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E-MailJohn Armour is Professor of Law and Finance at the University of Oxford; Colin Mayer is Peter Moores Professor of Management Studies at University of Oxford Saïd Business School; and Andrea Polo is Assistant Professor of Finance at LUISS Guido Carli University. This post is based on their article, forthcoming in Cambridge Handbook of Compliance (Cambridge University Press).
A firm’s “reputation” reflects the expectations of its partners of the benefits of trading with it in the future. An announcement by a regulator that a firm has engaged in misconduct may be expected to impact negatively on trading parties’ (i.e. consumers or investors) expectations for a firm’s future performance, and hence on its market value. How can we identify reputational losses from share price reactions? How large are these losses for different types of misconducts? In the article Naming and Shaming: Evidence from Event Studies, forthcoming in the Cambridge Handbook of Compliance (Cambridge University Press), we describe the results of previous studies, discuss the event study methodology and underline the empirical challenges. We then present the evidence from one unique study that meet all necessary conditions for identification of reputational sanctions from event studies (Armour et al. 2017) and draw implications for regulatory enforcement policy.
A growing empirical literature on reputational sanctions shows that such sanctions are large when a regulator reveals misconduct against customers or investors–i.e. mis-selling of products or financial misrepresentation—but are negligible when the misconduct is against a third party, with whom the firm does not trade. This last prediction receives support from studies considering breaches of environmental law, tort law or anti-bribery regulation. This literature based on US data, however, suffers from some methodological weaknesses.
To obtain precise estimates on the size of reputational sanctions in event studies the following three conditions need to be verified: 1) there should be a clearly defined revelation of information relating to a firm’s conduct, 2) all information relevant to the firm’s conduct should be released simultaneously, 3) the direct costs associated with the revelation of information (for example, in this case the size of both publicly imposed fines / compensation and private litigation) should be measurable when it is disclosed and distinguishable from the additional reputational loss. Data limitations, owing in particular to the structure of US enforcement institutions (investigations typically involve a sequence of public announcements that stretch over several years), have meant that these three conditions have not been satisfied in the prior literature.
We present the evidence from one unique study that meet all necessary conditions for identification of reputational sanctions from event studies (Armour, Mayer and Polo, 2017). This paper focuses on the UK, where in contrast to the US, during the period of this study, regulators only made public announcements at the successful completion of an enforcement process. The Financial Services Authority (“FSA”) and the London Stock Exchange (“LSE”) investigated firms for possible violations of financial regulation and listing rules but only made their investigations public once misconduct had been established and a fine and/or order to pay compensation had been imposed. This made the announcement of misconduct in the UK context a well-specified event, for which the reputational consequences can be established with far greater precision than in the US. The study confirms that reputational sanctions are very real: their stock price impact is on average nine times larger than the financial penalties imposed by the FSA/LSE. However, the reputational damage is unrelated to the scale of fines imposed by regulators or the compensation paid by firms. Moreover, also in this study, reputational losses are confined to misconduct that directly affects those who trade with the firm, such as customers and investors. The announcement of a fine for wrongdoing that harms third parties who do not trade with the firm has, if anything, a weakly positive effect on stock price.
These results have important implications for the design and effects of corporate and financial regulation. They suggest that, in some areas, the primary weapon that regulators have in their armoury are not fines but reputational sanctions. In relation to wrongs to trading partners, fines appear largely irrelevant to, and uncorrelated with, the overall loss inflicted on the firm by the announcement of its wrongdoing. In contrast, reputational incentives are either non-existent or perverse where the misconduct afflicts third parties. In these cases fines are the only effective sanction, and need to be substantially greater than they are at present if they are to have the same overall level of deterrence associated with wrongs harming trading partners.
Finally, a transmission mechanism that emerged in the last few years and deserves further research in the future is that political punishment of third party wrongs. While the direct economic consequences, in terms of reputational sanctions, of third party wrongs are very small, the political ramifications resulting from negative public reactions can be substantial. The large drops in share prices after revelations of third party wrongs in the case of BP’s oil spill in the Gulf of Mexico in 2010 or Barclays’ Libor-fixing scandal in 2012 illustrate the case. Initially the share prices of these companies only reflected the potential fines and class action settlements but then collapsed after a few hours when damaging political interventions were disclosed by the governments.
The full article is available for download here.
