Legal Responses to Conflict of Interest
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Description
Conflicts of interest abound in the law. The core attorney–client relationship is a classic example of a principal–agent relationship, with all the attendant and endemic tensions and risks of opportunistic behavior. The basic legal definition of attorney, as set forth in the standard law reference, “denotes an agent or substitute, or one who is appointed and authorized to act in the place or stead of another”. The ability to act on behalf of another of itself creates conflicts that are “intrinsic to the exercise of trust”. Much of legal regulation, including that directed at attorney–client relations, attempts to mediate the conflicts inherent in a world where dependence on agents is the norm. This chapter will assess distinct legal responses to conflicts of interest. The aim will not be to catalogue the range of conflicts that the law recognizes or to identify all of the various regulatory responses that may be tried. Rather, the object will be to use a couple of examples of significant conflicts of interest, whether labeled as such or not, to map the types of regulatory methodologies that may be employed. By mapping different responses to conflicts of interest onto certain regulatory patterns, the costs and benefits of different approaches can be assessed. In particular, identifying the range of regulatory responses may help clarify the competing tensions that exist in principal–agent relations, such as that between attorney and client. The primary risk is that of agent misbehavior in terms of misappropriation of goods or gains that properly belong to the principal. At the same time, however, there is a corresponding risk in burdening principal–agent relations with more direct legal oversight than they may bear, particularly if the costs of compliance exceed the gains to be had in representing a principal. The area that concerns me most is one in which it is unlikely that market mechanisms alone can protect the principals. This may be for a variety of reasons. Most significantly, there are undertakings in which the interest of the principals is both diffuse and of low overall value, but where the interest of the agent is highly concentrated and of great value. Another obstacle to parties protecting themselves through ordinary market mechanisms is high information costs that make effective monitoring difficult. This can result from either the difficulty of acquiring the information or the inability for a diffuse group to monitor at all. The latter may be partially moderated by the use of intermediaries, or “super-agents” as I refer to them in a paper with Daniel Ortiz, but this then moves the monitoring problem up one level to the issue of who monitors the monitors of the agents. The third obstacle is high barriers to entry for rivals to agents who may seek to win over the representation of the principals and, in so doing, provide assistance in scaling back agency costs. The higher the barriers to entry, the less effective market challenge becomes. The next question is how the law responds to such conflicts of interest. Here I would categorize three different mechanisms. The first is substantive regulation. By this, I mean specific prohibitions on certain substantive decisions of the agent. The classic examples include such obvious ones as rule of attorney professional conduct stating that client funds must be held in segregated accounts and may not be invested in the attorneys’ home, business, or other private undertakings. This approach turns on ex ante rules of prohibition on defined acts. Alternatively, there may be rules of prohibition applied ex post, what generally falls under the rubric of liability rules. Thus, we find liability regimes that create a risk of fine or even incarceration if a fiduciary bond is broken and there is resulting harm. Much of the “gatekeeper” system in the corporate and securities world turns on this sort of fiduciary liability and the prospect that gatekeepers will sufficiently internalize the prospective costs of a breach of their duties as a deterrent to misconduct. Finally, there is the prospect of what I shall term procedural regulations. Here, the examples are prohibitions not on substantive outcomes, but on the participation in decision making by conflicted agents. Examples here would include the prohibition on government officials negotiating contracts with firms in which they have or have had a financial involvement. At issue is not whether the contract was in the public interest or not, or whether it was subject to self-serving manipulation, but the appearance of corruption of the agent. What is significant here is that the emphasis is on process barriers that do not turn on a substantive assessment of the outcome of the transaction. I will conclude that, as a general matter, procedural regulation is the single most effective strategy for dealing with conflicts of interest. Substantive regulation is difficult to apply and suffers from the same information deficits as exist generally in the principal–agent relationship. Liability regimes suffer from a dependence on the proper ability of agents to internalize the cost calculus, something that may be compromised by heuristic biases that tend toward seeing desired short-term objectives free of the full liability consequences. Procedural regulation is effective in that it cuts straight to the heart of the matter, by attempting to remove the conflict of interest altogether.
Source Publication
Conflicts of Interest: Challenges and Solutions in Business, Law, Medicine, and Public Policy
Source Editors/Authors
Don A. Moore, Daylian M. Cain, George Loewenstein, Max H. Bazerman
Publication Date
2005
Recommended Citation
Issacharoff, Stephen, "Legal Responses to Conflict of Interest" (2005). Faculty Chapters. 934.
https://gretchen.law.nyu.edu/fac-chapt/934
