Prof. Howson BizAss – Fall 2012
BUSINESS ASSOCIATIONS
PART 1: INTRODUCTION
INTRODUCTION: SOLE PROPRIETORSHIPS
• Classical Firm: A business owned and managed by one person. Also known as a sole proprietorship. Owner is known as sole proprietor.
• Entrepreneur: The person who decides what to make and how to make it.
o The entrepreneur manages uncertainty: Makes decision involving deciding what consumers want, forecasting at what quantities and
price point consumers will buy a product or service if produced, forecasting whether and how employees can be hired.
o The entrepreneur also accepts full responsibility or unlimited liability for his business decisions. This means he is the firm’s
residual claimant, agreeing to pay himself last (only if business is profitable) and will use his own wealth to make good on promises
to employers, employees, suppliers and lenders.
• Coasean Firm
o Economist Coase believed the “firm” was the antithesis of the market with respect to the way economic resources are allocated.
! In Adam Smith’s market economy, each producer and consumer separately calculates his own self-interest and chooses what to
make and to buy based on price signals from the market. Thus, resources are allocated to their highest and best use, not in
response to governmental orders but by an invisible hand, through the separate, self-interested choices of all producers and
consumers.
! Inside a firm, resources are allocated pursuant to conscious orders or directions from the entrepreneur to his employees.
• Ex. Mary the baker:
o Outside the firm, Mary turns to the market for raw materials she cannot efficiently produce (eggs, flour, etc.), transport services from a
trucking firm, accounting from a CPA, etc. So for some things, Mary relies on market transactions.
o However, she doesn’t turn to the market for everything she cannot self-produce. Within the firm, she hires employees and directs them
to perform tasks (waiting on customers, baking) that cannot be handled efficiently via the market.
! According to Coase, “the firm” is what we call the set of relations that arise when resources are allocated by the entrepreneur
via commands to employees rather than the set of relations that arise when entrepreneur allocates resources via market
transactions with outsiders.
INTRODUCTION: THE BUSINESS ASSOCIATION
• Sometimes, those going into business need to obtain a substantial infusion of capital and management expertise to run a business. In these
situations, the sole proprietorship may not be the best form for the business.
• Some more practical forms for the business may be a partnership, LLC or corporation (various business associations)
• However, not everyone was a fan of the development of business associations.
Berle-Means Critique
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Prof. Howson BizAss – Fall 2012
By the end of the 19 century, a transformation in the American economy was underway. No longer was it dominated by sole proprietorships,
this time period saw the rise of corporations.
In 1932, Berle and Means predicted the power of corporations would continue to grow and that eventually, in every industrial sector, the
means of production would reside in an increasingly small # of corporations.
Key attributes of these corporations: complete separation of ownership from control, large number of geographically dispersed shareholders
disinterested in governance, managers that perpetuated themselves in office with almost total discretion in operating the firm.
Berle and Means saw this separation of ownership from control as posing a fundamental challenge to America’s free-market ideology,
rooted in the idea of the individual entrepreneur as the primary motor driving the economy.
o The modern corporation destroyed the theoretical underpinnings of free enterprise because “those in control of the wealth generated
by business, and therefore in a position to secure industrial efficiency and produce profits, are no longer owners entitled to the
bulk of the profits. This destroys the basis of the old assumption that the quest for profits will spur the owner of industrial
property to effective use”
Thus, Berle and Means concluded the corporation should be analyzed as a social organization with a view to determining how managers’
power should be constrained for the public good.
o From the New Deal onward for nearly 50 years, federal law and policy makers chose to pursue an approach to corporate governance
suggested by Berle and Means, treating the interests of both managers and shareholders as subordinate to the paramount claims of
society (subordinating private property in the means of production to legitimate claims of society).
o Ex. the entrepreneur’s right to hire and fire whoever he wanted for whatever reason, the right to set wages and working conditions, the
right to pollute air and water rather than incur costs to use less harmful means, would yield to competing societal interests.
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1980’s Return of Free Market Ideology
• 1980s saw a shift in a deregulatory approach.
