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A REPUTATIONAL THEORY OF
CORPORATE LAW
Roy Shapira*
How does corporate law matter? This Article provides a new perspective on the longstanding question by suggesting 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 businesspeople. This information reaches third parties and affects the way that outside observers treat the parties to the dispute. In other words, litigation affects behavior indirectly, through shaping reputational sanctions. The Article then explores how exactly information from the courtroom translates into the court of public opinion. By analyzing the content of media coverage of famous 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 whom 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 defendant companies produce smokescreens in an attempt to divert the public’s attention. Recognizing that corporate law affects behavior by facilitating reputational sanctions carries important policy implications. The Article reevaluates key doctrines in corporate and securities laws according to how they contribute to information production. In the process we refocus timely and practical debates, such as the desirability of open-ended standards and liberal pleading mechanisms and the proper scope of judicial review of the Securities and Exchange Commission’s actions. INTRODUCTION ........................................................................................................... 3 I. HOW THE LAW SHAPES REPUTATIONAL SANCTIONS: A GENERAL FRAMEWORK ........................................................................................................ 6
- John M. Olin Corporate Governance Fellow, Harvard Law School. Thanks for helpful comments and discussions go to Jennifer Arlen, Robert Clark, Charles Elson, Tamar Frankel, Howell Jackson, Renee Jones, Kobi Kastiel, Vic Khanna, Harvey Pitt, Edward Rock, Mark Roe, Steve Shavell, Andrew Tuch, Batia Wiesenfeld, and seminar participants at Harvard Law School, Tel Aviv University, Yale Law School, the Corporate Governance Fellows lunch group, and the First Annual Corporate and Securities Litigation Workshop. Financial support was provided by the John M. Olin Center for Law, Economics and Business.
A. Litigation’s Impact on Moral Sanctions: “Saints and Sinners”
- 2 STANFORD LAW & POLICY REVIEW [Vol. 26 :
- A. Reputational Sanctions: How They Work, and Why They Are Noisy
- B. How Litigation Affects Reputation - 1. First-Opinion Effects - 2. Second-Opinion Effects - 3. Multiple Layers of Reputation Information
- C. Applying the General Framework to Specific Legal Fields
- II. CORPORATE LITIGATION’S IMPACT ON NONLEGAL SANCTIONS - Revisited - Approach B. Litigation’s Impact on Reputational Sanctions: Towards a Novel - Reputation 1. Scolding Who? Individual Reputation vs. Organizational - How It Is Diffused 2. Scolding Compared to What? What Information Is Available vs. - 3. Scolding for What? Incompetence vs. Immorality
- III. THE DISNEY LITIGATION: A CASE STUDY
- A. Information Produced Before Litigation Started
- B. Information Produced During Litigation - 1. The Impact of the Process - 2. The Real Impact of the Verdict - a. Emphasizing the Context. - b. Scolding for Honest and Transient Mistakes................................... - c. Scolding Individuals Who Were Already Ousted. - 3. Lost in Translation: Additional Comments on Information Flows - a. Different Types of Intermediaries Cover Verdicts Differently. - b. Companies Affect the Information Flows from the Courtroom.
- C. How Generalizable Are the Lessons from Disney?
- CORPORATE LAW IV. IMPLICATIONS: THE INDIRECT DETERRENCE FUNCTION OF DELAWARE
- A. How Key Doctrines Contribute to Information Production - Approvals 1. Procedural Doctrines: Pleading Mechanisms and Settlements - a. The Pleading Stage. - b. The Settlement Stage. - Role of Indeterminacy 2. Substantive Review: How to Assess Director Liability and the - Collectively? a. Should Director Liability Be Assessed Individually or - b. The Role of Indeterminacy.
- like a Struggle” Theory B. How the Content of Corporate Law Is Determined: A “Make It Look
- V. THE REPUTATIONAL CONSEQUENCES OF SEC ENFORCEMENT ACTIONS
- A. Judge Rakoff vs. SEC Settlement Practices: The Existing Debate
- Information B. Identifying the Problem: How SEC Settlements Underproduce
- C. Explaining the Problem: Why the SEC Trades Information for Fines
- D. Solving the Problem: Can Enhanced Judicial Scrutiny Help?
