One area of testing on the FPE1 and FPE2 examinations will be in respect to basic legal issues in business. A specific area of testing could deal with the law of agency where one party, the principal, authorizes another party, their agent, to enter into and bind them to contracts on their behalf with an outside party, the third party.
Examples of agency relationships, where a party is designated by a principal as their agent, would result between specified employees and their employer, a life insurance agent and a life insurance company, an agent acting on behalf of a professional athlete. An agency relationship will also result if there is a financial power of attorney between two parties (e.g., if an elderly person allows a younger relative to handle their business affairs). Although the agency agreement between a principal and an agent is usually in writing, it can also be verbal.
A popular area of testing in respect to agency law is the difference between express authority and implied authority and actual authority and apparent authority. Express authority for an agent is what has been specified in a contract (written or verbal) as to the actions that can be pursued by the agent on behalf of the principal. For a life insurance agent, the insurer would provide the agent with the express authority to deliver a life insurance policy to an approved third party for insurance. The life agent though would be able to decide how to deliver the policy through implied authority (e.g., by registered mail, in person, etc). Implied authority is not stated explicitly. It results from what would normally be expected from an agent to carry out duties on behalf of the principal.
Let’s now examine the terms actual authority and apparent authority. Actual authority includes express authority and implied authority that is granted to an agent by the principal. Apparent authority is the authority that an outside party would logically expect the agent to have based on: industry or trade practices; representations by the principal; past dealings; the agent’s position (e.g., executive vice president); and other relevant information. Where the agent does not have actual authority, but apparent authority exists, the principal will still be bound to a contract entered into by its agent. Let’s look at some examples.
If you purchase a television at Sears or the Bay, you would logically expect the salesperson to have the power to make the sale on behalf of the retailer, based on trade practice. If, without your knowledge, the salesperson did not have the actual authority to complete the sale let’s say he’s a trainee he would still bind the employer to the contract through apparent authority. If the owner of a company implies that an assistant has the power to close a deal, even though she does not have the actual authority, that individual would have apparent authority to the outside world. In this case, the owner is said to be holding out (implying that the other party has actual authority). If John, the vice president of purchasing for XYZ Ltd., announces that he is resigning from the company in three weeks, and the company takes away his power to contract, the employer should notify this fact to outside customers. Otherwise, John still appears to have the authority to contract with these outside customers and could bind XYZ to further contracts before he leaves.
Finally ABC company, with five employees, appoints Mary as executive vice president, marketing. Internally, ABC company might not allow Mary to enter into contracts on behalf of the company. However, to an outside party it would seem logical, based on Mary’s title, that she has the power to contract on behalf of ABC. For example, if Mary books a conference room at an expensive hotel for an upcoming client presentation, and signs a contract which commits ABC to pay $2,500 for the facility, it would be implied by Mary’s title that she has the actual authority to sign the contract. The company is liable for the $2,500 payment, even if Mary should not have booked the conference room.
So, the rule with apparent authority is simple: If it looks like a duck, walks like a duck and quacks like a duck, it’s deemed to be a duck. If an agent enters into a contract with a third party and there is apparent authority, but no actual authority, the principal is bound to the contract. The third party is not penalized if there is apparent authority because the contract is legally binding on the principal. However, the principal can take action against the agent who overstepped their actual authority.
So what about the obligation of a third party in respect to entering into a contract with a principal through their agent? Good business sense dictates that if the third party believes that the agent has the authority to contract on behalf of the principal, the third party does not have to verify with the management of the principal, whether or not the agent has the actual authority to enter into the contract. If the agent appears to have the authority, the third party can assume that this is authorized through the internal management of the company. This is called the indoor management rule. For example, if you purchase a television through a salesperson at The Bay, you do not have to check with The Bay’s management to verify that the salesperson has the authority to make the sale.
What if the third party is not sure about whether or not the other party has the actual authority to act as an agent on behalf of the principal? This doubt might arise due to the position of the party, the magnitude of the transaction and other valid reasons. If good business sense dictates that the power of the agent or purported agent should be questioned before a contract is entered into, then no valid contract would exist if entered into by the third party.
For example, hotel management should verify with senior management of a company that a junior marketing representative of the company has the authority to book hotel facilities on behalf of that company. You phone a travel agency and the party you are talking with, Cindy, states that she is a secretary, and that the travel agent is out for lunch. Cindy offers to help you with some travel information, and you decide to book a package through Cindy. It’s unlikely that a secretary at a travel agency has the power to book a vacation package for a client. If a senior individual at a company notifies a client that she has resigned, should that client assume that the executive still has the power to enter into contracts on behalf of the employer? Also, if a contract is significant, such as a large loan or a merger, the third party should naturally question who has the authority to make the deal, from the other party.
Therefore, if you use the reasonable person test, a third party does have an obligation to question the authority of the other party if their power to contract is questionable.
Ron Foran, CFP, CFA, CLU, FCSI
President, Foran Financial Institute