Introduction: Legal Structures of Business Organizations

Introduction: Legal Structures of Business Organizations

In this lesson, you’re expected to learn about:
– types of business structures
– how to form and terminate an agency relationship
– the benefits, disadvantages, formation, and termination of a partnership

There are several legal forms of business organizations and the main ones are: partnerships, limited liability companies, and corporations. 

In the U.S., business associations are formed and governed largely under state law, and are also subject to extensive regulation under federal securities and tax laws.

On one hand, business organizations typically perform activities that would be unduly costly or time-consuming for an individual company to perform by itself; while on the other hand, they bear several other types of costs, including the so called agency costsor agency problem.

The decision as to which organizational structure to use depends on several factors such as:

• Costs
• Relationship between owners
• Desirability of linking ownership and direct management
• Limitation of potential individual liability
• Way of raising capital
• Size of the business
• Tax consequences

NOTE: Although we will see an overview of Agency Law in this lesson, the so called agency problem will be studied in the Corporate Governance lesson.

For the purpose of the following lessons, the explanations about the law of business organizations (or company law) will be done from the perspective of American Law.

[Optional] Finding the Right Business Structure
Watch this 4-minute video about types of business structures:
An agency is the fiduciary relationship that arises when one person (a principal) manifests assent to another person (an agent) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents to so act.

Agency is of fundamental importance to all businesses and it enables a principal to act through an agent, who may be an employee (to whom the principal has a greater control and responsibility) or an independent contractor (to whom the principal has a less extensive control and responsibility).

Formation and Termination of an Agency Relationship 

The agency relationship can be created by:

• Contract: oral or written.

• Ratification: to assent either to an act done by someone who has no previous authority to act or to an act that exceeded the authority granted to an agent.

• Estoppel: a person allows another to act for him/her to such an extent that a third party reasonably believes that an agency relationship exists.

• Necessity: a person acts for another in an emergency situation without express authority to do so.

Termination of an agency relationship can be by the voluntary act of the parties or by operation of law – i.e., death, permanent incapacity, bankruptcy, or material breach of the agency.

Duties of an Agent

The agent owes the following duties to the principal:  

• Obedience: the agent must adhere to the principal’s commands.

• Loyalty: the agent must act loyally for the principal’s benefit in all matters connected with the agency relationship – e.g., no self dealing, use of confidential information for his/her own purposes, not take action that would compete with the principal.

• Care: the agent has a duty to act with “care competence and diligence” normally exercised by agents in similar situations.

NOTE: The agent is personally liable to the principal if he/she signs unauthorized contracts, delegates his/her duties improperly, or commits torts for which the principal is responsible.
Liability of the principal for contracts made by the agent

Concerning the principal’s business, the agent is seen as an “extension of the principal”, his/her “alter ego”. Thus, when acting within the authority granted by the principal, the principal is bound contractually if the agent has acted with either actual authority or apparent authority.

 Actual Authority: the person has been easily identified as the agent – e.g., the agent who buys jewellery on the principal’s behalf in an auction backed by a power-of-attorney granted by the principal for this special purpose.

 Apparent Authority: it rests on conducts or words of the principal, which lead the third party to reasonably believe that the agent is acting with authority. For example, an employee officer’s position within a corporation provides apparent authority if a third party reasonably assumes the officer’s authority is consistent with his/her position, although the officer has no actual authority.

[Optional] What is an Agency Relationship?
Watch this 2-minute video about agency relationships:
Partnerships are associations of two or more persons to create business for profit.

Generally, each person in a partnership:
• is a co-owner (a general partner) with equal equity stake.
• is both principal and agent, and his/her actions can bind the partnership.
• is a fiduciary, with a duty of loyalty and care to every other partner.
• has equal vote and management power.
• needs to agree to the entrance of a new partner.
• has a duty to produce and to receive complete information on all aspects of the business.
• cannot compete against each other – the rule to avoid being found to have violated it is to “disclose or abstain” a parallel business.
• contributes money, property, labor or skill.
• expects to share the profits and losses of the business.

NOTE: Partnerships have a high level of contractual freedom which means the parties are free to stipulate in the partnership agreement most of the rules, as well as different rights and obligations of each partner.
Liability to Third Parties & Types of Partnerships

In a general partnership, there is an unlimited individual liability from every partner who is wholly liable for the activities of the other partners to the full extent of their personal assets, even beyond the shared assets of the partnership.

Except for specific cases, the partnership does not correspond to an independent legal entity and is not separate from its owners.

Benefits of a Partnership

• Partnerships are generally an inexpensive and easily formed business structure.

• It is cheaper to go into business together than to afford to finance the business on each partner’s own.

• It may be easier to get loans for capital because the credit can be secured by each partner’s ownership stake as they are equally invested in the success of the business.

• Flexibility in the decision making is greater as the general partners have a direct role in management.

• A good partnership should reap the benefits of being able to utilize the strengths, resources, and expertise of each partner.

Disadvantages of a Partnership

• Partnerships retain full, shared liability among the owners. Partners are not only liable for their own actions but also for the business debts and decisions made by other partners. In addition, the personal assets of all partners can be used to satisfy the partnership’s debt.

• With multiple partners, there are bound to be disagreements.

• Because partnerships are jointly owned, each partner must share the successes and profits of their business with the other partners. An unequal contribution of time, effort or resources can cause discord among partners.

• Property held by the partnership is held in “tenancy in partnership”.  This means that the creditors of the partnership take priority in partnership assets over creditors of individual partners if the firm is liquidated.

Formation and termination of a partnership

• A partnership may be created informally by agreement of its partners, which can be written (most common) or implied, and which has few legal requirements. Its existence does not depend upon filing documents with the state.

• The termination can be by expiration of the term of the partnership agreement; by subsequent agreement of the partners; by death, incapacity or withdrawal of one or more partners; or by sale, insolvency, or voluntary cessation of the business.

• Departing partners remain liable for partnership obligations existing at the time of their departure.

NOTE: The default rule is that a partnership depends on a good relationship between its partners; withdrawal of a single partner may unhinge the entire partnership.
Limited Liability Partnership (LLP)

Most of the characteristics explained above are applied specifically to a “general partnership”. The main differences of a limited partnership are:

• constitution is more formal and requires completion and filing of a statutory form.
• partners usually can only lose their investments.
• partnership does not correspond to an independent legal entity from its partners.
• partners have no management power and are neither principals nor agents of each other.
• partner’s interest is freely transferable.

[Optional] What is a Partnership?
Watch this 1-minute video to learn more:
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