Damage Control

Originally appeared in The Wall Street Journal Wednesday, December 11, 2002.

America’s tort system has become one of the most costly and inefficient methods of dispute resolution in the world, raising the costs of goods and services while reducing the availability of important products in the marketplace. All told, the legal system’s direct costs are more than $180 billion annually, roughly 2% of GDP. Furthermore, less than half of the money spent on tort litigation goes toward compensation. The bulk of the costs are administrative and legal fees. Today the Supreme Court will hear oral arguments in Campbell v. State Farm, a case that has the promise of restoring a sense of rationality to the legal system.

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When State Farm refused to settle a third-party claim against its customer, a lawsuit began that ended with the Supreme Court of Utah allowing a $1 million compensatory damage award to stand, along with $145 million in punitive damages. Rather than evaluate the need for punitive damages based on the case at hand, the plaintiffs painted a picture of State Farm’s actions over a 20- year period, not just in Utah and not just in third-party liability cases. This total disconnect between the alleged harm to the plaintiff and the damages awarded thus provides a unique opportunity to assess the state of damage claims in today’s legal system.

More specifically, plaintiffs accused State Farm of an elaborate nationwide “scheme” to generate profits at the expense of all consumers in every state. Aside from the real constitutional concerns of a state court in Utah overriding the legal and regulatory authority of other states, the ruling abandons any attempt to link damages to the harm done. Instead, the case exemplifies the arbitrary nature of today’s tort system. Should the decision stand, any actions by a business — even lawful activities totally unrelated to a given case — can justify a damage claim.

Ideally, the tort system should perform two functions: compensate victims and deter potentially dangerous behavior. The structure of damage awards should reflect these goals, with compensatory damages to ensure victims are made whole, and punitive damages that can be assessed to discipline bad actors. If these principles are applied correctly, torts are minimized, because any benefits of such behavior would be eliminated by the expected costs of the damage award. When awards are too low, bad actors are not deterred, and the number of accidents will be too high. Awards that are too large pose problems as well, as costs increase and products are no longer available. When awards are arbitrary, it becomes impossible to discern any relevant incentives from the pattern of damage awards, leaving businesses only to guess at what business practices will not instigate damage claims.

Unfortunately, the Campbell case has so far served to further separate behavior and damages, limiting any meaningful application of damages. Under the precepts established by the Utah courts, whenever a business steps into a courtroom, its general behavior as a corporate citizen, rather than a specific complaint, establishes the basis for punitive damages. General expansion of such an approach would complete the tort system’s transformation from a venue for dispute resolution to a tool for social justice and income redistribution. Needless to say, the uncertainty of such decisions provides no instruction for defendants or plaintiffs that would alter behavior in ways to reduce the number of cases that could be brought.

The vexing problem of scattershot damage awards is not new; the Supreme Court attempted to establish guidelines for punitive damages in the notorious Gore v. BMW, where a dispute over a $4,000 paint job generated a $4 million punitive damage award. In reversing the decision, the court found the punitive damage award excessive and recommended a proportionality between compensatory damages and punitive damages.

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In the Campbell case, punitive damages are 145 times greater than compensatory damages, clearly lacking any true sense of proportionality. The Supreme Court now has another opportunity to address the question of excessive punitive damages. Beyond the question of proportionality, the court can offer guidelines that define the parameters used to determine damage awards. This would be an important step forward, injecting rationality into the process of assessing damages and establishing a degree of certainty that will provide all parties greater incentives to avoid harmful or dangerous behavior.

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Mr. Gray, White House counsel to the first President Bush, is a Washington lawyer and chairman of Citizens for a Sound Economy.