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Business organization and finance legal and economic
principles 11th Edition Klein Digital Instant Download
Author(s): Klein, William A., Partnoy, Frank., Coffee, John C. jr.
ISBN(s): 9781599414492, 159941449X
Edition: 11
File Details: PDF, 4.61 MB
Year: 2010
Language: english
 i

BUSINESS ORGANIZATION AND FINANCE

LEGAL AND ECONOMIC PRINCIPLES

ELEVENTH EDITION

By
WILLIAM A. KLEIN
Maxwell Professor of Law Emeritus
University of California, Los Angeles

JOHN C. COFFEE, JR.

Adolf A. Berle Professor of Law
Columbia University
FRANK PARTNOY
George E. Barrette Professor in Law and Finance
University of San Diego

CONCEPTS AND INSIGHTS SERIES®

 ii
This publication was created to provide you with accurate and authoritative
information concerning the subject matter covered; however, this publication was not
necessarily prepared by persons licensed to practice law in a particular jurisdiction.
The publisher is not engaged in rendering legal or other professional advice and this
publication is not a substitute for the advice of an attorney. If you require legal or other
expert advice, you should seek the services of a competent attorney or other
professional.

Nothing contained herein is intended or written to be used for the purposes of 1)

avoiding penalties imposed under the federal Internal Revenue Code, or 2) promoting,
marketing or recommending to another party any transaction or matter addressed
herein.
© 1980, 1986, 1988, 1990, 1993, 1996, 2000, 2002, 2004 FOUNDATION PRESS

© 2007 THOMSON REUTERS/FOUNDATION PRESS

© 2010 By THOMSON REUTERS/FOUNDATION PRESS

195 Broadway, 9th Floor
New York, NY 10007
Phone Toll Free 1–877–888–1330
Fax (212) 367–6799
foundation–press.com
Printed in the United States of America

ISBN 978–1–59941–449–2

Mat #40700668
 iii

PREFACE
The principal objective of this book is to explain, in simple terms but
not simplistically, (a) the basic economic elements and legal principles, as
well as the language, of business organization and finance; (b) the
interrelationships between and among the economic elements and legal
principles; and (c) the practical importance of a basic understanding of
those elements, principles, and interrelationships. While we like to think
that the book contains some sophisticated ideas, we have tried to make it
understandable for a person with no background whatsoever in business, in
accounting, in economics, or in law. As our audience, we have tried to keep
in mind a bright young woman or man from a family of musicians, with a
college major in English, now entering a law school or a graduate school of
business—on the brink of discovering, with great surprise, that the study of
business can be interesting and enjoyable, as well as profitable, and that it
need not be intimidating. Another important goal was to humanize big
business; to overcome a natural tendency to think of corporations,
especially those big enough to have become household names, as bloodless
entities; to show that the word “corporation” or a name such as “General
Motors” is nothing more than a shorthand device for describing a complex
set of relationships among people—people with all the human
characteristics of the readers and their friends; and to demonstrate that an
awareness of this reality is essential to understanding and learning how to
deal with this kind of complex socioeconomic organization.
Because the book is intended for a bright but untutored audience, the
order in which topics are considered reflects our intuitive sense of the order
in which questions might occur to, and need to be answered for, such a
reader. To that extent, we have abandoned a potentially more sophisticated
logic that would have focused on such fundamental structural issues as
control, risk and return, duration (including termination and withdrawal),
conflicts of interest, and additional capital needs. We have also followed the
traditional format of separating the law of proprietorship (agency),
partnership, and corporations, resisting the temptation to demonstrate how
each of these can best be seen as a set of legal rules resolving in different
ways the underlying structural issues. We assume, however, that a
thoughtful reader will ultimately be unable

iv

to avoid recognition and appreciation of that basic theme and its importance
to an understanding of business organization.
The final three chapters are concerned with the field known as
“corporate finance.” At a superficial level, there is a break between these
chapters and the three that precede them. Yet there is continuity as well. The
various corporate securities (common stock, bonds, etc.) and market
instruments (options, margin loans, etc.) that are discussed in Chapter 4 can
perhaps best be understood as devices for allocating control, risk, and return
and for resolving other issues that are the underlying focal points of the first
three chapters. Thus, Chapter 4 represents an effort to provide an
understanding not just of the formal characteristics of financial instruments
but of their economic function as well. In Chapter 5 the inquiry turns to
valuation and considers the question of what difference it might make in the
valuation of an enterprise whether control, risk, etc., are allocated one way
rather than another. Chapter 5 also reviews some of the recent literature on
relationships between managers and shareholders and on financial theory
and contains a description of the markets in which securities are issued and
traded. Finally, Chapter 6 analyzes the complexities of modern financial
markets, and how they affect both the allocation of control, risk, and return,
as well as the tensions and conflicts that arise in business relationships.
Chapter 6 includes an assessment of the recent financial crisis, as well as
the challenges presented by new technologies, structured finance, and
derivatives.
This edition of the book—its eleventh over the span of nearly three
decades—will be the last to list William A. Klein as an author. Although
Professor Klein will be retiring from the book as coauthor with this edition,
his indelible imprint will remain. This book was his brainchild and will
remain committed to his goal that an introduction to finance could be
presented in a simple, direct style that minimized jargon and maximized
lucidity. The remaining authors will try and live up to the standard of
cogency that he set.

JOHN C. COFFEE,
JR.
FRANK PARTNOY

June 2010
 v

SUMMARY OF CONTENTS

PREFACE
INTRODUCTION

CHAPTER 1 THE SOLE PROPRIETOR

I. Ownership Attributes
II. Owners and Creditors
III. Owners and Ordinary Employees
IV. Owners and Ordinary Employees: Control
V. Organization Within Firms and Across Markets
VI. Owners and Managerial Employees: Control, Risk, and Duration of
Relationship
VII. Owners and Managerial Employees: Duty of Care
VIII. Owners and Managerial Employees: Loyalty
IX. Irreducible Divergencies of Interest
X. Avoidance of Conflict
XI. Recapitulation
XII. Speculation on Relationships Among Risk, Return, Control, Duration,
and Specificity
XIII. Transfer of Ownership—Purchase Subject to Debt and Option to
Purchase

CHAPTER 2 PARTNERSHIPS AND LIMITED LIABILITY

COMPANIES

I. Introduction
II. Reasons for Joint Ownership
III. Nature and Significance of ‘‘Partnership’’
IV. Formation
V. The Entity and Aggregate Concepts
VI. Fiduciary Obligation
VII. Contributions, Accounts, and Returns
VIII. Control, Agency, and Liability
IX. Duration and Transferability
X. Variations

CHAPTER 3 CORPORATIONS

I. A Brief Overview
II. The Development of the American Business Corporation: A Historical
Overview
III. The Reification Illusion

vi

IV. The Basic Structure for Control and Operation

V. Formation
VI. Obligations of Officers and Directors
VII. Corporate Accountability: The Issue of Separation of Ownership and
Control
VIII. Fundamental Changes: Mergers and Acquisitions
IX. A Slice of Financial History: ‘‘Watered Stock’’ and Its Lessons in
Fraud
X. Dividends, Retained Earnings, and Compensation
XI. Additional Capital
XII. The Shareholder as Lender
XIII. Federal Income Tax Considerations

CHAPTER 4 BASIC CORPORATE INVESTMENT DEVICES:

ECONOMIC ATTRIBUTES AND FORMAL CHARACTERISTICS

I. Introduction
II. Some Definitions
III. Types of Securities: Formal and Functional Characteristics
IV. Financial Alternatives Inside and Outside the Firm

CHAPTER 5 VALUATION, FINANCIAL STRATEGIES, AND CAPITAL

MARKETS

I. Valuation
II. Leverage and Choice of Capital Structure
III. Capital Structure
IV. Dividend Policy

CHAPTER 6 FINANCIAL MARKETS

I. Introduction
II. Rethinking Businses Organizations Using Derivatives
III. The Evolving Nature of Financial Markets
IV. Market Efficiency and Behavioral Finance
V. New Regulatory Approaches

INDEX
 xv

BUSINESS ORGANIZATION AND FINANCE

LEGAL AND ECONOMIC PRINCIPLES

 1

INTRODUCTION
We begin with an overview describing briefly (a) the people, or
participants, involved in business ventures, categorized according to their
economic roles, (b) the business issues with which they should be
concerned (the economic elements of their relationship) and the constraints
on their ability to achieve their goals, and (c) the legal rules and devices
that are used to achieve their organizational or contractual objectives.

I. PARTICIPANTS
The central figures in business organization are the owners and
managerial employees, but lenders may also play an important role (for
example, by imposing limitations on an owner’s freedom to hire or fire a
manager or to expand the business), and often it is important to consider
relationships with suppliers, customers, franchisees, and other people who
may affect the way the business operates.
An owner has what is called an equity or residual interest in the
business. Consider, by analogy, a person, Pamela, who buys a house, for use
as her personal residence, using $25,000 of her own money, plus $75,000
borrowed from a bank, to pay the total purchase price of $100,000. The
bank has a fixed claim for periodic interest payments and for ultimate
repayment of the $75,000. The bank is sometimes said to hold the debt
interest or debt claim in the house and Pamela the equity. Pamela’s equity
gives her a residual claim because when the house is sold and the debt must
be paid (or assumed by the new buyer), Pamela receives whatever is left of
the total sale price. For example, if the house is sold for $90,000, then,
assuming none of the $75,000 debt has previously been paid off, Pamela
will wind up with $15,000; if the house is sold for $120,000, she will wind
up with $45,000. If Pamela were to rent the house to a tenant, she would
receive the rent payments (barring misfortune) and would retain whatever is
left of these amounts after paying the loan interest, taxes, and other
expenses; that is, she would retain the residual. The holder of a residual
claim is subject to greater risk of gain or loss than is the holder of a fixed
claim. (These ideas are examined more fully in Chapter 1, Sec. II(F).)
Like the owner of a house, the owner of a business has a residual claim
in the cash flows that it generates. The owner of a business will also have
control—that is, the right to decide how the business is operated. The
control of an owner may, however, be limited by agreement with a lender or
other participant or by the practical necessity of delegating decision-making
power to managerial employees.

There may, of course, be more than one owner of a business. Indeed,

much of what is interesting and important about business organization is the
set of relationships among owners.
The categories of owner, employee, and lender are useful ideal types,
but one of the goals of this book is to show how they may merge with one
another—how they form the ends of a spectrum along which one can move
by varying the terms of the agreements among them. Thus, an ideal-type
owner has the full residual claim and full control. An ideal-type employee
has a fixed claim, to a salary, and is obligated to follow the directions
(accede to the control) of the owner. But part or all of the employee’s
compensation may be a bonus based on profits, which is a residual-type
claim that moves the employee along the spectrum in the direction of
ownership. An employee with this kind of residual claim may bargain for
the right to hire and fire all subordinate employees, thereby gaining a
degree of control that moves her or him even closer to the status of an
owner. Similarly, a lender may bargain for the right not only to fixed
interest payments but also to some portion of any gain on the sale of the
business and may have the right to veto the selection of key managerial
employees. Moreover, the greater the amount of the debt in relationship to
the total value of the business, the greater the risk to the lender and the
further the lender moves along the spectrum from lender to owner.

II. BARGAIN ELEMENTS AND CONSTRAINTS

 A. Bargain Elements
In business relationships, the fundamental bargain elements, which
people in business may refer to as the basic “deal points,” can be described
by four general concepts or terms: (a) risk of loss, (b) return, (c) control,
and (d) duration. These elements are interrelated, so the person with the
greatest risk of loss generally will have control, the importance of control
increases as duration increases, etc. (See Chapter 1, Sec. XII.)
Risk of loss refers to the allocation among the participants of losses
from the investment in or operation of the business. If the business fails,
who pays, or bears the burden of, debts, who is entitled to what portion of
any remaining assets, etc.?
Return refers to salaries, interest, and other fixed claims, and to shares
of the residual (the profit). Division of the residual presents some of the
most interesting possibilities. For example, partners A and B might agree to
split profits equally or they might agree that A will receive the first
$10,000, that they will split the next $30,000 equally, and that B will
receive 75 percent and A will receive 25 percent of all profits above
$40,000. They might agree to pay some share of profits to a manager. They
might grant to a lender an option to convert its fixed claim into some share
of the residual (with, perhaps, a corresponding

share of control). And so forth. Allocations of return have important effects

on incentives, as do allocations of loss.
Allocation of control determines who has the right to make the various
decisions affecting the business. Generally, control goes with the residual
claim, but, as has already been suggested, aspects of control may be
allocated to lenders, employees, or other participants.
Duration determines how long the relationships among participants will
last and is intended to include the conditions on which the relationship can
be terminated and on which a claim may be transferred. One of the most
important issues that owners of a business should consider, at the outset of
the venture, is what happens if one of them wants to withdraw. Should the
other owners be required to buy out the person who wants out, and, if so, on
what terms? The answer to this question will have vital implications for risk
of loss, return, and control.

B. Constraints
Participants in business arrangements will bargain over the elements of
risk of loss, return, control, and duration subject to three major constraints:
(a) conflict of interest, (b) government regulation, and (c) limits on the
feasibility of specifying in complete detail all the terms of the relationship.
Conflict of interest arises from the fact that people tend to pursue their
own self interest; that, consequently, they may cheat, steal, and shirk; and
that such self-serving behavior may be difficult to detect or control. The
presence of conflict of interest will have important implications for the
shaping of the bargain elements. For example, an owner may attempt to
deal with the possibility of shirking by a manager by making the manager’s
compensation dependent to some degree on the profits of the business.
Conflict may also be controlled by protective rules, such as prohibitions or
limitations on certain transactions between corporations and their officers
and directors.
Government regulation may limit the freedom of participants in a
business venture to adopt rules that they might have chosen. For example,
the bankruptcy laws limit the ability of a borrower to agree to an
expeditious foreclosure in the event of default on the loan. (See Chapter 4,
Sec. III(A)(4).)
Complete specificity of all outcomes in all possible situations is not
possible and even to the degree it is possible may not be worth the cost. To
the degree that specificity is not feasible, people must rely on other devices
such as sharing provisions that align their interests, vague general rules, and
the good faith and honesty of the other participants.

III. LEGAL RULES AND DEVICES

 This book examines three basic sets of legal rules or doctrines, and
legal devices, used in the creation of business arrangements or
organizations: those relating to the employment relationship, to
partnerships, and to corporations.