- CONCLUSION
4 STANFORD LAW & POLICY REVIEW [Vol. 26 : 1 affects the reputation of companies and businesspeople. Reputation therefore matters through corporate law. And corporate law matters through reputation. Realizing that corporate law affects behavior by facilitating reputational sanctions carries important policy implications. If corporate litigation does indeed generate a positive externality in the form of helping market players get better information, then key doctrines and institutions should be reevaluated according to how they contribute to information production. This Article offers alternative explanations to much-debated features of Delaware corporate law, such as the increased reliance on open-ended standards or the liberal use of pleading mechanisms. The Article also sheds light on previously overlooked dilemmas, such as whether to assess director liability individually or collectively and how to approve settlements in derivative and class actions. A few words on methodology are in order. The corporate governance literature deals extensively with “hard” market incentives, such as executive compensation, but neglects “soft” market incentives, such as maintaining a reputation for integrity. This is partly because analyzing reputational forces is challenging: they follow fuzzy dynamics and do not easily lend themselves to generalizations. My strategy in fleshing out these important yet understudied factors was to examine them from multiple angles and methodologies. I drew from the fast-emerging literature on reputation across disciplines (mainly economics and social psychology), gained insights from interviewing practitioners who work at the intersection of the court of law and the court of public opinion (mainly crisis management consultants and journalists),^5 and corroborated my arguments with existing statistical data. Then, to make the arguments more concrete and applicable, I delved into specific case studies and conducted content analyses of the media coverage of iconic corporate cases. I came up with several sets of insights as detailed below. Part I lays down the general theoretical framework. The Part generates two contributions: (i) explaining why reputational assessments are inherently inaccurate and (ii) fleshing out the ways in which the law affects their accuracy. When bad news about a company breaks and the company’s stakeholders consider whether to continue doing business with it in the future, they often lack the information or incentives to interpret the news correctly. As a result, the market overreacts to certain misbehaviors and underreacts to others. Stakeholders may stop doing business with perfectly fine companies or ignore warning signals and continue doing business with rotten companies. The
- The following interviews proved especially insightful: Charles Bakaly, head of the Litigation Communication Department of Edelman (Aug. 21, 2012); Bruce Carton, former senior counsel with the SEC’s enforcement department (May 21, 2013); Richard Clary, former head of litigation in Cravath, Swaine & Moore (Nov. 16, 2012); Eric Dezenhall, head of a crisis management firm (July 20, 2012); Michael Fertik, founder of Reputation.com (Feb. 11, 2013) (offering online reputation management services); Guy Rolnik, founding editor of a business journal (Nov. 15, 2013); a representative of Courtroom Connect (June 13, 201 3 ) (Courtroom Connect offers a service of live streaming coverage of litigation). For additional interviews in footnotes, see infra notes 34 , 79 , and 170.
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market, when left alone, has trouble calibrating reputational sanctions correctly. But in reality the market rarely is left alone. Market players continuously look for information that is being produced by the legal system to help them revise their initial reputational assessments. Reputational sanctions thus operate in the shadow of the law. Part II applies the general framework to corporate fiduciary duty litigation in Delaware. I first refocus the debate over the effectiveness of corporate-law enforcement. When measuring enforcement we should look not just at the outcomes (legal sanctions) or content (moral rebukes offered in dicta) of judicial opinions, but also at earlier stages in the litigation process: pleading, discovery, and trial. The litigation process itself affects corporate behavior at least as much as judicial opinions do, through flushing out information and facilitating reputational sanctions.^6 I then offer testable predictions on the reputational impact of litigation by outlining the factors that determine how information from the courtroom translates into reputational sanctions. One counterintuitive takeaway point is that judicial scolding does not necessarily hurt the misbehaving companies’ reputation. The reputational outcomes of litigation depend on questions such as whom the judge is scolding (is she singling out an ousted individual or criticizing an unhealthy corporate culture?), what she is scolding them for (honest incompetence or calculated disregard of market norms?), and what her scolding adds to the already existing information environment. Part III corroborates the theoretical arguments by delving into the famous Disney-Ovitz litigation^7 as a case study. I analyze the content of media coverage of the Disney-Ovitz debacle before, during, and after litigation. By adopting such a methodology we gain two sets of insights that develop the reputational theory of the law. First, we learn about the relative reputational impact of each phase in litigation. For example, we learn that the verdict’s reputational impact is much more limited and favorable towards the defendant company than was previously assumed. Second, we learn about the distortions in information flows. A lot of information gets lost in transmission from the courtroom to the court of public opinion. Different information intermediaries, such as mass media or law firms, selectively choose different pieces of information to convey to their respective audiences. And defendant companies try to hijack the information flows by producing smokescreens that divert the public’s attention. Part IV sketches out the normative implications of the reputational theory of corporate law. I reevaluate the desirability of key doctrines such as Zapata.^8
- The upshot is that even cases that settle produce reputational sanctions. For empirical support for this argument, see infra note 34 and the accompanying text.
