Chapter 2. What is a Sole Proprietorship and How does it Work?
A. What is a Sole Proprietorship? What is Sole Proprietorship Law? What are the Problems in Starting a Business as a Sole Proprietorship?
· Sole Proprietorship is the most common form of business. A sole proprietorship is a business structure without a legal structure, where the business and its owner are the same actual person and the same legal person.
· This is the “default” structure for a business with one owner. Unless the owner files papers to create some other structure, such as a corporation.
B. What are the problems in Operating a Business as a Sole Proprietorship?
1. Employees and Introduction to Principles of Agency
· Agency law involves delegation. Agency is the most basic example of one person acting on behalf of another.
· The first question we must answer, where one person is acting on behalf of another, is whether a principal-agent relationship exists.
o “Agency is the fiduciary relationship that arises when one person (the ‘principal’) manifests assent to another person (the ‘agent’) that the agent shall act on behalf of the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consent so to act.” – Restatement Third of Agency, § 1.01
o (1) manifestation of consent by the principal for the agent to act on the principal’s behalf; AND (2) Subject to the principal’s control; AND (3) The agent manifests consent
· Agency Problems Involving Torts
o You must first determine if an employer/employee relationship existed
§ It is critical to determine if the agent was an employee of the principal, because the principal is liable for the torts committed by its employee within the scope of that employee’s employment.
o Respondeat Superior – Whether agent is an employee (Apply Wilkinson test, below)
§ Whether the principal had the right to exert control over the manner and the means by which the agent performed his duty
§ It is not just the actual exercise of control that is critical. It is also the right to exercise control that is evaluated
· Under the doctrine of Respondeat Superior, principal/employers are vicariously liable (i.e. responsible) for the torts of their employee/agents that arise within the scope of the employee's employment.
o Restatement Second, § 228 – Conduct is within the scope of employment if, but only if:
§ It is the kind he’s employed to perform; (not in SC)
§ Occurs substantially w/in the authorized time/space limits;
§ Actuated, at least in part, by purpose to serve master; and
§ If force is intentionally used by servant against another, use of force is not unexpectable by master
· Conduct is NOT within scope of employment if it’s different in kind from that authorized, far beyond the authorized time/space limits, or too little actuated by a purpose to serve the master
· Various factors are involved in determined whether the principal has the right to exert enough control over the agent for the agent to be considered an “employee.” These factors are set forth in Comment (f) to Restatement Third of Agency, § 7.07.
§ Employees versus Independent Contractors (AKA “Non-Employee Agents)
· The distinction between employee and independent contractors (or non-employee agents) is important because employees and independent contractors create different potential liabilities for their principals.
o Principals are not responsible for the torts of their independent contractors (non-employee agents) unless the tort arises out of an area over which the principal exercised control or falls into one of the exceptions such as an inherently dangerous activity or a non-delegable duty.
· Wilkinson v. Wilkinson (SC 2009), In South Carolina, there is a balancing test of four factors to determine if someone acts as an employee or Ind. Contractor
o Direct evidence of a right to exercise control
o Furnishing of equipment
o Method of payment
o Right to fire
§ Intentional Torts
· Principals (employers) can be found to be liable for intentional torts of their agents (employees), when the employee's job is such that some part of the intentional tort might be characterized as being done with the intent of “serving the employer.”
· Some other jurisdictions look beyond the test of whether the intentional tort was committed with the purpose of serving the employer and find that a principal may be liable for the harm done as a result of the intentional torts of an agent if it is foreseeable that some harm might arise out of the specific employment/agency relationship, even if the exact harm which occurred was not foreseeable.
· In an effort to assess whether a particular harm was foreseeable, courts in these jurisdictions will ask whether the tort was of “characteristic risk” associated with the agency relationship.
§ Frolic and Detour
· When an employee leaves employment to do something for personal reasons, that is known as a “frolic.” If an employee is still engaged in employment but strays only slightly from the direct assignment, that is known as a mere “detour.”
o Apparent Agency
§ A principal (or alleged principal) could also incur liability for the wrongdoing committed by an agent (or an alleged agent), acting with apparent authority on behalf, or purportedly on behalf, of the principal (Third Restatement § 7.08).
§ Apparent agency arises in situations in which the person committing the tort is not the employee, or perhaps not even the agent, of the principal.
