A classical firm under US law is known as Sole Proprietorship and its owner as sole proprietor. The central actor, in the economic conception of the firm, is an entrepreneur.1 One may ask, what is the role of an entrepreneur? Right, an entrepreneur does two critical tasks, namely directing the business and employing a business judgement. The entrepreneur decides what to make and how to make it. It is not an easy task as it involves forecasting, that is, at what price, and in what quantities consumers would be willing to buy a product or service offered in the market, and the process also involves decision-making in respect of hiring a team of employees which can be organised to produce goods or service. It is evident that an element of uncertainty exists for the forecasted degree of successes, the entrepreneur thus accepts the responsibility in respect of his business which in legal terms may be termed an unlimited liability. From this perspective, a firm is what we call the set of relations that arise when resources are allocated by the entrepreneur via management's commands to her employees. All this leads to one thing that the authority to make decisions be vested in the hands of entrepreneur. And from this perspective a business association runs the gamut as a firm may be jointly owned by two persons or a firm may be a multinational organisation. However, in a modern corporation, the firm's managers do not own the controlling amount of the corporation's stock instead a great majority of corporation's shares remains in the hands of a large number of passive and geographically dispersed shareholders who have neither the means nor the will to control the decision making process and these powers are exercised by the managers of the corporation.
There are however, divergent opinions on the role of corporation that whether or not they have destroyed the theoretical underpinning of the free enterprise system.2 The modern economists have described the character of firm as an institution emerging out of contracts rather than its relationship with free market.3
As regards separation of ownership, control and agency relations it is submitted that the principals or the shareholders have no inherent rights of control and agents have no inherent obligation of obedience. Instead principal and agent contract with each other to determine how much control the principal will retain, and how much control will be given to agent. In this way, in a modern corporation managers assume the sole authority to manage the corp. But the relationship remains governed through contracted obligations of principal and agent. However, the ability of manger to use corporation's resources is limited and these objectives are achieved through monitoring of management's actions, bonding agreements, incentive schemes etc. When a corporation is established, it has the following goals: (i) Comparative Search for Best Investment (ii) Risk and Returns.
In order to opt for an appropriate business organisation one has to consider transactional cost for the choice of each organisational form. In determining transactional cost one has to consider: Bonded Rationality; Opportunism; and Time Specific Investment. That is why an individual firm has advantages over other in terms of costs.
When individuals choose to organise their business relationship by assuming roles within a firm, they do so with certain reasonable expectations in mind. It may be necessary to protect some of these expectations by contract.4 By structuring the relationship as that between employer and employee, or as a corporation, partnership, or LLC, the parties receive the benefit of state-provided rules and dispute resolution processes. Thus, the employer-employee relationship, the corporation, the partnership, and the LLC are often described as state-provided standard form of contracts. Most off-the-rack rules found in each state-provided standard form are 'enabling' in the sense that they provide parties with default rules that govern the relationship if the parties do not provide otherwise. To the extent that parties prefer, they can modify or change these default rules.5 It is also crucial to understand which rules are immutable to understand the rules is necessary in order to understand that whether or not these immutable rules will serve the interests of a particular member of the firm?6
Majoritarian rules are designed to provide investors with the result that most similarly-situated parties would prefer. By abandoning the search for tailored rules, law-makers may take assumptions about the contracting needs of prospective members of a firm and provide rules that will suit a large number of them.
Penalty default rules are designed to motivate one or more contracting parties to contract around the default.7 For example, a default rule might be intentionally set so as to penalise some or all of the parties as a means of forcing them to negotiate a rule that they prefer.
The law of agency imposes a fiduciary duty8 on agents, and other legal doctrines and also imposes some limits on the principal's right to discharge an employee. Thus, the need to limit contractually the right of action of either the proprietor or her agents depends, in part, on the extent to which adequate protection will be provided by ex-post-judicial enforcement of the state-provided rules.
Suppose that Sharon and Jake organise a brewery venture as an implicit team Sharon owns and operates a beer distributorship, and Jake owns and operates a brewery, initially, Jake sells all of his product to Sharon, and Sharon develops a network of dealers to whom she sells Jake's beer. After the distributor network is well established, Jake may be tempted to deal directly with Sharon's customers, thereby appropriating the profit attributable to Sharon's sale efforts. Because there is no contractual relationship between Sharon and Jake, Sharon may have no legal remedy. Consequently, Sharon will be unlikely to develop the distributorship in the first place without obtaining contractual protection for her investment. Under the common law of agency, Jake now owes a fiduciary duty to Sharon. He must deal with her in total candor, must account to her for all profits flowing from information he receives in her service, must not use or disclose Sharon's trade secrets, and may not carry on a competing business until after the agency relationship is terminated. In short, Jake, as an agent, is required to prefer Sharon's interests to his own.
From what has been stated above, the principles of US agency law state that:
-- Employment demands the highest duty of loyalty from an employee.9
-- Fruit of disloyal conduct cannot be retained and the employer is entitled to the accounting from his employee.10
-- Principals may dismiss agents for any reason.11
-- Principal and agents can agree by contract to change this rule.12
-- Employee cannot take business from employer while employed.13
-- Employee can use his skills and knowledge to seek a new job.14
-- There does not exist any public policy for good business decisions.15
-- Principal is liable for agent even if principal does not have actual16 knowledge of agent's actions if the agent is acting under apparent authority.
-- Principal is not liable for agent if third party knew or should have known the agent was acting outside of the scope of employment.17
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates. To see author's other areas of interest visit Zafars Blog on International Studies http://blogoninternationalstudy.blogspot.com/)
1. Frank Knight, Risk, Uncertainty and Profit (1921).
2. See Berle and Means, the modern corporation and private property, Macmillan (1933). Berle and Means categorised three types of possible responses to the economic power of the modern corporation and its managers. Society could bend the modern corporation and its managers to the will of the shareholders, so that shareholders, collectively, would act as real owners. Alternatively, society could recognise that corporate managers have absolute power, constrained only by their sense of morality and public duty. A third possibility would be to treat the interests of both managers and shareholders as subordinate to the paramount claims of society.
3. See Michael G. Jensen and William H. Meckling, Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure, S.J. Fin. Econ.305 (1976).
4. But it will not be necessary to draft contracts from scratch to cover every possible expectation or concern.
5. The standard form rules and the legal bargain are provided by the employment relationship and by corporate, partnership, and limited liability company law.
6. Tailored rules are designed to give contracting parties the exact rule that they would themselves choose if they were able to bargain costlessly over the matter in dispute. Any default rule could be said to be a tailored rule for parties that do not vary the rule by contract.
7. The goal of penalty defaults in not to economise on ex ante transaction costs. Instead, the goal is to force the parties to specify their own rules ex ante, instead of relying on a default rule provided by law.
8. Fiduciary duty can be described as a device for economising on transaction costs.
9. Community Counselling Services Inc v Reily, 317F.2d 239, Court of Appeal (4th circuit).
10. 1d.
11. 1d.
12. Economic and legal aspects of the firm.
13. 1d. n8.
14. Hamburger v Hamburger, 1995 WL 759679, SC of Massachnsetts.
15. Foley v Interactive Data Corp, 47 Cal.3d 654, 254 Cal Rptr, 211, Cal SC (1988).
16. Blackburn v Wither, 201 Cal. App.2d 518.
17. Sennott v Rodman & Renshaw, 474 F.2d 32.