Daniel J.H. Greenwood

Understanding Enterprise Liability: The Difference Between Tort and Contract

Q: If an agent commits a tort, or enters into an unauthorized contract, why should the principal be bound? Are the considerations the same in the two cases?

• I. Contract: Authority and Apparent Authority--The Importance of Reliance.
• A. Authority.
• Businesses (and individuals) authorize agents (including employees) to enter into contracts for them all the time.
• Example: the manager buys supplies.
• Large incorporated business: the board obviously can't approve every contract. A business can only function if powers are delegated. In a large firm, the board will delegate virtually all decisions, even employment decisions, to agents of the firm (e.g., the CEO).
• B. Apparent Authority.
• Who is responsible when an agent makes an unauthorized contract on behalf of its principal?
• Example: the manager buys the wrong supplies.
• As between the principal and a third party, it is the principal that is in the best position to ensure that agents act within the scope of their agency.
• In the common situation where the principal is an employer and the agent is its employee, the principal has supervision and control of its agents. Even if the agent is an independent contractor, the principal still generally will be more able to control the agent than a third party would--for one thing, it has the power to terminate the agency agreement.
• As between the principal and a third party, the principal is “less innocent” when an agent acts wrongfully, because it is the principal that put the agent into the position of apparent authority.
• Placing the burden on the principal makes commercial transactions simpler and easier. It would be very expensive and inconvenient for third parties to be required to investigate the details of every principal/agent relationship, or to be forced to rely on the reputation or credit of someone else’s agent. The existing rule allows third parties to rely on the principal’s credit, not the agent’s.
• Example: No one would sell pens on credit to a large company if they had to investigate whether the employee placing the order actually was authorized by someone with authority to authorize.
• C. Finding Apparent Authority.
• The law determines whether an agent has apparent authority by considering whether a reasonable third party would think that the agent did.
• So principals that want to do something odd, do so at their own risk.
• D. Lender liability, or the problem of the undisclosed (and unintended) principal. (Cargill)
• When one person controls another, courts may infer an agency relationship even when both parties deny it, thus making the “principal” liable on contracts it may never have expected to be subject to.
• If the third party was deceived, this is simply apparent authority.
• But if the third party knew it was dealing with the “agent,” the justification is that controlling principals should not be allowed to take the benefits of winning contracts while walking away from the costs of losing ones.
• E. Contract liability summarized.
• Organizational boundaries are simple ways to affect or signal
• incentive schemes (owners act differently from employees)
• risk allocation (which funds are being made available for a given enterprise and who will be liable if the funds are insufficient)
• team boundaries (the boundary between cooperation and competition, or between fiduciary/agency and market/contract relationships)
• accounting units (which transactions will be considered in calculating costs and expenses)
• The economy benefits if organizations are free to experiment with a wide variety of different organizational forms and limits.
• Generally, no one is injured by unusual or new organizational forms, provided that they are not deceived. Similarly, parties may have many different views on the allocation of risk, and, again providing that there is no deception, generally courts have no reason not to respect the parties' allocation.
• Standard forms (like using the word "Inc." or "Corp." to indicate that a business is incorporated) can signal to outsiders the rough dimensions of the organization they are dealing with.
• Credit checks and other intermediaries make it relatively cheap for third parties to protect against surprises or charge for assuming risk.
• As a result, unrestricted freedom to set organizational boundaries is generally useful with few costs.
• The main exception is deceit.
• If a third party is misled into thinking that it is dealing with one organization or individual rather than another, then the arguments for respecting planners' decisions about organizational form collapse.
• Many agency (and corporate law) formalities can be understood as meant to reduce the likelihood of deception.
• II. Tort liability: When and why is an enterprise responsible for its agents’ torts?
• A. When is the principal liable?
• Direct liability: The tortfeasor, whether an individual or an enterprise, is always liable for its own torts. But as noted above, corporations can act as a principal only by board resolution, so usually the issue is whether the acts of any given human being should be deemed corporate acts or not.
• Vicarious liability.
• Doctrinal test: If a principal exercises control over the day to day operations of an agent, the agent is known as a “servant” and the principal as a “master." (Non-servant agents are independent contractors). As a general rule, masters are liable for the torts of their servants committed within the scope of employment but not of their independent contractor agents.
• Difficult cases: People aren’t robots, so masters never entirely control servants. Conversely, independent contractors need to keep their clients’ business, so they are never entirely independent. How do (or should) courts distinguish? Look at the reasons for the vicarious liability rule.
• Note that the law focuses almost completely on control. A principal is liable for its agent’s tort when the principal controlled the agent; the courts seem to be thinking of control as something like the power a medieval lord had over his servants: the right to give orders, backed up by coercive force. But in the modern economy, servants have the legal right to quit and the basic coercive authority that employers have is the power to fire. So "control" is not clearly distinct from "market influence." Often, the principal’s real power is the ability to shift its business elsewhere (to cease using a contractor, for example). This provides planning opportunities for clever lawyers. If one can structure an agreement that appears to give the principal NO RIGHT to control, while leaving the principal the EFFECTIVE ABILITY to control, the principal may end up with all of the advantages of agency while retaining the ability to disavow agent torts.
