United States: Corporate Finances: Punitive Damages’ 800-Pound Gorilla

Last Updated: October 14 2014
Article by Andrew L. Frey

It seems perfectly obvious, to this writer at least, that by far the most significant factor fueling the drive over the past several decades to ever larger punitive awards is evidence of corporate finances, and jury instructions and arguments that punitive damages should be set on the basis thereof.

This post will explore the following elements of the issue: (1) Why is financial evidence such a dominating factor in many juries' punitive damages calculus?  (2)  When and why did this reliance on wealth in setting punishments arise?  (3) What are the economic and legal fallacies that undermine the validity of this practice? and (4) Do the Supreme Court's decisions in BMW and State Farm provide a viable basis for arguing against the prevailing judicial tolerance of the misuse of such evidence and argument?

While this post is unusually lengthy, the topic is one that requires extended treatment.

Why Do Corporate Finances Play Such A Major Role In Punishment-Setting?

Picture yourself as a kindergarten teacher, computer programmer, landscape designer, or retired postal worker who is serving on a jury in a civil trial at which punitive damages are in issue.  You have just awarded the plaintiff a million dollars in actual damages and found that her injuries were caused by reckless misconduct on the part of the defendant company in failing to recall a defectively designed product that caused the plaintiff's injuries, and that such conduct supports liability for punitive damages.  Your task now is to set the amount of punitive damages.

This task is totally unlike anything you have done before, and in performing it you are given precious little guidance in the jury instructions.  You may be told simply that you should select an amount that is appropriate to punish the defendant and deter it and others from similar conduct in the future, or you may be given a laundry list of factors to consider, without being told how to weigh the factors.  In contrast to criminal sentencing, you are not told a maximum permissible amount; nor do you know what level of award has been deemed proper in other, comparable cases.  Should the punitive damages be in the thousands?  Millions?  Hundreds of millions?  The predictable result of this lack of guidance, through no fault of the jurors, is a randomness and capriciousness in jury punitive verdicts.  This phenomenon is confirmed by empirical scholarly work.  See Sunstein, et al., Punitive Damages: How Juries Decide (U. Chi. Press 2002).

In such circumstances, a juror who is at sea naturally seeks some numerical frame of reference to anchor the inquiry.  The defendant's financial data—figures in the billions for many corporate defendants— supply such an anchor, and it's a whopper.  Use of financial evidence as a basis for setting punishments is driven home by the plaintiff's arguments (1) suggesting that only a very large penalty will "get the attention" of a very large corporate defendant, and (2) inviting use of a percentage of the defendant's net worth and making comparisons to penalties that might be imposed upon persons of modest means: "If a person earning $50,000 per year engaged in comparable conduct and you would set punitive damages at $5,000, or 10% of his annual income, why should this greedy corporation, with revenues of $5 billion a year, receive better treatment?"

Such arguments are in turn greatly reinforced in most jurisdictions by instructions identifying the defendant's finances as an affirmative basis for punishment-setting.  For example, Florida's pattern instruction provides that, in determining the amount of punitive damages "to be assessed as punishment against (defendant(s)) and as a deterrent to others," the jury "should consider the following" and then proceeds to list among the required considerations "the financial resources of (defendant(s))."

This anchoring effect is often exacerbated by the nature of the proceedings in the second—or punitive amount—phase of a bifurcated trial.  All too frequently, the defendant has prepared no case of its own for that phase, which consists of nothing but testimony from a plaintiff's expert regarding the defendant's finances and arguments of counsel, with the plaintiff's argument prominently featuring the kind of emphasis on the vast wealth of the defendant described above, and the defendant offering little more than insincere and ineffectual apologies.

