Law and Economics of Agency and Partnership

Introduction to Agency and Partnership

Agency and general partnerships serve as intermediate steps between contracts and complex business organizations.
The chapter provides an economic theory of how agency and partnership law facilitates economic transactions.
Law and economics scholarship has focused more on contract and corporations than on agency and partnership.
Coase's framework emphasizes the role of transaction costs in determining whether contracts or firms are used for economic activities.
When transaction costs are low, contracts are favored; when high, firms are preferred.
Agency costs arise when one party has greater expertise or knowledge (asymmetric information) or exercises discretion that is difficult to monitor.
Principals structure relationships with agents to align interests, but agency is essentially a special type of contract.
Agency costs contribute to the existence of firms, which internalize certain relationships like employment.
The agency cost approach views agency and firms as two-party problems or interconnected groups of such problems (the "nexus of contracts" view).

Distinguishing Agency from Contract

Agency differs from contract because it involves three parties: the principal, the agent, and the third party.
A principal owns property (assets), which can be physical or intangible (e.g., intellectual property, legal rights, reputation).
Property owners have the right to control asset use and profit from asset value increases.
An agent acts on behalf of a principal with mutual consent and subject to the principal's control.
The principal consents to the agent's use of the principal's property to increase or maintain its value for the principal's benefit.
The third party interacts with the agent while the agent works for the principal.
Agency law primarily concerns interactions between the agent and the third party, where the agent uses and risks the principal's assets under the principal's control.

Economic Purposes of Agency

Agency serves two economic purposes: transactional agency and employment.
Transactional agency: Agents act as contractual intermediaries, reducing costs associated with distance, time, knowledge differences, or multiple principals.
The law of transactional agency binds a principal to authorized contracts made by the agent without making the agent personally liable.
This facilitates transactions and lowers transaction costs for the principal, while also reducing participation costs for the agent.
Employment: Reduces transaction costs related to independent service providers.
Independent providers may lack specialized training, experience, firm culture knowledge, or loyalty.
The employment relationship allows employers to invest in job-specific training and information, maintaining long-term relationships.
Employers can use bonding devices (e.g., advancement prospects) as incentives for employees.
Employees benefit by avoiding ownership risks and burdens, such as maintaining capital and demand for services.
However, employees give up potential profits and risk employer bankruptcy or termination.
All employees are agents, but not all agents are employees. And All transactional agents are not employees.
Transactional agents are defined by their authority to contract, while employees are defined by their relationship with their employers.
Employers control how employees do their jobs, determine specific tasks and schedules, and often require exclusive service.
Both employees and transactional agents interact with third parties in ways that principals control, facilitating transactions and enhancing asset value.
Agency law protects third parties from unwanted, harmful interactions with employees, namely torts, through vicarious liability.

The Shift to Three-Party Relationships

Agency law shifts from two-party contracts to three-party relationships, creating unique benefits and costs.
The tripartite nature (principal, agent, third party) enables collusion between any two parties against the other.
The primary economic purpose of agency law is to enhance the benefits of agency by deterring such collusion.

Partnership Law

Partnership law extends beyond agency by involving multiple principals who jointly own assets.
A partnership, the default form of business with multiple owners, is defined as an association of two or more persons to carry on as co-owners of a business for profit.
Partnerships combine assets, including human capital, and joint control to provide superior goods/services and earn greater profits.
Partnerships involve contracts among principals (partnership agreement) and between the partnership and third parties.
Economists view business entities as contractual, with corporations characterized as a "nexus of contracts."
Partnerships involve relationships among partners, non-partner agents, and third parties.
Partnership law mitigates the multiparty nature by recognizing the partnership as an entity to facilitate transactions with third parties.
Recognizing the partnership as an entity reduces transaction costs by enabling it to make contracts and sue/be sued.
Partnership law makes agency law applicable unless displaced by specific provisions.
However, co-ownership by multiple partners creates complex problems that cannot be fully addressed merely by recognizing the partnership as an entity.