Chapter 1 focuses on the employment relationship, for which the

relevant legal doctrine is mostly agency law and contract law, with
individualized agreements (written or oral, express or implied) playing an
important role.
Chapter 2 is concerned with partnerships. Here the basic rules are found
in state statutes, mostly following the Uniform Partnership Act (UPA) but
with some important variations from state to state. Some of the variations
are derived from the recently promulgated Revised Uniform Partnership
Act (RUPA). The rules of agency and contract are also important for
partnerships. The statutory and common-law rules of partnership, agency,
and contract govern the rights and responsibilities of partners, but most of
them may be modified by agreement among the partners. In other words,
the UPA rules, like the common-law (that is, judge-made) rules of agency
and contract law, are mostly “default” provisions (provisions that apply in
the absence of agreement to the contrary).
Chapter 3 examines the organization of business in corporate form.
Here the basic organizational structure is prescribed in the corporations
code (set of statutory rules) of the state in which people choose to
incorporate. To a considerable extent, people using the corporate form are
not permitted to deviate from the basic formal structure prescribed by the
corporations codes, but important substantive organizational rules (e.g.,
rules relating to sale of an equity interest in the firm and to control) can be
tailored to individual needs either in the articles of incorporation or by-laws
(which are formal documents of the corporation) or in so-called “ancillary”
agreements (“side” agreements among people with interests in the
corporation, such as an agreement on how voting rights will be exercised or
an agreement by one investor to buy the interest of another on certain
conditions). The federal and state securities laws have an important bearing
on the nature of the organization of sizable businesses, most of which are
incorporated. Agency law is also relevant to corporations (for example, in
determining the obligations of officers and directors to the corporation).
Other legal instruments or devices playing important roles in business
organization are loan agreements, leases, and franchise agreements.
The purpose of presenting this list of legal rules and devices is not to
bore you into a gentle slumber. It is in part to give you some idea of what
you can expect to find later in the book, but, more importantly, to suggest
that the legal rules and devices on which law-school study tends to focus
are nothing more, nor less, than the tools by which people entering into
business relationships seek to resolve the issues described by the bargain
elements. A competent lawyer must know the tools and how to use them,
but a lawyer who uses the tools without an appreciation of the business
setting and the goals of the client will be unable to respond effectively to
the client’s needs. This proposition helps explain how this book was
conceived and written, and why.
 vii

TABLE OF CONTENTS
PREFACE
INTRODUCTION

CHAPTER 1 THE SOLE PROPRIETOR

I. OWNERSHIP ATTRIBUTES
A. Proprietorships as Organizations
B. Ownership and Management
C. Nature of Ownership Interest
II. OWNERS AND CREDITORS
A. Liability for Debts; Open Accounts
B. Liability for Debts; Unlimited Liability
C. Nonrecourse Loans
D. Business and Personal Debt
E. Debt and Equity
F. Leverage
G. Potential Equity Attributes of Debt
III. OWNERS AND ORDINARY EMPLOYEES
A. Introduction: Joint Enterprise Versus Purchased Inputs
B. Implied Standard Contracts and Their Appeal
C. Cooperation, Trust, Fairness, and Reputation
IV. OWNERS AND ORDINARY EMPLOYEES: CONTROL
A. The Servant–Type Agent and the Legal Right to Control
B. The Economic Significance of the Legal Right to Control
C. Vicarious Liability
 V. ORGANIZATION WITHIN FIRMS AND ACROSS MARKETS
VI. OWNERS AND MANAGERIAL EMPLOYEES: CONTROL, RISK,
AND DURATION OF RELATIONSHIP
A. Managers’ Resemblance to Co–Owners
B. Delegation of Broad Decision–Making Authority
C. Major Versus Minor Decisions
D. Duration of Relationship, Ease of Replacement, and Symbiosis MM
E. Mode of Compensation, Incentive, Risk, and the Employee’s Interest
in Control
F. Risk, Control, and Duration of Contract

viii

VII. OWNERS AND MANAGERIAL EMPLOYEES: DUTY OF CARE

A. Four Types of Lack of Due Care
B. Contracts Regarding Duty of Care
C. Limiting Scope of Authority
VIII. OWNERS AND MANAGERIAL EMPLOYEES: LOYALTY
A. Conflict Concerning Information Provided to Owner
B. Loyalty and Conflict Problems and Their Costs
C. Self–Dealing and the Use of Incentives
D. Self–Dealing, Joint Ventures, “Waste,” and the Mythical Ideal
E. The Legal Duty of Loyalty
F. Loyalty and Problems of Ambiguity
G. Absolute Barriers to Disloyalty
IX. IRREDUCIBLE DIVERGENCIES OF INTEREST
X. AVOIDANCE OF CONFLICT
XI. RECAPITULATION
XII. SPECULATION ON RELATIONSHIPS AMONG RISK, RETURN,
CONTROL, DURATION, AND SPECIFICITY
A. Risk and Return
B. Risk and Control
C. Duration and Specificity
D. Duration and Control
E. Duration and Risk
F. Risk and Control—Owners and Employees
XIII. TRANSFER OF OWNERSHIP—PURCHASE SUBJECT TO
DEBT AND OPTION TO PURCHASE
A. Purchase Subject to Debt
B. Option to Purchase
C. Lease With Option to Purchase

CHAPTER 2 PARTNERSHIPS AND LIMITED LIABILITY

COMPANIES

I. INTRODUCTION
A. Joint Ownership
B. Rules Designed for Small Firms
II. REASONS FOR JOINT OWNERSHIP
A. Joint Ownership Versus Purchased Inputs
B. The Need to Assemble At–Risk Capital

ix

C. Control Follows Risk

D. Restatement—An Extreme Case
E. Other Equity–Type Forms of Investment
F. Summary
G. The Element of Personal Services
H. Combining Capital and Services
III. NATURE AND SIGNIFICANCE OF “PARTNERSHIP”
A. Nature
B. Significance
IV. FORMATION
A. Creation Without Formality
B. The “Silent Partner”
C. Implied Terms
D. Tailor–Made Provisions
E. “Spoiling the Deal”
F. The Partnership Agreement as a Drafting Challenge
V. THE ENTITY AND AGGREGATE CONCEPTS
A. Reification and the Entity–Aggregate Distinction
B. Who Cares?
C. An Illustration
VI. FIDUCIARY OBLIGATION
A. Fiduciary Obligation—A Legal Duty of Fairness
B. Illustration: The Scope–of–Business Problem
C. Economic and Other Effects
D. Promoters—Drafting Around the Rule
E. Summary
VII. CONTRIBUTIONS, ACCOUNTS, AND RETURNS
A. Capital Accounts
B. Draw
C. Capital Accounts and Value of a Partner’s Interest
D. Additional Capital
E. Debt Held by, and Salaries Paid to, Partners
 VIII. CONTROL, AGENCY, AND LIABILITY
A. Introduction
B. Control
C. Partners as Agents of the Partnership
D. Liability

IX. DURATION AND TRANSFERABILITY

A. Terminology
B. Dissociation at Will
C. Providing for Continuity
D. Transferability
X. VARIATIONS
A. Limited Partnerships
B. Limited Liability Companies
C. Limited Liability Partnerships
D. Mining Partnerships

CHAPTER 3 CORPORATIONS

I. A BRIEF OVERVIEW
A. Preliminary Observations
B. The Important Characteristics
C. Variations: Closely Held, Intermediate, and Start–Up Corporations
II. THE DEVELOPMENT OF THE AMERICAN BUSINESS
CORPORATION: A HISTORICAL OVERVIEW
III. THE REIFICATION ILLUSION
A. “Decomposing” the Corporation
B. Illustrations
 IV. THE BASIC STRUCTURE FOR CONTROL AND OPERATION
A. Introduction
B. Shareholders
C. Directors
D. Officers
V. FORMATION
A. The Formal Process
B. Amendment
C. Negotiations at the Formation Stage
D. Duration and Transferability
E. Limited Liability and its Exceptions
F. Choice of Law
G. Purposes, Powers, and Ultra Vires
VI. OBLIGATIONS OF OFFICERS AND DIRECTORS
A. Duty of Care
B. Duty of Loyalty
C. Duties Regarding Information: Rule 10b–5

xi

VII. CORPORATE ACCOUNTABILITY: THE ISSUE OF SEPARATION

OF OWNERSHIP AND CONTROL
A. Implications of the Separation of Ownership and Control
B. The Mechanisms of Corporate Accountability
VIII. FUNDAMENTAL CHANGES: MERGERS AND ACQUISITIONS
IX. A SLICE OF FINANCIAL HISTORY: “WATERED STOCK” AND
ITS LESSONS IN FRAUD
X. DIVIDENDS, RETAINED EARNINGS, AND COMPENSATION
A. Dividends
B. Retained Earnings and Capital Gain
C. Compensation for Services
XI. ADDITIONAL CAPITAL
XII. THE SHAREHOLDER AS LENDER
XIII. FEDERAL INCOME TAX CONSIDERATIONS
A. Formation
B. Substituted Attributes
C. The Corporation as a Taxable Entity
D. Losses
E. “S” Corporations

CHAPTER 4 BASIC CORPORATE INVESTMENT DEVICES:

ECONOMIC ATTRIBUTES AND FORMAL CHARACTERISTICS

I. INTRODUCTION
II. SOME DEFINITIONS
A. Expected Return
B. Risk and Uncertainty
C. Yield
D. Risk Premium
E. Risk Aversion
F. Compensation for Volatility Risk
III. TYPES OF SECURITIES: FORMAL AND FUNCTIONAL
CHARACTERISTICS
A. Bonds, Debentures, and Notes
B. Shares of Common Stock

xii

C. Interests Derived From Common Stock

D. Preferred Stock
E. Other Forms of Investment
F. Miscellaneous Devices and Hedging
IV. FINANCIAL ALTERNATIVES INSIDE AND OUTSIDE THE FIRM

CHAPTER 5 VALUATION, FINANCIAL STRATEGIES, AND

CAPITAL MARKETS

I. VALUATION
A. The Interest Rate
B. Market Price
C. Discounted Present Value
D. The Discount Rate
E. Allowing for Risk: Two Methods
II. LEVERAGE AND CHOICE OF CAPITAL STRUCTURE
A. Introduction
B. Pure Leverage Effect
C. Leverage and Risk
D. Some Variations
E. Spurious Leverage
F. Leverage and Wealth
III. CAPITAL STRUCTURE
A. Introduction
B. A Hypothetical Corporation in a Simplified World
C. The Advantage of Unbundling
D. The Net Income Perspective
E. How Much Leverage?
F. Another View: Homemade Leverage
G. Extending the Argument: Arbitrage
H. Another Perspective: The One–Owner Corporation
I. Unleveraging
J. The Real World
K. Tax Effects
L. Monitoring Problems
M. Managerialism
N. Asymmetric Information and Signaling
O. Another Perspective: Extreme Leverage
IV. DIVIDEND POLICY
A. Constraints
B. The Conventional View

xiii

C. Separation of the Investment Decision and the Dividend Decision

D. Redemption

CHAPTER 6 FINANCIAL MARKETS

I. INTRODUCTION
II. RETHINKING BUSINESS ORGANIZATIONS USING
DERIVATIVES
A. Categories and Uses of Derivatives
B. Options
C. Forwards
D. Hybrids
E. Structured Finance
III. THE EVOLVING NATURE OF FINANCIAL MARKETS
A. Exchange and Over-the-Counter Markets
B. The Impact of Technology and New Trading Platforms
IV. MARKET EFFICIENCY AND BEHAVIORAL FINANCE
 V. NEW REGULATORY APPROACHES
A. Globalization and Foreign Competition
B. Disclosure and Accounting Harmonization
C. Deregulation

INDEX
 5

Chapter 1
THE SOLE PROPRIETOR
I. OWNERSHIP ATTRIBUTES

A. PROPRIETORSHIPS AS ORGANIZATIONS
Our objective is to understand the nature and functions of business organizations or entities. It is useful,
however, to begin with an examination of the sole proprietorship, which is a business owned directly by one
individual, called a sole proprietor. Since a sole proprietorship has no formal elements of co-ownership,1 it is
usually not thought of as “business organization” in the legal sense. The fact is, however, that a business owned by
a sole proprietor may be large and complex, involving many people other than the owner, and can plainly be an
“organization” in the nonlegal sense of the term.

B. OWNERSHIP AND MANAGEMENT

Suppose that a grocery store is owned by a person, Pamela, who devotes her full time to the management of
the store. That is, she owns and operates the store. The two functions, ownership and management (operation),
need not be combined in the same person. If Pamela hires a person to serve as manager in her place and delegates
broad decision-making powers to that person, she is still the owner and is still called a sole proprietor. The
possibility of specialization, or separation of functions, is an attribute of a sophisticated (and efficient) economic
system; it also produces the kinds of problems that require the application of lawyer skills. But that gets ahead of
our story.

C. NATURE OF OWNERSHIP INTEREST

As sole proprietor of the store, Pamela will acquire an inventory of goods to be sold. She will become the
owner of each individual item in that inventory. (Conceivably, however, some items might be held by Pamela, in
the store, on consignment—that is, under an agreement whereby she will sell on behalf of another person, who
retains legal title and certain risks associated with that retention of ownership.) In the eyes of the law, she owns the
food and other goods in the store in the same sense that she owns the food in her refrigerator at home or the shoes
on her feet. She will, of course, keep separate records or accounts

of the assets devoted to the business—for the purposes, among others, of filing tax returns and of determining for
her own purposes how well, or how badly, the business is doing. But the existence of such records does not
diminish our legal system’s concept of a sole proprietor’s direct ownership of the assets used in the business. It is
important to understand this point in order to be able later to appreciate the significance of incorporating the
business and thereby interposing a corporate “veil” between individuals and the assets that they devote to a
business.

II. OWNERS AND CREDITORS

A. LIABILITY FOR DEBTS; OPEN ACCOUNTS

Many of the goods in Pamela’s store will have been acquired on open account. For example, suppose that
Shirley, a soft-drink supplier with whom Pamela does business, delivers soft drinks twice a week but mails bills
monthly and allows 20 days for payment. The amount owed by Pamela to Shirley will depend on the amount of
soft drinks that Shirley delivers to the store, which can vary. Any indebtedness to Shirley on this open account
(sometimes called a trade account) is a personal obligation of Pamela to Shirley. Pamela must pay the amount
owed even if her business becomes worthless. Regardless how much she owes, she personally owns any soft
drinks that have not been sold to her customers. If she becomes bankrupt, they are an asset that is available to settle
the claims of all of her creditors.

B. LIABILITY FOR DEBTS; UNLIMITED LIABILITY

Shirley is a general creditor—as distinguished from a secured creditor. A secured creditor is one whose
claim is secured by specific property, and who has first claim to the proceeds of the sale of such property. All other
creditors are general creditors. Suppose that Pamela owes a total of $10,000 on open accounts with suppliers such
as Shirley. Suppose further that she has borrowed $15,000 from a bank for use in the business, on a promissory
note without security. (That is, she has borrowed $15,000 and has simply signed a piece of paper evidencing her
obligation to repay.) This, again, is a personal obligation; Pamela is bound to repay the $15,000 regardless what
happens to the business. This would also be true if the debt were secured by business or other property—for
example, if the debt were secured by a mortgage on the land and building used in the business. If the business fails,
Pamela can lose more than the amount that she initially decided to invest in the business. This is the frightening
prospect that is associated with the notion of personal liability.

C. NONRECOURSE LOANS
It is possible to avoid personal liability for business debts by executing a nonrecourse loan. Such a loan
would ordinarily be secured by specific property; the lender would agree that in the event of nonpayment its sole
recourse would be to sell the property and apply the proceeds to the debt. Such an arrangement would be unusual
in the kind of situation that we are examining. It would be especially unusual and difficult to arrange for accounts
with trade creditors such as the soft-drink distributor. But it is a potential device for avoiding personal liability—
that is, for limiting loss to the amounts initially invested in the business. A more convenient way to avoid personal
liability may be to incorporate the business; we come back to that in Chapter 3.

