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Business Organizations

Unit VII

Chapter 27 Principal–Agency Law

In this chapter you will:

• Describe a principal–agency relationship, how it is formed and dissolved, and the rights and liabilities thereunder.

Chapter 28 Sole Proprietorships and Partnerships

In this chapter you will:

• Describe a sole proprietorship, how it is formed and dissolved, and the rights and liabilities thereunder.

• Describe a partnership, how it is formed and dissolved, and the rights and liabilities thereunder.

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Chapter 29 Limited Partnerships

In this chapter you will:

• Describe the limited partnership form of business organization, its advantages and disadvantages, how it is formed and dissolved, and the rights and liabilities thereunder.

Chapter 30 Corporations

In this chapter you will:

• Describe a corporation, its unique characteristics, its classifications, how it is formed, and how it is managed.

Chapter 31 Federal Securities and Antitrust Laws

In this chapter you will:

• Identify the major types of federal securities and antitrust laws and describe their importance to business.

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Principal–Agency Law 27 In business as well as in our personal lives, it is often necessary to have others act on our behalf in order to carry out routine tasks that we may not have the time or expertise to perform ourselves. An entrepreneur might go into business for herself and initially perform all of the required tasks personally while the enterprise is in its early stages. But if the business is successful and the owner wants to expand its operations, it will be impossible to do so without hiring additional help to take on some of the responsibilities of the expanding venture. As new employees are hired, they may become agents of the owner, and thereby empowered to carry out certain tasks in her place. Put another way, the owner of a business can delegate some responsibilities to agents whom we nor- mally call employees and empower these agents to act on the owner’s behalf in accordance with the terms of employment. Thus, a used car salesman hired by the owner of a used car lot is empowered to sell cars on the owner’s behalf and can bind the owner to sales contracts he enters into with third parties (used car buyers).

Similarly, an individual can authorize another to act as his or her agent for the purpose of carrying out any legal task by executing a valid power of attorney. In both of these instances, if the agent acts on behalf of the principal (the employer on whose behalf the employee–agent acts) with the principal’s authority, the acts of the agent bind the principal exactly as if the principal had acted. This simple principle forms the basis of agency law and is of critical importance to the formation of business organizations we will discuss in this unit (e.g., sole proprietorships, partnerships, limited partnerships, corporations, and limited liability companies). In this chapter, we will explore the basic principles of the law of agency and discuss their application to employment relationships.

27.1 Creation of an Agency

Agency is a consensual relationship that comes into existence when one person authorizes another to act on his or her behalf to conduct some lawful business. An agent acts as a stand-in for the person he or she represents (called the principal) and, as long as the conduct is within the scope of employment, may enter into contracts on the principal’s behalf. When a duly authorized agent acts on behalf of a principal, it is as though the principal had acted.

Because the principal–agency relationship requires “consent,” only a person with the mental where- withal to enter into a contract can be a principal. If an incompetent (one lacking mental capacity) or a minor becomes a principal in a principal–agency relationship, for example, that person can disaf- firm, or choose to get out of the contract, at which time the principal–agency relationship would end. Interestingly, there is no requirement that the agent be competent. In most states, any person may be an agent, including incompetents and children. This is because principals are free to choose whomever they wish to act on their behalf, and this includes persons lacking full mental capacity (see the discussion of competency in Chapter 9, Contracts, Part I).

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Generally speaking, no formalities are necessary for the creation of a valid agency. Oral instructions as well as written ones can lead to its creation; even a conversation can lead to the formation of this relationship. Suppose, for example, that the owner of a large apart- ment complex said to the employee in charge of operations, “Please hire some staff to clean up the yard.” The principal (owner) has asked the employee, an agent, to enter into a contract on the principal’s behalf. One way to represent this relationship is shown in Figure 27.1.

Figure 27.1: A principal–agency relationship

Note that this diagram depicts two contracts. The first contract is the one forming the principal–agency relationship. This is a special type of employment arrangement in which the principal hires the employee/agent and gives him or her power to enter into contracts on the principal’s behalf. By so doing, the employer is allowing the employee/agent to act in his or her stead. When we say the agent “binds the principal,” we mean that the principal is legally obligated to pay for work done by the third party, just as though the principal had personally hired the third party. As you can see, few formalities are needed, only “orders,” to accomplish the creation of the principal–agency relationship. No specific form is required, or any legal filings or attorneys.

The second contract in the diagram is the one between the agent and the third party: the yard workers. As long as this particular agent had the authority from the principal to hire the workers, then the principal is obligated to pay the workers for the job done because the agent acted in place of the employer.

PRINCIPAL (Owner/Employer)

AGENT (Employee)

THIRD PARTY (Yard Workers)

Contract #1 (Forming the

principal–agency relationship)

Contract #2 (On behalf of the principal)

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The formation becomes more complicated, however, when it has to be in writing to be enforceable. Recall from Chapter 9 on contracts that the Statute of Frauds is the law cover- ing which contracts must be in writing to be enforceable:

1. The sale of real property; 2. The sale of goods worth greater than $500; and 3. A contract that cannot be performed in a year.

In the example given above, in which the apartment complex owner says, “Hire work- men,” the contract could be oral and still enforceable because it does not fall under any of the three criteria. But suppose that the principal had said to the agent, “I want you to go out and buy another apartment complex.” In that case, the contract between the agent and the third party would have to be in writing because it is for the sale of real property. Since the contract between the agent and the third party must be in writing, then the contract establishing the principal–agency relationship must also be in writing. This is referred to as the equal dignities rule, meaning that the principal–agency agreement is given the “same dignity” as the agent–third party contract: Each must be in writing and signed by the party to be charged (the defendant) if it goes to court. (See chapters 9 and 10 for fur- ther discussion of contract writing requirements.)

