Contract Law, Contractarian Law, and Fiduciary Law
Tamar Frankel*
c. 2001. All rights reserved. No part of this paper may be reproduced or cited without the permission of the author.

Introduction

The battle of the categories. For many years contract law and trust law, including agency and corporate fiduciary laws, were considered separate. About twenty years ago arguments were made that fiduciary law is a sub-category of contract. Others knew better. They recognized that the law of trust, and perhaps the law of other fiduciaries, involves property law. But the allure of contract was too great. They suggested that trust law is not contract law but “contractarian.” Ho should we choose? What difference does it make? I offer here guidelines for choice and argue that it makes a lot of difference.

Two condition underlie any business transaction and the laws that govern it: the parties are expected to tell the truth and keep their word. Contract, tort, fiduciary, and to some extent criminal law dealing with business transactions all aim at assuring the existence of these conditions. The differences between them reflect the extent to which parties are expected verify each others’ statements and ensure the reliability of each others’ promises, and the extent to which the law’s interference is necessary to achieve these goals.

Under some circumstances the costs of these verifications and assurances can be borne by the parties themselves. Under other circumstances some of these costs are reduced by the markets. As the costs rise, and the markets do not provide adequate coverage at a sustainable price, legal rules cover more of these costs in various ways. The following examples demonstrate the differences.

A. “Pure” Contract

1.Buying a newspaper. When I buy a newspaper the cost of verifying whether the seller tells the truth and keeps his word are negligible. I can verify the subject matter of the purchase, that is the newspaper that I choose, and exchange of the newspaper and the money simultaneously, so that the seller’s promise may be for a split second, if at all. Such a transaction constitutes the bedrock prototype of contract. Each party is expected to ensure that the other tells the truth and keeps his word.

2.Buying a $350,000 house. This transaction is far more complex than newspaper purchase and can teach us something about contract and fiduciary law. When I offer to buy the house and the seller agrees, the seller usually writes a short note stating that he has sold me the house for a specified price, and I pay the seller a small amount, for example, $5000.

The next day or a few days later, the we meet at the broker’s or lawyer’s office and sign a detailed contract providing for the date of possession and title transfer, inspections etc. At that time I deposit with the broker a far larger amount, for example, $50,000. The broker receives written directions to pay the money to the seller at the closing of the transaction and return the money to me if the closing does not materialize on the agreed upon date.

Thereafter, I seek a loan from his bank. I also asks an inspector to inspect the house, and the city fire department sends its own inspectors to determine that the alarms etc. are in place and good order. Any defects must then be corrected or the price of the house adjusted to cover their cost.

If all goes well, we meet on the agreed upon date in the lawyer’s office. The documents and checks are signed. Usually the representative of the financing bank is present with the check representing the loan to me, to be secured by a mortgage on the house I bought. The representative of the seller’s bank is also present to receive the payment of the mortgage debt and release the mortgage. All the documents, checks and statements are deposited with the lawyer. After the lawyer registers the various transactions, he delivers the checks to the seller and the broker for his commissions, and the keys to the house and the documents to me.

Like the sale of the newspaper, this transaction constitutes a contract between a seller and buyer. However, unlike the newspaper transactions, the seller’s statements cannot be verified as costlessly, and the parties’ mutual promises cannot be simultaneously performed with the signature of the contract.

Therefore, many of the seller’s statements are verified by reliable and independent third parties: the inspectors and town fire department that examine the house for defects, the lawyers that examine the title, and the title insurance company that adds a guarantee of the title. Many of these third party verifiers are fiduciaries.

Further, the transaction is sliced into stages, and at each stage the parties perform more or less the equivalent value of each other’s promises. Hence the buyer’s payment of the $5000 has the equivalent value of the paper signed by the seller. But the buyer’s payment of $50,000 is not the equivalent of the seller’s signature on the contract. If this large sum of money passed into the seller’s hands it would be a partial performance of the contract. Nothing but a claim would be handed over to me, the buyer. Yet, the seller demands some assurance that the buyer’s promises are reliable. If he waited until the closing date, he may lose opportunities to sell the house to others. Therefore, the buyer’s payment remains in suspended animation--in the hands of the broker, conditioned on the performance of the seller’s promises.

When all papers are signed at the closing, the whole amount of the price is paid. But it does not reach the hands of the seller until the transaction is registered in the name of the buyer. During that short period the documents and the money are in again suspended animation in the hands of the lawyer.

