Compensation's role in deterrence.

• Author: Gold, Russell M.
• Position: II. Reputational Harm and Optimal Deterrence B. Why Reputational Harm Matters for Optimizing Deterrence through Conclusion, with footnotes, p. 2021-2048

2. Why Reputational Harm Matters for Optimizing Deterrence

   Given the evidence that the threat of reputational harm deters wrongdoing, how should social policymakers account for reputational deterrence when seeking to optimize deterrence in class litigation? In short, it should be deducted from the magnitude of victim harm to achieve ideal net damages because it is not a deadweight loss. (180)

   If reputational harm were a deadweight loss to defendants, it would rightly be excluded when calculating damages because defendants would already internalize it. (181) If reputational harm to the defendant generates benefit for others, however, reputational harm plays an important role in calibrating optimal deterrence. (182)

   Cooter and Porat rightly explain that reputational harm is typically not a deadweight loss. (183) Rather, reputational harm often generates three benefits: conveying information about the wrongdoer to potential victims to help them avoid future harm, benefiting competitors of the wrongdoer, and deterring the particular wrongdoer and others because they anticipate this extralegal harm. (184) Consider what it would mean to embrace a contrary, deadweight-loss view (185): accepting that publicity from a lawsuit would not make a single person aware of potential future harm, deter a single firm (including the specific defendant), or benefit competitors by harming the competition. That is highly implausible and contrary to literature explaining that litigation makes consumers more aware of potential risks. (186)

   To account for the transfer value of reputational harms, courts would ideally achieve optimal deterrence by deducting the value of the benefits from the amount of harm the victim has suffered to calculate the amount of net damages necessary in an individual case. (187) Otherwise, the defendant's expected sanction would exceed the expected social harm. (188) Because these benefits are difficult to calculate practically, however, Cooter and Porat recommend that courts deduct the extent of the reputational harm as a proxy for third-party benefit from that harm. (189) Accordingly, optimal deterrence requires that potential defendants anticipate an award of damages equal to victim harm minus third-party benefits of the defendant's reputational harm (or, as a proxy, victim harm minus reputational harm).

   Whichever method is used to calculate the deduction, the magnitude of reputational harm and the benefits that it creates can be significant. (190) An empirical study of stock market impacts from employment discrimination class actions found that the average drop on the day a case is announced "is triple that of the average direct costs to the firm of settling the case." (191) Securities enforcement proceedings generate reputational losses exceeding legal penalties by more than 7.5 times. (192) In the criminal context, one study concluded that the reputational cost of corporate fraud encompassed 93.5% of the relevant stock market declines. (193)

   Moreover, for deterrence purposes, it is not important whether reputational harm will actually be significant in a particular case but rather whether firms fear significant reputational harm from litigation when they choose levels of activity and safety precautions. (194) And expected reputational harm can be significant. "[F]irm managers believe that serious legal proceedings ... can have potentially devastating effects on business." (195) Or as another study put it, "corporations fear the sting of adverse publicity attacks on their reputations more than they fear the law itself." (196)

   In sum, class actions generate significant reputational harm, particularly when filed, settled, or when they unearth evidence of wrongdoing. And reputational harms cannot be ignored for purpose of optimizing deterrence because they do not create a deadweight private loss.

   3. COMPENSATIONALISM

   When the award was finally settled, [the securities enforcer] kept the money [instead of giving it to the victims]. I likened it to the call to the sheriff's office when you report your car stolen, the sheriff calls you back two days later and says, "Good news, we found the car; bad news is, I am keeping it." (197) This Part contends that as a descriptive matter, the public values compensation in class actions, as seen largely through Congress's actions and its rhetoric surrounding those actions. (198) Indeed, scholars have widely recognized that the public views compensating victims as an important aim--if not the sole aim--of civil litigation. As one prominent scholar puts it, " [i]t could hardly be controverted that many private citizens find ... lawsuits [in which claimants are not meaningfully compensated] to be politically unwise, economically reckless, and morally offensive." (199) Another prominent scholar explains, "The 'aroma of gross profiteering' that many perceive rising from damage class actions troubles even those who support continuance of damage class actions and fuels the controversy over them." (200)

