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E-MailAmir Licht is Professor of Law at the Interdisciplinary Center Herzliya, Israel. This post is based on his recent paper, forthcoming in the Research Handbook on Fiduciary Law (Andrew Gold & D. Gordon Smith, eds.) This post is part of the Delaware law series; links to other posts in the series are available here.
While common law jurisdictions around the world exhibit substantial similarity in many basic features of fiduciary loyalty, fiduciary law is particularly diverse with regard to whether and to what extent should parties be allowed to define their relations contractually. This paper advances a theory of the extent and the limits of contractual freedom with regard to fiduciary obligations, or, put otherwise, of the irreducible core of such obligations. The key insight on which this theory hinges holds that fiduciary obligations constitute a social-institutional response to acute information asymmetries, especially of the unobservable and unverifiable kind.
It is trite law that a fiduciary and a beneficiary can agree on the former’s duties and liability. Now if the beneficiary can validly agree to a single breach she can surely agree to a handful, and if so, why not to every breach? The freedom of parties to fiduciary relations to negotiate the scope of the fiduciary’s legal responsibility thus has been hotly debated in different sub-fields of fiduciary law and in several common law jurisdictions.
A noteworthy branch of this debate has developed in corporate law, where the image of the corporation as a “nexus of contracts” has made a major impact. A sub-branch of this literature has debated contractual freedom in corporate law. Delaware allows for contracting around the duty of care but not with regard to the duty of loyalty or conduct not in good faith. In another sub-branch, legislative reforms throughout the United States created or revised contract-based business entities, most notably the limited liability company (LLC). Members of such entities can design the regime governing them, including by eliminating the duty of loyalty. Delaware courts, however, have treated such waivers restrictively and with great reluctance.
Fiduciary relations necessarily entail an agency problem and a risk of opportunistic behavior. Opportunism is a binary compound, consisting of two distinct factors—one motivational and one informational. Williamson’s definition of opportunism as “self-interest seeking with guile” reflects both facets. The motivational factor is self-interestedness; it is (nearly) straightforward. The informational factor refers to information asymmetries, while adding to it an element of nastiness—reflected in “guile”—that alludes to its elusive nature.
Within information asymmetries, the more pernicious are those that stem from unobservable and unverifiable information. English courts at least since the mid-eighteenth century have distinguished the motivational and informational factors and pointed out the latter type of information asymmetries as justifying Equity’s strict approach to the duty of loyalty. Some contemporary commentators, however, have dismissed those concerns as reflecting an outdated legal setting. One corollary of this view is that the law could support the formation of fiduciary relations but should not limit the party’s contractual freedom to shape such relations as they see fit, including by opting out of the duty of loyalty. Those who do not adhere to an unbridled contractatian approach in this debate tend to justify fiduciary law’s strict posture by appealing to transaction cost reasoning. In this view, fiduciary law more efficiently sets rules that the parties would adopt or, also efficiently, sets penalty default rules that they would not adopt.
The fiduciary’s informational advantage due to unobservable and unverifiable information provides her with power vis-à-vis the beneficiary. As a definitional matter, this power is absolute in that the beneficiary cannot fend against it, regardless of her resources, or technological advancement, or judicial expertise. A well-known “market for lemons” dynamic may ensue in such circumstances, in which the best response of the negotiating parties would be to continually discount their willingness to engage with one another. In the pure case, the market collapses. Thus, what may be optimal for particular parties at the individual level could lead to suboptimal outcomes at the social-institutional level. To avoid market failure due to contract failure, a societal-level intervention—a mandatory law—is necessary. In fiduciary law this intervention is embodied in the fiduciary’s unwaivable duty to account, at the core of which lies a duty of full disclosure.
To buttress the analysis this paper considers the obligation of full disclosure in insurance law. Traditional insurance law classifies insurance policies as contracts of “utmost good faith” (uberrima fides). This doctrine imposes on the insured a pre-contractual duty to make full disclosure of all material information. Failure to observe this duty entitles the insurer to avoid the policy and thus completely escape liability. Dixit shows that this uberrima fides legal rule is Pareto-improving when compared to the purely contractual approach. This social institution thus prevents the parties from falling into an Akerlofian spiral that could end in market failure—an undesirable result inasmuch as insurance markets are concerned.
The need for a strict full disclosure duty is in fact more pressing in fiduciary relations because principals in many fiduciary relations cannot fend for themselves as insurers can. First, while insurers are economically powerful, beneficiaries come in all shapes and sizes, including the meekest and poorest. Second, insurers face multiple clients whose distribution approximates that of the population and can rely on consortium fellows and reinsurers in order further to mitigate the idiosyncratic risk in their portfolio. In contrast, fiduciary relations often have a one-on-one structure or close to that. Unlike insurers, a typical beneficiary in such relations does not have access to the background information needed for assessing likely manifestations of opportunism by her fiduciary. Third, and perhaps most fundamentally, a key factor in insurance relations is the claim. Once a claim is made, the insurer gets an opportunity to discover information that would invalidate it. If the insured does not make a claim for coverage, the insurer does not care about any opportunistic behavior the former may engage in. In fiduciary relations, however, the fiduciary can act opportunistically through taking (“looting” or “tunneling”) and neglect (“shirking”) without ever making a claim to the beneficiary beyond claims for compensation. This feature exacerbates the beneficiary’s vulnerability due to his information inferiority, which strengthen the case for a strict full disclosure regime.
The full paper is available here.
