NARRATOR: Thanks for joining this episode of the No. 86 lecture series, where we discuss basic principles and applications of Corporate Law along with landmark cases. Today’s episode features Seth Oranburg, who is an Associate Professor at the University of New Hampshire Franklin Pierce School of Law. Professor Oranburg also co-directs the Program on Business, Organization, and Markets at the Classical Liberal Institute at New York University School of Law. As always, the Federalist Society takes no position on particular legal or public policy issues; all expressions of opinion are those of the speaker. PUBLIUS: What is the difference between a partnership and a corporation? What is the basic structure of a partnership? Can it be less formal than a corporation? PROFESSOR ORANBURG: Partnerships can be created by default. They're very easy to create accidentally. A partnership occurs anytime two or more people carry on a business for profit. So long as they're engaged in this common enterprise for profit, that's deemed a partnership, whether or not you file any paperwork. A lot of people are surprised by this and maybe say, "Okay, so why should I care?" The reason you should care is partners have liability for each other. You have joint and several liability as a partnership. If me and my neighbor decide to start mowing lawns together and we split the profits from buying a lawn mower and mowing our neighbors’ lawns, if my neighbor runs over somebody's garden hose and causes a big flood, I'm liable for that damage because I'm in partnership with him. Now, we didn't file any documents. We didn't create a partnership agreement, but we have unlimited joint and several liability for the caused by the partnership. That's a real risk factor. The benefit of a partnership is simply that it's cheap and easy. It's just the default that will happen if you do nothing else. But if you have the time and effort to set up any type of structure, you have every reason to do so because partnerships have unlimited liability for the partners, meaning you have no protection for your personal assets if the partnership does something harmful or wrong. You could form a partnership really cheaply and easily and then end] up losing everything you own because that partnership has engaged in some debt that it can't pay or some tort that results in a huge legal settlement. The big cost, the big downside, the big harm to partnerships is that there's unlimited liability making it really a poor choice for most business ventures. There are really only a few ventures that have very low liability where you would actively choose to form a partnership. The most common example is probably law. Where law partners, the risks that they are creating are malpractice risks or other professional groups. They typically form as partnerships. In large part because the agencies that license accountants and lawyers and doctors and things like that, don't permit them to avoid liability for their own malpractice. They're liable for that anyway. The partnership is not permitted to shield the partners from malpractice liability. If you're a bad lawyer doing bad work, you're going to be personally liable whether you try to have a corporate around you or not. That means that the benefits of other forms aren't as prevalent. But even that said, most newer law firms are forming as if they can, limited liability companies because then at least the partners aren't liable for the non-malpractice harms of the business. In short, there's no good reason for most people to look at forming a partnership. An LLC is usually a better choice for most small businesses today. Corporations are usually better choices for businesses that are raising money from outside investors. PUBLIUS: What about basic governance? Are there rules about that for a partnership, like the requirements for a corporation? Or can that be arranged in any way between the partners? PROFESSOR ORANBURG: Partners have joint and several liability for the torts, debts and crimes of a partnership. When the partnership goes into a business, let's say you create a roofing company and you hire people to install roofs. What are some risks? Well, one risk is that one of your employees will fall off a ladder, get hurt and sue. It's a real risk when you have people going up on ladders and putting themselves in harm's way. If the employee falls off the roof and sues the partnership and wins and the partnership doesn't have enough money to pay for the settlements or the verdict, the partners then are liable, each of them is liable for [ paying for that harm. There are some ways around this with the partnership. There are ways to insulate liability and there's ways to purchase insurance, but the simpler way is to form a different type of organization, one that has limited liability, like an LLC. A key thing to remember about any business organization is that there are default rules, some of which can be changed. When you ask a question like, "How is a partnership governed," what you really are asking are either how is a partnership governed by default, which we can answer by looking at the local partnership statute. It'll be an actual written statute in the state where the partnership is formed. Or you could ask to what extent can I change by agreement, by contract, from the default to some other rule that my particular partnership would prefer? Those are really two separate questions. On the first one, how is a partnership governed by default, the default in most states is one partner, one vote. If you have 10 partners, each person has an equal say. Regardless of how much money they contributed or how much money they receive, the finances are separate from the governance. Again, that's different from corporations where it's really $1, one vote or one share, I should say, one vote because shares can be sold at different times for