A New Model of Punitive Damages and the Incentive to Manage Earnings

Through several recent decisions, the U.S. Supreme court has limited the size of punitive damages awarded in tort cases. This paper analyzes recent U.S. Supreme Court decisions relative to the determination of punitive damages to determine how the incentive to manage earnings to minimize those damages may have changed. First, the paper summarizes the incentive as proposed by Hall and Stammerjohan (1997) and illustrates the application of that incentive by reference to the Exxon Valdez case where accounting measures of wealth or income were used in the jury instructions, the arguments by the plaintiffs, the appeal by the defendants, and the judicial review. Next, the paper explores the most recent United States Supreme Court decisions relative to determination of punitive damage awards. Those rulings have linked the dollar amount of punitive damages to the dollar amount of compensatory damages and have fundamentally changed the effect of defendant wealth on the size of punitive damages. Based on the review of recent cases, the paper builds a new model of the earnings management incentive relative to punitive damages. In the new environment, the relationship between firm wealth and the size of punitive damages is substantially changed and is complicated by the influence of the size of compensatory damages. Thus, the incentive to manage earnings is not as straightforward as it was at the time of Hall and Stammerjohan (1997). [PUBLICATION ABSTRACT]