A financial economic theory of punitive damages.

• Author: Rhee, Robert J.
• Position: Introduction, p.33-40

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.

TABLE OF CONTENTS INTRODUCTION I. THE CENTRAL PROBLEM OF 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 II. LAW AND ECONOMICS THEORY AND CRITIQUE A. Standard Law and Economics Theory B. Critique of the Standard Theory C. Toward a Complete Theory of Optimal Liability III. RISK ARBITRAGE IN SETTLEMENTS 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 IV. TOWARD OPTIMAL LIABILITY AND DETERRENCE 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 V. REASSESSING GORE, CAMPBELL, WILLIAMS, AND BAKER CONCLUSION INTRODUCTION

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...