• Emphasized the contractual nature of the firm rather than the distinction between the firm and the market.
o A firm is described as a nexus of contracts between the various claimants to a share of the profits generated by the business. This
includes not only shareholders, but also employees, customers, suppliers, lenders, and communities where plants are located.
o Emphasizes that the firm does not exist apart from its constituent relationships, so to speak of it as a separate entity with social
responsibility is inconsistent with its actual structure.
• Additionally, principle-agent theorists identified shareholders as the owners (principals) of the corporation, and managers are their agents.
o Principles have no inherent right of control and agents have no inherent obligation of obedience. Instead, they contract with each other
to determine how much control the principle will retain, and how much will be ceded to the agent.
o Modern corporation represents a consensual choice by shareholders and managers to cede authority of modern corporation entirely to
managers, however, with the use of various contractual devices that operate to limit the ability of managers to shirk (to use corporate
resources in ways that diverge from the best interests of shareholders.
! Ex. direct monitoring of manager actions, bonding agreements by managers that result in imposition of penalties if certain
events do or don’t occur, and an incentive scheme to align manager interests with shareholders’.
o All of these devices (above) used to limit agency costs involve expenses that reduce the net value of the return, so agency-cost
limiting mechanisms are justified only to the extent that the net return to shareholders is greater than it would be without such expense
Prof. Howson BizAss – Fall 2012
Recent Shocks
• New millennium has seen two significant shocks to the American economy and fait in corporate executives
• 2001: Enron collapse due to fraudulent accounting by numerous corporations to artificially inflate value of stock
• 2008: Collapse of major financial and industrial institutions that had undertaken excessive risk
• This has caused renewed interest in exploring government regulation and support of Berle and Means’ insights.
o Builds on Berle-Means insight that modern corporations do not have a traditional entrepreneur/owner, rather it has managers who
usually own a small % of corporate stock
o Because of the crises, federal government has exercised unprecedented legislative and regulatory authority to shape corporate
governance, including the following changes:
! Limits on structure and amount of executive pay
! Creation of costly new accounting mechanisms
! Expansion of shareholder’s rights to initiate changes in corporate governance.
INTRODUCTION: SELECTING A GOVERNANCE STRUCTURE
Role of the Corporate Lawyer
• Assists the prospective venture in the creation of an initial governance structure. As the venture grows, assists in adapting the organization as
required by changed circumstances.
• Acts as a transaction-cost engineer, understands that owners and managers of firms have a strong preference for private ordering over court
ordering. Therefore, needs to understand how to select and modify governance to minimize the use of litigation as governance tool, while
preserving availability of litigation to deal with circumstances that cannot be governed solely by private ordering.
Transaction Costs and Choice of Organizational Form
• Transaction cost economists have identified certain behavior and economic factors that explain why particular transactions are most
efficiently organized in a particular way.
o Bounded rationality: The idea that while individual intend to act rationally, there are cognitive limits on their ability to do so because
there are often too many variables to be considered.
o Opportunism: Self-interest seeking with guile. When individuals seek to further their own ends by taking advantage of the
information deficits of those with whom they deal.
o Team specific investment: When a person or asset has a higher value in its current team use than its value in its next best use
Discrete v. Relational Contracting
• Discrete contracting:
o The parties have no pre-existing obligations to each other. As they approach a venture, they negotiate a contract that anticipates and
provides a rule governing all contingencies. Nothing is left to be worked out in the future, limiting opportunism.
o Most likely to be successful when a team’s expected duration is short and number of exchanges between team members are few.
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o Weakness: Because of bounded rationality, parties will usually fail to identify and specifiy a result for a relevant contingency.
Relational contracting:
o A response to the defects of discrete contracting. Parties don’t attempt to provide an answer to all contingencies at the time the
relationship commences, but attempt to build a governance structure that allows them to solve problems if and when they arise.
o The goal is to reinforce the relationship itself, hoping that cooperation and harmony will become ingrained in the norms of the
relationship and that parties will continue to deal with each other in good faith
o Weakness: Does not eliminate the threat of opportunism. Threat of opportunistic request for readjustment is greater than with a
discrete contract where terms are all set in stone.
