The Economics of Punitive Damages

[ as published in For the Defense ]

The Economics of Punitive Damages

Patrick A. Gaughan, Ph.D.

College of Business
Fairleigh Dickinson University


Economatrix Research Associates, Inc.


This paper explores the economics of punitive damages as they relate to corporate defendants. The purposes of punitive damages are punishment and deterrence. However, punitive damages is a blunt tool that has difficulty isolating the wrongdoers who may possibly not even be with the company at the time of the trial. Other problems with punitive damages involve spillover effects where various corporate stakeholders may bear the punishing effects of punitive damages. In addition, there are often much better means, such as regulatory processes, of accomplishing deterrence than punitive damages. While punitive damages may not accomplish the goals of punishment and deterrence, they may have various other economic effects that juries may need to be made aware of prior to their reaching a decision. Other problems with punitive damages lie in the presentations that are sometimes made by experts called by plaintiffs. Defendants need to be make sure that juries are given sufficient financial information to fully understand the meaning of financial measures they may have been presented. Presentations of financial measures such as net worth and market capitalization may be highly flawed and prejudicial. In addition, other factors, such as adverse reputational effects may be worth to bring to a jury’s attention.


Punitive damages is a controversial topic in the legal profession and in the field of economics. This paper explores the economics of punitive damages as they relate to corporate defendants. The economic difference between large corporations and other potential defendants, such as individuals or smaller closely held companies, cause the effects of a punitive award to be different. In some circumstances these differences raise significant questions as to the appropriateness of punitive damages when imposed on large corporations.

Recent Decisions on Punitive Damages by the U.S. Supreme Court

Punitive damages have been with us for many years. Its roots can be traced back to English common law and beyond that (Owen 1976). Punitive damages is a penalty that is applied in addition to compensatory damages in situations where a defendant’s conduct is determined to be reprehensible (Second Restatement of Torts).

Punitive damages have twin goals: punishment and deterrence. In its decision of Pacific Mutual Life Insurance Co. v. Haslip (1991), the U.S. Supreme Court reaffirmed these goals by stating that “punitive damages are imposed for purposes of retribution and deterrence”. In later decisions, the Court consistently reaffirmed these purposes. For example, in Cooper Industries, Inc. v. Leatherman Tools Group, Inc. (2001) where the Court stated:

“Punitive damages may properly be imposed to further a State’s legitimate interests in punishing unlawful conduct and deterring its repetition.”

In TXO Production v. Alliance Resources (1993), the Court muddied the waters by upholding a punitive damages award of $10 million with a compensatory damages amount of $19,000. In this case, punitive damages were 526 times compensatory damages. Some had concluded that arguing that the use of such high ratios of punitive to compensatory damages is a violation of due process was a dead issue (Stuart 1994). However, the issue of the magnitude of the punitive/compensatory multiplier was still somewhat clouded due to the fact that in that case the Court also considered potential, not just actual, compensatory, damages. Thus, the TXO decision was not endorsement by the Supreme Court of such a high multiplier as it considered a denominator that was potentially significantly higher.

In BMW of North America v. Gore (1996), the U.S. Supreme Court found that an award of $145 million in punitive damages and $1 million in compensatory damages, a punitive/compensatory multiple of over 1,000 times, violated the due process clause of the Fourteenth Amendment of the United States Constitution. In reaching its decision, the Gore court set forth three factors or guideposts which courts should consider when reaching a decision on punitive damages:

(a) the degree of reprehensibility of the defendant’s conduct,

(b) the disparity between the actual and potential harm, and

(c) the disparity between a jury’s award of punitive damages and civil penalties imposed in other cases.

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

In April 7, 2003, the Court more explicitly addressed the punitive multiplier as well as other factors which may be taken into account when determining a punitive damages award. In State Farm Mutual Automobile Insurance Co. v. Campbell et al. (2003) the Court applied the Gore factors to a Utah case involving an insurer’s claims against their automobile insurance company. In going through the factors, the Court clarified how they apply to different lawsuits. The Campbell court was reluctant to set forth 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.” This decision was also precedent setting in that it was only the second time that the Supreme Court reduced a punitive damages award that was handed down by a jury. Even though BMW of North America v. Gore seemed to lend some stability to the process of arriving at and evaluating punitive awards, various state courts seem to have awarded punitive damages without bound or a reasonable basis. In Engle v. R.J. Reynolds Tobacco Co. (2000) a class action alleging smoking-related injuries in the State of Florida, a jury in 2002 awarded an unprecedented $144.8 billion. The fact that this award far exceeds the defendant’s ability to pay seemed to be lost in the verdict determination process. What was even more troubling was the specious analytical grounds upon which the verdict was based. The decision was later reversed by Florida’s Third District Court of Appeal. This case is mentioned as it shows that punitive damages remains a thorny and not fully understood problem for court, particularly in the field of mass torts (Barr 2001). While it is the most extreme example, it is not an isolated case. In a more recent decision, an Alabama court in November, 2003 awarded the plaintiffs $63.6 million in compensatory damages while awarding $11.8 billion in punitive damages in a natural gas royalty dispute where Exxon/Mobil Corp. was the defendant.

Some have theorized that part of the purpose of the Court’s decision in BMW of North American v. Gore was to send a message to lower courts to “tighten its grip on punitive awards”. If this is the case then it is clear that many state courts have yet to the message (McKee 2001).

Frequency of Punitive Damages

Punitive damages tend to be are awarded relatively infrequently. The majority of cases do not go to trial and of those that do go as far as a verdict, only a small percentage award punitive damages. Landes & Posner (1986) found that only 2% of product liability cases result in punitive damages. Another study showed an even smaller frequency. 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 (Peterson et al. 1987). Rustad and Koenig’s (1992) research undercovered only 344 cases with punitive damages in a quarter of a century of cases. Other studies showed a somewhat higher incidence of punitive damages. For example, the American Bar Foundation study found punitive damages in 4.9% of all verdicts in their research sample (Daniels and Martin 1990). A study conducted but the Justice Department found a somewhat higher rate – 6% (DeFrances et al. 1995). In addition, research has also raised concerns about the predictability of punitive damages. These concerns have been traced to the jury’s deliberative process and the difficulties that juries have in assigning consistent dollar amounts for the moral judgments they have to make (Kahneman et al. 2002).

