Posted by Rich Sweeney on July 9, 2008
In one of it’s less talked recent decisions, the Supreme Court dramatically reduced the ammout of punitive damages Exxon was forced to pay for allowing one of its tankers to spill 11 million gallons of crude oil into the Prince William Sound in Alaska in 1989. Writing for the majority, Justice Souter appeared to substantially limit the use of punitive damages, apparently capping them at the level of awarded compensatory damages. As an economist and someone who’s worked in litigation consulting, I’m inherently weary of our ability to effectively set numerical limits on future damages. While Souter didn’t actually set a dollar cap, capping a ratio seems equally as arbitrary to me. Moreover, in this instance, I’m afraid that the shortcomings of applying such a ratio will be particularly burdensome on the environment.
One of the main functions of punitive damages is to deter entities from taking similar actions in the future.* Compensatory damages, on the other hand, are awarded to place a clamaint in the position he would have been in had the wrongful act not taken place. In this decision, SCOTUS effectively says that the latter can never legally exceed the former. (At least in maritime cases. It’s not really clear to me how broadly this rule will apply). Yet I find Souter’s justification of this ratio deficient for two reasons. First, he never discusses the theoretical relationship between the two types of damages. Second, he sets his cap based on historical ratios, ignoring the endogeniety of risky behaviour with respect to the limit of potential punishment.
In a world where transaction costs were zero, all transactions were legal, and Ricardian intergenerational concerns prevailed, punitive damages would be unnecessary. An intelligent judge could fully and perfectly compensate all affected parties, and society would be indifferent as to whether or not a similar act occurred again. We wouldn’t worry about deterrence, and market forces would prevail.
The real world is, of course, much messier: Transaction costs abound, contracts are imperfect, society outlaws certain acts (like the sale of organs or children), and intergenerational compensation is complicated. On top of all that, our judicial system is a blunt instrument. Court costs and rules of merit/ standing serve to exclude most small or tangential claims. For all these reasons, it seems reasonable that society would seek some additional penalty, beyond just compensation of affected parties, in order to deter acts where the harm extends beyond the parties involved. We recognize that our legal system can’t perfectly compensate all effective parties, but still try to protect fringe claimants by deterring actions that will adversely affect them.
Pegging punitive damages to compensatory damages will dramatically limit our ability to protect potential fringe claimants and bias risky behaviour towards areas that we already do a poor job of valuing. Up until now, assuming the probability of being successfully prosecuted is 1, a firm considering a risky act (in this case, hiring an alcoholic to captain its oil tanker) had to respect the fact that a judge and jury could subsequently tack on punitive damages to the point where the total costs outweigh the benefits. Now however, they would only be deterred up to the point where the value of the risky act is less than 2X prospective compensatory damages. As I just described above, actual awarded compensatory damages become a smaller and smaller component of total damages as the harm done becomes more opaque or spread out over a larger group of individuals. We can surely think of lots of heinous acts where the harm is far away and difficult to directly quantify (although Souter apparently can’t), but right off the bat this seems to obviously describe environmental disasters such as Valdez.
Ok, quickly, on endogeniety and legal rules of thumb. Souter cites a host of statistics on past damages ratios in developing his proposed 1:1 limit. He writes that the majority of these cases were probably decided justly and therefore suggests we just impose this mean amount on the population as a whole in order to curb unfair outliers. However, this assumes that the distribution of acted upon risky endeavors will remain unchanged after the cap is enacted. What he fails to consider is the effect that the threat of unlimited punitive damages had a on preempting particularly harmful acts during the time period he’s studying. Previously, firms were concerned solely with the total damages amount, and the threat of massive punitive damages probably deterred a lot of risky environmental behavior. Now, however, disipated harm looks comparatively cheap, and therefore firms are going to purchase more of it, shifting the very ratio Souter is treating as fixed.
This is something I argue about with Johnny Walker, my Borkish** budding corporate lawyer roommate, all the time. He wants to cap medical malpractice damages, but refuses to acknowledge that this would encourage the most risky behaviour at the tails of the damages distribution. I have a feeling he’ll have something to say about this post. Most likely that I don’t understand the law at all.
* There are other possible legal justifications for awarding punitive damages aside from determent. Souter has a nice overview of the history of punitive damages beginning on p. 17 of the decision.
** Ok he’s not really Borkish at all, just pro tort reform. Speaking of Mr. Bork, for anyone else who thinks they’re for capping torts, I refer you to the single best editorial the New York Times has ever written. Irony isn’t even the word.