different prices. But one person with five million shares has more power than one person with 100 shares in a corporation. Whereas in a partnership, those two people are pari-passu, side by side with each other. It's why we describe partnerships as having flat governance and corporations, it's one reason why we describe them as having a hierarchical governance. But that flat structure also means that everyone sort of sits around the table and votes yes or no, but that can be changed by contracts. There is such a thing as a partnership agreement, depending on the state you live in, some states, most states, will allow partnerships to elect a different form of governance. In fact, if you wanted to, you could morph a partnership into something that functioned like a corporation. The question is why? Why would you do such a thing? Why would you have a corporation with unlimited liability and a ton of paperwork to get there? You should just form a corporation if that's what you want to do. PUBLIUS: Let’s say that I do want to form a corporation. What would that look like? How does it look different from the partnerships we were just talking about? PROFESSOR ORANBURG: There are several types of business structures and when we talk about business associations, we might draw a spectrum between corporations which are designed to be hierarchical and partnerships, which are designed to be flat. In a corporation, or a entity that is corporation-like, and there are new ones along the spectrum, like limited liability companies, which can act more corporate-like, or be structured more corporate-like by being, for example, manager managed, having a hierarchy, or being member managed, which is more like a partnership. But I always start by talking about corporations and partnerships as paradigms of two parts of a spectrum. In a corporation, you're going to have, at an idealized level, although not in every case, you're going to have some separation of ownership and control, at least in a large corporation, so the shareholders will vote for directors. The directors appoint officers. The officers execute the day-to-day function, and the shareholders who are the owners have limited control abilities, limited control rights over that whole enterprise and their vote and their ability to control is based on their dollars invested, typically. If you have invested $1 and someone else has invested three, that person who's invested three will always get their way over the person who invested one. It's really about $1, one vote, and the vote is to appoint representatives like in a republican democracy who is then going to perform the execution of the board's decision-making in terms of the day-to-day operation. A partnership on the other hand, is usually designed to be one person, one vote. It doesn't necessarily matter how much you've invested or how long you've been there, but you sit around a table and Joan says, "Yes," and Jamie says, "No," and Frederick says, "Yes," and two to one equals a yes. Majority rules. You can structure both of these to have all sorts of different rules, but these are the general paradigms that a partnership is going to be managed by its partners who are the owners. There's no separation of ownership control and it's a one person, one vote. Now between this, there's lots of room, right? There's lots of alternatives. There's lots of ways you can tweak a partnership to function differently. I've seen partnership set up as two tier partnerships with class A and class B partners, or even three tiers of partnership. There's limited partnerships where there are general partners who make the decisions and limited partners that act like passive investors. Then there's limited liability companies, which are incredibly flexible. They can be designed to function just like a partnership, except without liability for any of the partners with limited [01:04:30] liability for the partners, or they can be set up to function almost identically to a corporation where you're issuing shares. There are unit holders. The unit holders have an annual vote to elect managers. The managers appoint directors. The directors appoint officers, et cetera, and you have effectively a corporate structure. I would just simplify this and think about corporate-like, and partner-like organizational structures. And once you've got that, then you need to add, if you are interested in the emerging world, not just what has been for the last 200 years, but what the future will look like, a new concept of decentralized organization, which takes partnership to the next level where everyone involved, not just the partners, but everyone who's involved in the organization has some type of voting capacity. And these decentralized, autonomous organizations are even flatter than traditional partnerships, where you might have partners like in a law firm who make the decisions and then associates who are paid salaries and abide by the decisions. In a decentralized organization, it might be entirely flat where everyone is participatory, almost like a pure democracy. Again, think of a spectrum, and if you like civics, maybe the better analogy is going all the way from a republic to a pure democracy. And along the way, there are different nodes and those nodes reflect default rules. Imagine that each business association type is a book, and this is a good analogy because there is a book. There is a statute. There is a partnership law of Pennsylvania that you can pick up off a shelf and read, and there's a corporation's law of Pennsylvania you can pick off the shelf and read, and it's going to have a default. And if you simply form an organization in that state and you don't modify it in any way, you are going to put that organization, by default, somewhere along this republic to democracy spectrum by default. But an attorney can modify this organizational structure. Some are