The Shadow Effect of Punitive Damages

The research on the frequency of punitive damages could lead one to incorrectly conclude that punitives are so infrequently awarded that they need not be a major source of concern. What this research fails to consider, however, is that the threat of punitive damages permeates the negotiations of many lawsuits and may appear in settlements and not just verdicts. Defendants, concerned about the potential for high punitive damages, may agree to a settlement that implicitly incorporates their probability-adjusted estimate of their punitive damages exposure. This is what is known as the shadow effect of punitive damages.

Since it is not explicitly designated in settlements, the shadow effect is difficult to quantify. One study by Thomas Koenig (1998) featured insurance adjustor data and sought to determine what component of total settlements they allocated to punitive damages. He was able to trace 11% of the total settlement amounts to punitive damages. A value of 11% might seem small but when this percentage is considered in light of the frequency of punitive damages and the impact this would have on the expected value of a defendant’s punitive exposure, the value becomes more significant.

Taxes , Insurance and the Incidence of Punitive Damages

Even in settlement data, punitive damages are difficult to identify. This is due to the fact that when arriving at a settlement agreement, both parties, but especially the plaintiff, have an incentive to not identify settlement amounts as punitive damages. Settlement amounts designated as compensatory damages are not subject to Federal taxation (Section 104 of the Internal Revenue Code). The Federal tax laws were amended by the Omnibus Budget Reconciliation Act of 1989 and this law specifically excluded punitive damages (Dodge 1992). Designating an award as punitive damages lowers the net after-tax benefits to the plaintiff.

From a defendant’s perspective, some courts have demonstrated a reluctance to enforce insurance agreements for punitive damages. In addition, the defendant may possibly not have coverage for punitive damages while it may have coverage for compensatory damages. If these factors are relevant, the defendants may have an incentive to not identify a settlement amount as punitive damages (Priest 1989).

The economic incentives are such that designating parts of a settlement as punitive damages lowers the benefit to the plaintiff and may possibly raise the cost to the defendant. This is why even in settlement data, it is difficult to parse out the punitive component. It very well may be, and may even be a significant component of the total damages settlement paid, but one would not expect to give any part of the settlement designated as payments for punitive damages. It is ironic that it arguments in multiple tort cases, plaintiffs, some of whom may have accepted settlements amounts that implicitly included punitive damages, may argue at trial for a punitive award based upon the assertion that the defendant, who may have settled many prior cases, still has not paid monies for punitive damages.

Purposes of Punitive Damages

As noted earlier, the dual purposes of punitive damages are punishment and deterrence (Second Restatement of Torts 1979). In its recent decisions relating to punitive damages, Cooper Industries v. Leatherman and State Farm Mutual v. Campbell, the U.S. Supreme Court 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 (Gertz v. Robert Welch, Inc. 1974).” They are awarded for acts that are so extreme that the trier of the facts seeks additional penalties beyond compensatory damages.

Deterrence can take two forms: specific and general deterrence (Ellis 1982). 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 being the more important of the two goals (Owen 1994).

Economists hold that the most efficient outcome is optimal deterrence and that under and over deterrence are not desirable. Over deterrence occurs if resources are allocated to achieving deterrence in excess of the value of the harm that was avoided. Under deterrence occurs when insufficient resources are allocated to avoidance of a harm.

Clearly, there is an optimal level of deterrence. While this issue is quite relevant to the determination of punitive damages it has been discussed elsewhere in literature and is not the focus of this paper (Polinsky 1998).

Corporate Punishment and Corporate Governance

Punishing a corporation is very different than punishing an individual. When a judge or jury decides that an individual defendant needs to be punished, one has greater assurance that the specific individual defendant will bear the punishment. With corporate defendants, it may be more likely that parties other than the wrongdoers may bear the effects of the punishment (Coffee 1981). This is due to the nature of corporate organizations.

Shareholders are the owners of corporations. They elect directors who, in turn, select managers who run the company on a day-to-day basis. However, a broader group of individuals have a “stake” in corporations (Shleifer and Vishny 1997). That is, corporations are a grouping together of various stakeholders towards some common economic activity. Freeman has defined stakeholders to be “any group or individual who can affect or is affected by the achievement of the organization’s objectives (Freeman 1984).” However, management theorists have differed on just how broad or narrow to define stakeholders (Mitchell et al. 1997). Such stakeholders may or may not have an equity interest in the corporation. Groups who do not have an equity interest in the company include employees, management, suppliers, communities, recipients of tax receipts and possibly others depending on the circumstances.

Corporate Punishment and Spillover Effects

Punishment imposed upon a corporation may end up being borne by parties other than the wrongdoers. This may be a by product of the legal doctrine of vicarious liability where an employer can be found liable for acts of its employees. Another name for this is the respondent superior rule. The appropriateness of the application of this legal principle to punitive damages has long been a subject of debate (Morris, 1931). Economists, however, may refer to such effects that result from the application of this rule as spillover effects.

The term spillover effects is well known is microeconomics — especially the field of public finance. Another name for such effects is externalities. One definition of an externality or spillover effects is “A cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction. Sometimes the terms spillovers or neighborhood effects are substituted for the term externalities (Case and Fair 2002).”

Punitive damages is a very blunt tool for a judge or jury to use to try to punish wrongdoers. Due to its lack of precision, and sometimes lack of timeliness, it may be more likely that innocent parties will bear the adverse effects of such a imprecise instrument while the guilty individuals may have “long departed the scene”. In cases where the trial takes place many years after the alleged wrongful acts, the likelihood of being able to isolate wrongdoers may be pretty low. Good examples of this are the tobacco and asbestos litigation. In such cases, it may be more likely that equity and non-equity stakeholders may bear the effects of the punishment.

Punishment and Equity Stakeholders

Stock is the first security to be issued when a corporation is formed and the last to be retired. As owners of the company, equity holders hope to gain from corporate profitability. Such gains may come from dividends and possible capital gains. Plaintiffs often argue that since they gain from the corporation’s business activities, they should also bear the effects of punitive damages. Unfortunately, such simplistic reasoning is beset with flaws.

The first flaw is a function of the nature of stock ownership of large corporations. In closely held companies there may be little difference between shareholders and the firm’s management and decision-makers. Such firms may be managed more like sole proprietorships which are seeking the limited liability protection of the corporate business form. In such small, closely held companies, there may be some assurance that corporate penalties will in some way be borne by the parties who made the decisions that led to the wrongful acts and who may have also profiting from them. This situation may also be somewhat true for smaller publicly held companies where share ownership is concentrated in the hands of few shareholders who may also take an active role managing the company. The situation changes significantly, however, as one’s focus moves to larger publicly held corporations. Here the separation of ownership and control becomes a more important issue. Shareholders in large publicly held companies tend to have little if any control of the company. The larger the number of shares outstanding and the more widely distributed the equity base is, the less likely that any particular shareholder has significant control over the actions of the corporation.

