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Business Associations
University of Iowa School of Law
Yockey, Joseph W.

Business Associations Yockey Fall 2012

Basic Elements of each BA

1. Risk of Loss: what happens when the business fails?

2. Return

3. Control

4. Duration: Exit i.e. how long will the venture last or when can one leave the venture?

Body of Law influencing Business Association: 1) private contract law and 2) government regulations

Example of ROB the Vinyl Store Owner (choosing a form of BA)

Sole Proprietorship: Rob’s Vinyl Store

1. Risk of Loss: Rob

2. Return: entirely to Rob

3. Complete Control

4. Duration: as long as Rob decides

What happens when business is booming? A: stay a sole proprietor but hire help (agents)

Transaction Costs

What are transaction costs? The costs of doing a deal; economic equivalent of friction

Goal #1 of BA = Lower/Minimize Transaction Costs (make it as cheap as possible for the two parties to come together and make a deal/form a business)

Agency Costs

What are agency costs? The cost that result when an agent does something in her own self-interest and to the detriment of the principal

Goal #2 of BA = Lower Agency Costs

How can Rob lower agency costs? (Dick and Barry are not working hard)


1. Hire a supervisor

– Minimize cost at the supervisory level: financial incentives

– Incentivize with bonuses

2. General Partnership: co-ownership (no more sole proprietor)

– Rob will be in charge of the business

– Partner will be in charge of the employees and the partner has an incentive to supervise and monitor Dick and Barry because of business returns and potential bonuses

– 50% interest in the firm and 50% profits

– Any single partner is liable for all of the debts of the firm

– When you have more risk of loss try to obtain more control in order to minimize that loss

– Liability: most important are Control and Exit


1. Easy to form large amounts of capital because of shareholders

2. Board of Directors: entity responsible for managing operations of the firm

Corporate Lawyers:

1. Minimize Transactional Costs* eliminate the friction: Lawyers are Transaction Cost engineers

Compliance with regulations/Avoid Litigation: navigating the regulations that would affect the client’s BA; look for loopholes in the regulation which may negatively affect the association

Act as a mediator

Minimize personal liability

Private Ordering: example is drafting contracts that are legally enforceable

Lower Agency Costs

NOTE: Lawyers are the “tailors” when the client does not like a certain form of BA that has default rules provided by statutes

Role of State Law: gives us our standard form of Business Associations and default rules of internal governance

Law of Agency

Restatement § 1.01: Agency Defined

Agency is the fiduciary relationship that arises when one person (a “principal”) manifests assent to another person (an “agent”) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act

1. The manifestation of consent by P to A that A shall

– Act on P’s behalf

– Be Subject to P’s control

2. A’ s consent to so act (a complete meeting of the mind): serve to the principal’s control

Threshold Question: When is an agency relationship formed?

Once we have established an agency relationship exists, what does that mean, what are the business implications?

Principal, Agent, Third Party Relationships (PAT Triangle)

1. Agency relationship between P and A

2. A’s dealing with T

3. Create legal liability of P to T (and vice versa)

Gorton v. Doty (Agency Defined)


– Gorton plaintiff passenger was injured in a car accident after Doty loaned the car to Garst when driving Gorton and others to a football game.


– An agency Relationship result when on person’s consents that another will act on their behalf and be subject to his control and the other person consents to so act.


– Doty specifically and exclusively authorized Garst to drive her vehicle i.e. Doty manifested consent that Garst act on her behalf and he consented to do so and therefore was an agent

– Agency at its core is vicarious liability

Dissent: relationship between Garst and Doty is a bailment; passive permission is not sufficient to support agency

Majority stated: not essential that there be a contract between principal and agent

– For an agency relationship to be created no contract is necessary and can be completely inferred from the circumstances

– Only need some evidence of the requirements of acting on behalf/submitting to control

How to avoid liability?

– Check if the car insurance policy covers others driving her car or get a policy that covers other drivers

What is really going on here?

