Analytical Paper: Ethics

T W E L F T H E D I T I O N

BUSINESS LAW and the

REGULATION of BUSINESS

R i c h a r d A . M a n n Professor of Business Law

The University of North Carolina at Chapel Hill Member of the North Carolina Bar

B a r r y S . R o b e r t s Professor of Business Law

The University of North Carolina at Chapel Hill Member of the North Carolina and Pennsylvania Bars

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

Business Law and the Regulation of Business, 12th Edition Richard A. Mann Barry S. Roberts

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A B O U T T H E A U T H O R S

Richard A. Mann received a B.S. in mathematics from the University of North Carolina at Chapel Hill and a J.D. from Yale Law School. He is professor emeritus of Busi- ness Law at the Kenan-Flagler Business School, University of North Carolina at Chapel Hill, and is past president of the Southeastern Regional Business Law Association. He is a member of Who’s Who in America, Who’s Who in American Law, and the North Carolina Bar (inactive).

Professor Mann has written extensively on a number of legal topics, including bankruptcy, sales, secured transactions, real property, insurance law, and business associations. He has received the American Business Law Journal’s award both for the best article and for the best comment and, in addition, has served as a reviewer and staff editor for the publication. Professor Mann is a co-author of Smith and Roberson’s Business Law (sixteenth edition), as well as Essentials of Busi- ness Law and the Legal Environment (twelfth edition) and Contemporary Business Law.

Barry S. Roberts received a B.S. in business adminis- tration from Pennsylvania State University, a J.D. from the University of Pennsylvania, and an LL.M. from Harvard Law School. He served as a judicial clerk for the Pennsylvania Supreme Court prior to practicing law in Pittsburgh. He is professor of Business Law at the Kenan-Flagler Business School, University of North Carolina at Chapel Hill, and is a member of Who’s Who in American Law and the North Carolina and Pennsylvania Bars (inactive).

Professor Roberts has written numerous articles on such topics as antitrust, products liability, constitutional law, banking law, employment law, and business asso- ciations. He has been a reviewer and staff editor for the American Business Law Journal. He is a co-author of Smith and Roberson’s Business Law (sixteenth edition), as well as Essentials of Business Law and the Legal Environment (twelfth edition) and Contemporary Business Law.

iii

B R I E F C O N T E N T S

P A R T I INTRODUCTION TO LAW AND ETHICS 1 1 Introduction to Law 2 2 Business Ethics 15

P A R T I I THE LEGAL ENVIRONMENT OF BUSINESS 45 3 Civil Dispute Resolution 46 4 Constitutional Law 73 5 Administrative Law 95 6 Criminal Law 113 7 Intentional Torts 133 8 Negligence and Strict Liability 155

P A R T I I I CONTRACTS 183 9 Introduction to Contracts 184

10 Mutual Assent 202 11 Conduct Invalidating Assent 225 12 Consideration 245 13 Illegal Bargains 265 14 Contractual Capacity 285 15 Contracts in Writing 302 16 Third Parties to Contracts 328 17 Performance, Breach, and Discharge 347 18 Contract Remedies 365

P A R T I V SALES 385 19 Introduction to Sales and Leases 386

20 Performance 407 21 Transfer of Title and Risk of Loss 429 22 Product Liability: Warranties and Strict

Liability 446 23 Sales Remedies 475

P A R T V NEGOTIABLE INSTRUMENTS 499 24 Form and Content 500 25 Transfer and Holder in Due Course 517 26 Liability of Parties 549 27 Bank Deposits, Collections, and Funds

Transfers 569

P A R T V I AGENCY 595 28 Relationship of Principal and Agent 596 29 Relationship with Third Parties 619

P A R T V I I BUSINESS ASSOCIATIONS 647 30 Formation and Internal Relations of General

Partnerships 648 31 Operation and Dissolution of General

Partnerships 675 32 Limited Partnerships and Limited Liability

Companies 703 33 Nature and Formation of Corporations 728 34 Financial Structure of Corporations 752 35 Management Structure of Corporations 774 36 Fundamental Changes of Corporations 808

iv

P A R T V I I I DEBTOR AND CREDITOR RELATIONS 831 37 Secured Transactions and Suretyship 832 38 Bankruptcy 867

P A R T I X REGULATION OF BUSINESS 897 39 Securities Regulation 898 40 Intellectual Property 937 41 Employment Law 960 42 Antitrust 992 43 Accountants’ Legal Liability 1016 44 Consumer Protection 1029 45 Environmental Law 1054 46 International Business Law 1077

P A R T X PROPERTY 1099 47 Introduction to Property, Property Insurance,

Bailments, and Documents of Title 1100 48 Interests in Real Property 1130 49 Transfer and Control of Real Property 1150 50 Trusts and Wills 1168

A P P E N D I C E S

Appendix A The Constitution of the United States of America A-2

Appendix B Uniform Commercial Code (Selected Provisions) B-1

Appendix C Dictionary of Legal Terms C-1

Index I-1

Brief Contents v

T A B L E O F C O N T E N T S

P A R T I Introduction to Law and Ethics 1

1 Introduction to Law 2 Nature of Law 3 Classification of Law 4 Concept Review: Comparison of Civil and Criminal

Law 5 Sources of Law 5 Concept Review: Comparison of Law and Equity 8 Going Global: What is the WTO? 9 Legal Analysis 10 Applying the Law: Introduction to Law 13

2 Business Ethics 15 Law Versus Ethics 16 Ethical Theories 16 Ethical Standards in Business 19 Ethical Responsibilities of Business 20 BUSINESS ETHICS CASES 27 Pharmakon Drug Company 27 Mykon’s Dilemma 28 Oliver Winery, Inc. 33 JLM, Inc. 34 Sword Technology, Inc. 37 Vulcan, Inc. 40

P A R T I I The Legal Environment of Business 45

3 Civil Dispute Resolution 46 THE COURT SYSTEM 46 The Federal Courts 47 State Courts 49 JURISDICTION 49 Subject Matter Jurisdiction 50 Concept Review: Subject Matter Jurisdiction 53 Jurisdiction over the Parties 53 CIVIL DISPUTE RESOLUTION 56 Civil Procedure 56 Alternative Dispute Resolution 62

Concept Review: Comparison of Court Adjudication, Arbitration, and Mediation/Conciliation 64

Business Law in Action 66 Going Global: What about international dispute

resolution? 67

4 Constitutional Law 73 Basic Principles 74 Powers of Government 78 Limitations on Government 83 Concept Review: Limitations on Government 83 Ethical Dilemma: Who Is Responsible for Commercial

Speech? 90

5 Administrative Law 95 Operation of Administrative Agencies 96 Concept Review: Administrative Rulemaking 101 Limits on Administrative Agencies 103 Ethical Dilemma: Should the Terminally Ill Be Asked

to Await FDA Approval of Last-Chance Treatments? 109

6 Criminal Law 113 Nature of Crimes 114 Classification 115 Concept Review: Degrees of Mental Fault 115 White-Collar Crime 116 Crimes Against Business 120 Applying the Law: Criminal Law 120 Going Global: What about international

bribery? 124 Defenses to Crimes 126 Criminal Procedure 126 Concept Review: Constitutional Protection for

the Criminal Defendant 129

7 Intentional Torts 133 Harm to the Person 137 Harm to the Right of Dignity 140 Business Law in Action 142 Concept Review: Privacy 146 Harm to Property 146 Harm to Economic Interests 147 Concept Review: Intentional Torts 149 Ethical Dilemma: What May One Do to Attract Clients

from a Previous Employer? 150

vi

8 Negligence and Strict Liability 155 NEGLIGENCE 156 Breach of Duty of Care 156 Factual Cause 165 Scope of Liability (Proximate Cause) 165 Harm 168 Defenses to Negligence 169 STRICT LIABILITY 172 Activities Giving Rise to Strict Liability 172 Defenses to Strict Liability 175 Ethical Dilemma: What Are the Obligations of

a Bartender to His Patrons? 176

P A R T I I I Contracts 183

9 Introduction to Contracts 184 Development of the Law of Contracts 185 Going Global: What about international

contracts? 186 Definition of Contract 186 Requirements of a Contract 187 Classification of Contracts 190 Promissory Estoppel 193 Quasi Contracts or Restitution 195 Concept Review: Contracts, Promissory Estoppel,

and Quasi Contracts (Restitution) 195 Business Law in Action 197

10 Mutual Assent 202 OFFER 203 Essentials of an Offer 203 Duration of Offers 208 Applying the Law: Mutual Assent 211 ACCEPTANCE OF OFFER 213 Communication of Acceptance 213 Variant Acceptances 217 Business Law in Action 218 Concept Review: Offer and Acceptance 219

11 Conduct Invalidating Assent 225 Duress 225 Undue Influence 228 Fraud 230 Concept Review: Misrepresentation 234 Nonfraudulent Misrepresentation 234 Mistake 235 Applying the Law: Conduct Invalidating Assent 235 Concept Review: Conduct Invalidating Assent 238

12 Consideration 245 Legal Sufficiency 245 Concept Review: Consideration in Unilateral and

Bilateral Contracts 247

Bargained-for Exchange 254 Contracts Without Consideration 255 Business Law in Action 258 Ethical Dilemma: Should a Spouse’s Promise Be

Legally Binding? 260

13 Illegal Bargains 265 Violations of Statutes 265 Violations of Public Policy 269 Effect of Illegality 278 Business Law in Action 279 Ethical Dilemma: When Is a Bargain Too Hard? 280

14 Contractual Capacity 285 Minors 285 Business Law in Action 289 Incompetent Persons 294 Ethical Dilemma: Should a Merchant Sell to One Who

Lacks Capacity? 297

15 Contracts in Writing 302 STATUTE OF FRAUDS 303 Contracts Within the Statute of Frauds 303 Going Global: What about electronic commerce and

electronic signatures in international contracts? 305 Concept Review: The Statute of Frauds 312 Compliance with the Statute of Frauds 313 Effect of Noncompliance 315 Business Law in Action 315 PAROL EVIDENCE RULE 316 The Rule 316 Situations to Which the Rule Does Not Apply 318 Supplemental Evidence 319 INTERPRETATION OF CONTRACTS 320 Ethical Dilemma: What’s (Wrong) in a Contract? 321

16 Third Parties to Contracts 328 Assignment of Rights 328 Delegation of Duties 335 Third-Party Beneficiary Contracts 338 Applying the Law: Third Parties to Contracts 338

17 Performance, Breach, and Discharge 347 Conditions 347 Discharge by Performance 350 Discharge by Breach 351 Applying the Law: Performance, Breach, and

Discharge 352 Discharge by Agreement of the Parties 353 Discharge by Operation of Law 355

18 Contract Remedies 365 Monetary Damages 366 Business Law in Action 367 Remedies in Equity 372 Restitution 376 Limitations on Remedies 376

Table of Contents vii

P A R T I V Sales 385

19 Introduction to Sales and Leases 386 NATURE OF SALES AND LEASES 387 Definitions 387 Going Global: What law governs international sales? 389 Fundamental Principles of Article 2 and

Article 2A 391 FORMATION OF SALES AND LEASE

CONTRACTS 394 Manifestation of Mutual Assent 394 Consideration 399 Form of the Contract 399 Business Law in Action 400 Concept Review: Contract Law Compared with Law

of Sales 401 Ethical Dilemma: What Constitutes Unconscionability

in a Business? 402

20 Performance 407 Performance by the Seller 408 Performance by the Buyer 413 Obligations of Both Parties 418 Going Global: What about letters of credit? 419 Ethical Dilemma: Should a Buyer Refuse to Perform a

Contract Because a Legal Product May Be Unsafe? 423

21 Transfer of Title and Risk of Loss 429 Transfer of Title 429 Risk of Loss 435 Bulk Sales 441 Ethical Dilemma: Who Should Bear the Loss? 441

22 Product Liability: Warranties and Strict Liability 446 WARRANTIES 447 Types of Warranties 447 Obstacles to Warranty Actions 453 Concept Review: Warranties 456 STRICT LIABILITY IN TORT 457 Requirements of Strict Liability in Tort 457 Obstacles to Recovery 462 Concept Review: Product Liability 464 Business Law in Action 465 Restatement (Third) of Torts: Products Liability 466 Ethical Dilemma: When Should a Company Order

a Product Recall? 467

23 Sales Remedies 475 Remedies of the Seller 476 Remedies of the Buyer 481 Concept Review: Remedies of the Seller 482 Applying the Law: Sales Remedies 483 Concept Review: Remedies of the Buyer 488 Contractual Provisions Affecting Remedies 488

P A R T V Negotiable Instruments 499

24 Form and Content 500 Negotiability 501 Concept Review: Use of Negotiable Instruments 501 Types of Negotiable Instruments 502 Formal Requirements of Negotiable Instruments 505

25 Transfer and Holder in Due Course 517 TRANSFER 517 Negotiation 518 Indorsements 521 Concept Review: Indorsements 525 Applying the Law: Transfer of Negotiable

Instruments 525 HOLDER IN DUE COURSE 527 Requirements of a Holder in Due Course 527 Holder in Due Course Status 533 The Preferred Position of a Holder in Due

Course 536 Limitations upon Holder in Due Course Rights 539 Ethical Dilemma: What Responsibility Does

a Holder Have in Negotiating Commercial Paper? 542

26 Liability of Parties 549 CONTRACTUAL LIABILITY 549 Signature 550 Liability of Primary Parties 553 Liability of Secondary Parties 553 Concept Review: Contractual Liability 557 Business Law in Action 558 Termination of Liability 558 LIABILITY BASED ON WARRANTY 559 Warranties on Transfer 559 Warranties on Presentment 560 Ethical Dilemma: Who Gets to Pass the Buck on

a Forged Indorsement? 564

27 Bank Deposits, Collections, and Funds Transfers 569 BANK DEPOSITS AND COLLECTIONS 570 Collection of Items 570 Going Global: What about letters of credit? 571 Relationship Between Payor Bank and Its

Customer 575 ELECTRONIC FUNDS TRANSFER 581 Types of Electronic Funds Transfer 582 Business Law in Action 583 Consumer Funds Transfers 584 Wholesale Funds Transfers 585 Concept Review: Parties to a Funds Transfer 588 Ethical Dilemma: Can Embezzlement Ever Be

a Loan? 588

viii Table of Contents

P A R T V I Agency 595

28 Relationship of Principal and Agent 596 Nature of Agency 597 Creation of Agency 599 Duties of Agent to Principal 603 Duties of Principal to Agent 607 Termination of Agency 608 Applying the Law: Relationship of Principal and

Agent 612 Ethical Dilemma: Is Medicaid Designed to Protect

Inheritances? 613

29 Relationship with Third Parties 619 RELATIONSHIP OF PRINCIPAL AND THIRD

PERSONS 620 Contract Liability of the Principal 620 Business Law in Action 624 Business Law in Action 625 Tort Liability of Principal 630 Criminal Liability of the Principal 635 RELATIONSHIP OF AGENT AND THIRD

PERSONS 636 Contract Liability of Agent 636 Tort Liability of Agent 639 Rights of Agent Against Third Person 639 Ethical Dilemma: When Should an Agent’s

Power to Bind His Principal Terminate? 640

P A R T V I I Business Associations 647

30 Formation and Internal Relations of General Partnerships 648 CHOOSING A BUSINESS ASSOCIATION 648 Factors Affecting the Choice 649 Forms of Business Associations 650 Concept Review: General Partnership, Limited

Partnership, Limited Liability Company, and Corporation 652

Going Global: What about multinational enterprises? 653

FORMATION OF GENERAL PARTNERSHIPS 653

Nature of Partnership 653 Formation of a Partnership 654 RELATIONSHIPS AMONG PARTNERS 663 Duties Among Partners 663 Rights Among Partners 666 Concept Review: Partnership Property Compared with

Partner’s Interest 667

Ethical Dilemma: When Is an Opportunity a Partnership Opportunity? 670

31 Operation and Dissolution of General Partnerships 675 RELATIONSHIP OF PARTNERSHIP AND

PARTNERS WITH THIRD PARTIES 675 Contracts of Partnership 676 Business Law in Action 680 Torts and Crimes of Partnership 680 Notice to a Partner 681 Liability of Incoming Partner 681 DISSOCIATION AND DISSOLUTION OF

GENERAL PARTNERSHIPS UNDER THE RUPA 683

Dissociation 683 Dissolution 684 Concept Review: Dissociation and Dissolution Under

the RUPA 687 Dissociation Without Dissolution 689 DISSOLUTION OF GENERAL PARTNERSHIPS

UNDER THE UPA 693 Dissolution 693 Winding Up 693 Continuation After Dissolution 694 Ethical Dilemma: What Duty of Disclosure Is Owed to

Incoming Partners? 695

32 Limited Partnerships and Limited Liability Companies 703 Limited Partnerships 703 Concept Review: Comparison of General and Limited

Partners 709 Limited Liability Companies 710 Concept Review: Comparison of Member-Managed and

Manager-Managed LLCs 714 Applying the Law: Limited Partnerships and Limited

Liability Companies 715 Other Unincorporated Business Associations 720 Concept Review: Liability Limitations in LLPs 721

33 Nature and Formation of Corporations 728 NATURE OF CORPORATIONS 729 Corporate Attributes 729 Classification of Corporations 730 Business Law in Action 733 Business Law in Action 734 FORMATION OF A CORPORATION 734 Organizing the Corporation 734 Formalities of Incorporation 737 Concept Review: Comparison of Charter and

Bylaws 738 RECOGNITION OR DISREGARD OF

CORPORATENESS 738 Defective Incorporation 738 Piercing the Corporate Veil 741 CORPORATE POWERS 744

Table of Contents ix

Sources of Corporate Powers 744 Ultra Vires Acts 744 Liability for Torts and Crimes 744

34 Financial Structure of Corporations 752 DEBT SECURITIES 753 Going Global: What about foreign investment? 753 Authority to Issue Debt Securities 754 Types of Debt Securities 754 Business Law in Action 756 EQUITY SECURITIES 756 Issuance of Shares 756 Classes of Shares 760 Concept Review: Debt and Equity Securities 761 DIVIDENDS AND OTHER DISTRIBUTIONS 761 Types of Dividends and Other Distributions 761 Legal Restrictions on Dividends and Other

Distributions 762 Applying the Law: Financial Structure of

Corporations 764 Declaration and Payment of Distributions 766 Concept Review: Liability For Improper

Distributions 768 Liability for Improper Dividends and Distributions 768

35 Management Structure of Corporations 774 CORPORATE GOVERNANCE 774 ROLE OF SHAREHOLDERS 777 Voting Rights of Shareholders 777 Concept Review: Concentrations of Voting Power 782 Enforcement Rights of Shareholders 782 ROLE OF DIRECTORS AND OFFICERS 787 Function of the Board of Directors 789 Election and Tenure of Directors 790 Exercise of Directors’ Functions 791 Officers 792 Duties of Directors and Officers 793 Business Law in Action 801 Ethical Dilemma: Whom Does a Director Represent?

What Are a Director’s Duties? 802

36 Fundamental Changes of Corporations 808 Charter Amendments 809 Combinations 809 Dissolution 821 Concept Review: Fundamental Changes Under

Pre-1999 RMBCA 821 Ethical Dilemma: What Rights Do Minority

Shareholders Have? 825

P A R T V I I I Debtor and Creditor Relations 831

37 Secured Transactions and Suretyship 832 SECURED TRANSACTIONS IN PERSONAL

PROPERTY 833

Essentials of Secured Transactions 833 Classification of Collateral 834 Attachment 836 Perfection 839 Priorities Among Competing Interests 843 Concept Review: Applicable Method of Perfection 843 Concept Review: Requisites for Enforceability

of Security Interests 844 Concept Review: Priorities 848 Default 848 Business Law in Action 849 SURETYSHIP 852 Nature and Formation 852 Duties of Surety 854 Rights of Surety 854 Defenses of Surety and Principal Debtor 855 Ethical Dilemma: What Price Is ‘‘Reasonable’’

in Terms of Repossession? 859

38 Bankruptcy 867 FEDERAL BANKRUPTCY LAW 868 Going Global: What about transnational

bankruptcies? 869 Case Administration—Chapter 3 869 Creditors, the Debtor, and the Estate—

Chapter 5 871 Liquidation—Chapter 7 876 Applying the Law: Bankruptcy 878 Reorganization—Chapter 11 879 Adjustment of Debts of Individuals—

Chapter 13 883 Concept Review: Comparison of Bankruptcy

Proceedings 889 CREDITORS’ RIGHTS AND DEBTORS’ RELIEF

OUTSIDE OF BANKRUPTCY 889 Creditors’ Rights 890 Debtors’ Relief 890 Ethical Dilemma: For a Company Contemplating

Bankruptcy, When Is Disclosure the Best Policy? 892

P A R T I X Regulation of Business 897

39 Securities Regulation 898 THE SECURITIES ACT OF 1933 900 Definition of a Security 900 Registration of Securities 902 Exempt Securities 904 Exempt Transactions for Issuers 904 Exempt Transactions for Nonissuers 908 Concept Review: Exempt Transactions for Issuers

Under the 1933 Act 909 Liability 910 THE SECURITIES EXCHANGE ACT OF 1934 914

x Table of Contents

Disclosure 915 Concept Review: Disclosure Under the 1934 Act 919 Business Law in Action 920 Liability 920 Going Global: What about international securities

regulation? 928 Concept Review: Civil Liability Under the 1933 and

1934 Acts 931 Ethical Dilemma: What Information May a Corporate

Employee Disclose? 932

40 Intellectual Property 937 Trade Secrets 937 Trade Symbols 940 Trade Names 945 Copyrights 945 Patents 950 Going Global: How is intellectual property protected

internationally? 951 Concept Review: Intellectual Property 953 Ethical Dilemma: Who Holds the Copyright on Lecture

Notes? 954

41 Employment Law 960 Labor Law 961 Concept Review: Unfair Labor Practices 962 Employment Discrimination Law 962 Concept Review: Federal Employment Discrimination

Laws 977 Business Law in Action 978 Going Global: Do the antidiscrimination laws apply

outside the United States? 979 Employee Protection 979 Ethical Dilemma: What (Unwritten) Right to

a Job Does an Employee Have? 985

42 Antitrust 992 Sherman Antitrust Act 993 Going Global: Do the antitrust laws apply outside the

United States? 994 Concept Review: Restraints of Trade Under Sherman

Act 1002 Clayton Act 1005 Robinson-Patman Act 1008 Federal Trade Commission Act 1010 Ethical Dilemma: When Is an Agreement

Anticompetitive? 1011

43 Accountants’ Legal Liability 1016 Common Law 1016 Federal Securities Law 1020 Applying the Law: Accountants’ Legal Liability 1023 Concept Review: Accountants’ Liability Under Federal

Securities Law 1024

44 Consumer Protection 1029 State and Federal Consumer Protection Agencies 1030 Consumer Purchases 1035

Concept Review: Consumer Rescission Rights 1037 Consumer Credit Transactions 1037 Business Law in Action 1044 Creditors’ Remedies 1045 Ethical Dilemma: Should Some Be

Protected from High-Pressure Sales? 1048

45 Environmental Law 1054 COMMON LAW ACTIONS FOR

ENVIRONMENTAL DAMAGE 1054 Nuisance 1055 Trespass to Land 1055 Strict Liability for Abnormally Dangerous

Activities 1055 Problems Common to Private Causes of Action 1056 FEDERAL REGULATION OF THE

ENVIRONMENT 1056 The National Environmental Policy Act 1056 The Clean Air Act 1057 The Clean Water Act 1061 Hazardous Substances 1065 International Protection of the Ozone Layer 1070 Concept Review: Major Federal Environmental

Statutes 1071 Ethical Dilemma: Distant Concerns 1072

46 International Business Law 1077 The International Environment 1078 Jurisdiction over Actions of Foreign Governments 1080 Transacting Business Abroad 1083 Business Law in Action 1085 Forms of Multinational Enterprises 1091 Ethical Dilemma: Who May Seek Economic

Shelter Under U.S. Trade Law? 1094

P A R T X Property 1099

47 Introduction to Property, Property Insurance, Bailments, and Documents of Title 1100 INTRODUCTION TO PROPERTY AND PERSONAL

PROPERTY 1101 Kinds of Property 1101 Concept Review: Kinds of Property 1104 Transfer of Title to Personal Property 1105 PROPERTY INSURANCE 1108 Fire and Property Insurance 1108 Nature of Insurance Contracts 1109 Business Law in Action 1110 BAILMENTS AND DOCUMENTS OF TITLE

BAILMENTS 1113 Bailments 1113 Concept Review: Duties in a Bailment 1117

Table of Contents xi

Documents of Title 1118 Ethical Dilemma: Who Is Responsible for the

Operation of Rental Property? 1121

48 Interests in Real Property 1130 Freehold Estates 1130 Leasehold Estates 1132 Concept Review: Freehold Estates 1133 Concurrent Ownership 1139 Nonpossessory Interests 1141 Concept Review: Rights of Concurrent Owners 1142 Applying the Law: Interests in Real Property 1144

49 Transfer and Control of Real Property 1150 TRANSFER OF REAL PROPERTY 1151 Contract of Sale 1151 Deeds 1153 Secured Transactions 1154 Adverse Possession 1156 PUBLIC AND PRIVATE CONTROLS 1156 Zoning 1156 Eminent Domain 1157 Private Restrictions on Land Use 1159 Ethical Dilemma: Where Should Cities House

the Disadvantaged? 1162

50 Trusts and Wills 1168 TRUSTS 1168 Types of Trusts 1169 Creation of Trusts 1171 Concept Review: Allocation of Principal and

Income 1174 Termination of a Trust 1175 DECEDENT’S ESTATES 1175 Wills 1175 Business Law in Action 1180 Intestate Succession 1181 Administration of Estates 1182 Ethical Dilemma: When Should Life Support

Cease? 1182

A P P E N D I C E S

Appendix A The Constitution of the United States of America A-2

Appendix B Uniform Commercial Code (Selected Provisions) B-1

Appendix C Dictionary of Legal Terms C-1

Index I-1

xii Table of Contents

T A B L E O F C A S E S

Cases shown in red are new to this edition.