Separation of Ownership and Control

While shareholders are the “owners” of the company, they are not owners in the sense that a closely held company may have owners. For shareholders in large market capitalization companies, the shareholders have an investment in the company but are not active in its management. This separation of ownership and control has been a topic that has been discussed in corporate finance for many years (Berle and Means 2003). Part of this debate has centered on the agency problem where shareholders select agents to maximize the value of their investments (Jensen 2000). This can be a problem because these agents have their own agenda and may not take all of the actions that are needed for the betterment of shareholders. The agency problem underscores the limitations that shareholders face in the corporate governance arena.

Stock Ownership of U. S. Corporations

Share ownership of U.S. corporations has become increasingly concentrated in the hands of institutions as opposed to individuals (Brancato and Gaughan 1988). For example, Table 1 shows that the institutional holdings percentage of the Dow Jones Industrial Average companies was 65% as of June, 2003. The largest groups of institutions are mutual funds, pension funds and insurance companies. Each holds shares as investments for those for whom they have a fiduciary responsibility. The individuals for whom the shares are held by such intermediaries typically have little control or even contact with the corporations. The institutions themselves have become somewhat more active over the past decade, but due to the fact that their portfolios tend to be diversified and each company represents only a fraction of the total equity they might manage, they cannot devote significant resources to the micro-management of the companies in their portfolios (Ross et al. 2004).

Table 1: Institutional Holdings for Dow Jones Industrial Averages

Source: Vickers’ Database, as of June 02, 2003

While institutions may hold a large percentage of the total shares outstanding, even majority percentages, for large publicly held corporation it is unusual for any one institution to hold a controlling position in a given corporation. This is due to the pursuit of a diversified portfolio combined with other restrictions which are designed to prevent any one company from becoming to large a percent of a company’s investments (Roe 1996). There are exceptions and cases where certain shareholders may hold 51 or greater percent of shares but that is not the norm (Holderness and Sheehan 1988). This is one distinction between corporate share ownership in the U.S. compared to other parts of the world such as Europe. In Europe, such high controlling share positions are more common (Franks and Mayer 1990).

Non-Equity Stakeholders

Non-equity stakeholders can be categorized into two groups: internal and external. Internal stakeholders are employees who can be managers and non-management. Each has a vested interest in the success and growth of the company. Decisions are made at all levels of employment with broader policies usually being established at higher levels of management and more narrowly defined decisions being made at lower levels of authority. For larger companies with many layers of management the various layers become increasingly removed from each other. The more numerous the layers of management the greater probability that decisions may be made at one level, such as a lower level, that managers at higher levels may be unaware of. Such decisions could be ones which are the subject of the litigation.

In addition to management, other stakeholders include non-management employees. At most corporations, the ranks of the non-management employees are larger than those of management. In addition to employees, still other stakeholders include suppliers who may depend of a defendant’s corporation for an important component of its business. Suppliers benefit directly when corporations increase purchases and are hurt when such sources of business decline. However, corporations who incur increased costs, such litigation-related costs, they may be forced to curtail the scope of their operations. If this is the case, such actions may have an adverse effect on the utilization of inputs into their production process and the non-equity stakeholders who are providers of these inputs: employees and suppliers.

Another group of non-equity stakeholders who have an interest in the operations of a corporate defendant are creditors. They may have made large investments in company through their provision of debt capital. Increases in costs through litigation payments such as punitive damages, could have an adverse effect on their investments and their own stakeholders. Debt financing providers may have bargained with the debtor defendant to gain certain controls to protect their investment but controls over potential actions such as what might give rise to the lawsuit are unlikely to be parts of such controls and agreements (Smith and Warner 1979).

The trier of the fact faces a difficult task in trying to isolate the actual wrongdoers and endeavoring to make sure that they alone bear the impact of the punitive damages. The problem becomes even more complicated when one considers the turnover of employees. The combination of these issues makes it often likely that punishment in the form of punitive damages may not be focused upon the wrongdoers and that these wrongdoers may or may not be part of the current non-equity stakeholders as of the trial date.

Shareholder Wealth Effects

Litigation-related payments, like any other cost, lower corporate profitability and reduces the pool of monies available for dividends and, thereby, impedes capital gains. For this reason, the exposure to potentially large and unpredictable litigation payments can have an adverse effect on stock prices. Research studies have confirmed the impact that litigation can have on stock prices (Bizjak and Coles 1995). 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 December, 2001 in favor of five plaintiffs (see Figure 1) (Banerjee 2001). This was one of many asbestos cases that were brought against the company. Over the prior quarter of century, the company had settled almost 200,000 asbestos claims although many of them were settled for relatively modest amounts. The market reacted to the large verdict and what it implied about the potential litigation exposure that would occur if the other cases had a similar result.

Figure 1: Stock Performance of Halliburton, Co.

Source: Historical Prices from Yahoo Finance.

For companies with large litigation exposure, such as tobacco and asbestos defendants, the adverse shareholder wealth effects can be quite significant. Securities analysts have attempted to measure the magnitude of the large tobacco liabilities of Philip Morris Companies, Inc. which is now called Altria. As of the end of 2002 and 2001, Philip Morris USA, the tobacco subsidiary of Altria, was the object of 1,500 tobacco lawsuits (Altria Annual Report 2002). Some of these suits were class actions and multiple plaintiff cases. In February, 2001, Goldman Sachs issued a report that featured a “sum of the parts” analysis which computed total enterprise value and the value of each of the company’s subsidiaries contributed to that value. The various parts or business segments were valued using comparable multiples that were relevant to the four industry segments that made up the parent firm – Philip Morris Companies, Inc. This comparable multiples analysis is an accepted method of valuing businesses Gaughan (2004). The Goldman Sachs analysis measured what has been termed the “litigation overhang” and found it to be equal to $91.5 billion (Goldman Sachs Analyst Report 2001). Without the litigation exposure, their analysis showed that the value of the equity of Philip Morris Companies, Inc. would have equaled approximately $200 billion compared to the market value of the equity as of that time which was $108.7 billion. Goldman Sachs attributed this large difference to the market’s allowance for the uncertain tobacco liabilities.