Economic Purpose of Partnership Law

A primary economic purpose of partnership law, similar to transactional agency, is to facilitate partnership transactions with third parties by reducing transaction costs arising from uncertainties.
Multiple ownership also creates problems involving the relationship of partners to each other and to their shared property.
Shared ownership implies shared control, necessitating internal governance rules for exercising this control.
Recognizing the partnership as an entity provides a mechanism for joint control and dispute resolution.
Shared ownership creates the possibility of misappropriation of partnership property.
Partnership law aims to resolve uncertainties about joint property and prevent its misappropriation or improper use.
Recognizing the partnership as an entity facilitates the creation, preservation, and transfer of jointly owned property.
Partnership deters collusive behavior by:
Two or more partners colluding against the interests of other partners or the partnership entity.
One or more partners colluding with a third party against the interests of the partnership.
Multiple partners colluding against a third party.

Agency Law and the Problem of Collusion

An economic theory of agency law explains the law by focusing on three collusive possibilities:
- Principal-agent collusion
- Agent-third-party collusion
- Principal-third-party collusion

Principal-Agent Collusion

Agency law addresses various ways a principal can collude with its agent to the detriment of third parties.
Collusion to mislead the third party about the principal's intention to contract is addressed by the doctrines of actual and apparent authority.
Collusion to shift risks of harm from the principal's business onto third parties is addressed by vicarious tort liability for physical injury.
Collusion to mislead a third party about the nature of a transaction is addressed by vicarious liability for fraud.
Collusion using a fake agent to mislead a third party is addressed by apparent or ostensible agency or vicarious liability by estoppel.
Collusion to mislead a third party into thinking its transacting partner is a principal and not an agent gives rise to the rules governing the undisclosed principal.
Agency law permits the undisclosed principal device for limited purposes.
Collusion by an undisclosed principal to mislead the third party about the agent's solvency gives rise to the undisclosed principal's liability for certain unauthorized transactions by the agent.
Collusion to shield the principal from the consequences of unwelcome information is addressed by the doctrine of imputed knowledge.

Collusion to Mislead the Third Party about the Principal’s Intention to Contract (Actual and Apparent Authority)

Agency law deters principals from colluding with agents to mislead third parties about their intention to contract.
An opportunistic principal could collude with an agent to acquire a free option by expressly telling the agent that the agent is not authorized to make the contract.
The principal might hint, or the agent might simply understand, that the principal in fact wants the agent to make the contract, and the principal might misleadingly suggest to the third party that the agent is authorized
Courts developed the doctrine of apparent authority to deter such conduct.
Under the doctrine of apparent authority, if a principal "manifests" to a third party that an agent is authorized, and based on this manifestation the third party reasonably believes the agent is authorized, then the principal will be bound by a contract the agent makes with that third party even if the agent is not "actually authorized."
Agency law does not permit the principal to collude with the agent to acquire a free option by misleading the third party into thinking that the agent is not authorized, while simultaneously telling the agent that the agent is authorized.
Actual authority is sufficient to bind the principal to a contract with the agent, even if the third party was unreasonable in believing that the agent was authorized.
Agency law provides a presumption of collusive behavior that reduces the costs imposed on third parties by a principal's use of an agent by reducing the risk that the principal is using the agent in a collusive way.

