Order with Some Law: Combining Formal and Informal Sanctions to Induce Cooperation

This paper examines the interaction between legal and reputational sanctions in the design of an optimal deterrence regime, particularly in a setting where two parties are engaged in a long-term relationship (a “relational contract” setting). The paper makes three claims. First, both legal and reputational sanctions are costly: legal sanctions require spending resources on litigation while reputational sanctions lead to inefficient failures to trade. An optimal deterrence regime must make a trade-off between these two types of costs. Second, in achieving optimal deterrence, the two sanctions function as both substitutes and complements. As substitutes, relying more on one type of sanction requires less of the other in reaching any desired level of deterrence. As complements, legal sanctions, through generation of relevant information, can facilitate reputational sanctions. Especially when fault-based standards (such as “best efforts,” “commercially reasonable efforts,” or “good faith”) are used, so long as the court’s decision produces information that correlates with the underlying behavior, the parties can use that information to better tailor reputational sanctions and improve efficiency. Third, notwithstanding the multi-layered relationship, the paper shows that legal sanctions can be more effective at deterrence than reputational sanctions. Increasing damages produces additional deterrence through two channels: by inducing more plaintiffs to file suit and by granting a larger recovery to existing plaintiffs. Increasing reputational sanctions lacks the second, infra-marginal effect. The paper also applies the predictions from the theory to various empirical findings, and considers how courts might use the findings to aid in interpreting phrases like “best efforts” and “good faith.” 1 Professor of Law, Washington University in St. Louis School of Law, and Albert C. BeVier Research Professor of Law, University of Virginia School of Law, respectively. We would like to thank... Comments are welcome to [email protected] and [email protected]. Baker and Choi Preliminary and Incomplete Formal and Informal Sanctions Version: October 8, 2013