• B. Why is the principal liable?
• 1. Risk spreading: this is just the sense that it is unfair for one person -- the tort victim or, after suit, the agent -- to bear the costs when all of us, in some sense, benefit. Thus, all other things being equal, it makes some sense to have costs spread around so that no one feels it too much.
• 2. Responsibility rationale: Risk spreading conflicts with the primary reason for having a tort type system rather than a workmen's comp type system: the tort system imposes costs on the person who causes the injury and thus, hopefully, provides incentives for that person to change his/her behavior and avoid future accidents.
• 3. Systemic v. individual causes of accidents:
• In an organization, there may be little the individual can do to avoid accidents. A machine operator can be more careful, but the boss can do much more--ranging from payment schemes that emphasize quality over quantity, to changing the design of a particular machine, to reorganizing the entire production system.
• Imposing liability on the individual rather than the system often means that there is no incentive for the system to change.
• In contrast, if the legal responsibility is placed on the organization and the most effective accident avoider turns out to an individual, the organization can easily control the individual or shift the cost of liability to the individual (for example, by training, indemnification agreements, or firing careless employees). The organization may have effective means of changing individual behavior where that is the most efficient way of avoiding accidents. Through supervision, the organization should be able to identify and discipline or retrain negligent workers before an accident. Indeed, the organization may be able to take actions to change worker behavior even before the individual is aware that the behavior is unsafe.
• Thus, the responsibility rationale generally favors imposing liability on the organization.
• 4. Pricing: For the market to properly allocate social resources, items for sale must be sold at a price that includes all their costs, including accidents caused by the item or its production.
• Thus, tort liability should be imposed on the person best able to include this cost in the price -- usually the organization.
• If the cost of accidents is included in price, competitors will have an incentive to find less accident prone (and therefore cheaper) methods of production.
• 5. Coase Theorem: In a perfect, frictionless market, it might not matter on whom liability is imposed.
• If it is imposed on workmen, they will demand higher wages to compensate or refuse to work without an indemnification agreement that shifts the cost to the employer, and employers will have an incentive to reorganize so that they can lower tort rates and therefore, indirectly, wage rates.
• But that is a roundabout and indirect way of doing things; in the real world it is likely to cost a great deal and not lead to enough institutional change and to overproduction of accident related products.
• Thus, enterprise liability increases the probability that the true cost of production will be internalized and reflected in pricing of both labor and product.
• 6. Organizational v. Individual Information Processing and Accident Prevention.
• Tort liability at the individual level may appear like a bolt of lightening: not worth planning for in advance. An individual is likely to commit a negligent act many times without anything happening and accidents will happen many times without anyone being hurt. Thus by ordinary psychological processes the individual will discount the likelihood of tort injury or damages.
• The organization, on the other hand, is more likely to have actual statistics and to be able to objectively determine which behavior should be changed.
• 7. Collective Responsibility.
• In modern production, many products (and accidents) are the result of numerous individuals. Any attempt to determine who was responsible even for a relatively simple accident is necessarily somewhat arbitrary. Consider an auto accident: was the cause a careless driver, a car manufacturer that did not include additional safety devices, the politicians who subsidized single family housing and oil instead of inner cities and subways, or the driver’s boss who decided that the item had to be delivered immediately rather than shipped by train? Surely, allocating individual responsibility is much more difficult for a complex design error.
• Holding the entire organization responsible may eliminate some of these allocation problems and place the entire cost of the accident in front of a decision-maker who can change the maximum number of elements in the process.
• 8. The Enterprise Liability Rationale summarized.
• Where change is mostly cheaply made at the individual level, the organization can force the individual agent to internalize the costs of carelessness without the court system. Where change is best made at the organizational level, the organization is again best able to make those changes. And where accidents are most cheaply avoided by customers switching to a different product, enterprise liability will help assure that the cost of accidents is included in price and therefore considered by consumers.
• III. Enterprise Liability and the Question of Boundaries.
• The above rationales emphasize the importance of the enterprise as a locus of responsibility.
• But managers and lawyers get to define the edges of their enterprises. In contract cases, they will seek to allocate risk of contract liability to whichever party is best able to bear it, and courts should see their role mainly as identifying and enforcing the parties' decision. In tort cases, however, decisionmakers predictably will seek to separate likely profits from likely liability, placing them into different enterprises in order to leave tort victims without a remedy. There is no reason for courts to respect this anti-social behavior.
• The law therefore will be inherently complex, as courts seek to maintain the integrity of the enterprise liability rule while also respecting the authority of liability-creating actors to define their enterprises.
• The control and agency issues can be understood, then, as judicial attempts to define the boundaries of enterprises: who is the enterprise and who is not, for what purposes and what actions.