The impact of evidence and argument regarding a defendant's finances can make a huge difference.  I was involved some years ago in the appeal of a case in which the jury had returned a punitive verdict of more than $150 million.  In post-trial interviews, the jurors generally agreed that while the defendant manufacturer should have acted differently and punitive damages were appropriate, its conduct was not especially heinous.  For that reason, the jurors imposed what they considered to be only "modest" punitive damages—a "mere" 0.5% of the defendant's $30 billion net worth.  This is a striking, real-world example of the "anchoring effect" of financial evidence.  It is unlikely that the case was unique.

Why Do Many Courts Think That A Defendant's Wealth Is A Proper Benchmark?

In our legal system, criminal fines or judicial or administrative civil penalties, like punitive damages, are intended to serve the goals of effective deterrence and just punishment.  But fines and penalties are rarely if ever calibrated to the defendant's financial circumstances, except insofar as a defendant's impecuniousness may be grounds for lightening a monetary penalty that would otherwise be imposed.  Nevertheless, of the 48 States that allow the imposition of punitive damages, all but a handful have permitted evidence of the defendant's finances to be adduced and argued as a legitimate punishment-setting factor.  Where did this practice come from?

It is interesting to note that consideration of wealth was rare in nineteenth-century punitive damages case law.  For instance, the Iowa Supreme Court stated that "while some cases have held, that the pecuniary condition of the defendant may be shown, when plaintiff is entitled to vindictive damages * * * yet it is believed that the weight of authority is the other way."  Hunt v. Chicago & N.W.R.R., 26 Iowa 363, 373 (1868).  And it was the very end of the century before the first case reached the U.S. Supreme Court in which corporate finances had been admitted for punishment-setting purposes (Washington Gas-Light Co. v. Lansden, 172 U.S. 534 (1899)), though the Court's disposition of the case rendered it unnecessary to consider the propriety of the practice.

Today, however, there is a widespread belief that, at least when it comes to punitive damages, the punishment should fit not so much the crime as the criminal.  A big company will not be deterred, it is suggested, by a punishment that is proportionate only to the harm it has caused and the gravity of its misconduct but not to its net worth, income, or revenues.  This notion derives, I believe, from a faulty analogy to the intuitive notion—not at all unreasonable—that a punishment that is adequate to deter an actor of modest means will not suffice to deter a very wealthy person.

That concept makes sense with respect to wrongs that are motivated by non-economic considerations: the penalty that is needed to deter an individual from committing an assault, or painting racially offensive graffiti, or poisoning his neighbor's noisy dog will indeed vary with the wrongdoer's wealth because it is necessary to "monetarize" the satisfaction derived from the misconduct.  Thus, consideration of a defendant's wealth serves an entirely reasonable purpose when done in the context of an individual committing a non-economic tort.  Indeed, in at least some Scandinavian countries fines are set in terms of days of income.

This rationale falls apart, however, when the tort has economic motives.  In such circumstances, what dictates the amount of punishment needed to accomplish optimal deterrence is not the defendant's wealth but the economic circumstances of the transaction: What loss did the victim suffer?  What gain did the defendant expect and actually reap?  What penalty would be necessary to alter the economic calculus of the defendant and others similarly situated so that such conduct is seen as unprofitable and therefore not repeated?

Whether the defendant is rich or poor, large or small, the elimination of the prospect of profit from the misconduct is what governs the efficacy of the deterrence, and whether it is insufficient, appropriate, or excessive to accomplish its objective.  Put another way, it simply is not true that a rich defendant will, because of the size of its resources, be unresponsive to a sanction that removes the prospect of profit.  The pizza-delivery hypothetical below illustrates this point.

There is a second legitimate reason, in addition to setting an appropriate punishment for an individual's non-economically-motivated tort, for considering finances: to implement the virtually universal principle that punitive damages are meant to correct rather than destroy, so that awards that seriously impair a defendant's continuing economic viability are inappropriate.  This, however, is in the nature of an affirmative defense; it should be placed in issue only when the defendant seeks leniency based on limited financial capabilities.  Aside from these uses, the consideration of wealth as a basis for enlarging the punitive exaction beyond what would otherwise be warranted is, notwithstanding its current prevalence, both economically and legally illegitimate.