Agent’s Authority

The following is a general theory of principal–agency:

The principal is bound by the act of his or her agent when he has placed the agent in such a position that persons of ordinary prudence, reasonably conver- sant with business usages and customs, are thereby led to believe and assume that the agent is possessed of certain authority and to deal with him in reli- ance upon such assumption. (Feely Lumber Co. v. Bookstaver–Burns Lumber Co., 181 Wash. 503, 510, 43 P.2d 953 (1935))

So how much authority does this particular agent really have? The answer is that it depends on the type of authority granted to the agent by the principal. The most common type of authority is called actual express authority. In law, the phrase express authority means oral or written, so in these cases, the principal communicates orally or in writing to the agent that the agent has the authority to enter into the contract, as did the apartment owner. Any type of order from a principal to an agent, then, could be considered actual express authority.

When the principal orders his or her agent to “buy a building,” that order has two types of authority. First, because it was spoken, it has actual express authority; also, flowing out of that express authority is another type of authority called implied authority. This is the authority that comes from express authority and gives the agent the power to take any reasonable steps necessary to carry out the express authority granted by the principal. For example, it may be implied from the order to buy the building that the agent has to enter into additional contracts, such as hiring an attorney to review title and hiring a contractor to do an inspection. Although the principal did not order these two other contracts, the agent cannot unilaterally buy a building without entering into the additional obligations; thus, they too are authorized under the umbrella of implied authority.

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Agent’s Apparent Authority

An agent may have another type of authority called apparent authority. This is not cre- ated by any type of oral or written communication between the principal and the agent. Instead, apparent authority is the authority that an agent seems (or appears) to have to a reasonable person under the circumstances based upon the nature of the agency. Note that apparent authority is created by the principal, not the agent.

An example will suffice. If an employee is behind a desk in the lobby of a hotel, then it will appear to third parties that the employee can take money and assign rooms. The principal has allowed this employee to appear to the general public as an agent. Therefore, if a rea- sonable third party approaching the desk at the hotel gave the impostor money, the hotel would be liable for creating the appearance of an agent having authority. Such authority generally flows from the customs and practices of an industry or the general assumptions about a person’s position that a reasonably prudent person might make.

An agent with the appearance of authority is different from an employee who exceeds his or her authority. In the above example, the impostor had no authority, but the employer allowed the situation to exist. In the following situations, the agent has author- ity but exceeds it. Unfortunately for employers, they will be liable for these actions by an employee, since ultimately, the responsibility for hiring an errant employee lies with the employer. For example, it is generally true that the director of Human Resources has the power to hire new employees; thus, an interviewee who is offered a job by a company’s director of Human Resources can accept such an offer and bind the principal to honor it even if the specific HR director was not expressly authorized by management to make employment offers. The HR director’s apparent authority will bind the organization to the agreement.

Consider the following excerpts from Northern Assurance Company v. Lark et al., dealing with an agent who exceeded the scope of her authority.

Cases to Consider: Northern Assurance Company v. Lark et al.

Northern Assurance Company v. Lark et al., 845 F. Supp. 1301 (1993)

Barbara Nash is an employee of Sycamore Agency, Inc., an insurance sales enterprise. Sycamore offers its clients a selection of several insurance companies from which to choose auto insurance. Defendants Connie and William D. Lark were clients of Ms. Nash. . . .

Nash was aware that both William and Connie Lark were currently uninsured and that William had several driving violations of record. Connie Lark knew that she could not obtain coverage from North- ern Assurance for herself and William, because of his or her driving record and the prohibitive cost he would add to the premium. Notwithstanding that neither Connie nor William met Northern Assur- ance’s mandatory Personal Auto Acceptance Standards, on July 5, 1991, Nash offered to bind North- ern Assurance to coverage for Connie Lark (only) and to submit an application to Northern Assurance.

On July 8, 1991, Nash completed a majority of a Northern Assurance application/binder for insurance and mailed it to Connie Lark. Lark did not sign, return, or pay any consideration (continued)

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Cases to Consider: Northern Assurance Company v. Lark et al. (continued) regarding the application until July 22, 1991. On the evening of July 19, 1991, William Lark drove Connie Lark’s car; William’s car’s registration had expired. In the early morning hours of Saturday, July 20, 1991, William was intoxicated and at fault in an auto accident with William J. Summers.

Connie contacted Nash on July 22, 1991, and told Nash about the accident. Nash told Connie to bring in the application as soon as possible; Connie brought in the signed application and the initial premium payment that same day. The Agency Agreement between Sycamore (Nash’s employer) and Northern Assurance required Sycamore to notify Northern Assurance within five working days after issuing a binder. After Nash received the application, Sycamore added a “1” to the “effective date” on the Binder/application and thereby changed the date from July 5, 1991 to July 15, 1991. . . .

Under the criteria provided by Northern Assurance’s Personal Auto Acceptance Standards, North- ern Assurance would not have issued the Policy to Connie. Under the criteria provided by Northern Assurance’s Personal Auto Acceptance Standards, Sycamore/Nash was without authority to issue the Binder to Connie. The facts known to Nash regarding Connie and William prior to the time Nash issued the binder plainly indicated that Connie was an unacceptable risk for the Northern Assurance coverage bound by Nash. The criteria that Connie failed to meet include the following: (1) The Policy application did not name all automobile exposures in Connie’s household (William lived in her house but was not listed as a named insured); (2) Connie’s insurance had been cancelled/non-renewed dur- ing the past three years (the Amerisure policy); (3) Connie had been divorced within the past year; and, (4) Connie was not then currently insured for automobile liability by a standard carrier.