D. BUSINESS AND PERSONAL DEBT

Suppose that in addition to the $10,000 owed to trade creditors on open account, and the $15,000 owed to
the bank, Pamela owes $1,000 to another bank for expenses that she charged to her credit card on a recent
vacation. Obviously this amount is also a personal obligation of Pamela’s. If she fails to pay any of the debts, any
creditor can go after any asset. Her business creditors can seek recovery from her personal as well as her business
assets and her personal creditor can seek recovery from her business as well as her personal assets. In the event of
bankruptcy, no distinction is drawn between business and personal debts or between business and personal assets,
except that there are modest exemptions for certain personal assets. All non-exempt assets, business and personal,
are in the same pot and all creditors take a share from that pot based on the amount owed to them. (Compare Sec.
I(C) above.)

E. DEBT AND EQUITY

This brief reference to personal assets and obligations is intended to emphasize the personal nature of the
obligations that Pamela incurs in connection with her business. That point having been made, let us put aside those
obligations not connected with the business. At this point it is convenient to introduce the terms “debt” and
“equity.” Pamela’s business debt, in our example, amounts to a total of $25,000. The difference between the value
of the business and the amount of the debt is her equity in the business. Confusion can easily arise over the
quantity of debt and equity. For some purposes we may measure the amounts of debt and equity in terms of market
values and for other purposes in terms of less realistic but more readily accessible figures. Suppose, for example,
that after the bank made its $15,000 loan to Pamela, she experienced a series of reversals in her business that
reduced considerably her capacity to repay. The loan is now subject to a

far higher risk of default (nonpayment). If a similarly risky loan were made currently, the bank would demand a
higher interest rate, to compensate for the greater risk. Let’s assume, however, that repayment is not due for
another five years so the bank cannot raise the interest rate to reflect the increased riskiness. In these
circumstances, the bank’s claim will have a market value of less than $15,000. No one would pay $15,000 for the
note (that is, for the right to receive from Pamela interest for five years plus $15,000 at the end of the five years)
because new loans at the same level of risk would produce a higher interest payment. (Or loans at the same interest
rate would produce a lesser risk of default.) While the market value of the debt (evidenced by the promissory note)
will be less than $15,000, the $15,000 figure may still be used for various purposes on the books of the bank as
well as on Pamela’s books. Thus, there will be a difference between book value and market value. In that situation,
book “value” is not really a value figure; it is a historical record.
The same distinction can arise even more obviously with respect to Pamela’s equity interest. Suppose, for
example, that she initially bought the store (empty) for $75,000; that she acquired an inventory for $10,000 on
open account; and that she used the $15,000 borrowed from the bank to remodel the store. She has invested
$75,000 of her own money and $25,000 of borrowed funds or a total of $100,000. The book value of her equity is
$75,000. But suppose that no sooner had she acquired her inventory and remodeled her store than the community’s
leading employer announced that it was moving its plant to another state. Obviously, such an event would diminish
the market value of Pamela’s business and thus reduce the value of her equity in the business. It is unlikely,
however, that this misfortune would be reflected on the books that are kept for various purposes, so there would be
a disparity between book value of equity and market value of equity.

F. LEVERAGE
The word “leverage” is used to describe the financial consequences of the use of debt and equity. The use of
debt (“other people’s money”) creates financial leverage for the equity. The greater the debt the greater the
leverage. The greater the leverage the greater the potential gains and losses for the equity and the greater the risk of
loss for the debt. The effects of leverage result from the facts that (a) the debt holder (the lender) has a fixed claim
(that is, a claim for a fixed amount of interest and for repayment of the amount of the loan); (b) the return on the
investment or business financed by the debt is uncertain; and (c) the equity holder (the borrower) has a residual
claim (that is, the right to whatever is left after the debt holder’s claim is satisfied).
To illustrate, assume that Pamela invests in her business a total of $100,000, half of which is from her own
funds and half of which she

borrows, at an interest rate of 10 percent per year. Thus, she invests $50,000 of her own money and $50,000 of
borrowed funds and is obligated to make an annual interest payment of $5,000. The ratio of debt to equity is 1:1.
Assume that Pamela expects to earn $12,000 per year from the $100,000 investment in the business, net after all
expenses and allowances, including a reasonable amount for her own services, but before the interest payment. In
other words, she expects to earn, before interest, at the rate of 12 percent on the entire investment (a $12,000 return
on a $100,000 investment). If this outcome eventuates, leverage will work in her favor: she will have borrowed at
10 percent and invested at 12 percent. Her net return after the interest payment will be $7,000 ($12,000 less the
interest payment of $5,000), which will be 14 percent of her $50,000 equity investment. The total investment, with
a rate of return of 12 percent, will produce a rate of return on equity of 14 percent.
On the other hand, if the rate of return on the total investment (before interest) turns out to be less than the
rate of interest, leverage will work against Pamela. If, for example, the rate of return on the total investment is 8
percent, the net amount earned before interest will be $8,000; the interest payment will still be $5,000; and the
return on the equity will be $3,000 (6 percent of the $50,000 equity investment). The “breakeven” point occurs
where the return on total investment is 10 percent, the same rate as that paid on debt. At this point, there is no gain
or loss from the use of the borrowed funds; the rate of return on total investment, debt, and equity are all 10
percent.
These numbers and relationships, expanded to include the outcomes with returns on total investment at the
rates of 6 percent and 14 percent, are displayed in Table 1–1. For those who like graphs, the same information is
displayed in Graph 1–1.
TABLE 1–1
Effects of Leverage With Debt to Equity Ratio 1:1
 10

GRAPH 1–1.

If the ratio of debt to equity is increased, the effects of leverage are magnified. Table 1–2 displays these
effects where the ratio is 3:1 (debt $75,000 and equity $25,000). Note that again there is a “breakeven” point, at 10
percent, where the return on the total investment is equal to the rate of interest on the debt and where,
consequently, the rate of return on equity is the same as the rate of return on the total investment. But with the 3:1
ratio, when return on total investment is 12 percent, return on equity is 18 percent; and when return on total
investment is 6 percent, the rate of return on equity is a minus 6 percent. Thus, leverage creates risk and the greater
the leverage, the greater the risk.
TABLE 1–2
Effects of Leverage With Debt to Equity Ratio 3:1

11
 Similar effects are observed if one focuses on wealth rather than income. Suppose that we return to the
original debt and equity numbers of $50,000 each (ratio 1:1) and that Pamela sells the business for $110,000. This
represents a gain of 10 percent on the total amount initially invested. After repaying the $50,000 loan, Pamela will
retain the residue of $60,000, so she will have a gain of $10,000, or 20 percent, on her equity investment of
$50,000. If she sells the business for $90,000, the loss on the total investment will be 10 percent and the loss on
equity will be 20 percent. If the business is sold for $50,000 the loss on the equity is 100 percent and Pamela’s
investment is wiped out. The numbers are displayed in Table 1–3.
TABLE 1–3
Effects of Leverage on Wealth

G. POTENTIAL EQUITY ATTRIBUTES OF DEBT

The foregoing discussion, sharply distinguishing between debt and equity and between owners and creditors,
follows a traditional mode of analysis. That mode of analysis may be quite satisfactory for purposes of examining
legal doctrine. For purposes of economic analysis, however, we must take a more careful look at the relationship
between Pamela and her creditors—especially her general creditors (the only creditors thus far mentioned). Those
creditors may well be vitally concerned with how well Pamela is performing her task as manager of the business.
If she performs badly and cannot pay her debts, they will lose money; indeed, if the total amount of the debts
exceed the amount invested by Pamela (by no means a far-fetched possibility), the general creditors could lose
more money than she would. The point is that creditors are subject to varying degrees of risk of default. The
degree of risk will, of course, depend on the total value of the business as compared to the amount of the debt. As
the debt rises in relation to the value of the business, the risk to the general creditors rises. As the risk rises, the
general creditors will become more and more concerned with how the business is run and are likely to want
increasing degrees of control, especially if their funds are committed for more than a few months. The bank, in
particular, may condition its loan on Pamela’s acceptance of certain constraints on her power to manage (that is, it
may insist on negative controls). As risk rises, the bank is also likely to demand a

12

higher interest rate—that is, a higher return on its investment in the business. These attributes—risk and control,
plus returns that are dependent on the success of the business—are associated with ownership. We can see, then,
that the position of lender and that of owner are not clearly distinct categories but rather segments of a spectrum.
(Further discussion of the relationships among risk, return, control, and various other elements of economic
arrangements is found in Sec. XII of this chapter.)

III. OWNERS AND ORDINARY EMPLOYEES

A. INTRODUCTION: JOINT ENTERPRISE VERSUS PURCHASED INPUTS

We have examined two kinds of people involved in a simple economic enterprise—owners and creditors.
Now we are ready to consider another set of people with a stake in the enterprise—employees. Before proceeding,
however, it is important to note a subtle but important perspective that has been introduced into this descriptive
account. To some considerable degree, the relationships among creditors, suppliers, employees, and owners are
viewed here as ones involving contributors to a joint economic enterprise. A more customary approach would
depict the owner as the core of the enterprise and the other elements as inputs hired by the owner and having only
a very narrow interest in the enterprise. On this latter view, there is less jointness, less communality of interest.
Either view is permissible and both are useful. The joint-enterprise perspective seems to offer more fresh insights
and a better understanding of economic functions. If we were concerned solely with traditional, established legal
doctrine, the perspective in which the owner establishes the business and then hires capital, employees, and other
inputs would probably be more appropriate, though some legal institutions may be evolving in the direction of the
joint-undertaking model.

B. IMPLIED STANDARD CONTRACTS AND THEIR APPEAL

Suppose that Pamela hires Chuck, whose duties will be primarily to stock the shelves and keep the store
clean. In a small business it is unlikely that there will be a written contract spelling out the mutual rights and
obligations of Chuck and Pamela. Even though not spelled out in writing, however, a set of rights and obligations
does exist. The terms of this implicit agreement can be found in part in common-law doctrines of agency and
contract, and in part in modern legislation affecting the employment relationship (for example, in workers’
compensation laws, which provide compensation for certain injuries but which also limit actions that employees
might otherwise have against employers). In some settings union rules or contracts may be of considerable

13

relevance. But an individualized written agreement would be unusual. A number of considerations may help to
explain the absence of such an agreement here (and, by implication, the need for a written agreement elsewhere).
For the ordinary run-of-the-mill employment relationship the rules implied by law—the “default” rules—may be
satisfactory. Negotiation of an individualized agreement would take time and might call for the services of a
lawyer. The time that might be spent by Chuck and Pamela, and the potential fees for legal services, are what
economists call transaction costs. Here, those costs are not likely to be trivial. Chuck and Pamela may be unaware
of the opportunities for written agreements that vary the contractual terms implied by law and it may not be worth
their trouble to explore those opportunities. In other words, the information costs (another term familiar to
economists) may be too high. The benefits of a negotiated agreement may be low, partly because the terms of the
implied agreement may be pretty nearly satisfactory, partly because the employment may not be expected to last
for long, and partly because the economic environment may be such that if Chuck becomes dissatisfied with his
job, he can fairly readily find another job and if Pamela becomes dissatisfied with Chuck’s services, she can find
another worker without significant cost. One can begin to see, however, that as these various circumstances
change, the usefulness of negotiated agreements (and of legal services) may increase. Part of the contribution of
lawyers lies in their knowledge of the common-law or statutory rules—of the bargain implied by law in the
absence of express agreement—and their appreciation of when and how it is appropriate to try to modify the
“standard-form” bargain implied by law.

C. COOPERATION, TRUST, FAIRNESS, AND REPUTATION

Much of what follows in this book focuses on divergent interests and confrontation. Confrontation is, of
course, second nature to litigators and is the background to most of the case-method study of law in law schools.
Lawyers who specialize in helping to shape business transactions must, of course, be aware of divergent interests,
but they must also be sensitive to mutual interests and to the importance of cooperation, trust, reputation, and
fairness. Many people want to do a good job not only for the financial compensation but also because they take
pride in their work. Many people prefer cooperation to confrontation and most people recognize that cooperation
and teamwork are often essential to a successful venture. And many people have an internalized commitment to
fairness, honesty, and integrity, informed and shaped in part by business and social norms and customs. Even
people who are not fully committed internally to these values may recognize the importance of one’s reputation for
fairness, honesty, and integrity—particularly in repeat relationships.
These intangibles may lead people in business to a disdain for negotiation of detailed contractual
relationships—a disdain to which a

14

business lawyer must be sensitive. Indeed, a demand for a detailed contract may send the wrong signal—a signal
that one is not committed to cooperation, flexibility guided by fairness, and honesty. At the same time, the lawyer
must be aware of the fragility of such intangibles. One’s willingness to treat others honestly and fairly depends
heavily on reciprocity, and misunderstanding can easily undercut one’s sense of being treated honestly and fairly.
In light of this reality, a lawyer’s effort to recognize divergences in interests, and to anticipate and resolve potential
problems, may be thought of as mitigating the risk of misunderstanding and its toxic effect of relationships.
Consider, by way of example, a real estate developer who wants to hire a general contractor to build an
apartment building. The developer will be concerned about the contractor’s reputation for doing good work, for
doing it on time, for reasonableness in dealing with unanticipated problems, and for conformity with generally
accepted norms and customs in the industry. That reputation is likely to depend heavily on the contractor’s
internalized values and on a concern for his or her reputation. The contractor, in turn, will be concerned about the
developer’s reputation for prompt payment and for reasonable and fair reactions to problems that arise in the
construction process. There will, of course, be a set of plans for the apartment building, probably based on the
work of an architect and engineer. The plans will be drawn with full recognition that it will be impossible to
specify all the details and to anticipate all the problems; at some point greater specificity is not cost effective. To
this extent, trust, reputation, and fair dealing play a useful, even a vital, role. But the greater the detail in the plans
and the greater the anticipation of problems, the less the possibility of misunderstanding and the less the strain
placed on trust and fairness. At the same time, the stronger the commitment to fair dealing and the stronger the
concern for reputation, the less the need for specificity.