A A.E. Robinson Oil Co., Inc. v. County Forest Products,

Inc., 638 Alcoa Concrete & Masonry v. Stalker Bros., 266 Aldana v. Colonial Palms Plaza, Inc., 332 Alexander v. FedEx Ground Package System, Inc., 598 Alpert v. 28 Williams St. Corp., 814 Alzado v. Blinder, Robinson & Company, Inc., 705 American Manufacturing Mutual Insurance Company

v. Tison Hog Market, Inc., 856 American Needle, Inc. v. National Football League,

995 Anderson v. McOskar Enterprises, Inc., 273 Any Kind Checks Cashed, Inc. v. Talcott, 530 Arrowhead School District No. 75, Park County,

Montana v. Klyap, 369 Association for Molecular Pathology v. Myriad

Genetics, Inc., 951

B Bagley v. Mt. Bachelor, Inc., 275 Beam v. Stewart, 799 Belden, Inc. v. American Electronic Components, Inc.,

448 Berardi v. Meadowbrook Mall Company, 226 Berg v. Traylor, 287 Bigelow-Sanford, Inc. v. Gunny Corp., 484 Border State Bank of Greenbush v. Bagley Livestock

Exchange, Inc., 836 Borton v. Forest Hills Country Club, 1142 Bouton v. Byers, 193 Brehm v. Eisner, 795 Brentwood Academy v. Tennessee Secondary School

Athletic Association, 77 Brown v. Board of Education of Topeka, 89 Brown v. Entertainment Merchants Association, 84 Bulova Watch Company, Inc. v. K. Hattori & Co., 1092

Burlington Northern & Santa Fe Railway Company v. White, 963

Burningham v. Westgate Resorts, Ltd., 236

C Caldwell v. Bechtel, Inc., 12 Cappo v. Suda, 1161 Carter v. Tokai Financial Services, Inc., 388 Catamount Slate Products, Inc. v. Sheldon, 204 Chapa v. Traciers & Associates, 849 Christy v. Pilkinton, 356 Coastal Leasing Corporation v. T-Bar S Corporation,

489 Cohen v. Mirage Resorts, Inc., 819 Commerce & Industry Insurance Company v. Bayer

Corporation, 397 Conklin Farm v. Leibowitz, 682 Connes v. Molalla Transport System, Inc., 631 Construction Associates, Inc. v. Fargo Water

Equipment Co., 392 Conway v. Cutler Group, Inc., 1152 Cooke v. Fresh Express Foods Corporation, Inc., 822 Cooperative Centrale Raiffeisen-Boerenleenbank B.A.

v. Bailey, 511 Coopers & Lybrand v. Fox, 736 Cox Enterprises, Inc. v. Pension Benefit Guaranty

Corporation, 765

D Dahan v. Weiss, 313 Davis v. Watson Brothers Plumbing, Inc., 554 Denney v. Reppert, 250 Department of Revenue of Kentucky, et al. v. Davis, 79 Detroit Lions, Inc. v. Argovitz, 606 DiLorenzo v. Valve & Primer Corporation, 256 Dixon, Laukitis and Downing v. Busey Bank, 572 Dodge v. Ford Motor Co., 766 Donahue v. Rodd Electrotype Co., Inc., 787 Dunnam v. Burns, 268

xiii

E Eastman Kodak Co. v. Image Technical Services, Inc.,

1001 Ed Nowogroski Insurance, Inc. v. Rucker, 938 Edmonson v. Leesville Concrete Company, Inc., 59 Enea v. The Superior Court of Monterey County, 664 Environmental Protection Agency v. EME Homer City

Generation, L. P., 1058 Ernst & Ernst v. Hochfelder, 1021 Estate of Countryman v. Farmers Coop. Ass’n, 716

F F. Hoffmann-La Roche Ltd v. Empagran S.A., 1086 Faragher v. City of Boca Raton, 971 FCC v. Fox Television Stations, Inc., 105 Federal Ins. Co. v. Winters, 337 Federal Trade Commission v. Cyberspace.com LLC, 1031 Ferrell v. Mikula, 138 First State Bank of Sinai v. Hyland, 296 Fox v. Mountain West Electric, Inc., 190 Frank B. Hall & Co., Inc. v. Buck, 140 Freeman v. Quicken Loans, Inc., 1042 Furlong v. Alpha Chi Omega Sorority, 414

G Gaddy v. Douglass, 610 Galler v. Galler, 780 Greene v. Boddie-Noell Enterprises, Inc., 461

H Hadfield v. Gilchrist, 1114 Hamilton v. Lanning, 886 Harold Lang Jewelers, Inc. v. Johnson, 731 Harris v. Looney, 740 Harris v. Viegelahn, 884 Heinrich v. Titus-Will Sales, Inc., 433 Heritage Bank v. Bruha, 507 Herron v. Barnard, 1102 Hessler v. Crystal Lake Chrysler-Plymouth, Inc., 421 Hochster v. De La Tour, 353 Home Rentals Corp. v. Curtis, 1136 Hospital Corp. of America v. FTC, 1006 Household Credit Services, Inc. v. Pfennig, 1039

I In re KeyTronics, 657 In re L. B. Trucking, Inc., 451

In re Magness, 331 In re The Score Board, Inc., 289 In the Matter of 1545 Ocean Ave., LLC, 718 In the Matter of the Estate of Rowe, 1172 Inter-Tel Technologies, Inc. v. Linn Station Properties,

LLC, 742

J Jasdip Properties SC, LLC v. Estate of Richardson, 196 Jasper v. H. Nizam, Inc., 980 Jenkins v. Eckerd Corporation, 317 Jerman v. Carlisle, McNellie, Rini, Kramer & Ulrich

LPA, 1046

K Kalas v. Cook, 311 Keeney v. Keeney, 1170 Kelo v. City of New London, 1158 Kelso v. Bayer Corporation, 460 Kenco Homes, Inc. v. Williams, 478 Keser v. Chagnon, 293 Kimbrell’s of Sanford, Inc. v. KPS, Inc., 842 King v. VeriFone Holdings, Inc., 782 Kirtsaeng v. John Wiley & Sons, Inc., 947 Klein v. Pyrodyne Corporation, 173 Korzenik v. Supreme Radio, Inc., 528

L Leegin Creative Leather Products, Inc. v. PSKS, Inc., 998 Lefkowitz v. Great Minneapolis Surplus Store, Inc., 206 Leibling, P.C. v. Mellon PSFS (NJ) National

Association, 576 Louisiana v. Hamed, 124 Love v. Hardee’s Food Systems, Inc., 163

M Mackay v. Four Rivers Packing Co., 308 Madison Square Garden Corp., Ill. v. Carnera, 375 Mark Line Industries, Inc. v. Murillo Modular Group,

Ltd., 551 Maroun v. Wyreless Systems, Inc., 232 Martin v. Melland’s Inc., 439 Matrixx Initiatives, Inc. v. Siracusano, 921 Mayo Foundation for Medical Education and Research

v. United States, 97 McDowell Welding & Pipefitting, Inc. v. United States

Gypsum Co., 354

xiv Table of Cases

Merritt v. Craig, 378 Metropolitan Life Insurance Company v. RJR Nabisco,

Inc., 754 Michael Silvestri v. Optus Software, Inc., 348 Midwest Hatchery v. Doorenbos Poultry, 491 Miller v. McDonald’s Corporation, 600 Mims v. Arrow Financial Services, LLC, 51 Mirvish v. Mott, 1106 Montana Food, LLC v. Todosijevic, 712 Moore v. Kitsmiller, 170 Morrison v. National Australia Bank Ltd., 1088 Moulton Cavity & Mold Inc. v. Lyn-Flex Ind., 410 Mountain Peaks Financial Services, Inc. v. Roth-Steffen,

333 Murphy v. BDO Seidman, LLP, 1018

N NationsBank of Virginia, N.A. v. Barnes, 509 Neugebauer v. Neugebauer, 228 New England Rock Services, Inc. v. Empire Paving,

Inc., 251 Nitro-Lift Technologies, L.L.C. v. Howard, 65 Northern Corporation v. Chugach Electrical

Association, 357

O Omnicare, Inc. v. Laborers District Council

Construction Industry Pension Fund, 911 O’Neil v. Crane Co., 458 Osprey L.L.C. v. Kelly-Moore Paint Co., Inc., 216

P Palsgraf v. Long Island Railroad Co., 166 Palumbo v. Nikirk, 175 Parker v. Twentieth Century-Fox Film Corp., 58, 371 Parlato v. Equitable Life Assurance Society of the

United States, 626 Payroll Advance, Inc. v. Yates, 271 People v. Farell, 117 Perez v. Mortgage Bankers Ass’n., 99 Petition of Kinsman Transit Co., 167 Philip Morris USA v. Williams, 134 Pittsley v. Houser, 390 Prestenbach v. Collins, 373 Prine v. Blanton, 1176

R RadLAX Gateway Hotel, LLC v. Amalgamated Bank,

882 Ray v. Alad Corporation, 810 Reed v. King, 233 Republic of Argentina v. NML Capital, Ltd., 1081 Ricci v. Destefano, 968 RNR Investments Limited Partnership v. Peoples First

Community Bank, 678 Robertson v. Jacobs Cattle Co., 685 Robinson v. Durham, 432 Rosewood Care Center, Inc., v. Caterpillar, Inc., 306 Rubin v. Yellow Cab Company, 634 Ryan v. Friesenhahn, 158

S Sackett v. Environmental Protection Agency, 104 Schoenberger v. Chicago Transit Authority, 628 Schreiber v. Burlington Northern, Inc., 929 Securities and Exchange Commission v. Edwards, 901 Seigel v. Merrill Lynch, Pierce, Fenner & Smith, Inc.,

578 Shawnee Telecom Resources, Inc. v. Brown, 816 Sherrod v. Kidd, 208 Soldano v. O’Daniels, 160 South Florida Water Management District v.

Miccosukee Tribe of Indians, 1062 Speelman v. Pascal, 329 State of Qatar v. First American Bank of Virginia, 523 State of South Dakota v. Morse, 121 Steinberg v. Chicago Medical School, 188 Stine v. Stewart, 339 Strougo v. Bassini, 784

T Texaco, Inc. v. Pennzoil, Co., 147 The Hyatt Corporation v. Palm Beach National Bank,

519 Thomas v. Lloyd, 661 Thor Properties v. Willspring Holdings LLC, 212 Toyota Motor Manufacturing, Kentucky, Inc. v.

Williams, 974 Travelers Indemnity Co. v. Stedman, 562 Triffin v. Cigna Insurance Co., 536 Tucker v. Hayford, 1137

Table of Cases xv

U Union Planters Bank, National Association v. Rogers, 580 United States v. Bestfoods, 1068 United States v. E. I. du Pont de Nemours & Co., 1003 United States v. O’Hagan, 925

V Vance v. Ball State University, 965 Vanegas v. American Energy Services, 248

W Waddell v. L.V.R.V. Inc., 416 Wal-Mart Stores, Inc. v. Samara Brothers, Inc., 942

Watson Coatings, Inc. v. American Express Travel Related Services, Inc., 534

Whatley v. Estate of McDougal, 1178 White v. Samsung Electronics, 143 Williamson v. Mazda Motor of America, Inc., 74 Windows, Inc. v. Jordan Panel Systems Corp., 437 Womco, Inc. v. Navistar International Corporation,

454 Wood v. Pavlin, 1140 World-Wide Volkswagen Corp. v. Woodson, 54 Wyler v. Feuer, 708

Z Zelnick v. Adams, 291

xvi Table of Cases

T A B L E O F F I G U R E S

1-1 Law and Morals, 4

1-2 Classification of Law, 4

1-3 Hierarchy of Law, 6

2-1 Kohlberg’s Stages of Moral Development, 19

2-2 The Stakeholder Model, 23

2-3 Pharmakon Employment, 27

2-4 Pharmakon Affirmative Action Program, 28

2-5 Mykon R&D Expenditures, 30

2-6 Global Summary of the AIDS Epidemic, 31

2-7 Regional Statistics for HIV and AIDS End of 2013, 32

2-8 Stock Price of Vulcan, Inc. (note irregular intervals on time axis), 41

2-9 Average Daily Volume of Vulcan, Inc., Stock for Week (in 1,000s), 42

2-10 Purchases of Vulcan Stock by Selected Executives, 42

3-1 Federal Judicial System, 47

3-2 Circuit Courts of the United States, 48

3-3 State Court System, 49

3-4 Federal and State Jurisdiction, 52

3-5 Stare Decisis in the Dual Court System, 53

3-6 Jurisdiction, 56

3-7 Stages in Civil Procedure, 63

4-1 Separation of Powers: Checks and Balances, 76

4-2 Powers of Government, 82

5-1 Limits on Administrative Agencies, 103

7-1 Intent, 136

8-1 Negligence and Negligence Per Se, 158

8-2 Defenses to a Negligence Action, 170

9-1 Law Governing Contracts, 186

9-2 Contractual and Noncontractual Promises, 187

9-3 Validity of Agreements, 188

10-1 Duration of Revocable Offers, 214

10-2 Mutual Assent, 215

12-1 Modification of a Preexisting Contract, 253

12-2 Consideration, 259

14-1 Incapacity: Minors, Nonadjudicated Incompetents, and Intoxicated, 295

15-1 Parol Evidence Rule, 319

17-1 Discharge of Contracts, 359

18-1 Contract Remedies, 377

19-1 Battle of the Forms, 396

20-1 Tender of Performance by the Seller, 410

20-2 Performance by the Buyer, 418

21-1 Void Title, 431

21-2 Voidable Title, 432

21-3 Passage of Risk of Loss in Absence of Breach, 440

24-1 Order to Pay: Draft or Check, 503

24-2 Draft, 503

24-3 Check, 503

24-4 Promise to Pay: Promissory Note or Certificate of Deposit, 504

24-5 Note, 504

24-6 Certificate of Deposit, 504

25-1 Bearer Paper, 518

25-2 Negotiation of Bearer and Order Paper, 519

25-3 Stolen Order Paper, 519

25-4 Placement of Indorsement, 526

25-5 Rights of Transferees, 528

25-6 Effects of Alterations, 539

25-7 Alteration, 540

25-8 Availability of Defenses Against Holders and Holders in Due Course, 541

25-9 Rights of Holder in Due Course Under the Federal Trade Commission Rule, 541

26-1 Liability on Transfer, 561

xvii

26-2 Liability Based on Warranty, 562

27-1 Bank Collections, 571

27-2 Credit Transaction, 587

28-1 Duties of Principal and Agent, 607

29-1 Contract Liability of Disclosed Principal, 621

29-2 Contract Liability of Unidentified Principal, 622

29-3 Contract Liability of Undisclosed Principal, 623

29-4 Tort Liability, 630

30-1 Business Entities, 649

30-2 Tests for Existence of a Partnership, 657

31-1 Contract Liability, 676

31-2 Tort Liability, 681

33-1 Promoters’ Preincorporation Contracts Made in the Corporation’s Name, 735

34-1 Issuance of Shares, 759

34-2 Key Concepts in Legal Restrictions upon Distributions, 763

35-1 Management Structure of Corporations: The Statutory Model, 776

35-2 Management Structure of Typical Closely Held Corporation, 776

35-3 Management Structure of Typical Publicly Held Corporation, 776

35-4 Shareholder Suits, 786

36-1 Purchase of Shares, 812

37-1 Fundamental Rights of Secured Party and Debtor, 834

37-2 Suretyship Relationship, 852

37-3 Assumption of Mortgage, 853

37-4 Defenses of Surety and Principal Debtor, 855

38-1 Collection and Distribution of the Debtor’s Estate, 879

39-1 Registration and Exemptions Under the 1933 Act, 905

39-2 Registration and Liability Provisions of the 1933 Act, 914

39-3 Applicability of the 1934 Act, 915

39-4 Parties Forbidden to Trade on Inside Information, 924

41-1 Charges Filed with the EEOC in 2008–2014, 978

42-1 Sherman Act Violations Yielding a Corporate Fine of $300 Million or More, 993

42-2 Meeting Competition Defense, 1010

43-1 Accountants’ Liability to Third Parties for Negligent Misrepresentation, 1018

44-1 Magnuson-Moss Warranty Act, 1036

48-1 Assignment Compared with Sublease, 1134

49-1 Fundamental Rights of Mortgagor and Mortgagee, 1155

49-2 Eminent Domain, 1160

50-1 Trusts, 1169

50-2 Per Stirpes and Per Capita, 1181

xviii Table of Figures

P R E F A C E

THE TRADITION CONTINUES The twelfth edition of Business Law and the Regulation of Business continues the tradition of accuracy, com- prehensiveness, and authoritativeness associated with its earlier editions. This text covers its subject material in a succinct, nontechnical but authoritative manner, and provides depth sufficient to ensure easy compre- hension by today’s students.

Certified Public Accountant Preparation This text is designed for use in business law and legal envi- ronment of business courses generally offered in univer- sities, colleges, and schools of business and management. Because of its broad and deep coverage, this text may be readily adapted to specially designed courses in business law or the legal environment of business by assigning and emphasizing different combinations of chapters.

Furthermore, this text covers the following parts of the CPA Exam: (1) the legal responsibilities and liabil- ities of accountants section and (2) the corporate gover- nance portion of the business environment and concepts section. See the inside back cover of this text for a listing of the CPA Exam topics covered in this text as well as the chapters covering each topic.

Uniform CPA Examination Content Specifications The American Institute of CPAs (AICPA) Board of Examiners has approved and adopted content specifica- tion outlines (CSOs) for the four sections of the new computer-based Uniform CPA Examination: Auditing and Attestation, Financial Accounting and Reporting, Regulation, and Business Environment and Concepts. As updated, effective January 1, 2016, the CSOs include the following topics, which are covered in this textbook:

Regulation Section I. Ethics, Professional, and Legal Responsibilities

A. Legal Duties and Responsibilities [of Accountants] 1. Common law duties and liability to clients

and third parties 2. Federal statutory liability 3. Privileged communications, confidentiality, and

privacy acts II. Business Law

A. Agency 1. Formation and termination 2. Authority of agents and principals 3. Duties and liabilities of agents and principals

B. Contracts 1. Formation 2. Performance 3. Third-party assignments 4. Discharge, breach, and remedies

C. Uniform Commercial Code 1. Sales contracts 2. Negotiable instruments 3. Secured transactions 4. Documents of title and title transfer

D. Debtor-Creditor Relationships 1. Rights, duties, and liabilities of debtors, cred-

itors, and guarantors 2. Bankruptcy and insolvency

E. Government Regulation of Business 1. Federal securities regulation 2. Other federal laws and regulations (antitrust,

copyright, patents, labor, and employment) F. Business Structure (Selection of a Business Entity)

1. Advantages, disadvantages, implications, and constraints

2. Formation, operation, and termination 3. Financial structure, capitalization, profit and

loss allocation, and distributions 4. Rights, duties, legal obligations, and authority

of owners and management

xix

Business Environment and Concepts Section I. Corporate Governance

A. Rights, Duties, Responsibilities, Authority, and Ethics of the Board of Directors, Officers, and Other Employees

For more information, visit www.cpa-exam.org.

Business Ethics Emphasis The Chapter 2 Business Ethics case studies require stu- dents to make the value trade-offs that confront busi- nesspeople in their professional lives. (We gratefully acknowledge the assistance of James Leis in writing the Mykon’s Dilemma case.) Two-thirds of the chapters also contain an Ethical Dilemma, which presents a manage- rial situation involving ethical issues. A series of ques- tions leads students to explore the ethical dimensions of each situation. We wish to acknowledge and thank the following professors for their contributions in preparing the Ethical Dilemmas: Sandra K. Miller, professor of accounting, taxation, and business law, Widener Univer- sity, and Gregory P. Cermignano, associate professor of accounting and business law, Widener University. In addition, to provide further application of ethics in dif- ferent business contexts, an ethics question follows many cases. These questions are designed to encourage stu- dents to consider the ethical dimensions of the facts in the case or of the legal issue invoked by the facts.

NEW TO THIS EDITION • Going Global. A Going Global feature has been

added to fifteen chapters (Chapters 1, 3, 6, 9, 15, 19, 20, 27, 30, 34, 38, 39, 40, 41, and 42), thus integrat- ing international business law content throughout the text. This feature enables students to consider the international aspects of legal issues as they are cov- ered. The International Business Law chapter (Chap- ter 46) has been retained in its entirety.

• Up-to-Date and Expanded Coverage. The 2012 amendments to Uniform Commercial Code (UCC) Ar- ticle 4A has been added to Chapter 27. Coverage of limited liability companies has been updated and expanded in Chapter 32. Coverage of benefit corpora- tions has been added in Chapter 33. Coverage of sure- tyship in Chapter 37 has been updated and expanded. The Employment Law chapter (Chapter 41) covers the Genetic Information Nondiscrimination Act. The chapter on Securities Regulation (Chapter 39) covers the U.S. Securities and Exchange Commission’s new

Regulation A and new disclosure rules clarifying how companies can use social media to disseminate infor- mation. The Intellectual Property chapter (Chapter 40) includes the changes made by the Foreign and Economic Espionage Penalty Enhancement Act of 2012 to the Economic Espionage Act of 1996. The Environmental Law chapter (Chapter 45) includes coverage of the EPA’s regulation of greenhouse gases. The International Business Law chapter (Chapter 46) covers the United Nations Convention on the Law of the Sea (UNCLOS).

• New Cases. Twenty-nine legal cases are new to this edition. (See Table of Cases.) The new cases include recent U.S. Supreme Court decisions such as Nitro-Lift Technologies, L.L.C. v. Howard; Perez v. Mortgage Bankers Ass’n.; Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund; Harris v. Viegelahn; Association for Molecular Pathology v. Myriad Genetics, Inc.; Vance v. Ball State University; Environmental Protection Agency v. EME Homer City Generation, L. P.; and Republic of Argentina v. NML Capital, Ltd.

• Coverage of Recent U.S. Supreme Court Decisions. The Constitutional Law chapter (Chapter 4) discusses recent U.S. Supreme Court’s decisions in the cases challenging the constitutionality of (1) the Defense of Marriage Act, (2) a federal statute restricting how much money an individual donor may contribute in total to all candidates or committees during a politi- cal cycle, (3) Michigan’s constitutional amendment banning affirmative action in admissions to the state’s public universities, and (4) states’ refusal to license a marriage between two people of the same sex and to recognize a marriage between two people of the same sex when their marriage was lawfully li- censed and performed out of state. The Administra- tive Law chapter (Chapter 5) discusses the Supreme Court case making the Patient Protection and Afford- able Care Act’s tax credits available in those states that have a Federal Exchange. The Employment Law chapter (Chapter 41) covers the Supreme Court case holding that in disparate-treatment claims, an employer may not make an applicant’s religious prac- tice, confirmed or otherwise, a factor in employment decisions.

• Coverage of Restatement of Restitution. Chapters 9, 11, 13, 14, 15, 17, 18, and 50 cover the new Restate- ment (Third) of Restitution and Unjust Enrichment.

• Additional End-of-Chapter Question and Case Problems. Almost all of the chapters include one or more new questions and/or case problems.

xx Preface

KEY FEATURES

Excerpted Cases From our long classroom experience, we are of the opin- ion that fundamental legal principles can be learned more effectively from text and case materials having at least a degree of human interest. Accordingly, we have included a large number of recent cases, as well as earlier land- mark cases. All of the cases have the facts and decisions summarized for clarity and the opinions edited to pre- serve the language of the court. Each case is followed by an interpretation, which explains the significance of the case and how it relates to the textual material.

Case Critical Thinking Questions Each case is also followed by a critical thinking ques- tion to encourage students to examine the legal policy or reasoning behind the legal principle of the case or to apply it in a real-world context.

Ample Illustrations We have incorporated more than 220 classroom-tested figures, tables, diagrams, concept reviews, and chapter summaries. The figures, tables, and diagrams help stu- dents conceptualize the many abstract concepts in the law. The Concept Reviews not only summarize prior discussions but also indicate relationships between dif- ferent legal rules. Moreover, each chapter ends with a summary in the form of an annotated outline of the entire chapter, including key terms.

Applying the Law In a number of chapters, we have included a feature that provides a systematic legal analysis of a single con- cept presented in that chapter. It begins with the facts of a hypothetical case, followed by an identification of the broad legal issue presented by those facts. We then state the rule—or applicable legal principles, including definitions, which aid in resolving the legal issue—and apply it to the facts. Finally we state a legal conclusion or decision in the case. We wish to acknowledge and thank Professor Ann Olaz�abal, University of Miami, for her contribution in preparing this feature.

Business Law in Action A number of chapters include a scenario that illustrates the application of legal concepts in the chapter to busi- ness situations that commonly arise. We wish to acknowledge and thank Professor Ann Olaz�abal, Uni-

versity of Miami, for her contribution in preparing this feature.

Practical Advice Each chapter contains a number of statements that illustrate how legal concepts covered in that chapter can be applied to common business situations.

Chapter Outcomes Each chapter begins with a list of learning objectives for students.

Enhanced Readability To improve readability throughout the text, all unnecessary “legalese” has been eliminated, while nec- essary legal terms have been printed in boldface and clearly defined, explained, and illustrated. Each chapter is carefully organized with sufficient levels of subordi- nation to enhance the accessibility of the material. The text is enriched by numerous illustrative hypothetical and case examples that help students relate material to real-life experiences.

Classroom-Proven End-of- Chapter Materials Classroom-proven questions and case problems appear at the end of the chapters to test students’ understand- ing of major concepts. We have used the questions (based on hypothetical situations) and the case prob- lems (taken from reported court decisions) in our own classrooms and consider them excellent stimulants to classroom discussion. Students, in turn, have found the questions and case problems helpful in enabling them to apply the basic rules of law to factual situations.

Taking Sides Each chapter—except Chapters 1 and 2—has an end-of- chapter feature that requires students to apply critical thinking skills to a case-based fact situation. Students are asked to identify the relevant legal rules and develop arguments for both parties to the dispute. In addition, students are asked to explain how they think a court would resolve the dispute.

Pedagogical Benefits Classroom use and study of this book should provide students with the following benefits and skills:

1. Perception and appreciation of the scope, extent, and importance of the law.

Preface xxi

2. Basic knowledge of the fundamental concepts, principles, and rules of law that apply to business transactions.

3. Knowledge of the function and operation of courts and government administrative agencies.

4. Ability to recognize the potential legal problems that may arise in a doubtful or complicated situation and the necessity of consulting a lawyer and obtaining competent professional legal advice.

5. Development of analytical skills and reasoning power.

ADDITIONAL COURSE TOOLS

MindTap New for Business Law and the Regulation of Business, Twelfth Edition, MindTap is a personalized teaching ex- perience with relevant assignments that guide students to analyze, apply, and improve thinking, allowing you to measure skills and outcomes with ease. Personalized teaching becomes yours through a pre-built Learning Path designed with key student objectives and your syllabus in mind. The customizable online course allows you to con- trol what students see and when they see it. Relevant read- ings, multimedia, and activities within the learning path intuitively guide students up the levels of learning to (1) Prepare, (2) Engage, (3) Apply and (4) Analyze business law content. These activities are organized in a logical pro- gression to help elevate learning, promote critical thinking skills and produce better outcomes. Analytics and reports provide a snapshot of class progress, time in course, engagement and completion rates.

Instructors can personalize the experience by custom- izing authoritative Cengage Learning content and learn- ing tools. MindTap offers instructors the ability to add their own content in the Learning Path with apps that integrate into the MindTap framework seamlessly with Learning Management Systems (LMS).

Instructor’s Resources Access instructor resources by going to login.cengage. com, logging in with your faculty account username and password, and searching ISBN 9781305509559 to add instructor resources to your account “Bookshelf.”

• The Instructor’s Manual prepared by Richard A. Mann, Barry S. Roberts, and Beth D. Woods con- tains chapter outlines; teaching notes; answers to the Questions and Case Problems, and Taking Sides; and part openers that provide suggested research and outside activities for students.

• PowerPointV R

Slides clarify course content and guide student note-taking during lectures.

• The Test Bank contains thousands of true/false, multiple-choice, and essay questions. The questions vary in levels of difficulty and meet a full range of tagging requirements so that instructors can tailor their testing to meet their specific needs.

• Cengage Learning Testing Powered by Cognero is a flexible, online system that allows you to:

• author, edit, and manage test bank content from multiple Cengage Learning solutions

• create multiple test versions in an instant

• deliver tests from your LMS, your classroom or wherever you want

Business Law Digital Video Library Featuring more than ninety video clips that spark class discussion and clarify core legal principles, the Business Law Digital Video Library is organized into five series: Legal Conflicts in Business (includes specific modern business and e-commerce scenarios); Ask the Instructor (presents straightforward explanations of concepts for student review); Drama of the Law (features classic business scenarios that spark classroom participation); Real-World Legal (presents legal scenarios encountered in real businesses); and Business Ethics in Action (presents ethical dilemmas in business scenarios). For more information about the Digital Video Library, visit www.cengage.com/blaw/dvl.

ACKNOWLEDGMENTS We express our gratitude to the following professors for their helpful comments on this edition of the book:

Larry Cohen, Oakton Community College

Larry DiMatteo, University of Florida

J. Royce Fichtner, Drake University

Shara Galloway, Maryville College

Matthew S. Geimer, University of Wisconsin–Green Bay

Kyle Kaplan, Carson-Newman University

Dianne McDonald, Bucknell University

Jeff Nielsen, University of Utah

Virginia Rich, Caldwell College

Harold Silverman, Bridgewater State University

Samantha Sindles, Oakton Community College

xxii Preface

Roscoe B. Stephenson, III, Virginia Military Institute

Dale Thompson, University of St. Thomas

Patricia Wall, Middle Tennessee State University

We also are grateful to those who provided us with comments regarding earlier editions of the book:

William Dennis Ames, Indiana University–Purdue; Denise Bartles, Missouri Western State College; Joseph Boucher, University of Wisconsin–Madison; J. Lenora Bresler, University of South Florida; Susan Cabral, Salisbury State University; Elizabeth A. Cameron, Alma College; Harriet Caplan, Fort Hays State University; Ronald R. Caplette, Western Piedmont Community College; Theresa Clark, Methodist College; David Cooper, Fullerton College; Patricia DeFrain, Glendale College; James Doering, University of Wisconsin–Green Bay; Bruce Farrel Dorn, Oakton Community College; Kurt E. Erickson, Southwestern Michigan College; Vincent A. Errante, University of North Dakota; J. Royce Fichtner, Drake University; Robert A. Fidrych, University of Wisconsin–Platteville; Robert Freer, The Citadel; Steven J. Green, University of California– Berkeley; Walter Griggs, Virginia Commonwealth Uni- versity; Gary A. Hanson, Pepperdine University; Bruce L. Harms, University of Wisconsin–Madison; Charles Hartmann, Wright State University; Gregory T. Hinton, Fairmont State College; Clay Hipp, New Mexico State University; Georgia L. Holmes, Mankato State Univer- sity; Robert J. Hotopp, Indiana University–Southeast; Neely S. Inlow, Lynchburg College; Uldis E. Inveiss, Carroll College; Susan S. Jarvis, Pan American Univer- sity; Susan Glatthorn Johnson, University of South Florida; Catherine Jones-Rikkers, Grand Valley State University; John R. Jozwiak, Loyola University of Chi- cago; Jack E. Karns, East Carolina University; Robert H. Kieserman, Philadelphia College of Textiles and Sci- ence; Karl H. Kline, Lafayette College; Frank J. Kolb, Jr., Quinnipiac University; Ruth B. Kraft, Audrey Cohen College; Richard G. Kunkel, University of St. Thomas; Logan Langwith, College of St. Thomas; Vonda Laughlin, Carson-Newman College; Anne Lawton, Miami University; Michael Magasin, Pepper- dine University; Stephen M. Maple, University of India- napolis; Keith A. Maxwell, University of Puget Sound;

Douglas E. McClelland, Montana State University; Brad McDonald, Northern Illinois University; Sharlene McEvoy, Fairfield University; Russell A. Meade, Vir- ginia Tidewater Community College; Radlyn Mendoza, Old Dominion University; Debbie L. Mescon, Salisbury State University; D. Lynn Morison, Michigan State Uni- versity; Gregory C. Mosier, Oklahoma State University; Megan Mowrey, Clemson University; Darwin H. Mueller, Tacoma Community College; Lee J. Ness, University of North Dakota; Ann M. Olaz�abal, Univer- sity of Miami; Robert L. Peace, North Carolina State University; Neal A. Phillips, University of Delaware; James L. Porter, University of New Mexico; Frank Pri- miani, Green River Community College; Michael Rainey, Pepperdine University; Daniel L. Reynolds, Mid- dle Tennessee State University; Rhonda Ross, Saginaw Valley State University; Ellen Blumberg Rubert, College of Lake County; Linda B. Samuels, George Mason Uni- versity; Kurt Saunders, California State University–Nor- thridge; Pamella A. Seay, Edison Community College; Harold Silverman, Bridgewater State College; Kirke Snyder, Regis University; Beverly Stanis, Oakton Commu- nity College; Dorothy L. Steele, Montclair State College; Stanley E. Stettz, Lafayette College; Rene Thomas, Holyoke Community College; Edward L. Welsh, Jr., Mesa Commu- nity College; John T. Wendt, University of St. Thomas; Keith E. Werner, Wesleyan College; Scott White, University of Wisconsin–Platteville; John G. Williams, Northwestern State University; Raymond Wyrsch, Catholic University; Joseph Zavaglia, Jr., Brookdale Community College; and Raymond C. Zumoff, Camden County College.