Had Nash disclosed the true nature of the Connie Lark and William Lark risk to Northern Assurance within the required time period under the Agency Agreement, then Northern Assurance would not have issued the Policy. Had Nash disclosed that William Lark had been at fault in a collision on July 20, 1991, then Northern Assurance would not have issued the Policy. . . .

Connie does not have the legal authority unilaterally to bind an insurance company to a contract of insurance. Northern Assurance did not issue the Binder to Connie Lark: Sycamore issued the binder to Connie Lark. It is axiomatic that Sycamore must have contractual or common law authority to act on behalf of Northern Assurance to bind Northern Assurance to the Binder with Connie Lark.

Summers and the Larks argue merely that Sycamore, through Nash, “believed” that it was an agent of Northern Assurance and therefore Sycamore had the authority to bind Northern Assurance to the contract called a Binder. The question of agency is not resolved by referring to deposition answers regarding what the purported-agent “believed”; instead, this issue requires an analysis of the circum- stances to determine whether Nash was a contractual or common law agent. Sycamore was in fact not acting in the capacity as Northern Assurance’s contractual or common law agent when Sycamore issued the Binder. . . .

Agency is a consensual agreement between the principal and agent [citations omitted]; the keystone of the agency relationship is the principal’s ability to define and control the agent’s activities. The Agency Agreement is a contract in which Sycamore and Northern Assurance agreed that Sycamore Agency shall be Northern Assurance’s Agent in Terre Haute, Indiana. The Agency Agreement is the definitive document controlling the relationship between Sycamore and Northern Assurance. The Agency Agreement provides Sycamore the following authority: (continued)

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Cases to Consider: Northern Assurance Company v. Lark et al. (continued) Agent shall have the authority to receive and accept proposals for contracts of personal lines and commercial lines insurance (as defined by Company) as Company and Agent have authority lawfully to make; subject, however, to the restrictions placed upon Agent by the laws of the state . . . to the terms and conditions set forth herein, and to such gen- eral and specific instructions, authorizations, restrictions and criteria as may from time to time be given to Agent by Company in writing.

. . . Connie plainly did not meet mandatory requirements of Northern Assurance’s Personal Auto Acceptance Standards. She did not currently have auto insurance and she was not able to allow Northern Assurance to cover William—he was indisputably an unacceptable risk. The Personal Auto Acceptance Standards, which are implied into the Agency Agreement, expressly forbade Sycamore from binding coverage to an applicant with Connie’s characteristics. The Agency Agreement, there- fore, expressly directed the agent not to bind coverage for precisely the kind of risk presented by Connie Lark. The Agency Agreement is the definitive expression of the scope of Sycamore’s authority to act on behalf of Northern Assurance.

Even assuming that the Binder took effect immediately when mailed (or when discussed, as Connie argues), the Binder was not an enforceable contract between Northern Assurance and Connie Lark. Sycamore issued the Binder outside the scope of the contractual Agency Agreement. A principal is not bound to a contract executed by an agent if the agent does not act on behalf of the principal when executing the contract. Although Sycamore purported to act on behalf of Northern Assurance when Sycamore purportedly bound Northern Assurance to the contract (Binder), Northern Assur- ance was not so bound. Accordingly, Northern Assurance has no obligation to provide coverage to Connie (or William) under the Binder issued to Connie by Sycamore.

In addition to agency arising by written or parol (oral) agreement, an agency relationship may be implied by conduct also. This is the common law concept of apparent agency. Even if Northern Assurance and Sycamore had no express agency agreement, Sycamore could have been acting as Northern Assurance’s agent vis-à-vis Connie Lark if, and only if, Northern Assurance had acted toward Connie such that she would have been instilled with the reasonable belief that Sycamore was an agent for Northern Assurance. The evidence establishes that Northern Assurance had no contact with Connie regarding the Binder; absent any manifestation by Northern Assurance, there can be no apparent agency.

Moreover, Sycamore had neither the actual or “apparent” authority to issue to Connie Lark a Binder binding against Northern Assurance. Apparent authority is similar to apparent agency and requires a manifestation by the principal to the third party. There was no such manifestation in this case. Merely by providing Sycamore with Northern Assurance application forms, Northern Assurance did not instill Connie with the reasonable belief that Sycamore could bind coverage for any type of risk that Sycamore saw fit. Almost every contractual agent will have some indicia of authority from the principal; however, it would pervert the legal principle to say that every agent therefore has “appar- ent” authority to bind the principal to any type of contract.

Even if there was an apparent agency, it would be irrelevant. The conclusion that Sycamore issued the Binder outside the scope of its agency relationship applies with equal force whether the agency relationship is created by contract or implied by common law. Plain and simply, Sycamore had no authority to act on behalf of Northern Assurance when Sycamore issued the Binder to Connie Lark under the circumstances known to Sycamore at the time. . . . (continued)

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Authority and Giving Notice

As for apparent authority, the same principle holds true for contracts entered into by agents who have been terminated and behave as if they still work for the business. For example, if a traveling salesperson does not tell a client that he or she no longer works for the business, accepts money from the client, and absconds with it, the principal will be liable to repay the money, even though the agent no longer works for the client. Why? After an agency terminates, ex-agents have apparent authority to bind their principals. This is true until the principal lets third parties who have dealt with the agent in the nor- mal course of business know that the agency has been terminated.