- In re The Walt Disney Co. Derivative Litig., 907 A.2d 693 (Del. Ch. 2005).
- Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981).
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legal scholars.^12 I first show that reputational assessments are inherently inaccurate. Legal scholars often assume that the only issue with reputational sanctioning is whether misconduct is revealed or not: once bad news breaks, the market supposedly reacts automatically. But in reality the market reaction itself is the issue. Market players often lack the information or incentives to accurately interpret revelations of misconduct. As a result, the market underreacts to some types of revealed misconduct and overreacts to others. I then show how the accuracy of reputational sanctions is dictated by the legal system. Because market players find it hard to calibrate reputational judgments on their own, they often look for information coming from the legal system as a second opinion that helps them revise their initial reaction. In other words, the market reaction to revealed misconduct is shaped by the legal system’s reaction. The law thus affects behavior indirectly by shaping reputational sanctions. I finish by providing a blueprint for applying this general reputational theory of the law to specific legal fields. A. Reputational Sanctions: How They Work and Why They Are Noisy A company’s reputation can be defined as the set of beliefs that stakeholders hold regarding the company’s quality. Stakeholders cannot directly observe the company’s abilities and intentions. As a result, stakeholders form a rough proxy: using the company’s past actions as cues, they evaluate how the company is likely to behave in the future.^13 Customers make purchasing decisions based on their expectations about product quality; employees decide whether to apply for a job based on their beliefs about how top management will treat them; and so forth.^14 A reputational sanction thus is simply the process of updating beliefs and lowering expectations. When news about adverse actions by a company breaks, stakeholders downgrade their beliefs about the company’s quality. The company is now perceived as more likely to defect in the future, so stakeholders’ willingness to deal with it decreases. For example, investors hearing about a corporate governance scandal will start demanding higher
- For references to and critique of the conventional approach, see Christopher McKenna & Rowena Olegario, Corporate Reputation and Regulation in Historical Perspective , in THE OXFORD HANDBOOK 272 (Timothy G. Pollock & Michael L. Barnett eds., 2012); Juan Jose Ganuza et al., Product Liability Versus Reputation 2 (Feb. 3, 2013) (unpublished manuscript), available at http://www.webmeets.com/files/papers/earie/2013/ 371/EARIE%202013%20FGP%20JJG.pdf.
- A company’s reputation can be thought of as the cash value of the trust that different stakeholders put in the company. Karpoff, supra note 4 , at 363. I refrain from using the notion of trust here in order to avoid confusion between Bayesian belief-updating models and repeated-interaction models of reputation. See Luis Cabral, The Economics of Trust and Reputation (June 2005) (unpublished manuscript), available at http://pages.stern.nyu.edu/ ~lcabral/reputation/Reputation_June05.pdf.
- Reputation is thus somewhat audience-specific and attribute-specific: when talking about reputation we need to ask “reputation to whom?” and “for what?”
