Enterprise Organization Outline

Enterprise Organization
Professor Khanna
Fall 2004

I. Introduction – Themes in corporations
a. What is the balance of fairness?
b. What are the motivations of the parties?
c. Is there potential for opportunistic behavior? How are the parties trying to exploit each other?
d. Efficiency theorems – Keeping costs low (monitoring or otherwise) and maximizing profits. Seems like courts concentrate on fairness more than efficiency.
i. Pareto – no one experiences a loss from a transaction and at least one party gains. When both parties reveal their utilities from the transaction, the outcome will benefit both parties and no one will be made worse off (Pareto-efficient). In reality, someone is always made worse off by a transaction by absorbing costs of dealing.
ii. Kaldor Hicks – Aggregate gains to the winners exceed the aggregate losses to the losers, increasing the total wealth of the affected parties. Net benefits exceed the net costs, used most often in the real world. At least one parties gains as a result of transaction and everyone who suffered a loss gets compensated for it. The people who gain could in theory try to compensate the losers in some way. Try to reduce externalities (costs that go uncompensated and for which you give no consent). Note: people may classify costs and benefits differently.
iii. Coase – transactions occur in corporations rather than by individuals because the costs in making these deals is substantially reduced by acting in an organized hierarchy rather than just on the market and acting through each individual. Economizing transaction costs will inevitably increase agency costs. What are agency costs? (Jensen and Meckling)
1. Monitoring—Costs of supervising those you hire to make sure they are performing to capacity. Is it cheaper to go with a third party or a principal monitor?
2. Bonding—The costs of an agent convincing the principal he is 100% trustworthy. For example, hiring someone who wants to prove his worth to you on a trial basis would incentivize agent to do his best work and show he’s the person for the job. (examples: bringing clients in, getting the right deals, etc).
3. Residual—The costs that remain AFTER monitoring and bonding costs are incurred. For example, the cost to monitor paper clip usage would be more than the paper clips themselves and probably doesn’t tell you anything about your employees, so it’s okay to eat that residual cost. But phone usage can get pricey and reflect on productivity, so cost of monitoring phone usage may be less expensive than the phone usage itself so might not be willing to absorb this residual cost.
iv. Other reasons for corporations – establishes standard form terms for contracting with and through business organizations; establishes internal governance structures; alters property right to accommodate partition of assets into separate pools of corporate and personal assets.

II. Agency Relationships
a. Formation—consent (expressed or implied) that both parties intended to enter an agency relationship; the agreement is based on the facts before the court. No written agreement is necessary, just the parties’ conduct manifesting intention to enter an agency relationship. Termination occurs when one party objects to the relationship. If agency was formed for a set period of time, then the other party is able to sue for breach of contract if someone leaves early. Otherwise, the relationship automatically ends at the expiration date of the contract.
i. RS on Agency—(1) the manifestation of consent by one person to another that he shall act on the other’s behalf and (2) consent by the other to act accordingly.
ii. Jensen Farms v. Cargill—Warren grain company receiving loans from Cargill to sustain operation. Plaintiff farming group sues to say that Warren breached by not supplying plaintiffs contracted grain. Cargill’s loans were more than merely financing the grain operation, Cargill intended to have more paternalistic control over the business in order to keep a constant supply of grain for their own business (manifest intent). This is not merely a lending relationship, it’s an agency relationship because Warren must get Cargill’s approval for any grain sales they make beyond selling to Cargill, Cargill has access to records, etc. Warren acted as Cargill’s agent, they manifested their intentions, and thus, Cargill was rightly found to be jointly liable to plaintiffs for its role in Warren’s failure to supply. Their actions manifested an agency relationship.
b. Types of authority to act on behalf of the corporation—principals have strong incentive to monitor their agents so that principals avoid liability if the agent does something to bind the corporation. If you never imposed liability on principals, third parties would get exploited by agents. If you always imposed liability on principals, no one would hire agents. Must find a balance by splitting agent monitoring costs between the principal and the third party (to monitor what they can best monitor—cheapest cost avoider).
i. Actual—(board’s approval of agent’s conduct) expressly (binding) or implicitly granted authority to agent, some evidence of manifest intent. If implicit, may be inferred from lack of inaction in the past in responding to such conduct (implying it’s acceptable – ratification) or by the open-endedness of the grant of power.
ii. Apparent—(board’s approval of representations to a third party) a reasonable third party would understand that the person had the authority to act in that role based on his officer position, and there was some communication as evidence. If the third party knows the agent has no authority (or has some notice of doubt), cannot rely on this doctrine. For example, president/CEO is expected to bind corporation for ordinary business transactions, but not extraordinary ones (that would require board approval). If officer expresses doubts about his authority, outsider is put on notice to verify.
1. Note—apparent authority is based on a third-party’s beliefs about officer’s position and way he presents himself whereas implied actual authority is based on whether the board has condoned or granted the officer’s actions.
iii. Inherent—(status of the corporate officer dictates authority) power to bind the corporation to contracts. No communication to evidence this position, just that any person would understand that person’s title (CEO or president) to be capable of binding the corporation to such a transaction (and had no notice that otherwise this was not the case). RS(2d)A 161.
1. Nogales Service Center v. ARCO—truck stop wants to build a restaurant and motel and arranges a deal with an agent of ARCO to finance the operation and give a one-cent per gallon discount to the truck stop. ARCO then backs out on the discount saying the agent had no authority to enter such a transaction, he was merely a truck stop marketing manager. The court rejects their appeal because they failed to object to instructions which only dealt with actual or apparent authority. However, important to recognize that a truck stop marketing manager wouldn’t reasonably be expected to be able to judge oil industry economics. ARCO never communicated with the truck stop directly.
2. Jennings v. Mercantile Co.—real estate broker hired to sell and leaseback a property by a company meets with the VP to go over the terms and he says he has to go back to officers to get approval and the board will automatically approve it after that. The board rejects it instead and real estate broker sues for commission. The court said the real estate broker should not have relied on the VP for apparent authority to contract such a large deal given he had worked with lots of other big companies and officers. In big transactions like this one, it seems odd that anyone would assume a VP could sign off on such a deal without board approval. Company should absorb monitoring costs for ordinary business deals in the scope of employment. But in big transactions, the real estate broker (the agent) is the cheapest cost avoider for monitoring behavior and should recognize that something’s not right.
3. Menard v. Dage-MTI, Inc.—Menard wants to buy property from Dage and the Dage president takes a series of offers back to the board for approval but they keep rejecting. Menard knows president needs approval to go through with it. Finally, president just signs off on an offer on his own without the board’s approval (but says he has approval) and plaintiff sues to make the deal binding on the corporation. The court says that the plaintiff rightly relied on his actions because the president of a company has inherent authority to engage in such transactions. He had worked on deals like this before without approval so it was nothing out of the ordinary as in the Jennings case. Also, the board didn’t do anything about this until well after the deal had ended, showing they probably didn’t care so much.