Actual Notification With regard to third parties who have dealt with the agent in the past, the principal must provide actual notification of the agency’s termination. Such notification is generally effective when it is received by the third party. In actual notification, the principal sends that customer an e-mail, a letter, or some other personal communication that informs him or her that the agent is no longer employed. Failure to make this type of communication to

Cases to Consider: Northern Assurance Company v. Lark et al. (continued) In the face of Sycamore’s misrepresentations and knowing omissions to Northern Assurance regard- ing Connie’s application, Summers and the Larks first argue that the Policy was not fraudulently procured because all facts were known to Northern Assurance by imputation through its agent— Sycamore. The position that the policy-dooming information known by Sycamore was imputed to Northern Assurance is unsound for two reasons. First, as discussed above, Sycamore was not North- ern Assurance’s agent for purposes of the application, because Sycamore submitted that applica- tion outside the scope of its agency relationship with Northern Assurance. Therefore, the principle of imputed knowledge does not impute Sycamore’s knowledge of Connie’s situation to Northern Assurance. Second, Sycamore’s own material misrepresentations and knowing omissions played a substantial role in Northern Assurance’s decision to issue the Policy. Even if one could conceive of an “agent” who misrepresents material matters to its principal, the agent’s own acts would preclude use of the common law fiction of imputed knowledge. . . .

The conclusion that Northern Assurance has no obligation to provide coverage for Connie Lark, William Lark, or Connie’s automobile in turn resolves all other outstanding issues and motions in this matter.

Read the full text of the case here: http://scholar.google.com/scholar_case?case=71255814384980 18461&hl=en&as_sdt=2,33.

Questions to Consider

1. This case is concerned with the concept of “imputed knowledge.” What knowledge was known by the agent that was imputed to the insurance company?

2. If the insurance company had really known the driving record, would it have issued the insur- ance policy?

3. How can a principal guard against imputed knowledge?

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third parties with whom the agent has had contractual relations will result in liability for the principal. It is also important that the principal take away from the agent all appear- ances of agency, such as business cards, letterhead, company cars, and briefcases with the company logo, when the agent (employee) is terminated.

Constructive Notice The second type of notice is called constructive notice because it is not given to any one particular person, but is “notice to the world.” Persons who may have been aware of the agency but who did not deal with the agent directly can be given constructive notice of the agency termination by publication of a legal notice in a newspaper of general circula- tion in the geographic area or areas in which the person acted as an agent. Constructive notice will effectively destroy an agent’s implied authority to bind his or her principal with respect to third parties. Managers must be very careful when posting such a notice not to publish anything defamatory about the agent, lest they risk a tort lawsuit. Instead, they should make an announcement in a newspaper or trade magazine that says some- thing to the effect of “We are pleased to announce that Brenda East is taking over as the sales agent for Motley Dutcher, who is no longer working for the company.” This type of notice is effective for anyone that might know of the agency relationship but who has not actually entered into a contract.

Agency by Estoppel

In special circumstances, a principal who has not actually empowered an agent to act on his or her behalf can be bound by acts of the agent under an estoppel theory: This is known as agency by estoppel. If the principal misleads a third party into believing that a person who is not an agent is in fact the principal’s agent, then the principal will later be unable to disavow acts of the purported agent. For instance, say that a sole proprietor leads an innocent third party to believe that a specific person is his or her agent when no actual agency exists. If so, any contracts entered into by the third party with the purported agent, in reliance on the principal’s misrepresentations, will bind that principal as if the purported agent were in fact a duly authorized agent. Note, though, that a purported agent’s misrepresentations will not bind the principal unless they are made in the pres- ence of the principal, who did not disavow them. The following examples will illustrate:

• Arnold misrepresents himself or herself to be Paula’s new purchasing agent to Tom, an innocent third party, in the presence of Paula, who does not correct Arnold’s misstatement. Arnold subsequently sends Tom, a wholesaler, a writ- ten order for $100,000 worth of electronics equipment for resale in Paula’s busi- ness. If Paula rejects the shipment when it arrives, Tom is entitled to sue her for damages, including his or her lost profits and shipping and insurance costs, as Arnold had apparent authority to order the goods as Paula’s purported agent.

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• Archibald, an unemployed charlatan, tells Tina that he is a new partner in the accounting firm of Adam, Bloom, and Chang, P.C., a prestigious small firm in Tina’s city. Tina, believing his or her assertions, pays him a sizable retainer for his or her purported firm to handle her company’s payroll and maintain her books. If Archibald cashes the check and skips town, Tina has no recourse against Adam, Bloom, and Chang, P.C., as the firm did not mislead her. She did not verify Archibald’s statements with the firm, and the firm is not responsible for allowing her to be misled by the false statement.

27.2 Termination of an Agency

A principal–agency relationship can be terminated in one of three ways: by the con-sent of the parties, by the completion of the agency purpose or expiration of the agency period, or by operation of law. Termination by Consent of the Parties

If the principal and the agent mutually agree to end the relationship, this is called ter- mination by consent of the parties. Generally speaking, an agency can be terminated at any time by the mutual consent of the principal and the agent. In the event that only one of the parties wishes to end the relationship, however, then the party leaving the relationship may be liable. That party has the “power” to leave but not the right. This means that the other party cannot force him to stay in the relationship, but because he does not have the right to leave, he will incur liability in the form of monetary damages. Thus, if an agent agrees to serve a principal for a period of five years but quits at the end of the first year, the principal may be able to recover compensatory damages. These would include the difference between what he would have paid the agent under their agreement and what he must pay a replacement agent for the remaining period of the breached agreement. In addition, the principal may be entitled to incidental and conse- quential damages, such as the cost of conducting an employment search to replace the agent. In summary, it is possible to end an agency before its term expires, but ending it may lead to a party incurring damages.

