Basic idea of Agency Theory (P: Principal, A: Agent)

Professor Robert H. Sitkoff of Harvard Law School published an article that should warm the heart of your favorite law-and-economics geek who also happens to make his or her living as a trusts and estates lawyer. The article’s entitled An Economic Theory of Fiduciary Law, and below are a few excerpts I found especially interesting and relevant for practitioners (especially litigators).

The Agency Problem

The law tends to impose fiduciary obligation in circumstances that present what economists call a principal-agent or agency problem. An agency problem arises whenever one person, the principal, engages another person, the agent, to undertake imperfectly observable discretionary actions that affect the welfare of the principal. Agency problems therefore arise not only in relationships governed by the common law of agency, but also in trust law, corporate law, and a host of other contexts.

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Loyalty and Care

The primary fiduciary duties are the duties of loyalty and care. The duty of loyalty proscribes misappropriation and regulates conflicts of interest by requiring a fiduciary to act in the “best” or even “sole” interests of the principal. . . .

The duty of care prescribes the fiduciary’s standard of care by establishing a “reasonableness” or “prudence” standard that is informed by industry norms and practices. The fiduciary standard of care is objective, measured by reference to a reasonable or prudent person in like circumstances. If a fiduciary has specialized skills relevant to the principal’s retention of the fiduciary, then the applicable standard of care is that of a reasonable or prudent person in possession of those skills.

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Compensation and Disgorgement

In the event of a fiduciary’s breach of duty, the principal is entitled to an election among remedies that include compensatory damages to offset any losses incurred or to makeup any gains forgone owing to the fiduciary’s breach, or to disgorgement by the fiduciary of any profit accruing to the fiduciary by reason of the breach. The former is a standard measure of make-whole compensatory damages. The latter is a restitutionary remedy that, within the American tradition, is commonly implemented by way of a constructive trust to prevent the unjust enrichment of the breaching fiduciary.

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