Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law

Abstract:     
Conventional legal and economic analysis assumes that opportunistic behavior is discouraged and cooperation encouraged within firms primarily through the use of legal and market incentives. This presumption is embodied in the modern view that the corporation is best described as a "nexus of contracts," a collection of explicit and implicit agreements voluntarily negotiated among the selfishly rational parties who join in the corporate enterprise. In this article we take a different approach. We start from the observation that, in many circumstances, legal and market sanctions provide at best imperfect means of regulating behavior within the firm. We consider an alternate hypothesis: that corporate participants often cooperate with each other not because of external constraints, but because of internal ones. In particular, we argue that the behavioral phenomena of internalized trust and trustworthiness play important roles in encouraging cooperation within firms.

In support of this claim, we survey the extensive experimental evidence that has been produced over the past four decades on human behavior in "social dilemmas." This evidence demonstrates that internalized trust is a common phenomenon; that it is at least in part learned rather than innate; and that different individuals vary in their inclinations toward trust. Most important, the experimental evidence indicates that decisions whether or not to trust others are in large part determined by social context rather than external payoffs. By altering social context - subjects' perceptions of others' beliefs, expectations, likely actions, and relationships to themselves - experimenters can reliably produce everything from nearly universal trust, to an almost complete absence of trust, in subjects in social dilemmas. In other words, most people behave as if they have two personalities or preference functions. One is competitive and self-regarding. The other is cooperative and other-regarding. Social framing is key in triggering when the cooperative personality emerges.

These behavioral findings carry important implications for corporate law. For example, in this article we demonstrate first that the phenomenon of trust offers insight into the substantive structure of corporate law and particularly the nature and purpose of that elusive legal concept, fiduciary duty. In the process, it adds weight to the claims of anticontractarian corporate scholars who argue against the notion that corporate officers and directors should be free to contract out of their fiduciary duty of loyalty. Second, the experimental evidence on trust sheds light on how corporate law works, by suggesting how judicial opinions in corporate cases direct corporate officers' and directors' behavior not only by altering their external incentives but also by changing their internalized preferences. This possibility helps explain the notoriously puzzling relationship between the duty of care and the business judgment rule. Third, trust highlights the limited power of law by explaining how cooperative patterns of behavior can sometimes develop within firms even when external incentives, such as legal sanctions, are unavailable or ineffective. In the process, it underscores the dangers of the contractarian approach by suggesting how an excessive emphasis on external sanctions - including formal contract and even the rhetoric of contract - may be not only ineffective but counterproductive, serving to undermine trust and trustworthiness within the firm.

Accepted Paper Series