We express our thanks and appreciation to Debra Corvey for administrative assistance. For their support, we extend our thanks to Karlene Fogelin Knebel and Joanne Erwick Roberts. And we are grateful to Vicky True-Baker, Sarah Blasco, and Ann Borman of Cengage Learning for their invaluable assistance and cooperation in connection with the preparation of this text.

This text is dedicated also to our children Lilli-Marie Knebel Mann, Justin Erwick Roberts, and Matthew Charles Roberts.

Richard A. Mann

Barry S. Roberts

Preface xxiii

PART I I N T R O D U C T I O N

T O L A W A N D E T H I C S

CISG

CHAPTER 1 Introduction to Law

CHAPTER 2 Business Ethics

C H A P T E R 1

INTRODUCTION TO LAW

The life of the law has not been logic; it has been experience. OLIVER WENDELL HOLMES, THE COMMON LAW (1881)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Identify and describe the basic functions of law.

2. Distinguish between (a) law and justice and (b) law and morals.

3. Distinguish between (a) substantive and procedural law, (b) public and private law, and (c) civil and criminal law.

4. Identify and describe the sources of law.

5. Explain the principle of stare decisis.

L aw concerns the relations between individuals as such relations affect the social and economic order. It is both the product of civilization and the means

by which civilization is maintained. As such, law reflects the social, economic, political, religious, and moral phi- losophy of society.

Law is an instrument of social control. Its function is to regulate, within certain limitations, human conduct and human relations. Accordingly, the laws of the United States affect the life of every U.S. citizen. At the same time, the laws of each state influence the life of each of its citizens and the lives of many noncitizens as well. The rights and duties of all individuals, as well as the safety and security of all people and their property, depend on the law.

The law is pervasive. It permits, forbids, or regulates practically every human activity and affects all persons

either directly or indirectly. Law is, in part, prohibitory: certain acts must not be committed. For example, one must not steal; one must not murder. Law is also partly mandatory: certain acts must be done or be done in a prescribed way. Thus, taxes must be paid; corporations must make and file certain reports with state or federal authorities; traffic must keep to the right. Finally, law is permissive: certain acts may be done. For instance, one may or may not enter into a contract; one may or may not dispose of one’s estate by will.

Because the areas of law are so highly interrelated, you will find it helpful to begin the study of the differ- ent areas of business law by first considering the na- ture, classification, and sources of law. This will enable you not only to understand each specific area of law better but also to understand its relationship to other areas of law.

2

NATURE OF LAW [1-1] The law has evolved slowly, and it will continue to change. It is not a pure science based on unchanging and universal truths. Rather, it results from a continu- ous striving to develop a workable set of rules that bal- ance the individual and group rights of a society.

Definition of Law [1-1a] Scholars and citizens in general often ask a fundamen- tal but difficult question regarding law: what is it? Numerous philosophers and jurists (legal scholars) have attempted to define it. American jurists and Supreme Court Justices Oliver Wendell Holmes and Benjamin Cardozo defined law as predictions of the way in which a court will decide specific legal questions. The English jurist William Blackstone, on the other hand, defined law as “a rule of civil conduct prescribed by the supreme power in a state, commanding what is right, and prohibiting what is wrong.”

Because of its great complexity, many legal scholars have attempted to explain the law by outlining its essential characteristics. Roscoe Pound, a distinguished American jurist and former dean of the Harvard Law School, described law as having multiple meanings:

First we may mean the legal order, that is, the r�egime of ordering human activities and relations through systematic application of the force of politically organized society, or through social pressure in such a society backed by such force. We use the term “law” in this sense when we speak of “respect for law” or for the “end of law.”

Second we may mean the aggregate of laws or legal precepts; the body of authoritative grounds of judicial and administrative action established in such a society. We may mean the body of received and established materials on which judicial and administrative determinations pro- ceed. We use the term in this sense when we speak of “systems of law” or of “justice according to law.”

Third we may mean what Justice Cardozo has happily styled “the judicial process.” We may mean the process of determining controversies, whether as it actually takes place, or as the public, the jurists, and the practitioners in the courts hold it ought to take place.

Functions of Law [1-1b] At a general level the primary function of law is to maintain stability in the social, political, and economic system while simultaneously permitting change. The law accomplishes this basic function by performing a number of specific functions, among them dispute

resolution, protection of property, and preservation of the state.

Disputes, which arise inevitably in any modern soci- ety, may involve criminal matters, such as theft, or non- criminal matters, such as an automobile accident. Because disputes threaten social stability, the law has established an elaborate and evolving set of rules to resolve them. In addition, the legal system has instituted societal remedies, usually administered by the courts, in place of private remedies such as revenge.

A second crucial function of law is to protect the private ownership of property and to assist in the mak- ing of voluntary agreements (called contracts) regarding exchanges of property and services. Accordingly, a sig- nificant portion of law, as well as this text, involves property and its disposition, including the law of prop- erty, contracts, sales, commercial paper, and business associations.

A third essential function of the law is preservation of the state. In our system, law ensures that changes in political structure and leadership are brought about by political action, such as elections, legislation, and refer- enda, rather than by revolution, sedition, and rebellion.

Law and Morals [1-1c] Although moral concepts greatly influence the law, morals and law are not the same. You might think of them as two intersecting circles (see Figure 1-1). The area common to both circles includes the vast body of ideas that are both moral and legal. For instance, “Thou shall not kill” and “Thou shall not steal” are both moral precepts and legal constraints.

On the other hand, the part of the legal circle that does not intersect the morality circle includes many rules of law that are completely unrelated to morals, such as the rules stating that you must drive on the right side of the road and that you must register before you can vote. Likewise, the part of the morality circle that does not intersect the legal circle includes moral precepts not enforced by legal sanctions, such as the idea that you should not silently stand by and watch a blind man walk off a cliff or that you should provide food to a starving child.

Law and Justice [1-1d] Law and justice represent separate and distinct con- cepts. Without law, however, there can be no justice. Although defining justice is at least as difficult as defin- ing law, justice generally may be defined as the fair, equitable, and impartial treatment of the competing interests and desires of individuals and groups with due regard for the common good.

Chapter 1 Introduction to Law 3

On the other hand, law is no guarantee of justice. Some of history’s most monstrous acts have been com- mitted pursuant to “law.” Examples include the actions of Nazi Germany during the 1930s and 1940s and the actions of the South African government under apart- heid from 1948 until 1994. Totalitarian societies often have shaped formal legal systems around the atrocities they have sanctioned.

CLASSIFICATION OF LAW [1-2] Because the subject is vast, classifying the law into cate- gories is helpful. Though a number of categories are possible, the most useful ones are (1) substantive and procedural, (2) public and private, and (3) civil and

criminal. See Figure 1-2, which illustrates a classifica- tion of law.

Basic to understanding these classifications are the terms right and duty. A right is the capacity of a per- son, with the aid of the law, to require another person or persons to perform, or to refrain from performing, a certain act. Thus, if Alice sells and delivers goods to Bob for the agreed price of $500 payable at a certain date, Alice is capable, with the aid of the courts, of enforcing the payment by Bob of the $500. A duty is the obligation the law imposes upon a person to per- form, or to refrain from performing, a certain act. Duty and right are correlatives: no right can rest upon one person without a corresponding duty resting upon some other person, or in some cases upon all other persons.

FIGURE 1-2 Classification of Law

Substantive Law

Procedural Law

Constitutional Law Criminal Law Administrative Law

Torts Contracts Sales Commercial Paper Agency Partnerships Corporations Property

Public Law

Private LawLaw

FIGURE 1-1 Law and Morals

“Thou shall not kill”

Law “You must drive on the right side

of the road”

Morals “You should not

silently stand by and watch a blind man

walk off a cliff”

4 Introduction to Law and Ethics Part I

Substantive and Procedural Law [1-2a] Substantive law creates, defines, and regulates legal rights and duties. Thus, the rules of contract law that determine a binding contract are rules of substantive law. On the other hand, procedural law sets forth the rules for enforcing those rights that exist by reason of the substantive law. Thus, procedural law defines the method by which to obtain a remedy in court.

Public and Private Law [1-2b] Public law is the branch of substantive law that deals with the government’s rights and powers and its rela- tionship to individuals or groups. Public law consists of constitutional, administrative, and criminal law. Private law is that part of substantive law governing individu- als and legal entities (such as corporations) in their rela- tionships with one another. Business law is primarily private law.

Civil and Criminal Law [1-2c] The civil law defines duties, the violation of which con- stitutes a wrong against the party injured by the viola- tion. In contrast, the criminal law establishes duties, the violation of which is a wrong against the whole commu- nity. Civil law is a part of private law, whereas criminal law is a part of public law. (The term civil law should be distinguished from the concept of a civil law system, which is discussed later in this chapter.) In a civil action the injured party sues to recover compensation for the damage and injury sustained as a result of the defend- ant’s wrongful conduct. The party bringing a civil action

(the plaintiff) has the burden of proof, which the plain- tiff must sustain by a preponderance (greater weight) of the evidence. The purpose of the civil law is to compen- sate the injured party, not, as in the case of criminal law, to punish the wrongdoer. The principal forms of relief the civil law affords are a judgment for money damages and a decree ordering the defendant to perform a specified act or to desist from specified conduct.

A crime is any act prohibited or omission required by public law in the interest of protecting the public and made punishable by the government in a judicial pro- ceeding brought (prosecuted) by it. The government must prove criminal guilt beyond a reasonable doubt, which is a significantly higher burden of proof than that required in a civil action. Crimes are prohibited and punished on the grounds of public policy, which may include the safe- guarding of government, human life, or private property. Additional purposes of criminal law include deterrence and rehabilitation. See Concept Review 1-1 for a com- parison of civil and criminal law.

SOURCES OF LAW [1-3] The sources of law in the U.S. legal system are the fed- eral and state constitutions, federal treaties, interstate compacts, federal and state statutes and executive orders, the ordinances of countless local municipal gov- ernments, the rules and regulations of federal and state administrative agencies, and an ever-increasing volume of reported federal and state court decisions.

The supreme law of the land is the U.S. Constitution, which provides in turn that federal statutes and treaties shall be paramount to state constitutions and statutes.

CONCEPT REVIEW 1-1 C O M P A R I S O N O F C I V I L A N D C R I M I N A L L A W

Civil Law Criminal Law

Commencement of Action Aggrieved individual (plaintiff) sues State or federal government prosecutes

Purpose Compensation Deterrence

Punishment Deterrence Rehabilitation Preservation of peace

Burden of Proof Preponderance of the evidence Beyond a reasonable doubt

Principal Sanctions Monetary damages Equitable remedies

Capital punishment Imprisonment Fines

Chapter 1 Introduction to Law 5

Federal legislation is of great significance as a source of law. Other federal actions having the force of law are executive orders by the President and rules and regula- tions set by federal administrative officials, agencies, and commissions. The federal courts also contribute consid- erably to the body of law in the United States.

The same pattern exists in every state. The para- mount law of each state is contained in its written con- stitution. (Although a state constitution cannot deprive citizens of federal constitutional rights, it can guarantee rights beyond those provided in the U.S. Constitution.) State constitutions tend to be more specific than the U.S. Constitution and, generally, have been amended more frequently. Subordinate to the state constitution are the statutes enacted by the state’s legislature and

the case law developed by its judiciary. Likewise, rules and regulations of state administrative agencies have the force of law, as do executive orders issued by the governors of most states. In addition, cities, towns, and villages have limited legislative powers to pass ordinan- ces and resolutions within their respective municipal areas. See Figure 1-3, which illustrates this hierarchy.

Constitutional Law [1-3a] A constitution—the fundamental law of a particular level of government—establishes the governmental structure and allocates power among governmental levels, thereby defining political relationships. One of the fundamental principles on which our government is founded is that of

FIGURE 1-3 Hierarchy of Law

Treaties Federal Statutes

Federal Administrative Law

Federal Common Law

State Constitution

State Statutes

State Administrative Law

State Common Law

U.S. Constitution

6 Introduction to Law and Ethics Part I

separation of powers. As incorporated into the U.S. Con- stitution, this means that government consists of three dis- tinct and independent branches—the federal judiciary, the Congress, and the executive branch.

A constitution also restricts the powers of government and specifies the rights and liberties of the people. For example, the Constitution of the United States not only specifically states what rights and authority are vested in the national government but also specifically enumerates certain rights and liberties of the people. Moreover, the Ninth Amendment to the U.S. Constitution makes it clear that this enumeration of rights does not in any way deny or limit other rights that the people retain.

All other law in the United States is subordinate to the federal Constitution. No law, federal or state, is valid if it violates the federal Constitution. Under the principle of judicial review, the Supreme Court of the United States determines the constitutionality of all laws.

Judicial Law [1-3b] The U.S. legal system, a common law system like the sys- tem first developed in England, relies heavily on the judi- ciary as a source of law and on the adversary system for settling disputes. In an adversary system the parties, not the court, must initiate and conduct litigation. This approach is based on the belief that the truth is more likely to emerge from the investigation and presentation of evidence by two opposing parties, both motivated by self-interest, than from judicial investigation motivated only by official duty. In addition to the United States and England, the common law system is used in other Eng- lish-speaking countries, including Canada and Australia.

In distinct contrast to the common law system are civil law systems, which are based on Roman law. Civil law systems depend on comprehensive legislative enact- ments (called codes) and an inquisitorial system of determining disputes. In the inquisitorial system, the ju- diciary initiates litigation, investigates pertinent facts, and conducts the presentation of evidence. The civil law system prevails in most of Europe, Scotland, the state of Louisiana, the province of Quebec, Latin Amer- ica, and parts of Africa and Asia.

Common Law The courts in common law systems have developed a body of law that serves as precedent for determining later controversies. In this sense, common law, also called case law or judge-made law, is distin- guished from other sources of law, such as legislation and administrative rulings.

To evolve in a stable and predictable manner, the com- mon law has developed by application of stare decisis

(“to stand by the decisions”). Under the principle of stare decisis, courts adhere to and rely on rules of law that they or superior courts relied on and applied in prior sim- ilar decisions. Judicial decisions thus have two uses: (1) to determine with finality the case currently being decided and (2) to indicate how the court will decide similar cases in the future. Stare decisis does not, however, preclude courts from correcting erroneous decisions or from choos- ing among conflicting precedents. Thus, the doctrine allows sufficient flexibility for the common law to change. The strength of the common law is its ability to adapt to change without losing its sense of direction.

Equity As the common law developed in England, it became overly rigid and beset with technicalities. As a consequence, in many cases no remedies were provided because the judges insisted that a claim must fall within one of the recognized forms of action. Moreover, courts of common law could provide only limited rem- edies; the principal type of relief obtainable was a mon- etary judgment. Consequently, individuals who could not obtain adequate relief from monetary awards began to petition the king directly for justice. He, in turn, came to delegate these petitions to his chancellor.

Gradually, there evolved what was in effect a new and supplementary system of needed judicial relief for those who could not receive adequate remedies through the common law. This new system, called equity, was administered by a court of chancery presided over by the chancellor. The chancellor, deciding cases on “equity and good conscience,” regularly provided relief where common law judges had refused to act or where the remedy at law was inadequate. Thus, there grew up, side by side, two systems of law administered by different tri- bunals, the common law courts and the courts of equity.

An important difference between common law and eq- uity is that the chancellor could issue a decree, or order, compelling a defendant to do, or refrain from doing, a specified act. A defendant who did not comply with this order could be held in contempt of court and punished by fine or imprisonment. This power of compulsion avail- able in a court of equity opened the door to many needed remedies not available in a court of common law.

Courts of equity in some cases recognized rights that were enforceable at common law, but they provided more effective remedies. For example, in a court of eq- uity, for breach of a land contract the buyer could obtain a decree of specific performance commanding the defendant seller to perform his part of the contract by transferring title to the land. Another powerful and effective remedy available only in the courts of equity was the injunction, a court order requiring a party to

Chapter 1 Introduction to Law 7

do or refrain from doing a specified act. Another rem- edy not available elsewhere was reformation, where, upon the ground of mutual mistake, an action could be brought to reform or change the language of a written agreement to conform to the actual intention of the contracting parties. An action for rescission of a con- tract, which allowed a party to invalidate a contract under certain circumstances, was another remedy.

Although courts of equity provided remedies not available in courts of law, they granted such remedies only at their discretion, not as a matter of right. This discretion was exercised according to the general legal principles, or maxims, formulated by equity courts over the years.

In nearly every jurisdiction in the United States, courts of common law and equity have merged into a single court that administers both systems of law. Ves- tiges of the old division remain, however. For example, the right to a trial by jury applies only to actions at law, but not, under federal law and in almost every state, to suits filed in equity.

See Concept Review 1-2 for a comparison of law and equity.

Restatements of Law The common law of the United States results from the independent decisions of the state and federal courts. The rapid increase in the number of decisions by these courts led to the establish- ment of the American Law Institute (ALI) in 1923. The ALI is composed of a distinguished group of lawyers, judges, and law professors who set out to prepare

an orderly restatement of the general common law of the United States, including in that term not only the law devel- oped solely by judicial decision, but also the law that has grown from the application by the courts of statutes that were generally enacted and were in force for many years.

Currently the ALI is made up of more than 4,300 law- yers, judges, and law professors.

Regarded as the authoritative statement of the com- mon law of the United States, the Restatements cover many important areas of the common law, including torts, contracts, agency, property, and trusts. Although not law in themselves, they are highly persuasive, and courts frequently have used them to support their opin- ions. Because they provide a concise and clear state- ment of much of the common law, relevant portions of the Restatements are relied on frequently in this book.

Legislative Law [1-3c] Since the end of the nineteenth century, legislation has become the primary source of new law and ordered social change in the United States. The annual volume of legislative law is enormous. Justice Felix Frankfurt- er’s remarks to the New York City Bar in 1947 are even more appropriate in the twenty-first century:

Inevitably the work of the Supreme Court reflects the great shift in the center of gravity of law-making. Broadly speak- ing, the number of cases disposed of by opinions has not changed from term to term. But even as late as 1875 more than 40 percent of the controversies before the Court were common-law litigation, fifty years later only 5 percent, while today cases not resting on statutes are reduced almost to zero. It is therefore accurate to say that courts have ceased to be the primary makers of law in the sense in which they “legislated” the common law. It is certainly true of the Supreme Court that almost every case has a statute at its heart or close to it.

This emphasis on legislative or statutory law has occurred because common law, which develops evolu- tionarily and haphazardly, is not well suited for making drastic or comprehensive changes. Moreover, while

CONCEPT REVIEW 1-2 C O M P A R I S O N O F L A W A N D E Q U I T Y

Law Equity

Availability Generally Discretionary: if remedy at law is inadequate

Precedents Stare decisis Equitable maxims

Jury If either party demands None in federal and almost all states

Remedies Judgment for monetary damages Decree of specific performance, injunction, reformation, rescission

8 Introduction to Law and Ethics Part I

courts tend to be hesitant about overruling prior deci- sions, legislatures commonly repeal prior enactments. In addition, legislatures may choose the issues they wish to address, whereas courts may deal only with those issues presented by actual cases. As a result, legislatures are better equipped to make the dramatic, sweeping, and rel- atively rapid changes in the law that technological, social, and economic innovations compel.

While some business law topics, such as contracts, agency, property, and trusts, still are governed princi- pally by the common law, most areas of commercial law, including partnerships, corporations, sales, commercial paper, secured transactions, insurance, securities regulation, antitrust, and bankruptcy, have become largely statutory. Because most states enacted their own statutes dealing with these branches of com- mercial law, a great diversity developed among the states and hampered the conduct of commerce on a national scale. The increased need for greater uniform- ity led to the development of a number of proposed uniform laws that would reduce the conflicts among state laws.

The most successful example is the Uniform Com- mercial Code (UCC), which was prepared under the joint sponsorship and direction of the ALI and the Uni- form Law Commission (ULC), which is also known as the National Conference of Commissioners on Uniform State Laws (NCCUSL). All fifty states (although Louisi- ana has adopted only Articles 1, 3, 4, 5, 7, and 8), the District of Columbia, and the Virgin Islands have adopted the UCC.

The ULC has drafted more than three hundred uni- form laws, including the Uniform Partnership Act, the Uniform Limited Partnership Act, and the Uniform

Probate Code. The ALI has developed a number of model statutory formulations, including the Model Code of Evi- dence, the Model Penal Code, and a Model Land Devel- opment Code. In addition, the American Bar Association has promulgated the Model Business Corporation Act.

Treaties A treaty is an agreement between or among independent nations. The U.S. Constitution authorizes the President to enter into treaties with the advice and consent of the Senate, “providing two thirds of the Senators present concur.”

Treaties may be entered into only by the federal gov- ernment, not by the states. A treaty signed by the Presi- dent and approved by the Senate has the legal force of a federal statute. Accordingly, a federal treaty may supersede a prior federal statute, while a federal statute may supersede a prior treaty. Like statutes, treaties are subordinate to the federal Constitution and subject to judicial review.

Executive Orders In addition to the executive functions, the President of the United States also has authority to issue laws, which are called executive orders. This authority typically derives from specific del- egation by federal legislation. An executive order may amend, revoke, or supersede a prior executive order. An example of an executive order is the one issued by Presi- dent Johnson in 1965 prohibiting discrimination by fed- eral contractors on the basis of race, color, sex, religion, or national origin in employment on any work the contractor performed during the period of the federal contract.

The governors of most states enjoy comparable authority to issue executive orders.

G O I N G G L O B A L What is the WTO?

Nations have entered intobilateral and multilateral treaties to facilitate and regulate trade and to protect their national interests. Probably the most impor- tant multilateral trade treaty is the General Agreement on Tariffs and Trade (GATT), which the World Trade Organization (WTO) replaced as an international orga- nization. The WTO officially com-

menced on January 1, 1995, and has at least 160 members, includ- ing the United States, accounting for more than 97 percent of world trade. (Approximately twenty-five countries are observers and are seeking membership.) Its basic pur- pose is to facilitate the flow of trade by establishing agreements on potential trade barriers, such as import quotas, customs, export

regulations, antidumping restric- tions (the prohibition against sell- ing goods for less than their fair market value), subsidies, and import fees. The WTO administers trade agreements, acts as a forum for trade negotiations, handles trade disputes, monitors national trade policies, and provides technical assis- tance and training for developing countries.

Chapter 1 Introduction to Law 9

Administrative Law [1-3d] Administrative law is the branch of public law that is created by administrative agencies in the form of rules, regulations, orders, and decisions to carry out the reg- ulatory powers and duties of those agencies. It also deals with controversies arising among individuals and these public officials and agencies. Administrative functions and activities concern general matters of public health, safety, and welfare, including the estab- lishment and maintenance of military forces, police, citizenship and naturalization, taxation, environmental protection, and the regulation of transportation, inter- state highways, waterways, television, radio, and trade and commerce.

Because of the increasing complexity of the nation’s social, economic, and industrial life, the scope of administrative law has expanded enormously. In 1952 Justice Jackson stated, “the rise of administrative bodies has been the most significant legal trend of the last cen- tury, and perhaps more values today are affected by their decisions than by those of all the courts, review of administrative decisions apart.” This is evidenced by the great increase in the number and activities of fed- eral government boards, commissions, and other agen- cies. Certainly, agencies create more legal rules and decide more controversies than all the legislatures and courts combined.

LEGAL ANALYSIS [1-4] Decisions in state trial courts generally are not reported or published. The precedent a trial court sets is not suf- ficiently weighty to warrant permanent reporting. Except in New York and a few other states where selected opinions of trial courts are published, decisions in trial courts are simply filed in the office of the clerk of the court, where they are available for public inspec- tion. Decisions of state courts of appeals are published in consecutively numbered volumes called “reports.” In most states, court decisions are found in the official state reports of that state. In addition, state reports are published by West Publishing Company in a regional reporter called the National Reporter System, com- posed of the following: Atlantic (A., A.2d, or A.3d); South Eastern (S.E. or S.E.2d); South Western (S.W., S.W.2d, or S.W.3d); New York Supplement (N.Y.S. or N.Y.S.2d); North Western (N.W. or N.W.2d); North Eastern (N.E. or N.E.2d); Southern (So., So.2d, or So.3d); Pacific (P., P.2d, or P.3d); and California Re- porter (Cal.Rptr., Cal.Rptr.2d, or Cal.Rptr.3d). At least

twenty states no longer publish official reports and have designated a commercial reporter as the authorita- tive source of state case law.

After they are published, these opinions, or “cases,” are referred to (“cited”) by giving (1) the name of the case; (2) the volume, name, and page of the official state report, if any, in which it is published; (3) the vol- ume, name, and page of the particular set and series of the National Reporter System; and (4) the volume, name, and page of any other selected case series. For instance, Lefkowitz v. Great Minneapolis Surplus Store, Inc., 251 Minn. 188, 86 N.W.2d 689 (1957), indicates that the opinion in this case may be found in Volume 251 of the official Minnesota Reports at page 188 and in Volume 86 of the North Western Reporter, Second Series, at page 689, and that the opinion was delivered in 1957.

The decisions of courts in the federal system are found in a number of reports. U.S. District Court opin- ions appear in the Federal Supplement (F.Supp. or F.Supp.2d). Decisions of the U.S. Court of Appeals are found in the Federal Reporter (Fed., F.2d, or F.3d), and the U.S. Supreme Court’s opinions are published in the U.S. Supreme Court Reports (U.S.), Supreme Court Re- porter (S.Ct.), and Lawyers Edition (L.Ed.). While all U.S. Supreme Court decisions are reported, not every case decided by the U.S. District Courts and the U.S. Courts of Appeals is reported. Each circuit has estab- lished rules determining which decisions are published.

In reading the title of a case, such as “Jones v. Brown,” the “v.” or “vs.” means versus or against. In the trial court, Jones is the plaintiff, the person who filed the suit, and Brown is the defendant, the person against whom the suit was brought. When the case is appealed, some, but not all, courts of appeals or appel- late courts place the name of the party who appeals, or the appellant, first, so that “Jones v. Brown” in the trial court becomes, if Brown loses and hence becomes the appellant, “Brown v. Jones” in the appellate court. Therefore, it is not always possible to determine from the title itself who was the plaintiff and who was the defendant. You must carefully read the facts of each case and clearly identify each party in your mind to understand the discussion by the appellate court. In a criminal case the caption in the trial court will first des- ignate the prosecuting government unit and then will indicate the defendant, as in “State v. Jones” or “Commonwealth v. Brown.”

The study of reported cases requires an understand- ing and application of legal analysis. Normally, the reported opinion in a case sets forth (1) the essential

10 Introduction to Law and Ethics Part I

facts, the nature of the action, the parties, what hap- pened to bring about the controversy, what happened in the lower court, and what pleadings are material to the issues; (2) the issues of law or fact; (3) the legal principles involved; (4) the application of these princi- ples; and (5) the decision.