IV. OWNERS AND ORDINARY EMPLOYEES: CONTROL

A. THE SERVANT–TYPE AGENT AND THE LEGAL RIGHT TO CONTROL

In the common parlance, Chuck is an “employee.” In legal terminology, Pamela is the “principal” and Chuck
is an “agent.” Within this category of principal and agent, the law of agency defines a subcategory that covers the
Pamela–Chuck relationship, namely, “master” and “servant.” Pamela is the “master” and Chuck is the “servant.”
These terms are used to describe a relationship in which one person (the master) “controls or has the right to
control the physical conduct of the other” (the servant). (Quotation from Restatement of the Law, Agency (2d),
Sec. 2.) This means that Pamela has the right not only to expect Chuck to perform particular tasks but also to tell
him how to perform them. The term “servant” is somewhat confusing. In law, it does not

15

imply servility. The employees of large corporations, working as electricians, carpenters, truck drivers, and the
like, as well as the white-collar workers and the executives all the way up to the top person, are “servants” in the
legal sense. Similarly, the term “agent” has a broader scope in law than in common parlance; it includes any person
who has agreed with another person (the “principal”) to “act on his behalf and subject to his control.” Restatement,
Agency (2d), Sec. 1.
A nonservant agent is one who agrees to act on behalf of the principal but is not subject to the principal’s
control over how the task is performed. For example, suppose Pamela says to Shirley, “I want you to go to Sam,
the soft drink distributor, and buy ten cases of root beer for me.” If Shirley agrees to do as Pamela has asked, she
becomes Pamela’s agent; when she goes to Sam she does so on behalf of Pamela. If Shirley orders the ten cases of
root beer from Sam, Pamela becomes contractually bound to Sam.
Apart from the agent’s power to bind the principal, there is another important characteristic of the principal-
agent relationship. Agents are held to owe a duty of loyalty, or “fiduciary obligation,” to their principals. Thus, as
an agent of Pamela, Shirley cannot act in a self-serving way. For example, if it happened that Shirley had ten cases
of root beer in her garage, she could not sell that root beer to Pamela at a profit without informing Pamela of the
source. If she did, Pamela could recover Shirley’s profit, even if the price charged by Shirley were the same as the
price that would have been charged by Sam.
A principal may be bound by the acts of an agent under any one of three separate principles. First, the
principal is bound if the agent’s act was authorized, either explicitly or implicitly. Thus, in the example of Pamela
and Shirley and the root beer, Shirley has explicit authority to buy the ten cases of root beer from Sam. Shirley
would also have implicit authority to incur any customary expenses for delivery. Second, a principal is bound by
an agent’s acts if the agent had apparent (or ostensible) authority—that is, if the principal engages in conduct that
leads a third person reasonably to believe that the agent had authority. For example, suppose Pamela says to Sam,
“Shirley is authorized to buy root beer from you for me.” Later, Pamela says to Shirley, “Don’t ever buy root beer
from Sam again,” but does not communicate this revocation of authority to Sam. Suppose Shirley then goes to
Sam and buys ten cases of root beer purportedly for Pamela. On the way to Pamela’s store, Shirley’s truck catches
fire and the root beer is destroyed. Pamela must pay Sam for the root beer, on the legal theory that Shirley had
apparent authority to buy it for her and that she, Pamela, is bound by virtue of that apparent authority.
The third basis for liability is called inherent agency power and operates where there is neither authority nor
apparent authority. Suppose Pamela not only owns but manages her grocery store and that the store is called,
“Pamela’s Grocery.” Then she secretly sells the store to

16

Miguel, who tells her that he wants her to continue to run the store and to keep the fact of his ownership a secret.
He also tells her never to buy soft drinks from Sam. Pamela does in fact buy soft drinks from Sam, and runs up a
large bill with him. Sam continues to believe that Pamela is the owner of the store; he has never heard of Miguel.
Suppose Pamela loses interest in the store and badly mismanages it and that by the time Miguel figures out what is
going on, all is lost: the debts far exceed the assets, the customers are shopping elsewhere, and Miguel is forced to
go out of business. He is liable for the debts to suppliers other than Sam because Pamela had authority to deal with
them. He will also be held liable for the debt to Sam, under the legal doctrine of inherent agency power, which in
this case means that a general agent (Pamela) binds an undisclosed principal (Miguel) to contracts that are within
the usual scope of authority of agents of the same type (here, store managers), even where the agent had neither
authority nor apparent authority.

B. THE ECONOMIC SIGNIFICANCE OF THE LEGAL RIGHT TO CONTROL

1. Relation to Power to Terminate. The economic significance of Pamela’s legal right to control the
manner in which Chuck does his job should not be exaggerated. If Pamela did not have that legal right as a matter
of law, what difference would it make? Suppose that the right did not exist and that Pamela did not like the way
Chuck was going about the job of stocking shelves. She could still let him know how she thought the job should be
done and could indicate that if he did not begin to do it that way, she would fire him. That is precisely the same
option that she has in dealing with an independent contractor such as the soft-drink supplier, Shirley. Suppose that
Pamela dislikes something about the manner in which Shirley is running her business. Pamela has no legal right to
order Shirley to do things differently. But she can certainly suggest that she would like to see a change and that she
is prepared to “fire” (that is, stop doing business with) Shirley if no changes are made.
There is, of course, a major economic difference between Shirley and Chuck that relates to control. Chuck
works only for Pamela and his performance affects only her. Shirley presumably supplies soft drinks to many
customers other than Pamela. If Pamela wants Shirley to change her method of operation in ways that will affect
those other customers of Shirley, then Shirley must take account of the effects on the other customers. This may be
the vital economic distinction between servant-type agents like Chuck, who work only for one person and are
subject to the legal right of control of that person, and people like Shirley, who are not subject to such control (and
who may or may not be classified as agents with respect to some of their activities). The point about Pamela’s
ability to “fire” Shirley, and thereby affect Shirley’s conduct, is nonetheless a useful and interesting one.

17

2. Relation to Duration of Contract. On the other side of the coin, even though Pamela has the legal right
to tell Chuck how to do his job, if he doesn’t want to do it her way he can quit, just as Shirley can quit supplying
soft drinks rather than go along with Pamela’s demands. The legal right to control physical conduct will affect
contract damages in case there is such a dispute. Suppose that Pamela has a week-to-week contract both with
Chuck and with Shirley. If on the first day of the week Chuck refuses to follow orders, Pamela can fire him
without paying damages for breach of the employment contract. If, on the other hand, Shirley refuses to take
Pamela’s advice about how to run her business and Pamela “fires” Shirley at the same time, Pamela will be liable
for damages for breach of contract. Since the contracts with Chuck and Shirley are of short duration, as such
contracts are likely to be, the damages will probably be trivial. Thus, the economic importance of the right to
control is in part a function of the duration of the contract. Generally, as duration increases the importance of
control increases. (Compare Sec. XII(D) of this chapter.)
3. Relation to Incentives. This is not to say that control is unimportant or that Pamela will have the same
concern about control of Shirley as she does about control of Chuck. It is clear that the manner in which Chuck
performs his job will directly affect Pamela’s business. If he is slow, she will need more help and that will cost her
money. If he is indifferent to customers, that too may cost her money. If Pamela were to reflect on the importance
of control, she might ask herself three interrelated questions. First, is it feasible to provide financial incentives that
will induce Chuck or Shirley (or others) to perform in ways that will promote my interests? Chuck is likely to be
paid a fixed hourly, daily, or weekly wage. There may be some financial incentive for him to perform well (the
possibility of promotion, for example), but such incentive is likely to be attenuated at best. Since Pamela cannot
count on the effect of financial incentive, she may need to rely on the power to control Chuck’s performance
directly. Shirley, on the other hand, does have an incentive to sell as many soft drinks as possible and in this
respect her interests coincide with those of Pamela. Pamela may consider this incentive (combined with other
factors) sufficient to protect her own interests. It seems plausible to generalize, then, that there is an important
relationship between incentives and power to control. For some employees, particularly those in higher-level
management positions, incentives can be provided that tend to align the interests of an employee with those of the
employer and to the extent that this happens the importance of control to the employer diminishes. (Compare Sec.
VI(E) below.)
4. Relation to Feasible Degree of Specificity. The second question that Pamela might ask herself is, to
what extent is it possible to specify in advance precisely what it is that I want? To the extent that specificity can be
achieved, the importance of control diminishes. Pamela

18

can tell Shirley how many cans of each kind of soft drink she wants, when she wants them, and where they are to
be placed. That is sufficient. With Chuck, specificity is more difficult. She can tell him that she wants a clean store
and well-stocked shelves, but some discretion must be exercised (by Chuck or Pamela) over such matters as when
to put aside the mop and start stocking the shelves, whether to interrupt these activities to help a customer, and so
on. These are matters that may require judgment and experience that cannot readily be imparted to Chuck.
Consequently, Pamela may value the power to direct his efforts, the power to control how he does his job. The
need for judgment or discretion which is the other side of the coin of the difficulty of specifying desired results, is
also related to incentives. If it is difficult to specify the desired output or performance, or to observe or measure it,
incentive compensation may not be feasible and control may be important. Thus, we see the interrelatedness of
control, incentives, and specificity. If it were feasible for Pamela to specify in advance, in a contract with Chuck,
exactly what he should do from minute to minute, and if it were easy to observe his level of compliance with the
requirements of the contract, it might not be important for her to have the right to tell him what to do and there
might be little if any need for incentives (other than the incentive to avoid being fired). If Pamela assumes that
Shirley has a strong incentive to do a good job stocking the shelves with soft drinks, Pamela may be unconcerned
about specifying how Shirley performs her task or about not having control over Shirley. These principles hold as
well for top executives of large corporations: because control and specificity are difficult at best (it is a practical
reality that executives must have broad discretion), incentives (such as bonuses based on profits) become
important. One of the tasks of a business lawyer is to draft employment contracts, which may include provisions
specifying the employee’s duties (e.g., the grocery-store manager hires and supervises other employees and is
required to be at the store 40 hours a week), the scope of the employer’s control (e.g., the owner retains the right to
override the manager’s decisions on hiring but not on firing), and the terms of incentive compensation (e.g., the
manager is eligible for a bonus based on profits, with profits having a special definition designed to encourage the
manager to invest in the future).2 A good lawyer will be aware of the relationships among these elements of the
contract (and their relationship in turn with other elements such as duration).
5. Relation to Availability of Replacements. The third question that Pamela may ask in relation to control
is the extent to which she can find replacements for either Shirley or Chuck. If Chuck can easily be replaced by
more effective workers, Pamela may decide that that alternative is more attractive than trying to tell him how to
perform. By the same token, Chuck’s knowledge that he can be replaced
 19

should have a significant effect on his conduct. The availability of replacements or substitutes will depend on
Chuck’s uniqueness. This will in turn depend on a variety of factors such as the general labor market in the
relevant area. For purposes of examining problems of business organization, however, probably the most important
variable is the unique knowledge of the particular job that Chuck may (or may not) have acquired. In any event,
competition for jobs is an important element in shaping economic relationships and will affect reliance on other
devices such as specificity, incentives, and the power to control.

C. VICARIOUS LIABILITY
The question of control, in the context of owners and ordinary employees, has been examined at some length
because of its instructive value regarding relationships between owners and managers and, in turn, among co-
owners. There is one other element of the master-servant relationship that deserves brief attention in the present
context—namely, vicarious liability. If Chuck, while performing his duties, negligently injures a customer, the
customer can recover damages not only from Chuck but also from Pamela. This is true no matter how many times
Pamela has told Chuck to be careful and no matter how careful he has been in the past. In other words, Pamela is
liable regardless that she was personally without fault. This is a matter of obvious importance to Pamela. The
reason why it is not as important as one might think is simply that Pamela can protect herself by buying liability
insurance. As we shall see, however, Pamela may also be exposed to contract liability—for example, liability for
the cost of merchandise. Insurance is not available to protect against this kind of liability. It is better examined
later, however, in the context of the owner-manager relationship.

V. ORGANIZATION WITHIN FIRMS AND ACROSS MARKETS

It is useful at this point to digress somewhat in order to offer a brief sketch of an important theoretical aspect
of the issues that have been and will be discussed. This digression should enrich one’s understanding of what
follows.
In the parlance of economics, the relationship between Pamela and Shirley is referred to as organization of
economic activity across markets or in the marketplace. The relationship between Pamela and Chuck is said to be
organization of economic activity within a firm. Chuck is thought to be part of the firm for this purpose (that is, for
the purpose of comparing the Pamela–Shirley and the Pamela–Chuck relationships). Economists then worry about
the question of why activities are sometimes organized across markets and sometimes within the firm, about what
seem to be the most important characteristics of the firm, and

20

about how firms operate. These issues have proved to be surprisingly intractable. It is worth noting that lawyers
would view the Pamela–Shirley relationship as that of buyer and seller, of a businessperson dealing at arm’s length
with another businessperson (called, in law, an independent contractor); and that this perspective is closely parallel
to that of economists, who would describe the relationship in terms of independent economic entities engaged in a
marketplace transaction (or series of transactions). The legal and economic perspectives are not so neatly parallel
with respect to the employer-employee (Pamela–Chuck) relationship. Economic theory, by viewing employer and
employee as members of a firm, though in different roles, places greater stress on the communality or jointness of
the endeavor than does the hierarchical legal concept of master and servant, of boss and fungible hireling.
However useful economists may find the distinction between organization within firms and organization
across markets, the distinction may not be of much value to lawyers concerned with the legal and economic
aspects of shaping particular business arrangements. Lawyers who focus on “business organization” are concerned
with relationships among co-owners and between owners and managers while economists, when they study and
theorize about “firms,” are more concerned with the entire enterprise and its relationship to other enterprises. For
lawyers, there is little need for manageable theories and much need for unscientific but sensible solutions to
problems arising from complex relationships among a large number of relevant variables. Those variables include
risk, control, duration, incentives, availability of objective tests of success, opportunities for stealing and for
cheating and shirking and other forms of self-dealing, and ability to predict the future. It does seem plain, in any
event, that it may be useful for some purposes to think in terms of degrees of conformance to the concept of the
firm or the market, rather than in all-or-nothing terms. Thus, for example, within a firm, certain employees may be
paid on a piece-work basis, which is a market-type arrangement. They might nonetheless be members of the firm
to the extent that their conduct in various respects is subject to the control of the person who pays them. Perhaps
the economic concept of firm v. market could usefully be replaced with that of firmishness.
There may be times, nonetheless, when a lawyer may find it useful to think consciously about the polar cases
of organization across markets and organization within a firm, in order to generate ideas about how best to tailor an
intermediate relationship to meet a client’s needs. For example, suppose that Pamela believes her grocery store
must have a meat department, but the butcher who has worked for her has quit and she knows little about buying
and selling meat. One option available to her might be to rent space in her store to an independent meat-business
operator. That would be organization across a market. Among the advantages would be that Pamela would not be
exposed to the risk of

21

losing money from the meat operation and would be relieved of concern with the management of that part of the
store. Among the problems (for Pamela and her lawyer) would be the need to ensure that the meat department
contributed to, rather than detracted from, the attractiveness of the store to its customers. Another option for
Pamela might be to hire a butcher on straight salary. That would be organization within the firm. One advantage of
such an arrangement would be that Pamela would have control over the style of operation; there would be little
need to negotiate about that and little danger of conflict (because as long as the butcher receives the salary, he or
she probably will be content to let Pamela make operating decisions). If one were to start with the idea of
organization within the firm (that is, hiring a butcher on straight salary) and think about moving in the direction of
organization across markets, one might think about compensation based on the meat department’s sales or profits.
That would create incentives tending to reduce the need for Pamela to exercise control, supervision, and review.
Some consideration might be given to requiring the butcher to supply all equipment or to making the butcher
responsible for paying other meat-department employees. Any of these provisions moving the agreement in the
direction of organization across markets would tend to require reconsideration of the issue of control: a butcher
assuming more of the risk of the business would want more control over it. A good lawyer should be aware of the
various organizational possibilities and their implications for all aspects of the contract. The dichotomy used by
economists—markets v. firms—can be a useful device for stimulating and enhancing that awareness. (For further
discussion of incentive compensation, risk, and control, see Sec. VI(E) below.)

VI. OWNERS AND MANAGERIAL EMPLOYEES: CONTROL, RISK, AND DURATION OF

RELATIONSHIP

A. MANAGERS’ RESEMBLANCE TO CO–OWNERS

Many of the elements of the relationship between Pamela and Chuck will be present in similar form in
Pamela’s relationship with higher-level, managerial employees. But as we begin to think of owner-manager
relationships, we begin to see that the issues of control, reward, risk, and so forth will begin to resemble more
closely those that arise among co-owners. That is, the issues will begin to resemble more closely those within the
realm of “business organization” rather than “labor-management.”