Collusion to Shield the Principal from Tort Liability (Vicarious Liability)

Agency law deters principals from using agents unreasonably to shield themselves from tort liability resulting from physical harm to third parties caused by activities related to the principal's business.
Vicarious liability is the doctrine that accomplishes this goal.
Absent vicarious liability, a principal could use agents to shift these risks to third parties by hiring judgment-proof agents to engage in risky conduct related to the agents' employment and then fail to adequately monitor and control the agents' conduct.
Principals who hire agents as employees are generally in a good position to monitor the conduct of these agents and require them to take reasonable precautions that they might otherwise not have sufficient incentive to take.
Employer principals have an advantage over the tort system in encouraging desirable behavior because they can use devices such as bonding to ensure that agents conform to the principal's requirements, including precaution taking.
Employer's ability to monitor agents and require precaution taking is defined as possessing "physical" control over the agents, meaning control over the means of doing the work, as opposed to control over just the result.
By avoiding costs associated with paying or insuring against tort liability as well as those associated with monitoring and precaution taking, principals could collude with judgment-proof agents by hiring them and offering them higher wages out of the saved tort liability costs.
Apart from vicarious liability, employers who negligently supervise their employees are directly liable to victims of their employees' torts.
Economic scholars starting with Shaven have referred to conduct that may increase the risk of accidents but that the negligence standard does not usually take into account as "activity level" effects.
Employers generally control the activity level of their enterprises (including how often, and when, their employees perform certain tasks) and not simply the details of the employees' work.
The collusion theory helps explain some of the key features of vicarious liability.
- First, vicarious liability is a form of strict liability, but only in part. Vicarious liability requires that the employee be negligent ( or in some cases commit an intentional tort), and then holds the employer strictly liable for the employee's tortious conduct.
- Second, vicarious liability does not attach to all agency relationships, but only those between employers and employees.
- Third, vicarious liability applies only when the employee-agent is acting within the scope of her employment.

Collusion to Mislead the Third Party about the Transaction (Vicarious Liability for Fraud)

A principal is vicariously liable for an agent's fraud if the agent acts with apparent authority, even if the agent is a transactional agent and not an employee.
The explanation for the separate and unique treatment of vicarious liability for fraud is that the nature of the collusive behavior is different in fraud cases.
In fraud cases, the principal uses an agent to mislead the third party about the nature of the transaction the agent is making on the principal's behalf.
Agency can facilitate fraud because agents can use the principal's good name and reputation to lead a third party to have confidence in the legitimacy of a transaction.
Absent vicarious liability for fraud, a principal would have too great an incentive either to look the other way (fail to monitor) when its agents commit frauds, or encourage its agents to commit frauds, that benefit the principal but enable the principal to deny having made any false statements itself.
Courts are more willing to find vicarious liability for fraud than vicarious liability for intentional physical torts, which courts often find to be outside the "scope of employment."
If a court believes that an agent commits a fraud solely to benefit the agent and not the principal in any way, the court can find that the agent was not acting with apparent authority, and deny vicarious liability.

Collusion to Mislead the Third Party into Thinking that an Agency Relationship Exists (Apparent Agency)

Apparent agency holds a principal responsible for the conduct of someone the principal holds out to be an agent even though there is no actual agency relationship.
The collusion problem is essentially the same: principals and agents together mislead third parties into reasonably believing that an agency relationship exists when it does not.
In the tort context, the same conduct that leads the third party to think that there is an agency relationship also leads the third party to think that the agent is an employee acting within the scope of employment.
For the principal to be held liable, the nature of the collusive misleading must be connected to the harm caused by that misleading conduct.

Collusion to Mislead the Third Party into Thinking an Agency Relationship Does not Exist (Rights of Undisclosed Principal and Liability of an Undisclosed Principal’s Agent)

Agency law allows a principal to hide its identity in certain situations and then, after the agent makes a contract on the undisclosed principal's behalf with a third party, to reveal the principal's identity and claim that the third party has a contract with the principal as well as with the agent.
The undisclosed principal rule is in fact a form of principal-agent collusion to deceive the third party about the principal's existence and identity, but agency law permits this collusive conduct because the benefits may outweigh its costs.
Agency law allows the undisclosed principal device, despite its collusive nature, when the principals purpose is simply to capture more of the contractual surplus, and thereby protect its investments in information and expertise.
If a principal and agent collude to hide the principal's identity for other, illegitimate purposes, agency law steps in to protect the third party.
For example, the undisclosed principal does not become a part of the contract, and so cannot sue the third party, if either the principal or the agent knew that the third party would not have dealt with the principal at all ( as opposed to at a different price) if the third party had known the principal's identity.