The Economic Fallacy Underlying Use Of Wealth As A Punishment Criterion In Cases Of Corporate Wrongdoing.

Economists who are knowledgeable about deterrence theory are virtually unanimous in the view that it makes no sense to set punitive damages on the basis of corporate financial data.  Why is that so?  It is because the theoretical basis for considering a defendant's wealth falls apart when it comes to economically motivated torts.  Where the wrongdoer acts to realize economic benefits—as is almost always the case when corporations or other organizations are subjected to punitive damages—the "right" penalty for deterrence purposes is one set at a level that removes the economic incentives for the wrongful conduct.  [I put to one side for purposes of this discussion the distinct problems caused by the fact that, in the case of conduct giving rise to multiple lawsuits, no single jury is empowered to punish the defendant for the totality of its conduct or in an amount sufficient to change its overall conduct.  Rather, under Philip Morris USA v. Williams, the punishment must be apportioned to the case at hand.]

Ordinarily, economic theory tells us, compensatory damages provide the proper level of deterrence, and an overlay of substantial punitive damages risks undesirable over-deterrence.  In any event, the optimal level of monetary liability for deterrence purposes has nothing to do with the wrongdoer's size.  Big companies are as much interested in profits as little ones; remove the prospect of profit, and the big company will be as much deterred.

An illustration will demonstrate the point.  Suppose there are two pizza delivery companies — Joe's Pizzeria and Nationwide Pizza — competing in a particular city for business by promising the fastest home delivery.  And suppose further that each company seeks to make good on its swift delivery promises by encouraging its drivers to speed, ignore red lights, and park illegally.  Finally, suppose Nationwide is 100 times the size of Joe's.  The level of penalty necessary to induce these businesses to stop ignoring the traffic laws is the amount that makes it unprofitable to reap whatever benefits attach to the extra increment of speed realized by illegal driving.  That penalty is the same for each, despite their disparity in size.  True, if $100 per violation is the right amount, no individual penalty will compel Nationwide's board of directors to address the practice; but that isn't necessary, as the accumulation of fines will cause the local branch to start losing money; that in turn will jeopardize the branch manager's job and therefore induce him to reform his drivers' practices.

In fact, enhancing penalties based on net worth or other financial indicia will actually result in larger companies having to pay a higher proportion of net worth in punitive damages.  Consider two insurance companies, Goliath Insurance and David Insurance, that are morally equivalent.  Each has the same claims-handling procedures, and the same proportion of their employees are bad apples.  Suppose that Goliath processes one million claims a year and David 100,000, and that Goliath's net worth is ten times as great as David's.  Each is successfully sued for bad-faith mishandling of one claim in every 20,000 it processes, and found liable for punitive damages in such instances.  If each individual case resulted in punitive damages set at 1% of net worth, any seeming parity of treatment would be a mirage.  In fact, Goliath would pay not 10 times as much as David, as might seem appropriate given their respective sizes and equivalent culpability, but 100 times as much (10 times as many cases X 10 times as large a punishment in each case); and it would forfeit 50% of its net worth to David's 5%.

In short, the conventional theory entirely overlooks that larger companies have more transactions, which generate more litigation, which in turn creates greater punitive damages exposure.  If the penalties are also jacked up because of the company's size, the result is manifest double-counting and disproportionately higher liability.  This makes no economic sense.

"But," you might still ask (especially if you are a plaintiff's lawyer), "don't the punitive damages have to be large enough to cause the company to change its policies?"  The answer is an emphatic "no."  First and foremost, the verdict of any single jury is not a reliable indicator of objective reality.  Rather, the verdict in any given case is the product of a host of unpredictable and possibly idiosyncratic factors, including the comparative skill of the lawyers; the demeanor and attractiveness of each side's expert witnesses; the impact of hindsight bias, which is a recognized phenomenon skewing jurors' assessments of the propriety of pre-accident conduct; and the personal experiences and belief sets of the particular six or nine or twelve people constituting the jury; etc.