Termination by Completion of Agency Purpose or Expiration of Agency Period

If an agency is entered into for a specific purpose, then the agency automatically termi- nates upon the completion of that purpose. For example, if an agency was created for the purpose of the agent purchasing a specific piece of real estate for the principal, then once the agent completes his or her assigned task, the agency relationship ends. Likewise, an agency that is set up to expire after a set period of time or upon the happening of a given event automatically terminates when the specified time period expires or the specified event occurs.

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Termination by Operation of Law

Termination by operation of law means automatic expiration. A number of circum- stances will automatically terminate the principal–agency relationship. These include death, incompetence, or bankruptcy of the principal, or death of the agent. (Note that the incompetence or bankruptcy of the agent does not necessarily terminate an agency.) Sub- sequent illegality or impossibility of performance also causes an agency to be terminated by operation of law, since the purpose of the agency cannot be fulfilled. If the impossibil- ity of performance or illegality is only temporary, however, then the agency resumes as soon as the impediment to completing its purpose is fulfilled.

For example, if XYZ Corp. hires Adam Agent to purchase electronics goods from a spe- cific country for resale in the United States during the next five years at a set salary, and Congress places an embargo on that country a year after the contract was entered into, the agency terminates by operation of law. However, if Congress removes the sanctions a year later, then the agency would resume for the remaining three-year period called for in the original agreement.

27.3 Principal’s Duties in an Agency Agreement

In every agency, a principal owes certain duties to the agent (see Table 27.1 for a side-by-side comparison of principals’ and agents’ duties and rights). These duties are gen-erally described by statute or understood to be basic tenets of principal–agency law. They include the following:

• The duty to compensate the agent for services (unless compensation is waived by the agent);

• The duty to indemnify the agent for any reasonable costs incurred or losses suf- fered as a result of the agency; and

• The duty to cooperate with the agent in carrying out the purposes of the agency.

In addition to these duties that arise by operation of law in every agency, the principal can have other duties specified in the agency agreement. A principal who breaches any duty owed his or her agent will be liable to the agent for damages.

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Table 27.1: Select duties and rights of principals and agents under agency law

Principals Agents

Duties To compensate the agent for services Other duties specified in the agency agreement

To reimburse the agent for any reasonable costs incurred

To be loyal to principal

To indemnify the agent for losses suffered To be obedient to principal

To cooperate with the agent in carrying out the purposes of the agency (provide necessary information and resources; not to interfere with agent’s duties)

To inform the principal of relevant facts agent learns relating to the agency

To exercise due care in carrying out the responsibilities of the agency

To render an accurate accounting of expenses or income received in conducting the principal’s business

To put the principal’s interests over the agent’s personal interests

Rights To recover damages from agent who disregards directions of the principal

To receive agreed-upon remuneration

To obtain an accounting from the agent To receive compensation

To recover moneys collected by agent on behalf of principal

Of indemnification against consequences of lawful acts or those done in good faith

To obtain details of any secret profit made by agent and recover it

To forfeit remuneration of the agent who misconducts the principal’s business

Liabilities Liable for contracts entered into by disclosed and partially disclosed agents

Personally liable for contracts entered into on behalf of partially disclosed and undisclosed principals

Liable for torts committed by agents within the scope of employment

Liable for all torts committed while in the scope of employment

Liable for criminal acts of agents if authorized

Liable for all criminal acts while in the scope of employment

Duty to Compensate the Agent

Unless a gratuitous agency was clearly intended, the agent is entitled to be compensated for services rendered to the principal. A gratuitous agent is one who works for free, such as a volunteer at a food bank who enters into contracts with vendors to procure goods. Therefore, unless someone is a gratuitous agent, compensation is implied in law, whether or not it was ever discussed with the principal. The agent is entitled to compensation for the reasonable value of the services rendered.

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Duty of Reimbursement and Indemnification

An agent will often need to spend money on behalf of the principal in order to carry out the duties of the agency. If these expenditures are reasonable and necessary to further the interests of the principal, the agent (upon giving an accounting of them) is entitled to have the principal reimburse him or her: The principal has the duty of reimbursement. An accounting means that the agent reports the expenses to the principal and provides proof of their costs. In addition, agents can sometimes suffer personal losses while engaged in the business of the agency. As long as these losses were reasonably foreseeable by the prin- cipal at the time of entering into the agency and were not caused by the willful acts of the agent, the agent is entitled to indemnification for such losses. For example, if an agent is injured through the fault of a third party or through his or her own negligence while con- ducting agency business, the principal must indemnify the agent for all medical expenses and related losses flowing from the injury. Likewise, an agent whose personal property is damaged or destroyed while carrying out agency business is generally entitled to indem- nification by the principal for such losses.

Duty of Cooperation

A principal must render any reasonable assistance necessary to allow the agent to carry out the responsibilities of the agency. This duty of cooperation extends to providing the agent with any necessary information or resources needed to perform the assigned agency duties. It also includes a duty of the principal not to interfere with the agent while the agent attempts to carry out the duties of the agency.

