Trust, trustworthiness, and the behavioral foundations of corporate law.

• Jurisdiction: United States
• Date: 01 June 2001
• Author: Blair, Margaret M.

Conventional legal and economic analysis assumes that opportunistic behavior is discouraged and that cooperation is encouraged within firms primarily

through the use of legal and market incentives. This presumption is embedded 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 rationally selfish 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 importantly, 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 in subjects in social dilemmas everything from nearly universal trust to an almost complete absence of trust. 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 into the nature and purpose of that elusive legal concept, fiduciary duty. Second, the experimental evidence on trust sheds light on how corporate law works, by suggesting that judicial opinions in corporate cases influence 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 limits 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 that 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.

INTRODUCTION

A corporation is a collective enterprise. Shareholders and creditors provide financial capital, while managers and employees offer up expertise, loyalty, and long hours. In making these contributions, individuals who participate in corporations often expose themselves to great risk of loss from other participants' failures or misbehavior.(1) Yet investments are made, companies are built, and value is created from complex joint production.

How is this done? Contemporary legal scholarship generally assumes that shareholders, creditors, managers, and employees cooperate with each other because the market and the law give them incentives to do so. In accord with conventional economic analysis, these parties are presumed to be rational actors concerned only with maximizing their own gains. Thus the primary factors thought to discourage corporate participants from stealing, shirking their duties, or otherwise mistreating each other are market incentives and legal rules, including contract rules. These assumptions are embedded in the modern view that the corporation is best understood as a "nexus of contracts," a collection of express and implied agreements voluntarily negotiated among the rationally selfish actors who join in the corporate enterprise.(2)

In this Article we take a different approach. Although we do not abandon economic analysis, we revisit one of its basic assumptions--the assumption that people always behave in a rationally selfish fashion.(3) We posit that corporate participants cooperate with each other not just 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 discouraging opportunistic behavior among corporate participants. (Because these two behaviors are so closely linked, we sometimes refer to the combination as "trust behavior," or simply "trust.")(4)

We contend that people often trust, and often behave trustworthily, to a far greater degree than can possibly be explained by legal or market incentives. Although this picture of internalized trust conflicts with the neoclassical portrait of homo economicus as a hyperrational, purely self-interested actor, it is supported not only by casual observation but by an overwhelming amount of empirical evidence. Decades of experimental work on human behavior in "social dilemmas" establishes that trust is a reality.(5) This work also demonstrates that people do not trust randomly. To the contrary, a variety of factors have been identified that predictably elicit greater or lesser degrees of trust. One of the most important is social context--individuals' perceptions of others' motivations, beliefs, likely behaviors, and relationships to themselves. By manipulating social context, experimenters can reliably produce everything from nearly universal trust to an almost complete absence of trust among subjects in social dilemmas.

These behavioral findings have enormous importance for a wide range of social and legal relationships and institutions in which cooperative, other-regarding behavior is of value. Examples include marriages, nonprofit firms, "relational" contracts, even the community as a whole.(6) In this Article, however, we focus on one particular institution in which we believe trust plays an especially critical role--the business corporation.

We believe that an understanding of the role of trust and of the variables that encourage or discourage it is essential for understanding both the business world and much of corporate law. Focusing on the role of trust sheds light on a number of debates and difficulties in corporate scholarship. Examples include the nature of corporate fiduciary duties, the ways in which corporate case law constrains and directs behavior, and the puzzling persistence of cooperative patterns of behavior in firms in circumstances in which legal and market sanctions are ineffective or unavailable. Accordingly, we suggest there is tremendous value to be added by incorporating the phenomenon of trust into legal scholarship. There is also danger in failing to do so--danger not only for academics but for lawmakers, practicing lawyers, and businessfolk. This is because one of the most important lessons of trust is that cooperation is not always best promoted by promising rewards and threatening punishments. To the contrary, attempts to employ external incentives can often reduce levels of trust and trustworthiness within the firm by eroding corporate participants' internal motivations.

We begin our analysis in Part I by defining what we mean by "trust" and "trustworthiness." We describe trust as a willingness to make oneself vulnerable to another, based on the belief that the trusted person will choose not to exploit one's vulnerability (that is, will behave trustworthily). We then develop the idea of trustworthiness as an unwillingness to exploit a trusting person's vulnerability even when external rewards favor doing so. Our focus is on the importance of internal factors--tastes, preferences, intrinsic character--in producing trustworthiness that in turn encourages trust in others.

We then turn to the question of why trust and trustworthiness may have special importance in business institutions. It is widely recognized that one of the most pressing economic problems associated with doing business in the corporate form is the "agency cost" problem of encouraging managers, employees, and other corporate agents faithfully to serve the firm's interests rather than their own. We have also recently argued elsewhere that a second key economic problem in corporations is the "team production" problem of encouraging corporate participants to make mutual investments that expose them to each other's opportunism.(7) Market incentives and legal sanctions can reduce agency costs and foster team production to some extent. But markets and law work best when the situation is transparent and opportunistic behavior can be detected and punished. Trust can work even when the situation is opaque. As a result, business firms that cultivate and support trust can enjoy a competitive advantage over those that do not. This reality is well-recognized among management theorists and business consultants, who have produced an extensive literature on the importance of creating and maintaining trust within and between business organizations.(8) The centrality of trust to business firms has been overlooked, however, by contractarian corporate scholars who emphasize market incentives, enforceable contracts, and other external constraints on...