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.IntroductionIn 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.4The 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."11So 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. …