Organizing as a Firm vs. Organizing Contractually
• Organizing contractually
o Team members retain ownership and control over the productive assets used to produce their part of the team’s goods or services.
o The autonomy of each team member makes it hard for a team to adjust to changed circumstances and exposes the team to the cost of
opportunistic threats of withdrawal.
o Teams organized via contract will experience substantial costs from having team members’ compensation and incentives misaligned
and from the haggling to correct these misalignments.
! Ex. team member can become more or less valuable than was expected ex ante (before contracting) and it will have to be
readjusted in the contract.
• Organizing as a firm
o Avoids the haggling costs, because all allocation of resources is at the direction of the entrepreneur unilaterally
o Allows the firm to adapt quickly to changed circumstances
o Disadvantage for an employee: if employee surrenders control over her own business she becomes subject to employer’s opportunism,
whereas if organized contractually, she can secure rights.
o Challenge for firm that is jointly owned: how to allocate management rights and responsibilities between co-owners.
State Provided Governance Structures
• By structuring a business relationship as that between an employer and employee, or as a corporation, partnership or LLC, the parties receive
the benefit of state provided rules and dispute resolution processes.
• Whereas, by organizing via contract, one would have to draft the contract to try and cover every possible expectation or concern.
• Most state-provided rules found in each state provided form are enabling
o They provide parties with default rules that govern parties if they do not provide otherwise.
o Parties can modify or change the default rules.
• However, some rules are immutable, and cannot be trumped by private ordering.
• Tailored rules
o Designed to give contracting parties the exact rule that they would themselves choose if they were able to bargain costlessly over the
matter in. The availability of tailored results via ex-post judging allows parties to avoid the costs of negotiating and executing a
contract covering all possible contingencies.
Prof. Howson BizAss – Fall 2012
o However, because of bounded rationality, a lawmaker cannot know what rule the particular parties would select (when writing
legislation) and a judge and jury cannot always determine ex post the rule for which parties would have bargained.
• Majoritarian rules
o Rules designed to provide investors with the results that most similarly situated parties would prefer.
o Those who don’t like the rules can vary them ex ante or chose a different business form that has more suitable rules.
o While advocates of tailored rules speak literally, advocates of majoritarian speak metaphorically, seeking the rule that will best protect
the rational ex ante expectations of parties similarly situated, not the exact parties that are in dispute.
• Penalty default rules
o Designed to motivate one or more contracting parties to contract around the default.
o The goal is not to economize on ex ante transaction costs, but to force the parties to specify their own rules ex ante, instead of relying
on the default rules.
Nonjudicial Mechanisms That Supplement Private Ordering
• The Markets
o A variety of markets play a role in the governance of firms and how lawmakers design the rules of business associations.
o These markets influence business associations’ governance, making it less necessary for lawmakers to intercede
o Product market: If team members perform with a lack of skill and diligence, nobody will buy the product and the firm can go out of
existence as other firms will provide a superior product.
o Capital market: From time to time firms need to raise additional capital, so they have to compete with other firms seeking capital.
Prospective capital providers seek the best return on investment, so firms that aren’t well run wont be able to raise capital to survive.
o National securities market: Ownership of the nation’s largest firms are usually traded on the stock markets, providing liquidity to
investors by permitting them a means of buying or selling investments. The markets provide a changing and accurate measure of the
relative value of firms and their managers, lessening judicial and regulatory checks on managers’ conduct.
o Labor market: Individuals realize the value of their human capital as employees by selling their services in the labor market,
competing with other employees (or firm managers) for rewards. If an employee is not diligent or loyal, he won’t advance or receive
good recommendations, or could be discharged. Even in a team environment where employees/managers stick together, slackers on
the team will cause the firm to do poorly and result in a change in employment/management. Thus the discipline of the labor market
can reduce the need for ex-ante contracting, or setting up costly monitoring systems.
• Trust
o Economists usually leave this factor out in analyzing why firms can serve the interest of team members better than contracts between
autonomous producers.
o The social science idea is that traditionally cooperative behavior within a particular group (including trust and trustworthiness) often
enhances the group’s overall welfare. If the group does well, each member of the group usually does well.
• Norms
o Most activity within a firm is governed not just by judicially enforceable contracts, but by norms, or non legally enforceable rules
and standards (NLERS).
o NLERS form a great part of what is sometimes known as a firm’s corporate culture.
