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Business Organizations
University of Connecticut School of Law
McClane, Jeremy R.


Business Organizations

Fall 2014

I. Introduction – Basic Principles


-Pareto efficiency: Resources are distributed such that no reallocation of resources can make at least one person better off without making at least one other person worse off (Pareto-optimal)

-Transfers are Pareto efficient when create a net utility gain, or at least one party experiences a gain and no party experiences a loss

-This kind of efficiency isn’t used much in corps: it assumes the original distribution of assets is legitimate, and it limits the negotiation space for welfare-improving trades

-Kaldor-Hicks efficiency: An act/rule is efficient if at least one party would gain from it after all those who suffered a loss as a result of the transaction or policy were fully compensated

-Aggregate monetary gains to winners > aggregate monetary losses to losers (inc. in total wealth)

-This is the type of efficiency used in corps: it still assumes the original distribution is legitimate, but it is more workable than Pareto

-Courts rarely use the language of efficiency to justify their decisions; they use the moral term “fairness.” Possible that they mean fairness to SH; b/c SH are claimants to corporation’s income/assets, protecting their interests is consistent with increasing total corporate wealth (K-H efficiency)

Modern Theory of the Firm

àCoase: transaction costs

-Costs associated with transactions b/w market participants are substantial; firms exist because it can be more efficient to organize complex tasks w/in a hierarchical organization than on a market

-When complex transactions involved, market forms of transacting require too much negotiation or wasted effort to discover best prices

àAgency cost theory

-Reliance on agents gives rise to specific form of transactions costs

-Agents seen as maximizers of their own interests rather than interests of their principals

-To the extent the incentives of the agent (i.e., person or interest that possesses discretionary power over some aspect of the principal’s investment in the relationship) differ from the incentives of the principal herself, a potential cost will arise à Agency cost is any cost associated with the exercise of discretion over the principal’s property by an agent

-Examples: salaries/benefits (in case of corporate managers); failure to optimize firm value (because managers don’t get all the gains from risky decisions but do bear a lot of the costs if the choices are bad)

-Three general sources of agency costs:

1. Monitoring costs (costs that owners expend to ensure agent loyalty)

2. Bonding costs (costs that agents expend to ensure owners of their reliability)

3. Residual costs (costs that arise from differences of interest)

-The corporation gives rise to agency problems: conflict b/w managers and investor/owners; ability of majority owners to control returns in a way that discriminates against minority owners; agency problem b/w firm and all other parties with whom it transacts (e.g., creditors)

II. The Law of Agency

Agency Formation and Termination


-Restatement: Agency relationship arises when one person (principal) manifests assent to another person (agent) that agent shall act on principal’s behalf and subject to principal’s control, and agent manifests assent or otherwise consent so to act

-Types of agents: (1) special agents – agency limited to single act/transaction; (2) general agents – agency contemplates series of acts/transactions.

-Types of principals: (1) disclosed – third parties transacting w/agent understand that agent is acting on behalf of a particular principal; (2) undisclosed – third parties are unaware of a principal and believe that agent is himself a principal; (3) partially disclosed – third parties understand that they are dealing with an agent but do not know the identity of the principal

-Principal’s control: Agent can be (1) employee/servant – principal controls details of way agent goes about the task; or (2) independent contractor – principal has less control, agent exercises independent judgment over task

-Agency relationships may be implied even when the parties have not explicitly agreed to an agency relationship, see Jenson Farms (below)


-Either the principal or agent can terminate an agency at any time

-Agency will never continue over objection of one party (no specific enforcement), but revocation/ renunciation may give rise to claim for damages for breach of K if there was a fixed set term of agency

-If a principal grants authority for a stated term, authority expires automatically at conclusion of term. If no term is stated, authority terminates at the end of a reasonable term. A special agency terminates when the specific act contemplated is performed or after a reasonable time has elapsed.

Jenson Farms Co. v. Cargill, Inc. (Minnesota 1981)

Facts: Warren bought grain from farmers and resold to Cargill in exchange for loans from Cargill. Warren and Cargill entered into several short-term agency relationships in which Warren contracted on Cargill’s behalf with various farmers. Cargill also reviewed Warren’s operations and expenses and recommended that certain actions be taken. By the end, Warren was heavily indebted to Cargill and Cargill wanted to make Warren’s business decisions. Farmers sued Cargill and Warren because Warren defaulted on contracts made with farmers for sale of grain. They alleged that Cargill was jointly liable for Warren’s indebtedness because it acted as Warren’s principal.

Holding: Cargill acted as Warren’s principal and is liable for Warren’s debts.

Reasoning: An agreement may result in the creation of an agency relationship even though the parties did not call it an agency and did not intend the legal consequences of the relation

tes that any changes would have to be authorized by P. On 12/2, T buys a new car, which A agrees to insure effective immediately. A and T agree that T will come in to sign paperwork on 12/5. In the meantime, on 12/4, T gets in a car accident. On 12/5, T fills out the paperwork as planned, and reports the accident. P denies coverage because A was not authorized to renew T’s policy without authorization from P.

Holding: A had the inherent authority to bind coverage by P. The insurance policy was in full force, and P has to give coverage to T.

Reasoning: Neither an actual nor apparent authority theory applies to this case. Inherent agency power indicates the power of an agent that is derived not from authority, apparent or estoppel, but from the agency relation itself. This inherent authority exists for the protection of persons harmed by P’s A. In this case, A’s renewal of T’s policy constitutes an act which usually accompanies or is incidental to insurance transactions that A is authorized to conduct. A acted within the usual and ordinary scope of its authority. T could have reasonably believed, based on A’s conduct, that A had authority to orally bind coverage. (T’s past dealings were all done through A; there was no communication between T and P, so it was reasonable for T to take A’s representations at face value.) T had no reason to know of P’s policy regarding authorization of changes.

Notes: This theory of inherent power is useful when P is undisclosed (no apparent authority).

Agency by estoppel or ratification- where A’s act is not authorized by P or is not within any inherent agency power of A, P may still be bound by A’s acts by estoppel/ratification (Restatement 3rd Agency §2.05). Customary elements of estoppel: failure to act when knowledge and an opportunity to act arise, plus reasonable change in position on the part of T. Alternatively, accepting benefits under an unauthorized K will constitute acceptance (affirmance) of obligations as well as benefits. (§4.01, 4.07)

Liability in Tort

P is liable for torts committed by employees/servants, but not by independent contractors. (Only the employer-employee agency relationship ordinarily triggers vicarious liability for torts committed within A’s scope of employment.)

*Restatement 3rd Agency §2.04 (respondeat superior), §7.07 (when is an employee acting w/in scope of employment)