B. DELEGATION OF BROAD DECISION–MAKING AUTHORITY

Suppose that Pamela decides to withdraw from the active management of the business and to hire a general
manager, Morris, to run the business. To some significant degree, Pamela will need to rely on

22

Morris’s judgment about how to manage the store—about such matters as prices, subordinate personnel,
merchandise quality, and so on. These decisions will be much broader in scope and greater in impact on the
success or failure of the business than the decisions made by lower-level employees such as Chuck. The delegation
of decision-making authority is largely unavoidable; the purpose of hiring a general manager is to shift to that
person the burden of making important decisions as problems arise. Many of those problems cannot be anticipated
and, even if they could, the correct solution could not be specified in advance. Pamela must of necessity rely on
Morris’s competence and on his good faith. It is true, to be sure, that not all managerial roles call for the same
degree of power to make important decisions. The manager of an apartment building, for example, may perform
mostly routine functions. In such situations, problems relating to delegation of authority tend to diminish in
significance. But all that implies is that some “managers” do not in fact perform managerial functions in the
ordinary economic sense of the term, regardless of their title. From an economic perspective, they resemble Chuck
more closely than they resemble Morris.

C. MAJOR VERSUS MINOR DECISIONS

As an employee of Pamela, Morris will, like Chuck, be subject to her legal right to control. If all goes well,
Pamela will not need to exercise control, but she may consider it very important to have the right to do so. It is,
after all, her money (or assets) that will be at risk. Ordinarily, a person with money invested at substantial risk will
want to have the right to review and control decisions that can materially affect the value of that investment. This
kind of need for control is, of course, limited. Pamela’s concern will be mostly with basic policy decisions and she
need not be much concerned with minor, day-to-day decisions and routine operating decisions.

D. DURATION OF RELATIONSHIP, EASE OF REPLACEMENT, AND SYMBIOSIS

Pamela’s relationship with Morris, like her relationship with Chuck, will be affected significantly by the ease
with which Morris can be replaced. This will depend in part on general economic circumstances such as the
number of grocery stores in the area and the number of trained managers. It will also depend, however, on the
specific training or knowledge that Morris acquires in managing Pamela’s store. As that specific training or
knowledge increases, Morris becomes more and more valuable to Pamela and more and more difficult for her to
replace. To that extent, Pamela will become dependent on Morris and will find it costly to replace him. But this is a
two-way street. Morris will have acquired training that is valuable to Pamela, and to Pamela alone, and to this
extent he is dependent on her. This kind of symbiotic relationship

23

can obviously lead to discord over division of the gains from the joint endeavor. Part of the job of a lawyer is to
anticipate such problems and to help provide, in advance, formulas for their resolution. For example, Morris might
be protected by providing that if he is discharged without cause he is entitled to a substantial payment (severance
pay or liquidated damages). Pamela might be protected by making part of Morris’s salary or bonus payable in the
future and forfeitable if he quits without cause. Unfortunately, the drafting of such provisions is by no means an
easy task. The parties may be unwilling to pay for the lawyer’s services. They may be unwilling to spend their own
time on the issue. And they may prefer to avoid what they hope is an unnecessary confrontation on what may be a
highly charged and possibly irreconcilable matter. Many lawyers consider it unwise to raise such issues, fearing
that if they do, they may spoil the deal. (See Chapter 2, Sec. IV(E).)

E. MODE OF COMPENSATION, INCENTIVE, RISK, AND THE EMPLOYEE’S INTEREST IN CONTROL

Pamela’s relationship with Morris will also be affected by how he is compensated. In order to provide Morris
with proper incentives, Pamela may insist that part of his reward be contingent on the success of the business.
Morris might, in fact, demand such an arrangement. At the same time, there is likely to be a limit to the risk Morris
is willing to take and he will probably insist on some assured minimal level of compensation. Thus, the
compensation “package” may consist of a salary (a fixed claim) plus a bonus based on profits (a residual claim).
The presence of an element of incentive compensation like a bonus based on profits shifts some of the risk of the
business to Morris; that is an attribute of any residual, as opposed to fixed, claim. It aligns Morris’s objectives and
interests with those of Pamela, and thereby allows her to be less concerned with the need for supervision, review,
and control. But as Morris’s rewards become increasingly dependent on the success of the business, he will
become more concerned about control. If he is paid nothing but a fixed wage, he may be willing to follow any
orders that Pamela wants to give him (though he may object because of concern for his future). If, on the other
hand, his rewards are heavily dependent on the profits of the business, he may want some assurance of freedom
from interference by Pamela in his operation of the business. At the same time, if Morris’s compensation is heavily
dependent on profit, Morris may be tempted to take excessive risks, figuring that he will share in any gains but the
losses will fall entirely on Pamela. This becomes particularly a problem if the business is at some risk of failure
and Morris is near retirement age and thus not concerned about how his reputation will affect his future
employment (the “end game” situation). Thus, Pamela may think it essential to preserve control (as well as to think
carefully about the compensation package).

24

Thus, there are potential conflicts over compensation and its relation to risk and control. The conflict can be
addressed in negotiation, but may be difficult to resolve to the satisfaction of both Morris and Pamela, even where
each is fully committed to cooperation and reciprocal fairness. Moreover, it should be noted that the formulation of
an incentive compensation formula can be a formidable task. For example, Pamela and Morris may decide that
Morris is to receive some portion of the net profits of the business. But the concept of “net profits” is not self-
defining; it requires a determination, for example, of the appropriate rate of depreciation of assets used in the
business. Beyond that, there is the very real possibility that profits will be affected by circumstances such as the
behavior of competitors or a widespread improvement in the economy, which may not be related to Morris’s
performance. There may be good reasons for making the incentive compensation contingent on profits over a fairly
long period of time—for example, five years—but then what happens if Pamela wants to sell out after three years?
Problems like these, again, can be difficult to resolve in advance, and are fraught with potential antagonism. One
can easily appreciate why Morris and Pamela may at the outset choose to pretend that they don’t exist or why they
may want to assume that mutually acceptable solutions will appear as concrete issues arise.
In connection with the issue of control, it is worth noting that under basic principles of contract law, even
where an employee has expressly bargained for control, the employer may resume control, subject only to liability
for damages. A court will not grant “specific performance” of a contract provision relating to control; that is, it will
not issue an order compelling the employer to allow the employee to exercise control in accordance with the
contract. For example, suppose that Pamela agrees that Morris is to make all decisions relating to the hiring and
firing of other employees. Now suppose that Pamela fires Chuck and Morris objects. Morris is not entitled to
reverse Pamela’s decision and rehire Chuck. Morris cannot go to court and get an order compelling Pamela to
abide by her contract with him. He can continue to work for Pamela and sue her for damages—which would be
difficult to establish. Or he can quit (since Pamela’s action is likely to be a “material breach” of his contract of
employment) and sue for damages—which again might be difficult to prove. (He would be required to seek
another comparable job and his damages would be the difference between what he would have earned working for
Pamela over the term of his employment contract and what he in fact earned at the other job.) One frequently
stated rationale for this legal result (no specific performance of the agreement giving Morris the right to hire and
fire) is that money damages are an adequate remedy for the breach of the contract. If one grants that assumption as
to the adequacy of the damages remedy, then the rule can be defended on grounds of economic efficiency. Morris
will have his damages and this is an adequate substitute for his right to exercise control; he is made whole. Pamela
pays damages, and presumably she

25

was willing to do so as the price of reneging on the contract; she should be at least as well off as she would have
been if she had been stuck with her promise, and possibly better off. All is for the best in this best of all possible
worlds. Maybe.

F. RISK, CONTROL, AND DURATION OF CONTRACT

The problems of contingent reward (risk) and control, whose interrelationship we have just seen, are in turn
related to the problem of the duration of the relationship—in other words, to the problem of termination. Like any
other employee, Morris will want as much security of employment as he can get. He will want the option of
keeping his job as long as he wants it, though he will have to accept the fact that in most private employment he
cannot expect too much in this regard. Pamela may want to tie up Morris’s services for as long as possible, without
committing herself, though again she will not have much expectation of being able to do so. Where Morris’s
compensation is contingent to some significant degree on the success of the business, the issue of duration of the
contract will take on added importance. At the outset Morris may consider that he will need a substantial period of
time to achieve his profit-making expectations. Moreover, if he is to receive a portion of the yearly profits he may
want to be able to remain in command in order to protect what he has been able to create. As the length of the
contract period increases, however, it becomes increasingly difficult to anticipate and deal with the problems
arising from changing circumstances. To a considerable extent it will be necessary to leave problems for resolution
as they arise, relying on the proposition that by and large the outcomes prescribed by law, in the absence of explicit
agreement, will be consistent with what the parties would have provided had they tried to anticipate and resolve all
conceivable issues. But in some circumstances, the failure to resolve issues in some detail in advance will lead to
acrimony and costly litigation. That is a risk that perhaps the parties should try to take into account, however
vaguely, at the beginning of their association; it is questionable whether many people do so.
A common problem relating to the duration aspect of the owner-employee bargain arises from the difficulty
of enforcing the employee’s obligations. To take the simplest kind of case, imagine that an employer agrees to pay
an employee a fixed salary for five years. An obvious danger is that the employee will become lazy and do a bad
job—though just good enough to avoid giving cause for dismissal. A less obvious danger arises where the
employee is extremely successful. When that happens, the employee may demand a higher salary or may ask to be
released from the contract in order to take a better-paying job elsewhere. If the employer insists on enforcing the
contract, the employee may threaten, subtly, to start a “slowdown.” There may be little that the employer can do in
response to this kind of threat, except accede to the employee’s demands. The situation suggested here is perhaps
most easily

26

explained by reference to the world of sports and entertainment. Suppose an unsensational college football player
signs a long-term contract with a professional team at a generous salary. If he turns out worse than expected he still
gets paid. But suppose he turns out to be rookie of the year. Now he demands a higher salary and says that if he
doesn’t get it he won’t have a good attitude toward the game—or he may just decide to quit and live off berries in
the woods. He is likely to get a raise. The contract will turn out to be something of a one-way street in favor of the
athlete. While this kind of phenomenon is perhaps most common, and most dramatic, in contracts with potential
superstar performers in sports and entertainment, it can also occur in the more mundane world of business. It is one
element explaining why employers in ordinary businesses may be reluctant to enter into long-term contracts with
executives. The executive whose performance turns out to be barely adequate will receive the full benefit of such a
contract; the executive whose performance is exceptionally good may be able to extract more than the contract
provides. This is not to say that employment contracts have no efficacy in tying up the employee; they do
substantially constrain the employee’s freedom to bargain for better terms. It is only to say that, because of
problems of proof (and of ethics?), the benefits of the bargain may be less than they seem.
One other aspect of the durational element deserves brief mention. Special problems may arise from the
difference in time horizons of the employer and employee (or of other participants in an economic venture). Again,
the point can be made most forcefully by analogy to the entertainment business. A film star (or director) may be
concerned about his or her reputation over the long haul; such a person may have a long time horizon. The
producer or investor, on the other hand, may be interested only in the profits on the film currently in production;
such a person may have a short-term, “fast buck” attitude. This potential conflict may (and often does) lead to hard
bargaining over the issue of control of the quality of the film. (And if the star can command sufficient resources, he
or she may resolve the conflict by becoming the producer.) In an ordinary business such as a grocery store the
same kind of conflict can arise. The manager may be seeking a fast profit in order to enhance his or her bonus or
improve opportunities for employment with competitors. The owner may have the opposite perspective. Or the
roles may be reversed, with the owner seeking the fast profit to enhance the potential sales price of the business
and the manager concerned about the longer term. Similar divergencies can lead to conflict among co-workers. It
scarcely needs to be said that this kind of potential conflict may be very difficult to cope with in advance; and in
the absence of advance agreement, it may be extremely difficult to resolve if it arises. In many cases, participants
in a venture may simply have to rely on the reasonableness, fairness, and integrity of the other participants, or hope
for the best.

27
 VII. OWNERS AND MANAGERIAL EMPLOYEES: DUTY OF CARE

A. FOUR TYPES OF LACK OF DUE CARE

We have just examined some of the economic aspects of the relationship between Pamela and Morris. Now
we turn to what may be called the legal aspects (which are intertwined with economic considerations and
implications). We can begin with Morris’s duty of care. Let’s consider four situations.
1. Negligent Injury to Third Person. Case 1. Suppose that Morris, while driving to the bank to
deposit the day’s receipts, negligently hits and injures an innocent pedestrian. Assume that there is no insurance to
cover this event. The injured person can recover damages either from Morris or from Pamela. Morris is personally
liable because he was personally negligent and his negligence caused harm. The fact that he was acting on behalf
of Pamela in her business does not shield him from liability as a matter of law (though as a practical matter the
injured person is likely to seek recovery from Pamela rather than from Morris). Pamela is liable because of the
legal doctrine of respondeat superior. The Pamela–Morris relationship is in legal conception like the Pamela–
Chuck relationship, one of master and servant. Pamela, the master, is liable for personal injuries to third persons
caused by her servant, Morris, in the scope of his employment. Suppose that the injured person sues Morris instead
of Pamela and recovers a judgment of $10,000 from him. Morris is not entitled to reimbursement from Pamela. He
is stuck. Beyond that, and perhaps surprisingly to a person not familiar with the law, if the victim sues Pamela and
recovers $10,000 from her, Pamela has the right (at least under the rules of traditional agency law) to recover that
amount from Morris. The theory is that the primary liability is that of Morris for his own negligence and that the
ultimate burden of the loss should rest on him. Pamela is only vicariously and secondarily liable. That is the law.
There is no reason to suppose, however, that that is the practice. Actual recovery by an employer from a negligent
employee for damages paid by the employer to a third party would seem harsh, perhaps even unjust. One does not
hear of such recoveries and presumably they are rare. But the possibility exists.
2. Negligent Injury to Employer. Case 2. Suppose that Morris carelessly drops his lighted cigarette in
a wastebasket and the ensuing fire causes $10,000 damage to the store. Again, assume that there is no insurance.
Pamela is entitled to recover the $10,000 from Morris because of his carelessness. Again, in practice the liability is
not likely to be enforced. Imagine, for example, that an employee on the assembly line at a General Motors plant
negligently drops a wrench into moving parts and causes $10,000 worth of damage. It is extremely unlikely that

28

General Motors would seek to recover from the employee, even if we assume that there is no provision in the
union-negotiated contract on the matter, or, for that matter, even if the employee were not represented by a union.
The employee might well be fired or subjected to some lesser form of discipline, but the suggestion that General
Motors might seek money damages seems unrealistic. And this is true even if we imagine an employee who has
sufficient assets to pay any judgment without going bankrupt. As we shall see, however, the possibility of a
corporation seeking recovery from officers and directors for injuries caused by their lack of care has not seemed to
most people to be unrealistic. Far from it. (See Chapter 3, Sec. IV(A).) And this is true regardless that such liability
can be sufficient to bankrupt the officer or director. Indeed, legislation in some states imposes significant barriers
to efforts by corporations to provide protection against such liability for officers and directors. But that again gets
ahead of our story.
3. Incompetent Business Decision. Case 3. Suppose that Morris causes a $10,000 loss by the exercise
of extremely bad judgment in the operation of the business. Suppose, for example, that he stupidly orders far too
much of a perishable commodity and it rots in the storeroom. Assuming that Morris had general authority to order
such commodities in such quantities (or reasonably appeared to the supplier to have such authority), Pamela must
pay for what was ordered and delivered. Again, she is entitled to recover from Morris, unless he had made a
reasonable decision that simply turned out badly. No doubt the scope of the concept of a reasonable decision would
be broad; Morris must have considerable leeway, as a matter of business necessity. But there are limits that Morris
can transcend and beyond those limits he is said to have failed to exercise due care and becomes liable for his
dereliction. In this situation, however, there is an added practical element that makes the problem far more serious
than those depicted in the first two examples. Insurance will not be available. (Note that we are not concerned here
with theft by Morris, for which insurance may be available.)
 4. Inaccurate Information. Case 4. Consider problems associated with Morris’s duty to supply
Pamela with information. Suppose that Morris is responsible for sending to Pamela monthly reports on the
operations of the business and that, by virtue of his carelessness, these reports seriously understate earnings. Now
suppose that Pamela, relying on these reports, sells the business to a third person for an amount substantially below
what she would have insisted upon had she known the true facts. Again, Pamela may have a right to recover from
Morris. Recovery would be based on a theory of negligence or lack of due care. To change the facts, however, let’s
suppose that Pamela sells the business to Morris. Here, Morris would benefit from his error and the legal standards
are understandably far more favorable to Pamela than

29

they are when there is no such element of potentially self-serving behavior on the part of Morris.