8 STANFORD LAW & POLICY REVIEW [Vol. 26 : 1 returns for their investment. The aggregate of diminished business opportunities constitutes the reputational sanction for violating market norms. But the most interesting (and understudied) question remains: How exactly do stakeholders update their beliefs? How many business opportunities are diminished by a given misconduct? After all, we know from everyday experience that not all bad news is created equal. Similar adverse actions cause different reputational outcomes. Some companies weather bad news relatively unscathed while other companies go bankrupt. Some top executives take the fall when their companies misbehave while other executives are unaffected. So what explains the variation in market reactions? For our purposes, it suffices to focus on one important determinant of reputational sanctions: indicativeness of future behavior. Stakeholders learning about a corporate misconduct try to infer how indicative of future behavior the specific adverse action is. Remember that reputational sanctions rest on self-interest: stakeholders will punish the company only when they deem the bad news relevant to their own future interactions with the company. In other words, the revelation of bad news about a company does not automatically translate into reputational sanctions. Public revelation of misconduct is a necessary but insufficient condition. The process of translating bad news into reputational assessments requires not just facts about what happened but also interpretations of how things happened. To generalize: when stakeholders believe that the bad outcome resulted from an isolated temporary mistake (such as a rogue low-level employee), the reputational sanction will be relatively low. By contrast, when stakeholders believe that the bad outcome resulted from a deep-seated organizational flaw (such as a total breakdown of checks and balances), the reputational sanction will be relatively high. After all, no one wants to work for, buy from, or invest in companies with deep-rooted problems that likely will resurface.^15 The next crucial step is to acknowledge that market players often have the wrong perception of how things happened. Stakeholders often interpret an isolated mistake as a deep-seated flaw, and vice versa. Several factors combine to make reputational assessments systematically noisy. First, stakeholders are asymmetrically informed about the inner workings of the company. While market players may know with some certainty what happened, it is usually hard for outsiders to tell exactly how things happened:
- A good illustration of these dynamics of reputational sanctions comes from stock market reactions to airplane crashes. A study found that the market reacts differently depending on how the crash was reported by the press. When the Wall Street Journal attributes the crash to internal causes, such as maintenance problems, the stock prices decline dramatically. By contrast, when the Journal reports that the crash was caused by external conditions, such as unanticipated weather conditions, the market does not react negatively. See Mark L. Mitchell & Michael T. Maloney, Crisis in the Cockpit? The Role of Market Forces in Promoting Air Travel Safety , 32 J.L. & ECON. 329 (1989).
10 STANFORD LAW & POLICY REVIEW [Vol. 26 : 1 corporate governance).^20 Similarly, the media criticize shady accounting practices based on the visibility of companies rather than the size of the discrepancy: large, well-known companies get more negative coverage for more minor deviations.^21 Taken together, the emerging pieces of evidence suggest that reputational sanctions exact heavy social costs. The costs of reputational sanctions stem not just from instances where the market does not detect corporate misbehavior. Even when market players become aware of corporate misconduct, their reaction to it is often inaccurate. Stakeholders may stop doing business with perfectly fine companies, or they may ignore early warning signs and continue doing business with rotten companies. Most importantly, the evidence suggests that the market systematically overreacts to certain misbehaviors and underreacts to others.^22 Not all mistakes in reputational assessments cancel themselves out. As a result, reputational forces distort primary behavior. Companies may pick projects based on their reputational value and not on their “real” value. Reputational incentives push companies to excessively avoid some worthy behaviors (reputational overdeterrence) and excessively engage in some bad behaviors (reputational underdeterrence). So far we have explained why market players, when left alone, will have trouble producing accurate reputation information. But in reality the market is rarely left alone. Adverse actions are interpreted and assessed not just by market arbiters, but also by legal arbiters. The legal system produces as a by- product an informational public good: a version of what and how things happened in given cases.^23 The next Subpart maps the different ways in which the information coming out of the legal system affects reputational sanctions. B. How Litigation Affects Reputation Many Law and Social Norms analyses assume away complementarities between law and reputation, instead treating the two systems as independent of each other.^24 In this Subpart, I challenge the conventional view by fleshing out
- See John E. Core et al., The Power of the Pen and Executive Compensation , 88 J. FIN. ECON. 1, 17 (2008).
- See Gregory S. Miller, The Press as a Watchdog for Accounting Fraud , 44 J. ACCNT. RES. 1001 (2006).
- For an elaboration see Shapira, supra note 17 , at Subpart I.C (providing, also, examples of biases that lead to over/underdeterrence, such as the state of the overall economy—the market underreacts when the economy is booming and overreacts when the economy is down; the saliency of the issue in question; and the type of harm done—the market underreacts to multiple small harms and concealed harms, and overreacts to harms to easily identifiable victims).
- See Érica Gorga & Michael Halberstam, Litigation Discovery and Corporate Governance: The Missing Story About the “Genius of American Corporate Law , ” 63 EMORY L.J. 1427 - 28 (2014).
- For the conventional approach, see supra note 12. To illustrate, consider Polinsky and Shavell’s proposal to abolish product liability for widely sold products. The logic of
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two channels through which the law influences reputational sanctions: “first- opinion effects,” which occur before the market reacts to misconduct, and “second-opinion effects,” which occur after the market’s initial reaction.
