This post was originally published on promarket.org – the blog of the Stigler Center at the University of Chicago Booth School of Business.

What deters corporate misbehavior? Two of the most frequent answers are regulation and reputation. Yet so far the literatures on the legal system and market system (reputation) of control have developed largely independently of each other, without fleshing out interdependencies. My previous ProMarket post dealt with how the effectiveness of regulation is a function of the reputation environment. When regulators’ reputations are noisy, the risk of regulatory capture increases. This post turns our attention to the flip side: how the effectiveness of reputation is a function of the regulatory environment. When regulation is more captured, the power of reputation as a system of controlling corporate misbehavior goes down.[1]

Special interest groups can use their influence over regulation to water down not just potential legal sanctions but also potential reputational sanctions. That is, special interests may rely on ineffective regulators to fight battles in the court of public opinion for them. One common theme is using the regulator as a shield. We often observe regulated companies fending off allegations by referring to the regulators’ choice not to interfere. A good illustration comes from emissions of toxic chemicals. Chemical companies that get accused of mishandling toxic emissions frequently refer to the Environmental Protection Agency (EPA)’s decision not to ban/regulate the chemical as proof that nothing is wrong with how the company handles it.

A related, more proactive tactic is using the regulator as a validator. In this variation, special interests write the press release for the regulator (often literally). Having your version come out of the mouth or letterhead of the regulator increases the version’s chances to be well-received by your stakeholders. For example, a 2014 Pulitzer Prize-winning report by the New York Times spotlighted the relationships between energy companies and state attorney generals: the company sends a draft to the attorney general, who in turn changes just a few words, copy-pastes, and releases the draft on an his official letterhead.[2]

Similar dynamics are in play with the Securities and Exchange Commission (SEC) enforcement actions.[3] The SEC practice of settling quickly without requiring admission was heavily criticized, but from the wrong reasons. As we discussed here a few weeks ago, there is little reason to believe that SEC settlements leave money on the table, but a lot of reason to believe they leave information on the table. Part of it is because defendant companies get to negotiate the language of the regulator’s press release when the settlement is announced. The settlement is beneficial for both parties but bad for market discipline and therefore bad for the public. The SEC gets to maximize the observable yardsticks on which they are measured: amount of cases brought and fines collected.[4] In return, the SEC gives in on the less salient aspects, namely the information that is being produced as a result of their investigation. In other words, the SEC scores point for maximizing legal outcomes (which are under their direct responsibility), while giving in on the reputational outcome (which they are not measured against). Defendant companies, in the meantime, count the (insurable) legal fines as the cost of doing business, while avoiding much larger (uninsurable) reputational fines by controlling the way that the Wall Street Journal reports on their case. Yet another example comes from antitrust attorney Gary Reback, who shared in his ProMarket interview a story about how Google’s lobbyists nudged the Federal Trade Commission to publically rebut accusations that Reback made in an op-ed. 

Armed with these illustrative examples, let us try to understand why using the regulator as validator works, what is the problem with it, and how we can mitigate it.

The reason that companies use regulators to tell their story is because the source matters. It is not just what is being said but also who says it. Communication scientists and reputation scholars have fleshed out over the years the determinants of source credibility.[5] Regulators often check the box for several key features that make a source credible: First, they are perceived as independent, in a sense of not standing to gain from adopting a certain version. Second, they are perceived as an expert on the subject matter. Finally, they are perceived as not interested in persuading the audience—they do not try to sell you something but rather to tell you something.

Note the emphasis on “perceived as.” The strategy of regulators as validators is not problematic per se from a societal perspective. It becomes problematic only if the public over-estimates the regulator’s independence, expertise, and motives. All too often, that would be the case. Even a well-respected and public-spirited regulator may lack the time, information, or simply willingness to fight off attempts to use her as a certifier of the regulated entity’s version.[6]

Similarly, when regulated companies use the regulators as shields, they may be right. It could be the case that an omnipotent regulator diligently monitored and saw no reason to interfere. In such cases, the regulator’s inaction indeed certifies the company’s claim that allegations against it are unfounded. But regulated companies are well aware of the fact that regulators are usually anything but omnipotent. To recast our chemical companies example: they knew that the regulatory framework under which the regulator operates (TSCA) was broken, and so that regulatory inaction should not mean endorsement. In many cases the regulated companies themselves do all they can to make sure the regulator cannot diligently monitor the situation. They use one arm to delay regulatory action and then turn around waving the other arm in a “nothing to see here” fashion, assuring the public that a very diligent regulator is on the case.

Go back to the story about energy companies sending drafts to attorney generals. When the reporter asked for a response, the attorney general office said that “it is the content of the request not the source of the request that is relevant.” They were wrong. The source does matter. As long as the public overestimates the source, the prospect of market discipline takes a hit. Consumers, employees, and other stakeholders will not downgrade their beliefs about the misbehaving company as much as they should have had it not been for the false validation by regulation. Public officials should therefore strive to communicate what the facts tell them rather than outsourcing their press releases.

As for us academics, we should strive to better understand and raise awareness of the interactions between regulation and reputation. A lot is at stake here. While this post covered the aspect of too few reputational sanctions, regulatory capture could also lead to too many reputational rewards. For instance, when voluntary compliance programs are not designed effectively, they could backfire and amount to greenwashing.[7]

Roy Shapira is a Fellow at the Stigle Center at the University of Chicago Booth School of Business. The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.

 

[1] To be sure, the relationships between the two systems are much more complex. There are bound to be substitution effects as well. That is, when the legal system of control is weak, there is increased demand for non-legal control, which could induce more reliance on reputation. My point in this post refers less to size (how much regulatory intervention we get) and more to quality (how effective is the regulation).

[2] Eric Lipton, Energy Firms in Secretive Alliance with Attorneys General, N.Y. Times, Dec. 6, 2014, http://www.nytimes.com/2014/12/07/us/politics/energy-firms-in-secretive-alliance-with-attorneys-general.html?_r=1.

[3] For elaboration see Roy Shapira, A Reputational Theory of Corporate Law, 26 Stanford Law & Policy Review 1 (2015), at part V.

[4] See generally Bengt Holmstrom & Paul Milgrom, Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design, 7 Journal of Law, Economics & Organization 24 (1991); and specifically to the SEC: Jonathan Macey, The Death of Corporate Reputation (2013).

[5] See the entries on Source Credibility and Third-Party Endorsement in The Sage Encyclopedia of Corporate Reputation (Carroll, ed., 2016).

[6] Note: the regulator-as-validator strategy works only when the regulator is weak enough not to resist it, but not so weak that the public will discount anything she says. Again, for the strategy to work the public has to overestimate the abilities of the regulator.

[7] See for example Magali Delmas & Arturo Keller, Free Riding in Voluntary Environmental Programs: The Case of the U.S. EPA WasteWise Program, 38 Policy Sciences 91 (2005).