Litigation-related liabilities are but one form of relevant information that markets consider when determining equity values. Increases in such liabilities due to punitive damages may cause stock prices to decline adversely affecting shareholders. Markets tend to be somewhat efficient (with exceptions) in processing of relevant information.

While shareholders may lose some or all of the value of their investment, they are generally not involved in the decision making process that may have led to the award. Some may 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 sizeable stock positions (see Pound 2003). Given the expected shareholder wealth effects, it may be useful for juries to be made aware of these effects which affect shareholders regardless of whether the shares are owned directly or indirectly through institutions.

Regional Economic Effects

Other corporate stakeholders may include communities where the defendant corporations do substantial business. These communities may be recipients of tax receipts and charitable contributions. For smaller communities with a less diversified economic or industrial base, changes in the level of these expenditures can have a significant impact of regional economies. In such communities plant closures can cause dramatic adverse effects such that might be manifested in rising unemployment and declining regional output. Increases in costs caused by large litigation liabilities may cause companies to shrink the size of their work force. This occurred in 2002 when ABB, the large European conglomerate, announced that it was eliminating 12,000 jobs, over 7% of its workforce, as a result of the combined pressure of litigation expenses along with a weak economy and its debt burden ( 2002). Displaced workers may be forced to try to replace higher paid manufacturing jobs with lower paying and compensating position (Patch 1995). These effects may be more pronounced during weak economic times when there are fewer opportunities for workers to mitigate their damages due to a soft employment market. If unionized manufacturing jobs are lost they may be replaced by lower paying service positions (Ehrenberg & Smith 2000). An example of such concentrated regional economic effects occurred in communities such as Allentown and Bethlehem, Pennsylvania when the steel industry contracted and companies were forced to lay off workers and close plants decline (Strohmeyer 1994).

The other spillover effects on stakeholders can occur if the costs of the litigation cause a defendant corporation to downsize or limit expenditures it would have devoted to other stakeholders such as communities (such as in the form of charitable contributions). Macroeconomic theory shows that such cutbacks in expenditures will have total adverse effects that are a multiple of the original reduction. Such expenditures are explained in major principles of economic textbooks in the contest of Keynesian expenditure multipliers (see Samuelson and Nordhaus 1998). Insofar as the affected corporations may be regionally concentrated, these adverse effects would also be more concentrated within a region. Regional expenditure multipliers which attempt to measure the aggregate impact of expenditures may be used to quantitatively measure the total adverse impact that a cutback in corporate expenditures might have. These multipliers try to measure how many dollars are ultimately spent when a given dollar is spent. Economic models exist which attempt to measure the magnitude of such multipliers ( Rickman and Schwer 1995). Such multipliers may be one tool that can be employed when trying to measure the adverse impact a reduction in expenditures caused by cutbacks in the wake of a significant punitive award may have.


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 increases in cigarette prices in response to the “Master Settlement Agreement Between the States and the U.S. Tobacco Producers” (1998) and its billion dollar payments . In the pharmaceutical industry, research has also showed how drug prices are higher in a more active litigation environment (Manning 1997). Price increases brought on by litigation-related costs are similar to per unit or excise taxes which microeconomic theory has shown to be a form of regressive taxation. “Taxes on tobacco and alcohol are examples of regressive taxes, since poor individuals spend a larger fraction of their income on these goods (Stiglitz 1997).” 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 may increase in response to cost increases by producers will be determined by the price elasticity of demand for the products as well as by other factors. With an inelastic demand, prices may increase with a comparatively smaller quantity decrease while with elastic demand, quantity demanded will respond comparatively more. Economists have long established that 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 (Taylor 1998). It is also normal that the price elasticity of demand tends to be higher in the long run than in the short run (Parkin 2000). 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 is 0.70 — both of which are in the inelastic range (Grossman 2001). However, these estimates were drawn from a different world in which prices were lower and quantity demanded was less elastic than it now appears to be.

The time dimension of the price elasticity of cigarette demand is quite apparent when considering the responsiveness of quality demanded to price changes caused by the MSA and tax increases. The initial responsiveness was relatively sluggish but consumers did adjust and this adjustment process did have an adverse effect on the major cigarette manufacturers. Initially, presumably due to the inelastic nature of the demand for the product, sales of cigarettes declined but 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 purchase lower cost cigarettes from smaller manufacturers (Fairclough 2002). While at the time the Master Settlement Agreement was signed the major cigarette manufacturers commanded a market share in the high 90s, 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 precise price effects and impact on consumers. Data on historical elasticities may not be that helpful if prices change significantly and we move into a new, more responsive or elastic part of the demand curve (assuming the curve does not shift due to other factors) However, juries need to understand that when a company’s costs change they may have to adjust their prices and possibly their level of business activity. Punitive damages are a cost and corporations have to respond to changing costs. These price effects may 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 be enlightened about through economic expert testimony.

Punishment of Corporations and Focusing on the Wrongdoers

Having discussed the nature of corporations, which are broad entities composed of different groups of stakeholders, it is not hard to understand that the use of such a blunt tool as punitive damages may fail to inflict punishment on the wrongdoers. This is not a novel concept as it has been debated in law journals for decades (Coffee 1980). As noted earlier, the parties responsible for the wrongful acts that caused the harm could be middle level managers who may even have long left the employ of the corporation prior to a trial. It may even be the case that the upper management of the company was not aware of the actions of these employees.

The problem of isolating the wrongdoers becomes even more complicated when ones considers the turnover of employees. Employee turnover has increased greatly over the past few decades. This is even true for upper managers and directors. Brickley showed that the average tenure of a chief executive is eight years (Brickley 1999). A recent Booz Allen Hamilton (2003) study provides some evidence that the rate of CEO turnover may be accelerating. Hermalin and Weisbach (1998) showed that the average tenure of corporate directors is nine years. Given the length of time between a wrongful act that results in a lawsuit and the date of trial, it is quite conceivable that many, if not all of the wrongdoers, are not even with the company at the time of trial. Plaintiffs who seek punitive damages may not even care if the individual wrongdoers are pursued as they may only seek an outcome that yields the greatest financial payout. In such instances, however, punitive penalties will be paid by those other than the wrongdoers.

The imposition of punitive damages may not hurt the wrongdoers but may cause various stakeholders to pay a financial penalty for actions they had no part in. This problem is particularly true in cases where there is a long lag between when the alleged wrongdoing has occurred and the trial. A jury should be made aware of the expected effects so as to make an enlightened judgement.