The fact is that the same body of evidence frequently produces different outcomes in different cases.  For that reason, any single verdict may be aberrational, and no single jury should be accorded power disproportionate to its task, which is to resolve the dispute of the parties before it.  (I hear no one saying that if the defendant wins the first case, it should be immune from liability in any future cases involving the same allegations, yet that is every bit as reasonable as supposing that a single jury should be empowered to compel a defendant to change its practices through a punitive award that will "get the attention of the board of directors.")

There is also the associated problem of overdeterrence.  Blockbuster verdicts, to the extent they are in fact effective to bring about changes, may induce companies to take excessive precautions that raise the costs to consumers of goods and services beyond any associated benefit or that reduce the availability or utility of products.  This happened in the 1980s with child vaccines and general aviation aircraft.  A regime of punitive awards tied to the defendant's finances is a prescription for overdeterrence.

In addition, in my experience most awards of punitive damages are met with considerable skepticism by company personnel, who often genuinely believe that the company did nothing wrong and ought not change its policies because a jury, in the isolated and emotional crucible of the courtroom, came to a contrary conclusion.  In other words, the outcome of a particular case is one datum—but only one—to be considered in deciding whether changes are in order; it should not be converted into the proverbial 800-pound gorilla, sweeping aside all other inputs.  If enough juries reach the same conclusion (and often a finding of punishable, or even merely tortious, conduct is an outlier), the accumulated liability will provide ample incentive for change.  But no single jury should be given power disproportionate to the matter before it.

The way that each jury is confined to its proper domain is through the requirement that punitive damages be reasonably related to a plaintiff's actual damages.  When the same conduct by a defendant has inflicted injuries to or losses on many plaintiffs, confining each jury that finds liability to punitive damages that are proportioned to the plaintiff's harms ensures that the overall punishment most fairly reflects the collective consensus of all the juries that have considered the defendant's conduct.  On the other hand, if punishment is linked to the defendant's finances, the jury is effectively set free from any constraint of proportionality.  As we next see, this concern played a role in the Supreme Court's discussion of wealth and punitive damages in the seminal State Farm case.

The Legal Failings Of Wealth-Based Punitive Damages.

Not only does the use of corporate finances in punishment-setting make no sense as a means of achieving rational deterrence, but there is an increasing recognition in more sophisticated judicial circles that this particular idol has feet of clay.  Leading the charge here is the U.S. Supreme Court, which, in the landmark decision in State Farm Mutual Automobile Insurance Co. v. Campbell, criticized the Utah Supreme Court's reliance on State Farm's financial circumstances to justify the punitive award in that case.

State Farm was an insurance bad-faith case growing out of the defendant's failure to settle a claim against its insured within policy limits.  In reinstating the jury's $145 million punitive verdict, the Utah Supreme Court emphasized that the award was not out of line with State Farm's multi-billion-dollar finances.  The United States Supreme Court, however, took a markedly different stance, stating in no uncertain terms that "[t]he wealth of a defendant cannot justify an otherwise unconstitutional punitive damages award."

While this criticism came as something of a surprise to many observers, it was in fact foreshadowed by the Court's disregard, and perhaps implicit rejection, of the plaintiff's argument in BMW of North America, Inc. v. Gore that the $2 million punishment there at issue could be upheld because it was so small in relation to BMW's net worth.  Had the Court found merit in that oft-made argument, it would presumably have affirmed the judgment in BMW rather than reversing it.  The same is true of the Court's most recent punitive damages decision, Exxon Shipping Co. v. Baker, in which the Court held that punitive awards in maritime cases generally may not exceed the amount of compensatory damages—without regard to the fact that the defendant in the case before it was one of the two largest companies in the world.