– On what grounds did defendant move for a mistrial? Implication by plaintiff that defendant Doty carried insurance

– What effect will this decision have on Doty? Other drivers? Incentive for others to get insurance

A Gay Jenson Farms v. Cargill, Inc. (Washta, IA) (Creditor-Debtor turned Agency)


– Farmers enter into a contract with Warren to store their grain in an elevator and Cargill financed/loaned Warren capital

– Cargill gives a revolving line of credit and gets a right of first refusal

– Warren defaults to the farmers and the farmers sue Cargill despite the fact that the farmers signed all contracts with Warren

– Cargill, based on its relationship with Warren, became the principal of Warren the agent and will therefore be liable


– A creditor that assumes control of its debtor’s business may become liable as principal for the debtor’s acts in connections with the business

Rationale: (the test)

1. Manifestation of consent to act on behalf and be under control (Agent agrees to act on behalf of the Principal and agrees to work under the control of the principal)

– A manifestation of consent by Cargill that Warren act on Cargill’s behalf by procuring the grain for Cargill as part of its ordinary operations, which operations were financed by Cargill

– Warren became subject to Cargill’s control when Cargill interfered with Warren’s operations

2. Agent’s consent to so act

– Warren’s consent to so act was sort of ignored

Restatement § 14(O): When does a creditor become a principal?

Creditor becomes a principal at the point at which it assumes de facto control over the conduct of the debtor

Nine factors Re: Control (Text pg. 10-11): important to take into totality to figure out which way it cuts


1. Fixed price schedule and maintain the substance of having the company be an independent supplier

2. Passive involvement: veto power or change the relationship/nature of the deal depending on performance

Law as a Business Cost: The Example of McDonald’s

– Franchisor gets a majority of control of the product

– Every action against McDonald’s the franchisor is held liable

– McDonald’s is marketing/selling consistency and in order to achieve that standard must have control over their agencies and are likely to take on the risk of litigation

Liability of Principal for Contracts (K)

Restatement § 6.01

When an agent acting with actual or apparent authority makes a contract on behalf of a disclosed principal

1. The principal and the third party are parties to the contract


2. The agent is not a

pe of his authority to be. In the face of explicit instructions not to do something, an agent has no actual authority to do it.

– Did Humble have apparent authority? No. There was no holding out by the principal: Plaintiff didn’t even know that the principals existed. If you don’t know that there is a principal, how can there be a holding out?

– Inherent Authority: in undisclosed principal cases what is the scope of the agent’s authority?

o Watteau: the [undisclosed] principal is liable for all the acts, which are within the authority usually confided to an agent of that character

o Holding Principal liable in these very narrow set of facts

– Watteau = Controversy: How did Restatement (Third) of Agency change this result?

– State’s that follow Watteau: why? If we are going to allow the principal to gain from being undisclosed, then they should be liable for the risks and a third party should be able to attach them (fairness argument

– Who is the Cheaper Cost Avoider? Usually the principal

NOTE: Try to go after the manager i.e. Humble under breach of contract theory

Restatement § 2.06 Liability of Undisclosed Principal: notice wrinkle in the restatement of taking reasonable steps to give notice

Note 3 pg. 30

T wants to argue Apparent Authority:

– Knows about P Corporation (principal is disclosed)

– T is an artist

– Industry practice

– Why not implied authority? Because there is no express authority (for implied authority you are building upon express authority)

Liability of Principal to Third Parties in Tort: Servants v. Independent Contractors

Hoddeson v. Koos Brothers (estoppel)


– Hoddeson walks into the store and gives money to buy furniture to an impostor

– She is trying to hold the furniture store liable for her loss


– If a business by negligence of duty enables a person not an agent to transact business with a customer, estoppel prevents the business owner (principal) from defensively availing himself of the impostor’s lack of authority in order to escape from liability


– Not apparent authority because there was no manifestation of authority conferred to agent (Why doesn’t Koos’ failure to police its sales floor constitute the requisite manifestation? A manifestation is conduct by a person, observable by others that expresses meaning – Restatement Third 1.03 cmt. b.)

AGENCY by ESTOPPEL: principal subject to liability for failure to act which replaces the manifestation requirement

On remand, what will Hoddeson have to prove to make out a case of agency estoppel (tortious dereliction of duty owed to an invited customer)

1. Acts or omissions by the principal, either intentional or negligent, which create an appearance of authority in the purported agent: failure to police there store floor that creates negligent omission giving appearance of authority

2. Third party reasonably and in good faith acts in reliance on such appearance of authority and

3. The third party changed her position in reliance upon the appearance of authority