c. Third-party Effects
i. Torts – we ascertain tort liability from evaluating contractual relationships because we know parties are able to contract for liabilities and what their costs will be.
1. Respondeat superior (master-servant relationship incurs liability on the principal but independent contractor relationship does not). Factors which imply this relationship are—extent of control, distinct occupation/business, works without supervision, skill required, who buys supplies, length of time, method of payment, regular business of principal, intent to have master-servant relationship, whether principal is in business or not, could person sell independent products, who controls the day-to-day operations, is termination of agreement unilateral or bilateral, who pays the bills. RS Agency 220(2).
2. Franchise example—by contracting out, franchise owners have greater incentive to upkeep the store and make it profitable because they own the operation. A large corporation trying to effectively monitor all of these franchises would be expensive and ineffective; by contracting out, the individual owners sustain more control and have more incentive to make the place profitable. In profit-sharing relationships, people have more incentive to work than just hourly-wages. You may start as centrally-controlled company to build up brand equity by controlling all operations (Humble) but then once you establish brand equity you can independently contract to gain greater profits (Sun Oil). Once there is brand equity, franchise owners want to buy into that company’s profits and will try hard to make the franchise profitable. Franchise owners are best able to prevent accidents because they are on site, but parent companies have the money and resources to investigate what steps should be taken to prevent accidents and can easily spread the costs of liability.
a. Humble Oil v. Martin—plaintiff gets hit by rolling car at a gas station because employee failed to use parking brake. The employee’s principal is technically the gas station owner, while the gas station owner’s principal is Humble (deep-pockets). Because Humble paid 75% of station’s operation costs, had specific uniforms, supervisor must do what Humbles tells him to do, etc, they were found liable because they had a master-servant relationship with station. Policy concern—Impose liability on large corporations so they effectively monitor their agents. It’s easier to get the Humble franchises to absorb more monitoring because they are in a master-servant relationship and need the commission.
b. Hoover v. Sun Oil—car catches on fire while employee is filling up gas tank. In this case, the principal gas company was not found liable because its relationship to the gas station was that of an independent contractor and more advisory than in Humble. He had a lease contract where they share in the profits. A representative checks in but just gives advice rather than controlling behavior, doesn’t retain as much control as in Humble. It’s harder to get independent contractors to absorb more monitoring costs because they are not getting commission, so they would not be the cheapest cost avoider.
d. Duty of Loyalty to Principal – the relationship between the agent and the principal, generally imposes fiduciary duties to act in the best interest of the principal because of a relationship of trust and vulnerability. RSA 390 – agent owes principal obligation to deal fairly with principal, fully disclose to him all facts that reasonably affect principal’s judgment.
i. Tarnowski v. Resop—plaintiff hires an agent to purchase a route of jukeboxes for him. The agent contracts with various sellers for a route of old, outdated, junky jukeboxes. Plaintiff sues for the “kickback” commission made by the agent on these deals and the sellers for the down payment the agent made on hi