Collusion to Mislead the Third Party about an Agent’s Solvency (Liabilities of Undisclosed Principal)

Agency law makes third parties liable to undisclosed principals and also makes undisclosed principals liable to third parties.
The main concern here is that the undisclosed principal may use an insolvent agent to make the contract with the third party.
Some cases occur when the undisclosed principal claims that the alleged agent was in fact not an agent at all, and when the undisclosed principal claims that the agent acted without authority.
In some cases, however, the conduct of undisclosed principals can in fact mislead third parties about the agents' solvency.
In these cases, agency law steps in to protect third parties, even if they were negligent in failing to investigate the agent's creditworthiness on their own.
A. Gay Jenson Farms v Cargill
- Warren, a grain elevator, was an intermediary between Cargill and wheat-growing farmers. The farmers sold their wheat on credit to Warren, which in turn sold the wheat to Cargill. Cargill also provided all the financing for Warren.
- The court found an agency relationship existed based on two provisions of the Restatement (Second) of Agency.
  - The first,§ 140, says that a creditor can become a principal if it exercises sufficient control over its debtor.
  - The court relied on Restatement § 14K, which says a buyer is a principal of the seller if the seller is acting on behalf of the buyer.
The dual role might have enabled Cargill to collude with Warren (more precisely with Warren's corrupt managers) against the farmers by manipulating ( and therefore controlling) Warren's profits.
Holding Cargill liable sent a message that courts would not allow a principal to use the undisclosed principal device to collude with an agent to mislead third parties about the agent's solvency.
Watteau v Fenwick
- A man who appeared to be the owner of a tavern but was in fact the agent of an undisclosed principal, purchased supplies for the tavern from a third party and then did not make payment. The court held that the third party could recover from the undisclosed principal.
- The Watteau rule discourages undisclosed principals from hiring insolvent agents to make contracts on their behalf, while creating the impression that the agent owns the assets of the business.

Collusion to Mislead the Third Party about the Principal’s Solvency (Undisclosed Principal, Warranty of Authority)

Agency law discourages illegitimate collusion in the undisclosed principal context by binding the agent as well as the undisclosed principal to the contract the agent makes with the third party.
In the disclosed principal situation, if the principal is bound, the third party gets exactly what it contracted for and there is no reason to think the parties intended to have the agent act as guaran tor of the contract unless the agent expressly agreed to do so.

Collusion to Shield the Principal from Harmful Information (Notification and Imputed Knowledge)

A principal can collude with an agent to impose costs on third parties is to use the agent to shield the principal from harmful information.
Agency law rules discourage this type of collusive conduct, in this case by imputing an agent's knowledge to the principal if that knowledge is within the scope of the agent's responsibilities, and by deeming notifications to an agent sufficient if an agent is either actually or apparently authorized to receive them.

Agent-Third Party Collusion

Agents can decide to throw in their lot with third parties rather than collude with the principal against third parties.
The possibility of agent-third-party collusion is the main reason that the law imposes fiduciary duties, most notably the duty of loyalty, on agents.
The less reasonable the third party's belief, the more likely it is that the third party is really colluding with the agent against the principal's interests rather than that principal and agent are colluding to mislead the third party.
Similarly, if the agent is acting with the third party against the interests of the principal, the doctrine of imputed knowledge does not apply under the "adverse interest" exception.

Principal-Third Party Collusion

Agency law protects against the possibility of the principal and the third party cutting the agent out of his commission once the agent expends the effort to find the third party and make the principal aware of its interest in contracting.
Agency law imposes some duties on principals in their relationships with agents that go beyond ordinary contract duties.
- Principals owe a duty of indemnity to agents who incur certain costs and liabilities in the course of doing their work.
- Another duty owed by the principal is the duty to act in good faith toward the agent.