A serviceable method of analyzing and briefing cases after a careful reading and comprehension of the opin- ion is for students to write in their own language a brief containing the following:

1. the facts of the case

2. the issue or question involved

3. the decision of the court

4. the reasons for the decision

The following excerpt from Professor Karl Llewellyn’s The Bramble Bush contains a number of useful sugges- tions for reading cases:

The first thing to do with an opinion, then, is read it. The next thing is to get clear the actual decision, the judgment rendered. Who won, the plaintiff or defendant? And watch your step here. You are after in first instance the plaintiff and defendant below, in the trial court. In order to follow through what happened you must therefore first know the outcome below; else you do not see what was appealed from, nor by whom. You now follow through in order to see exactly what further judgment has been rendered on appeal. The stage is then clear of form—although of course you do not yet know all that these forms mean, that they imply. You can turn now to what you want peculiarly to know. Given the actual judgments below and above as your indispensable framework—what has the case decided, and what can you derive from it as to what will be decided later?

You will be looking, in the opinion, or in the prelimi- nary matter plus the opinion, for the following: a state- ment of the facts the court assumes; a statement of the precise way the question has come before the court— which includes what the plaintiff wanted below, and what the defendant did about it, the judgement below, and what the trial court did that is complained of; then the outcome on appeal, the judgment; and, finally the reasons this court gives for doing what it did. This does not look so bad. But it is much worse than it looks.

For all our cases are decided, all our opinions are writ- ten, all our predictions, all our arguments are made, on cer- tain four assumptions. They are the first presuppositions of our study. They must be rutted into you till you can juggle with them standing on your head and in your sleep.

1. The court must decide the dispute that is before it. It cannot refuse because the job is hard, or dubious, or dangerous.

2. The court can decide only the particular dispute which is before it. When it speaks to that question it speaks ex cathedra, with authority, with finality, with an almost magic power. When it speaks to the question before it, it announces law, and if what it announces is new, it legislates, it makes the law. But when it speaks to any other question at all, it says mere words, which no man needs to follow. Are such words worthless? They are not. We know them as judicial dicta; when they are wholly off the point at issue we call them obiter dicta—words dropped along the road, wayside remarks. Yet even wayside remarks shed light on the remarker. They may be very useful in the future to him, or to us. But he will not feel bound to them, as to his ex cathedra utterance. They came not hallowed by a Delphic frenzy. He may be slow to change them; but not so slow as in the other case.

3. The court can decide the particular dispute only according to a general rule which covers a whole class of like disputes. Our legal theory does not admit of single decisions standing on their own. If judges are free, are indeed forced, to decide new cases for which there is no rule, they must at least make a new rule as they decide. So far, good. But how wide, or how narrow, is the general rule in this particular case? That is a troublesome matter. The practice of our case-law, however, is I think fairly stated thus: it pays to be suspicious of gen- eral rules which look too wide; it pays to go slow in feeling certain that a wide rule has been laid down at all, or that, if seemingly laid down, it will be followed. For there is a fourth accepted canon:

4. Everything, everything, everything, big or small, a judge may say in an opinion, is to be read with pri- mary reference to the particular dispute, the partic- ular question before him. You are not to think that the words mean what they might if they stood alone. You are to have your eye on the case in hand, and to learn how to interpret all that has been said merely as a reason for deciding that case that way.

By way of example, the following edited case of Caldwell v. Bechtel, Inc. is presented and then briefed using Llewellyn’s suggested format. (Note: The cases in the rest of this text have their facts and deci- sion summarized for the reader’s convenience. The edited portion of the case begins with the judge’s name.)

Chapter 1 Introduction to Law 11

C A L D W E L L V . B E C H T E L , I N C . U n i t e d S t a t e s C o u r t o f A p p e a l s , D i s t r i c t o f C o l u m b i a C i r c u i t , 1 9 8 0

6 3 1 F . 2 d 9 8 9

OPINION MacKinnon, J. We are here concerned with a claim for damages by a worker who allegedly contracted silicosis while he was mucking in a tunnel under construction as part of the metropolitan subway system (Washington Metropolitan Area Transit Author- ity [WMATA]). The basic issue is whether a consultant engineering firm owed the worker a duty to protect him against unreasonable risk of harm.

*** In attempting to convince the court that it owes no

duty of reasonable care to protect appellant’s safety, Bechtel argues that by its contract with WMATA it assumed duties only to WMATA. Appellant has not brought action, however, for breach of contract but rather seeks damages for an asserted breach of the duty of reasonable care. Unlike contractual duties, which are imposed by agreement of the parties to a contract, a duty of due care under tort law is based primarily upon social policy. The law imposes upon individuals certain expectations of conduct, such as the expectancy that their actions will not cause foreseeable injury to another. These societal expectations, as formed through the com- mon law, comprise the concept of duty.

Society’s expectations, and the concomitant duties imposed, vary in response to the activity engaged in by the defendant. If defendant is driving a car, he will be held to exercise the degree of care normally exercised by a reasonable person in like circumstances. Or if defend- ant is engaged in the practice of his profession, he will be held to exercise a degree of care consistent with his superior knowledge and skill. Hence, when defendant Bechtel engaged in consulting engineering services, the company was required to observe a standard of care or- dinarily adhered to by one providing such services, pos- sessing such skill and expertise.

A secondary but equally important principle involved in a determination of duty is to whom the duty is owed. The answer to this question is usually framed in terms of the foreseeable plaintiff, in other words, one who might foreseeably be injured by defendant’s conduct. This sec- ondary principle also serves to distinguish tort law from contract law. While in contract law, only one to whom the contract specifies that a duty be rendered will have a cause of action for its breach, in tort law, society, not the contract, specifies to whom the duty is owed, and this has traditionally been the foreseeable plaintiff.

It is important to keep these differences between con- tract and tort duties in mind when examining whether Bechtel’s undertaking of contractual duties to WMATA created a duty of reasonable care toward Caldwell. Dean Prosser expressed the relationship in this terse fashion.

[B]y entering into a contract with A, the defendant may place himself in such a relation toward B that the law will impose upon him an obligation, sounding in tort and not in contract, to act in such a way that B will not be injured. The incidental fact of the existence of the contract with A does not negative the responsibility of the actor when he enters upon a course of affirmative conduct which may be expected to affect the interests of another person.

*** Analyzing the common law, Prosser noted that courts

have found a duty to act for the protection of another when certain relationships exist, such as carrier-passenger, innkeeper-guest, shipper-seaman, employer-employee, shopkeeper-visitor, host-social guest, jailer-prisoner, and school-pupil. These holdings suggest that courts have been eroding the general rule that there is no duty to act to help another in distress, by creating exceptions based upon a relationship between the actors.

*** We find that case law provides many such analogous

situations from which the principles deserving of appli- cation to this case may be culled. The foregoing con- cepts of duty converge in this case, as the facts include both the WMATA-Bechtel contractual relationship from which it was foreseeable that a negligent under- taking by Bechtel might injure the appellant, and a spe- cial relationship established between Bechtel and the appellant because of Bechtel’s superior skills, knowl- edge of the dangerous condition, and ability to protect appellant.

We reverse the summary judgment of the district court, and hold that as a matter of law, on the record as we are required to view it at this time, Bechtel owed Caldwell a duty of due care to take reasonable steps to protect him from the foreseeable risk of harm to his health posed by the excessive concentration of silica dust in the Metro tunnels. We remand so that Caldwell will have an opportunity to prove, if he can, the other elements of his negligence action.

12 Introduction to Law and Ethics Part I

You can and should use this same legal analysis when learning the substantive concepts presented in this text and applying them to the end-of-chapter questions and case problems. By way of example, in a number of chapters throughout the text we have included a boxed feature called “Applying the Law,” which provides a systematic legal analysis of a single concept learned in the chapter.

This feature begins with the facts of a hypothetical case, followed by an identification of the broad legal issue pre- sented by those facts. We then state the rule of law—or applicable legal principles, including definitions, which aid in resolving the legal issue—and apply it to the facts. Finally we state a legal conclusion, or decision in the case. An example of this type of legal analysis follows.

B R I E F O F C A L D W E L L V . B E C H T E L , I N C .

FACTS Caldwell was a laborer who now suffers from silicosis. He claims that he contracted the disease while working in a tunnel under construction as part of the Washington Metropolitan Area Transportation Authority (WMATA). He brought his action for dam- ages against Bechtel, Inc., a consultant engineering firm under contract with WMATA for the project.

ISSUE Did Bechtel breach a duty of due care owed to Caldwell to take reasonable steps to protect him from the foreseeable risk of harm to his health posed by the exces- sive concentration of silica dust in the subway tunnels?

DECISION In favor of Caldwell. Summary judg- ment reversed and case remanded to the district court.

REASONS Caldwell has not brought an action for breach of contract as Bechtel seems to believe. Rather,

he seeks damages for an alleged breach of the duty of reasonable care. Unlike contractual duties, which are imposed by agreement of the parties to a contract, a duty of due care under tort law is based primarily on social policy. That is, the law imposes upon individuals the expectation that their actions will not cause foresee- able injury to another. These societal expectations com- prise the concept of duty—a concept that varies in response to the activity engaged in by the individual. Moreover, the duty is owed to anyone who might fore- seeably be injured by the conduct of the actor in ques- tion. In contrast, under contract law, a duty is owed only to those parties specified in the contract. Here, by entering into a contract with WMATA, Bechtel placed itself in such a relation toward Caldwell that the law will impose upon it an obligation in tort, and not in contract, to act in such a way that Caldwell would not be injured.

A P P L Y I N G T H E L A W

INTRODUCTION TO LAW

Facts Jackson bought a new car and planned to sell his old one for about $2,500. But before he did so, he hap- pened to receive a call from his cousin, Trina, who had just graduated from college. Among other things, Trina told Jackson she needed a car but did not have much money. Feeling generous, Jackson told Trina he would give her his old car. But the next day a coworker offered Jackson $3,500 for his old car, and Jackson sold it to the coworker.

Issue Did Jackson have the right to sell his car to the coworker, or legally had he already made a gift of it to Trina?

Rule of Law A gift is the transfer of ownership of prop- erty from one person to another without anything in return. The person making the gift is called the donor, and the per- son receiving it is known as the donee. A valid gift requires

(1) the donor’s present intent to transfer the property and (2) delivery of the property.

Application In this case, Jackson is the would-be donor and Trina is the would-be donee. To find that Jackson had already made a gift of the car to Trina, both Jackson’s intent to give it to her and delivery of the car to Trina would need to be demonstrated. It is evident from their telephone con- versation that Jackson did intend at that point to give the car to Trina. It is equally apparent from his conduct that he later changed his mind, because he sold it to someone else the next day. Consequently, he did not deliver the car to Trina.

Conclusion Because the donor did not deliver the prop- erty to the donee, legally no gift was made. Jackson was free to sell the car.

Chapter 1 Introduction to Law 13

C H A P T E R S U M M A R Y Nature of Law

Definition of Law “a rule of civil conduct prescribed by the supreme power in a state, commanding what is right, and prohibiting what is wrong” (William Blackstone)

Functions of Law to maintain stability in the social, political, and economic system through dispute resolution, protection of property, and the preservation of the state, while simultaneously permitting ordered change

Laws and Morals are different but overlapping; law provides sanctions while morals do not

Law and Justice are separate and distinct concepts; justice is the fair, equitable, and impartial treatment of competing interests with due regard for the common good

Classification of Law

Substantive and Procedural • Substantive Law law creating rights and duties • Procedural Law rules for enforcing substantive law

Public and Private • Public Law law dealing with the relationship between government and individuals • Private Law law governing the relationships among individuals and legal entities

Civil and Criminal • Civil Law law dealing with rights and duties, the violation of which constitutes a wrong

against an individual or other legal entity • Criminal Law law establishing duties that, if violated, constitute a wrong against the entire

community

Sources of Law

Constitutional Law fundamental law of a government establishing its powers and limitations

Judicial Law • Common Law body of law developed by the courts that serves as precedent for determination

of later controversies • Equity body of law based upon principles distinct from common law and providing remedies

not available at law

Legislative Law statutes adopted by legislative bodies • Treaties agreements between or among independent nations • Executive Orders laws issued by the President or by the governor of a state

Administrative Law law created by administrative agencies in the form of rules, regulations, orders, and decisions to carry out the regulatory powers and duties of those agencies

14 Introduction to Law and Ethics Part I

C H A P T E R 2

BUSINESS ETHICS

Our characters are the result of our conduct. ARISTOTLE, NICOMACHEAN ETHICS (C. 335 BCE)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Describe the difference between law and ethics.

2. Compare the various ethical theories.

3. Describe cost-benefit analysis and explain when it should be used and when it should be avoided.

4. Explain Kohlberg’s stages of moral development.

5. Explain the ethical responsibilities of business.

B usiness ethics is a subset of ethics: no special set of ethical principles applies only to the world of business. Immoral acts are immoral, whether or

not a businessperson has committed them. In the last few years, countless business wrongs, such as insider trading, fraudulent earnings statements and other accounting misconduct, price-fixing, concealment of dangerous defects in products, reckless lending and improper foreclosures in the housing market, and brib- ery, have been reported almost daily. Companies such as Enron, WorldCom, Adelphia, Parmalat, Arthur Andersen, and Global Crossing have violated the law, and some of these firms no longer exist as a result of these ethical lapses. In 2004, Martha Stewart was con- victed of obstructing justice and lying to investigators about a stock sale. More recently, Bernie Madoff perpe- trated the largest Ponzi scheme in history with an esti- mated loss of $20 billion in principal and approximately

$65 billion in paper losses. In May 2011, Galleon Group (a hedge fund) billionaire Raj Rajaratnam was found guilty of fourteen counts of conspiracy and secur- ities fraud. In 2013, large international banks faced a widening scandal—and substantial fines—over attempts to rig benchmark interest rates, including the London Interbank Offered Rate (LIBOR).

Ethics can be defined broadly as the study of what is right or good for human beings. It attempts to deter- mine what people ought to do, or what goals they should pursue. Business ethics, as a branch of applied ethics, is the study and determination of what is right and good in business settings. Business ethics seeks to understand the moral issues that arise from business practices, institutions, and decision making and their relationship to generalized human values. Unlike legal analyses, analyses of ethics have no central authority, such as courts or legislatures, upon which to rely; nor

15

do they follow clear-cut universal standards. Nonethe- less, despite these inherent limitations, it still may be possible to make meaningful ethical judgments. To improve ethical decision making, it is important to understand how others have approached the task.

Some examples of the many business ethics questions may clarify the definition of business ethics. In the employment relationship, countless ethical issues arise regarding the safety and compensation of workers, their civil rights (such as equal treatment, privacy, and free- dom from sexual harassment), and the legitimacy of whistle-blowing. In the relationship between business and its customers, ethical issues permeate marketing techniques, product safety, and consumer protection. The relationship between business and its owners bris- tles with ethical questions involving corporate gover- nance, shareholder voting, and management’s duties to the shareholders. The relationship among competing businesses involves numerous ethical matters, including fair competition and the effects of collusion. The inter- action between business and society at large presents additional ethical dimensions: pollution of the physical environment, commitment to the community’s eco- nomic and social infrastructure, and depletion of natu- ral resources. Not only do all of these issues recur at the international level, but also additional ones present themselves, such as bribery of foreign officials, exploita- tion of developing countries, and conflicts among dif- fering cultures and value systems.

In resolving the ethical issues raised by business conduct, it is helpful to use a seeing-knowing-doing model. First, the decision maker should see (identify) the ethical issues involved in the proposed conduct, including the ethical implications of the various avail- able options. Second, the decision maker should know (resolve) what to do by choosing the best option. Finally, the decision maker should do (implement) the chosen option by developing and implementing strategies.

This chapter first surveys the most prominent ethical theories (the knowing part of the decision, on which the great majority of philosophers and ethicists have focused). The chapter then examines ethical standards in business and the ethical responsibilities of business. It concludes with five ethical business cases, which give the student the opportunity to apply the seeing-knowing- doing model. The student (1) identifies the ethical issues presented in these cases; (2) resolves these issues by using one of the ethical theories described in the chapter, some other ethical theory, or a combination of the theories; and (3) develops strategies for implementing the ethical resolution.

LAW VERSUS ETHICS [2-1] As discussed in Chapter 1, moral concepts strongly affect the law, but law and morality are not the same. Although it is tempting to say “if it’s legal, it’s moral,” such a proposition is generally too simplistic. For example, it would seem gravely immoral to stand by silently while a blind man walks off a cliff if one could prevent the fall by shouting a warning, even though one would not be legally obligated to do so. Similarly, moral questions arise concerning “legal” business prac- tices, such as failing to fulfill a promise that is not legally binding; exporting products banned in the United States to developing countries where they are not prohibited; or slaughtering baby seals for fur coats. The mere fact that these practices are legal does not prevent them from being challenged on moral grounds.

Just as it is possible for legal acts to be immoral, it is equally possible for illegal acts to seem morally pref- erable to following the law. For example, it is the moral conviction of the great majority of people that those who sheltered Jews in violation of Nazi edicts during World War II and those who committed acts of civil disobedience in the 1950s and 1960s to challenge segregation laws in the United States were acting prop- erly and that the laws themselves were immoral.

ETHICAL THEORIES [2-2] Philosophers have sought for centuries to develop de- pendable and universal methods for making ethical judgments. In earlier times, some thinkers analogized the discovery of ethical principles with the derivation of mathematical proofs. They asserted that people could discover fundamental ethical rules by applying careful reasoning a priori. (A priori reasoning is based on theory rather than experimentation and deductively draws conclusions from cause to effect and from gener- alizations to particular instances.) In more recent times, many philosophers have concluded that although care- ful reasoning and deep thought assist substantially in moral reasoning, experience reveals that the complex- ities of the world defeat most attempts to fashion pre- cise, a priori guidelines. Nevertheless, a review of the most significant ethical theories can aid the analysis of business ethics issues.

Ethical Fundamentalism [2-2a] Under ethical fundamentalism, or absolutism, individu- als look to a central authority or set of rules to guide

16 Introduction to Law and Ethics Part I

them in ethical decision making. Some look to the Bible; others look to the Koran or to the writings of Karl Marx or to any number of living or deceased prophets. The essential characteristic of this approach is a reli- ance on a central repository of wisdom. In some cases, such reliance is total. In others, followers of a religion or a spiritual leader may believe that all members of the group are obligated to assess moral dilemmas inde- pendently, according to each person’s understanding of the dictates of the fundamental principles.

Ethical Relativism [2-2b] Ethical relativism is a doctrine asserting that actions must be judged by what individuals feel is right or wrong for themselves. It holds that when any two indi- viduals or cultures differ regarding the morality of a particular issue or action, they are both correct because morality is relative. However, although ethical relativ- ism promotes open-mindedness and tolerance, it has limitations. If each person’s actions are always correct for that person, then his behavior is, by definition, moral and therefore exempt from criticism. Once a per- son concludes that criticizing or punishing behavior in some cases is appropriate, he abandons ethical relativ- ism and faces the task of developing a broader ethical methodology.

Although bearing a surface resemblance to ethical relativism, situational ethics actually differs substan- tially. Situational ethics holds that developing precise guidelines for effectively navigating ethical dilemmas is difficult because real-life decision making is so complex. To judge the morality of someone’s behavior, the per- son judging must actually put herself in the other per- son’s shoes to understand what motivated the other to choose a particular course of action. Situational ethics, however, does not cede the ultimate judgment of the propriety of an action to the actor; rather, it insists that, prior to evaluation, a person’s decision or act be viewed from the actor’s perspective.

Utilitarianism [2-2c] Utilitarianism is a doctrine that assesses good and evil in terms of the consequences of actions. Those actions that produce the greatest net pleasure compared with net pain are better in a moral sense than those that pro- duce less net pleasure. As Jeremy Bentham, one of the most influential proponents of utilitarianism, pro- claimed, a good or moral act is one that results in “the greatest happiness for the greatest number.”

The two major forms of utilitarianism are act utilita- rianism and rule utilitarianism. Act utilitarianism

assesses each separate act according to whether it maxi- mizes pleasure over pain. For example, if telling a lie in a particular situation produces more overall pleasure than pain, then an act utilitarian would support lying as the moral thing to do. Rule utilitarians, disturbed by the unpredictability of act utilitarianism and its poten- tial for abuse, follow a different approach. Rule utilita- rianism holds that general rules must be established and followed even though, in some instances, following rules may produce less overall pleasure than not follow- ing them. It applies utilitarian principles in developing rules; thus, it supports rules that on balance produce the greatest satisfaction. Determining whether telling a lie in a given instance would produce greater pleasure than telling the truth is less important to the rule utilitarian than deciding whether a general practice of lying would maximize society’s pleasure. If lying would not maximize pleasure generally, then one should follow a rule of not lying even though on occasion telling a lie would pro- duce greater pleasure than would telling the truth.

Utilitarian notions underlie cost-benefit analysis, an analytical tool used by many business and government managers today. Cost-benefit analysis first quantifies in monetary terms and then compares the direct and indi- rect costs and benefits of program alternatives for meet- ing a specified objective. Cost-benefit analysis seeks the greatest economic efficiency according to the underlying notion that, given two potential acts, the act achieving the greatest output at the least cost promotes the great- est marginal happiness over the less-efficient act, other things being equal.

The chief criticism of utilitarianism is that in some important instances it ignores justice. A number of sit- uations would maximize the pleasure of the majority at great social cost to a minority. Another major criticism of utilitarianism is that measuring pleasure and pain in the fashion its supporters advocate is extremely diffi- cult, if not impossible.

Deontology [2-2d] Deontological theories (from the Greek word deon, meaning duty or obligation) address the practical prob- lems of utilitarianism by holding that certain underlying principles are right or wrong regardless of any pleasure or pain calculations. Believing that actions cannot be measured simply by their results but rather must be judged by means and motives as well, deontologists judge the morality of acts not so much by their conse- quences but by the motives that lead to them. A person not only must achieve just results but also must employ the proper means.

Chapter 2 Business Ethics 17

The eighteenth-century philosopher Immanuel Kant proffered the best-known deontological theory. Under Kant’s categorical imperative, for an action to be moral it (1) must potentially be a universal law that could be applied consistently and (2) must respect the autonomy and rationality of all human beings and not treat them as an expedient. That is, one should not do anything that he or she would not have everyone do in a similar situation. For example, you should not lie to colleagues unless you support the right of all colleagues to lie to one another. Similarly, you should not cheat others unless you advocate everyone’s right to cheat. We apply Kantian reasoning when we challenge someone’s behav- ior by asking: what if everybody acted that way?

Under Kant’s approach, it would be improper to assert a principle to which one claimed personal excep- tion, such as insisting that it was acceptable for you to cheat but not for anyone else to do so. This principle could not be universalized because everyone would then insist on similar rules from which only they were exempt.

Kant’s philosophy also rejects notions of the end jus- tifying the means. To Kant, every person is an end in himself or herself. Each person deserves respect simply because of his or her humanity. Thus, any sacrifice of a person for the greater good of society would be unac- ceptable to Kant.

In many respects, Kant’s categorical imperative is a variation of the Golden Rule; and, like the Golden Rule, the categorical imperative appeals to the individu- al’s self-centeredness.

As does every theory, Kantian ethics has its critics. Just as deontologists criticize utilitarians for excessive pragmatism and flexible moral guidelines, utilitarians and others criticize deontologists for rigidity and exces- sive formalism. For example, if one inflexibly adopts as a rule to tell the truth, one ignores situations in which lying might well be justified. A person hiding a terrified wife from her angry, abusive husband would seem to be acting morally by falsely denying that the wife is at the person’s house. Yet a deontologist, feeling bound to tell the truth, might ignore the consequences of truthfulness, tell the husband where his wife is, and create the possi- bility of a terrible tragedy. Another criticism of deonto- logical theories is that the proper course may be difficult to determine when values or assumptions conflict.

Social Ethics Theories [2-2e] Social ethics theories assert that special obligations arise from the social nature of human beings. Such theories focus not only on each person’s obligations to other

members of society but also on the individual’s rights and obligations within the society. For example, social egalitarians believe that society should provide each person with equal amounts of goods and services regardless of the contribution each makes to increase society’s wealth.

Two other ethics theories have received widespread attention in recent years. One is the theory of distribu- tive justice proposed by Harvard philosopher John Rawls, which seeks to analyze the type of society that people in a “natural state” would establish if they could not determine in advance whether they would be talented, rich, healthy, or ambitious, relative to other members of society. According to distributive justice, the society contemplated through this “veil of igno- rance” is the one that should be developed because it considers the needs and rights of all its members. Rawls did not argue that such a society would be strictly egal- itarian and that it would unfairly penalize those who turned out to be the most talented and ambitious. Instead, Rawls suggested that such a society would stress equality of opportunity, not of results. On the other hand, Rawls stressed that society would pay heed to the least advantaged to ensure that they did not suf- fer unduly and that they enjoyed society’s benefits. To Rawls, society must be premised on justice. Everyone is entitled to his or her fair share in society, a fairness all must work to guarantee.

In contrast to Rawls, another Harvard philosopher, Robert Nozick, stressed liberty, not justice, as the most important obligation that society owes its members. Libertarians stress market outcomes as the basis for dis- tributing society’s rewards. Only to the extent that one meets market demands does one deserve society’s bene- fits. Libertarians oppose social interference in the lives of those who do not violate the rules of the market- place; that is, in the lives of those who do not cheat others and who disclose honestly the nature of their transactions with others. The fact that some end up with fortunes while others accumulate little simply proves that some can play in the market effectively while others cannot. To libertarians, this is not unjust. What is unjust to them is any attempt by society to take wealth earned by citizens and distribute it to those who did not earn it.

These theories and others (e.g., Marxism) judge soci- ety in moral terms by its organization and by the way in which it distributes goods and services. They demon- strate the difficulty of ethical decision making in the context of a social organization: behavior that is consis- tently ethical from individual to individual may not necessarily produce a just society.

18 Introduction to Law and Ethics Part I

Other Theories [2-2f] The preceding theories do not exhaust the possible approaches to evaluating ethical behavior; several other theories also deserve mention. Intuitionism holds that a rational person possesses inherent powers to assess the cor- rectness of actions. Though an individual may refine and strengthen these powers, they are just as basic to humanity as our instincts for survival and self-defense. Just as some people are better artists or musicians, some people have more insight into ethical behavior than others. Consistent with intuitionism is the good person philosophy, which declares that if individuals wish to act morally, they should seek out and emulate those who always seem to know the right choice in any given situation and who always seem to do the right thing. One variation of these ethical approaches is the Television Test, which directs us to imag- ine that every ethical decision we make is being broadcast on nationwide television. An appropriate decision is one we would be comfortable broadcasting on national televi- sion for all to witness.

ETHICAL STANDARDS IN BUSINESS [2-3] In this section, we explore the application of the theo- ries of ethical behavior to the world of business.

Choosing an Ethical System [2-3a] In their efforts to resolve the moral dilemmas facing humankind, philosophers and other thinkers have struggled for years to refine the various systems previ- ously discussed. All of the systems are limited, however, in terms of applicability and tend to produce unaccept- able prescriptions for action in some circumstances. But to say that each system has limits is not to say it is use- less. On the contrary, a number of these systems pro- vide insight into ethical decision making and help us formulate issues and resolve moral dilemmas. Further- more, concluding that moral standards are difficult to articulate and that moral boundaries are imprecise is not the same as concluding that moral standards are unnecessary or nonexistent.

Research by the noted psychologist Lawrence Kohl- berg provides some insight into ethical decision making

and lends credibility to the notion that moral growth, like physical growth, is part of the human condition. Kohlberg observed that people progress through se- quential stages of moral development according to two major variables: age and reasoning. During the first level—the preconventional level—a child’s conduct is a reaction to the fear of punishment and, later, to the pleasure of reward. Although people who operate at this level may behave in a moral manner, they do so without understanding why their behavior is moral. The rules are imposed upon them. During adoles- cence—Kohlberg’s conventional level—people conform their behavior to meet the expectations of groups, such as family, peers, and eventually society. The motivation for conformity is loyalty, affection, and trust. Most adults operate at this level. According to Kohlberg, some reach the third level—the postconventional level—at which they accept and conform to moral principles because they understand why the principles are right and binding. At this level, moral principles are voluntar- ily internalized, not externally imposed. Moreover, indi- viduals at this stage develop their own universal ethical principles and may even question the laws and values that society and others have adopted (see Figure 2-1 for Kohlberg’s stages of moral development).

Kohlberg believed that not all people reach the third, or even the second, stage. He therefore argued that essential to the study of ethics was the explora- tion of ways to help people achieve the advanced stage of postconventional thought. Other psychologists assert that individuals do not pass sequentially from stage to stage but rather function in all three stages simultaneously.

Whatever the source of our ethical approach, we can- not avoid facing moral dilemmas that challenge us to recognize and do the right thing. Moreover, for those who plan business careers, such dilemmas necessarily will have implications for many others—employees, shareholders, suppliers, customers, and society at large.

Corporations as Moral Agents [2-3b] Because corporations are not persons but rather artifi- cial entities created by the state, whether they can or should be held morally accountable is difficult to

FIGURE 2-1 Kohlberg’s Stages of Moral Development

Levels Perspective Justification

Preconventional (Childhood) Self Punishment/Reward

Conventional (Adolescent) Group Group Norms

Postconventional (Adult) Universal Moral Principles

Chapter 2 Business Ethics 19

determine. Though, clearly, individuals within corpora- tions can be held morally responsible, the corporate en- tity presents unique problems.