Prof. Howson BizAss – Fall 2012
o A difference between NLERS and contracts is that when parties disagree as to whether performance has been satisfied, courts can
impose penalties in the latter case, but only parties can do so in the former.
o Firms that have effective NLERS get more loyal and diligent performance out of team members than firms without NLERS or firms
with ineffective NLERS
! Effective: high-tech firms NLERS that lead engineers to work intensely on critical projects
! Ineffective: NLERS that encourage not working too hard in an industrial workplace.
PART 2: AGENCY
DUTIES OF AGENT AND PRINCIPLE TO EACH OTHER
Restatement Third of Agency: 1.01, 1.02, 1.03
• (1) Agency is the fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his
behalf and subject to his control, and consent by the other so to act.
• (2) The one for whom action is to be taken is the principle
• (3) The one who is to act is the agent.
Introduction
• Agency law: A set of standard form rules that provide a backdrop for contracts or market transactions among team members.
o Governs relations between team members in a firm
o Governs relations between the firm and outsiders
• A firm is created by unifying the ownership and control of the team in the hands of one or more owners (referred to as the principal) while
other team members agree to serve as employees (referred to as agents).
o Principal enters the firm by investing his money to acquire assets needed by the team, and by agreeing to employ one or more agents
to carry out, under his control, a portion of the team’s work.
• Other team members, the employees, signal their entry into the firm by agreeing to provide services to the firm subject to the dictates and
control of the owner (principal)
• At common law this mutual assent created the principal-agent relationship, which could be terminated at will by either party. As long as
the relationship exists, the agent is subject to the principal’s control with respect to services performed.
o This ability to discharge at will gives the principal substantial power to act opportunistically to discharge or threaten discharge
o An employee can also opportunistically withdraw, threaten to withdraw, and thereafter convert to personal use skills or information
acquired while employed by the firm.
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Prof. Howson BizAss – Fall 2012
However, the law of agency imposes a fiduciary duty on agents and other legal doctrines impose some limits on the principal’s right to
discharge an employee.
o Thus, the need to contractually limit the right of action of either principal or agent depends on the extent to which adequate protection
is offered by ex post judicial enforcement of state-provided rules.
Fiduciary Limits on Agent’s Right of Action
• Employees owe a fiduciary duty to their principals under the common law of agency
o Employee must deal with principal in complete candor, must account to employee for all profits flowing from information he
acquired in service, must not use or disclose employer’s trade secrets, and may not carry on a competing business until the agency
relationship is terminated.
o Employee must prefer employer’s interests to his own.
• Fiduciary duty is an implied contractual device supplied to principal and agency by the state, substituting for an express contractual
specification of what an agent may or may not do.
• If employee acts opportunistically, he runs risk of violating his fiduciary duty.
Community Counseling Service, Inc. v. Reilly (4th Cir.) 1963
• RULE: Prior to severing the employment relationship, an employee cannot solicit for himself future business which his employment requires
him to solicit for his employer.
• Defendant Reilly was an employee of CCS, a professional fund-raising organization used by Catholic parishes. Reilly’s job was to seek out
likely prospects for CCS’s services.
• During his employment, he solicited the business of three parishes for himself.
• Court held that it was irrelevant that Reilly didn’t begin working on those parishes campaigns until after his resignation from CCS, because
the substantial fees he collected were partly due to his disloyal conduct during his employment when he owed a duty to solicit only for CCS.
Hamburger v. Hamburger (Mass Superior Court, 1995)
• RULE: An employee is free to make logistical arrangements, such as financing and lease plans, for a new company, while he is still
employed by another company. He is entitled to use his general knowledge, experience, memory and skill in establishing his new company.
o Customer lists are not trade secrets if readily available from published sources.
• Defendant David (son and nephew of owners of Ace), while employed by Ace Wire and Burlap Company, made financing and leasehold
arrangements for a rival company he planned to start. Immediately upon resignation, he began to solicit many Ace customers. He arranged
financing for his new company by getting it from a main client of Ace, and he used Ace customer lists and pricing information obtained
during employment for customer solicitation after he quit.
o Knowledge about Ace’s customers and pricing was part of the general knowledge, experience, memory and skill David had acquired
as sales manager.
o Customer lists were not considered trade secrets because information was readily available from published source (business directory)
Non-compete agreements
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Prof. Howson BizAss – Fall 2012
As an alternative to relying solely on fiduciary duty, principals may contract for greater protection from post-employment competition in the
form of non-compete agreements.
