SOME LEGAL AND ECONOMIC ASPECTS OF FIDUCIARY REMUNERATION
| Date | 01 May 1983 |
| DOI | http://doi.org/10.1111/j.1468-2230.1983.tb02518.x |
| Published date | 01 May 1983 |
SOME LEGAL AND ECONOMIC
ASPECTS OF FIDUCIARY REMUNERATION
I
INTRODUCTION
IT
is a salient characteristic of our social arrangements that the owners
of property often place its management
in
the hands of others. The
reasons for this are manifold: infancy, incompetence, lack of time and
lack of the necessary expertise are some of the major reasons. Given
that it is often the personal shortcomings or limitations of the property
owners that account for the employment of others to manage their
affairs, it would be unrealistic in the extreme to expect that they could
protect their own interests by some suitable contractual arrangement.
It follows, therefore, that this type of relationship cannot
of
necessity
be dealt with by private ordering. Inevitably there will be a need for the
legal system to address itself to this problem. This it does through the
rules relating to fiduciaries which broadly speaking are those who
control and affect the legal rights of property belonging to others.
Much has been written on the nature of the status
of
fiduciaries but one
feature has been somewhat ignored and, that is, it is predominantly not
a relationship of altruism.
No
doubt many fiduciaries act out of
a
disinterested spirit of
noblesse
oblige
but many do not and what we
wish to discuss is how the law should approach the issue of fiduciary
remuneration.
I1
RISK,
INCENTIVE
AND
MONITORING
COST
When two persons enter into a contractual relationship the outcome of
which is uncertain they must distribute between them the risks and
gasins of their enterprise. They will wish
(1)
to realise the maximum net
gain from their joint enterprise, and
(2)
to distribute risk between
them in the least burdensome way. These objectives
will
often, indeed
usually, conflict. For example, when a
firm
hires
a
salesman to sell its
products, objective
(1)
is best realised by an incentive contract under
which the salesman is paid solely by percentage commission of sales;
but objective
(2)
is best realised
if
he is paid a simple salary regardless of
sales since the salesman is almost certainly more risk averse than is the
firm (which pools the joint risks
of
many salesmen-rather as an
insurance company pools casualty risks). This problem is discussed in
the economic theory literature under the title of the principal
and agent prob1em.l For lawyers seeking an understanding of this
type of problem some basic concepts of economic theory will prove
helpful.
M.
Harris and A. Raviv, “Some Results on Incentive Contracts
”
(1978)
68
(1)
American Economic
Review
20-30;
S.
Ross, “The Economic Theory
of
Agency: The
Principal’s Problem
”
(1973) 63
(2)
Am.Econ.Rev. 134-139;
S.
N.
S.
Cheung,
The Theory
ofSlrare
Tenancy
(1969);
S.
Shavell,
‘‘
Risk Sharing
&
Incentive in the Principal
&
Agent
Relationship
”
(1979)
10
(I)
Bell
J.Econ.
55-73.
289
M.L.R.-2
290
THE MODERN LAW REVIEW
pol.
46
Expected Value
The expected value of
a
risky contract is a mathematical concept. It is
the sum of the values of each possible outcome, multiplied by the
probability of that outcome occurring.
For
example, a lottery ticket
worth
El0
if you win,
or
zero if you lose, has an expected value of
€2
when the probability of winning
is
20
per cent. since
“2
x
€101
+
[*8
x
fO]
=
E2.
Risk Aversion
A person
(or
firm)
is
risk averse when
if
offered the choice between
Ex
on the one hand and
a
risky lottery ticket whose expected value is
Ex
on
the other hand, hle
(or
it) prefers the certainty of the
Ex
to the lottery
ticket. Most people are risk averse most of the time, at least
in
respect
of large sums.a
Risk Neutrality
A person (or firm) is risk neutral
if
he (or it)
is
indifferent between a
certain sum of
fx
and
a
lottery ticket whose expected value
is
Ex.
An
insurance company can be risk neutral with respect to the type
of
risks
it insures because it pools many risks. The law of large numbers
(popularly known as the law of averages) ensures that it will be able
to
cover payments
so
long as premiums at least equal the expected value
of each risk.g
Monitoring
Cost
Where one person (a principal) hires another (an agent) to carry out a
task he must monitor performance of the task. This cost is very low
where a clearly observable outcome is closely correlated with the task
for which the agent was hired-simple tasks such as house painting fall
into this category. But often this cost is not low. There may be no easily
observable outcome to serve as an index of effort, or the relationship
between outcome and effort may not be clear, or the amount of effort
needed
or
required may be something determined exclusively by the
agents4 Here the: agent will have an opportunity to shirk. The principal
may find that some expenditure on monitoring the agent’s performance
is thus worthwhile. Random spot checks on production lines are an
example
of
this. Where, however, the agent can be employed on an
incentive contract (piece rates for skilled labour for example) then the
need to monitor is reduced.6
In general the principal-agent relationship can be regulated by the
following three
“
ideal types
”
of contractual arrangement:
Hence most house owners insure against fire risk even though the expected value
of
3
Thus the insurer can undertake
a
contractual liability knowing that he will have to
payouts under the policy
is
much lower than the premium paid.
meet only the
average
risk.
e.g.
health services.
In a perfect incentive contract there will be no need for any monitoring.
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