Commentators are divided on the issue. Some insist that only people can engage in behavior that can be judged in moral terms. Opponents of this view concede that corporations are not persons in any literal sense but insist that the attributes of responsibility inherent in corporations are sufficient to justify judging corporate behavior from a moral perspective.

ETHICAL RESPONSIBILITIES OF BUSINESS [2-4] Many people assert that the only responsibility of busi- ness is to maximize profit and that this obligation over- rides any ethical or social responsibility. Although our economic system of modified capitalism is based on the pursuit of self-interest, it also contains components to check this motivation of greed. Our system always has recognized the need for some form of regulation, whether by the “invisible hand” of competition, the self-regulation of business, or government regulation.

Regulation of Business [2-4a] As explained and justified by Adam Smith in The Wealth of Nations (1776), the capitalistic system is com- posed of six “institutions”: economic motivation, private productive property, free enterprise, free markets, com- petition, and limited government. As long as all these constituent institutions continue to exist and operate in balance, the factors of production—land, capital, and labor—combine to produce an efficient allocation of resources for individual consumers and for the economy as a whole. To achieve this outcome, however, Smith’s model requires that a number of conditions be satisfied: “standardized products, numerous firms in markets, each firm with a small share and unable by its actions alone to exert significant influence over price, no barriers to entry, and output carried to the point where each seller’s marginal cost equals the going market price.” E. Singer, Antitrust Economics and Legal Analysis.

History has demonstrated that the actual operation of the economy has satisfied almost none of these assumptions. More specifically, the actual competitive process falls considerably short of the assumptions of the classic economic model of perfect competition:

Competitive industries are never perfectly competitive in this sense. Many of the resources they employ cannot be shifted to other employments without substantial cost and

delay. The allocation of those resources, as between indus- tries or as to relative proportions within a single industry, is unlikely to have been made in a way that affords the best possible expenditure of economic effort. Information is incomplete, motivation confused, and decision therefore ill informed and often unwise. Variations in efficiency are not directly reflected in variations of profit. Success is derived in large part from competitive selling efforts, which in the aggregate may be wasteful, and from differentiation of products, which may be undertaken partly by methods designed to impair the opportunity of the buyer to com- pare quality and price.

C. Edwards, Maintaining Competition

In addition to capitalism’s failure to allocate resour- ces efficiently, it cannot be relied on to achieve all of the social and public policy objectives a pluralistic de- mocracy requires. For example, the free enterprise model simply does not address equitable distribution of wealth, national defense, conservation of natural resources, full employment, stability in economic cycles, protection against economic dislocations, health and safety, social security, and other important social and economic goals. Increased regulation of business has occurred not only to preserve the competitive process in our economic system but also to achieve social goals extrinsic to the efficient allocation of resources, the “invisible hand” and self-regulation by business having failed to bring about these desired results. Such inter- vention attempts (1) to regulate both “legal” monopo- lies, such as those conferred by law through copyrights, patents, and trade symbols, and “natural” monopolies, such as utilities, transportation, and communications; (2) to preserve competition by correcting imperfections in the market system; (3) to protect specific groups, especially labor and agriculture, from marketplace fail- ures; and (4) to promote other social goals. Successful government regulation involves a delicate balance between regulations that attempt to preserve competi- tion and those that attempt to advance other social objectives. The latter should not undermine the basic competitive processes that provide an efficient alloca- tion of economic resources.

Corporate Governance [2-4b] In addition to the broad demands of maintaining a competitive and fair marketplace, another factor demanding the ethical and social responsibility of busi- ness is the sheer size and power of individual corpora- tions. The five thousand largest U.S. firms currently produce more than half of the nation’s gross national product.

20 Introduction to Law and Ethics Part I

In a classic study published in 1932, Adolf Berle and Gardiner Means concluded that great amounts of eco- nomic power had been concentrated in a relatively few large corporations, that the ownership of these corpora- tions had become widely dispersed, and that the share- holders had become far removed from active participation in management. Since their original study, these trends have continued steadily. The five hundred to one thousand large publicly held corporations own the great bulk of the industrial wealth of the United States. Moreover, these corporations are controlled by a small group of corporate officers.

Historically, the boards of many publicly held corpo- rations consisted mainly or entirely of inside directors (corporate officers who also serve on the board of directors). During the past two decades, however, as a result of regulations by the U.S. Securities and Exchange Commission and the stock exchanges, the number and influence of outside directors has increased substantially. Now the boards of the great majority of publicly held corporations consist primarily of outside directors, and these corporations have audit committees consisting entirely of outside directors. Nevertheless, a number of instances of corporate misconduct have been revealed in the first years of this century. In response to these business scandals—involving companies such as Enron, WorldCom, Global Crossing, Adelphia, and Arthur Andersen—in 2002 Congress passed the Sarbanes- Oxley Act. This legislation seeks to prevent these types of scandals by increasing corporate responsibility through the imposition of additional corporate governance require- ments on publicly held corporations. (This statute is dis- cussed further in Chapters 6, 35, 39, and 43.)

Moreover, in July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was enacted, representing the most significant change to U.S. financial regulation since the New Deal. Its purposes include improving accountability and transparency in the financial system, protecting con- sumers from abusive financial services practices, and improving corporate governance in publicly held com- panies. (The Dodd-Frank Act is discussed further in Chapters 27, 34, 35, 36, 39, 44, and 49.) These devel- opments raise a large number of social, policy, and eth- ical issues about the governance of large, publicly owned corporations. Many observers insist that compa- nies playing such an important economic role should have a responsibility to undertake projects that benefit society in ways that go beyond mere financial efficiency in producing goods and services. In some instances, the idea of corporate obligations comes from industrialists themselves.

Arguments Against Social Responsibility [2-4c] A number of arguments oppose business involvement in socially responsible activities: profitability, unfair- ness, accountability, and expertise.

Profitability As Milton Friedman and others have argued, businesses are artificial entities established to permit people to engage in profit-making, not social, activities. Without profits, they assert, there is little rea- son for a corporation to exist and no real way to meas- ure the effectiveness of corporate activities. Businesses are not organized to engage in social activities; they are structured to produce goods and services for which they receive money. Their social obligation is to return as much of this money as possible to their direct stake- holders. In a free market with significant competition, the selfish pursuits of corporations will lead to maxi- mizing output, minimizing costs, and establishing fair prices. All other concerns distract companies and inter- fere with achieving these goals.

Unfairness Whenever companies stray from their designated role of profit-maker, they take unfair advantage of company employees and shareholders. For example, a company may support the arts or edu- cation or spend excess funds on health and safety; how- ever, these funds rightfully belong to the shareholders or employees. The company’s decision to disburse these funds to others who may well be less deserving than the shareholders and employees is unfair. Furthermore, consumers can express their desires through the mar- ketplace, and shareholders and employees can decide privately whether they wish to make charitable contri- butions. In most cases, senior management consults the board of directors about supporting social concerns but does not seek the approval of the company’s major stakeholders, thereby effectively disenfranchising these shareholders from actions that reduce their benefits from the corporation.

Accountability Corporations, as previously noted, are private institutions that are subject to a lower stand- ard of accountability than are public bodies. Accord- ingly, a company may decide to support a wide range of social causes and yet submit to little public scrutiny. But a substantial potential for abuse exists in such cases. For one thing, a company could provide funding for a vari- ety of causes its employees or shareholders did not support. It also could provide money “with strings attached,” thereby controlling the recipients’ agendas for less than socially beneficial purposes. For example, a

Chapter 2 Business Ethics 21

drug company that contributes to a consumer group might implicitly or explicitly condition its assistance on the group’s agreement never to criticize the company or the drug industry.

This lack of accountability warrants particular con- cern because of the enormous power corporations wield in modern society. Many large companies, like Wal- mart, Toyota, or ExxonMobil, generate and spend more money in a year than all but a handful of the world’s countries. If these companies suddenly began to vigorously pursue their own social agendas, their influ- ence might well rival, and perhaps undermine, that of their national government. In a country like the United States, founded on the principles of limited government and the balance of powers, too much corporate involvement in social affairs might well present substan- tial problems. Without clear guidelines and accountabil- ity, companies pursuing their private visions of socially responsible behavior might well distort the entire proc- ess of governance.

There is a clear alternative to corporations engaging in socially responsible action. If society wishes to increase the resources devoted to needy causes, it has the power to do so. Let the corporations seek profits without the burden of a social agenda, let the consum- ers vote in the marketplace for the products and serv- ices they desire, and let the government tax a portion of corporate profits for socially beneficial causes.

Expertise Even though a corporation has an exper- tise in producing and selling its product, it may not possess a talent for recognizing or managing socially useful activities. Corporations become successful in the market because they can identify and meet the needs of their customers. Nothing suggests that this talent spills over into nonbusiness arenas. In fact, critics of corpo- rate participation in social activities worry that corpo- rations will prove unable to distinguish the true needs of society from their own narrow self-interests.

Arguments in Favor of Social Responsibility [2-4d] First, it should be recognized that even the critics of business acknowledge that the prime responsibility of business is to make a reasonable return on its invest- ment by producing a quality product at a reasonable price. They do not suggest that business entities be charitable institutions. They do assert, however, that business has certain obligations beyond making a profit or not harming society. Such critics contend that business must help to resolve societal problems, and

they offer a number of arguments in support of their position.

The Social Contract Society creates corpora- tions and gives them a special social status, including the granting of limited liability, which insulates owners from liability for debts their organizations incur. Sup- porters of social roles for corporations assert that lim- ited liability and other rights granted to companies carry a responsibility: corporations, just like other members of society, must contribute to its betterment. Therefore, companies owe a moral debt to society to contribute to its overall well-being. Society needs a host of improvements, such as pollution control, safe prod- ucts, a free marketplace, quality education, cures for ill- ness, and freedom from crime. Corporations can help in each of these areas. Granted, deciding which social needs deserve corporate attention is difficult; however, this challenge does not lessen a company’s obligation to choose a cause. Corporate America cannot ignore the multitude of pressing needs that remain, despite the efforts of government and private charities.

A derivative of the social contract theory is the stakeholder model for the societal role of the business corporation. Under the stakeholder model, a corpora- tion has fiduciary responsibilities—duty of utmost loy- alty and good faith—to all of its stakeholders, not just its stockholders. Historically, the stockholder model for the role of business has been the norm. Under this theory, a corporation is viewed as private property owned by and for the benefit of its owners—the stock- holders of the corporation. (For a full discussion of this legal model, see Chapter 35.) The stakeholder model, on the other hand, holds that corporations are responsible to society at large and more directly to all those constituencies on which they depend for their survival. Thus, it is argued that a corporation should be managed for the benefit of all of its stakeholders— stockholders, employees, customers, suppliers, and managers, as well as the local communities in which it operates. (See Figure 2-2 for the stakeholder model of corporate responsibility; compare it with Figure 35-1.)

Less Government Regulation According to another argument in favor of corporate social respon- sibility, the more responsibly companies act, the less the government must regulate them. This idea, if accu- rate, would likely appeal to those corporations that typically view regulation with distaste, perceiving it as a crude and expensive way of achieving social goals. To them, regulation often imposes inappropriate, overly broad rules that hamper productivity and

22 Introduction to Law and Ethics Part I

require extensive recordkeeping procedures to docu- ment compliance. If companies can use more flexible, voluntary methods of meeting a social norm, such as pollution control, then government will be less tempted to legislate norms.

The argument can be taken further. Not only does anticipatory corporate action lessen the likelihood of government regulation, but also social involvement by companies creates a climate of trust and respect that reduces the overall inclination of government to inter- fere in company business. For example, a government agency is much more likely to show some leniency to- ward a socially responsible company than toward one that ignores social plights.

Long-Run Profits Perhaps the most persuasive argument in favor of corporate involvement in social causes is that such involvement actually makes good business sense. Consumers often support good corpo- rate images and avoid bad ones. For example, consum- ers generally prefer to patronize stores with “easy return” policies. Even though the law does not require such policies, companies institute them because they create goodwill—an intangible though indispensable asset for ensuring repeat customers. In the long run, enhanced goodwill often rebounds to stronger profits. Moreover, corporate actions to improve the well-being of their communities make these communities more attractive to citizens and more profitable for business.

C H A P T E R S U M M A R Y

Definitions

Ethics study of what is right or good for human beings

Business Ethics study of what is right and good in a business setting

Ethical Theories

Ethical Fundamentalism individuals look to a central authority or set of rules to guide them in ethical decision making

Ethical Relativism asserts that actions must be judged by what individuals subjectively feel is right or wrong for themselves

Situational Ethics one must judge a person’s actions by first putting oneself in the actor’s situation

Utilitarianism moral actions are those that produce the greatest net pleasure compared with net pain • Act Utilitarianism assesses each separate act according to whether it maximizes pleasure over pain • Rule Utilitarianism supports rules that on balance produce the greatest pleasure for society • Cost-Benefit Analysis quantifies the benefits and costs of alternatives

FIGURE 2-2 The Stakeholder Model

Managers

Employees

Community

Stockholders

Customers

Suppliers

Corporation

Chapter 2 Business Ethics 23

Deontology holds that actions must be judged by their motives and means as well as their results

Social Ethics Theories focus on a person’s obligations to other members in society and on the individual’s rights and obligations within society • Social Egalitarians believe that society should provide all its members with equal amounts of

goods and services regardless of their relative contributions • Distributive Justice stresses equality of opportunity rather than results • Libertarians stress market outcomes as the basis for distributing society’s rewards

Other Theories • Intuitionism a rational person possesses inherent powers to assess the correctness of actions • Good Person individuals should seek out and emulate good role models

Ethical Standards in Business

Choosing an Ethical System Kohlberg’s stages of moral development is a widely accepted model (see Figure 2-1)

Corporations as Moral Agents because a corporation is a statutorily created entity, it is not clear whether it should be held morally responsible

Ethical Responsibilities of Business

Regulation of Business government regulation has been necessary because all the conditions for perfect competition have not been satisfied and free competition cannot by itself achieve other societal objectives

Corporate Governance vast amounts of wealth and power have become concentrated in a small number of corporations, which in turn are controlled by a small group of corporate officers

Arguments Against Social Responsibility • Profitability because corporations are artificial entities established for profit-making activities,

their only social obligation should be to return as much money as possible to shareholders • Unfairness whenever corporations engage in social activities, such as supporting the arts or

education, they divert funds rightfully belonging to shareholders and/or employees to unrelated third parties

• Accountability a corporation is subject to less public accountability than public bodies are • Expertise although a corporation may have a high level of expertise in selling its goods and

services, there is absolutely no guarantee that any promotion of social activities will be carried on with the same degree of competence

Arguments in Favor of Social Responsibility • The Social Contract because society allows for the creation of corporations and gives them

special rights, including a grant of limited liability, corporations owe a responsibility to society • Less Government Regulation by taking a more proactive role in addressing society’s problems,

corporations create a climate of trust and respect that has the effect of reducing government regulation

• Long-Run Profits corporate involvement in social causes creates goodwill, which simply makes good business sense

Q U E S T I O N S

1. You have an employee who has a chemical imbalance in the brain that causes him to be severely unstable. The medication that is available to deal with this schizo- phrenic condition is extremely powerful and decreases

the taker’s life span by one to two years for every year that the user takes it. You know that his doctors and family believe that it is in his best interest to take the medication. What course of action should you follow?

24 Introduction to Law and Ethics Part I

2. You have a very shy employee who is from another country. After a time, you notice that the quality of her performance is deteriorating rapidly. You find an appropriate time to speak with her and determine that she is extremely distraught. She tells you that her family has arranged a marriage for her and that she refuses to obey their contract. She further states to you that she is thinking about committing suicide. Two weeks later, af- ter her poor performance continues, you determine that she is on the verge of a nervous breakdown; and once again she informs you that she is going to commit suicide.

What should you do? Consider further that you can petition a court to have her involuntarily committed to a mental hospital. You know, however, that her family would consider such a commitment an extreme insult and that they might seek retribution. Does this prospect alter your decision?

3. You receive a telephone call from a company you never do business with requesting a reference on one of your employees, Mary Sunshine. You believe Mary performs in a generally incompetent manner, and you would be delighted to see her take another job. You give her a glowing reference. Is this right? Explain.

4. You have just received a report suggesting that a chemi- cal your company uses in its manufacturing process is very dangerous. You have not read the report, but you are generally aware of its contents. You believe that the chemical can be replaced fairly easily, but that if word gets out, panic may set in among employees and commu- nity members. A reporter asks if you have seen the report, and you say no. Is your behavior right or wrong? Explain.

5. You and Joe Jones, your neighbor and friend, bought lot- tery tickets at the corner drugstore. While watching the lottery drawing on television with you that night, Joe leaped from the couch, waved his lottery ticket, and shouted, “I’ve got the winning number!” Suddenly, he clutched his chest, keeled over, and died on the spot. You are the only living person who knows that Joe, not you, bought the winning ticket. If you substitute his ticket for yours, no one will know of the switch and you will be $10 million richer. Joe’s only living relative is a rich aunt whom he despised. Will you switch his ticket for yours? Explain.

6. Omega, Inc., a publicly held corporation, has assets of $100 million and annual earnings in the range of $13 to $15 million. Omega owns three aluminum plants, which are profitable, and one plastics plant, which is losing $4 million a year. Because of its very high operating costs, the plastics plant shows no sign of ever becoming profita- ble, and there is no evidence that the plant and the underlying real estate will increase in value. Omega decides to sell the plastics plant. The only bidder for the

plant is Gold, who intends to use the plant for a new purpose: to introduce automation, and to replace all existing employees. Would it be ethical for Omega to turn down Gold’s bid and keep the plastics plant operat- ing indefinitely, for the purpose of preserving the employ- ees’ jobs? Explain.

7. You are the sales manager of a two-year-old electronics firm. At times, the firm has seemed on the brink of fail- ure, but recently it has begun to be profitable. In large part, the profitability is due to the aggressive and talented sales force you have recruited. Two months ago, you hired Alice North, an honors graduate from the State University, who decided that she was tired of the Research Department and wanted to try sales.

Almost immediately after you sent Alice out for train- ing with Brad West, your best salesperson, he began reporting to you an unexpected turn of events. According to Brad, “Alice is terrific: she’s confident, smooth, and persistent. Unfortunately, a lot of our buyers are good old boys who just aren’t comfortable around young, bright women. Just last week, Hiram Jones, one of our biggest customers, told me that he simply won’t continue to do business with ‘young chicks’ who think they invented the world. It’s not that Alice is a know-it-all. She’s not. It’s just that these guys like to booze it up a bit, tell some off-color jokes, and then get down to busi- ness. Alice doesn’t drink, and, although she never objects to the jokes, it’s clear she thinks they’re offensive.” Brad felt that several potential deals had fallen through “because the mood just wasn’t right with Alice there.” Brad added, “I don’t like a lot of these guys’ styles myself, but I go along to make the sales. I just do not think Alice is going to make it.”

When you call Alice in to discuss the situation, she concedes the accuracy of Brad’s report but indicates that she’s not to blame and insists that she be kept on the job. You feel committed to equal opportunity but don’t want to jeopardize your company’s ability to survive. What should you do?

8. Major Company subcontracted the development of part of a large technology system to Start-up Company, a small corporation specializing in custom computer sys- tems. The contract, which was a major breakthrough for Start-up Company and crucial to its future, provided for an initial development fee and subsequent progress pay- ments, as well as a final date for completion.

Start-up Company provided Major Company with periodic reports indicating that everything was on sched- ule. After several months, however, the status reports stopped coming, and the company missed delivery of the schematics, the second major milestone. As an in-house technical consultant for Major Company, you visited Start-up Company and found not only that it was far behind schedule but also that it had lied about its previous progress. Moreover, you determined that this slippage put

Chapter 2 Business Ethics 25

the schedule for the entire project in severe jeopardy. The cause of Start-up’s slippage was the removal of personnel from your project to work on short-term contracts to obtain money to meet the weekly payroll.

Your company decided that you should stay at Start- up Company to monitor its work and to assist in the design of the project. After six weeks and some progress, Start-up is still way behind its delivery dates. Nonethe- less, you are now familiar enough with the project to complete it in-house with Major’s personnel.

Start-up is still experiencing severe cash flow problems and repeatedly requests payment from Major. But your CEO, furious with Start-up’s lies and deceptions, wishes to “bury” Start-up and finish the project using Major Company’s internal resources. She knows that withhold- ing payment to Start-up will put it out of business. What do you do? Explain.

9. A customer requested certain sophisticated tests on equip- ment he purchased from your factory. Such tests are very expensive and must be performed by a third party. The equipment was tested as requested and met all of the industry standards, but showed anomalies that could not be explained. Though the problem appeared to be very minor, you decided to inspect the unit to try to under- stand the test data—a very expensive and time-consum- ing process. You informed the customer of this decision. A problem was found, but it was minor and was highly unlikely ever to cause the unit to fail. Rebuilding the equipment would be very expensive and time-consuming; moreover, notifying the customer that you were planning to rebuild the unit would also put your overall manufac- turing procedures in question. Should you fix the prob- lem, ship the equipment as is, or inform the customer?

10. You are a project manager for a company making a major proposal to a Middle Eastern country. Your major competition is from Japan.

a. Your local agent, who is closely tied to a very influen- tial sheikh, would receive a 5 percent commission if the proposal were accepted. Near the date for the deci- sion, the agent asks you for $150,000 to “grease the skids” so that your proposal is accepted. What do you do?

b. What do you do if, after you say no, the agent goes to your vice president, who provides the money?

c. Your overseas operation learns that most other foreign companies in this Middle Eastern location bol- ster their business by exchanging currency on the gray market. You discover that your division is twice as profitable as budgeted due to the amount of domestic currency you have received on the gray market. What do you do?

11. Explain what relevance ethics has to business.

12. How should the financial interests of stockholders be bal- anced with the varied interests of stakeholders? If you were writing a code of conduct for your company, how would you address this issue?

13. A company adopts a policy that (a) prohibits romantic relationships between employees of different rank and (b) permits romantic relationships between employees of the same rank only if both employees waive in writing their rights to sue the company should the relationship end. Violation of this rule is grounds for dismissal. Is this rule ethical? If not, how should it be revised? Explain.

14. A company prohibits any employee from making dispar- aging comments about the company through any social media, including online blogs, email, and other electronic media. Violation of this rule is grounds for dismissal. Explain whether this rule is ethical.

26 Introduction to Law and Ethics Part I

B U S I N E S S E T H I C S C A S E S The business ethics cases that follow are based on the kinds of situations that companies regularly face when conducting business. You should first read each case carefully and in its entirety before attempting to analyze it. Second, you should identify the most important ethi- cal issues arising from the situation. Often it is helpful to prioritize these issues. Third, you should identify the viable options for addressing these issues and the ethi- cal implications of the identified options. This might include examining the options from the perspectives of the various ethical theories as well as the affected stake- holders. Fourth, you should reach a definite resolution of the ethical issues by choosing what you think is the best option. You should have a well-articulated ration- ale for your resolution. Finally, you should develop a strategy for implementing your resolution.

PHARMAKON DRUG COMPANY

Background William Wilson, senior vice president of research, de- velopment, and medical (RD&M) at Pharmakon Drug Company, received both his Ph.D. in biochemistry and his M.D. from the University of Oklahoma. Upon com- pletion of his residency, Dr. Wilson joined the faculty at Harvard Medical School. He left Harvard after five years to join the research group at Merck & Co. Three years later, he went to GlaxoSmithKline as director of RD&M, and, after eight years, Dr. Wilson joined Phar- makon in his current position.

William Wilson has always been highly respected as a scientist, a manager, and an individual. He has also been an outstanding leader in the scientific community, particularly in the effort to attract more minorities into the field.

Pharmakon concentrates its research efforts in the areas of antivirals (with a focus on HIV), cardiovascu- lar, respiratory, muscle relaxants, gastrointestinal, the central nervous system, and consumer health care (i.e., nonprescription or over-the-counter [OTC] medicines). Dr. Wilson is on the board of directors of Pharmakon and the company’s executive committee. He reports directly to the chairman of the board and CEO, Mr. Jarred Swenstrum.

Declining Growth During the previous eight years, Pharmakon experi- enced tremendous growth: 253 percent overall with yearly growth ranging from 12 percent to 25 percent. During this period, Pharmakon’s RD&M budget grew from $79 million to $403 million, and the number of employees rose from 1,192 to 3,273 (see Figure 2-3). During the previous two years, however, growth in rev- enue and earnings had slowed considerably. Moreover, in the current year, Pharmakon’s revenues of $3.55 bil- lion and earnings before taxes of $1.12 billion were up only 2 percent from the previous year. Furthermore, both revenues and earnings are projected to be flat or declining for the next five years.

The cessation of this period’s tremendous growth and the likelihood of future decline have been brought about principally by two causes. First, a number of Pharmakon’s most important patents have expired and competition from generics has begun and could con- tinue to erode its products’ market shares. Second, as new types of health-care delivery organizations evolve, pharmaceutical companies’ revenues and earnings will in all likelihood be adversely affected.

Problem and Proposed Solutions In response, the board of directors has decided that the company must emphasize two conflicting goals: increase the number of new drugs brought to market and cut back on the workforce in anticipation of rising

FIGURE 2-3 Pharmakon Employment

Attribute/Years Ago 1 2 3 4 5 6 7 8

Total Employment 3,273 3,079 2,765 2,372 1,927 1,619 1,306 1,192

Minority Employment

272 (8.35%)

238 (7.7%)

196 (7.15%)

143 (6.0%)

109 (5.7%)

75 (4.6%)

53 (4.1%)

32 (2.7%)

Revenue ($ million) 3,481 3,087 2,702 2,184 1,750 1,479 1,214 986

Profit ($ million) 1,106 1,021 996 869 724 634 520 340

RD&M Budget ($ million) 403 381 357 274 195 126 96 79

Chapter 2 Business Ethics 27

labor and marketing costs and declining revenues. Accordingly, Dr. Wilson has been instructed to cut costs significantly and to reduce his workforce by 15 percent over the next six months.

Dr. Wilson called a meeting with his management team to discuss the workforce reduction. One of his managers, Leashia Harmon, argued that the layoffs should be made “so that recent gains in minority hiring are not wiped out.” The percentage of minority employ- ees had increased from 2.7 percent eight years ago to 8.3 percent in the previous year (see Figure 2-3). The mi- nority population in communities in which Pharmakon has major facilities has remained over the years at approximately 23 percent. About 20 percent of the RD&M workforce have a Ph.D. in a physical science or in pharmacology, and another 3 percent have an M.D.

Dr. Harmon, a Ph.D. in pharmacology and head of clinical studies, is the only minority on Dr. Wilson’s seven-member management team. Dr. Harmon argued that RD&M has worked long and hard to increase mi- nority employment and has been a leader in promoting Pharmakon’s affirmative action plan (see Figure 2-4). Therefore, she asserted, all layoffs should reflect this commitment, even if it meant disproportionate layoffs of nonminorities.

Dr. Anson Peake, another member of Dr. Wilson’s management team and director of new products, argued that Pharmakon’s RD&M division has never discharged a worker except for cause and should adhere as closely as possible to that policy by terminating individuals solely based on merit. Dr. Rachel Waugh, director of product

development, pointed out that the enormous growth in employment over the last eight years—almost a trebling of the workforce—had made the company’s employee performance evaluation system less than reliable. Conse- quently, she contended that because laying off 15 percent of her group would be extremely difficult and subjective, she preferred to follow a system of seniority.

Dr. Wilson immediately recognized that any system of reducing the workforce would be difficult to imple- ment. Moreover, he was concerned about being fair to employees and maintaining the best qualified group to carry out the area’s mission. He was very troubled by a merit or seniority system if it could not maintain the minority gains. In fact, he had even thought about the possibility of using this difficult situation to increase the percentage of minorities to bring it more in line with the minority percentage of the communities in which Pharmakon had major facilities.

MYKON’S DILEMMA Jack Spratt, the newly appointed CEO of Mykon Pharmaceuticals, Inc., sat at his desk and scratched his head for the thousandth time that night. His friends never tired of telling him that unless he stopped this habit he would remove what little hair he had left. Nevertheless, he had good reason to be perplexed— the decisions he made would determine the future of the company and, literally, the life or death of thou- sands of people.

FIGURE 2-4 Pharmakon Affirmative Action Program

Pharmakon Drug Company Equal Employment Opportunity Affirmative Action Program

POLICY

It is the policy of Pharmakon Drug Co. to provide equal employment opportunities without regard to race, color, religion, sex, national origin, sexual orientation, disability, and veteran status. The Company will also take affirmative action to employ and advance individual appli- cants from all segments of our society. This policy relates to all phases of employment, includ- ing, but not limited to, recruiting, hiring, placement, promotion, demotion, layoff, recall, termination, compensation, and training. In communities where Pharmakon has facilities, it is our policy to be a leader in providing equal employment for all of its citizens.