Partnership Law and the Problems of Shared Ownership and Control

Partnership law differs from agency because it involves multiple owners.
The partnership device facilitates transactions by promoting the pooling of resources.
The partnership relationship poses unique risks that can be grouped into two categories:
- Partners acting together on behalf of the partnership against the interest of third parties.
- Partners acting with third parties against the interests of the partnership.

Partnership Transactions, Interactions with Third Parties, and Interpartner Collusion

One of partnership law's primary concerns is regulating interactions between the partnership and third parties.
The interactions divided into the beneficial ones (contracts) and harmful ones (torts).
Recognizing the partner ship as an entity and making the partnership entity responsible for both types of interactions reduces the overall costs of these interactions.
Much of what makes partnership law in this area unique is its focus on the role of, and problems created by, divided ownership and control.

Partner Authority to Contract with Third Parties

The existence of multiple owners creates potentially more complicated questions of authority than those in agency law, and additional collusive possibilities, because part ners can collude with each other, as well as with non-partner agents of the partnership, to mislead third parties about the partnership's intention to contract.
Partnership law, like agency law, deters collusive behavior through its rules determining which partners have authority to bind the partnership or authorize other non-partner agents to bind the partnership.
The current version of the Uniform Partnership Act makes all partners agents of the partnership and gives them apparent authority to bind the partnership so long as the partner is "apparently carrying on in the ordinary course the partnership business or business of the kind carried on by the partnership."
Like apparent authority in agency, which requires a principal to "manifest" to a third party that the agent has authority, the only manifestation necessary for a partner to have apparent authority is the partner's position as a partner.
Moreover, partnership appar ent authority does not require a "reasonable belief" by the third party in the partner's authority, as agency law does.
Partnership law entities third parties to presume that all partners have the right of full control over the business.
One explanation for the broader rule of apparent authority in partnership law than in agency law is the possibility of collusion among partners, who co-own the business and share in its control, to mislead third parties about a contracting partner's author ity.
Broadening apparent authority beyond that in agency law is one way to discourage the additional collusive technique present in partnership.
The broader partnership apparent authority rule acts as a penalty or information-forcing default to induce the partnership to disclose to third parties any limitations on an individual partner's authority rather than keep those limitations secret.
Partnership law does protect the partnership against partner-third party collusion by denying the third party the right to enforce a contract when the risk of partner-third party collusion is great.
The ability of a person who never was or no longer is a partner to bind a partnership is more limited than the broad apparent authority rule for an actual, current partner.
With respect to transactions made by an apparent partner (partner by estoppel), only those partners consenting to the representation of authority by the apparent part ner are bound, and the partnership is bound only if the actual partners unanimously consent.
With respect to a former (dissociated) partner, although the partner ship statute provides a limited term of "lingering apparent authority" to protect third parties who deal with the dissociated partner, the statute imposes a reasonable belief requirement on third parties, including a duty of inquiry into the partner's depar ture.

Partner Torts and Vicarious Partnership Liability

Just as a partnership entity can make contracts through non-partner agents, a partner ship entity is vicariously liable for the torts of its employees. In both cases, agency law applies and there is no special role for partnership law beyond a rule recognizing the partnership as an entity.
Partnerships have an incentive to admit into the partnership insolvent partners to engage in risky activities.
The concern that partners might collude against third parties by agreeing to shift control over and responsibility for risky activities to only a subset of insolvent partners justifies extending vicarious tort liability of the partnership to partner torts.

