Law and Reputation

Roy Shapira is Associate Professor at IDC Herzliya Radzyner Law School. This post is based on his recently published book, Law and Reputation: How the Legal System Shapes Behavior by Producing Information.

“Reputation matters” has become a mantra in the business world. And corporate legal scholars have been increasingly referring to reputational concerns as important forces that shape our behavior across a wide range of phenomena. Yet so far the legal literature has stayed remarkably silent on exactly how reputation works, or how reputation interacts with the law. My new book, titled Law and Reputation (Cambridge University Press, 2020), examines these important questions.

The book starts with the basic questions of what reputation is and why it is noisy. Not all bad news is created equal. Some companies and businessmen emerge from failures unscathed while others go bankrupt. To better understand why similar behaviors lead to different reputational outcomes, I break the process of reputational sanctioning into its different components: revelation, diffusion, certification, and attribution of information. Damning information has to be widely diffused so that it reaches a critical mass of stakeholders in order for the reputational sanction to be meaningful. Information that was widely diffused has to be certified as credible for the company’s stakeholders to consider it seriously. And information that was diffused and certified has to first be attributed to deep-seated flaws that are likely to reoccur in the future, in order for the company’s stakeholders to update their beliefs and act on it.

Law enforcement—both private and public—can affect the process of reputational sanctioning along each of the abovementioned stages. Think for example about internal emails exposed during the discovery stage, revealing a systematic cover-up or total lack of checks and balances throughout the corporate hierarchy. Litigation thus affects reputation by uncovering information to which market players were not privy. Litigation also affects reputations without producing new information, simply by changing the framing, credibility, and saliency of existing pieces of information. In particular, litigation shapes the scope and tenor of media coverage. To illustrate, I analyze the content analysis of the investigative projects that won the Pulitzer Prize over the last twenty years, finding that “legal sources” (court documents, regulatory investigation reports, and so on) are more often than note the key source for such media investigations (a separate article elaborates).

The bulk of the book is dedicated to specific applications of the law-and-reputation framework. Consider the following three issues, all frequently debated in this blog.

The first example comes from corporate fiduciary duty litigation. Directors may not fear the highly unlikely prospect of paying out of pocket in litigation, but they fear the nonlegal costs that come with litigation, such as having their shenanigans or faulty processes exposed in discovery and called out by an expert Delaware judge. By analyzing corporate law doctrines through their impact on information production, we get a fresh perspective on much-debated features, such as Delaware’s recent expansion of shareholders’ right to inspect the company’s books and records (I wrote elsewhere about the rise of section 220 and how it is reshaping deal negotiations and oversight duties).

A second application concerns the SEC’s enforcement practices, which became the center of national debate in the wake of the 2007-2009 financial crisis. While the existing debate revolves around the amount of money being paid or admissions being collected in SEC settlements, the reputational framework offers an alternative way to measure the effectiveness of SEC enforcement. The real problem with SEC settlements is not that the SEC leaves money on the table, but rather that the SEC leaves information on the table. Both the SEC and big-firm defendants have incentives to settle quickly and for high amounts, in exchange for limiting the public release of damning information. Such information-underproduction dynamics are good for both parties but bad for society at large. The reputational framework helps us identify solutions, like evaluating the proper scope of judicial review of SEC actions.

A third, timely issue that the reputational framework sheds light on is the proliferation of mandatory arbitration clauses that effectively waive class actions. With the blessing of the Supreme Court, mandatory arbitration provisions with class action waivers have become common in contract, consumer, and labor law. Policymakers now consider importing this trend to corporate and securities laws as well. The existing debate centers around consent and compensation: Can shareholders be held to consent to arbitration provisions in the company’s corporate governance documents? Are shareholders better off with arbitration, given that litigation currently offers them very little compensation (with high fees)? Yet the extant debate misses the forest for the trees. Even if shifting from litigation to arbitration may be good for a specific company and its investors, it may prove detrimental to the market overall. We will lose the positive externality (in the form of quality information on corporate behavior) that comes with litigation. A shift to mandatory arbitration may therefore reduce the administrative costs of litigation, but hurt the ability of the market to discipline itself. In other words, mandatory arbitration provisions may reduce the effectiveness of reputational deterrence, and therefore be bad for investors as a group.

My book thus centers around one overarching point: the law shapes behavior not just through imposing sanctions, but also through producing information. In the course of fleshing out this point and examining the interactions between law and reputation, the book contributes to various other debates beyond the ones highlighted here, such as the desirability of heightened pleading standards, or whether to assess director liability individually or collectively.

At a more general level, delving into the interconnections between law and reputation allows us to revisit the age-old policy debate over legal intervention. Two binary camps have been dominating this debate: one advocates “leaving things to the market” while the other calls for “ramping up legal sanctioning.” Yet those who oppose legal intervention fail to recognize the importance of the legal system for the functioning of market discipline. And those who advocate for more legal sanctions fail to recognize the ability of the legal system to shape behavior indirectly, without interfering with business decisions. Sometimes the most effective and realistic way to promote deterrence is not to increase legal sanctions, but to increase the quantity and quality of information production.

The book is available here.

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