27.4 Agent’s Duties in an Agency Agreement

Like the principal, the agent has certain obligations that flow from the agency agree-ment by operation of law and by the express terms of the agency agreement. The agent’s duties arising by operation of law include the following: • The duty of loyalty; • The duty of obedience; • The duty to inform the principal of relevant facts relating to the agency learned

by the agent; • The duty to exercise due care in carrying out the responsibilities of the agency;

and • The duty to render an accounting of expenses or income received by the agent in

conducting the principal’s business.

These duties are described in more depth in the following sections.

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Section 27.4 Agent’s Duties in an Agency Agreement CHAPTER 27

Duty of Loyalty

Agency is a fiduciary relationship (a relationship based on trust in which the agent must exercise absolute good faith in his or her dealings on behalf of the principal). The duty of loyalty requires that the agent place the interests of the principal above his or her own. The agent must deal honestly and in good faith in carrying out his or her duties as assigned by the principal.

An agent can breach the duty of loyalty in a number of ways. These include through the obvious means of stealing or misappropriating funds from the principal, and the much more subtle means of competing with the principal or using information learned by means of the agency relationship to further his or her own interests rather than those of the prin- cipal. An agent cannot keep gifts (or illicit bribes, for that matter) received in the normal course of conducting agency business on the principal’s behalf; such gains are considered the rightful property of the principal and must be turned over to the principal by the agent who receives them.

Duty of Obedience

The agent’s duty of obedience to the principal requires following the reasonable instruc- tions of the principal relating to the agency. Failure to do so will subject the agent to liabil- ity for any resulting loss the principal suffers.

Duty to Communicate to the Principal Relevant Information Learned About the Agency

A principal is deemed to have constructive knowledge of any relevant information the agent learns during the course of performing his or her duties under the agency. This is also called imputed knowledge. For example, assume that Jack is an insurance agent working for Huge Insurance Company. A good buddy of Jack’s comes into his agency and asks Jack to write an automobile policy for him. The friend is a well-known alcoholic and has a history of convictions for driving while intoxicated (DWI). Nevertheless, because he is a good friend, Jack decides to write the insurance policy despite its going against company policy. Jack’s knowledge that his or her friend is an alcoholic with DWI arrests is imputed to Huge Insurance. It is as if Huge were writing the policy with the information. Therefore, when the friend runs over a pedestrian and kills him, Huge Insurance will have to pay out the claim because it is as if the company had issued the policy with full aware- ness of the friend’s drinking problems.

Because relevant information learned by the agent is presumed as a matter of law to be known by the principal, agents must communicate any relevant information they learn relating to the agency to their principals immediately. If they fail to do so, they can be held personally responsible for any losses suffered by the principal as a result of their failure to disclose the relevant information. While this might be all well and good in theory, it is also true that the insurance company is more likely to have the money to pay than is the agent (see Northern Assurance Co. v. Nash).

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Section 27.5 Vicarious Liability CHAPTER 27

Duty to Exercise Due Care in Conducting Agency Business

Agents must exercise the duties of their agency with reasonable care. Failure to do so can result in tort liability for negligence. Agents who have special skills, such as attorneys, physicians, or architects, must exercise a level of professionalism and expertise that is acceptable in their profession; failure to do so can result in liability to the principal for malpractice.

Duty to Render an Accounting

Agents must keep accurate records of expenses incurred on behalf of their principals for which they are entitled to reimbursement or indemnification, as well as of any income or other benefit derived from the agency to which the principal is entitled. Agents must ren- der a formal accounting to their principals from time to time, whenever an accounting is reasonably requested by the principal or as otherwise provided by the agency agreement.

27.5 Vicarious Liability

It might seem hard to believe that an employer could be liable for the actions of an errant employee, especially when the employee’s actions are tortious. The law, how-ever, protects the injured party, and few employees can pay for their actions. The bur- den therefore falls onto the employer responsible for hiring an employee who commits a tort, as described in the sections that follow. As discussed in Chapter 21, Establishing the Employment Relationship, such liability is often referred to as respondeat superior, mean- ing the employer answers (pays) for the torts of his or her servant (employee).

Liability of the Principal for the Agent’s Torts

Principals are liable for the torts committed by their employees if the employees were within the scope of employment. The names of the parties change when an employee commits a tort—from that of employer–employee or principal–agent to that of master–servant. Recall from Chapter 21 that holding the master liable for the torts of his or her servants is called respondeat superior and includes the employer paying damages for its employees while on the job. The servant, of course, is also liable for his or her own torts with regard to third parties the servant injures while engaged in agency business. Usually, though, ser- vants do not have the money necessary to make a lawsuit worthwhile, nor insurance for actions taken while at work; as a result, most third parties seek redress from the servant’s employer, or the master.

In order for the principal–master to be held liable for the servant’s torts, two tests must be met:

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Section 27.5 Vicarious Liability CHAPTER 27

1. There must be a master–servant relationship, wherein the servant is under the direct control of the master (e.g., the servant must be an employee of the master); and

2. The tort must have been committed by the servant while engaged in conducting work-related business.

If, for example, an innocent bystander is injured by the driver of a delivery truck while making a delivery, the injured person can hold the driver’s employer liable for the injuries suffered. But not so if the driver injures someone while driving his or her own car on the way to work, since he or she would not at that time have been engaged in conducting agency business. That is, he or she would not have been within the scope of employment (see Chapter 21 and Table 21.1 for more on employment relationships). For this reason, employers usually invest in third-party liability insurance to protect them from the conse- quences of such incidents.

