Disclosure norms.

• Author: Talley, Eric
• Position: Symposium on Norms and Corporate Law

INTRODUCTION

Most law and economics scholars agree that private information represents a significant practical impediment to efficiency.(1) This consensus is richly deserved--in many real-world market settings, economic actors possess proprietary knowledge about the underlying characteristics of the transactions at issue. Sellers of real estate, for instance, often know about the existence of creaky floors, leaky roofs, and insect infestations.(2) Issuers of securities are privy to confidential data on financial fundamentals.(3) Used car dealers possess hidden knowledge about latent mechanical defects and repair histories.(4) Corporate fiduciaries have superior information about the merits of a proposed transaction or business combination.(5)

In each of these examples (and countless others), informed parties have an incentive to capitalize on their advantage by devising strategies to exploit their less knowledgeable counterparts. Anticipating this possibility, of course, uninformed individuals may respond with cautious strategies of their own calculated to minimize their exposure. Though individually rational, such strategic maneuvering is nevertheless socially undesirable, for it tends to distort--often significantly--the dynamics of the negotiation process, discouraging value-enhancing bargains from being struck (and perhaps even encouraging value-destroying ones). Within such contexts lies a possible invitation for courts to regulate the incidence and magnitude of inefficiencies due to informational asymmetry.

And have courts ever obliged. Examples abound in which legal doctrines have been devised in an attempt--active or passive--to encourage accurate information disclosure, particularly within corporate settings, with the ostensible goal of ameliorating the dangers posed by adverse selection. The law of express and implied warranties, for example, has general and far-reaching implications for both ordinary market transactions(6) and for "due-diligence" disputes within the mergers and acquisitions context.(7) Corporate law discourages officers and directors from causing their firms to enter into interested transactions without first disclosing the conflict to disinterested directors or shareholders and seeking approval.(8) And perhaps most notoriously, both federal and state securities laws impose a daunting and complex labyrinth of disclosure regulations on individual issuers, insiders, and traders--regulations that are frequently enforceable through private rights of action.(9) In all of these contexts (and in many others), those who fail to make the requisite disclosures or who disclose inaccurate information bear a significant risk of downstream legal liability.

Perhaps because of the considerable stakes involved, judicial inquiries into the accuracy of corporate information disclosure are now relatively commonplace. And, perhaps concomitantly, such inquiries have drawn sharp criticism from those who would advocate a more noninterventionist position. Many critics marshal at least two related arguments in support of their normative stance.

First, they contend that while third-party adjudicators are reasonably skilled arbiters of truth in garden-variety disputes, judges and juries are considerably more susceptible to judgment errors in complex disclosure disputes, where the allegedly misleading information is "soft," speculative, or predictive in nature. Indeed, impartial adjudicators may be particularly likely to err in such contexts, having first to reconstruct and interpret the often technical language that attends such disclosures, and then to assess the ultimate accuracy of such statements long after the fact. These tasks are no simple feats for judges and juries, who generally possess neither technical familiarity with the underlying issues, nor any direct knowledge of the actual context in which the initial disclosures were made.(10) Consequently, the argument goes, the inevitable inaccuracies that result may significantly undercut the deterrent incentives provided by legal sanctions, perhaps even rendering such sanctions counter-productive.(11)

Second, critics maintain that legal liability is far from the sole instrument for encouraging honesty in informationally sensitive markets. On the contrary, they assert that even without courts (or perhaps especially without them), extralegal "norms" of disclosure can evolve over time as a less formal, but nonetheless effective, instrument of deterrence. Indeed, many actors within corporate contexts are repeat players who fear being punished in future market transactions should they develop a reputation for nondisclosure or misrepresentation. Moreover, individuals and organizations that develop trustworthy reputations are likely to be the ones that survive in the longer term, and may, in the process, inculcate among their employees and managers a set of shared preferences for open and honest disclosure. In fact, because reputational sanctions are invoked by the parties themselves, such desires are far less susceptible to the errors and inaccuracies that plague third-party adjudication. Consequently, critics conclude, extralegal norms possess a greater capacity for effecting honest and efficient dissemination than does an inept, inaccurate, and indulgent system of regulation by judicial hindsight.(12)

The purpose of this Article is to interrogate the relationship between judicial error and extralegal norms more formally, focusing particularly on typical corporate disclosure contexts. In so doing, I shall argue that this relationship is far less clear-cut than much of the literature suggests. Using a formal, game-theoretic model of information disclosure, I demonstrate that in the presence of judicial error, a society that benefits from extralegal norms of honest disclosure might ironically favor more expansive legal regulation than would a similarly situated society in which norms are weak or nonexistent. Thus, in contrast to the common argument that norms can (or should) substitute for error-prone law, I argue that the two phenomena may frequently complement each other.

The intuition behind my thesis is a bit subtle, and its detailed explication is therefore relegated to the formal analysis below.(13) Nevertheless, the core intuitions emanate directly from a sequence of relatively simple observations. First, and most fundamentally, law is an inherently multidimensional policy instrument. Nearly every legal rule serves at least two distinct functions (if not more): a liability function (which determines when one is deemed to have acted wrongly) and a sanctioning function (which determines the monetary and/or nonmonetary consequences that attend wrongful conduct). Significantly, there is no a priori reason to believe that law and norms must interact uniformly across these constituent functions.

Second, norms of honesty often have the effect of augmenting the sanctioning function of law, contributing additional social penalties that further deter wrongful behavior.(14) This extralegal contribution to sanctions enables courts to reduce the magnitude of legal sanctions without compromising their target level of deterrence.

Third, as noted above, unlike their legal counterparts, norm-based sanctions are often exercised by market participants directly, without the intervention of a third party. Thus, such sanctions are frequently less susceptible to the verification errors that typically hamper third-party adjudication. In turn, this implies that as error-prone courts reduce legal sanctions to accommodate social sanctions, the aggregate costs of sanctioning errors borne by market participants will also decline.

Therein lies the rub: the reduction in sanctioning-error costs identified above may be sufficiently large to permit courts to expand law's reach in other dimensions, such as its liability function. In other words, because extralegal norms facilitate milder legal sanctions, efficiency-minded courts may become more interventionist in situations that they would otherwise eschew for fear of imposing excessive risk. Hence, by enabling milder legal penalties, truth-telling norms may ironically encourage courts to become more aggressive in specifying the universe of circumstances that trigger liability in the first place--effectively causing the long arm of the law to grow even longer (albeit somewhat less muscular). A society with both error-prone courts and extralegal norms of honesty, then, may very well end up implementing liability triggers that appear more aggressive than those of a society possessing equally error-prone courts, but less-developed norms of disclosure.

While examining the potential complementarity of law and norms is an interesting conceptual exercise, it is not merely an academic curiosity. On the contrary, it carries important lessons for lawyers, judges, and legal scholars who are engaged both in the positive inquiry about the practical domain of norms and in the prescriptive enterprise of designing law in the presence of norms. Regarding the former endeavor, much of the law and economics literature tends to portray individual behavior as relatively binary in nature--falling under the headings of "law compliance" or "norm following," but rarely both simultaneously.(15) By demonstrating the capacity for law to complement norms, my argument suggests that scholars seeking to identify the practical domain of norms should be cautious about overlooking or dismissing arenas of conduct that are already governed by existing liability rules.(16) Indeed, when norms and law are complements of one another, the two phenomena are likely to be highly correlated as an empirical matter. Thus, existing legal rules may be where we should begin our search for norms, not end it.

Likewise, the potential complementarity between law and norms implies that reform-minded scholars should be cautious about advocating the retrenchment or elimination...