Reputational Penalties

A reputational penalty refers first to damage sustained by a firm’s reputation as a result of firm actions that observers evaluate as negative or “bad” (e.g., selfish, opportunistic, illegitimate, unethical, or illegal actions, or subpar performance). While corporate reputation is generally thought of as a perceptual evaluation of the firm, a second view of reputational penalties sees them as tangible, undesirable consequences that follow negative behavior, which are attributable to reputational damage. For example, misbehavior may lead a firm to suffer reduced sales, stock price declines, reduced access to exchange partners, less advantageous terms of trade, or revocation of licenses, certifications, or contracts. This entry discusses reputation as a form of social control, the consequences of negative corporate behaviors, strong and weak reputational penalties, and whether reputational penalties serve to deter bad behavior.

Reputation as Social Control

Reputational penalties (of both the categories described earlier) play an integral part in reputation’s social control function. A reputation provides information about how an actor is likely to behave in the future, so that positive reputations lead others to see the actor as an attractive exchange partner and poor reputations impede exchange. Consequently, reputations are thought to motivate actors to treat partners fairly and appropriately because if selfish or inappropriate acts were detected, the offender would suffer a reputational penalty (including tangible negative consequences of the types described earlier) as word spread through the community. In this way, reputation and reputational penalties have the potential to serve as a powerful social control mechanism that deters corporate bad behaviors.

Of course, it is easy to see that firms engage in various forms of misconduct and do so with disappointing frequency. Extreme cases like Enron and Arthur Anderson are accompanied by literally hundreds of cases of earnings restatements, financial fraud, product recalls, and innumerable less egregious negative behaviors. What do we know, then, about corporate reputational penalties, their negative consequences, and their deterrent effects? Research presents a nuanced picture and raises important questions about the straightforward logic described earlier.

If corporate reputations are perceptual evaluations of the firm’s quality and propensities, it is clearly foundational to assess how those perceptions change—that is, what the penalty to reputation as such is—after the firm engages in bad behaviors. However, we know less about how negative behaviors change perceptions of firms than we do about the consequences of those behaviors. For example, it seems clear that Arthur Andersen’s reputation suffered fatal damage from its flawed handling of the Enron account, leading to widespread client defections well before its criminal conviction for obstructing justice. But while the tangible consequences of its tarnished reputation are quite visible, the actual perceptual damage is not. That said, studies examining the Fortune “Most Admired Companies” survey have shown that firms suffer reputational damage in the wake of illegal activities (Environmental Protection Agency violations), practices that smack of managerial self-interest (poison pills), practices that suggest violation of implicit contracts (downsizings), and rejection of social responsibilities. On the other hand, there is also evidence that firms scoring poorly on the prominent KLD social responsibility indices suffer little if any reputational penalty for doing so, at least from the perspective of the Fortune survey.

Consequences of Negative Corporate Behaviors

In contrast to the relatively few studies of perceptual changes as such, dozens of studies examine the consequences of a wide range of corporate negative behaviors. Many of these focus on corporate misconduct and associated declines in firms’ stock valuations. Often, these declines far exceed the value of fines, legal judgments and fees, and related costs, and the “excess” decline is interpreted as the tangible reputational penalty imposed on violating firms. Studies often estimate these penalties in the range of several percentage points, with some ranging as high as 20 percent of the stock’s initial valuation. Other research shows other tangible penalties, for example, through reduced sales following product-related transgressions (e.g., recalls).

As managers make the decisions to engage in questionable behavior, it is also critical to understand what reputational penalties have been imposed on them. Studies have shown that the managers in office when their firm engages in illegal or inappropriate behavior (mostly financial fraud and earnings restatements) are at greater risk of turnover and have difficulties regaining employment. Thus, both managers and their firms suffer significant consequences for misconduct and wrongdoing.

Strong and Weak Reputational Penalties

Going further, research has examined when penalties are stronger or weaker. A variety of contingency variables have been discussed and examined. First among them is whether high reputation leads to greater reputational penalties following transgressions. Some studies indicate that misconduct by high-reputation actors attracts more attention (e.g., by the media) and more strongly violates stakeholders’ expectations. Others suggest that high reputation can act as a buffer and reduce damage incurred in the face of negative events. Recent work has advanced contingency arguments, for example, that the issue turns on stakeholders’ level of organizational identification. Research also suggests that firms suffer smaller penalties when the misconduct does not involve ongoing exchange partners of the firm (e.g., environmental violations) or when the firm’s market power or other assets (e.g., relational ones) allow it to mitigate potential consequences.

Deterrence

The significant reputational penalties that firms and managers face for misconduct raise a question as to whether reputational penalties actually deter bad behaviors and if so to what extent. Here, research seems to have focused more on which firms engage in wrongdoing and why. High-reputation firms, having more to lose, would seem likely to do so less frequently. Research evidence, however, is mixed. Indeed, one prominent study finds that high-reputation firms are actually more likely to engage in financial restatements and attributes this to hubris and performance pressures. Enron and Arthur Andersen are prominent examples of firms that had strong reputations before their transgressions came to light.

Overall, the deterrent effects of reputational penalties are not well understood. These effects are the last link in the cycle through which reputation and reputational penalties are thought to act as a social control mechanism, so this is an important gap. One potential explanation is that pressures and incentives toward misconduct may often appear to be proximal and clear, whereas the reputational penalties and negative consequences may often appear as distant and uncertain. This is speculative, however, and emphasizes the need for research that links potential penalties and incidence of wrongdoing and so more directly explores this crucial link in the reputation-as-deterrent cycle.