Vicarious Partner Liability for Contracts and Torts

A big issue in partnership law is the vicarious personal liability of partners for the con tracts and torts of a general partnership.
If the partnership is an entity and the entity is the principal, the question naturally arises why partners should bear personal vicarious liability for acts of the partnership in which they were not involved.
The basic problem is that absent vicarious partner liability, the partners could collude to undercapitalize the partnership entity ex ante, or have the partners drain the partnership of assets ex post (i.e., after some liability arises).
If the partnership entity lacks suffi cient partnership property to satisfy contract and tort judgments, and only the entity is liable, the partners will have insufficient incentives to honor the partnership's contract obligations and take reasonable precautions to avoid partnership torts against third parties, and hence provide proper incentives for reasonable behavior.
Non-partner agents generally do not have similar ability to deplete the principal's assets, apart from managerial agents who would generally face personal liability for any asset depletion that occurs
The law of general partnership (the default business entity for multiple owners) makes all partners personally liable for all the debts of the business, whether arising out of contracts or torts.
To combat this collusive concern, the law of general partnership (the default business entity for multiple owners) makes all partners personally liable for all the debts of the business, whether arising out of contracts or torts.
The law attempts to strike a balance between protecting third parties and enabling partnerships to function effectively.
The traditional alternative entity to the general partnership that maintains many of the attributes of the general partners but restricts personal liability is the limited partner ship. A limited partnership has at least one general partner, who remains personally lia ble, and at least one limited partner, who does not incur vicarious personal liability.
More recently, the law has recognized limited liability partnerships, limited liability companies, and other similar entities, which offer all co-owners limited liability, with out restricting their ability to share in the control of the business.

Misappropriation of Partnership Property and Partner Collusion with Third Parties

Apart from partner interactions with third parties, the other key feature of partnership law that distinguishes it from ordinary agency is the fact of co-ownership of partnership property.
As with third-party interactions, the entity theory of partnership plays an important role here because making the partnership entity the nominal holder of partnership property reduces transaction costs.
General partners typically have a greater ability than non-partner agents (apart from managerial agents) to control partnership property.
Partners may collude with third parties (or with other partners) against the partnership with respect to the partnership property.
The rules designed to deter collusion against the partnership are generally defaults.
Partnership law has a number of features that protect partnership property from misappropriation by partners.
- Specifically, the fiduciary duties of partners aim to deter partners from failing to enhance partnership property by depriving the partners of opportunities rightfully belonging to the partnership; from diminishing existing part nership property by acting on behalf of a party with an adverse interest to the partner ship; and from reducing the returns to partnership property by competing against the partnership business.
The partnership statute forbids partner conduct that threatens to harm, interfere with, or otherwise adversely affect partnership property.
- The statute provides that partnership property belongs to the partnership entity, and not to the individual partners.
- Partners may use partnership property only for the benefit of the partnership, and not for their own purposes or the purposes of others.
- A partner has no right to receive, and can not be forced to accept, a distribution "in kind," that is, of nonmonetary partnership prop erty.
Once property becomes partnership property, any non-partnership use by partners of partnership prop erty is effectively deemed a misappropriation in the absence of ex ante or ex post partner ship consent.
Partners cannot use partnership property to satisfy their own personal debts and other non-partnership obligations.
Partners cannot use partnership property to satisfy their own personal debts and other non-partnership obligations. The only property the creditors of individual partners can access is the partner's "interest in the partnership," that is, the monetary distributions the partner is entitled to get as a partner.
Professors Hansmann and Kraakman have argued that this rule, which they call asset partitioning, is one of the prime benefits of recognizing legal entities.

Conclusion

Agency and partnership bridge the gap between contract and the firm.
Both facilitate contracting: agency enables contractual intermediation, and partnership enables the pooling of resources in the joint pursuit of an enterprise.
The main concern of agency law is to address the problems caused by moving from the two-party contractual relations to three-party relationships, which creates the potential for any two parties to collude against the interests of the third.
Partnership differs from agency in that it involves multiple owners who have the right and ability to exercise control over shared partnership property.
That .fact creates a need for partnership law to address additional collusive possibilities involving partners, whether acting on behalf of the partnership in dealing with third parties or acting against the interest of the partnership by misappropriating the partnership property.