more susceptible to modification than others. It would be very difficult and potentially unwise to have a corporation function like a decentralized, autonomous organization. You'd really have to contort it. It'd be like taking a custom suit and turning it into a dress, right? You might as well start from whole cloth to design something that radically different, but like a suit, you can also, I don't know, shorten the sleeves or adjust the waist, and those nips and tucks are frequently done by corporate attorneys. And so, you want to first pick the defaults. Go into the store and you want to get the suit or the dress that generally fits you the best and then you make some modifications to get it to fit you exactly. [01:07:30] But you do that by picking the default structure that fits along this organizational spectrum that best meets the business' needs. PUBLIUS: The default structure for a corporation is likely to involve agents who manage the day-to-day operations of the company. How do they fit into corporate governance? What is the legal definition of an agent? PROFESSOR ORANBURG: Agency is simply a law that pertains to when one person is doing something on behalf of the other. There's always two people involved in an agency relationship known as the agents and the principal. Effectively, agency is a body of law that governs the rights and responsibilities between agents who do things for principals. Principals in corporate contexts are like shareholders, the owners, and the agents are the directors or the officers, but it's much broader than that. I mean, if I ask my friend to go to the corner store and get a sandwich and bring it back for me, that person is acting as my agent for the purpose of getting a sandwich and that agent owes certain duties. If I give my friend $5 and he walks to the store and buys himself three sodas and chugs them and comes back with nothing, he's violated some agency responsibilities, some of his fiduciary duties to me. He has an obligation in simply doing that work to act in accordance with his scope of agency. It's really a simple concept because we engage people in agency all the time. It gets a little more complex when we get into the details of how do you form an agency relationship and what is the scope of that relationship. But in general, agency is simply a relationship between an and a principal, the agent being the person who's going to do the work. The principal is the one who's going to expect the benefit from the work. And this creates a certain tension, which is inherent so long as you assume that people have some level of self-interest. And the agent may have a self-interest in self-dealing, benefiting themselves as opposed to the principal or shirking, just simply being lazy. If you hire someone to guard your warehouse and they're supposed to stay up all night long from 9:00 PM to 5:00 AM, standing guard, diligently watching your warehouse to ensure no one comes to rob it. If no one's watching that guard, that guard might take a nap, might have a cigarette break, might get on his phone and play Candy Crush. These are all examples of shirking. It's natural and it's just part of human behavior. Agency law is designed to make those behaviors, those undesirable behaviors, at least from the principal's standpoint, legally problematic and to provide some legal action for an agent who isn't fulfilling its duties to the principal. In general, agent's authority to act on behalf of their principal comes from the principle and it comes from the principal in one of two ways. Either the principal says or writes or what we call manifests to the agent an intention for the agent to act on the principal's behalf. This is a direct relationship. I say to John, "Hey John, can you go to the corner store and get me a turkey sandwich? Here's five bucks," right? I've made a manifestation to John that I want him to act as my agent and now he has the scope of agency to go down to the corner store and he has my $5 and he has some duties to accomplish this in an appropriate manner without, I don't know, stealing my money or taking the long way around and not bringing it back for several hours, et cetera, and that's called actual authority. Actual authority is where the principal makes a manifestation to the agent directly, gives them instructions as to what to do, and there is a broader scope to this. Let's say that John routinely goes to the store and picks up sandwiches on my account. Well, maybe I didn't say it expressly one time, but it's implied that every Tuesday, John goes to the deli and picks up a turkey sandwich. There could be implied actual authority as well as express actual authority. That's the first concept. When the principal makes a manifestation to the agent that produces actual authority. When the words are clear and unequivocal, it's express actual authority and there's also a concept of implied actual authority that comes from the circumstances of that relationship. But again, it has to come from the principal and it goes to the agent, but the principal could also make a manifestation to the wider world. I might go to the deli myself on Wednesday and say to the man at the counter, the owner of the deli, that, "I have a new colleague, John, and he's going to be picking up sandwiches on my account on Tuesdays" now, once again, I'm the principal. Someone's going to be doing something on my behalf. Someone's going to be picking up sandwiches for me, but what's notably different about this is my manifestation, my words were not spoken to John the agent, but to a third party. And so, this is a different way of creating an agency relationship because now I have manifested that John is my agent, not to John, but to a third party, and that's called a parent agency as opposed to actual agency. It appears to the third party, to the deli owner, that John has this authority and that also