B. The combined contract and fiduciary relationships.

1.One transaction-two legal regimes. The legal regime governing the newspaper transaction and the sale of the house between the buyer and seller, is contract. The legal regime governing the relationship between the buyer and seller on the one hand and the broker and lawyer on the other hand, is a combined contract and fiduciary regime. The escrow agents-the broker and the lawyer--enter into a contract with the parties for their services in exchange for fees. In exchange for his services the broker is entitled to receive a commission, upon the completion of the transaction. In exchange for his services the lawyer receives fees, usually determined in advance. That is the contract part of the relationship between them and the parties.

The broker and lawyer also serve as escrow agents. That is the fiduciary part of the relationship with the parties.¹ The money that they receive as escrow agents does not constitute payment to them, and is not given in exchange of any obligation that they have. In fact, payments to a person as a fiduciary are accompanied by obligations and not by entitlements--the converse of payments under a contract.

Fiduciary obligations are imposed to ensure that a fiduciary WILL NOT BENEFIT from the money entrusted to him. Contract rights are imposed to ensure that the contract party WILL RECEIVE THE MONEY AND BENEFIT FROM IT. Entrusted money is not given in an exchange. Contract money is given in an exchange.

2.The different purpose of entrusting money to others. While in contract payment by Party A to Party B is in exchange for benefits from Party B to Party A, payment to fiduciaries, such as escrow agents is given for the purpose of effective performance if the fiduciary’s services to the entrustor. The parties in the house sale transaction needed to transfer the buyer’s money to a trusted person to enforce their arrangement. Similarly, a money manager needs control over the managed money in order to effectively perform his managerial duties. A physician needs control over the patient’s body in order to perform a life’s saving operation

The entrustors’ depend on their fiduciaries not because of love and affection, or lack of sophistication, but because the entrustors’ property and power that the fiduciaries hold captive. The entrustment is necessary to perform their functions effectively.

3.Fiduciary obligations arise without consideration. Fiduciary obligations arise whether or not the fiduciary is paid to undertake them. If I give $50 to my friend to by groceries for me, as a favor, my friend may not use the money for any other purpose. If he managed to get the groceries for less than $50 he must return the rest to me. He must account for the money he received. Moreover, the undertakings do not entitle my friend to compensation by virtue of the undertaking. Entitlement to compensation must arise independently, on the basis of a contract or other legal source, such as a statute.²

4.Confusing contract and fiduciary relationship. Both contract and fiduciary relationships are based on agreement. However, contract has no monopoly on consensual relationships. Not every agreement gives rise to contract or contractarian relationship. Many non-contractual arrangements are also based on agreements. Fiduciary relationships election of directors and political office holders, appointment of agents and trustees, marriage, and adoption. Consent is the shared element of contract, contractarian, fiduciary relationship and others. The rules of consent, such as mistake, duress, undue influence, and alike apply to the creation of fiduciary relationship, as they do to contract and contractarian relationships and others.³

C.Fiduciary relationships in money management. Although the example of escrow agents may suffice, I would like to base my examples of fiduciary rules on a stronger and more prevalent fiduciary relationship: the money manager. This relationships demonsrtates the inadequacy of contract rules.

1.Employing a money manager. When I employ a money manager we enter into a contract under which he undertakes to manage my money in exchange for a fee--a classic contract. For efficiency reasons I transfer to this manager all my life’s savings.

I would like, however, to ensure that he uses my money for my benefit only, and that he does not benefit except for the fees that I agreed to pay him. I would like to ensure that he does not get a kickback from the brokers to whom he will be giving the trades of my assets. I would like to know that he would manage my money carefully and according to my instructions and needs. I would like to ensure that his creditors would not be able to reach my money to pay his debts. I would like, in fact, to know if he gets into financial difficulties, because that may increase the temptation to use my money in his control. I would like to be able to terminate the relationship and take my money if I lose my confidence in him. I have many more demands without which I would not entrust my life’s savings to him. I also want assurances for these wishes.

Let it be clear that I do not ask for an altruist. I do not expect the money manager to give me anything that belongs to him. I ask him to be honest. I ask him not to take what does not belong to him. AND I ask him to be honest even if there is no policeman around. For that I call him a moral person. This morality consists of self-limitation. Doing what is right-not stealing, even when the chances of being caught are very slim.⁴

There is no way for me to verify what the money manager will do unless I leave my job and sit with him and watch what he is doing and learn money management to evaluate his performance--in short, unless I do what he is doing. But then, I do not need him. My fiduciary would like to assure me. But his cost of such assurance are higher than the fees that I will pay him.

