Eternal Issue
No Perfect Solution
Principal-agent problems
• Can be present in any contract.
• Agent has better information than principal;
costly for principal to assure himself of agent’s
performance quality.
• Reduces value of agent’s performance.
• Greater as complexity and discretion increase.
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Regulatory Strategies
Governance Strategies
Agent
Constraints
Affiliation
Terms
Appointment Decision
Rights
Rights
Agent
Incentives
Ex ante
Rules
(tender
offers)
Entry
(disclosures
on
borrowing)
Selection
(appointing
directors)
Trusteeship
(outside
directors
on audit
comm.)
Ex post
Standards
(self
dealing)
Exit (right to Removal
sell stock)
(removing
directors)
Initiation
(resolutions)
Veto (merger Reward
ratification)
(stock
options)
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Coase’s “Theory of the firm”
• Some people get the Nobel prize for
complicated and technical work that is difficult
to understand. Coase is at the other extreme.
His contribution to economics has consisted of
thinking through certain questions carefully
and in the process demonstrating that ideas
accepted by virtually the entire profession
were false.
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Why are there firms?
• Markets coordinate economic activity without
conscious direction.
• Firms are “supersession of the price
mechanism”.
– “islands of conscious power in this ocean of
unconscious cooperation like lumps of butter
coagulating in a pail of buttermilk.”
• D.H. Robertson
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Price mechanism has costs.
• Discover prices
• Negotiate/write/enforce contracts
• Price fluctuation risks
• Firms are institutional arrangements that
coordinate some types of economic activity more
cheaply than markets.
• Key is absence of price mechanism
– Precontracted resources (labor, capital)
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Explaining firms
• “People adopt other forms which they hope
will produce the right result. They change the
forms of contracts, taking account of it. They
do lots of things. The firm itself is a response
to that, but lots of contracts are as well. Even
the form of markets, what you can trade: The
rules and regulations of the submarket or
produce exchange are designed to reduce
transaction costs.” – Ronald Coase
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Why we care
• “What Coase – and everything that follows
from him – helps us do is answer the question
‘What is the boundary of the firm, and how
hard should that boundary be?’ It helps you
think about things like whether to buy, build
or partner.”
– Charles Conn, Pres. Ticketmaster Online
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Regulatory Strategies
Governance Strategies
Agent
Constraints
Affiliation
Terms
Appointment Decision
Rights
Rights
Agent
Incentives
Ex ante
Rules
(tender
offers)
Entry
(disclosures
on
borrowing)
Selection
(appointing
directors)
Trusteeship
(outside
directors
on audit
comm.)
Ex post
Standards
(self
dealing)
Exit (right to Removal
sell stock)
(removing
directors)
Initiation
(resolutions)
Veto (merger Reward
ratification)
(stock
options)
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Fiduciary Duty
•
•
•
•
•
Hamburger v. Hamburger, 1995 WL 579679 (Sup.Ct. Mass. 1995)
David (son of Joe) becomes sales manager.
Uncle Ted “increasingly resentful”, tries to fire David.
Ted tells David future depends on whether Joe or Ted lives longer.
David leases space, gets financing, quits, starts competitor, solicits
Ace’s employees and customers.
• No violation of fiduciary duty to arrange financing and lease
space, despite being “key employee”.
• No violation in post-employment solicitations of EE and
customers.
• “Under the circumstances in which he found himself, David took
the only reasonable course open to him and did so in a way which
the court finds did not violate any legal obligation to Ted or Ace.”
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CCS & Hamburger
• Background fiduciary obligation
– Impact of employment contract (CCS) vs. at-will
status (Hamburger)
– Can be supplemented via additional contracting
(covenant not to compete)
– But, courts limit scope of some contractual
provisions.
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Fiduciary duties & creditors
• Role of background agency principles
– Actual authority: P manifests consent to A
(expressly or by implication)
– Apparent authority: P manifests consent that A act
for P to 3rd Party (expressly or by implication)
– Inherent authority: P has not manifested consent
for A to act to anyone, but based on expectations
of 3rd Parties
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Blackburn v. Witter
19 Cal. Rptr. 842 (Ca.App. 1962)
• “Respondent is a widow….”
• Sharp Dean Witter salesman (Long) flimflams widow by
persuading her to sell stocks and invest in special promissory
notes (from non-existent company).
• Did Blackburn know (or should she have known) that Long’s
actions in connection with the notes were unauthorized?
• If there were warning signs that a reasonable person would
have heeded pointing to lack of authority, then no apparent
authority.
– Long using “rediform” receipts, omission of transactions from
monthly accounts
• But – Dean Witter knew of Long’s gambling debts and drinking
problems and that he was “churning” accounts to get
commissions.
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California Law on Point
• CA Civ Code s2317: “Ostensible authority is such
as a principal, intentionally or by want of ordinary
care, causes or allows a third person to believe
the agent to possess.”
• CA Civ Code s2334: “A principal is bound by acts
of his agent, under a merely ostensible authority,
to those persons only who have in good faith, and
without want of ordinary care, incurred a liability
or parted with value, upon the faith thereof.”
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Sennott v. Rodman & Renshaw
474 F.2d 32 (7th Cir. 1973)
• Fraudulent securities activity by former associate of
firm who was son of partner.
• Jordan leaves firm in 1958.
• Sennott asks Jordan to buy stock for him in 1964 via
R&R; Jordan uses special phone to place order.
• Jordan offers Sennott options in Skyline via his
father at large discount; Jordan simply takes $.
• Sennott does not cooperate with R&R investigation.
• Sennott learns of Jordan’s past.
• Court finds no reliance on apparent authority of
Jordan in fraudulent transactions for options.
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Blackburn & Sennott
• Standard, not rule – harder to find contractual
solutions ex ante.
• Unifying approach: who is in the best position
to prevent problem?
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Self Dealing
• What is it?
• Does it exist any time a partner is on both sides of a
transaction?
• Is it curable by advance disclosure?
• Is it OK if the partnership suffers no harm?
• Vigneau v. Storch Engineers
– Merluzzo and Vigneau violate their fiduciary duties by not
disclosing involvements in projects and so must disgorge all
profits
– Connecticut puts burden of proof on the fiduciary to prove
fair dealing and providing clear and convincing evidence to
support fair dealing.
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Fiduciary duty & management
• Covalt v. High, 675 P.2d 999 (NM App. 1983) – C
& H Partnership owns building it rents to C&H,
Inc. C leaves C&H, Inc. Demands C&H Partnership
raise rent. H refuses to agree. No breach of duty.
• Issue turns on whether there is a gap in
partnership contract that should be judicially
filled by fiduciary duty.
• Would rational investors in the shoes of the
parties intend to grant each other the right to
vote selfishly without risk of judicial review?
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Recap
• Fundamental problem is solving principalagent issue.
• Governance issues are critical to successful
operation of businesses.
• Choosing the proper entity is important.
• You have great flexibility to design an
organization to meet your needs
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