grants John the scope of going to the store and purchasing those sandwiches. Those are the two main ideas, but again, they both require the principal to manifest either to the agent or to the outside world, a desire to allow someone to act and is authorized to act on the principal's behalf. There was a concept in a prior version of the restatement of agency, the second restatement of agency. It's not found in the third restatement. You may want to hear it and then forget about it, but it comes up sometimes in cases. It's called inherent authority. Inherent authority is the idea that a person has authority simply by virtue of having a certain role or title. There is an inherent authority vested in the chief executive officer of a corporation to cause the corporation to enter into ordinary transactions. I guess the CEO could place a call for 40 deli sandwiches and if you're the CEO of a business, you can assume that the CEO has this inherent authority to order sandwiches on behalf of the principal, the corporation. The reason why, I think, the restatement third has moved away from this is that by calling someone a CEO, by saying, "You are the CEO," that is a manifestation. This is really a type of apparent authority. When I give someone the name, "You are the CEO of my business of my corporation," then I'm cloaking them with the apparent authority to do CEO things, and that is another way to think about this inherent authority. But once again, to get back to basics, the agency relationship begins with a manifestation by the principal, and then it either is manifest directly to an agent or to a third party who's going to interface with that agent and that creates the scope of the agency, the scope of authority, and the limits to which the agent can bind me, the principal. PUBLIUS: Last question - if something goes wrong, who is liable? Is the agent responsible or the principal who gave the authorization in the first place? PROFESSOR ORANBURG: In agency and principal relationships, liability runs both ways. There are times where a principal can be liable for an agent and the doctrine there is respondeat superior. It basically is Latin for let the master answer and the idea is that if I have authorized someone to take a certain course of action, I may have certain liabilities for harms caused by that course of action, hence let the master answer for the harms of the servant. Let the principal answer for the harms of the agent. Now that's going to be limited by the actual and implied scope of the agent's duties. And so, there's conversations around the respondeat superior doctrine about whether if the agent was in the scope of the agency relationship or on a frolic and a detour, and there are technical differences there. But if you ask someone to work for you, you do take on some responsibility if they harm someone, either through tort or crime or contract during the course, and in the scope of that employment. The principal may also owe certain duties directly to the agent, such as a duty of candor or duty of information. These are usually less contentious, but there is a bilateral relationship here. And so, it's worth noting that there can be liabilities, not just from the agent to the principal. The agent can liabilities to the principal because the... In fact, the agent does. I mean, the nature of agency is to be liable to the principal. When you accept an agency role, whether as an employee or in any other capacity, you now have fiduciary duties. You have duties to the principal. You cannot shirk. You cannot self-deal. You cannot use their opportunities. There's a number of reasons why a principal could sue an agent for violating various duties. And so, there is agency liability. And finally, there is liability to the principal. There are certain things the principal has an obligation to do such as providing information to the agent. But for the most part, the doctrine that is usually the most interesting is the concept of respondeat superior, where an agent goes out in the world and does some harm, right? And the question is whether or not the... And usually this is interesting with corporations because what happens if some independent contractor for a toxic waste disposal company dumps the waste in a swamp instead of paying for it to be disposed of properly and this causes some great deal of environmental harm? Questions will arise about whether the company is liable for this agent's environmental harm for this environmental tort and the questions will depend on a number of things, including whether he was operating within the scope of agency and whether the principal had instituted appropriate controls to make sure that the agent was not going to violate law. Was there some implication that the corporation wanted the agent to do this as cheaply as possible? And so, we see those issues come up in corporate law, mostly because corporations have more money than people. If you want to sue somebody, you should sue someone rich because if you sue someone poor and you win, you can't get more than they have so better to go after deep pockets. If the corporation, as usual, has the deeper pockets than the agent, you're going to need to have some theory of principal liability for the agent's behavior in order to make that recovery. NARRATOR: Thank you for listening to this episode of the No. 86 Lecture series on Corporate Law. The spirit of debate of our Founding Fathers animates all of the No. 86 content, encouraging discussion and critical reflection relative to how each subject is widely understood and taught in law schools and among law students. Subscribe to the No. 86 Lecture series on your favorite podcast platform to have each episode delivered the moment it’s released. You can also go to no86.fedsoc.org for lectures and videos on Federalism, Contracts, Jurisprudence and more. Thanks for listening. See you in class!