Business Associations
Gadinis
Spring 2011
I. INTRODUCTION
a. Theory of the firm
i. Coase – The nature of the firm (1937)
1. Corps are a way of hierarchically organizing an exploitation of assets that can produce products in an efficient way – A way to eliminate the costs produced by imperfect info
ii. Williamson – Transaction cost economics (1989)
1. Suppose A chooses contractor B among many competitors; when A needs the same task repeated, he may have incentives to use B again
2. Over time, B learns to do what A wants; B cannot be redeployed easily
3. Given this situation between A and B, it makes sense for these two parties to become one – this explains vertical integration
b. Objective of Corp Law
i. To maximize efficient use of firm assets for shareholders
ii. Pareto Efficiency: all parties experience a net utility gain for the transaction (or at least no loss), no one experiences a loss, so its better for everyone (asset owners, laborers, etc) to get together and produce this new asset without any of them losing anything in the process
1. NOTE: here we’re talking about the parties to the transaction only, we do not contemplate 3rd parties, etc
2. Problems
a. This is difficult to achieve in practice because its common that someone will suffer a loss
b. Severely limits the negotiation space for welfare-improving trades
c. Assumes that the original wealth distribution is legitimate
iii. Kaldor-Hicks efficiency: transaction produces total gains sufficient to provide compensation to all those who suffered any loss, i.e. total welfare increases (“pie gets bigger”) even if losers are not actually compensated.
1. Total amount of wealth for all parties involved increases, however there are some people who might lose and who might not be compensated for their losses
2. still assumes initial wealth distribution is legitimate
3. more workable and generally accepted as the proper definition of “efficiency.”
4. The fact that the aggregate wealth increases means that we do have enough to compensate if we wanted to, but it doesn’t mean that we do this
5. Efficiency means that the aggregate wealth increases, the pie gets bigger, but there still might be some losers
iv. In reality Judges refer to other concepts: fairness, good faith, loyalty – decisions have moral foundation rather than economic
c. Fairness: in corp law means fairness to shareholders
1. We know that shareholders are looking for ways to maximize their returns, which means getting a larger pie – KEY: shareholder maximization = kaldor-hicks efficiency
d. Three Key Relationships (basic problems) in Corporations
i. Among shareholders
1. Need to manage the relationship between all the contributors to the corp
ii. Between shareholders and managers
iii. Between firm and outside parties (mostly creditors, clients, etc)
e. Agency Cost Economics (Jensen & Meckling 1976)
i. Main tool of analysis for these relationships
ii. Uneconomic decisions for the firm may be in the interest of the manager
iii. Types of Agency Costs
1. Monitoring costs: Principals incur costs to ensure agent loyalty – To make sure that he is only using money for benefit of firm and not himself
2. Bonding costs: Costs not incurred by corp, but incurred by agents themselves who are trying to ensure the shareholders/principals about their abilities
a. EX – paying a law school, then law firms know you will know the law
3. Residual costs: Agents have diff incentives from principals and may use firm assets differently
II. AGENCY
a. Agent (A) can bind the principal (P) to a third party (T)
i. P – Principal – party who wants to achieve something
ii. A – Agent – hired party: Has ability to contract with third parties on behalf of the principal
iii. T – Third Party: Enters into a K with the agent
b. Background Rules:
i. Formation of an agency relationship
1. Special agents (limited to a single act or transaction) v. general agents (series of acts or transactions)
2. Disclosure to T:
a. P disclosed; P undisclosed; P partially disclosed – T knows that there is a P but doesn’t know his identity
3. Right to Control:
a. Employee (or “servant”): P can supervise the agent very closely
b. Independent contractor: P takes no interest in what agent does or how he goes about achieving the goal set out by the principal
ii. Termination at Will
1. Termination is always at will because these relationships are based on consent – Any party can terminate the relationship
iii. P’s liability for A’s authorized and unauthorized contracts, and for torts committed by A
iv. A’s duties to P
c. Agency Definition: RS3 §1.01: Agency…arises when…a principal manifests assent to an agent that:
i. The agent shall act on the principal’s behalf and subject to the principal’s control
ii. The agent manifests assent or otherwise consents so to act
d. Arises out of consent and may be terminated at will
i. Consent may be manifested by actions of the parties that demonstrate P’s control over A – thus can be express or implied
ii. Jason Farms v. Cargill: Cargill acted in a way that implied consent: Cargill’s approval required for mortgages or dividends; Constant recommendations; Criticism about finances, salaries, inventory; Financing all warren’s grain purchases. The point of the relationship was better access to grain for Cargill from Jason Farms, they were not going to make much from the loan, so this was more than a mere loan from a bank.