Deterrence Theory and the Changing Litigation Environment

The role of the probability of detection and deterrence theory was analyzed at length by Polinsky and Shavell (1998). Their approach to computing a punitive penalty is not new and can actually be traced to Jeremy Bentham(1881) and the Utilitarians. 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.

Since 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, was 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 such reasoning they expressed a total damages multiplier and a punitive damages multiplier as follows:

(1) Damages Multiplier: = (1/p)
where H = harm caused, p = prob of being found liable and D = total damages

(2) D = H/p = H (1/p)
while the Punitive Damages Multiplier = [(1-p)/p]

The probabilities of being detected and found liable may be different at the time the wrongful act was committed and the trial. This lag can be many years. If a jury is attempting to assess the deterrence effects and utilize a Polinsky – Shavell type of probability analysis, it would be useful to differentiate between ex ante and ex post probabilities. The ex ante probability would be 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 reason in this manner), the ex-post probability 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 although punishment is backward looking (Ellis 1982). To the extent that the litigation environment has changed during the intervening 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 evident with the spate of new asbestos cases, along with other prominent examples such as the recent high profile pharmaceutical industry lawsuits, give weight to such a conclusion as least in certain litigation markets. An aggressive, organized and well financed plaintiff’s bar stands ready to attack potentially liable deep pocketed defendants (France 2001). 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 following section 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. Its not like they 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 (Berenson 2003).

The probability analysis makes for an interesting economics discussion but some research implies it may be less relevant from a practical viewpoint. Using a sample of 500 jury eligible citizens, Professor W. Kip Viscuisi (2001) has showed that sample juries failed to properly apply probability based negligence rules. This is not surprising as many juries may not have any exposure to probability theory.

Deterrence: Comparing Gains and Losses

In mass torts a company may make payments in many of thousands of lawsuits it faced. Some have even paid billions of dollars in settlement payments. For example, as of 2003, Wyeth had paid in excess of $14 billion in connection with its diet drug litigation (Wyeth 2002). As part of the evaluation of the deterrence effects a jury may want to consider the costs of the litigation, including settlement payments and other costs including legal fees etc., compared to the gains the defendant made from the product. These gains would normally be the profits the company derived from the product. It may be the case in some mass torts that the gains may be small compared to the costs that the company incurred. In addition, the costs may involve more costs than merely the direct litigation expenses. Other costs, such as adverse publicity and tarnished reputation may be quite significant (Karpoff and Lott 1999). These costs will be discussed separately later in this paper.

It may be the case that a simple comparison shows that the costs far outweighed the gains. Corporations try to avoid projects that pay rate of return less than threshold levels such as the cost of capital (Keown 2002). Generating losses are an obvious problem. This serves both specific and general deterrence in that other companies seeing the defendant made investments that were costly in several ways would obviously not want to replicate such errors

Deterrence and Regulatory Processes

We have discussed how punitive is a very imprecise tool to use to try to achieve deterrence. It can have significant adverse effects while possibly providing little assurance that the guilty individuals will be punished. Still a jury may want know that the defendant is deterred from engaging in similar behavior in the future. A major step in its deterrence evaluation process should be to consider the regulatory processes that may be in effect in the industry.

Regulation can be internal and external. Internal refers to the steps that the defendant has taken to make sure it will not commit the same acts in the future. Presumably, the defendant may present testimony to this effect at trial assuming that it does not deny engaging in the wrongful acts. It is also possible that the defendant might put forward a defense that it did not engage in the acts but that it has taken measures to make sure that such acts would not be committed in the future.

In addition to internal steps, a defendant may be operating in an industry that is subject to significant external controls. An example of an industry where such controls are in place is the tobacco industry. Under the Master Settlement Agreement, the marketing activities of the tobacco industry are overseen by the National Association of Attorneys Generals (NAAG). NAAG has a specific tobacco committee which monitors the industry and is empowered to take aggressive legal actions if it determines that the companies have violated the MSA. (While NAAG closely monitors the marketing activities of the major tobacco companies it appears that some of the smaller manufacturers seem to have at times “fallen through the cracks.)” If a jury wanted to deter one of the major tobacco companies from engaging in improper marketing activities in the future, it should consider that NAAG would be better able to prevent such actions than a jury. The jury would have to evaluate whether an additional punitive penalty for an act that may have occurred many years before, in addition to the billions of dollars in payments that this industry has and will have made through the MSA, would add to the deterrence already in place. In addition, the jury would have to also consider the other organizations, such as health-related and anti-smoking organizations, that monitor the industry, and determine if a punitive award would add deterrence that internal controls, NAAG and these various groups does not already provide.

Some industries are closely regulated while others are not. The insurance industry in the United States, which has been the targets of many lawsuits, is an example of a closely regulated industry. Insurance companies must be authorized to do business in each state 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 (Black and Skipper 2000). An example of how such regulatory processes work much better than attempted deterrence through the court system is the many vanishing premium lawsuits that have been brought against life insurance companies. 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 not sufficient. By the time many of these lawsuits worked their way to the trial stage, the problem, to the extent that it ever did exist, an issue which is disputed by defendants, was already dealt with by the regulators of the industry. The National Association of Insurance Commissioners puts forward model regulations which tend to be 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 sales people 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 which 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. Some are unregulated while others are closely regulated. In light of the fact that regulators may be able to effectively accomplish deterrence, 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.

Deterrence and Punishment and Mergers and Acquisitions

A record number of mergers and acquisitions occurred in the fifth merger wave. This wave began in approximately 1993-1994 and ended approximately in 2001 (Gaughan 2002). In acquisitions an acquirer typically adds the assets while assuming the liabilities of the target corporation. Unfortunately, some of these liabilities, such as off balance sheet liabilities involving litigation obligations, are difficult to predict and even foresee. These contingent liabilities can be so difficult to predict that they may not be carried on the balance sheet as a known liability. It may only be years after an acquisition that the liability becomes more fully known and quantifiable. The potential of looming off balance sheet liabilities was discovered in the 1990s when various acquirers become a target of a whole new wave of asbestos lawsuits. Some of them were forced into bankruptcy as a result of these acquired liabilities. One example is Halliburton Corporation which filed for Chapter 11 bankruptcy protection due to asbestos liabilities its assumed which it acquired Dresser Industries in 1998 for $7.7 billion. The byproduct of this acquisition was 200,000 asbestos claims (Clark and Woellert 2002). Another example of huge acquired asbestos liabilities is McDermott, International, Inc. which incurred them through its acquisition of Babcok & Wilcox. Still another example of a company which inherited large litigation-related liabilities is ABB, the Zurich-based international conglomerate. It inherited these asbestos liabilities as a result of its $1.6 billion acquisition of Combustion Engineering in 1990 (Wall Street Journal 1989). Ironically, ABB sold Combustion’s operations in 200 0 but was forced to still bear the liabilities for that company’s asbestos exposure. While punitive damages may often be inappropriate for companies not involved in acquisitions, it may be even more difficult to justify in the case of acquired entities. The management of the acquiring entity may have no knowledge of the actions that may result in these lawsuits in the future. In addition, it may never have engaged in alleged acts and thus may not need to be deterred. However, if punitive damages are imposed, the acquirer’s stakeholders may be punished while the acquirer may have no responsibility for the wrongful acts.