RESPONSIBILITY FOR IMPLEMENTATION

The head of each division is ultimately responsible for initiating, administering, and controlling activities within all areas of responsibility necessary to ensure full implementation of this policy.

The managers of each location or area are responsible for the implementation of this policy.

All other members of management are responsible for conducting day-to-day activities in a manner to ensure compliance with this policy.

28 Introduction to Law and Ethics Part I

As a young, ambitious scientist, Spratt had gained international fame and considerable fortune while rising quickly through the ranks of the scientists at Mykon. After receiving a degree from the Executive MBA pro- gram at the Kenan-Flagler Business School, University of North Carolina at Chapel Hill, he assumed, in rapid succession, a number of administrative positions at the company, culminating in his appointment as CEO. But no one had told him that finding cures for previously incurable diseases would be fraught with moral dilem- mas. Although it was 3:00 a.m., Spratt remained at his desk, unable to stop thinking about his difficult choices. His preoccupation was made worse by the knowledge that pressure from governments and consumers would only increase each day he failed to reach a decision. This pressure had mounted relentlessly since the fateful day he announced that Mykon had discovered the cure for AIDS. But the cure brought with it a curse: there was not enough to go around.

Background Mykon, a major international research-based pharma- ceutical group, engages in the research, development, manufacture, and marketing of human health-care products for sale in both the prescription and over-the- counter (OTC) markets. The company’s principal pre- scription medicines include a range of products in the following areas: antiviral, neuromuscular blocking, car- diovascular, anti-inflammatory, immunosuppressive, systemic antibacterial, and central nervous system. Mykon also manufactures other products such as mus- cle relaxants, antidepressants, anticonvulsants, and re- spiratory stimulants. In addition, the company markets drugs for the treatment of congestive heart failure and the prevention of organ rejection following transplant.

Mykon’s OTC business primarily consists of cough and cold preparations and several topical antibiotics. The company seeks to expand its OTC business in vari- ous ways, including the reclassification of some of its prescription drugs to OTC status. Mykon’s OTC sales represented 14 percent of the company’s sales during last year.

Mykon has a long tradition of excellence in research and development (R&D). The company’s expenditures on R&D for the last three financial years constituted 15 percent of its sales.

Mykon focuses its R&D on the following selected therapeutic areas, listed in descending order of expendi- ture amount: antivirals and other antibiotics, cardiovascu- lar, central nervous system, anticancer, anti-inflammatory, respiratory, and neuromuscular.

Mykon sells its products internationally in more than 120 countries and has a significant presence in two of the largest pharmaceutical markets—the United States and Europe—and a growing presence in Japan. It generated approximately 43 percent and 35 percent of the company’s sales from the previous year in the United States and Europe, respectively. The company sells essentially the same range of products throughout the world.

Production Mykon carries out most of its production in Rotterdam in the Netherlands and in Research Triangle Park, North Carolina, in the United States. The latter is the company’s world headquarters. The company’s manu- facturing processes typically consist of three stages: the manufacture of active chemicals, the incorporation of these chemicals into products designed for use by the consumer, and packaging. The firm has an ongoing program of capital expenditure to provide up-to-date production facilities and relies on advanced technology, automation, and computerization of its manufacturing capability to help maintain its competitive position.

Production facilities are also located in ten other countries to meet the needs of local markets and to overcome legal restrictions on the importation of fin- ished products. These facilities principally engage in product formulation and packaging, although plants in certain countries manufacture active chemicals. Last year, Mykon had more than seventeen thousand employees, 27 percent of whom were in the United States. Approximately 21 percent of Mykon’s employ- ees were engaged in R&D, largely in the Netherlands and the United States. Although unions represent a number of the firm’s employees, the firm has not expe- rienced any significant labor disputes in recent years, and it considers its employee relations to be good.

Research and Development In the pharmaceutical industry, R&D is both expensive and prolonged, entailing considerable uncertainty. The process of producing a commercial drug typically takes between eight and twelve years as it proceeds from dis- covery through development to regulatory approval and finally to the product launch. No assurance exists that new compounds will survive the development process or obtain the requisite regulatory approvals. In addition, research conducted by other pharmaceutical companies may lead at any time to the introduction of competing or improved treatments.

Chapter 2 Business Ethics 29

Last year Mykon incurred approximately 95 percent of its R&D expenditures in the Netherlands and the United States. Figure 2-5 sets out the firm’s annual ex- penditure on R&D in dollars and as a percentage of sales for each of the last three financial years.

Jack Spratt Every society, every institution, every company, and most important, every individual should fol- low those precepts that society holds most dear. The pursuit of profits must be consistent with and subordinate to these ideals, the most impor- tant of which is the Golden Rule. To work for the betterment of humanity is the reason I became a scientist in the first place. As a child, Banting and Best were my heroes. I could think of no vocation that held greater promise to help mankind. Now that I am CEO I intend to have these beliefs included in our company’s mission statement.

These sentiments, expressed by Jack Spratt in a news- magazine interview, capture the intensity and drive that animate the man. None who knew him was surprised when he set out years ago—fueled by his prodigious energy, guided by his brilliant mind, and financed by Mykon—for the inner reaches of the Amazon Basin to find naturally occurring medicines. Spratt considered it to be his manifest destiny to discover the cure for some dread disease.

His search was not totally blind. Some years earlier, Frans Berger, a well-known but eccentric scientist, had written extensively about the variety of plant life and fungi that flourished in the jungles of the Bobonaza River region deep in the Amazon watershed. Although he spent twenty years there and discovered nothing of medical significance, the vast number and intriguing uniqueness of his specimens convinced Spratt that it was just a matter of time before a major breakthrough would occur.

Spratt also had some scientific evidence. While work- ing in Mykon’s laboratory to finance his graduate edu- cation in biology and genetics, Spratt and his supervisors had noticed that several fungi not only could restore damaged skin but also, when combined with synthetic polymers, had significant effects on inter- nal cells. Several more years of scientific expeditions and investigations proved promising enough for Mykon to send Spratt and a twenty-person exploration team to the Amazon Basin for two years. Two years became five, and the enormous quantity of specimens sent back eventually took over an entire wing of the company’s sizable laboratories in Research Triangle Park, North Carolina.

Upon Spratt’s return, he headed up a group of Mykon scientists who examined the Amazonian fungi for pharmacological activity. After several years of promising beginnings and disappointing endings, they discovered that one fungus destroyed the recently iden- tified virus HIV. Years later, the company managed to

FIGURE 2-5 Mykon R&D Expenditures

15.8

15.6

15.4

15.2

15.0

14.8

14.6

14.4

14.2

370

380

360

350

340

330

320

310

300

290

280 3

years ago

2 years ago

Expenditures

Percentage

Millions of Dollars

Percentage of Sales

1 year ago

30 Introduction to Law and Ethics Part I

produce enough of the drug (code named Sprattalin) derived from the fungus to inform the Food and Drug Administration (FDA) that it was testing what appeared to be a cure for HIV. It was the happiest moment of Jack Spratt’s life. The years of determined effort, not to mention the $800 million Mykon had invested, would now be more than fully rewarded.

Spratt’s joy was short-lived, though. Public aware- ness of the drug quickly spread, and groups pressured the FDA to shorten or eliminate its normal approval process, which ordinarily takes more than seven years. People dying from the virus’s effects demanded immedi- ate access to the drug.

The Drug Mirroring the insidiousness of HIV itself, the structure of Sprattalin is extraordinarily complex. Consequently, it takes four to seven months to produce a small quan- tity, only 25 percent of which is usable. It is expensive; each unit of Sprattalin costs Mykon $20,000 to pro- duce. The projected dosage ranges from ten units for asymptomatic HIV-positive patients who have normal white blood cell counts to fifty units for patients with low white blood cell counts and full-blown AIDS. The

drug appears to eliminate the virus from all patients regardless of their stage of the disease. However, it does not have any restorative effect on patients’ compro- mised immune systems. Accordingly, it is expected that asymptomatic HIV-positive patients will revert to their normal life expectancies. It is not clear what the life ex- pectancy will be of patients with full-blown AIDS, although it is almost certain that their life expectancy would be curtailed.

Supply of Sprattalin The company has esti- mated that the first two years of production would yield enough Sprattalin to cure 6 percent of all asymp- tomatic HIV-positive patients. Alternatively, the supply would be sufficient to treat 4 percent of all patients with full-blown AIDS. Children constitute 9 percent of all people living with HIV/AIDS. See Figures 2-6 and 2-7 for statistics on the HIV/AIDS epidemic.

Interested parties have argued that the solution to production problems is clear: build larger facilities. However, even with production levels as low as they are, the bottleneck in supply occurs elsewhere. The fun- gus on which the whole process depends is incredibly rare, growing only in two small regions near Jatun Molino, Ecuador, along the Bobonaza River. At current

FIGURE 2-6 Global Summary of the AIDS Epidemic

Global Summary of the HIV/AIDS Epidemic, December 2013

Number of people living with HIV/AIDS in 2013

Total

Adults

Children under 15 years

People newly infected with HIV in 2013

Total

Adults

Children under 15 years

AIDS deaths in 2013

Total

Adults

Children under 15 years

0 10 20 30 40 50

0 1 2 3 4 5

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5

Millions

Source: World Health Organization, HIV/AIDS Department (accessed March 2015).

Chapter 2 Business Ethics 31

harvesting rates, scientists predict that all known depos- its will be depleted in three years, and many of them insist that production should be scaled back to allow the fungus to regenerate itself.

Presently there are no known methods of cultivating the fungus in the laboratory. Apparently, the delicate ecology that allows it to exist in only one region of the earth is somehow distressed enough by either transport or lab conditions to render it unable to grow and pro- duce the drug’s precursor. Scientists are feverishly try- ing to discover those factors that will support successful culture. However, with limited quantities of the starting material and most of that pressured into production, the company has enjoyed no success in this endeavor. Because of Sprattalin’s complexity, attempts to synthesize the drug have failed completely, mainly because it is not known how the drug works; thus, Sprattalin’s effectiveness remains shrouded in mystery.

Allocation of Sprattalin In response to the insufficient supply, a number of powerful consumer groups have made public their suggestions regarding the allocation of Sprattalin. One proposition advanced would use medical records to establish a waiting list of possible recipients based on the length of time they have been in treatment for the virus. The argument is that those people who have waited the longest and are most in danger of dying should be the first to find relief.

Other groups propose an opposite approach, arguing that because supply is so drastically short, Mykon should make Sprattalin available only to asymptomatic HIV patients. They require the least concentrations of the drug to become well, thus extending the drug’s sup- ply. They also have the greatest likelihood of returning to full life expectancies. Under this proposal, people

who have full-blown AIDS would be ineligible for treat- ment. Such patients have previously come to terms with their impending mortality; have fewer psychological adjustments to make; and represent, on a dosage basis, two to five healthier patients. In meting the drug out in this manner, proponents argue, the drug can more readily meet the highest public health objectives to eradicate the virus and prevent further transmission.

Others propose that only patients who contracted the virus through no fault of their own should have pri- ority. This approach would first make Sprattalin avail- able to children who were born with the virus, hemophiliacs and others who got the virus from blood transfusions, rape victims, and health-care workers.

One member of Sprattalin’s executive committee has suggested a free market approach: the drug should go to the highest bidder.

Pricing of Sprattalin In addition to supply problems, Mykon has come under considerable criti- cism for its proposed pricing structure. Because of ex- traordinarily high development and production costs, the company has tentatively priced the drug at levels unattainable for most people afflicted with HIV. Per- haps never before in the history of medicine has the ability to pay been so starkly presented as those who can pay will live, while those who cannot pay will die.

Even at these prices, though, demand far exceeds supply. Jack Spratt and the rest of the Mykon execu- tives predict that the company could easily sell avail- able supplies at twice the proposed price.

A growing number of Mykon executives disagree with the passive stance the company has taken in pricing the product. In their view, a 20 percent markup represents a meager return for the prolonged risk and high levels of

FIGURE 2-7 Regional Statistics for HIV and AIDS End of 2013

Region

Adults and Children Living with HIV/AIDS

Adults and Children

Newly Infected Adult

Prevalence

AIDS-Related Deaths in Adults

and Children

Sub-Saharan Africa 24.7 million 1.5 million 4.7% 1.1 million

North Africa and Middle East 230,000 25,000 0.1% 15,000

Asia and Pacific 4.8 million 350,000 0.2% 250,000

Latin America 1.6 million 94,000 0.4% 47,000

Caribbean 250,000 12,000 0.9% 11,000

Eastern Europe and Central Asia 1.1 million 110,000 0.6% 53,000

Western and Central Europe and North America

2.3 million 88,000 0.3% 27,000

Global Total 35.0 million 2.1 million 0.8% 1.5 million

Source: World Health Organization, HIV/AIDS Department (accessed March 2015).

32 Introduction to Law and Ethics Part I

spending that the company incurred to develop the drug. Moreover, it leaves little surplus for future investment. Furthermore, eight years is too long to amortize the R&D expenses because Sprattalin, though the first, is unlikely to be the last anti-HIV drug, now that Mykon has blazed a path. Other, more heavily capitalized com- panies are racing to reverse engineer the drug, and the availability of competing drugs remains only a matter of time. Accordingly, the company cannot realistically count on an eight-year window of opportunity.

Foreign markets further exacerbate the pricing per- plexity. Other countries, with less privatized health care, have already promised their citizens access to Sprattalin at any price. Some industrial countries, for instance, are willing to pay up to $2 million per patient. They do not, however, wish to subsidize the drug for the United States. At the same time, some voi- ces in the United States insist that supplies should go first to U.S. citizens.

On the other hand, countries with the most severe concentration of the HIV infection cannot afford to pay even Mykon’s actual costs. Jack Spratt feels a very real moral obligation to help at least some of these peo- ple, whether they can pay or not.

Making the Decision In the past few months, Jack Spratt had seen many aspects of the most important project in his life become not only public knowledge but also public domain. Because of the enormous social and political conse- quences of the discovery, it is unlikely that the govern- ment will allow Mykon to control the destiny of either Sprattalin or ultimately the company.

Addressing the public’s concern over access to the drug while ensuring future prosperity of his company had become like walking a tightrope with strangers holding each end of the rope. He knew of no way to satisfy everyone. As Jack Spratt sat at his desk, sleep remained an eon away.

OLIVER WINERY, INC.

Background Paul Oliver, Sr., immigrated to the United States from Greece. After working for several wineries, he started Oliver Winery, Inc., which eventually found a market niche in nonvarietal jug wines. Through mass-market- ing techniques, the company established a substantial presence in this segment of the market. Ten years ago,

Paul, Jr., joined the firm after receiving a degree in enology (the study of wine making). He convinced his father of the desirability of entering a different segment of the wine market: premium varietals. To do this, the company needed a large infusion of capital to purchase appropriate vineyards. Reluctantly, Paul, Sr., agreed to take the company public. The initial public offering succeeded, and 40 percent of the company’s stock went into outsiders’ hands. Also, for the first time, outsiders served on the board of directors. Although Paul, Jr., wanted to use a new name for the premium varietal to appeal to a more upscale market, his father insisted on using the name Oliver.

Board Meeting The board of directors met, along with Janet Stabler, the director of marketing of Oliver Winery, Inc. The following directors were in attendance:

Paul Oliver, Sr., chairman of the board, founder of the company

Paul Oliver, Jr., CEO, has an advanced degree in enology

Cyrus Abbott, CFO, has an MBA

Arlene Dale, comptroller, has a CPA with a master’s degree in accounting

Raj Ray, COO, has a master’s degree in industrial engineering

LaTasha Lane, vice president legal, has a J.D. degree

Elisabeth Constable, union representative to the board, has a GED degree

Rev. John W. Calvin, outside director, has a Doctor of Divinity degree

Carlos Menendez, outside director, has an MFA degree

Oliver, Sr.: The next item on the agenda is a pro- posal to develop a new line of wines. Janet Stabler will briefly present the proposal.

Stabler: Thank you. The proposal is to enter the for- tified wine market. It’s the only type of wine in which unit sales are increasing. We’ll make the wines cheaply and package them in pint bottles with screw-on caps. Our chief competitors are Canandaigua with Richard’s Wild Irish Rose, Gallo with Thunderbird and Night Train Express, and Mogen David with MD 20/20. We’ll market the wine with little or no media advertis- ing by strategically sampling the product to targeted consumers. That’s it in a nutshell.

Oliver, Sr.: Any questions before we vote? Menendez: Who’ll buy this wine?

Chapter 2 Business Ethics 33

Calvin: From what I know about the consumers of your competitors, it appears to me that it’s bought by homeless winos.

Stabler: Not entirely. For example, pensioners on a fixed income would find the price of the wine appealing. Thunderbird has been recently introduced into England and has become very popular with the yuppie crowd.

Calvin: Then why put it in pint bottles? Stabler: For the convenience of consumers. Menendez: Why would pensioners want a small

bottle? Calvin: Homeless people want it in pints so they can

fit it in their hip pockets. They obviously don’t have a wine cellar to lay away their favorite bottles of Mad Dog.

Stabler: The pint size also keeps the price as low as possible.

Calvin: Translation: The homeless don’t have to panhandle as long before they can make a purchase. Also, why would you increase the alcoholic content to 18 percent and make it so sweet if it weren’t for the wino market?

Stabler: Many people like sweet dessert wines, and 18 percent is not that much more than other types of wines that have 12 percent alcohol.

Menendez: Is it legal? Lane: Sure. We sell to the retailers. It may be against

the law to sell to intoxicated persons, but that’s the retailers’ business. We cannot control what they do.

Calvin: Isn’t this product intended for a perpetually intoxicated audience that many people consider to be ill? Wouldn’t we be taking advantage of their illness by selling highly sugared alcohol that suppresses their appetite? I’ve spoken to drinkers who claim to live on a gallon of this type of product a day.

Oliver, Jr.: What will this do to our image? We’re still trying to get our premium wines accepted.

Stabler: Of course we won’t use the Oliver name on these wines. We will use another name.

Menendez: Is it okay to do that? Stabler: Why not? Canandaigua, Gallo, and Mogen

David all do the same thing. None of them put their corporate name on this low-end product.

Abbott: We’re getting away from the crux of the mat- ter. Profit margins would be at least 10 percent higher on this line than our others. Moreover, unit sales might increase over time. Our other lines are stagnant or decreasing. The public shareholders are grousing.

Dale: Not to mention that our stock options have become almost worthless. I’m only a few years from retirement. We need to increase the profitability of the company.

Ray: Operationally, this proposal is a great fit. We can use the grapes we reject from the premium line. It will also insulate us from bad grape years because any grape will do for this wine. We can fill a lot of our unused capacity.

Constable: And hire back some of the workers who were laid off!

Stabler: It’s a marketing dream. Just give out some samples to “bell cows.”

Menendez: What are bell cows? Stabler: Opinion leaders who will induce other con-

sumers to switch to our brand. Calvin: You mean wino gurus? Oliver, Sr.: Look, if we don’t do it, others will. In

fact, they already have. Abbott: And they’ll get richer, and we’ll get poorer. Lane: Gallo pulled out of several of these skid-row

markets as did Canandaigua. Little good it did. The alcoholics just switched to malt liquor, vodka, or any- thing they could get their hands on.

Dale: I think our concern is misplaced. These people are the dregs of society. They contribute nothing.

Calvin: They’re human beings who need help. We’re profiting off their misfortune and misery.

Oliver, Sr.: We can take that up when we decide on what charities to support. Anyone opposed to the pro- posal?

Calvin: Is this a done deal? I believe we should con- tribute half of our profits from this product to support homeless shelters and other programs that benefit indi- gent and homeless people. If not, I must resign from this board.

Sources Carrie Dolan, “Gallo Conducts Test to Placate Critics

of Its Cheap Wine,” The Wall Street Journal, June 16, 1989, p. B3.

Alix M. Freedman, “Winos and Thunderbird Are a Subject Gallo Doesn’t Like to Discuss,” The Wall Street Journal, February 25, 1988, p. 1.

Frank J. Prial, “Experiments by a Wine Maker Fails to Thwart Street Drunks,” The New York Times, February 11, 1990, p. A29.

JLM, INC.

Background Sitting in her office, Ellen Fulbright, director of human resources (HR) for JLM, Inc., thought over the

34 Introduction to Law and Ethics Part I

decisions confronting her. To help her decide, she men- tally reviewed how they had arisen.

After receiving her MBA and J.D. degrees from a highly regarded university, she joined a prestigious New York law firm where she specialized in employ- ment law. After seven years at the law firm, she was hired by one of the firm’s clients as general counsel. When that company was acquired by JLM, she joined its legal staff and within a few years had been pro- moted to her current position.

Fulbright’s rapid advancement resulted from her having made a positive impression on Rasheed Raven, JLM’s CEO. Raven is a hard-driving, bottom-line-ori- ented pragmatist in his early forties. Raven, a graduate of Howard University, had begun his business career on Wall Street, which he astounded with his aggressive but successful takeover strategies. After acquiring fif- teen unrelated manufacturing companies, he decided to try his hand at the turnaround business. He organized JLM as an umbrella for his acquired companies. Soon he earned the reputation as the best in the business by transforming JLM into the leader in the industry.

JLM is a highly successful turnaround company. Typically, JLM purchases companies that are in serious financial trouble and manages them until they become successful companies. At that time, JLM either retains them in its own portfolio of companies or sells them off to other enterprises.

Reference Letter Policy About a year after Fulbright had become HR director, Raven called her into his office and showed her a news- paper article. It reported, in somewhat sensational fash- ion, that several defamation suits had resulted in multimillion-dollar judgments against companies that had written negative letters of references about former employees. Raven told her that he was concerned about this and that he wanted her to develop an HR policy covering letters of reference.

In researching the issue, she discovered several articles in which the authors decried the recent spate of companies that had decided to stop writing letters of reference. According to their data, they believed that these companies had overreacted to the actual risk posed by defamation suits. Based on these articles and her own inclination toward full disclosure, she pro- posed that the company continue to permit letters of reference but that all letters with negative comments must be reviewed by her.

Raven did not receive her proposal favorably and sought a second opinion from her old law firm. His

analysis of the firm’s advice was: “We get nothing but brownie points for writing reference letters, but we face the possibility of incurring the cost of a legal defense or, worse yet, a court judgment. This is a no-brainer. We have no upside and all downside.” Raven ordered that, henceforth, company employees would no longer write letters of reference but would simply verify dates of employment.

Although Fulbright was personally and professio- nally miffed by his decision, she drew up the policy statement as directed. Fulbright believed that because JLM frequently took over companies that needed immediate downsizing, this policy would be unfair and extremely detrimental to longtime employees of newly purchased companies.

Takeover of Diversified Manufacturing, Inc. After a number of years of steady growth, Diversified Manufacturing began experiencing huge financial losses and its immediate survival was in serious doubt. After careful consideration, Raven decided that Diversified was an ideal takeover target in that its core businesses were extremely strong and presented great long-term economic viability.

Upon acquiring Diversified, JLM quickly decided that it had to rid Diversified of some of its poorly per- forming companies and that it had to reduce the size of Diversified’s home office staff by 25 percent. Raven relentlessly orchestrated the reduction in force, but at Fulbright’s urging he provided the discharged execu- tives with above-average severance packages, including excellent outplacement services.

The Problem The reduction in force was disruptive and demoralizing in all the usual ways. But for Fulbright there was a fur- ther complication: the “no reference letter” policy. She was extremely troubled by its application to three dis- charged Diversified employees and to one discharged JLM employee.

The Salacious Sales Manager Soon after taking over Diversified, Fulbright became all too aware of the story of Ken Byrd, Diversified’s then national sales manager. Ken is an affable man of fifty who had been an unusually effective sales manager. Throughout his career, his sales figures had always doubled those of his peers. He achieved rapid advancement despite a fatal flaw: he is an inveterate and indiscreet womanizer.

Chapter 2 Business Ethics 35

He could not control his hands, which slapped backs so well, nor his tongue, which persuaded so eloquently. He had two approaches to women. With a woman of equal or superior rank in the company, he would politely, but inexorably, attempt to sweep her off her feet. With these women, he would be extremely charm- ing and attentive, taking great care to avoid being of- fensive or harassing. In contrast, with a woman of subordinate rank, he would physically harass her. Less openly, but much too often, he would come up behind a woman, reach around her, and grab her. He invaria- bly found this amusing—his victims, however, did not.

Fulbright could not believe that such a manager had stayed employed at Diversified so long, let alone been continually promoted to positions of greater responsi- bility and power. As Fulbright investigated the situa- tion, she discovered that numerous sexual harassment complaints had been filed with Diversified concerning Byrd’s behavior. To protect Byrd, Diversified dealt with these complaints by providing money and undeserved promotions to the complainants to smooth over their anger. Thus, Diversified successfully kept the com- plaints in-house and away from the courts and the Equal Employment Opportunity Commission.

After JLM’s takeover of Diversified, Fulbright quickly discharged Byrd. Her satisfaction in getting rid of him was short-lived, however. His golden tongue and stellar sales record had landed him several job offers. Her dilemma was that she was uncomfortable about unleashing this deviant on an unsuspecting new employer. But JLM’s policy forbade her from writing any letters or answering questions from prospective employers.

The Fruitless Juice Melissa Cuthbertson had been a vice president in procurement for Diversified’s Birch-Wood division with direct responsibility over the ordering of supplies and raw materials. Birch-Wood manufactured a full line of baby food products, including fruit juices that were labeled “100% fruit juice.” To cut costs, Stanley Aker, the division’s presi- dent, had arranged for an unscrupulous supplier to provide high-fructose corn syrup labeled as juice con- centrate. Because standard testing in the industry was unable to detect the substitution, the company did not get caught. Emboldened, Aker gradually increased the proportion of corn syrup until there were only trace amounts of fruit juice left in the “juice.” A company employee discovered the practice and after the take- over brought the matter to Fulbright’s attention through JLM’s internal whistle-blowing channel, which Fulbright had established. She referred the matter to

Raven, who called in Aker and Cuthbertson and con- fronted them with the accusation. They admitted it all, explaining that nutritionally the corn syrup was equiva- lent to the fruit juice. But at 60 percent of the cost of fruit juice, the corn syrup made a big difference to the bottom line. Raven told them that such conduct was not permitted and that they must properly dispose of the adulterated juice.

That night Aker and Cuthbertson had the juice moved from Birch-Wood’s New York warehouse and shipped to its Puerto Rico warehouse. Over the course of the next few days, the “juice” was sold in Latin America as “apple juice.” Aker reported to Raven that the juice had been properly disposed of and that Birch- Wood had sustained only a small loss during that quar- ter. When Raven discovered the truth, he immediately discharged Aker and Cuthbertson, telling them “that if he had anything to do with it, neither of them would ever work again.” Fulbright was to meet soon with Raven to discuss what should be done about Aker and Cuthbertson.

The Compassionate CFO Jackson Cobb, JLM’s former chief financial officer, is a brilliant ana- lyst. Through hard work, he had earned an excellent education that honed his innate mathematical gifts. His natural curiosity led him to read widely, and this enabled him to bring disparate facts and concepts to bear on his often-novel analyses of financial matters. But he had no interest in implementing his insights, for his only enjoyment was the process of discovering con- nections. Fortune—or fate—had brought him together with Raven, who is twenty years younger than Cobb. Theirs was definitely a case of opposites attracting. Raven cared little about ideas; he cared primarily about money. Cobb cared little about money; he cared pri- marily about ideas. Raven took Cobb’s insights and translated them into action with spectacular success. Their relationship brought new meaning to the concept of synergy. When Raven formed JLM, he brought Cobb on as CFO and installed him in an adjoining office.

Their relationship continued to flourish, as did JLM’s bottom line, until Cobb’s wife became terminally ill. During the eighteen months she languished, Cobb spent as much time as he could taking care of her. Af- ter forty years of marriage, he was unwilling to leave her welfare to the “kindness of strangers.” At his own expense, he installed a state-of-the-art communication center in his home. By virtue of computers, modems, video cameras, faxes, copiers, mobile telephones, and the like, he had available to him the same data and

36 Introduction to Law and Ethics Part I

information as he had at his office. He could be reached by telephone at all times. But he was not in the office next to Raven; he was not present at Raven’s daily breakfast meetings; he was not on the corporate jet en route to business meetings. After their many years of working together, Raven was enraged at the loss of immediate access to Cobb. He felt that Cobb had betrayed him and demanded that Cobb resume his old working hours. Cobb refused, and Raven fired him. Because of his age, Cobb was experiencing difficulty in finding new employment, and Fulbright wanted to write a letter on his behalf.

SWORD TECHNOLOGY, INC.

Background Sitting in his office, Stephen Hag, CEO of Sword Tech- nology, Inc., contemplated the problems that had been perplexing him for some time. They had begun when he took his company international, and they kept com- ing. But today he was no more successful in devising a solution than he had been previously. Slowly, his thoughts drifted to those early days years ago when he and his sister Marian started the company.