e. Liability in Contract (P must perform contract entered by A)
i. Actual Authority: that which a reasonable person in A’s position would infer from P’s conduct
1. Express if communication was explicit
2. Implied (or incidental) if A’s actions were reasonably calculated to discharge P’s explicit instructions
a. Including actions that are necessary in order to achieve P’s express desires, but are not specifically included in the express orders
ii. Apparent Authority: T could reasonably infer from P’s actions that A had the power to enter into the contract (White v Thomas)
iii. Inherent Authority: T could reasonably infer from A’s actions that A had the power to enter into the contract (Gallant Insurance v Isaac)
1. RS2 §8A: inherent agency power indicates the power of an agent which is derived not from authority, but solely from the agency relation and exists for the protections of persons harmed by or dealing with a servant or other agent (equitable concept)
2. RS2 §161: A general agent for a disclosed or partially disclosed principal subjects his principal to liability for acts done on his account which usually accompany or are incidental to transactions which the agent is authorized to conduct if, although they are forbidden by the principal, the other party reasonably believes that the agent is authorized to do them and has no notice that he is not so authorized.
3. KEY: only discuss Inherent Authority once its clear that there is no actual or apparent authority
4. T believes that A is authorized to do these actions because they customarily are authorized to do such actions
f. When is it reasonable for T to infer authority from P’s or A’s actions?
i. Examine monitoring costs:
1. White v. Thomas: T were unreasonable to rely on A’s oral confirmations about authority; they should have asked to see evidence of authorization, because it was expedient for them to do so (monitoring costs lower for T, higher for P). FACTS: P had authorized A to buy up to $250k worth of land, A ended up buying $327k worth and negotiated and sold part to T (white) to make back difference; P wanted to rescind sale of extra land to T.
2. Gallant Insurance v. Isaac: T was reasonable in believing that A was authorized to verbally conclude contract because of past dealings (monitoring costs higher for T, lower for P). FACTS: Car insurance case where Gallant EE gave insurance without complete paperwork, accident before paperwork was complete but promise of insurance was already made.
g. P’s Liability for A’s torts: Respondeat Superior
i. KEY: Control distinguishes independent contractors (no liability for P) from employees (liability for P)
ii. RS3 §2.04: An employer is subject to liability for torts committed by employees while acting in the scope of their employment (Respondeat Superior) – thus not all agents can generate tort liabilities for their Ps
iii. RS3 §7.07(3)(a): An employee is an agent whose principal controls or has the right to control the manner and means of the agent’s performance of work
iv. NOTE: Same product (e.g. painting a house) can be structured either as an independent contract or as employment – the relationship is defined by the parties
1. If you watch over the house painter all day and control his actions – he is an EE
2. If you leave with basic instructions and come back later and the house is painted, then he is an IC
v. Other alternatives besides control
1. Strict liability – P is always liable – By imposing this, the P starts to care what the A is doing, wants to create a safe environment for him to perform his task
2. No Fault – P is never liable – but typically p’s want to hook liability on the Ps because they have deeper pockets than As generally
h. Elements of Control: Humble Oil v. Sunoco
i. Direct Control – Ownership
1. Humble Oil: Setting hours of operation; sold only Humble products; Humble held title to goods that Schneider sold on consignment; Lease was terminable at will; Rent was “based on the amount of H’s products sold,” and H paid a big share of Schneider’s operating costs; Humble could require periodic reports
ii. Independent Ownership
1. Sunoco: Barone set hours of operation; B could sell non-sunoco products; Barone took title to goods; Lease was terminable annually; B had “overall risk of profit and loss,” though subsidies from Sunoco ensured competitiveness; No reports, but rep visited weekly to advise
i. Degree of Control as a strategic choice for running business
i. Ownership
1. Owner has direct control over all aspects of business
2. But this involves high monitoring costs to ensure quality of service by EEs
ii. Independently Run
1. Company Owner less involved in day-to-day of each biz
2. Manager/EE more invested in quality of service, more incentive to make a better biz
3. Low monitoring costs for Owner BUT they must decide who would make a good/bad manager/EE
j. The Governance of Agency Relationships: The Duty Principles
i. Agent’s Conduct towards P
1. Express agreement btw parties ex ante
2. Exit rights (termination) by either party
3. Fiduciary relationship in Agency – A’s Fiduciary Duty to P: to always act in P’s interests
a. In types of agency relationships where goals are open ended, its difficult to determine ex ante all the actions that A must take, to stipulate all the outcomes and determine all the scenarios A might face and dictate solutions; So Fiduciary principle is a general concept that controls this area
b. Duty of Loyalty
c. Duty of Care
ii. Duty of Loyalty: not to acquire a material benefit from a third party in connection with P’s business
1. RS3 §8.02: An agent has a duty not to acquire a material benefit from a third party in connection with transactions conducted or other actions taken on behalf of the principal
a. If there is a material benefit to the transaction, its all for P, A cannot take or keep anything for herself
2. RS3 §8.03: An agent cannot act as an adverse party to principal… UNLESS
3. RS3 §8.06:…
a. Agent acts fairly, and in good faith (corp law)
b. Agent discloses all material facts to P (securities regulations)
iii. Tarnowski v. Resop: p hires D to investigate value of a biz, D defrauds p by taking money from biz to overvalue firm. HELD: court gives p more than he originally invested as punitive measure to discourage behavior by A that would harm P.