- First-Opinion Effects The first type of effect that the law generates is that of setting a reputational sanction in motion. The most intuitive and studied example comes from disclosure requirements, which incentivize corporate decision-makers to publicly reveal information relating to corporate misconduct. Whistleblower laws also mitigate the asymmetric information about corporate failures, by incentivizing employees to reveal information about their companies’ misconduct. Aside from legislation and regulations, litigation—our focus in this Article—can draw market players’ attention to previously unnoticed corporate misbehavior. Sometimes a company breaches its explicit or implicit contractual obligations toward a certain stakeholder, but the harmed party finds it too costly to communicate the violation to third parties. The legal system gives the harmed party a right to sue the company for damages, thus indirectly setting the wheels of reputational sanctions in motion. The mere filing of a lawsuit (not to mention information revealed during litigation) may attract the attention of other stakeholders and propel them to downgrade their beliefs about the company.^25 In all these cases, the law has a “revealing misconduct” effect on the market. When the legal system facilitates the injection of new information into the market, it reduces the detection costs of reputation control systems, thus increasing the chances that misbehavior will be punished by the market. Another channel through which the law sets reputational sanctions in motion is reduction of the enforcement costs of reputation control systems: the costs of acting against detected misbehavior.^26 After all, not all revealed misconduct is automatically punished by the market. Sometimes market players know the facts (i.e., learn about a certain suspect behavior) but are unclear about what norms are pertinent to the facts. The legal system helps by such a proposal is that if nonlegal forces are strong enough to carry most of the burden of deterrence, then it is not cost-effective to keep a costly adjudication system simply for the sake of an incremental contribution to deterrence. A. Mitchell Polinsky & Steven Shavell, The Uneasy Case for Product Liability , 123 HARV. L. REV. 1437 (2010). At the heart of such an argument lies an implicit assumption that the legal system and the nonlegal system are independent of each other. Polinsky and Shavell assume that we can remove the law— remove the background threat of litigation—and the market forces will continue to function just the same.
- Cf. G. Richard Shell, Opportunism and Trust in the Negotiation of Commercial Contracts: Toward a New Cause of Action , 44 VAND. L. REV. 221, 271 n.223 (1991) (noting the common practice to search for past and pending legal disputes of potential business counterparties).
- The terminology follows Robert Clark’s typology in Laws, Markets, and Morals (Jan. 2010) (unpublished manuscript) (on file with author).
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information. As a result, the legal system’s version often relies on information to which market arbiters were not privy when they made their initial assessments. A classic example comes from the revelation during discovery of intra-company e-mail communications that tell us exactly what top managers knew and when they knew it. The legal system thus can serve as a safety valve for reputation systems. In instances where market players greatly under- or overreacted, the legal system later provides a more balanced perspective of how things happened, thereby allowing market players to go back and correct their initial assessment. But even more important than correcting specific under- and overreactions ex post, the mere background threat of litigation affects all future reputational assessments ex ante. The possibility of litigation disciplines those who dispense reputational sanctions. Market arbiters anticipate the possibility that nuanced information on the misbehavior in question will later be produced in litigation and invest more in their initial assessments. In that sense, the legal system facilitates a market for corporate watchdogs’ reputation. Information produced during litigation helps stakeholders better assess not only the behavior of defendant companies, but also the expertise and integrity of watchdogs.^29 The background threat of litigation also affects those who suffer from reputational sanctions. Faced with the possibility that their denials will be exposed in discovery as lies, misbehaving companies are more disciplined in how they fight accusations.^30
- Multiple Layers of Reputation Information One important clarification is in order: I do not claim that the legal system is categorically better and more accurate than reputation systems. Like reputation systems, the legal system’s assessments suffer from a plethora of distortions, such as asymmetric information, lack of expertise, strategic behavior, and divergent incentives. Indeed, in many cases we cannot trust the legal system to produce the positive externality of accurate reputation information. So I do not portray the legal and market systems in a horserace over which produces more accurate information. I rather view the two systems as providing multiple layers of reputation information. The combination of two flawed systems (legal and reputation) produces better reputation assessments than each system on its own. This is because the systems’ flaws are imperfectly correlated. Some of the distortions of the market’s first opinion are cancelled out by the legal system’s second opinion, and vice versa. The two systems can be thought of as creating a diversified portfolio of reputational assessments, mitigating the risk of extreme mistakes (that is, the risk that stakeholders will boycott perfectly good companies or
- See Shapira, supra note 17 , at Subpart II.B.3.
