INTRODUCTION I. HOW THE LAW SHAPES REPUTATIONAL SANCTIONS: A GENERAL FRAMEWORK 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 A. Litigation's Impact on Moral Sanctions: "Saints and Sinners" Revisited B. Litigation's Impact on Reputational Sanctions: Towards a Novel Approach 1. Scolding Who? Individual Reputation vs. Organizational Reputation 2. Scolding Compared to What? What Information Is Available vs. How It Is Diffused 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? IV. IMPLICATIONS : THE INDIRECT DETERRENCE FUNCTION OF DELAWARE CORPORATE LAW A. How Key Doctrines Contribute to Information Production 1. Procedural Doctrines: Pleading Mechanisms and Settlements Approvals a. The Pleading Stage b. The Settlement Stage 2. Substantive Review: How to Assess Director Liability and the Role of Indeterminacy a. Should Director Liability Be Assessed Individually or Collectively? b. The Role of Indeterminacy B. How the Content of Corporate Law Is Determined: A "Make It Look like a Struggle" Theory V. THE REPUTATIONAL CONSEQUENCES OF SEC ENFORCEMENT ACTIONS A. Judge Rakoff vs. SEC Settlement Practices: The Existing Debate B. Identifying the Problem: How SEC Settlements Underproduce Information C. Explaining the Problem: Why the SEC Trades Information for Fines D. Solving the Problem: Can Enhanced Judicial Scrutiny Help? CONCLUSION Introduction
How does corporate law work? This question has puzzled academics for decades. The puzzle stems from the fact that the managers and directors who are supposed to be disciplined by corporate law almost never pay out of pocket for their misbehaviors. (1) In other words, corporate law lacks sanctions. Without sanctions, where does deterrence come from? The corporate governance literature has suggested in response that deterrence comes not from the law or direct financial sanctions, but rather from indirect reputational sanctions. Managers do their best not because they fear direct sanctions, but rather because they wish to protect their long-term reputation in the labor market or among their peers. (2) But such an answer only generates a second puzzle: how do indirect, reputational sanctions work? (3)
This Article provides a new perspective on these puzzles by arguing that corporate law affects behavior indirectly, through shaping reputational sanctions. In the process of litigation or regulatory investigations, the legal system produces information on the behavior of the parties to the dispute. This information reaches third parties and affects the way that outside observers treat parties to the dispute (regardless and beyond the effects of direct legal outcomes). In other words, information from litigation and investigations shape the market reaction to misbehavior.
The way to solve the aforementioned puzzles is therefore to marry them: look at law and reputation together, as complementing each other. The corporate governance literature has rested on the assumption that reputation matters (4) but has remained remarkably silent on how exactly reputation matters. What explains the variation in reputational sanctions? Why do some companies and businesspeople emerge from failure unscathed while others go bankrupt? Some of the answers, this Article claims, can be found in the information-production function of the law. The law serves as an important channel that 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 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) I then revisit the regulatory competition debate. (9) The existing literature already recognized that if Delaware wishes its law to remain the dominant state corporate law, it has to balance between appeasing the public and Washington in order to prevent federal intervention and appeasing corporate...