B. CONTRACTS REGARDING DUTY OF CARE

We have seen four possible instances of a failure on the part of Morris to do his job properly—instances of
what the law refers to as a failure to exercise due care. Let us now suppose that before Morris and Pamela enter
into their employment contract, they try to minimize their potential liabilities and negotiate with each other over
who will bear the burden of unavoidable losses.
1. Insurance for Negligent Injury to Third Person. In Case 1, involving tort liability to a third person,
damages are likely to be covered by insurance. The insurance policy is likely to be taken out by Pamela. Such a
policy would not necessarily protect Morris but may be drafted to do so. If the parties think about the issue in
advance it seems likely that Morris will insist that Pamela buy protection for him, or will insist on added
compensation so that he can buy his own policy. Not all potential problems of tort liability can be resolved by the
purchase of insurance, however. Adequate insurance may not be available, for example, for defamation of an
employee or a customer. The chance that such behavior will occur may be exceedingly remote, but if the parties
want to resolve the matter by agreement in advance, they will be confronted with difficult problems of definition.
These problems of definition can, perhaps, be appreciated more fully as they arise in a context not involving
insurance.
2. Self Insurance by Employer. Suppose that Pamela is a wealthy person who is willing to accept the risk
of tort liability to third persons both for herself and for Morris. In other words, suppose that she wants to be a self-
insurer as to injuries arising from the business. Morris may be willing to accept the protection afforded by her
promise to him to assume all liability (that is, by an indemnity agreement, under which Pamela agrees to indemnify
Morris for liabilities that he may incur). The question then arises, will the law uphold such an agreement relieving
Morris of his common-law duty to Pamela? In this context, the answer undoubtedly is “yes.” (Note that such an
agreement would not affect the right of the injured person to collect from either Morris or Pamela.) As suggested
above, however, when Pamela and Morris try to draft the terms of the agreement, they may experience
considerable difficulty. While Pamela may be willing to assume the burden of Morris’s “ordinary” negligence, she
may not be willing to assume the burden of injuries caused by “gross” negligence, or willful behavior, or behavior
stemming from Morris’s personal activities or self-serving schemes. It may be extremely difficult for Morris and
Pamela to agree on a verbal formulation of the limits of Pamela’s assumption of liability.

30

3. Waiver of Liability for Negligent Injury to Employer. Pamela may also want to be a self-insurer with
respect to the kinds of injuries involved in Case 2. Again, she and Morris may be prepared to agree on the matter.
Here, however, the contemplated injury is one directly to Pamela and it may not be quite so clear that the
agreement will be enforceable. Courts have shown some reluctance to enforce bargains in which one party is
relieved of liability for negligent harm directly to another (though not so much in the case of arm’s-length bargains
affecting people like Pamela, who presumably can take of themselves). Again, the scope of Pamela’s waiver of her
rights against Morris may be difficult to define.
4. Waiver of Liability for Incompetent Business Decisions; Effects on Behavior of Employee. Similar
problems of definition will also arise in connection with any effort to relieve Morris of liability for the kinds of
harm inflicted on Pamela in situations like Case 3 (lack of due care in making business decisions). In these kinds
of situations, however, we can begin to see another aspect of the problem—one that is present in the first two
situations but is more readily understandable in the third. Suppose that the agreement between Pamela and Morris
generally relieves Morris of liability for even seriously defective business decisions, but leaves open some
possibility that Morris will be liable for what Pamela may regard as an outrageously stupid or careless action. The
question is, how will such a possibility affect Morris’s behavior? To some extent, no doubt, the effects will be
desirable from almost any reasonable perspective. If the possibility of outrageous action can be reduced by the
threat of liability, both Pamela and Morris may be better off: Pamela can expect to earn more and can afford to pay
more to Morris. On the other hand, there is a real danger that Morris will overreact and will adopt conservative,
costly, self-protective strategies that will reduce the returns from the business for both Pamela and Morris. Viewing
the matter from Pamela’s perspective, extreme care must be exercised in arrangements that expose her employees
to liability for their mistakes. On the one hand, if Morris has too little reason to worry about his potential liability
he may be too careless. On the other hand, if he has too much reason to worry (or thinks he has), he may become
too conservative and may incur too many costs in trying to avoid liability.

C. LIMITING SCOPE OF AUTHORITY

1. Problems of Internal Business Practice. Pamela may seek to limit her exposure to loss resulting from
Morris’s weak business decisions by limiting the scope of his authority to act for her. There are, however, a
number of circumstances that constrain her freedom to do this. Suppose, for example, that Pamela has doubts
about Morris’s judgment in ordering fresh vegetables and wants to limit his purchasing

31

authority. Suppose further that she has in the past ordered as much as $20,000 worth of fresh vegetables in a week
and that this is not extraordinary, but she wants to limit Morris to ordering $10,000 worth a week. The first
problem is that such a limitation may simply be a bad business strategy. There may be occasions when it will be
extremely useful for Morris to have the authority to act as Pamela herself would have acted. In general, people
who manage businesses must have considerable decision-making authority if they are to make a success of the
business. It may be counterproductive to try too hard to limit their freedom of action.
2. Problems of Notification of Others. A second problem in attempting to limit Morris’s authority is that
such a limit will not bind the supplier unless the supplier knows about it and knows that it has been reached. If
Pamela simply tells Morris not to order more than $10,000 worth of fresh vegetables a week and does not so
advise the supplier or suppliers, then as long as larger orders are customary in the trade, Pamela will be liable for
the full amount of such larger orders. And this is true, under the law of agency, even if the suppliers are unaware of
Pamela’s existence and believe that Morris is the owner of the store. See Restatement, Agency (2d), Sec. 8A and
194. If a supplier is in fact aware of the limitation on Morris’s authority then that supplier will be bound by that
limitation, and if the supplier then provides more than $10,000 worth of fresh vegetables Pamela is not obligated to
pay for the excess. But it may be difficult to formulate the precise limits of each of a number of potential suppliers,
in terms acceptable to them, and to find devices for keeping each of them informed about whether aggregate limits
have been reached. Moreover, if the limits are ambiguous Morris may become unduly concerned about his own
exposure to risk of liability (to the supplier or to Pamela) for exceeding his authority. In situations where
limitations are of necessity to some degree ambiguous, managers (and other employees) will seek to obtain
protection against liability for exceeding their authority—or will demand greater compensation, to take account of
the risk. But to the degree that the employee is protected from the risk, the employer will not be. Finally, Morris’s
bad judgment may not be reflected in any single decision upon which limits can be placed, but rather in a series of
interrelated decisions or in some failure to take affirmative action to prevent loss. Because of these various
circumstances, Pamela cannot avoid exposure to significant loss, even beyond her investment in the business, for
Morris’s errors in judgment.
3. Liabilities of Creditors. In certain circumstances a creditor that exercises control over the operation of
another firm to which it has extended credit may become liable for the debtor firm’s obligations to other creditors.3
Suppose, for example, that Pamela has not paid her bills as they have become due and has fallen deeply in debt to
a number of

32
creditors including the wholesale grocery company from which she buys most of her goods. The wholesaler may
want to help Pamela stay in business because that is the only way it can hope to recover the money it is owed and
because it hopes to keep Pamela as a customer. The wholesaler may think that Pamela needs better management,
however, and may insist (as a condition of continuing to extend credit to Pamela and not forcing her into
bankruptcy) that she hire as manager a person selected by it or that she take various other actions designed to
protect the wholesaler’s interests. Pamela’s equity may well be negative, so all the financial risk is on the
wholesaler and it may consider that this amount of control is the least it is entitled to. But as this scenario unfolds,
there may come a time when it seems that the business is being run more by, and for the benefit of, the wholesaler
than Pamela and the possibility arises that a court may treat the wholesaler as a proprietor, with liability for the
debts previously incurred by Pamela in operating the business. This kind of outcome may reflect legalistic myopia
rather than common sense. The other creditors may wind up with a windfall (a claim, against the wholesaler, that
they had no reason to anticipate or rely on) and other firms in the future in positions like that of the wholesaler
may be deterred from preventing a wasteful termination of a business. On the other hand, a creditor that does want
to take control of a debtor’s business can bargain with the other creditors or can invoke the bankruptcy laws in a
manner designed to keep the debtor operating. See Chapter 4, Sec. III(A)(4).

VIII. OWNERS AND MANAGERIAL EMPLOYEES: LOYALTY

A. CONFLICT CONCERNING INFORMATION PROVIDED TO OWNER

1. In Connection With Purchase of Ownership Interests by Employee. Morris’s carelessness can also
produce losses for Pamela in situations like those illustrated in Case 4, involving information supplied by Morris.
Here, however, we have the element of potential conflict of interest in a clearer setting. (In the earlier cases there is
also a form of conflict of interest—for example, the conflict between Pamela’s interest in profits and Morris’s
interest in protecting himself from liability—but the conflict was not so apparent and, perhaps, not so serious.) In
Case 4, we can also conveniently introduce the possibility of a review by an outsider. In the initial statement of the
Case 4 hypothetical, Morris carelessly understated the profits of the business and Pamela relied on this information
in selling to an outsider. Morris’s negligence caused harm to Pamela, but there was nothing that would typically be
called “conflict of interest” on Morris’s part since he was not benefited by the understatement; there was no
economic incentive to err. (There may have been a conflict between Pamela’s desire for maximum effort by Morris
and Morris’s interest in taking life easy, but this divergence is not usually referred to as a “conflict of interest.”)

33

Where Morris is the buyer, the incentive to err in the direction of understatement is obvious. In this two-
person situation, of course, Pamela would be aware of the potential for deliberate error and would be on her guard.
Difficult issues of legal doctrine revolve around how far courts should go in situations such as this in protecting
people like Pamela from unwise bargains based on less-than-adequate information. These issues are associated
with the fact that Morris is both an employee who, in the eyes of the law, owes a duty of loyalty (see Sec. VIII(E)
below) to Pamela, and a buyer who, in reality, will be looking out for his own interests. It might be tempting,
especially in slightly different contexts, to adopt a flat rule prohibiting dealings between Morris and Pamela that
raise conflicts between Morris’s duty of loyalty and his self-interest. But the potential advantage to both Morris
and Pamela of being able to deal with each other is too great to be stifled by rigid legal prohibitions. In the
corporate context, courts have in the past adopted rules tending to force the parties to watch out for their own
interests, but the more recent trend seems to be toward judicial scrutiny to ensure full disclosure by the corporate
counterparts of Morris (managers and other “insiders”) and protection of the counterparts of Pamela
(shareholders). (See Chapter 3, Sec. IV(B).)
2. Regarding Performance by Manager. Purchases of the business (or an interest in it) by employees are,
of course, relatively infrequent events in the life of a particular business. A far more common divergence of
interest in the supplying of information by managers to owners relates to the manager’s success in running the
business. Pamela will want to have an accurate and honest appraisal of Morris’s operation of the business and to a
considerable extent will need to rely on Morris to supply the needed information. No matter how honest and
faithful Morris may be, however, his response to this need of Pamela will be affected by his own interest in making
himself look as good as possible. Thus, he is likely to emphasize good news and to downplay or explain away bad
news. Beyond this, Morris may be a crook and may want to hide the fact that he is stealing.
3. Role of Auditors. A common device for dealing with both these problems is for Pamela to hire an
outsider to examine the books and the operations of the business. The person who performs this function is likely
to be an accountant who performs a function called “auditing.” The degree of care that the auditor takes in
reviewing books and records will be a major determinant of the likelihood of uncovering theft, innocent
exaggeration, or inaccuracy. While there are certain standard procedures used in typical audits, where the
accountant is hired to serve the private interests of a person like Pamela, the degree of care presumably is
negotiable. One must remember, however, that audits cost money and the more careful the audit, the more
expensive it will become. In selecting an auditing firm and in defining the scope of its review, Pamela inevitably
becomes involved, consciously or not, in a

34

decision-making process involving the comparison of costs and benefits. Information cannot be obtained without
cost, and recognition of that reality is essential to an understanding of much of economic organization, including
business relationships.
4. Loyalty of Auditors. Another aspect of the auditing function is perhaps less obvious, at least in the
context of the large, publicly held firm. This aspect has to do with the question of whose interests the auditor is
obligated to serve. If Pamela hires an auditor to help her to watch out over her private interests in the business then
it seems plain that the auditor’s loyalty should be to Pamela (notwithstanding auditors’ image of themselves as
independent professionals). But what about Morris’s interests (bearing in mind that in some circumstances it may
be Morris who actually selects the auditor)? Understandably, Morris will want to present a favorable picture of his
conduct of the business. A person unfamiliar with accounting and auditing procedures might assume that these
conflicting orientations present no problem since all the auditor needs to do is present an objective picture of the
business. The fact is, however, that accountants, especially as the business becomes complex, are faced with
“judgment calls” on all sorts of issues (e.g., whether a contested liability should be treated as a current cost; or
when profit should be reported on a contract on which performance has not been completed). If the auditor calls
too many of the close ones against Morris, he may want to have some way of presenting his view of events in a
manner more favorable to himself. If he has the power, he may fire the existing auditor and hire one who is more
sympathetic to his own interests. The likely effect of such a prospect on the behavior of an auditor should be
obvious. If Morris cannot fire an unsympathetic auditor, he might conceivably insist on an additional auditor to
represent him and promote his cause. This would mean two sets of outside reports to Pamela, but that is likely to
be excessively costly. The most likely outcome of the conflict between Pamela and Morris over audits will be an
effort by the auditor to walk the fine line, trying to serve the interests of both Pamela and Morris as well as
possible. We need not pursue this matter of the conflict between Pamela and Morris over control of the auditor. It
is sufficient for present purposes to note the interests on both sides and the fact that information cannot be supplied
without cost.

