THE SHADOW EFFECT OF PUNITIVE DAMAGES ON SETTLEMENTS THOMAS KOENIG* I. Introduction . .............................. 170 A. The Tort Reformers' View .................. 172 B. The Plaintiffs' Attorneys' View ............... 176 II. The Impact of Punitive Damages on Pre-Verdict Settlements 178 A. Research on Punitive Damages Claims ........... 178 B. Florida . ............................... 178 C. California . ............................. 179 D. Alabama . .............................. 180 1. Professor Priest's Study of Alabama Claims ..... 181 2. State-Wide Data on Alabama Punitive Damages Filings ................. 182 E. Texas Public Policy Foundation Study ........... 184 F. Texas Department of Insurance Closed Claim Study... 187 1. Methodology . ........................ 187 2. Texas Verdicts . ....................... 189 3. Punitive Damages Settlements Under $25,000 ... 190 4. The Shadow Effect in Larger Settlements ...... 192 5. The Shadow Effect By Type of Injury ........ 195 6. The Financial Impact of Texas Tort Reform ..... 197 G. ISO 27-State Study ........................ 201 III. Studies of Post-Trial Dispositions of Punitive Awards ..... 202 A. RAND's Study of Post-Verdict Settlements ........ 202 B. Landes and Posner Study ................... 204 C. GAO Study ............................. 205 D. Post-Verdict Adjustments of Product Liability Awards 205 E. Post-Verdict Adjustments of Medical Malpractice .... 207 F. The Washington Legal Foundation Study ......... 207 IV. Conclusion ............................... 208 * Thomas H. Koenig, Professor of Sociology and Law, Policy and Society doctoral program, Northeastern University; B.A., University of California at Santa Cruz, 1971; Ph.D., University of California at Santa Cruz, 1979. I wish to thank Paul Vestal and Clare Pramuk of the Texas Board of Insurance's technical analysis division for providing statistical information utilized in this Article. Professor Michael Rustad also provided valuable data and invaluable comments. WISCONSIN LAW REVIEW I. INTRODUCTION For the past decade, the punitive damages debate has focused on the frequency, size, ratios and predictability of verdicts.' Tort reformers argued that punitive damages verdicts, particularly in personal injury cases, were a lottery which threatened American competitiveness by crippling United States corporations. Academic researchers testing these claims have consistently concluded, in contrast, that punitive damages verdicts are rare, predictable, employed responsibly, and subject to vigorous post-verdict review.2 Recent empirical research finds that "[flar from picking numbers out of the air, jurors and judges across dozens of jurisdictions and many case categories determine punitive damage award levels with a startling consistency." 3 However, the fact that large punitive damages are very unusual is of little comfort to risk-averse business executives who worry that their firm might be an exception to the general pattern. Fear of the occasional runaway jury may lead to an inflated settlement.' 1. See generally Marc Galanter, Real World Torts: An Antidote to Anecdote, 55 MD. L. REV. 1093 (1996) (reviewing empirical studies on punitive damages); Michael Rustad & Thomas Koenig, The Supreme Court and Junk Social Science: Selective Distortion in Amicus Briefs, 72 N.C. L. REV. 91 (1993) (discussing and evaluating dueling studies of punitive damages). 2. See Michael L. Rustad, Unraveling Punitive Damages: Current Data and FurtherInquiry, 1998 Wis. L. REv. 15; see also Theodore Eisenberg & Martin T. Wells, Punitive Awards After BMW, a New Capping System, and the Reported Opinion Bias, 1998 Wis. L. REV. 387. 3. Theodore Eisenberg et al., The Predictability of Punitive Damages, 26 J. LEGAL STUD. 623, 649 (1997). The authors note: This result may surprise both defenders and critics of punitive damages. Much of the recent debate about award levels focuses on whether the frequent appellate reductions of punitive damages are a sufficient check. Defenders claim that posttrial and appellate reductions impose a rationality on award levels while critics assert that such review is insufficient. Our data, which consist of judgments entered by judges after jury verdicts, suggest an essential rationality and connection to compensatory damages at the trial court level. Id. (citations omitted). 