- See, e.g. , MICHAEL REGESTER & JUDY LARKIN, RISK ISSUES AND CRISIS MANAGEMENT IN PUBLIC RELATIONS 200 (4th ed. 2008 ).
14 STANFORD LAW & POLICY REVIEW [Vol. 26 : 1 interact with rotten companies). Indeed, the literature on second opinions in other contexts has long recognized that a combination of a “hot” first opinion and a “cold” second opinion is often optimal.^31 The market system strikes first and produces information that is more timely and accessible than the version produced by the legal system. The legal system then produces information that is often more accurate and complete than the initial market’s version. Overall, the existence of a well-functioning legal system facilitates better reputation systems. Still, in specific contexts the information produced during litigation has zero or even negative impact on reputational evaluations. In order to predict better the reputational impact, we need to introduce more context- specific details, focusing on one area of market activity and law at a time. The next Subpart shows how to apply the theory to specific legal fields. C. Applying the General Framework to Specific Legal Fields What are the conditions that determine the magnitude and direction of reputational consequences? One way to answer this question is to adopt a supply-and-demand framework. The legal system impacts reputational sanctions only when market players are constantly looking to reevaluate their beliefs (high demand) and legal institutions are perceived as a capable and credible source of information (supply meets demand). Many legal disputes— think, for example, about family law or torts committed by individuals— interest only the disputants themselves. The demand for information production in such disputes is virtually zero. In other legal disputes the demand for reputation information may be great, but the legal system fails to supply quality information. Think, for example, about medical malpractice: the reputation of caregivers is important and extremely hard to assess, but since the legal arbiters presiding over medical malpractice disputes are inexpert jurors who do not produce detailed opinions, the legal system supplies little meaningful reputation information. In the context of corporate and securities litigation, it seems that both conditions of the supply-and-demand equation are met. The demand for credible reputation information is high. Stakeholders have every reason to continuously reevaluate their assessment of companies’ abilities and intentions. The combination of high stakes involved in interacting with companies and various asymmetric information problems increases the value of getting second opinions on the quality of management integrity.^32 And private intermediaries such as securities analysts or institutional investors enjoy enough sophistication
- See Adrian Vermeule, Second Opinions and Institutional Design , 97 VA. L. REV. 1435, 1450- 5 1 (2011).
- Cf. JONATHAN R. MACEY, THE DEATH OF CORPORATE REPUTATION 20 (2013) (ar- guing that in the financial sector it is especially hard to distinguish high- from low-quality players); Jeffrey N. Gordon, The Rise of Independent Directors in the United States, 1950- 2005 , 59 STAN. L. REV. 1465, 1489 n.85 (2007) (arguing that bad outcomes cannot be easily attributed to specific companies or directors because of confounding variables).
16 STANFORD LAW & POLICY REVIEW [Vol. 26 : 1 sanctions. Corporate decision-makers practically never pay out of pocket for their misbehavior,^38 so presumably the law lacks teeth. An influential strand of the literature suggested that corporate law’s teeth consist in facilitating nonlegal sanctions. But so far the existing accounts have failed to develop a satisfactory theory of how nonlegal forces work or how exactly the law facilitates them. I start this Part by identifying the gaps in the existing approach. Current accounts focus on how judicial comments induce guilty feelings among misbehaving directors or on social shaming among misbehaving directors’ peers.^39 In other words, the current approach deals narrowly with how verdicts ramp up the moral sanctions for misbehaving. In reality, though, verdicts are rare, and the moral rebukes offered in them seldom reach their presumed audiences. It therefore makes sense to shift our focus to how the litigation process as a whole (not just verdicts) shapes the reputational (not just moral) sanctions for misbehaving. I outline three important factors that determine how information from the courtroom translates into the court of public opinion. The main takeaway point is that, counterintuitively, not every case of judicial scolding hurts the company’s reputation. To predict the reputational impact, we need to ask who the judge is scolding (an ousted individual or an unhealthy corporate culture?); what she is scolding for (honest incompetence or calculated disregard for shareholder interests?); and what her scolding adds to the preexisting information environment. A. Litigation’s Impact on Moral Sanctions: “Saints and Sinners” Revisited Delaware fiduciary duty litigation features a striking pattern: no sanctioning but lots of talking. Delaware judges usually refrain from imposing legal sanctions on company decision-makers, but they do not shy away from criticizing the directors’ behavior whenever they see fit.^40 This fact pattern of lengthy, fact-intensive, judgmental verdicts raises a puzzle: what is the point in preaching if you are not going to sanction? If Delaware courts are not enforcing fiduciary duties, why do they bother talking about them so much? Several prominent corporate legal scholars suggest a solution to this puzzle: preaching is the point, they claim. Preaching is not an afterthought but rather the main function of Delaware decisional law. It is through richly detailed narratives of good and bad corporate behavior that Delaware judges
- Supra note 1. The main justifications for refraining from sanctioning are discouragement of productive risk-taking in businesses, judicial incompetence, and the ability of shareholders to fend for themselves by diversifying risks.
