“Reputation matters” is by now almost a mantra. Scholars of commercial law increasingly refer to reputational concerns as important forces that shape our behavior – a “system of control” of sorts. The idea – backed by mounting empirical evidence – is that news about corporate misbehavior should bring with it declines in stock prices, in consumers’ willingness to pay, and in employee motivation. Companies and business people anticipate the risk of diminished future business opportunities, and it encourages them to avoid misbehaving, the argument goes. Yet so far the literature has stayed remarkably silent on how exactly reputation matters, or how reputation interacts with the law. Why do some companies and businessmen emerge out of failures relatively unscathed while others go bankrupt? Why do some companies get credit for their social-responsibility activities while others do not? The legal literature is short on answers. But an emerging interdisciplinary literature about reputation provides important lessons that we should heed. Consider the following two.

First, a reputational system of control is costly, too, (just less transparently so). Legal scholars are usually aware of the costs of legal systems, and can relatively easily quantify them. But the costs of non-legal systems are less transparent to us, and we tend to underplay those costs. The legal literature suffers from an “indefensible optimism about the actual operation of information markets.”[1] Too often we treat reputation as a straightforward, binary process: If you misbehave, your future business opportunities diminish; if you behave well, your future business opportunities flourish. But research shows that in reality reputation is inherently noisy. Market players often lack the incentives and information needed to accurately update their willingness to do business with the company in question. As a result, the market systematically overreacts to certain types of behaviors, and underreacts to others. Stakeholders may stop doing business with perfectly fine companies or ignore warning signals and continue doing business with rotten companies.

Second, the effectiveness of a reputational system of control is affected by the legal system, and vice versa. The process of reputational sanctioning – that is, stakeholders reading bad news and reducing their willingness to do business with the company – does not operate in a vacuum. The same bad news that ignites an initial market reaction may also prompt litigation or regulatory investigations. Then, in the process of determining whether to impose penalties, the legal system produces as a byproduct information on the behavior of the parties to the dispute: what top managers knew about the problem, when they knew it, whether they could have stopped it, and so forth. This information is available to outside observers and affects the way that these third parties treat the parties to the dispute. In other words, the legal system provides better information for the public to base reputational judgments on. Law and reputation are not strictly independent of each other, but may complement each other.

Recognizing the role that the law plays in providing useful information for evaluating reputations carries important policy implications. On a general level, it suggests a more cautious approach to advocating for legal nonintervention. When Polinsky & Shavell argue for abolishing product liability for widely-sold products,[2] they treat reputation as an alternative to the legal system. Manufacturers, their argument goes, will invest in the quality and safety of their products even without the threat of legal liability, simply because they care about maintaining their reputations. At the heart of such an argument lies an implicit assumption that if we remove the background threat of litigation, the market forces will continue to function in the same way. But in reality the strength of market forces is (among other things) a function of the existing legal system. If we remove the background threat of litigation, reputational penalties may become more cacophonic.  In other words, scaling back litigation or regulation may have unintended consequences of raising the costs of non-legal sanctions.

On a more specific level, we can use the reputational framework to reevaluate key doctrines according to how they contribute to the quality and quantity of information produced. For example, several much-debated features of Delaware corporate law, such as open-ended standards or using a more stringent standard of review in the pleading stage, can create better information.[3] In other words, Delaware decisional law is aimed at flushing out disputes and letting big cases proceed to discovery, which in turn supplies quality information to the market on the behavior of disputants. By contrast, the SEC practice of allowing defendants to settle cases without admitting or denying the allegations (spotlighted in U.S. District Judge Jed Rakoff’s trifecta of cases[4]) doesn’t produce enough relevant information, and so may be good for the parties to enforcement actions but bad for the public.

To be sure, how reputation works is hard to capture in neat models or data points. Policy implications depend on the context and should be treated with caution. Still, a better understanding of how law and reputation interact would be useful. The debate over legal intervention tends to focus on just two points of view. One camp advocates leaving things to the market while the other calls for increasing legal penalties. Yet those who oppose legal intervention underestimate how it helps the market discipline itself. And those who advocate for more legal sanctions do not recognize that the legal system can shape behavior indirectly, without interfering with business decisions. Sometimes the most effective and realistic way to deter bad behavior is not to increase legal sanctions, but to increase the quantity and quality of information.

ENDNOTES

[1] Cass R. Sunstein, On Rumors 22 (2009).

[2] Mitchell Polinsky & Steven Shavell, The Uneasy Case for Product Liability, 123 Harv. L. Rev. 1437 (2010).

[3] Roy Shapira, A Reputational Theory of Corporate Law, 26 Stan. L. & Pol’y Rev. 1 (2015).

[4] SEC v. Bank of America, 653 F. Supp. 2d 507 (S.D.N.Y. 2009); SEC v. Vitesse Semiconductor Corp., 771 F. Supp. 2d 304 (S.D.N.Y 2011); SEC v. Citigroup Global Mkts. Inc., F. Supp. 2d 328 (S.D.N.Y. 2011).

This post comes to us from Roy Shapira, assistant professor at the Interdisciplinary Center (IDC) in Israel and a fellow at the Stigler Center at the University of Chicago’s Booth School of Business. It is based on his recent paper, “Reputation through Litigation: How the Legal System Shapes Behavior by Producing Information,” available here.