When a lawsuit is pursued against a acquirer which has merged the target into its operations, the plaintiff may seek to substitute the financial resources of the acquirer for the target and to use the acquirer’s assets as some type of indicia or gauge for the magnitude of punitive damages. If this is allowed, the magnitude of punitive damages could be far greater if a target is acquired by a large “deep pocketed” corporation. How can it be reasonable to have one level of punitive damages if the company remains independent and another, far greater, level of punitive damages if this corporation is acquired? Clearly, the acts of the wrongdoers are the same and the magnitude of the harm, for which compensatory damages has presumably fully compensated the plaintiffs, is invariant. The only factor that differs is the resources of the two corporations. Such an outcome makes little sense.

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 (Frank et al. 2001). While many punitive damages statutes discuss net worth, the simplistic application of net worth can often be of little value to a jury, and at times, can actually be very misleading.

In State Farm Mutual Automobile Insurance Co. v. Campbell at al. the U.S. Supreme Court addressed the introduction of the net worth of State Farm in the determination of punitive damages. The Court had already expressed concerns reservations about this issue 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).” In Campbell the Court expressed reservations about the use of evidence on a defendant’s wealth when it stated that “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.” In addressing the plaintiff’s attempts to introduce the wealth of the defendant, the Supreme Court expressed concern that the wealth of a large corporate defendant could bias the jury and possibly result in an award that bore little relationship to the actual harm caused. If the wealth of a defendant is allowed to be a factor for the jury’s consideration, it could lead to a situation where we have higher punitive/compensatory multiples for larger defendants versus smaller ones. Such a result could compound the problem that the Supreme Court in Campbell was concerned about – multiples greater than single digits.

Net Worth

Net worth is the difference between the value of a company’s assets and liabilities on its balance sheet (Moyer et al. 2003). Balance sheets are not prepared for the purposes of serving as a guide for juries to assess punitive damages. They show the assets of a company and the claims on those assets in the form of both debt and equity claims. The assets include both tangible and intangible assets. Intangible assets are assets that does not possess physical substance (Weygandt et al. 2003). Within the intangible category are assets such as 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 that and the total purchase price of the company (Pratt 2003). Clearly, it is very difficult for a defendant to use goodwill or other possibly other intangible assets to pay a punitive penalty. 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 that a defendant that could use 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 2 shows that in 2001 the net worth of AOL Time Warner equaled $152 billion (Annual Report of AOL Time Warner 2002). Of this total $127.4 billion was goodwill which represented. By 2002 shareholder equity had fallen by approximately $100 billion. Most of this decline was a decrease in goodwill which had fallen to $37 billion from $127.4 billion! Accounting principles and policies required that companies regularly revisit goodwill to determine if an impairment exists (FAS 142). AOL Time Warner responded to the adoption of the accounting rule change enacted in January 1, 2002 which requires that a company regularly monitor its goodwill and determine if an impairment exists. If such an impairment exists, as defined by determining of the carrying value of the goodwill is greater than its fair market value, then the company is required to take an impairment loss. As part of that evaluation, AOL Time Warner took a change of $54.199 billion when the rule was first enacted and than anther charge at the end of that year equal to $45.538 billion.

Table 2 AOL Time Warner Inc.
Consolidated Balance Sheet

It is generally assumed that the goal of punitive damages is not to put the defendant out of business. Indeed, the Fifth Circuit in Jackson v. Johns Manville Corp (1984) expressed concerns that punitive damages could result in the destruction of the corporate defendant. 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, for AOL Time Warner, property, plant and equipment equal approximately $12.15 billion – almost a quarter of unadjusted total shareholder equity.

Net worth is not designed for being a gauge by which a jury can determine punitive damages. However, in spite of its obvious flaws, other measures that are 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 put forward by plaintiffs as an alternative to net worth. One of the appealing features it has for plaintiffs is that it may be an even greater value than net worth. As an example, Table 3 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 Table 3 market capitalization was 253 percent higher than net worth as of December 2002. Part of the reason for this difference is that assets are not recorded on a company’s balance sheet at market values. However, another reason is that market capitalization reflects the market’s evaluation of the company’s ability to generate earnings and cash flow in the future. It is very influenced by the state of the market which, in turn, can vary considerably. As far as the determination of punitive damages is concerned, market capitalization is even more flawed than net worth.

 Table 3 Current Components for Dow Jones Industrial Averages –
as of December 2002

Note Difference (%) shows how much higher the Market Cap is over Net Worth Average
Net Worth (= Stockholders’ Equity) is taken from the company’s balance sheet (4th Quarter)

The most fundamental flaw of market capitalization as a gauge for a jury to consider in determining punitive damages is that it is not an asset of the corporation. Market capitalization is the value of the total outstanding equity of a public company at a moment in time. A corporate defendant does not own this asset. Instead, it is a claim that equity holders have against the future gains of the company. Earlier in this paper we have already discussed the fact that shareholders may not have any responsibility, or possibly not even 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 usefulness of market capitalization becomes totally inappropriate.