The company’s first product was an investment newsletter stressing technical analysis in securities investing. A few years later, he developed what became a “killer app”: a computer program that defines an entirely new market and through customer loyalty substantially dominates that market. His soft- ware program enabled investors to track their invest- ments in stocks, bonds, and futures. By combining powerful analytical tools with an accessible graphical interface, it appealed to both professional and amateur investors. Moreover, it required users to download in- formation from the company’s database. With one of the most extensive databases and the cheapest down- loading rates in the industry, the company soon con- trolled the U.S. market. Sword then went public through a highly successful IPO (an initial public offering of the company’s common stock), and its stock is traded on the NASDAQ Stock Market. The company is required to file periodic reports with the Securities and Exchange Commission.

The company used cash from sales of software, online charges, and the IPO to try to enter the hard- ware side of the computer industry. It began manufac- turing modems and other computer peripherals. A nagging problem, however, plagued the company’s manufacturing efforts. Although Sword’s modem could

convert data more quickly and efficiently than most of its competitors, because of high labor costs, it was unable to market its modem successfully. To reduce manufacturing costs, especially labor costs, the com- pany decided to move its manufacturing facilities over- seas. And that’s when the trouble began.

Stephen’s thoughts returned to the present. He reop- ened the folder labeled “Confidential: International Issues” and began perusing its contents.

Transfer Pricing The first item he saw was an opinion letter from the company’s tax attorney. It dealt with Excalibur Tech- nology, the first overseas company Sword established. Excalibur, a wholly owned subsidiary of Sword, is incorporated in Tolemac, an emerging country with a rapidly growing economy. To encourage foreign invest- ment, Tolemac taxes corporate profits at a significantly lower rate than the United States and other industrial nations. Excalibur manufactures modems for Sword pursuant to a licensing agreement under which Excali- bur pays Sword a royalty equal to a specified percent- age of the modems’ gross sales. Excalibur sells all of its output at a fair market price to Sword, which then markets the modems in the United States. Stephen had been closely involved in structuring this arrangement and had insisted on keeping the royalty rate low to minimize taxable income for Sword. Stephen reread the opinion letter:

Section 482 of the Internal Revenue Code author- izes the Internal Revenue Service to allocate gross income, deductions, credits, and other common allowances among two or more organizations, trades, or businesses under common ownership or control whenever it determines that this action is necessary “in order to prevent evasion of taxes or clearly to reflect the income of any such organiza- tions, trades, or businesses.” IRS Regulation 1.482-2(e) governing the sale or trade of intan- gibles between related persons mandates an appropriate allocation to reflect the price that an unrelated party under the same circumstances would have paid, which normally includes profit to the seller. The Regulations provide four meth- ods for determining an arm’s-length price. In our opinion, under the only method applicable to the circumstances of Sword Technology, Inc., and Excalibur Technology, the royalty rate should be at least three times the current one. If the IRS were to reach the same conclusion, then the com- pany would be liable for the taxes it underpaid

Chapter 2 Business Ethics 37

because of the understatement of income. More- over, the company would be liable for a penalty of either 20 percent or 40 percent of the tax defi- ciency, unless the company can show that it had reasonable cause and acted in good faith.

Stephen had spoken to the tax attorney at length and learned that the probability of an audit was about 10 percent and that many multinational companies play similar “games” with their transfer pricing. The attor- ney also told him that he believed that if the company were audited, there was at least a 90 percent probabil- ity that the IRS would agree with his conclusion and at least a 70 percent probability that it would impose a penalty. Because the dollar amount of the contingent tax liability was not an insignificant amount, Stephen had been concerned about it for the six weeks since he had received the letter.

Customs and Customs Soon after Excalibur had manufactured the first ship- ment of modems, a new problem arose: getting them out of Tolemac. It took far too long to clear customs, thus undermining their carefully planned just-in-time manufacturing schedules. Stephen hired a local export broker, who distributed cash gifts to customs officials. Miraculously, the clearance time shortened and manu- facturing schedules were maintained. The export broker billed the company for his services and the amount of the cash gifts. Although the broker assured Stephen that such gifts were entirely customary, Stephen was not entirely comfortable with the practice.

The Thorn in His Side Tolemac was not Stephen’s only problem. Six months after commencing operations in Tolemac, Sword began serious negotiations to enter the Liarg market. Liarg is a developing country with a large population and a larger national debt. Previously, Sword had encoun- tered great difficulties in exporting products to Liarg. Stephen’s sister, Marian, COO of Sword, took on the challenge of establishing a Liarg presence.

They decided that setting up a manufacturing facility in Liarg would achieve two objectives: greater access to the Liarg marketplace and lower-cost modems. At first, the Liarg government insisted that Sword enter into a joint venture, with the government having a 51 percent in- terest. Sword was unwilling to invest in such an arrange- ment, countering with a proposal for a wholly owned subsidiary. Marian conducted extensive negotiations with

the government, assisted by a Liarg consulting firm that specialized in lobbying governmental officials. As part of these negotiations, Sword made contributions to the reelection campaigns of key Liarg legislators who were opposed to wholly owned subsidiaries of foreign corporations. After the legislators’ reelection, the nego- tiations quickly reached a successful conclusion. On clos- ing the contract, Sword flew several Liarg officials and their wives to Lake Tahoe for a lavish three-day celebra- tion. All of these expenses were reported in the com- pany’s financial statements as payments for legal and consulting fees.

Marian then hired an international engineering firm to help design the manufacturing plant. Two weeks later, they submitted plans for the plant and its opera- tions that fully complied with Liarg regulations regard- ing worker health and safety as well as environmental protection. But, as Marian had explained to Stephen, the plant’s design fell far short of complying with U.S. requirements. Marian noted that, under the proposed design, the workers would face exposure to moderately high levels of toxic chemicals and hazardous materials. The design also would degrade the water supply of nearby towns. However, the design would generate sig- nificant savings in capital and operational costs as com- pared with the design used in their U.S. facility. Marian assured Stephen that all quality control systems were in place so the modems produced in this plant would be indistinguishable from their U.S. counterparts. Stephen and Marian have had long discussions about what to do about the plant.

Stephen then took from the folder an article that had appeared in a number of U.S. newspapers.

Children and Chips A twelve-year-old Liarg child recently spoke at an international conference in New York denouncing the exploitation of children in the Liarg computer chip industry. The child informed the outraged audience that he had worked in such a plant from age four to age ten. He asserted that he was just one of many children who were so employed. He described the deplorable working conditions: poor ventilation, long hours, inadequate food, and sub- standard housing. The pay was low. But, because their families could not afford to keep them at home, the children were hired out to the factory owners, who especially wanted young children because their small fingers made them adept at many assembly processes.

38 Introduction to Law and Ethics Part I

Stephen had read the article countless times, thinking about his own children. He knew that if they set up a plant in Liarg, they would have to buy chip compo- nents from Liarg suppliers. He also knew that there would be no way for Sword to ensure that the chips had not been made with child labor.

Another labor issue also troubled Stephen. Marian told him that she had met considerable resistance from the Liarg executives they had hired when she suggested that women should be hired at the supervisory level. They maintained that it was not done and would make it impossible to hire and control a satisfactory work- force at the plant. Moreover, they insisted on hiring their relatives as supervisors. When Marian protested this nepotism, they assured her that it was customary and asserted that they could not trust anyone not related to them.

To Outsource or Not to Outsource Once again Stephen glanced over the cost data. Sword’s labor costs for supporting its database serv- ices and hardware were eviscerating the company’s profits. After racking his brain endlessly, he had con- cluded that wherever it made financial and strategic sense, Sword should utilize business process outsourc- ing (BPO); that is, long-term contracting out of non- core business processes to an outside provider in order to lower costs and thereby increase shareholder value.

Stephen had examined a number of potential countries on the basis of many factors, including time zone, com- munications infrastructure, technical training, English language skills of the workforce, and—most critically— costs. Liarg had emerged as the optimal choice. He anticipated reducing labor and associated overhead costs by 45 to 50 percent.

He planned to start by offshoring half of the call center operations, soon to be followed by a third of the low-end software development such as maintenance and coding. Assuming all went as he envisioned, he expected to move offshore back-office operations and higher-level software development. As his imagination soared, he saw the potential to amplify the company’s operations with round-the-clock development.

Stephen realized that embarking on this course would result in reducing the staffing at the company’s U.S. call centers. He expected he could achieve some reductions through attrition and reassignment, but con- siderable layoffs would be necessary. He hoped that outsourcing the low-end software development would

enable the company to redeploy its software developers to higher-level and more profitable assignments. More- over, the recent rollback in the number of visas had resulted in difficulty in hiring sufficient numbers of soft- ware developers with the necessary skills. If Sword were to offshore back-office operations, Stephen expected an impact on current employees comparable to offshoring the call centers.

On top of all these concerns had come a letter from the company’s outside legal counsel regarding payments made to foreign officials.

Memorandum of Law

The Foreign Corrupt Practices Act makes it unlawful for any person, and certain foreign issuers of securities, or any of its officers, direc- tors, employees, or agents or its stockholders act- ing on its behalf to offer or give anything of value directly or indirectly to any foreign official, politi- cal party, or political official for the purpose of

1. influencing any act or decision of that person or party in his or its official capacity,

2. inducing an act or omission in violation of his or its lawful duty, or

3. inducing such person or party to use its influ- ence to affect a decision of a foreign govern- ment in order to assist the domestic concern in obtaining or retaining business.

An offer or promise to make a prohibited payment is a violation even if the offer is not accepted or the promise is not performed. The 1988 amendments explicitly excluded facilitating or expediting payments made to expedite or secure the performance of routine govern- mental actions by a foreign official, political party, or party official. Routine government action does not include any decision by a foreign official regarding the award of new business or the continuation of old busi- ness. The amendments also added an affirmative defense for payments that are lawful under the written laws or regulations of the foreign official’s country. Violations are punishable by fines of up to $2 million for compa- nies; individuals may be fined a maximum of $100,000 or imprisoned up to five years, or both. Moreover, under the Alternative Fines Act, the actual fine may be up to twice the benefit that the person sought to obtain by making the corrupt payment. Fines imposed upon individuals may not be paid directly or indirectly by the domestic company or other business entity on whose behalf the individuals acted. In addition, the courts may impose civil penalties of up to $16,000.

Chapter 2 Business Ethics 39

The statute also imposes internal control requirements on all reporting companies. Such companies must

1. make and keep books, records, and accounts, that in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; and

2. devise and maintain a system of internal controls that ensure that transactions are executed as author- ized and recorded in conformity with generally accepted accounting principles, thereby establishing accountability with regard to assets and ensuring that access to those assets is permitted only with management’s authorization.

Any person who knowingly circumvents or know- ingly fails to implement a system of internal accounting controls or knowingly falsifies any book, record, or account is subject to criminal liability.

VULCAN, INC.

The Company Vulcan, Inc., is a multinational Fortune 200 company engaging principally in the exploration for and extraction of minerals. It is listed on the New York Stock Exchange and has more than 615 million shares outstanding.

The Meeting (March 7) On March 5, Stewart Myer, the company’s CEO, per- sonally telephoned Martha Bordeaux, the vice president for finance; Lamont Johnson, the chief geologist; and Natasha Bylinski, the vice president for acquisitions, to arrange a March 7 meeting at the Atlanta airport. He emphasized to each of them the need for the utmost se- crecy, directing them to arrange their travel to Atlanta as a connection to other and different destinations. When they all arrived at the meeting room, Myer reem- phasized the need for complete secrecy. He then asked Johnson to present his report.

The Report Johnson read his report:

Over the past few years we have conducted exten- sive aerial geophysical surveys of the areas west of the Great Plains. These revealed numerous anomalies or extreme variations in the conductivity of rocks. One appeared particularly encouraging, so late last year we began a ground geophysical

survey of the southwest portion of the Z segment in Montana. This survey confirmed the presence of anomalies. Accordingly, on January 14 we drilled some core samples and sent them to our lab. The results were so extraordinarily promising that on February 10 we obtained more core samples and had them chemically assayed. On February 25, we received the assay, which revealed an average mineral content of 1.17 percent copper and 8.6 percent zinc over 600 feet of the sample’s 650- foot length.

Johnson then commented, “In my forty years in the business I have never seen such remarkable test results. On a scale of one to ten, this is an eleven.”

The Reaction Bordeaux exclaimed, “Our stock price will go through the roof!” Bylinski retorted, “So will land prices!”

The Strategy Myer interrupted, “Look, we’re not here to celebrate. There are a lot of better places to do that. We can’t keep a lid on this for very long, so we have to strike soon. We need to line up the right agents to acquire the land. We must fragment the acquisitions to keep the sellers in the dark. Most critical is maintaining absolute secrecy. No one else in the company must know this. I will decide who needs to know, and I will tell them. It is your duty to the company to keep totally quiet. Now, let’s discuss the acquisition plan.”

When asked how he had managed to obtain core samples without tipping off the owners of the land, Johnson explained, “We pretended to be a motion pic- ture company looking for locations to remake the movie High Noon. We drilled the samples in isolated areas and quickly filled the holes. To further cover our tracks we drilled some barren core samples from land we owned and hid the cores on our land.”

The Plan Bylinski outlined the plan to acquire the land. “We only own about 20 percent of the land we want, and we have options on another 15 percent. However, we cur- rently own none of the principal portion. So we have a lot of work to do. We will employ several agents to negotiate the purchases. We will instruct them not to disclose that they are acting for us. In fact, we will order them not to disclose they are acting for anyone. We need to acquire approximately twenty square miles of additional land.”

40 Introduction to Law and Ethics Part I

Bordeaux asked, “What if the locals start getting curious?”

Myer replied, “I’ll deal with that later if it arises.”

Stock Options On March 15, Vulcan issued stock options at $23.50 per share to thirty of its executives, including Myer, Bordeaux, Johnson, and Bylinski. At this time neither the stock option committee nor the board of directors had been informed of the strike or the pending land ac- quisition program.

The Rumors While the land acquisition plan was nearing comple- tion, rumors about a major strike by Vulcan began cir- culating throughout the business community. On the morning of March 20, Bordeaux read an account in a national newspaper reporting that ore samples had been sent out of Montana and inferring from that fact that Vulcan had made a rich strike. Bordeaux called Myer and told him about the article.

The Press Release Myer prepared the following press release, which appeared in morning newspapers of general circulation on March 21:

During the past few days the press has reported drilling activities by Vulcan and rumors of a sub- stantial copper discovery. These reports greatly

exaggerate. Vulcan has engaged in normal geophysi- cal explorations throughout the West. We routinely send core samples to verify our visual examinations. Most of the areas drilled have been barren or mar- ginal. When we have additional information we will issue a statement to shareholders and the public.

Land Acquired On April 6, Vulcan completed its land acquisition pro- gram. It had employed seven different agents. In total, it had acquired thirty-seven parcels from twenty-two differ- ent sellers at prices ranging from $300 to $600 per acre. The land cost a total of approximately $6 million.

Official Announcement At 10:00 a.m. on April 11, Myer released on behalf of Vulcan an official announcement of a strike in Montana containing at least 30 million tons of high-grade copper and zinc ore. The release appeared on the wire services at 10:30 a.m. The price of Vulcan stock shot up eleven points to $38 by the close of business that day and continued to rise, reaching a price of $56 on May 16. (Figures 2-8 and 2-9 show the price and volume of Vulcan stock.)

Loose Lips Prior to the April 11 official announcement, a number of people purchased Vulcan stock with knowledge of the mineral discovery. Some people also purchased land adjacent to Vulcan’s holdings in Montana. These pur- chasers included the following:

FIGURE 2-8 Stock Price of Vulcan, Inc. (note irregular intervals on time axis)

60

50

40

30

20

10

0

14 Ja

n

10 Fe

b

25 Fe

b 1 M

ar 7 M

ar

15 M

ar

18 M

ar

21 M

ar 6 A

pr

15 A

pr 2 M

ay

16 M

ay 11

A pr

Chapter 2 Business Ethics 41

The Vulcan Executives Myer, Bordeaux, Johnson, and Bylinski each purchased shares or calls on several occasions during this time period. See Figure 2-10 for a listing of their purchases.

The Eager Eavesdropper After leaving the March 7 meeting, Bordeaux and Bylinski went to the airport lounge to wait for their flights. They excitedly— and loudly—discussed what they had learned at the meeting. Several people overheard their remarks, and one of them, Rae Bodie, immediately called her broker

and bought fifteen hundred shares of Vulcan stock. Ms. Bodie also purchased a large tract of land next to Vulcan’s site in Montana for approximately $600 per acre.

The Crestfallen Security Guard On March 9, Johnson went into the home office very early to finish up the exploratory work on the new find. At the elevator he encountered Celia Tidey, one of the company’s security guards. Johnson knew her fairly well since they both had worked for Vulcan for

FIGURE 2-9 Average Daily Volume of Vulcan, Inc., Stock for Week (in 1,000s)

450

400

350

300

250

200

150

100

50

0

14 Ja

n

21 Ja

n

28 Ja

n 4 F

eb

11 Fe

b

18 Fe

b

25 Fe

b 4 M

ar

11 M

ar

18 M

ar 1 A

pr 8 A

pr

15 A

pr

22 A

pr

29 A

pr

6 M ay

13 M

ay

20 M

ay

25 M

ar

FIGURE 2-10 Purchases of Vulcan Stock by Selected Executives

Purchaser Date Shares Price Calls Price

Myer Jan. 20 10,000 18.00 Feb. 25 10,000 20.00

March 2 15,000 21.25 March 7 5,000 22.25 March 15 5,000 23.75

Bordeaux March 7 10,000 22.00

March 15 7,500 23.75 March 18 5,000 24.00

Johnson Jan. 20 5,000 18.00 Feb. 25 8,000 20.00

March 1 12,000 21.00 March 7 6,000 22.00 March 15 4,000 23.50

Bylinski March 7 5,000 22.00

March 15 3,000 23.50 March 18 4,000 24.25

42 Introduction to Law and Ethics Part I

more than fifteen years. Noting her despondent vis- age, Johnson asked her what was wrong. She related to him her tale of woe: her husband had become disabled and lost his job while her son needed an expensive medical procedure and their health insur- ance did not cover it. Johnson felt great empathy for her plight. He told her that big doings were afoot at Vulcan and that if she bought Vulcan stock soon she would make a lot of money in a month or so. She took her savings and bought two hundred shares of Vulcan stock, which were as many shares as she could buy.

The Avaricious Agent William Baggio, one of the agents hired to acquire the land, inferred that what- ever was up had to be good for Vulcan. Accordingly, on March 21, he purchased twenty-five hundred shares of Vulcan and five thousand acres of land adjacent to the Vulcan property.

The Trusted Tippee On March 8, Myer called Theodore Griffey, his oldest and dearest friend. After

getting Griffey to swear absolute confidentiality, Myer told him all the details of the strike. After hanging up the telephone, Griffey immediately purchased fifteen thousand shares of Vulcan stock. Griffey then told his father and sister about the land; both of them bought fifteen thousand shares.

The Scampering Stockbroker Morris Lynch, Myer’s stockbroker, was intrigued by Myer’s pur- chases of an unusually large volume of Vulcan shares. During the last two weeks of March, he put a number of his other clients into Vulcan, telling them, “I’ve looked at this stock and it’s good for you.” About a dozen of his clients purchased a total of eight thou- sand shares.

The Land Grab After the official announcement on April 11, several of Vulcan’s competitors began exploring the area and purchased large tracks of land, bidding up the price of land to $2,250 per acre. Both Bodie and Baggio sold their newly acquired land to Vulcan competitors at this higher price.

Chapter 2 Business Ethics 43

PART II T H E L E G A L

E N V I R O N M E N T O F B U S I N E S S

CISG

CHAPTER 3 Civil Dispute Resolution

CHAPTER 4 Constitutional Law

CHAPTER 5 Administrative Law

CHAPTER 6 Criminal Law

CHAPTER 7 Intentional Torts

CHAPTER 8 Negligence and Strict Liability

C H A P T E R 3

CIVIL DISPUTE RESOLUTION

Laws are a dead letter without courts to expound and define their true meaning and operation. ALEXANDER HAMILTON, THE FEDERALIST (1787)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. List and describe the courts in the federal court system and in a typical state court system.

2. Distinguish among exclusive federal jurisdiction, concurrent federal jurisdiction, and exclusive state jurisdiction.

3. Distinguish among (a) subject matter jurisdiction and jurisdiction over the parties

and (b) the three types of jurisdiction over the parties.

4. List and explain the various stages of a civil proceeding.

5. Compare and contrast litigation, arbitration, conciliation, and mediation.

A s discussed in Chapter 1, substantive law sets forth the rights and duties of individuals and other legal entities, whereas procedural law

determines how these rights are asserted. Procedural law attempts to accomplish two competing objectives: (1) to be fair and impartial and (2) to operate effi- ciently. The judicial process in the United States repre- sents a balance between these two objectives as well as a commitment to the adversary system.

In the first part of this chapter, we will describe the structure and function of the federal and state court systems. The second part of this chapter deals with jurisdiction; the third part discusses civil dispute resolu- tion, including the procedure in civil lawsuits.

THE COURT SYSTEM Courts are impartial tribunals (seats of judgment) estab- lished by government bodies to settle disputes. A court may render a binding decision only when it has juris- diction over the dispute and the parties to that dispute; that is, when it has a right to hear and make a judg- ment in a case. The United States has a dual court sys- tem: the federal government has its own independent system, as does each of the fifty states and the District of Columbia.

46

THE FEDERAL COURTS [3-1] Article III of the U.S. Constitution states that the judi- cial power of the United States shall be vested in one Supreme Court and such lower courts as Congress may establish. Congress has established a lower federal court system consisting of a number of special courts, district courts, and courts of appeals. Judges in the fed- eral court system are appointed for life by the Presi- dent, subject to confirmation by the Senate. The structure of the federal court system is illustrated in Figure 3-1.

District Courts [3-1a] The district courts are general trial courts in the federal system. Most federal cases begin in the district court, and it is here that issues of fact are decided. The district court is generally presided over by one judge, although in certain cases three judges preside. In a few cases, an appeal from a judgment or decree of a district court is taken directly to the Supreme Court. In most cases, however, appeals go to the Circuit Court of Appeals of the appropriate circuit, the decision of which is final in most cases.

Congress has established ninety-four federal judi- cial districts, each of which is located entirely in a particular state. All states have at least one district; about half of the states contain more than one district. For instance, California and New York each have four districts, Illinois has three, and Wisconsin has two, while about half of the states each make up a single district.

Courts of Appeals [3-1b] Congress has established twelve judicial circuits (eleven numbered circuits plus the D.C. circuit), each having a court known as the Court of Appeals, which primarily hears appeals from the district courts located within its circuit (see Figure 3-2). In addition, these courts review decisions of many administrative agencies, the Tax Court, and the Bankruptcy Courts. Congress has also established the U.S. Court of Appeals for the Federal Circuit, which is discussed later in the section on “Special Courts.” The U.S. Courts of Appeals generally hear cases in panels of three judges, although in some instances all judges of the circuit will sit en banc to decide a case.

The function of appellate courts is to examine the record of a case on appeal and to determine whether the trial court committed prejudicial error (error sub- stantially affecting the appellant’s rights and duties). If so, the appellate court will reverse or modify the judg- ment of the lower court and, if necessary, remand or send it back to the lower court for further proceeding. If there is no prejudicial error, the appellate court will affirm the decision of the lower court.

The Supreme Court [3-1c] The nation’s highest tribunal is the U.S. Supreme Court, which consists of nine justices (a Chief Justice and eight Associate Justices) who sit as a group in Washington, D.C. A quorum consists of any six justi- ces. In certain types of cases, the U.S. Supreme Court has original jurisdiction (the right to hear a case first). The Court’s principal function, nonetheless, is to review

FIGURE 3-1 Federal Judicial System

U.S. Court of Appeals for the Federal Circuit

Highest State CourtsU.S. Supreme Court

U.S. Courts of Appeals

Court of Federal Claims Patent and Trademark Office Court of International Trade

U.S. District Courts Tax Court

Bankruptcy Court

Many Administrative

Agencies

Chapter 3 Civil Dispute Resolution 47

decisions of the Federal Courts of Appeals and, in some instances, decisions involving federal law resolved by the highest state courts. Cases reach the Supreme Court under its appellate jurisdiction by one of two routes. Very few come by way of appeal by right. The Court must hear these cases if one of the parties requests the review. In 1988, Congress enacted legislation that almost completely eliminated the right to appeal to the U.S. Supreme Court.

The second way in which the Supreme Court may review a decision of a lower court is by the discretion- ary writ of certiorari, which requires a lower court to produce the records of a case it has tried. Now almost all cases reaching the Supreme Court come to it by means of writs of certiorari. If four Justices vote to hear the case, the Court grants writs when there is a federal question of substantial importance or a conflict in the decisions of the U.S. Circuit Courts of Appeals. Only a small percentage of the petitions to the Supreme Court for review by certiorari are granted, however, because the Court uses the writ as a device to choose which cases it wants to hear.

Special Courts [3-1d] The special courts in the federal judicial system include the U.S. Court of Federal Claims, the U.S. Bankruptcy Courts, the U.S. Tax Court, and the U.S. Court of Appeals for the Federal Circuit. These courts have juris- diction over particular subject matter. The U.S. Court of Federal Claims has national jurisdiction to hear claims against the United States. The U.S. Bankruptcy Courts have jurisdiction to hear and decide certain mat- ters under the Federal Bankruptcy Code, subject to review by the U.S. District Court. The U.S. Tax Court has national jurisdiction over certain cases involving federal taxes. The U.S. Court of International Trade has nationwide jurisdiction over cases involving inter- national trade and customs issues. The U.S. Court of Appeals for the Federal Circuit has national jurisdiction and reviews decisions of the Court of Federal Claims, the Patent and Trademark Office, the U.S. Court of International Trade, the Merit Systems Protection Board, and the U.S. Court of Veterans Appeals, as well as patent cases decided by U.S. District Courts.

FIGURE 3-2 Circuit Courts of the United States

Illinois

Hawaii

Alaska

9 9

9

10

5

8 7

6

11

3

4

2

1 1

3

9

Guam

San Francisco

Northern Marianna

Islands

California

Nevada

Arizona

Oregon

Washington

Montana

Idaho

Wyoming

Colorado Denver

New Mexico

Kansas

Oklahoma

Texas

Miss.

Louisiana

New Orleans Florida

No. Dakota

So. Dakota

Minnesota Michigan

lowa Nebraska

Missouri St. Louis

Arkansas

Wisconsin Michigan

Chicago

Indiana Ohio

Cincinnati

Kentucky

Tennessee

Alabama Georgia

Atlanta

So. Carolina

No. Carolina

W. Va. Virginia

New York

Vermont

Puerto Rico

Maine

New Hampshire Boston Mass. Rhode Is.

Virgin Islands

Connecticut New York Pennsylvania

New Jersey Philadelphia

Delaware Maryland District of Columbia Washington D.C.

D.C. Circuit Washington, D.C.

Richmond

Federal Circuit Washington, D.C.

Utah

Source: Administrative Office of The United States Courts, http://www.uscourts.gov/court_locator.aspx.

48 The Legal Environment of Business Part II

STATE COURTS [3-2] Each of the fifty states and the District of Columbia has its own independent court system. In most states, the voters elect judges for a stated term. The structure of state court systems varies from state to state. Figure 3-3 shows a typical system.

Inferior Trial Courts [3-2a] At the bottom of the state court system are the inferior trial courts, which decide the least serious criminal and civil matters. Usually, inferior trial courts do not keep a complete written record of trial proceedings. Minor criminal cases such as traffic offenses are heard in inferior trial courts, which are referred to as municipal courts, justice of the peace courts, or traffic courts. These courts also conduct preliminary hearings in more serious criminal cases.

Small claims courts are inferior trial courts that hear civil cases involving a limited amount of money. Usu- ally there is no jury, the procedure is informal, and nei- ther side employs an attorney. An appeal from a small claims court is taken to the trial court of general juris- diction, where a new trial (called a trial de novo), in which the small claims court’s decision is given no weight, is begun.

Trial Courts [3-2b] Each state has trial courts of general jurisdiction, which may be called county, district, superior, circuit, or com- mon pleas courts. (In New York the trial court is called

the Supreme Court.) These courts do not have a dollar limitation on their jurisdiction in civil cases and hear all criminal cases other than minor offenses. Unlike the inferior trial courts, these trial courts of general juris- diction maintain formal records of their proceedings as procedural safeguards.

Many states have special trial courts that have jurisdiction over particular areas. For example, many states have probate courts with jurisdiction over the administration of wills and estates as well as family courts with jurisdiction over divorce and child custody cases.

Appellate Courts [3-2c] At the summit of the state court system is the state’s court of last resort, a reviewing court generally called the supreme court of the state. Except for those cases in which review by the U.S. Supreme Court is available, the decision of the highest state tribunal is final. In addi- tion, most states also have created intermediate appellate courts to handle the large volume of cases in which review is sought. Review by such a court is usually by right. Further review is in most cases at the highest court’s discretion.