Independent contractors are not deemed agents of their employers but rather self-employed and solely responsible for their own torts (see Chapter 21 for discussion of independent contractors versus employees; see Chapter 28 for a discussion of sole proprietorships). In determining whether a given person is an employee or an independent contractor, the most important factor courts weigh is whether or not the employee is “controlled” by the employer in terms of the details of the work performed. Other factors include the number of hours worked by the person on the principal’s behalf every week, whether the person has other clients, and whether the person exerts independent judgment in carrying out his or her duties. Thus, a gardener who works for the Jones family two hours per week and has 20 other clients in the area is not an employee but rather an independent contractor. However, a gardener who works exclusively for the Jones family for 20 hours per week, has no other clients, and follows the daily directions of the Jones family might be consid- ered an employee. The difference can be crucial if the gardener injures himself or herself or someone else during the course of his or her employment, for the Jones family would not be responsible for such injuries in the former case but would be liable for them in the latter (see also Chapter 8, Negligence, Strict Liability, and Product Liability).

Liability of Agents for Contracts Entered Into on the Principal’s Behalf

As a general rule, agents are not personally liable for contracts they enter into on behalf of their principals as long as they are within the scope of their authority. When an autho- rized agent enters into a contract on behalf of a principal, it is as though the principal had entered into the contract himself or herself. The agent is merely a facilitator and not a party to the contract.

There are situations, however, in which an agent does have personal liability for a contract that he or she entered into on behalf of a principal. This can occur in two different types of situations. First, if the agent enters into an unauthorized contract, he or she will be personally liable because of acting outside the scope of employment, and thus, not as an agent. Second, agents may be personally liable in situations where their status is partially disclosed or undisclosed, which we will discuss in more detail below.

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Section 27.6 Types of Agents CHAPTER 27

Agent’s Unauthorized Contracts

If an agent enters into a contract with a third party without having actual, implied, or apparent authority, the principal is not bound under the resulting agreement. However, the agent is personally liable because a principal–agency relationship did not exist. Thus, it is as though the so-called agent is entering into the contract for himself or herself, not another. However, if there is a principal–agency relationship and the agent exceeds the scope of his or her powers or violates the agreement, then the principal is still liable. Sup- pose, for example, that an agent is authorized by his or her principal to bid up to $100,000 at auction for a piece of unimproved real estate and the agent bids $120,000. Despite the fact that the agent bid over the authorized amount, the principal is nevertheless liable because the agent had authority to bid.

Principals are free to honor unauthorized contracts (ones in which the agent had no author- ity whatsoever; not ones in which the agent exceeded his or her authority) entered into by their agents if they choose but are under no obligation to do so. If a principal elects to honor an unauthorized contract entered into on his or her behalf by an agent, he or she can do so by a process called ratification, which means assenting to the contract terms after the fact. Ratification involves an affirmance by the principal of a previously unauthorized act by the agent. Once an unauthorized contract has been ratified by the principal, the agent is no longer liable under it, since the liability for performing the contract has been assumed by the principal.

27.6 Types of Agents

You might be surprised to learn that there are three different types of agents: dis-closed, partially disclosed, and undisclosed. Depending on which type of agent one is dealing with, the principal has different degrees of liability, as discussed in each of the sections below.

Disclosed Principal

A disclosed principal is one whose existence and identity are known to the third party. For example, the agent may say to the third party, “I am an agent of Northstar Bank, and they have authorized me to enter into this contract on their behalf.” In this example, both the existence and the identity of the principal are known to the third party, as is the fact that there is a principal–agency relationship. The third party is on notice that he or she is dealing with an agent and knows who that principal is. As a result, the law is well settled that the principal has all of the liability for the contract and the agent has none.

Partially Disclosed Principal

A partially disclosed principal is one whose existence is known to the third party but whose identity is not. Thus, the agent in this case may say, “I am Bill Butler, an agent for a principal who wishes to remain unidentified.” Such contracts are common in instances where the principal fears that the third party might be unwilling to deal with him or

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Key Terms CHAPTER 27

accounting The process in which an agent reports the expenses incurred in the course of duty to the principal and provides proof of costs.

actual express authority A grant of power to an agent from a principal, either orally or in writing.

actual notice or notification Personal notice from a principal to a third party that the agent is no longer employed by the principal and has no authority to bind the principal to contracts.

agency A consensual relationship that comes into existence when one person authorizes another to enter into a contract on his or her behalf.

agency by estoppel When a principal misleads a third party into believing that an unauthorized person is his or her agent (e.g., by silent assent).

apparent authority The authority an agent seems to have to a reasonable third party.

constructive notice Notice “to the world” via a communication of mass media that the agent is no longer employed by the principal.

disaffirming Choosing to get out of a contract or principal–agency relationship by an incompetent person (one lacking mental capacity) or a minor.

disclosed principal A principal whose existence and identity are known to the third party.

duty of cooperation The legal obligation of the principal to render any reasonable assistance necessary to allow the agent to carry out the responsibilities of the agency.

duty of reimbursement The legal obliga- tion of a principal to pay back the agent for monies expended in carrying out the principal’s business.

duty to exercise due care The obligation of an agent to exercise the duties of agency with reasonable care.

where the identity of the principal might drive up the price of the contract if it were known. In such contracts, the principal and the agent have joint liability and both can be sued if the contract is breached.