Another flaw of market capitalization, which was quite apparent in the AOL Time Warner example, is that it is not a stable measure. While the number of shares outstanding is often relatively stable, market capitalization varies with the movement in share prices. The significant variability of share prices is well known (Barsky and DeLong 1990). The relevance of this to punitive damages is that if a punitive award is based upon an unstable measure of wealth, we could have widely varying amounts of punitive damages depending on what the market capitalization is at the time the measure is presented to the jury. As an example, lets us say the Schering Plough Corporation has been found liable for punitive damages and the jury chose to base the amount of the award on the market capitalization of the company as of April, 2003. The amount of the award would be very different from the value that prevailed for the prior year. This is shown in Figure 2 which reveals that stock price of Schering had fallen from $32.81 on March 1, 2002 to $17.53 just a year later – a decline of almost 50%. Some of this decline can be attributed to a decline in the market and the drug sector, in particular, and another part is attributable to company-specific factors. This decline in the value of the stock implies that if the trial were held in the first quarter of 2002, the jury would be using a substantially higher gauge to determine punitive damages than what would prevail if the trial were delayed a year. The example of AOL Time Warner is even more extreme where the company’s stock price fell from $51.25 in January, 2001 to $10.85 by April, 2003.

Using market capitalization as a gauge for punitive damages can result in one level of award when the market is up or when the market, perhaps incorrectly, is optimistic about a company’s prospects, and another very different award when the market is down or investors are just not as keen on a particular company. Clearly, market capitalization fails in possessing one very desirable quality – stability. This assumes, however, it were an appropriate measure to start off with which it is not.

Figure 2: Stock Prices of Schering-Plough: 2002 – 2003
Source: Historical Prices from Yahoo Finance.

Still another flaw of market capitalization lies in the anticipatory nature of market’s internalization of new information. When a significant award is made, the market will react to the news of the verdict (if it had not already anticipated it) and the stock price would fall depending on the magnitude of the verdict. An example was the recent decline in the price of Altria’s stock in response to the aforementioned Miles verdict (Susan Miles et al. v. Philip Morris Companies, Inc. 2003). The decline in the stock price around that announcement date is shown in Figure 3.

Once the news of an adverse punitive verdict reaches the market, the declining stock price causes the company’s market capitalization to be significantly lower after the announcement. This means that on the date that the company would have to make the payment, market capitalization is lower than the value that the jury might have used to reach the verdict. If market capitalization were to somehow reflect a company’s wealth, which it does not, the defendant it would be significantly less wealthier after a significant verdict than before.

For corporate subsidiaries, market capitalization poses even further problems. A parent company may “hold” several corporate subsidiaries. The parent company’s stock represents equity claims to the earnings and cash flows of its various subsidiaries. A subsidiary of a public company may not have a separate stock price. In some instances, the company may have issued a tracking stock which is stock which tracks the performance of a specific subsidiary that remains a part of the parent company. For example, AT&T issued the largest stock offering in U.S. history when sold $10.6 billion in AT&T wireless tracking stock in April, 2000 (Smart et al. 2004). However, most companies do not have tracking stocks. It is the norm that a subsidiary does not have a separate stock and thus does not have its own 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 was otherwise appropriate which it is not.

Comparisons to the Finances of Individuals

Another approach put forward by some experts retained by plaintiffs is to compare a proposed punitive penalty to the impact of a fixed fine on an average household (Dillman 1993). The median household income and wealth are often derived from surveys that are conducted by governmental entities such as the Federal Reserve Bank Survey of Consumer Finances (2001). The approach that is sometimes used is to consider the impact of a specific monetary penalty, such as $100 or $1,000 on a household’s wealth. The percentage of household wealth that these amounts constitute is then applied by some plaintiff witnesses to the net worth of the defendant corporation. Some assert that it is analogous to “common size statement” analysis that is done in corporate finance (Dillman 1993). The appeal of this for plaintiffs who are suing larger corporate defendants is that amounts of money that a typical juror would consider large, appear relatively small when compared to a defendant’s net worth or annual income. Plaintiff’s attorneys would then tell the jury that they need to come up with a larger amount in order to cause the corporation to “feel the same pain” that a household would feel if it were fined a certain percentage of its net worth. The problem with this exercise is that while computational easy, the comparison of the finances of a corporation to that of a household is irrelevant and misleading. Corporations are far more complex structures than families. As we have already discussed, major corporations involve the complex interactions of various different stakeholders – many of whom are far removed from the decision making process. Corporations operate in a competitive world where they compete with other companies for market share and maintain resources so as to retain and enhance their competitive position. They engage in many other activities, such as acquiring other corporations, that while significant to corporate America, only highlight the stark differences between corporate structures and families.

Even the data for family finances that is used to compare with those of a corporations are misapplied. The data from the Survey of Consumer Finances lacks the reliability of data on corporate financial statements that underwent an audit process. The Federal Reserve has grappled for years with the reliability of its data which are derived from voluntary surveys with respondents who are sometimes asked to provide instant recall to complex questions about their finances, such as what is the value of a business they may own (Kennickell 2002). Respondents may simply not know the answers to the questions and others may not want to respond accurately. Obviously, data gathered through an accountant’s auditing process is of very different quality. The comparison of the two inherently different data sets make for a very misleading result. The Survey of Consumer Finances was designed for other research purposes, such as telling the central bank about trends in banking and savings behavior of households. It may serve this purpose well, but will fail when it is misapplied to a purpose for which it was never intended.

Reputational Costs

Corporations usually work to develop a positive image in the marketplace. Towards that end they may devote significant expenditures in public relations. This is based upon the belief that having a good image in the market and being considered a “good citizen” is good business. Conversely, having a negative image creates a more difficult sales environment. Being the target of punitive damages claims, whether legitimate or not, carries with it costs beyond the merely the direct monetary penalties the defendant faces. These costs have been documented in various research studies. Karpoff and Lott (1999) have shown that such costs can be substantial. They measured them by examining the stock market declines around the announcements of suits involving punitive claims. They found that the market declined by more than what could be explained by compensatory and punitive damages awarded. They had conducted earlier studies which showed how reputational penalties are reflected in stock market declines (Karpoff and Lott 1993). Other economists have found that media coverage of punitive verdicts was skewed. Steven Garber (1998) found that coverage of punitive verdicts was higher the greater the size of the award while defense verdicts garnered virtually no newspaper coverage. The same was true when large awards were reduced – the reductions received minimal coverage. Given the orientation of the media in its treatment of punitive damages, companies have great incentives to try to avoid being the target of such suits.