§ If there are circumstances which led the injured third party to reasonably believe that an employment or agency relationship existed between the principal and the alleged agent and those circumstances existed because of some action or inaction (i.e. manifestation) on the part of the principal, then the principal might still be liable, even if no employment relationship existed, under a theory of apparent agency.
§ Many courts, but not all, will also require that the injury to the third party resulted because of the third party's reasonable, but incorrect, belief that the alleged agent was, in fact, an agent of the principal.
· In other words, some showing that if the alleged agent were under the control of the principal, then the principal would, or could, have exercised control to avoid the tort which took place.
§ Apparent Agency Involves:
· A reasonable belief by the third party that the alleged agent is an agent of the principal (i.e. reasonable reliance);
· Some action or inaction by the principal to create (or to fail to dispel) that reasonable belief on the part of the third party; and
· Some showing (in many cases) that the third party's injury could have been avoided had the alleged principal exercised control over the alleged agent. In other words, the third party's injury arose out of that third party's reasonable belief that an employee/agency relationship existed.
· Agency Problems Involving Contracts
o An agent has the authority to bind a principal to an agreement, provided that the agent has some form of authority. Restatement Second, § 7, defines “authority” as the “power of the agent to affect the legal relations of the principal by acts done in accordance with the principal’s manifestations of consent to him.”
o There are various forms of authority through which an agent may bind a principal to an agreement. They include:
§ Actual Authority (both expressed and implied) – Actual Authority exists when the principal communicates to the agent about the activities in which the agent may engage and the obligations the agent may undertake. This communication may be spoken or written; it may be through silence or implied in the job. There are two forms of actual authority: express and implied.
· Actual Express Authority involves examining the princ
· Acts or omissions (generally wrongful) by the principal, either intentional or negligent, which create an appearance of authority in the purported agent.
· The third party reasonably, and in good faith, acts in reliance on that appearance of authority.
· The third party changes her position in reliance upon that appearance of authority.
Estoppel might arise when the principal takes some improper action. Yet, the improper action is not sufficient to amount to a “manifestation” to the third party. Therefore, it would be difficult to show apparent authority. Note that while estoppel is used in a variety of contexts to bind a variety of individuals, in the agency context, estoppel is not used to create a binding contract that may be enforced by both parties. Estoppel is used to prevent one party (typically the principal) from denying a purported agent's authority when the third party wants to enforce that contract.
2. Other Agency Relationships in Business
a. Franchises and Other Business Relationships
· Agency in a franchise situation if franchisor/principal has the requisite degree of control over the franchisee/agent.
· Miller v. McDonald’s Corporation – Rule (DE): if, in practical effect, franchise agreement goes beyond stage of setting standards and allocates to the franchisor the right to exercise control over the daily operations of the franchise, an agency relationship exists.
· Allen v. Greenville Hotel Partners, Inc. – In SC, “[t]he test to determine agency is whether or not the purported principal has the right to control the conduct of its alleged agent.”
C. How Does a Sole Proprietorship Grow?
1. Funding by the Owner
· The first investment in a sole proprietorship is almost always by the owner. This shows others that the owner is committed to the venture. Additionally, the entrepreneur will invest some money in the idea to build a prototype or to do a market study, to convince potential providers of capital that the idea has potential. This money does not have to come out of the owner’s pocket. The owner can obtain these funds by mortgage, borrowing from friends, or even by using a personal bank loan or credit card advance. It is important to remember that this money goes in as an investment (or “equity”), not as a loan (or “debt”) to be repaid to the entrepreneur.
2. Overview of Debt and Equity
· In essence, all financing for a business is either (1) Debt, or (2) Equity, or (3) some combination of debt and equity.
· Debt Funding – a loan that the business is legally obligated to repay—generally with interest
o Riskier for the business
o Creditors are repaid before owners are
· Equity Funding – an investment that the business receives for selling part ownership in the business. Unlike with a loan, the business is not legally obligated to repay this investment.
o Riskier for investors
3. Borrowing Money
4. Sharing Profits With a Lender
· In re Estate of Fenimore – Sharing profits with a lender will often turn that lender into a partner and not a creditor. Therefore, will become an investor and have a subordinate claim to creditors.