶

The court examined what the company said about its own assessment of its ability to survive the volume of litigation and concluded that the company had to be in a better position than the court in assessing the impact on the company. If the company states it can survive, how is the court able to conclude otherwise? However, in retrospect, both were wrong. Armed with hindsight that the Texas Appeals Court did not have at the time, we know that such reasoning was flawed. The lesson one can take from this is that in spite of optimistic statements that a company makes in its filings and submissions to shareholders, the company may not be able to accurately assess the potential exposure from future lawsuits – particularly when many lawsuits are outstanding. It has become very difficult to predict what the future litigation volume will be. However, at a minimum, one can conclude that the jury should at least consider the volume of other cases. Believing that the company would not be in jeopardy from such cases, the court in Malone did not allow the jury to consider other lawsuits and their potential effects.

Summary

The issue of punitive damages continues to be hotly debated, even though punitive damages are awarded in only a small minority of lawsuits. Some assert that this relative infrequency implies that punitive damages should not be a cause for concern. Others point out that such damages are unpredictable and are often explicitly incorporated into settlement values. This process is sometimes referred to as the shadow effect of punitive damages.

The courts have been clear that the twin purposes of punitive damages are punishment and deterrence. However, punitive damages applied to corporations differ from those applied to individuals. The reason is that corporations are very different from individuals. A corporation is a group of various stakeholders who are affected, in different ways, by a punitive verdict. Examples of stakeholders are shareholders, employees, consumers, suppliers, and communities. A punitive award is a cost like any other cost that a company faces. Increased costs can have ripple effects on the stakeholders. This is an economic effect that a jury may want to know more about prior to rendering a verdict.

Plaintiffs often present certain financial measures for a jury’s consideration in determining punitive damages. They may include measures such as a corporation’s net worth. The use of these measures can be quite misleading, however, as they may suggest to a jury that a company’s ability to pay a judgment is greater than it actually is. If such measures are deemed appropriate, they should be adjusted for components such as goodwill and other intangibles.

Punitive damages may involve more costs than the monetary award itself. In addition to defense costs, companies that are the targets of punitive suits may incur significant reputational costs. They may incur these costs when suits are filed or following punitive awards, but they may not necessarily see them go away even if awards are reversed on appeal.

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