The Uncertain Litigation Environment

Another interesting aspect of the litigation market is that companies are often 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 upon their best estimates of the magnitude of the litigation-related exposure. As discussed earlier, such liabilities are referred to as contingent liabilities and accounting rules require that they be accrued when they are highly probable and estimable (Pratt 2003). Specifically the Financial Accounting Standards Board states that the following factors should be considered whether an accrual or disclosures of a litigation liability is necessary:

a) The period in which the underlying cause (i.e., the cause of action) of the pending or threatened litigation or of the actual or possible claim or assessment occurred.

b) The degree of probability of an unfavorable outcome.

c) The ability to make a reasonable estimate of the amount of loss.”(FASB No. 5)

Some firms have attempted to apply sophisticated statistical analysis to calculate litigation reserves (Allen and Savage 2003). One assumes that a public company’s financial statements represent their best estimates, however, the number and outcome of current and future cases, is often quite uncertain. This became particularly true in the 1990s and early 2000’s when the volume of certain types of cases grew dramatically. A notable remarkable example is the asbestos lawsuits (Olson 2003). A settlement was entered into on January 15, 1993 that was supposed to include all future claims against the entity founded by the asbestos defendants – the Center for Claims Resolution (Georgine v. Amchem 1993). 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. Following this decision and the onslaught of asbestos suits, many previously healthy companies were forced to file for Chapter 11 bankruptcy. Table 4 shows that the lists of companies filing Chapter 11 due to asbestos liabilities include some of whom are leading names in American industry.

Table 4: Selected Asbestos Chapter 11 Filer

While the asbestos defendants thought they had the litigation problem contained through the Georgine settlement, the uncertainty of litigation is underscored by the dramatic reversals that this litigation took. For companies facing mass tort lawsuits, the outstanding volume of litigation and the potential impact this may have on the health of the company is a factor that should be consideration 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 can be found in Owens Corning Fiberglas Corporation v. Roy Malone et al (1998). In this case the Supreme Court of Texas agreed with the trial court and the court of appeals in concluding the a punitive award would not have an adverse effect of the financial health of Owen Corning. 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.

The court considered what the defendant itself stated 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 defendant states it can survive, how is the court able to conclude otherwise? However, in retrospect, both were wrong. Armed with hindsight now that the company and Texas Appeals Court did not have at the time, we know that such reasoning was incorrect. The lesson we can take form this is that in spite of optimistic statements a company may make in its filings and submissions to shareholders, the company may not be able to accurately assess the potential exposure from future lawsuits – particularly when there are many of them outstanding. The world of litigation has becomes so difficult to predict that it is very hard to forecast what the future litigation volume will be. However, at a minimum, we can conclude that the jury should at least be able to 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

Apportionment and Punitive Damages

In addition to considering the outstanding volume of cases, it may be misleading to present to a jury in a particular venue the total value of whatever financial measures are to be presented. For example, if the defendant is a corporation that does business throughout the United States but not abroad, and is subject to lawsuits for mass torts throughout the United States, considering the full value of the various financial measures, such as total corporate net worth, may in the aggregate lead to a consideration of financial values well in excess of the company’s total financial resources. One way to attempt to deal with this problem is to apportion the financial values to fit the volume of business in the venue where the litigation is centered. This may mean that the defendant in a state-wide class action presents a percent of the total measures, let us say net worth (assuming for the purposes of this example that unadjusted net worth were an appropriate measure), that represents that share of the defendant’s total national business that the state comprises. The U.S. Court of Appeals for the Ninth Circuit agreed that apportionment was appropriate in White v. Ford Motor Company (2002) where the court concluded that the jury should only consider the business in the State of Nevada as opposed to the national sales of the product in question. Experts need to be aware that this percentage may vary over time. Therefore, they may need to evaluate more than one year of data when putting forward a percentage.

The apportionment process becomes somewhat more complicated when the venue is not a state, such as in a state-wide class action, but is a more narrowly defined case involving an individual or group of plaintiffs. Here there may be basis for more narrowly defined apportionment.


The issue of punitive damages continues to be hotly debated. This is the case even though punitive damages are awarded in only a small minority of lawsuits. Some assert this is 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.

Courts have been clear that the twin purposes of punitive damages is punishment and deterrence. However, the pursuit of these goals for corporations as opposed to individuals can be very different simply because corporations are very different than individuals. Corporations are a grouping together of various stakeholders. These stakeholders may be affected very differently by a punitive verdict. Examples of such stakeholders are stockholders, employees, consumers, suppliers, and communities. Punitive damage awards are a cost like any other cost that a company may face. Increased costs can have ripple effects on the stakeholders. A jury should be made aware of these expected economic impacts prior to rendering a verdict.

When evaluating the expected deterrence effects of a punitive damage award, a jury should consider the other deterrence that may already be in place. This may include both internal and external deterrence. Internal deterrence refers to the steps the defendant may have taken to prevent outcome such as that which is at issue in the lawsuit. External deterrence considers the regulatory processes that may be in effect at the time of the trial. While punishment is backward looking, its effects are forward looking. Deterrence, however, is forward looking.

Plaintiffs often put forward certain financial measures for a jury’s consideration in determining punitive damages. They may include measures such as a corporation’s net worth. However, the use of these measures can be quite misleading as they may imply to a jury a greater ability to pay a judgment that a company may actually have. If such measures are deemed to be appropriate, at a minimum they should be adjusted for components such as goodwill and other intangibles.

The outcome of litigation and its impact of a corporate defendant can be quite unpredictable. This is particularly the case for defendants in multiple tort actions. While punitive damages may be designed to punish and deter, it is generally agreed that it is not intended to destroy a corporate defendant. However, what level of damages, especially in light of the volume of additional lawsuits, will force a company into bankruptcy is often difficult to predict.

Punitive damages may involve more costs than the 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 may not necessarily seem them go away if awards are reversed on appeal.


  • It should be noted that Halliburton’s stock price had been declining since May 2001, when the stock price was as high as $49.25, due to not only asbestos liabilities but also to a general market decline as well as due to fallout from the Enron debacle. However, the sharp decline on December 7, 2001 can be more directly attributed to the recent asbestos verdict.
  • Since the issuance of that report Philip Morris Companies, now Altria, has merged its Miller Brewing to subsidiary into the South African Brewing Company to form SABMiller plc.
  • There is abundant literature in corporate finance on market efficiency which refers to the speed with which markets process and respond to relevant information. There is still a wide debate in finance as just how efficient markets are and to what extent there exist market anomalies or exceptions to market efficiency.
  • The acquirer may be insulated from such exposure through its corporation structure, depending on how the deal was structured. This is often topic of debate in the litigation.
  • The stock price trends of Schering-Plough are used as an example to show the variation in a company’s equity values. No separate investigation has been done on the source of this equity variation.


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