So how can this gap be bridged? It is bridged by the law. We both ask for enforceable rules to protect me and bestow on him the reputation for an honest and reputable fiduciary.

D.Fiduciary law and contract law

1.Fiduciary rules. Fiduciary rules are based on recognition that entrusted money and power remain the property of the entrustor, and that the fiduciary is expected to perform his service functions with care and loyalty. The care is similar to lack of negligence, and loyalty is honesty. I emphasize again that a fiduciary need not contribute or give the entrustors anything that belongs to him. He must be honest even if there is no policeman around. The rules are imposed in recognition that temptation may be strong when no one is watching, and the cost of monitoring fiduciaries is very high.

In their relationships with their fiduciaries entrustors have a legal right to rely on the honesty and care of their fiduciaries. In contrast to contract (and presumably to contractarian, although I am not sure) entrustors do not have to fend for themselves. They need not ask for information, as contract parties must under the rule of caveat emprtor. The fiduciaries must disclosure material information to the entrustors, without being asked. All with respect to the entrusted property or power.

Fiduciary duties include the wishes that I described above: a prohibition on using entrusted property except for the purpose for which it was entrusted; segregating and earmarking the entrusted property, avoiding conflict of interest situations, avoiding dealing with entrusted property in any way for the benefit of anyone except the entrustors and many more. All with respect to the entrusted property or power.

2.Most of fiduciary rules are default rules. The parties may specify the fiduciaries’ duties and expand or restrict the fiduciary’s powers. The extent to which they can restrict the fiduciary duties that accompany these powers is not so clear. A person may appoint a money manager with full discretion. But if he allows the manager to do with the entrusted money as the manager pleases, and to consume it and give it away as the manager fancies, the courts may hold the arrangement to be a gift, or hold that the waivers lacked informed and independent consent. The parties may set the terms, but not the legal category to which their relationship belongs. That is the courts’ prerogative, which the parties may not usurp.

Entrustors’ waivers of fiduciary default rules are binding only after the fiduciaries have disclosed to the entrustors the necessary information to ensure that the entrustor’s consent is informed. Their consent must therefore be both informed and independent. The waivers move the relationship from the format of fiduciary to the format of contract. After notice and information, entrustors must fend for themselves in giving consent.

3.The property component in fiduciary relationship is reflected also in the remedies for breach of fiduciary duties. In addition to damages and injunction entrustors may sue fiduciaries for accounting for ill-gotten profits and in some cases the government may sue fiduciaries under criminal law.

E.Why not specify fiduciary duties in contract? These same duties can be specified in a contract. To be sure, they may. I assume that most entrustors would seek agreements that include the fiduciary duties. Specifying fiduciary duties is costly. Default rules are less costly. Further, under contract, entrusted money or power becomes the property of the recipient, such as the broker, the money manager and the lawyer. They become entrustors’ debtors. Entrustors will have claims in debt and breach of contract, not claims of property owners whose property was misused. If the fiduciaries become bankrupt, entrustors will stand in line with other creditors to claim their own entrusted property. Thus, contract claims are far weaker claims.

1.Effect on fiduciaries. If fiduciaries become debtors, the very nature and perhaps soul of the exchange as we know it will be subverted. People are entitled to the benefits of their bargains. The contract that the fiduciaries sign may include a duty to be honest and not to deal with the entrusted money or power except as directed and for the benefit of the entrustors. It is difficult for a person in an exchange mode to distinguish the dollar with which he can do what he wants, from the dollar with which he not entitled to do anything for himself. If he is entitled to the money and it is vested in him, how can he be viewed as a thief of that money? It is easier for such a person to see that for his services he is entitled to money that is his own, and in connection with these service he holds other peoples’ money to which he is not entitled. That is the fiduciary concept and structure.

2.Effect on entrustors. If I believed (and perhaps if you believed) that TIAA-CREFF viewed my life’s savings as it own, and was only my debtor I would pay my taxes and take the money out. You may, of course ask why I put my money in the bank, that is my debtor and owes me no fiduciary duties. The answer lies in a regulatory system that renders a debtor subject to more than any fiduciary duties that I know, and includes a safety net of government back insurance. I know other countries in which people will not put their savings in the banks because the safety net is missing and the government borrows the savers money, and does not always pay up.

