Governance Institutions and Outcomes
New Directions in Modern Economics series
Edited by Mehmet Ugur and David Sunderland
Chapter 4: Legal versus Reputational Penalties in Deterring Corporate Misconduct
Peter-Jan Engelen INTRODUCTION Traditionally, most countries rely heavily on public law enforcement through court-imposed or supervisory-imposed legal sanctions to insure corporations to comply with the law. Most regulators ignore financial markets as one of the channels to induce companies to behave responsibly. This chapter examines the relationship between formal legal governance institutions and the role of market-imposed reputational penalties. Its aim is to establish the relative effectiveness of both types of institutions in encouraging responsible corporate behaviour. As the field of economic governance compares the performance of different institutions under different conditions (Dixit, 2009), this chapter contributes to the literature on market-induced versus public enforcement mechanisms. Specifically, we focus on the effectiveness of public versus marketinduced enforcement efforts of illegal insider trading by corporate insiders. We test whether there is any interaction between a country’s public enforcement power and the magnitude of reputational penalties companies experience for the illegal insider trading of their managers. The analysis combines two recent datasets on the United States and six European countries covering illegal insider trading practices by the company’s CEO and other executives. This is the first cross-country study which links the magnitude of reputational penalties to differences in the country’s level of law enforcement. As law enforcement varies significantly cross-country, one can postulate to observe different reputational penalties for our set of seven countries. We test the hypothesis of any substitution effect between legal penalties and reputational penalties. If this is the case, our results can have important consequences for a country’s...
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