A Reputational Theory of Corporate Law

How does corporate law matter? My recent paper suggests that the main impact of corporate law is not in imposing sanctions, but rather in producing information. The process of litigation or regulatory investigations produces information on the behavior of defendant companies and businessmen. This information reaches third parties, and affects the way that outside observers treat the parties to the dispute. In other words, corporate and securities litigation affects behavior indirectly, through shaping the reputations of companies and businessmen.

The paper explores how exactly information from the courtroom translates into the court of public opinion. By analyzing the content of media coverage of iconic corporate law cases we gain two sets of insights. First, we learn that judicial scolding does not necessarily hurt the misbehaving company’s reputation. The reputational impact of litigation depends on factors such as who the judge is scolding, what she is scolding them for, and how her scolding compares to the preexisting information environment. Second, we flesh out the ways in which information flows from the courtroom get distorted. Information intermediaries selectively disseminate certain pieces of information and ignore others. And the defendant companies produce smokescreens in an attempt to divert the public’s attention.

Recognizing that reputation matters and that the legal system affects reputations carries important policy implications. For one, the reputational perspective calls for reevaluating key doctrines in corporate law according to how they contribute to information production. Consider for example how Delaware uses stringent standards when determining whether to impose legal sanctions, but more lax standards in the pleading stage. In other words, Delaware courts let big cases proceed to discovery and trial even when the odds that these complaints will ultimately win are slim.[1] Such liberal pleading standards generate a previously-overlooked informational benefit: when cases proceed to discovery market players may gain access to reputation-relevant information that they were not previously privy to. Other doctrines that shape the quantity and quality of information production include the use of open-ended standards (such as good faith), and the question whether to assess director liability individually or collectively.

The reputational theory also offers a fresh perspective on the effectiveness of SEC enforcement. The SEC’s longstanding practice of settling the majority of enforcement actions with a “neither-admit-nor-deny” pact has faced mounting criticism following the Bank of America and Citigroup cases.[2] I argue that 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 to the settlement, but bad for society overall.

As is often the case with timely topics, SEC settlement practices have been undergoing changes since my paper was originally written. When evaluating current changes we need to heed the distinction between the quantity and quality of information. SEC settlements do produce more information than other settlements, but the information that the SEC typically releases is not reputation-relevant. It does not help market players distinguish between good and bad actors. From this perspective, the internal changes to SEC practices (led by Chairwoman White[3]) seem promising, as they lead to more admissions in a certain type of cases (think about the recent JPMorgan settlement). On the other hand, the external changes to SEC practices (led by the recent Court of Appeals’ Citigroup decision[4]) seem problematic, as they limit the ability to question whether a given settlement is informative or not.

Lastly and more generally, the reputational perspective can enrich our understanding of regulators’ behavior. After all, regulators care about their reputations too. The literature on regulatory competition has recognized that both Delaware and the SEC try to strike a balance. They cater to the general public (and political overseers) by being tough on corporate America, but not so tough as to alienate the regulated entities.[5] My reputational perspective offers an explanation to how exactly regulators engage in such a balancing act. Regulators face tradeoffs when choosing between enforcing directly (imposing sanctions) and enforcing indirectly (producing damning information). Both Delaware and the SEC seem to pick the method of enforcement that makes them look tough in the eyes of outsiders but is actually less hurtful to the regulated entities.

To use the famous Disney case[6] as an example: several corporate legal scholars view Disney as a show trial meant to convince the public that Delaware got the then-burning issue of inflated executive pay under control. My contribution is in adding that “no incumbent managers were harmed during the filming of this show.” Delaware got the presumed mitigating-backlash benefit without really hurting Disney. The judicial scolding was directed at individuals who were no longer part of the company, and as a result the company and its incumbent managers did not suffer reputational harms (and did not pay legal fines). Delaware courts can therefore use judicial scolding as a low-visibility favoritism tool: allowing Delaware to appear tougher on corporate America than it actually is. Similar “make it look like a struggle” dynamics apply to the SEC, albeit with interesting twists. Delaware tends to refrain from imposing legal sanctions, but does not shy away from offering strong criticism; while the SEC tends to maximize the direct legal outcomes (amount of fines collected), but refrains from offering strong criticism.

One overarching theme throughout my inquiries is the focus on diffusion of information. The corporate and securities law literature is dominated by classic economic analysis and agency theory. As a result, little attention is given to informational issues: market players are assumed either to have information or not to have it.[7] I shift our focus to questions such as how information is diffused (contrary to popular belief, information does not fall on individuals like manna from the sky), what is the role of information intermediaries such as mass media,[8] and what types of messages are perceived as being more credible than others.

ENDNOTES

[1] This is the essence of famous doctrines such as Zapata (Zapata Corp. v. Maldanado, 430 A.2d 799 (Del. 1981)), which applies an enhanced standard of review to the special litigation committee conduct; or Kaplan (Kaplan v. Wyatt, 499 A.2d 1184 (Del. 1988)), which makes the question of how much discovery to accord to plaintiffs a matter of court discretion.

[2]. SEC v. Citigroup Global Mkts. Inc., 827 F. Supp. 2d 328 (S.D.N.Y. 2011); SEC v. Bank of Am., 653 F. Supp. 2d 507 (S.D.N.Y. 2009).

[3] James B. Stewart, S.E.C. Has a Message for Firms Not Used to Admitting Guilt, N.Y. Times (Jun. 21, 2013).

[4] SEC v. Citigroup Global Mkts. Inc., 752 F. 3d 285(2014).

[5] See generally Mark J. Roe, Delaware’s Competition, 117 Harv. L. Rev. 588 (2003).

[6] In re The Walt Disney Co. Derivative Litig., 907 A.2d 693 (Del. Ch. 2005).

[7]. On the gap in the literature regarding the corporate governance role of the media, see Alexander Dyck & Luigi Zingales, The Corporate Governance Role of the Media, in The Right to Tell (2002).

[8] Because most people do not read judicial opinions, the role of the media and other information intermediaries in selectively diffusing information from the courtroom becomes especially important.

This post comes to us from Roy Shapira, a John M. Olin Corporate Governance Fellow at Harvard Law School. The post is based on his recent paper, which is entitled “A Reputational Theory of Corporate Law”. The paper was recently published in 26 Stanford Law and Policy Review 1 (2015), and is available to download here.