- See Rock, supra note 2.
- For empirical support for the argument that Delaware courts rely heavily on moralism, see John C. Coates, Managing Disputes Through Contract: Evidence from M&A 35 n.54 (Aug. 14, 2011) (unpublished manuscript), available at http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=1975423.
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control corporate behavior.^41 Once the morality tales of corporate saints and sinners become publicly available, they unleash all sorts of nonlegal forces. In one version of this “saints and sinners” approach to corporate law, directors hate being dressed down in verdicts because it reduces the esteem that they get from colleagues and peers (“external moral sanctions”).^42 In another version, directors who are subject to judicial scolding suffer not from disesteem of others but rather from their own sense of guilt (“internal moral sanctions”).^43 And because judges elicit the opprobrium of third parties and/or guilt feelings of first parties simply by what they say, they get to sanction and deter misbehavior without imposing legal sanctions. The saints and sinners theory of corporate law does a great job of spotlighting one indirect deterrence element of corporate law. It correctly directs our attention to the possibility that corporate litigation shapes behavior not just through the outcomes but also through the content of judicial opinions. But as the following paragraphs explain, the existing approach has too narrow a focus. I propose here a shift in perspective: from focusing just on how judicial comments affect moral judgments^44 to focusing on how the litigation process as a whole affects reputational judgments. First, focusing just on judicial opinions is problematic because most legal disputes settle. Judges get very few chances to offer moral rebukes in verdicts.^45 Cases that settle do not produce moralistic impact, but they may nevertheless affect the market reaction: not by shaping moral beliefs but rather by shaping factual beliefs. The process itself prior to settlements (pleading, discovery, and trial) sheds light on reputation-relevant information. Indeed, recent empirical studies show that market players monitor and react to events during the early stages of the process.^46 Second, focusing just on moralistic impact is problematic because the typical verdict sends mixed messages: by legally exonerating defendants, the verdict dilutes the power of any moralistic condemnations made in dicta. The
- The two most representative accounts are Rock, supra note 2 , and Blair & Stout, supra note 1. While there are various other accounts of corporate law and social norms that vary in nuances, they all share enough similarities to be grouped for our purposes under the “saints and sinners” umbrella term.
- See Rock, supra note 2.
- See Blair & Stout, supra note 1.
- For acknowledgments that existing accounts focus on moralistic and not reputational consequences, see, for example, Rock, supra note 2 , at 1013 (focusing on disesteem); David A. Skeel, Jr., Shaming in Corporate Law , 149 U. PA. L. REV. 1811, 1814, 1856 (2001) (focusing on moral disapproval). The few analyses that touch the reputational outcomes of litigation do not develop it into a full theory. See, e.g. , Gordon, supra note 32 , at
- See Miller, supra note 35 , at 329.
- Supra note 34 ; see also JOHN D. LYTTON, HOLDING BISHOPS ACCOUNTABLE 205 (2008); Gorga & Halberstam, supra note 23 (noting that the corporate law literature fails to recognize the importance of discovery in shaping corporate behavior).