Courts will enforce the agreements if they are reasonable given the duration, geographical coverage, and the nature of the employer’s
risk from such competition. See below for example of an unreasonable agreement.
Robbins v. Finlay (Utah 1982)
o Court refused to enforce a non-compete agreement that prohibited defendant Finlay, a hearing aid salesman, from competing with
plaintiff Robbins for a period of one year because his job required little training, company’s investment in training him was small, and
there was no showing that his services were special, unique or extraordinary, even if their value to Robbins was high.
o The broad language of agreement was unrestrained by any limit keyed to uniqueness of employer’s services, trade secrets,
confidentiality or even competitive unfairness, it just baldly restrained competition.
General knowledge or expertise acquired through employment in a common calling cannot be appropriated as a trade secret
Note: they are illegal in California.
Fiduciary Limits on Firm’s Right to Discharge Employee at Will
• A firm has the power to discharge a valued employee without cause. This is the employment-at-will doctrine.
• However, the firm generally may not discharge that employee in bad faith.
Foley v. Interactive Data Corp. (CA Supreme Court, 1988)
• RULE: The presumption that an employment relationship of indefinite duration is intended to be terminable at-will may be overcome by
evidence of contrary intent, either express or implied.
• Foley was an exemplary employee of IDC for seven years. He told a former supervisor that his current supervisor was under investigation by
the FBI for embezzlement from his former employer, and was advised “not to discuss rumors,” and then told he was being replaced for
“performance reasons” and could transfer to a position in another division. He agreed to demotion, but then was told he could either resign or
be fired. He then filed suit for wrongful discharge, referring to IDC’s written “termination guidelines” setting forth express grounds for
discharge and a seven step predetermination procedure.
• Court held:
o Repeated oral assurances of job security and an exemplary employment record contributed to Foley’s reasonable expectation he
would only be fired for good cause.
o Foley reasonably relied on company’s personnel manual/policies for a reasonable expectation that he’d only be fired for good cause.
o Finally, the one-year non-compete agreement he signed may have been probative evidence that the parties intended a continuing
relationship, with limits upon IDC’s termination authority.
• Foley asserted three theories:
o 1. Tort cause of action alleging a discharge in violation of public policy
! Foley failed to show a violation of fundamental public policy. Past decisions recognizing a tort action for discharge in violation
of public policy seek to protect the public by protecting the employee who refuses to commit a crime, who reports criminal
activity or other illegal/unethical/unsafe to proper authorities. Here, the disclosure was to employer, not authorities, which only
served the employer’s interests and not the public.
Prof. Howson BizAss – Fall 2012
o 2. Contract cause of action for breach of an implied-in-fact promise to discharge for good cause only
! Foley sufficiently alleged a breach of implied-in-fact contract and should have opportunity to prove allegations
o 3. Cause of action alleging a tortious breach of the implied covenant of good faith and fair dealing.
! Breach of covenant of good faith and fair dealing may give rise to contract, but not tort damages.
! A breach of implied contract does not place employee in the same economic dilemma that an insured faces when insurer in bad
faith refuses to pay a claim or accept a settlement offer within policy limits, because insurer cannot turn to the marketplace to
find another insurance company to cover loss already incurred, whereas employee can, and must (to mitigate damages), make
reasonable efforts to find new employment
AUTHORITY IN RELATION TO THIRD PARTIES
Restatement Third of Agency: 2.01-2.06, 3.01, 3.03
• 2.01-2.02: Actual Authority
• 2.03: Apparent Authority
• 2.04: Respondeat Superior
• 2.05: Estoppel to Deny Existence of Agency Relationship
• 2.06: Liability of Undisclosed Principal
• 3.01: Creation of Actual Authority
• 3.03: Creation of Apparent Authority
Introduction
• Does the agent speak for the firm or only for herself?
