Mandatory Arbitration and the Market for Reputation

Is mandatory arbitration of shareholder claims desirable? 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)?

My recent article, Mandatory Arbitration and the Market for Reputation (forthcoming in the Boston University Law Review), adopts a different, information-production perspective. It examines how the choice between litigation and arbitration affects the effectiveness of market discipline. Litigation, regardless of the legal outcomes, produces a positive externality: information on corporate behavior. Internal memos, emails, spreadsheets, and transcripts that are exposed in the process give us a glimpse into how the company-in-question is ran. This information helps outside observers reassess their willingness to do business with the parties to the dispute. In other words, litigation shapes the reputations of companies and businesspersons. By shifting from litigation to arbitration, we are likely to save administrative costs, but lose some of the effectiveness of reputational deterrence. While adopting a mandatory arbitration provision can be desirable for a given company, the ex ante effects of allowing such provisions are therefore likely to be overall detrimental to the market.

Those in favor of market arbitration often base their argument on the notion that ending shareholder litigation as we came to know it is not a bad thing. They cite evidence on how shareholder litigation fares badly in compensating victims and amounts to little more than a transfer of wealth from investors to lawyers. Yet compensation is not the only measuring stick, or even the most important one. When evaluating a proposed shift from litigation to arbitration, we should also consider deterrence. The critical question is whether litigation has a salutary effect on corporate behavior. Litigation will have such a salutary effect whenever it makes defendants internalize the costs of their misbehavior. Importantly, litigation can make defendants behave better not just by threatening them with legal sanctions, but also indirectly, by threatening them with non-legal sanctions. Litigation can facilitate reputational penalties: the risk of having damning information about how you behaved become public, thereby reducing the willingness of outside observers to trust and do business with you going forward.

Litigation affects reputation by uncovering information to which market players were not privy. Think for example about internal emails exposed during discovery, revealing a systematic cover-up or total lack of checks and balances throughout the corporate hierarchy. Litigation also affects reputations without producing new information, simply by changing the framing, credibility, and saliency of existing pieces of information.

To provide some sense of the magnitude of the reputational effects of litigation, I look at a proxy: the media coverage of corporate behavior. A burgeoning multi-disciplinary literature documents the important role that media scrutiny plays in corporate governance. I ask the prior question, namely, what determines media scrutiny: Which corporate governance debacles are being covered and which are not? How are they covered? And so on. By triangulating several qualitative methods—interviewing reporters, going over a reporters-only database of tip sheets, scouring course syllabi in journalism schools, and conducting content analysis of prizewinning journalistic projects—I make the case that litigation is a key source of impactful media coverage of corporate behavior (a separate article elaborates). To illustrate, consider how in over half of all the investigative projects that won the Pulitzer Prize between 1995-2015, legal sources played the “but-for” role. That is, without access to legal documents, the reporters would not have been able to publish their impactful stories. Allowing mandatory arbitration will reduce these “law-as-source” benefits, thereby severely limiting the media’s role in corporate governance.

The article then highlights how shareholder litigation produces information differently than other types of litigaiton. For one, shareholder litigaiton is more front-loaded. The main event always comes early: think about the demand requirement in derivative actions or the pleading stage in securities class actions. As a result, plaintiffs in shareholder litigation find it harder to survive motions to dismiss and reach discovery. Yet, counterintuitively, that does not mean that shareholder litigation is less informative. Plaintiffs have developed pre-discovery investigatory tools, such as requesting to inspect the company’s books and records (Delaware’s Section 220 requests) or locating current or former employees willing to share damning information. These tools allow not just for better pleading but also for production of reputation-relevant information.

The article finishes by sketching policy implications. Recognizing the informational role of litigation puts a thumb on the scales against importing mandatory arbitration provisions to corporate and securities laws. If courts and regulators nevertheless decide to enforce such provisions, we should at a minimum set basic rules ensuring that shareholder arbitration would produce meaningful information. For example, we can mandate “explained awards,” whereby the arbitrator provides a short, publicly available factual description of what happened, as well as reasoning for her decision.

The insights developed in the article on the link between litigation and reputation carry implications beyond the arbitration debate. The article uses them to reevaluate the desirability of recent developments in Delaware law, such as the doctrines developed in Corwin, Trulia, and Lavin v. West Corp., according to how they contribute to the quantity and quality of information flows. A doctrine like Corwin, which expands the deferential business judgment standard of review, should seemingly curtail plaintiffs’ ability and incentives to reach discovery and produce valuable information on corporate behavior. However, more recent developments of Delaware doctrine have seemingly restored balance. Plaintiffs’ lawyers reacted to Corwin by concentrating efforts on making section 220 demands. Delaware’s 2017 Lavin ruling facilitated this alternative channel of information production, by stating that a Corwin defense (that is, an informed shareholder vote) does not absolve the company from having to produce documents in section 220 demands. Then, the 2019 KT4 Partners ruling further boosted the chances of information production, by broadening the scope of inside information that should be provided under section 220 demands. In the past year alone there have been several vivid examples for plaintiffs successfully obtaining relevant, damning information through the section 220 channel. From this vantage point, Delaware’s recent doctrinal developments seem to have struck the right balance between deference to business judgements and ability to extract information on problematic behavior.

There is a broader point here. Securities markets are fraught with asymmetric information and super-charged incentives to cheat. Reputational deterrence is important to their proper functioning. And litigation seems to be important to the proper functioning of reputational deterrence. The direct costs of litigation are well-researched and salient to us, while the costs of reputational under-deterrence are not. My article is an attempt to caution against replacing litigation with arbitration without first gaining better evidence and a better understanding of the positive externalities of litigation.

The complete article is available here.