We have extended fiduciary duties to medical doctors. When we entrust our bodies to surgeons we do so for the sole purpose of healing us, not for the purpose of selling our organs to others. They are not required to be altruistic. Just honest. That is so clear that it raises a chuckle when I mention it. Why is it so hard to understand that the same rule applies to money managers? Why is it so hard to accept the default rules that accompany these kinds of services?

F.Two hard cases. Two employment relationship show how I would draw the line. In one case the employer agree to pay the employee a percentage of the gross income from his sales (percentage pay). In the other the employer agrees to give the employee a year end bonus (bonus pay). In both cases the parties struck a contract bargain. In my opinion, the employer in the percentage pay case is a fiduciary of his employee with respect to the information on the amount owed. In the second case, he is not a fiduciary with respect to the exercise of his discretion.

The difficulty stems from the fact that both cases deal with the same transaction and the same purpose: payment to the employee for work performed. In percentage pay case the measure is fixed in advance but the employer holds the books, as it is entitled to do. In the second case the employer is vested with full discretion to give or withhold the bonus.

The first case is easier. The information about the employee’s performance (sales) is in the hands of the employer. Although he is entitled to the books’ information he also holds the information in trust for the employee, for the purpose of determining the employee’s percentage pay. If he gives the employee untrue information or does not account to the employee, he is liable for breach of fiduciary duty, not merely for breach of contract.

The second bonus pay case is more difficult. For me the question is: what is the purpose of the discretion given to the employer? Was it given for the benefit of the employee or for the benefit of the employer? The employee benefits from the bonus. But that is not the subject matter we discuss. We discuss the discretion of the employer. Was the employer expected to use the discretion for the employee’s benefit or for his own?

We may wish to distinguish here between the situation in which the employee receives a reasonable salary for his work and another situation in which the bonus is main compensation for the work. If the bonus is “the icing on the cake” I would argue that the power to determine the bonus is part of the contract law, including the rule of fair treatment. If the employer raises the employee’s expectations through years of practice, the courts may incorporate these practices into the parties’ agreement, and breach of these expectations may be deemed unfair treatment in the employer’s use of discretion.

In addition, if the employer is arbitrary in meting out bonuses, the bonuses will lose their incentive value for the employer. Arbitrary decisions do not link good performance to rewards. Only a predictable measure of bonuses will be effective. That is why in many cases bonuses have acquired a consistent measure and predictability.

In addition, because the relationship between employer and employees is long term, even as some employees leave and others join, market sanctions can be effective in curbing the employers deceptive promises of bonuses. Who will rely on a promise of a bonus that is set arbitrarily and unpredictably? Once the word is out, the employer’s promises will be evaluated in accordance with its actual practices. Promised bonuses that are not fairly determined will lose their value, and hurt the employer’s reputation among employees. Such an employer may attract only employees who cannot obtain positions elsewhere, and suffer more than the benefits of the right to arbitrarily determine the measure of its bonuses. Thus, contract law may be the appropriate legal regime for controversy.

What can be said for applying fiduciary law? Arguably, the employer’s discretion is power to determine the employee’s salary. If the fixed salary is very low and the bonuses very high, there is a point in which the employee would work for near to nothing. Therefore, the power to determine what is in effect a salary or a significant part of a salary is held not only for the employer’s benefit but also for the employee’s benefit. The employer therefore acts as a fiduciary for the employee, as well as for himself. This conflict of interest requires a fair determination and predictable outcome. If the employer abuses his discretion then perhaps the court may award the employee a fair salary under an equitable rule of quantum meruit.

I believe that contract rules are more appropriate in this case. A relationship or the part of the relationship-the discretionary part--that starts with a significant conflict of interest should not be considered fiduciary. Default rules will not clarify the situation. The practice and market forces seem to significantly reduce unfair decisions. Employees can usually bargain. And finally, the actions of the employer in the past may constitute a limitation on arbitrary changes in its practice without prior notice.

The second case is more difficult, but also more unusual. The contract is faulty if one party determines the full consideration for the exchange. Fiduciary law does not seem to fit because it is unclear that the power to determine the salary is vested for the benefit of the employee. I would opt for the equitable remedy of quantum meruit, if applicable in the circumstances.

Conclusion. Theoretically, contract and fiduciary relationships are based on the desire to ensure truth and reliability of promises. Theoretically, the difference between them is merely different degree of information by the parties. A simple distinction may be helpful: money and power given for the benefit of the receiver is subject to contract law. Money and power given for the benefit of the giver is subject to fiduciary law.