Undisclosed Principal

Finally, there are instances in which the agent may say, “Yes, I am Bill Butler and I would like to buy that car.” The agent has not disclosed he is an agent, nor has he disclosed the existence of a principal. In fact, the third party thinks he or she is entering into a contract with Bill Butler. Because the appearance of this transaction makes it look as if the contract is between Bill Butler and a third party, this situation is known as an undisclosed princi- pal. As far as the third party is concerned, the agent acts solely on his or her own behalf and is thus personally liable for the performance of the contract if the undisclosed princi- pal fails to perform. If the third party later learns of the undisclosed principal’s identity, the third party may hold both the agent and the undisclosed principal liable under the contract. If you work for someone who asks you to act in this capacity, consider the fact that you will be held personally liable on the contract. If your principal refuses to pay for the car, then you, as the agent, will be held liable.

Key Terms

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Key Terms CHAPTER 27

duty to indemnify The legal obligation of the principal to reimburse the agent for losses suffered in carrying out the princi- pal’s business.

duty to render an accounting The duty of an agent to keep accurate records of expenses incurred on behalf of the principal.

equal dignities rule A rule that states if the contract between the agent and third party must be in writing, then the contract between the principal and the agent must also be in writing.

errant employee An employee who does not follow the instructions of his or her employer.

gratuitous agent An agent who works for free and whom the principal has no legal obligation to pay.

implied authority The permission neces- sary to carry out the work ordered under express authority; the authority that flows from express authority.

imputed knowledge The principal’s con- structive awareness of any relevant infor- mation the agent learns during the course of performing his or her duties under the agency.

incompetent A person who is lacks men- tal capacity. An incompetent who has been declared so by the court is non compos men- tis, and that person’s contracts are void.

indemnify To secure against loss or dam- age that may occur; to compensate for loss or damage that took place; to insure or hold harmless.

malpractice Improper conduct, negli- gence, or incompetent performance of professional duties.

parol agreement Oral, rather than written, agreement.

partially disclosed principal A principal whose existence is known to the third party, but whose identity is not.

party to be charged The party to be sued or the defendant (who has signed a con- tract) in a breach of contract lawsuit; the party sought to be bound by a contract.

principal The name given to an employer in a principal–agency relationship.

principal–master A principal who is held responsible for a tort committed by the agent–servant while conducting work- related business for the principal.

ratification When a principal agrees to an agent’s contracts after the fact; this assumes that the agent had no author- ity to enter into the contract in the first place. Can apply to contracts by minors or incompetent persons as well.

scope of employment The boundaries outlining what a specific person is autho- rized to do at work.

termination by consent of the par- ties When both the principal and the agent mutually agree to end the agency relationship.

termination by operation of law The end of a principal–agency relationship owing to death, incompetence, or bankruptcy of the principal; death of the agent; or illegal- ity or impossibility of performance.

undisclosed principal Neither the exis- tence nor the identity of the principal is known to the third party.

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Critical Thinking and Discussion Questions CHAPTER 27

Critical Thinking and Discussion Questions

1. What is a principal–agency relationship, and what formalities are necessary in order to enter into one?

2. What are the three basic means by which an agency can be terminated? 3. Explain what effect each of the following has on an existing principal–agency

relationship: a. The death of the agent b. The death of the principal c. The bankruptcy of the agent d. The bankruptcy of the principal 4. What are the basic duties owed by a principal to an agent in every agency rela-

tionship? What are the basic duties that all agents owe their principals? 5. What is the agent’s contractual liability in contracts entered into with third par-

ties on behalf of disclosed principals? Partially disclosed principals? Undisclosed principals?

6. Marsha asks Muhammad, a fellow student at State U who is a computer whiz, to purchase a computer for her that in his or her judgment would best meet her needs. She tells him that he can spend up to $1,500 on a complete system, includ- ing an inexpensive printer. Muhammad, after many hours of research to put together the most cost-effective system at the lowest possible price for Marsha, places an order with Computer World on Marsha’s behalf and asks that the com- plete system be shipped to Marsha.

a. Is Muhammad Marsha’s agent under the facts given? If so, does he need written authorization before he can purchase the system on Marsha’s behalf?

b. If Muhammad orders a system for $1,500 from Computer World after identifying himself as Marsha’s agent, is Muhammad liable on the contract if Marsha refuses the computer system when it is delivered? Explain.

c. If Muhammad finds a $4,000 computer system on clearance for $2,000 and orders it for Marsha, who is liable on the contract if Marsha refuses to accept it when the system is delivered, assuming that there is no issue with the Statute of Frauds? Explain.

7. Barbara hires Enrique as a consultant to set up and maintain her computer net- work. Enrique works at Barbara’s business site approximately five to 10 hours per week and bills Barbara at a rate of $100 per hour for his or her work. He does not have an office in Barbara’s place of business and is not on the payroll. He works unsupervised and sets his or her own schedule and hours on an as-needed basis. In addition to working for Barbara, Enrique does consulting work for sev- eral other clients on an ongoing basis.

a. Is Enrique an employee or an independent contractor? b. What practical difference does it make whether Enrique is an independent

contractor or an employee? c. Would Enrique be considered an employee under the previous facts if he

worked 20 hours per week for the past three years for Barbara and had no other clients?

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8. Jasmine hires Jemal to run her business as general manager under a three-year contract. After six months, the parties have a falling-out, and Jemal gives Jasmine notice of his or her intention to resign from his or her position. He expresses the willingness to stay on for up to 60 days to allow Jasmine to recruit a suitable successor.

a. If Jasmine is unwilling to release Jemal from his or her contractual obligation, can she force him to stay on as her agent for the contractual three-year term?

b. If Jasmine cannot convince Jemal to stay on as her general manager, what recourse does she have against him? Explain.

c. Assuming that Jasmine can find several suitable replacements for Jemal for a lesser salary than she had agreed to pay him, what recourse will she have against Jemal?

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