The Court began its discussion of the wealth issue in State Farm by criticizing the Utah court's reliance on wealth as an "argument[] that seek[s] to defend a departure from well-established constraints on punitive damages," because the defendant's financial condition "bear[s] no relation to the award's reasonableness or proportionality to the harm."  This observation picked up on a central theme of Justice Breyer's concurring opinion in BMW, which had emphasized the disconnect between wealth evidence and the excessiveness benchmarks identified in that case and reaffirmed in State Farm: reprehensibility; relationship to plaintiff's damages; and relationship to legislative or administrative penalties for similar conduct.  Whether the defendant is a large company or a small one has nothing to do with the reprehensibility of its conduct, the harm that it caused or threatened to the plaintiff, or the criminal fines or civil penalties potentially attaching to the conduct.  Reliance on corporate finances is therefore, in practical effect, a mechanism for nullifying the analysis that the Supreme Court has found to be constitutionally necessary.

This reasoning led to the Court's conclusion that State Farm's wealth could not validate the otherwise unconstitutional award.  Logically, it would appear to follow that evidence of a corporate defendant's finances should generally be inadmissible.  But plaintiffs and some courts have treated a seemingly offhand comment in State Farm, quoting from a somewhat enigmatic passage in Justice Breyer's BMW concurrence, as nullifying the rest of the Court's analysis of the use of wealth and allowing its unrestricted use at least during the trial itself.  The passage begins by seeming to criticize the use of wealth evidence as "provid[ing] an open-ended basis for inflating awards when the defendant is wealthy," but then goes on to state:

That does not make its use unlawful or inappropriate; it simply means that the factor cannot make up for the failure of other factors, such as reprehensibility, to constrain significantly an award that purports to punish a defendant's conduct.

In this writer's opinion, it is wholly unreasonable to ascribe such nullifying effect to this stray passage.  The passage does not indicate what relevance wealth evidence is thought to have, or in what respects its use might not be "unlawful" or "inappropriate."  And, as noted above, there are certain legitimate uses of wealth evidence—to "monetarize" the value of non-economic misconduct to an individual defendant and to avoid an economically debilitating award; perhaps the quoted comment is intended to convey nothing more than that such uses are not foreclosed.

In the end, if an arguably excessive award cannot be justified by reference to the defendant's finances, what legitimate purpose could such evidence serve?  Plaintiffs have suggested that the evidence would still constitute a proper consideration in setting an award within the constitutionally permissible range, and it is true that the Supreme Court's language does not explicitly prohibit such use.  But the relevance objections outlined earlier in this article remain.  And beyond that, as a practical matter the anchoring effect of wealth evidence in the jury's selection of a punishment will overwhelm the other, more pertinent considerations such as reprehensibility and relationship to actual damages, causing the prejudicial effect of the evidence to swamp any probative value it might be thought to possess.

True, verdicts driven to unconstitutional levels will be subject to remittitur in a process that, under State Farm, cannot properly consider wealth to sustain an award that would otherwise be excessive.  But this is no remedy for the harm done by placing evidence of wealth before juries and encouraging them by argument and instruction to rely on such evidence to augment the punishment they would otherwise impose.  And when such evidence, arguments, and instructions drive verdicts to levels that must then be reduced—as they often do—the reduction in most jurisdictions is only to the highest constitutionally allowable level, even though a jury not dazzled by huge net worth, revenue, and income data might have returned a verdict well below that level.  This defeats the right to a jury trial and demeans the punishment-setting process.

To sum up, evidence of a defendant's wealth has a legitimate role to play in setting punitive damages only in very limited circumstances.  In the typical case of a corporate or other organizational offender accused of an economically-motivated tort, financial data have no proper role to play in the process, and such evidence and any argument urging that punishment be calibrated to the defendant's size should be barred.

Tags: Corporate Wealth

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