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on reputational impact: highlighting the main factors that determine how information from litigation translates into reputational sanctions. B. Litigation’s Impact on Reputational Sanctions: Towards a Novel Approach The starting point of a reputational theory of corporate law is a “negative” one, telling us what we cannot do: we cannot simply assume that litigation hurts the reputation of the companies and the businesspeople involved. Reputational sanctions work in fuzzy ways that do not lend themselves to generalizations. Counterintuitively, sometimes judicial scolding may actually help the defendant company’s reputation. In this Subpart, I build on insights from the reputation and crisis management literatures in order to take the next “positive” steps for a reputational theory: generate testable predictions. I flesh out three key questions we should ask when trying to predict the reputational outcomes of specific disputes. First, we should ask “scolding who ?” There is a huge difference between criticizing singled-out individuals and criticizing the company’s systematic failures. In other words, a reputational theory should distinguish between individual- and organizational-level reputations. Second, we should ask “scolding compared to what?” In legal disputes with big and visible companies, information coming from the legal system is not read in isolation but rather appears against the background of an already existing market reaction. In most cases stakeholders have already learned about the misbehavior and formed opinions. A reputational analysis of litigation therefore should concentrate on relative impact: do not ask whether the judge’s version is unfavorable to the company—ask whether it is more or less favorable than the prevalent version accepted in the market prior to litigation. Finally, we should ask “scolding for what? ” In reputational terms, the type of sin matters: there is a difference between bad outcomes caused by honest incompetence and bad outcomes caused by calculated disregard for market norms.
- Scolding Who? Individual Reputation vs. Organizational Reputation Litigation affects the reputation of individuals differently than it affects companies. Legal scholars usually ignore this distinction altogether, implicitly assuming that any judicial scorning of individuals reflects badly on their companies.^52 But the reputation literature suggests that scolding an individual does not necessarily impact the company’s reputation negatively. It depends on factors such as the scolded individual’s place in the hierarchy, whether she still
- But see Skeel, supra note 44 , at 1855.
20 STANFORD LAW & POLICY REVIEW [Vol. 26 : 1 holds office, or what other top managers knew about her actions.^53 Granted, in many cases the intuitive answer applies: dressing down an individual manager does reflect badly on the company. But there also are common scenarios where, counterintuitively, dressing down specific managers may actually boost the company’s reputation (or at least not hurt it). Consider two examples. First, the judge often dresses down a manager who is already gone or on her way out of the company. Such judicial finger-wagging would probably damage the ousted manager’s labor-market reputation, but it could help repair the company ’s reputation. This is because singling out one individual as a sinner gives rise to a “scapegoating” dynamic. As the crisis management literature shows, one of the most effective recovery strategies for companies is decoupling: acknowledging the problem while isolating and localizing it.^54 And scapegoating is an especially effective form of decoupling. By attributing the problem to a rogue element that was subsequently purged, the company distances itself from the wrongdoing. Accordingly, when a judge singles out the ousted manager for opprobrium, she lends credibility to the decoupling claims and directs the public’s attention away from more systematic problems. In another typical scenario, the judge scolds a manager for making mistakes out of incompetence. Here again, the individual’s labor-market reputation will probably take a hit (who wants to hire an incompetent manager?). But the impact on the company’s reputation is not necessarily negative and could even be positive. Crisis management experts maintain that companies in crises stand better chances of repairing their reputation when individual managers are portrayed as less than perfect.^55 If stakeholders perceive the leader as perfect and in total control, they assume that she could have prevented the adverse outcome. As a result, stakeholders will interpret the company’s misconduct as intentional and indicative of future behavior (that is, arising from deep-rooted disregard for shareholder interests and market norms in general). By contrast, if stakeholders perceive the leader as less than perfect, they are more likely to interpret the adverse outcomes as a result of more easily fixable mistakes.^56
- See, e.g. , ERIC DEZENHALL & JOHN WEBER, DAMAGE CONTROL 141 (2007); E. Deanne Brocato et al., When Things Go Wrong: Account Strategy Following a Corporate Crisis Event , 15 CORP. REPUTATION REV. 35, 36 (2012) (“Both theoretical and empirical research on corporate crises suggest that individuals and corporations may be viewed differently when evaluated, following a corporate crisis event.”).
- See, e.g. , Anna Lamin & Srilata Zaheer, Wall Street vs. Main Street: Firm Strategies for Defending Legitimacy and Their Impact on Different Stakeholders , 23 ORG. SCI. 47, 50- 5 4 (2012).
- See DEZENHALL & WEBER, supra note 53.
- To be sure, in the business world it is sometimes better to be (perceived as) immoral than incompetent. Still, there are areas where incompetence is considered less deep- seated and easier to root out than lack of integrity. Cf. KIMBERLY D. ELSBACH, ORGANIZATIONAL PERCEPTION MANAGEMENT 60 (2006); John Hendry, The Principal’s Other Problems: Honest Incompetence and the Specification of Objectives , 27 ACAD. MGMT. REV.