B. LOYALTY AND CONFLICT PROBLEMS AND THEIR COSTS

We have examined the problems associated with what the law refers to as the duty of care and have begun to
see some problems having to do with the duty of loyalty in supplying information. The duty of loyalty is, of
course, a more general obligation of employees (and other agents and fiduciaries). Problems of Morris’s
faithfulness, loyalty, and devotion to

35

duty are especially troublesome because they are difficult to define and even more difficult to monitor. Viewing the
matter negatively, Pamela will be concerned about the possibilities of stealing, cheating, and shirking and how to
prevent or limit them. For convenience, we can refer to stealing, cheating, shirking and other such volitional or
controllable conduct as self-dealing. By a variety of techniques, an employer can control the incidence of self-
dealing by employees, but not without costs in time or money. There is likely, therefore, to be a residual loss to the
employer from the employee’s self-dealing that it is not worthwhile to try to prevent. For example, to detect
Exploring the Variety of Random
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The Project Gutenberg eBook of Black April
 This ebook is for the use of anyone anywhere in the United
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Title: Black April

Author: Julia Peterkin

Release date: January 3, 2024 [eBook #72611]

Language: English

Original publication: unknown: Grosset & Dunlap, 1927

Credits: Tim Lindell, David E. Brown, and the Online Distributed

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*** START OF THE PROJECT GUTENBERG EBOOK BLACK APRIL ***

BLACK APRIL
 BLACK APRIL

by Julia Peterkin

GROSSET & DUNLAP, Publishers

by arrangement with
THE BOBBS-MERRILL COMPANY
 Copyright, 1927
By The Bobbs-Merrill Company

Printed in the United States of America

 To

JULIUS MOOD
 CONTENTS
CHAPTER PAGE
I April’s Father 11
II April’s Son 21
III Cousin Big Sue 40
IV Julia 52
V Blue Brook 57
VI Uncle Bill 66
VII A Birth-Night Supper 73
VIII The Premises 84
IX Saturday Afternoon 89
X The Barnyard 100
XI Hunting ’Possums and Turkeys 129
XII Duck-Hunting 138
XIII The Quilting 159
XIV Church 180
XV Field Work 199
XVI Plowing 203
XVII Hog-Killing 231
XVIII Joy and April 268
XIX At April’s House 287
XX Seeking 308
BLACK APRIL
 BLACK APRIL

I
APRIL’S FATHER

The cool spring dusk fell drowsy and soft over Sandy Island, all but
blotting out a log cabin that nestled under great moss-hung oaks
close to the river’s edge. The small drab weather-stained house
would scarcely have shown except for the fire that burned inside,
sending a bright glow through its wide-open door and showers of
sparks up its short stick-and-clay chimney.
A gaunt, elderly black man strode hastily toward it along the path
leading up from the river and went inside, but in a few minutes he
came to stand in the doorway, his bulk well-nigh filling it as one
broad shoulder leaned dejectedly against the lintel. When a moan
came from inside, his brawny hands clenched and buckled in a
foolish helpless way, and a frown knitted his forehead as he cast a
glance at the old black woman who pattered back and forth from the
hearth to the bed in the corner with a cupful of root-tea or a bit of
hot grease in a spoon or a pinch of salt in the palm of her hand.
Once in a while she called to him that everything was going well. To-
morrow this same girl would laugh at all these groans and tears.
Birthing a child is tough work. He must have patience. Long
patience. Nobody can hurry a slow-coming child.
The fire crackled and leaped higher, lighting the dirt-daubed cracks
of the walls, shining under the bed where it played over the freshly
sharpened point of a plow-share. A share ground and filed and put
under a bed is the best thing in the world to cut birth-pains, but this
one lagged with its work. Its clean edge glittered bright enough, yet
as time dragged on the pains lingered and the expected child tarried
with its coming.
The moon must be to blame. This new moon was right for planting
seed but wrong for birthing. Swift labor comes with a waning moon,
not a growing one.
The man heaved a deep sigh and looked out into the gathering
twilight. The slender young moon was dropping fast. This birthing
ought to get over. When the river’s tide turned, life could go out
mighty quickly. Ebb tide is a dangerous time for sick people.
Old Granny was too slow. Too easy-going. When this same girl was
born sixteen years ago, or was it seventeen, Granny had a long race
with Death and lost, yet here she was poking around with her roots
and teas, trifling away the time.
“Granny,” he stopped to clear the huskiness out of his throat, “better
make haste. De tide’ll soon turn. Ebb tide ain’ to be trusted, you
know.”
A wry smile shriveled Granny’s face. “You’s too short-patienced,
Breeze. Dis is a long-patienced task. It takes time. You better go cut
one more turn o’ fat lightwood an’ fetch em in. De fire is got to keep
up shine to-night.”
A pitiful moan from the corner stopped her talk, and, with an
echoing grunt, the man stepped down into the yard.
Granny’s shaking head bobbed faster as she watched him hurry to
the wood-pile and pick up the ax. Her trembling hands drew her
shawl closer around her bent shoulders. Lord, how time does change
people, she muttered to herself. Breeze was no mild fellow in his
youth. No. He was a wild scamp. But when his own girl got in
trouble, he r’ared around and wanted to kill the man that fooled her.
As if she wasn’t to blame too. A good thing the girl had sense
enough to keep her mouth shut. Nobody could make her say who
the father of her child was. She was a shut-mouthed creature. But
spoiled to death. Rotten spoiled. No wonder. Here she was,
disgracing her father’s house, after he had raised her nice as could
be, but he hadn’t a hard word for her. Not one. If he hadn’t humored
her all her life to everything heart could wish, she’d get to work and
finish this birthing before dark, instead of keeping people fretted
with worry-ation all day and now, more than likely, half the night.
But as long as her soft-hearted old father took her part, Granny was
helpless, and her scolding did no good.
The sturdy ax-cuts that rang out gave Granny an idea. That ax was
sharp and clean. The plow-share was hampered with rust. Why
wouldn’t the ax cut the birth-pains far better? Hurrying back to the
door she quavered out shrilly, “Bring me dat ax, Breeze! Hurry wid
em.”
He came with it, but halted at the door. He had ground that ax only
this morning. Its edge was awful keen. This was no time to be
risking anything. Granny had better be careful.
Granny stretched her old neck forward and her forehead furrowed
with a frown as she said sharply that as long as she’d been catching
children, if she couldn’t rule an ax, she’d better quit right now and
go home! She couldn’t stand for people to meddle with her when
she was doing her best. What did a man know about birthing? Put
the ax beside the share. Together they’d fetch the child like a lamb
a-jumping!
When steel jangled against steel under the bed, Granny ordered
sharply, “Now you git out de door till I call you. You ought to be glad
for de pain to suffer dis gal. I’m so shame of how e done, I can’ hold
my head up. I hope to Gawd you’ll lick em till e can’ stand up, soon
as e gits out dis bed. I never did hear no ’oman make sich a racket!
E ought not to much as crack e teeth! I wish e was my gal. I’d show
em how to be runnin’ round a-gittin’ chillen, stead o’ gittin’ a nice
settled man fo’ a husband.” Granny eyed the girl, then her unhappy
old father, severely, but her talk was to no purpose, for old Breeze’s
eyes were bloodshot with pity, his very soul distressed.
“You’s wrong, Granny. I used to t’ink like you, but I know better
now. If de gal’ll git thu dis safe, I wouldn’ hold no hard feelin’s
’gainst em. Never in dis world.” He leaned over the bed and gave the
girl’s shoulder a gentle pat, but Granny hurried him away. This was
no time for petting and being soft. Some hard work waited to be
done. The sooner the girl got at it, the sooner it would be finished.
“Quit you’ crazy talk an’ go on out de door! Don’ come back in dis
room, not less I call you.”
Granny spoke so sharply, he obeyed humbly, without another word.
The breath of the earth was thick in the air, a good clean smell that
went clear to the marrow of the man’s bones. God made the first
man out of dust, and all men go back to it in the end. The earth had
been sleeping, resting through the winter, but now, with the turn of
the year, it had roused, and it offered life to all that were fit and
strong. The corn crop, planted on the last young moon when the
dogwood blooms were the size of squirrel ears, was up to a stand
wherever the crows let it alone. Pesky devils! They watched every
blade that peeped through the ground and plucked it out with the
mother grain, cawing right in the face of the scare-crow that stood
up in the field to scare them, although its head, made out of a pot,
and its stuffed crocus sack body were ugly enough to scare a man.
To-morrow he’d hide and call them. He could fool them close enough
to shoot them. It was a pity to waste shells on birds unfit for man or
beast to eat and with too little grease on their bones to add a drop
to the soap pot, but there’d soon be another mouth to feed here.
To-morrow, he must plant the cotton while the young moon waxed
strong. There was much to do. He needed help. Maybe this child
being born would be a boy-child, a help for his old age. A sorrowful
woman will bear a boy-child, nine times out of ten, and God knows,
that girl had been sorrowful. When she helped him plant the corn,
she had dropped a tear in mighty nigh every hill along with the seed.
No wonder it grew fast.
Soon as the moon waned, the root crops, potatoes, pindars, chufas,
turnips, must be planted. Field plants have no sense. If you plant
crops that fruit above the ground on a waning moon, they get all
mixed up and bear nothing but heavy roots, and root crops planted
on a waxing moon will go all to rank tops no matter how you try to
stop them. Plants have to be helped along or they waste time and
labor, just the same as children you undertake to raise. That poor
little girl was started off wrong.
She was born on a moon so wrong that her mammy died in her
birthing. He had done his best to raise the little motherless creature
right, but he made a bad mistake when he let her go to Blue Brook
without him last summer. She went to meet his kin and to attend the
revival meeting. She was full of life and raven for pleasure. He
couldn’t refuse her when she asked to go. But he hadn’t made her
understand that those Blue Brook men were wicked devils. He knew
it. He had been one of them himself. Poor little girl, she knew it now!
Now when it was too late for anybody to help her out of her trouble.
Years ago, over thirty of them, he had left Blue Brook and come to
Sandy Island on account of a girl. She had named her child April
because it was born this very month. Afterward, she had married
and forgotten him. Now she was dead, but her child, April, was the
finest man on Blue Brook. Barely middle-aged, April was already the
plantation foreman, ruling the other farm-hands, telling them what
to do, what not to do, and raising the best crops in years. April had
made a name for himself. Everybody who came from Blue Brook had
something to say about him, either of his kindness or of his
meanness, his long patience or his quick temper, his open-
handedness or his close-fistedness. On Blue Brook, April was a man
among men.
He had seen him, a tall, lean, black, broad-shouldered fellow, so
much like himself that it was a wonder everybody didn’t know that
he was April’s daddy. But they didn’t. For April’s mother had been as
close-mouthed as the girl lying yonder on the bed. She never did tell
who fooled her and made her have sin. She died without telling.
Some day he’d like to tell April himself. But after all, what was the
use? April had taken the name of his mother’s lawful husband and
he loved the man who had raised him as well as an own father could
have done. Why upset them?
Granny’s shambling steps inside the cabin took his thoughts back to
the girl there. If the child was born on this rising tide, it would more
than likely be a boy-child. April would be a good name for him too.
April was a lucky month to be born in; it was a lucky name too. If
the child came a girl, Katy, the name of April’s mother, would be a
good name for it.
The spring air wafted clouds of fragrance from the underwoods
bordering the forest. Crab-apple thickets and white haw trees were
in full bloom. Yellow jasmine smothered whole tree-tops. Cherokee
roses starry with blossoms sprawled over rail fences and rotting
stumps, piercing through all other scents with their delicate perfume.
Sandy Island looked just so, smelled just so, on that April night
when he came here so many years ago. He thought then that he’d
go back some day and fetch Katy here to stay with him. But the
years had tricked him, fooled him. They had rolled by so fast he’d
lost track of them, and of Katy and her boy, April. Now, he was
almost an old man, and Katy was up yonder in Heaven. His own
lawful wife and his other boy, his yard son, were up there too. Had
Katy told them about April? Or would she stay shut-mouthed for ever
and ever?
As he wondered and pondered about the ways of people in Heaven,
the river, gorged by a high spring tide, slowly flooded the rice-fields
encircling the island. The black water lapped softly as it rippled over
the broken dikes and passed through the rotted flood-gates, hiding
the new green shoots of the marsh grass and uprooting the tall
faded blades, that had stood through the winter on the boggy mud
flats.
Frogs chanted. Marsh-hens chattered. Wood ducks piped and
splashed. Ganits flew in long lines toward the sunset, squawking
hoarsely and flapping the air with blue and white wings. Partridges
whistled. Doves mourned. Where were the groans from the bed in
the corner? Maybe all was over at last.
Granny stood in the door beckoning him to come. Her harshness
was all gone. She hobbled down the steps and came tottering to
meet him, then laying a bony hand on his shoulder she whispered
that the ax was too sharp. It had cut the pains off altogether. They
had ceased too soon and she couldn’t get them started again. She
had tried every tea she knew. Every root. Every ointment. Every
charm. She was at her row’s end. This moon was all wrong for
birthing. A young moon makes things go contrarywise. The child
should have waited a week longer to start coming. And two weeks
would have been still better.
The girl had dozed off in spite of everything. He must come and try
to rouse her up. Girls behave so crazy these days. They do like
nobody ever had birthed a child before them. She was fretted half to
death the way this girl carried on. He must come and make her
behave. If she had been a nice decent girl, all this would never have
been.
The girl’s eyes opened and looked up at him, and he leaned low over
the bed to hear her whispered words. She spoke with worn-out tired
breath, begging him to go and get help from somewhere. She hated
to die in sin, and leave him, but she couldn’t hold out much longer.
Death already had her feet cold as ice, it was creeping up to her
knees. Couldn’t he take the boat and go across the river to Blue
Brook? Wasn’t somebody there who could come to help her?
He studied. Certainly there was. Maum Hannah, his own first cousin,
had a string of charm beads their old grandmother had brought all
the way from Africa when she came on a slave ship. They and the
charm words that ruled them were left in Maum Hannah’s hands.
Ever since he was a boy, living on Blue Brook, he had heard people
say that those beads had never failed to help a woman birth a child
safely. No matter how it came, head foremost, foot foremost, or
hand foremost, it was all the same when those charm beads got to
working.
He’d go fetch Maum Hannah. She’d come. Old as she was, she’d risk
the booming river if her beads were needed to help a child come
into the world.
His boat was a dug-out and narrow for two people in a river running
backward in a flood-tide, but she’d come. He felt sure of it.
Barefooted, bareheaded, without a coat, he ran down the steep
slope to the black water’s edge, and soon the sharp bow of his boat,
driven by one short paddle, sliced through the current. Swift
wheeling circles of water marked every steady dip it made. Hugging
the willow banks, the boat hurried on, then cut straight across the
river. Thank God, the high-running tide made the rice-fields a clear
sheet of water. The boat could take a bee line to Blue Brook without
bothering about how the channel ran beyond the river. The landing
aimed for was on a deep, clear blue creek, which gave the plantation
its name, Blue Brook. The man’s knees were shaking as he stepped
out of the boat and dragged it higher up on the bank to wait until he
came back with Maum Hannah and the beads. Up the path he
trotted, to the Quarters where the long low houses made blurs of
darkness under tall black trees. The thick-leaved branches rose
against the sky, where the fires of sunset had lately died and the
moon had gone to its bed.
Rattly wagons hurried over the roads. Cattle bellowed. Children
shouted. Dogs barked. An ax rang sharply and a clear voice sent up
a song. “Bye an’ bye, when de mawnin’ comes!” How trustful it
sounded. He tried to hum the tune, but fear gnawed at his heart and
beat drums in his ears and throat and breast.
He was born and reared on Blue Brook. He knew every path and
road on it. Every field and ditch and thicket. Every moss-hung oak.
He had lived right yonder in the foreman’s house with his
grandfather, the plantation foreman. The foreman now was his son!
His blood kin. A proud fellow, that April! Lord, how April strutted and
gave himself airs!
The darkness melted everything into one. The whiteness of the Big
House was dim.
Fences, cabins, trees, earth were being swallowed up by the night.
Maum Hannah’s cabin was the last in those two long rows of houses,
and firelight shining out from her wide-open door sent a glow clear
across her yard. She was at home. It wouldn’t take long to get her
and the charm beads into the boat, then back across the river.
Black people were gathered in the doorways, most of them his kin
with whom he’d like to stop and talk, but there was no time for one
extra word, even with April, the foreman. Dogs ran up to him,
sniffed, recognized that he was of the same blood as their masters,
and went back to lie down.
 II
APRIL’S SON