• The law of agency provides standard form rules on which creditors may rely.
o See the cited portions of Restatement Third of Agency above
• Traditional common law rules are designed to protect a principal’s property interests. Under the common law, a third party who deals
with an agent does so at his own peril. The agent’s actions will bind the principal only if he manifested his assent to those actions.
o Actual authority: Occurs when the principal manifests his consent directly to the agent. The consent may be expressly
manifested, or it may be implied from the conduct of the principal (i.e. silent acquiescence).
! If actual authority exists, the principal is bound by the agent’s authorized actions, even if the party with whom the agent deals
is unaware that the agent has actual authority, and even if it would be unusual for an agent to have such authority.
o Apparent authority: Arises when the agent is without actual authority, but the principal manifests his consent directly to a third
party dealing with the agent. Apparent authority can be created expressly or impliedly.
! A third party can bind a principal on the basis of apparent authority only if the third party reasonably believed that the
agent was authorized.
• Traditional common law rules were ill-suited for the needs of modern commerce. Courts kept having to strain to protect third parties even
when principal’s manifestations of consent were illusory at best. The result? A growing recognition of a new category of authority.
• Inherent authority
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Prof. Howson BizAss – Fall 2012
o A gap-filling device used by courts to achieve a fair and efficient allocation of the losses from an agent’s unauthorized actions.
o Does not arise from manifestations of consent of the type contemplated by traditional common law rules.
o Springs from a desire to protect reasonable expectations of outsiders who deal with an agent.
o Demands the possibility of the principal’s being bound through the agent’s minor deviations.
2 categories of cases for disputes between principals and third parties over authority of agents:
o 1. Cases in which an agent exceeds her authority in an attempt to further the interests of the principal.
o 2. Cases involving totally opportunistic action, where the agent intentionally misleads both principal and third party.
Blackburn v. Witter (CA District Court of Appeal, 1962)
• RULE: A principal who puts an agent in a position that enables the agent, while apparently acting within his authority, to commit a fraud
upon a third person is subject to liability for the fraud.
• While employed by Dean Witter & Co., defendant Long had acted as an investment advisor for plaintiff Blackburn. Long was trusted until he
persuaded Blackburn to invest in a nonexistent company by selling him some of her stock in exchange for his personal note (rather than a
check made out to Dean Witter. Although Blackburn questioned Long about discrepancies in the transactions, he told her he was acting for
his Dean Witter and that the investment was recommended by them. When Long’s fraud came to light, Blackburn filed suit to recover losses.
• Court found that Dean Witter as employer placed Long in a position to defraud their customers.
o Liability in this case rested on the theory of apparent authority as Long had no authority as an employee of Dean Witter to borrow
money for his personal use or take money from a client and give his personal note rather than security for it.
! “Ostensible (apparent) authority I such as a principal, intentionally or by want of ordinary care, causes or allows a third person
to believe the agent to posses”
o Here, Dean Witter impliedly manifested consent for Long’s actions to Blackburn because, by want of ordinary care, it allowed Long
to continue on as an employee knowing Long was drinking in excess, gambling heavily, encouraging customers to buy and sell stock
merely for the purpose of promoting volume to inflate his commissions, and did nothing to advise customers about it.
Sennott v. Rodman & Renshaw (7th Cir. 1973)
• RULE: A partnership will not be vicariously liable for the actions of its partner if the partner did not knowingly assist and participate in
efforts to defraud, and the fraud victim did not rely on the apparent authority of the defrauder.
• (1) Rothbart’s father did not knowingly assist and participate in the fraud:
o Defendant Rothbart, a securities dealer, had been employed by Rodman & Renshaw (defendant) for a period of time after 1958. He
was also a member of the Chicago Board of Trade and engaged as a trader for his own account in commodities. Through the Board he
met plaintiff Sennott, who was also an active trader.
o Rothbart asserted to Sennott that Rothbart’s father, a partner at Rodman, thought a particular stock was good, so Sennott asked
Rothabart to buy him some. For a while, things were good in the relationship. Then Rothbart pretended to purchase special stock
options of a company called Skyline for Sennott, which were allegedly available through Rothbart’s father, but no options ever
existed. Rothbart put the money in his wife’s checking account and used the funds to pay off his own trading losses.
• (2) Sennott did not rely on Rodman’s apparent authority