1. Very difficult to monitor fraud because people are purposely evading you with their behavior – so cost to monitor is very high. Thus court is harsh because its so hard for P to monitor A
iv. In re Gleeson: HELD: no matter what, a person cannot be both a trustee and tenant, effectively dealing with himself – it violates the rights
were individual creditors
b. HOWEVER – the indy creditors have to wait for the partnership creditors to be fully satisfied to lay claim on the partnership assets
3. Thus – IF RUPA is controlling state law OR §723 applies, THEN use bankruptcy act rules. If UPA controls AND §723 does not apply, use UPA rules.
f. Partnership Governance
i. Ordinary matters: majority decisions binding for all
1. UPA §18(h): Any difference arising as to ordinary matters connected with the partnership business may be decided by a majority of the partners; but no act in contravention of any agreement between the partners may be done rightfully without the consent of all the partners.
2. UPA §9(1): Every partner is an agent of the partnership for the purpose of its business, and the act of every partner… for apparently carrying on in the usual way the business of the partnership of which he is a member binds the partnership, unless the partner so acting has in fact no authority to act for the partnership in the particular matter, and the person with whom he is dealing has knowledge of the fact that he has no such authority.
3. Requires a majority of the partners, so even minority partners are bound by decision regardless of consequences
4. Nabisco v Stroud: Stroud’s Food Center run by S and Freeman (equal 50% partners); at some point S decided to leave the partnership so he went out and told Nabisco that he would not be liable for any products sold; Freeman went ahead and ordered products from Nabisco. HELD: F’s actions binding on S because F was acting as an agent of partnership in the ordinary course of biz. So even tho neither can have a majority, the fact that F is acting in the ordinary course of biz of the company, he has the power to bind the partnership.
ii. Extraordinary Matters
1. UPA §9(2): An act of a partner which is not apparently for the carrying on of the business of the partnership in the usual way does not bind the partnership unless authorized by the other partners.
2. The RULE is consent – All partners need to agree – every partner can block the decision if it is something that the partnership doesn’t do in its ordinary course of biz
3. NOTE: silence by a partner is implied consent, and this is binding
4. If a partner disagrees with a decision, then third-party should cease work, otherwise only “authorizing” partners would be liable individually but the partnership would not
5. NOTE: Minimum due diligence required by third party – they should check the authorization of the partner that’s ordering the work to be safe
g. Partnership Dissolution:
i. Under UPA
1. Dissolution (§29): any change of partnership relations including withdrawal, e.g., the exit of a partner
2. Winding up (§37): orderly liquidation and settlement of partnership affairs – EX – selling assets, satisfying creditors, etc
3. Termination (§30): partnership ceases entirely at the end of winding up
ii. Under RUPA
1. Dissociation (§601): a partner leaves but the partnership continues, e.g. pursuant to agreement
2. Dissolution (§801): the onset of liquidating of partnership assets and winding up its affairs
iii. RULE: Parties can contract to avoid statutory winding-up of assets following dissolution (Adams v Jarvis)
1. UPA §37: Unless otherwise agreed the partners… have the right to wind up the partnership affairs…
2. Adams v. Jarvis: Tomahawk Clinic has three partners, including Jarvis and Adams. There are specific terms for the partnership, however this K has one term that says what will happen in case of dissolution, and a second term that says what happens when a partner withdraws – and they don’t vogue. HELD: the court gives precedent to what the parties agreed to, the court wanted to maintain the bargain of the parties, so it allowed a withdraw.
iv. RULE: Distribution in-kind rejected in Dreifuerst (EXCEPT under special circumstances like Rinke)
1. UPA §38(1): When dissolution is caused in any way, except in contravention of the partnership agreement… each partner, unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners.
2. Dreifuerst: three bros were running these feedmills; partnership called DDD Partners; they had two feedmills, one in one location and one in another; later they bros decided to dissolve the partnership; Lower court said they’d cut the assets in two, cutting them in kind. HELD: the court interpreted the statute – §38(1): if the partnership is dissolved then the law doesn’t allow distribution in-kind, rather requires payment of assets in cash
3. Rinke: RULE: special circumstance where in-kind distribution is fair. Where no creditors will be paid by the proceeds and the former partners are the only people who will buy the assets. Breaking up assets destroys value, so in-kind here is most equitable solution.
4. POLICY: ultimately the court says the best rule is sale if we believe the best solution is to get the partners to buy each other out.