Taking Maum Hannah’s three steps as one, he called out a breathless

greeting:
“How you do, Cun [Cousin] Hannah?”
She was stirring a pot on the hearth and the long spoon clattered
against the iron sides she dropped it. “Who dat call me?” She limped
backward a few halting paces and gazed at him with questioning
eyes.
“Dis is me, old man Breeze! Git you birthin’ beads quick an’ come go
home wid me!”
She stared at him vacantly. “Fo’ Gawd’s sake, who is you?” She
whispered sharply.
“You don’ know me? Is you gone blind, Hannah?”
Her arms dropped weakly as she peered at him, taking in his bare
feet, his patched clothes, his shirt, open at the neck, showing the
swell of his throat, the panting of his breast. With a sudden burst of
laughter she reached out and took his hand. “Lawd, Breeze, I
thought sho’ you was Grampa’s sperit come fo’ me! You scared me
well-nigh to death, son! Come on een an’ set down! Jedus, I’m glad
to see you! But you is de very spit o’ Grampa!”
“I can’ set, Hannah. I ain’ Grampa’s sperit, but I sho’ did come to git
you! My li’l’ gal is ’bout to die, Hannah. E can’ birth e chile to save
life, no matter how hard e try. Git Gramma’s birthin’ beads. You got
to go wid me. I couldn’ stan’ to le’ dat li’l’ gal die, an’ don’ do all I
can to save em. E’s so pitiful in e pain.”
Maum Hannah grunted. “Pain don’ kill a ’oman, son. It takes pain to
make em work steady till de task is done. I can’ stop no pain! No,
Jedus! De gal might be well by now anyhow.”
But he was firm. “Listen to me, Hannah! You got to go home wid me
to-night! Now! In a hurry! Make haste, too!”
“It’s a mighty black night since de moon is gone down.”
“Bein’ black don’ matter. I know de way. You come on, Hannah.”
“I declare to Gawd, my cripple knee is so painful I don’ know ef I
could git in a boat.”
“Den I’ll tote you, but you sho’ got to come.”
“I’m mighty ’f’aid o’ boats an’ water in de daytime much less at
night.” She leaned down to fix the sticks on the fire, but he caught
her roughly by the arm.
“Don’ you tarry, Hannah. You come on right now!”
“What kind o’ boat you got?”
“De boat’s narrow an’ de river’s high, but you got strong heart, enty?
You’ll be as safe wid me in dat boat as ef you was settin’ right here
by de fire in your rockin’ chair. I promised my li’l’ gal to fetch you an’
you’ birthin’ beads ef e would hold out till I git back. You better
come on! Gramma’ll hant you sho’ as you fail me to-night!”
Maum Hannah sighed deep. “I know I got to go, scared as I is. A
boat on a floodin’ river is a turrible t’ing, but I sho’ don’ want
Gramma’s sperit to git no grudge against me. Catchin’ chillen is
Jedus’ business anyhow, an’ de river belongs to Jedus, same as me
an’ you, I reckon. You wait till I git de beads out de trunk.
Sometimes I wish Gramma didn’ leave me dem beads. It’s de truth!”
She groped her way to the shed-room and fumbled in a trunk, then
called out that she needed a light. He broke a splinter off from a
stick of fat lightwood on the hearth and, lighting it, took it to her.
The small flame blazed up, sputtering and hissing, and spat black
drops of tar on the clean floor, on the quilt covered bed, on the wide
white apron she was tying around her waist. The shaking hand that
held it was to blame.
“How come you’ hand is a-tremblin’ so, Breeze?” she asked gently.
“You is pure shakin’ like a leaf. Trust in Gawd, son. You’ gal b’longs
to Him, not to you. Jedus ain’ gwine fail em now when e have need.”
The light wavered wildly as he raised an arm to draw his shirt-sleeve
across his eyes. Big teardrops rolled down his cheeks, and his face
twitched dumbly.
“You mus’ scuse me, Hannah. I’m so weakened down wid frettin’
until de water dreans out my eyes. My mind keeps a runnin’ back to
de time dis same li’l’ gal’s own mammy was taken dis same way.
When de tide turned, e went out wid em. Dat’s how come I’m
hurryin’ you so fas’. We mus’ git back whilst de tide is risin’.”
He stood, straight and tall, and strong for his years, but the troubled
look in his eyes made the old midwife wonder.
Her weight tilted the narrow boat so far to one side that some of the
black river water slid over its edge and ran down cold on her feet.
“Jedus hab mussy!” she groaned. “If dis boat do go down, I’ll sho’
git drowned to-night! I can’ swim, not a lick.”
“You set still, Hannah. Dis boat knows better’n to turn over to-night.
I got em trained. E’s got sense like people. E knows e’s got to take
me an’ you safe.”
“I’m mighty glad to hear dat, son, mighty glad.”
The boat was already gliding swiftly past the black willows on the
Blue Brook’s bank and around the bend where the thick trees made
shadows and long tresses of gray moss waved overhead. Soon
they’d reach the river. When a dark bird flew across the stream
Maum Hannah shivered and whispered, “Do, Jedus, hab mussy,” but
Breeze muttered, “Dat ain’ nuttin’ but a summer duck.”
The whole world lay still, wrapped by the night, quiet, save for the
swish of the water against the sides of the boat as the noiseless dips
of the steady-plying paddle thrust it on.
As they neared Sandy Island the shrill cry of an owl in the distance
caused the boat to falter in its forward going.
“Wha’ dat, Breeze?”
“Dat’s one o’ dem blue-dartin’ owls. Dat ain’ no sign o’ death.”
Ripples from the boat broke into glittering sparkles of light laid by
the stars on the water. The river murmured. Trees along the bank
were full of strange shadowy shapes. Whenever the lightest rustle of
wind drifted through the black branches, low smothered sobs fell
from them.
A tall sycamore with its white outstretched arms high up toward
heaven, reached toward the river waving, beckoning.
The night air was cool, but Maum Hannah took up the edge of her
apron and wiped off big drops of sweat that broke out cold as ice on
her forehead. “Do, Jedus, hab mussy!” she prayed.
The new moon had gone to bed. Now was the time evil spirits walk
and take people’s souls out of their bodies. Pines on the island made
soft moans. The darkness quivered with whispers. Only the firelight
shining out from the cabin on the hill made a clear red star to guide
them.
The narrow boat swerved and turned in-shore. A cypress knee,
hidden by the water, bumped hard against it, but didn’t stop its leap
toward the bank. Old Breeze eased himself past Maum Hannah, and
hopping out on the wet sand drew the boat up a little higher on the
hill.
“Git up, Hannah. Le’ me hold all two o’ you’ hands. Step slow. Hist
you’ foot. Don’ miss an’ trip. Now you’s on dry land.”
“T’ank Gawd! Praise Jedus’ name!”
“You got de beads, enty?”
“Sho’ I got ’em. Dem beads is all de luck I got in dis world. If dey
was to git lost, I’d be ruint fo’ true. Pure ruint!”
The steep climb cut her breath and stopped her flow of talk, but
Granny who had heard them coming, croaked out:
“Yunnuh better make haste. De chile is done come, but de gal won’
wake up an’ finish de job. Yunnuh come on.”
Maum Hannah lifted the long dark string of beads from around her
neck and handed them to old Breeze. “Run wid ’em, son. Put ’em
round de gal’s neck. Right on e naked skin. If I try to walk fast I
might fall down an’ broke my leg.”
Breath scarcely came and went through the girl’s parted lips, and
her teeth showed white. Were they clenched? Old Breeze pressed on
the round chin to see. Thank God the mouth could open!
Maum Hannah got inside the room at last. The charm words that
went with the beads would set things right. Death might as well go
on home! Let the girl rest. She was tired. Things could wait while
she had her nap out.
The big hickory armchair, drawn close to the fire, held a feather
pillow on its cowhide seat, and lying in the nest it made was a small
black human being. Granny laughed as she picked it up and put it
into Maum Hannah’s hands, saying:
“A boy-chile! An’ born wid a caul on e face!”
“Great Gawd, what is dis! You hear dis news, Breeze? Dis chile was
born wid a caul on e face!”
The man turned his troubled eyes away from the bed. “Wha’ you
say, Hannah?”
Laughing with pleasure Maum Hannah and Granny both told him
again. His grandson had been blessed with second-sight. He had
been born on the small of the moon and with a caul over his face.
He would have second sight. He’d always be able to see things that
stay hidden from other people. Hants and spirits and plat-eyes and
ghosts. Things to come and things long gone would all walk clear
before him. They couldn’t hide from this child’s eyes.
“Hotten another pot o’ water, Granny. Lemme warm em good, an’
make em cry.” Maum Hannah cradled the child tenderly in her hands,
then held him low so the firelight could shine in his face. With a
quick laugh she caught him by one foot and holding him upside
down smacked him sharply with three brisk slaps.
“Cry, suh!” she scolded. “Ketch air an’ holler! I hate to lick you so
hard soon as you git here, but I got to make you fret out loud.” A
poor weak bleating sounded and she handed the child to Granny.
“You fix em, whilst I finish up wid de mammy.”

“Wake up, gal!” she plead, shaking the girl’s limp arm. “Wake up!”
The rigid eyelids fluttered open and a faint smile played over the
girl’s face. She was too weary to draw her breath. The pain had
sapped all her strength, every bit.
Maum Hannah stooped and looked under the bed.
“Great Gawd,” she grunted. “Who dat put a’ ax under dis bed? No
wonder de pains quit altogedder. You ought to had chunked dese
irons out de door!” She did it forthwith herself.
“Now! All two is gone! Open you’ eyes, gal! Ketch a long breat. Dat’s
de way. Hol’ you’ two hands togedder. So. Blow in ’em! Hard. Hard
as you kin! Make a stiff win’ wid you’ mouth! Blow you’ fingers off.
Dat’s de way!”
Then something else went wrong. Where was a spider’s web?
Granny ought to have had one ready. Every good midwife should
find one as soon as she takes a case. Maum Hannah’s eyes were too
dim to see a web on the dark rafters overhead. Somebody must find
one and fetch it quickly. Life can leak out fast. Spider webs can dam
it up better than anything else. But, lord, they are hard to find at
night! Where was Breeze?
One was found at last. Then it took careful handling to get it well
covered with clean soot from the back of the chimney. Thank God
for those beads. The girl would have lost heart and given up except
for them and the charm words which Maum Hannah kept saying
over and over. With those beads working, things had to come right.
Had to. And they could not help working. Couldn’t, thank God.

The next morning’s sunshine showed plenty of gossamer webs spun

with shining wheels. Long threads of frail silk were strung across the
yard from bush to bush, traps set by the spiders for gnats and
mosquitoes, strong enough to hold a fly once in a while. But it takes
a house spider’s stout close-woven web to hold soot and do good.
For a house spider to make its home under your roof is good luck,
for sooner or later the cloth it weaves and spins will save
somebody’s life.
Old Breeze got up early and cooked the breakfast, fixed himself a bit
to eat and a swallow or two of sweetened water to drink and went
to the field to work, but the two old women sat by the fire and
nodded until the sun waxed warm and its yellow light glowed into
the room through the wide-open door. Then their tired old bodies
livened and their heads raised up and leaned together while
whispered talk crept back and forth between them. Granny held that
Breeze was a good kind man to take the girl’s trouble as he did.
Many a man would have put her out-of-doors. Girls are mighty wild
and careless these days. But their parents are to blame for it too.
Half the children born on Sandy Island were unfathered. It wasn’t
right. Yet how can you stop them? Maum Hannah sighed and shook
her head. It was a pity. And yet, after all, every child comes into the
world by the same old road.
A thousand husbands couldn’t make that journey one whit easier.
The preachers say God made the birthing pain tough when He got
vexed with Eve in the Garden of Eden. He wanted all women to
know how heavy His hand can be. Yet Eve had a lawful husband,
and did that help her any?
Granny blinked at the fire and studied a while, then with a sly look at
the bed she whispered that this same little boy-child was got right
yonder at Blue Brook during the protracted meeting last summer.
Her wizened face showed she knew more than she cared to tell. Not
that it was anything to her whose child it was.
She fidgeted with her tin cup and spoon and peeped at Maum
Hannah out of the corner of her eye, then asked with pretended
indifference:
“What’s de name o’ de gentleman what’s de foreman at Blue Brook
now?”
“E’s name April.”
“Enty?” Granny affected surprise. “Is e got a fambly?” she presently
ventured in spite of Maum Hannah’s shut-mouthed manner.
“Sho’, e’s got a fambly. E’s got a fine wife an’ a house full o’ chillen
too.”
“Well, I declare!” Granny mirated pleasantly. “Was any o’ dem born
wid a caul?”
“No, dey wasn’t. I never did hear o’ but one or two people bein’ born
wid a caul. Ol’ Uncle Isaac, yonder to Blue Brook is one, and e’s de
best conjure doctor I ever seen.”
“Who was de other one?” Granny inquired so mildly that Maum
Hannah stole a look at her hard, dried furrowed face. There was no
use to beat about the bush with Granny, so she answered:
“April, de foreman at Blue Brook, was de other one. Dese same ol’
hands o’ mine caught April when e come into dis world, just like
deys caught all o’ April’s chillen.”
“You mean, April’s yard chillen, enty?” Granny looked her straight in
the eyes like a hawk, but Maum Hannah met the look calmly,
without any sign of annoyance.
“I dunno what you’s aimin’ at, Granny. April’s a fine man. Blue Brook
never did have no better foreman. An’ his mammy, Katy, was one o’
de best women ever lived. April was she onliest child. April was born
dis same month. Dat’s how come Katy named him April. April’s a
lucky month an’ a lucky name, too. Wha’ you gwine name you li’l’
boy-chile, daughter?”
Granny looked toward the bed and listened for the answer.
“I dunno, ma’am,” the girl answered weakly, and Granny sweetened
her coffee with a few drops more of molasses. She stirred and
stirred until Maum Hannah suggested:
“April’s a fine name. Whyn’t you name em dat? When I git back to
Blue Brook, I’ll tell de foreman I named a li’l’ boy-chile at him. Dat
would please em too. E might would send em a present. April’s a
mighty free-handed man, an’ e sho’ thinks de world o’ me too.”
Granny waited to taste the sweetened coffee until she heard what
the girl said. The girl didn’t make any answer at first, but presently
she said with a sorrowful sigh, she’d have to think about the baby’s
name. She couldn’t decide in a hurry. Sometimes a wrong name will
even kill a baby. She must go slow and choose a name that was
certain to bring her baby health and luck.
She talked it over with her father and named the baby Breeze, for
him. No foreman in the world was a finer man, or a kinder, stronger,
wiser one. The breeze for which he was named could have been no
pleasanter, no sweeter, than the breeze that blew in from the river
that very morning.
The old man beamed with pleasure. He was glad to have the child
named for him. But since the month was April, why not name him
April Breeze? Then he’d have two good-luck names, and two would
be better than one.
“We could call em li’l’ Breeze, enty?” she asked with a catch in her
voice.