4. Senator Orrin Hatch, in hearings to examine the effect of punitive damages on the legal system, noted: [M]any critics of the current system argue that punitive damages are often awarded haphazardly and excessively. Some say that large punitive awards are an important factor in the decline of our civil justice system. In fact, the very risk of bloated awards can scare defendants into settling for excessive sums rather than risking the determination of an unsympathetic jury. The costs of excessive punitive damage awards or unnecessary settlements ultimately are passed on to the consumer; in effect, to each and every one of us as Americans in the form of higher prices for the products 1998:169 Shadow Effect of Punitive Damages 171 The punitive damages debate is now shifting from disputes over verdicts to the "shadow effect"' of the remedy-the use of punitive damages verdicts as a reference point for parties bargaining over settlement dollars in the "shadow" of the law.6 Since ninety-seven percent of all cases settle out of court,7 an understanding of punitive damages awards is of less practical significance than knowledge of the impact of these verdicts on claim settlement.' This Article will review the existing empirical information to provide insight into the largely unexplored shadow effect of punitive damages on settlement. and services we buy. These costs create inflation, unemployment, and even harm our Nation's competitiveness in the global economy. Manufacturers and other businesses are often forced to discontinue products or scrap research and development projects out of fear of facing excessive punitive damage awards in court. Punitive Damages in Financial Injury Cases-The RAND Report: Hearing Before the Comm. on the Judiciary, 105th Cong. 1 (1997) [hereinafter RAND Report Hearing] (statement of Senator Orrin G. Hatch). 5. The term "shadow effect" is used because the parties are negotiating in the shadow of the legal system. The major purpose of verdict reporters is to assist settling parties in setting lower and outer limits of possible exposure. 6. See Dan L. Goldwasser, State Legislative Initiatives on Behalf of the Accounting Profession, in ACCOUNTANTS' LIABILITY 1994, at 143 (PLI Litig. & Admin. Practice Course Handbook Series No. 506, 1994) (noting that punitive damages verdicts may be infrequent in many states, but nevertheless there is an important "shadow effect" caused by the presence of punitive damages claims). 7. Many claims are filed, but few are chosen for trial. The National Center for State Courts estimates that 86.5 million cases of all kinds were filed in 1994 in state courts. See NATIONAL CENTER FOR STATE COURTS, EXAMINING THE WORK OF STATE COURTS, 1994, at 10 (1996). About half of the cases relate to traffic violations. See id. Less than one in five filings are civil. See id. The declining state of the American family is reflected in domestic filings, which constitute 4.7 million out of the 86.5 million state court filings. See id. at 10. Tort litigation accounted for about 17% of civil litigation filings. See id. at 8. Only about 2.9% of the tort cases ever reach a jury trial. See id. at 34. Fewer than 3 % of tort filings ever reach the verdict stage. Of the 3 % of cases reaching trial, plaintiffs win roughly 1 in 2 times (49%). See id. at 36. Punitive damages are awarded in only about 4% of the plaintiff victories. See id. at 37. 8. As Ruth Gastel of the Insurance Information Institute explains: Lawsuits represent only a small portion of total liability claims, however. Only 2 percent of such claims are settled by verdict and only one third of claims become lawsuits. Nevertheless, lawsuit verdicts are important because they influence the damage amount sought by plaintiffs and the size of out-of- court settlements. Ruth Gastel, The Liability System, INS. INFO. INST. REP. 1 (Feb. 1998). 9. As Michael Saks has noted, little is known about the settlement process: "Although pre-trial settlements are the principal stage at which tort disputes are resolved, they inspire little more than a footnote in the policy debate and research on the litigation system." Michael J. Saks, Do We Really Know Anything About the Behavior of the Tort Litigation System-and Why Not?, 140 U. PA. L. REv. 1147, 1212 (1992). WISCONSIN LAW REVIEW This Article is the first systematic examination of the existing state of knowledge about a largely unknown dimension of the litigation system. Part II presents a secondary analysis of the empirical studies of punitive damages claims in Florida, California, Alabama, Texas and a 27-state overview. Part III reviews the growing body of empirical research on a second aspect of the shadow effect-post-verdict settlements of punitive damages awards. My thesis is that even though the empirical research consistently shows that punitive damages are rare and well-controlled by the judiciary, this remedy plays a significant role in driving settlements. The empirical evidence suggests that the business community's fear of runaway punitive damages is exaggerated. However, what litigators "define as real, becomes real in their consequences. "10 A belief that punitive damages are "out of control" and randomly