A Simple Model of Corporate Fiduciary Duties: With an Application to Corporate Compliance

Abstract

This article models the duty of care as a response to moral hazard where the principal seeks to induce effort that is costly to the agent and unobservable by the principal. The duty of loyalty, by contrast, is modeled as a response to adverse selection where the principal seeks truthful disclosure of private information held by the agent. This model of corporate loyalty differs importantly with standard adverse selection models, however, in that the principal cannot use an observable and verifiable outcome as a screening mechanism to ensure honest disclosure and must rely upon an external third-party audit technology, such as the court system. This article extends these simple models to the issue of corporate compliance and argues that the optimal judicial approach would define the duty to monitor as a subset of due care–and not loyalty–but hold that the usual legal protections provided for due care violations no longer apply. The framework set forth provides a theoretical justification for drawing such a conceptual distinction.

Keywords: Corporate Governance, Fiduciary Duties, Corporate Compliance, Asymmetric Information

JEL Classification: D82, G34, K22, O16