   That the public values compensation is important because it means that compensation plays an important role in the magnitude of class actions' reputational deterrence, as explained below. (201)

1. Congressional Compensationalism

   The most significant legislative changes to modern class action practice--CAFA and the PSLRA--claimed to protect victim compensation. Nowhere is this congressional sentiment clearer than in CAFA. Congress passed CAFA with resounding bipartisan support, (202) largely behind rhetoric criticizing settlements where victims were left with nothing more than a coupon for a discount on their next purchase from the defendant. (203)

   In different contexts, both the FAIR Funds Act and the FTC Improvement Act allow federal agencies to displace (or at least supplement) the traditional role of private class actions and pursue victim compensation. The legislative history of both statutes similarly reveals Congress creating compensatory tools for government enforcement while claiming dissatisfaction with victim compensation in class actions. (204)

   Whether Congress actually sought to protect the public's preferences for compensation in civil litigation or whether that contention was merely rhetorical, (205) that Congress couched its efforts in compensatory terms signals a belief amongst Members that the public values compensation in civil litigation.

   1. Class Action Fairness Act of 2005

      CAFA--the most significant legislative change to class actions--provides a stark example of Congress's narrative about protecting compensation and its claim that lack of compensation undermined the social legitimacy of the class device. (206) CAFA followed years of "significant criticism due to the great imbalance between the often worthless coupons that class members received and the sizeable fees their attorneys reaped." (207) The congressional debate was marked from start to finish by "invok[ing] the large fees that accompanied worthless coupons as evidence of a 'broken' system that produced 'outrageous decisions.'" (208) Or as the text of the final bill explained, the lack of compensation for victims had "undermined public respect for our judicial system." (209) That CAFA passed with strong, bipartisan support suggests that the narrative of insufficient compensation becoming a problem for class actions' legitimacy and reining in runaway attorneys' fees gained traction or at least proved popular enough to provide cover for other objectives. (210)

      To address this compensation problem, Congress required courts awarding contingency-based attorneys' fees in coupon settlement cases to determine the award based on the value of coupons actually redeemed rather than the theoretical value of coupons issued. (211) Moreover, Congress required courts to issue a written finding after a hearing that proposed coupon settlements are "fair, reasonable, and adequate for class members" before such settlements could be approved. (212) CAFA's coupon settlement provisions help to protect some role for class action compensation.

   2. Private Securities Litigation Reform Act of 1995

      The PSLRA too was pitched as a means to provide more meaningful compensation to class members. (213) The conference report describes "testimony that counsel in securities class actions often receive a disproportionate share of settlement awards" (214) and testimony about "rampant" "manipulation by class action lawyers of the clients whom they purportedly represent," (215) sounding much like the charges critics would levy against all class actions ten years later in support of CAFA. Although the findings in the PSLRA regarding compensation are not as explicit on the face of the legislation as in CAFA, the PSLRA too found Members of Congress claiming to protect victim compensation.

      Congress left its mandate vague but linked class compensation to attorney compensation. It provided that "[t]otal attorneys' fees and expenses awarded by the court to counsel for the plaintiff class shall not exceed a reasonable percentage of the amount of any damages and prejudgment interest actually paid to the class." (216) In so doing, like CAFA's coupon settlement provision, the PSLRA linked attorneys' fees to actual victim compensation. Linking fees to compensation protects compensation by tying it to the agent's (class counsel's) incentives. (217) If victims were not compensated, neither would attorneys be. Much like CAFA, the PSLRA garnered broad support in Congress. (218)

   3. FAIR Funds Act

      The FAIR (219) Funds Act (220) too was headlined by rhetoric evincing discontent with securities class actions' inefficacy at victim compensation. (221) The most powerful evidence comes from Congressman Baker, the Member who proposed FAIR Funds as an alternative to the traditional compensatory mechanism for securities violations: the private class action. (222) The quote in the epigraph above, analogizing compensation-less cases to the sheriff finding...