JURISDICTION Jurisdiction means the power or authority of a court to hear and decide a given case. To resolve a lawsuit, a court must have two kinds of jurisdiction. The first is

FIGURE 3-3 State Court System

State Supreme Court

Intermediate Appellate Court

Trial Courts

Special Courts

Inferior Trial Courts

Chapter 3 Civil Dispute Resolution 49

jurisdiction over the subject matter of the lawsuit. If a court lacks jurisdiction over the subject matter of a case, no action it takes in the case will have legal effect.

The second kind of jurisdiction is over the parties to a lawsuit. This jurisdiction is required for the court to render an enforceable judgment that affects the parties’ rights and duties. A court usually may obtain jurisdic- tion over the defendant in a lawsuit if (1) the defendant lives and is present in the court’s territory or (2) the transaction giving rise to the case has a substantial con- nection to the court’s territory. The court obtains juris- diction over the plaintiff when the plaintiff voluntarily submits to the court’s power by filing a complaint with the court.

SUBJECT MATTER JURISDICTION [3-3] Subject matter jurisdiction refers to the authority of a particular court to judge a controversy of a particular kind. Federal courts have limited subject matter juris- diction. State courts have jurisdiction over all matters that the Constitution or the Congress neither denies them nor gives exclusively to the federal courts.

Federal Jurisdiction [3-3a] The federal courts have, to the exclusion of the state courts, subject matter jurisdiction over some areas. Such jurisdiction is called exclusive federal jurisdiction. Federal jurisdiction is exclusive only if Congress so pro- vides, either explicitly or implicitly. If Congress does not so provide and the area is one over which federal courts have subject matter jurisdiction, they share this jurisdiction with the state courts. Such jurisdiction is known as concurrent federal jurisdiction.

Exclusive Federal Jurisdiction The federal courts have exclusive jurisdiction over federal criminal prosecutions; admiralty, bankruptcy, antitrust, patent, trademark, and copyright cases; suits against the United States; and cases arising under certain federal statutes that expressly provide for exclusive federal jurisdiction.

Concurrent Federal Jurisdiction The two types of concurrent federal jurisdiction are federal ques- tion jurisdiction and diversity jurisdiction. The first arises whenever there is a federal question over which the federal courts do not have exclusive jurisdiction. A federal question is any case arising under the Constitu- tion, statutes, or treaties of the United States. There is no minimum dollar requirement in federal question

cases. When a state court hears a concurrent federal question case, it applies federal substantive law but its own procedural rules.

The second type of concurrent federal jurisdiction occurs in a civil suit in which there is diversity of citi- zenship and the amount in controversy exceeds $75,000. As the following case explains, the jurisdic- tional requirement is satisfied if the claim for the amount is made in good faith, unless it is clear to a legal certainty that the claim does not meet or exceed the required amount. Diversity of citizenship exists (1) when the plaintiffs are citizens of a state or states different from the state or states of which the defend- ants are citizens, (2) when a foreign country brings an action against citizens of the United State, or (3) when the controversy is between citizens of a state and citi- zens of a foreign country. The citizenship of an individ- ual litigant (party in a lawsuit) is the state in which the individual resides or is domiciled, whereas that of a corporate litigant is both the state of incorporation and the state in which its principal place of business is located. For example, if the amount in controversy exceeds $75,000, then diversity of citizenship jurisdiction would be satisfied if Ada, a citizen of California, sues Bob, a citizen of Idaho. If, however, Carol, a citizen of Virginia, and Dianne, a citizen of North Carolina, sue Evan, a citizen of Georgia, and Farley, a citizen of North Carolina, there is not diversity of citizenship, because both Dianne, a plaintiff, and Farley, a defendant, are citizens of North Carolina.

When a federal district court hears a case solely under diversity of citizenship jurisdiction, no federal question is involved; and, accordingly, the federal courts must apply state substantive law. The conflict of law rules of the state in which the district court is located determine which state’s substantive law is to be used in the case. (Conflict of laws is discussed later.) Federal courts apply federal procedural rules in diver- sity cases.

In any case involving concurrent jurisdiction, the plaintiff has the choice of bringing the action in either an appropriate federal court or state court. If the plain- tiff brings the case in a state court, however, the de- fendant usually may have it removed (shifted) to a federal court for the district in which the state court is located.

PRACTICAL ADVICE If you have the option, consider whether you want to bring your lawsuit in a federal or state court.

50 The Legal Environment of Business Part II

M I M S V . A R R O W F I N A N C I A L S E R V I C E S , L L C S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 1 2

5 6 5 U . S . ___ , 1 3 2 S . C t . 7 4 0 , 1 8 1 L . E d . 2 d 8 8 1

FACTS Numerous consumer complaints about abuses of telephone technology—for example, computer- ized calls to private homes—prompted Congress to pass the Telephone Consumer Protection Act of 1991 (TCPA). Congress determined that federal legislation was needed because telemarketers, by operating inter- state, were escaping state-law prohibitions on intrusive nuisance calls. The TCPA bans certain practices invasive of privacy and directs the Federal Communications Commission (FCC or Commission) to establish imple- menting regulations. It authorizes the states to bring civil actions to enjoin prohibited practices and to recover damages for their residents. The TCPA provides that jurisdiction over state-initiated TCPA suits lies exclusively in the U.S. district courts. Congress also pro- vided for civil actions by private parties.

Marcus D. Mims, complaining of multiple viola- tions of the TCPA by Arrow Financial Services, LLC (Arrow), a debt-collection agency, commenced an action for damages against Arrow in the U.S. District Court for the Southern District of Florida, invoking the court’s federal question jurisdiction. The District Court, affirmed by the U.S. Court of Appeals for the Eleventh Circuit, dismissed Mims’s complaint for want of sub- ject-matter jurisdiction. Both courts relied on Congress’ specification in Section 227(b)(3) of the TCPA that a private person may seek redress for violations of the Act (or of the Commission’s regulations thereunder) “in an appropriate court of [a] State,” “if [such an action is] otherwise permitted by the laws or rules of court of [that] State.” The U.S. Supreme Court granted certiorari.

DECISION The judgment of the United States Court of Appeals for the Eleventh Circuit is reversed, and the case is remanded.

OPINION Ginsburg, J. Federal courts, though “courts of limited jurisdiction,” [citation], in the main “have no more right to decline the exercise of jurisdic- tion which is given, then to usurp that which is not giv- en.” [Citation.] Congress granted federal courts general federal-question jurisdiction in 1875. [Citation.] *** “The district courts shall have original jurisdiction of all civil actions arising under the Constitution, laws, or treaties of the United States.” 28 U.S.C. §1331. The statute originally included an amount-in-controversy

requirement, set at $500. [Citation.] Recognizing the responsibility of federal courts to decide claims, large or small, arising under federal law, Congress in 1980 elimi- nated the amount-in-controversy requirement in federal- question (but not diversity) cases. [Citation.] ***

Because federal law creates the right of action and provides the rules of decision, Mims’s TCPA claim, in 28 U.S.C. §1331’s words, plainly “aris[es] under” the “laws … of the United States.” ***

Arrow agrees that this action arises under federal law, [citation], but urges that Congress vested exclusive adju- dicatory authority over private TCPA actions in state courts. In cases “arising under” federal law, we note, there is a “deeply rooted presumption in favor of concur- rent state court jurisdiction,” rebuttable if “Congress affirmatively ousts the state courts of jurisdiction over a particular federal claim.” [Citation.] The presumption of concurrent state-court jurisdiction, we have recognized, can be overcome “by an explicit statutory directive, by unmistakable implication from legislative history, or by a clear incompatibility between state-court jurisdiction and federal interests.” [Citation.]

*** Arrow’s arguments do not persuade us that Congress

has eliminated §1331 jurisdiction over private actions under the TCPA.

*** Nothing in the permissive language of §227(b)(3)

makes state-court jurisdiction exclusive, or otherwise purports to oust federal courts of their 28 U.S.C. §1331 jurisdiction over federal claims. ***

Title 47 U.S.C. §227(b)(3) does not state that a pri- vate plaintiff may bring an action under the TCPA “only” in state court, or “exclusively” in state court. ***

*** Nothing in the text, structure, purpose, or legisla-

tive history of the TCPA calls for displacement of the federal-question jurisdiction U.S. district courts ordinarily have under 28 U.S.C. §1331. In the absence of direction from Congress stronger than any Arrow has advanced, we apply the familiar default rule: Federal courts have §1331 jurisdiction over claims that arise under federal law. Because federal law gives rise to the claim for relief Mims has stated and specifies the substantive rules of decision, the Eleventh Circuit erred in dismissing Mims’s case for lack of subject-matter jurisdiction.

Chapter 3 Civil Dispute Resolution 51

Exclusive State Jurisdiction [3-3b] The state courts have exclusive jurisdiction over all other matters. All matters not granted to the federal courts in the Constitution or by Congress are solely within the jurisdiction of the states. Accordingly, exclusive state jurisdiction would include cases involving diversity of citizenship in which the amount in controversy is $75,000 or less. In addition, the state courts have exclu- sive jurisdiction over all cases to which the federal judi- cial power does not reach, including, but by no means limited to, property, torts, contract, agency, commercial transactions, and most crimes.

A court in one state may be a proper forum for a case even though some or all of the relevant events occurred in another state. For example, a California plaintiff may sue a Washington defendant in Washing- ton over a car accident that occurred in Oregon. Because of Oregon’s connections to the accident, Wash- ington may choose, under its conflict of laws rules, to apply the substantive law of Oregon. Conflict of laws rules vary from state to state.

The jurisdiction of the federal and state courts is illustrated in Figure 3-4. Also see Concept Review 3-1.

PRACTICAL ADVICE Consider including in your contracts a choice-of-law provision specifying which jurisdiction’s law will apply.

Stare Decisis in the Dual Court System [3-3c] The doctrine of stare decisis presents certain problems when there are two parallel court systems. As a conse- quence, in the United States, stare decisis works approxi- mately as follows (also illustrated in Figure 3-5):

1. The U.S. Supreme Court has never held itself to be bound rigidly by its own decisions, and lower federal courts and state courts have followed that course with respect to their own decisions.

2. A decision of the U.S. Supreme Court on a federal ques- tion is binding on all other courts, federal or state.

3. On a federal question, although a decision of a fed- eral court other than the Supreme Court may be per- suasive in a state court, it is not binding.

4. A decision of a state court may be persuasive in the federal courts, but it is not binding except in cases in which federal jurisdiction is based on diver- sity of citizenship. In such a case, the federal courts must apply state law as determined by the highest state court.

5. Decisions of the federal courts (other than the U.S. Supreme Court) are not binding on other federal courts of equal or inferior rank unless the latter owe obedience to the deciding court. For example, a deci- sion of the Fifth Circuit Court of Appeals binds

INTERPRETATION Federal courts retain juris- diction over causes of action created by federal law, unless the federal law in question, expressly or by fair implication, excludes federal court jurisdiction.

CRITICAL THINKING QUESTION Why would Congress have specifically granted private party TCPA jurisdiction to the state courts when those courts al- ready had concurrent jurisdiction in federal question cases?

FIGURE 3-4 Federal and State Jurisdiction

All other matters

Concurrent Jurisdiction 1. Federal questions 2. Diversity of citizenship

Concurrent JurisdictionConcurrent Jurisdiction 1. Federal questions1. Federal questions 2. Diversity of citizenship2. Diversity of citizenship

Exclusive State

Jurisdiction

Exclusive Federal Jurisdiction 1. Federal crimes 2. Bankruptcy 3. Patents 4. Copyright and trademarks 5. Admiralty 6. Antitrust 7. Suits against the United States 8. Specified federal statutes

52 The Legal Environment of Business Part II

district courts in the Fifth Circuit but binds no other federal court.

6. A decision of a state court is binding on all courts inferior to it in its jurisdiction. Thus, the decision of the highest court in a state binds all other courts in that state.

7. A decision of a state court is not binding on courts in another state except in cases in which the latter courts are required, under their conflict of laws rules, to apply the law of the first state as determined by the highest court in that state. For example, if a North Carolina court is required to apply Virginia law, it must follow decisions of the Supreme Court of Virginia.

JURISDICTION OVER THE PARTIES [3-4] In addition to subject matter jurisdiction, a court also must have jurisdiction over the parties, which is the power to bind the parties involved in the dispute. The court obtains jurisdiction over the plaintiff when she voluntarily submits to the court’s power by filing a complaint with the court. A court may obtain jurisdiction over the defendant in three possible ways: (1) in personam jurisdiction, (2) in rem jurisdiction, or (3) attachment jurisdiction. In addition, the exercise of jurisdiction over a defendant must satisfy the

CONCEPT REVIEW 3-1 S U B J E C T M A T T E R J U R I S D I C T I O N

Type of Jurisdiction Court Substantive Law Applied Procedural Law Applied

Exclusive federal Federal Federal Federal

Concurrent: federal question Federal State

Federal Federal

Federal State

Concurrent: diversity Federal State

State State

Federal State

Exclusive state State State State

FIGURE 3-5 Stare Decisis in the Dual Court System

Binding on questions of federal law

Binding on questions of state law

State Supreme Court

State Intermediate Appellate Court

State Trial Court

U.S. Supreme Court

U.S. Circuit Court of Appeals

U.S. District Court in that Circuit

Chapter 3 Civil Dispute Resolution 53

constitutionally imposed requirements of reasonable notification and a reasonable opportunity to be heard. Moreover, the court’s exercise of jurisdiction over a defendant is valid under the Due Process Clause of the U.S. Constitution only if the defendant has minimum contacts with the state sufficient to prevent the court’s assertion of jurisdiction from offending “traditional

notions of fair play and substantial justice.” For a court constitutionally to assert jurisdiction over a de- fendant, the defendant must have engaged in either purposeful acts in the state or acts outside the state that are of such a nature that the defendant could rea- sonably foresee being sued in that state, as discussed in the next case.

W O R L D - W I D E V O L K S W A G E N C O R P . V . W O O D S O N S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 1 9 8 0

4 4 4 U . S . 2 8 6 , 1 0 0 S . C t . 5 5 9 , 6 2 L . E d . 2 d 4 9 0

FACTS Harry and Kay Robinson purchased a new Audi automobile from Seaway Volkswagen, Inc. (Sea- way) in Massena, New York. The Robinsons, who had resided in New York for years, left for a new home in Arizona. As they drove through Oklahoma, another car struck their Audi from behind, causing a fire that severely burned Kay and her two children.

The Robinsons brought a products-liability suit in the District Court in Oklahoma, claiming their injuries resulted from defective design of the Audi gas tank and fuel system. They joined as defendants the manufacturer (Audi), the regional distributor (World-Wide Volkswa- gen Corp.), and the retail distributor (Seaway).

World-Wide and Seaway entered special appearances, asserting that Oklahoma’s exercise of jurisdiction over them offended limitations on state jurisdiction imposed by the Due Process Clause of the Fourteenth Amendment. The Oklahoma Supreme Court upheld the assertion of state jurisdiction, and World-Wide and Seaway appealed.

DECISION Judgment of Oklahoma Supreme Court reversed.

OPINION White, J. The Due Process Clause of the Fourteenth Amendment limits the power of a state court to render a valid personal judgment against a nonresident defendant. [Citation.] A judgment rendered in violation of due process is void in the rendering State and is not entitled to full faith and credit elsewhere. [Citation.] Due process requires that the defendant be given adequate notice of the suit, [citation], and be subject to the per- sonal jurisdiction of the court, [citation]. In the present case, it is not contended that notice was inadequate; the only question is whether these particular petitioners were subject to the jurisdiction of the Oklahoma courts.

As has long been settled, and as we reaffirm today, a state court may exercise personal jurisdiction over a non- resident defendant only so long as there exist “minimum contacts” between the defendant and the forum State.

[Citation.] The concept of minimum contacts, in turn, can be seen to perform two related, but distinguishable, functions. It protects the defendant against the burdens of litigating in a distant or inconvenient forum. And it acts to ensure that the States, through their courts, do not reach out beyond the limits imposed on them by their status as coequal sovereigns in a federal system.

The protection against inconvenient litigation is typi- cally described in terms of “reasonableness” or “fairness.” We have said that the defendant’s contacts with the forum State must be such that maintenance of the suit “does not offend ‘traditional notions of fair play and sub- stantial justice.’” [Citation.] The relationship between the defendant and the forum must be such that it is “reasonable *** to require the corporation to defend the particular suit which is brought there.” [Citation.] Implicit in this emphasis on reasonableness is the understanding that the burden on the defendant, while always a primary concern, will in an appropriate case be considered in light of other relevant factors, including the forum State’s inter- est in adjudicating the dispute [citation]; the plaintiff’s interest in obtaining convenient and effective relief, [cita- tion], at least when that interest is not adequately pro- tected by the plaintiff’s power to choose the forum, [citation]; the interstate judicial system’s interest in obtain- ing the most efficient resolution of controversies; and the shared interest of the several States in furthering funda- mental substantive social policies, [citation].

*** Applying these principles to the case at hand, we find

in the record before us a total absence of those affiliating circumstances that are a necessary predicate to any exer- cise of state-court jurisdiction. Petitioners carry on no ac- tivity whatsoever in Oklahoma. They close no sales and perform no services there. They avail themselves of none of the privileges and benefits of Oklahoma law. They solicit no business there either through salespersons or through advertising reasonably calculated to reach the State. Nor does the record show that they regularly sell

54 The Legal Environment of Business Part II

In Personam Jurisdiction [3-4a] In personam jurisdiction, or personal jurisdiction, is the jurisdiction of a court over the parties to a lawsuit, in con- trast to its jurisdiction over their property. A court obtains in personam jurisdiction over a defendant either (1) by serving process on the party within the state in which the court is located or (2) by reasonable notification to a party outside the state in those instances where a “long-arm stat- ute” applies. To serve process means to deliver a sum- mons, which is an order to respond to a complaint lodged against a party. (The terms summons and complaint are explained more fully later in this chapter.)

Personal jurisdiction may be obtained by personally serving process upon a defendant within a state if that person is domiciled in that state. The U.S. Supreme Court has held that a state may exercise personal juris- diction over a nonresident defendant who is temporar- ily present if the defendant is personally served in that state. Personal jurisdiction also may arise from a party’s consent. For example, parties to a contract may agree that any dispute concerning that contract will be subject to the jurisdiction of a specific court.

Most states have adopted long-arm statutes to expand their jurisdictional reach beyond those persons who may be personally served within the state. These statutes allow courts to obtain jurisdiction over nonresi- dent defendants under the following conditions, as long as the exercise of jurisdiction does not offend tradi- tional notions of fair play and substantial justice: if the defendant (1) has committed a tort (civil wrong) within the state, (2) owns property within the state and that property is the subject matter of the lawsuit, (3) has entered into a contract within the state, or (4) has transacted business within the state and that business is the subject matter of the lawsuit.

PRACTICAL ADVICE Consider including in your contracts a choice-of-forum provision specifying what court will have jurisdiction over any litigation arising from the contract.

In Rem Jurisdiction [3-4b] Courts in a state have the jurisdiction to adjudicate claims to property situated within the state if the plain- tiff gives those persons who have an interest in the property reasonable notice and an opportunity to be heard. Such jurisdiction over property is called in rem jurisdiction. For example, if Carpenter and Miller are involved in a lawsuit over property located in Kansas, then an appropriate court in Kansas would have in rem jurisdiction to adjudicate claims over this property as long as both parties are given notice of the lawsuit and a reasonable opportunity to contest the claim.

Attachment Jurisdiction [3-4c] Attachment jurisdiction, or quasi in rem jurisdiction, like in rem jurisdiction, is jurisdiction over property rather than over a person. But attachment jurisdiction is invoked by seizing the defendant’s property located within the state to obtain payment of a claim against the defendant that is unrelated to the property seized. For example, Allen, a resident of Ohio, has obtained a valid judgment in the amount of $20,000 against Bradley, a citi- zen of Kentucky. Allen can attach Bradley’s automobile, which is located in Ohio, to satisfy his court judgment against Bradley.

See Figure 3-6, which outlines the concepts of sub- ject matter and party jurisdiction.

Venue [3-4d] Venue, which often is confused with jurisdiction, con- cerns the geographic area in which a lawsuit should be brought. The purpose of venue is to regulate the distri- bution of cases within a specific court system and to identify a convenient forum. In the federal court sys- tem, venue determines the district or districts in a given state in which suit may be brought. State rules of venue typically require that a suit be initiated in a county where one of the defendants lives. In matters involving real estate, most venue rules require that a suit be initi- ated in the county where the property is situated.

cars at wholesale or retail to Oklahoma customers or res- idents or that they indirectly, through others, serve or seek to serve the Oklahoma market. In short, respondents seek to base jurisdiction on one, isolated occurrence and whatever inferences can be drawn therefrom: the fortui- tous circumstance that a single Audi automobile, sold in New York to New York residents, happened to suffer an accident while passing through Oklahoma.

INTERPRETATION Sufficient minimal con- tacts between the defendant and the state must exist for a state to exercise jurisdiction.

CRITICAL THINKING QUESTION Ex- plain the public policy reasons for subjecting non- residents doing business in a state to the in personam jurisdiction of the courts within that state.

Chapter 3 Civil Dispute Resolution 55

CIVIL DISPUTE RESOLUTION As mentioned in Chapter 1, one of the primary func- tions of law is to provide for the peaceful resolution of disputes. Accordingly, our legal system has established an elaborate set of government mechanisms to settle disputes. The most prominent of these is judicial dis- pute resolution, called litigation. Judicial resolution of civil disputes is governed by the rules of civil procedure, which is discussed in the first part of this section. Judi- cial resolution of criminal cases is governed by the rules of criminal procedure, which are covered in Chapter 6. Dispute resolution by administrative agencies, which is also common, is discussed in Chapter 5.

As an alternative to government dispute resolution, several nongovernmental methods of dispute resolution, such as arbitration, have developed. These will be dis- cussed in the second part of this section.

PRACTICAL ADVICE If you become involved in litigation, make full disclosure to your attorney and do not discuss the lawsuit without consulting your attorney.

CIVIL PROCEDURE [3-5] A civil dispute that enters the judicial system must follow the rules of civil procedure. These rules are designed to resolve the dispute justly, promptly, and inexpensively.

To acquaint you with civil procedure, we will carry a hypothetical action through the trial court to the highest court of review in the state. Although there are technical differences in trial and appellate procedure among the states and the federal courts, the following illustration will give you a general understanding of the trial and appeal of cases. Assume that Pam Pederson, a pedestrian, is struck while crossing a street in Chicago by an automobile driven by David Dryden. Pederson suffers serious personal injuries, incurs heavy medical and hospital expenses, and is unable to work for sev- eral months. She desires that Dryden pay her for the loss and damages she sustained. After attempts at settle- ment fail, Pederson brings an action at law against Dryden. Thus, Pederson is the plaintiff and Dryden the defendant. Each party is represented by a lawyer. Let us follow the progress of the case.

The Pleadings [3-5a] The pleadings are a series of responsive, formal, written statements in which each side to a lawsuit states its claims and defenses. The purpose of pleadings is to give notice and to establish the issues of fact and law the parties dispute. An “issue of fact” is a dispute between the parties regarding the events that gave rise to the law- suit. In contrast, an “issue of law” is a dispute between the parties as to what legal rules apply to these facts. Issues of fact are decided by the jury, or by the judge when there is no jury, whereas issues of law are decided by the judge.

FIGURE 3-6 Jurisdiction

In rem

Long-arm statute

Defendant present

Personal Quasi in rem

Parties

State Concurrent Federal

Subject Matter

Jurisdiction

56 The Legal Environment of Business Part II

Complaint and Summons A lawsuit begins when Pederson, the plaintiff, files with the clerk of the trial court a complaint against Dryden that contains (1) a statement of the claim and supporting facts show- ing that she is entitled to relief and (2) a demand for that relief. Pederson’s complaint alleges that while exer- cising due and reasonable care for her own safety, she was struck by Dryden’s automobile, which was being driven negligently by Dryden, causing her personal inju- ries and damages of $50,000, for which Pederson requests judgment.

Once the plaintiff has filed a complaint, the clerk issues a summons to be served upon the defendant to notify him that a suit has been brought against him. If the defendant has contacts with the state sufficient to show that the state’s assertion of jurisdiction over the defendant is constitutional, proper service of the sum- mons establishes the court’s jurisdiction over the person of the defendant. The county sheriff or a deputy sheriff serves a summons and a copy of the complaint on Dryden, the defendant, commanding him to file his appearance and answer with the clerk of the court within a specific time, usually thirty days from the date the summons was served.

Responses to Complaint At this point, Dryden has several options. If he fails to respond at all, a default judgment will be entered against him. He may make pretrial motions contesting the court’s jurisdic- tion over him or asserting that the action is barred by the statute of limitations, which requires suits to be brought within a specified time. Dryden also may move, or request, that the complaint be made more def- inite and certain, or he may instead move that the com- plaint be dismissed for failure to state a claim on which relief may be granted. Such a motion is sometimes called a demurrer; it essentially asserts that even if all of Pederson’s allegations were true, she still would not be entitled to the relief she seeks and that therefore there is no need for a trial of the facts. The court rules on this motion as a matter of law. If it rules in favor of the defendant, the plaintiff may appeal the ruling.

If he does not make any pretrial motions, or if they are denied, Dryden will respond to the complaint by fil- ing an answer, which may contain denials, admissions, affirmative defenses, and counterclaims. Dryden might answer the complaint by denying its allegations of neg- ligence and stating that he was driving his car at a low speed and with reasonable care (a denial) when his car struck Pederson (an admission), who had dashed across the street in front of his car without looking in any direction to see whether cars or other vehicles were

approaching; that, accordingly, Pederson’s injuries were caused by her own negligence (an affirmative defense); and that, therefore, she should not be permitted to recover any damages. Dryden might further state that Pederson caused damage to his car and request a judg- ment for $2,000 (a counterclaim). These pleadings cre- ate an issue of fact regarding whether Dryden or Pederson, or both, failed to exercise due and reasonable care under the circumstances and were thus negligent and liable for their carelessness.

If the defendant counterclaims, the plaintiff must respond through a reply, which also may contain admissions, denials, and affirmative defenses.

Pretrial Procedure [3-5b] Judgment on the Pleadings After the plead- ings, either party may move for judgment on the pleadings, which requests the judge to rule as a matter of law whether the facts as alleged in the pleadings of the nonmoving party are sufficient to warrant granting the requested relief.

Discovery In preparation for trial and even before completion of the pleadings stage, each party has the right to obtain relevant evidence, or information that may lead to evidence, from the other party. This proce- dure, known as discovery, includes (1) pretrial deposi- tions consisting of sworn testimony, taken out of court, of the opposing party or other witnesses; (2) sworn answers by the opposing party to written interrogatories, or questions; (3) production of documents and physical objects in the possession of the opposing party or, by a court-ordered subpoena, in the possession of nonparties; (4) court-ordered examination by a physician of the opposing party, as needed; and (5) admissions of facts obtained by a request for admissions submitted to the opposing party. By using discovery properly, each party may become fully informed of relevant evidence and avoid surprise at trial. Another purpose of this proce- dure is to facilitate settlements by giving both parties as much relevant information as possible.

Pretrial Conference Also furthering these objec- tives is the pretrial conference between the judge and the attorneys representing the parties. The basic pur- poses of the pretrial conference are (1) to simplify the issues in dispute by amending the pleadings, admitting or stipulating facts, and identifying witnesses and docu- ments to be presented at trial and (2) to encourage settlement of the dispute without trial. (More than 90 percent of all cases are settled before going to trial.) If no settlement occurs, the judge will enter a pretrial

Chapter 3 Civil Dispute Resolution 57

order containing all of the amendments, stipulations, admissions, and other matters agreed to during the pre- trial conference. The order supersedes the pleadings and controls the remainder of the trial.

Summary Judgment The evidence disclosed by discovery may be so clear that a trial to determine the facts becomes unnecessary. If this is so, either party

may move for a summary judgment, which requests the judge to rule that, because there are no issues of fact to be determined by trial, the party thus moving should prevail as a matter of law. A summary judgment is a final binding determination on the merits made by the judge before a trial. The following case involving actress Shirley MacLaine explains the rules courts use to determine whether to grant summary judgment.

P A R K E R V . T W E N T I E T H C E N T U R Y - F O X F I L M C O R P . S u p r e m e C o u r t o f C a l i f o r n i a , 1 9 7 0

3 C a l . 3 d 1 7 6 , 8 9 C a l . R p t r . 7 3 7 , 4 7 4 P . 2 d 6 8 9

FACTS Shirley MacLaine Parker, a well-known actress, contracted with Twentieth Century-Fox Film Corporation in August 1965 to play the female lead in Fox’s upcoming production of Bloomer Girl, a motion picture musical that was to be filmed in California. Fox agreed to pay Parker $750,000 for fourteen weeks of her services. Fox decided to cancel its plans for Bloomer Girl before production had begun and, instead, offered Parker the female lead in another film, Big Country, Big Man, a dramatic western to be filmed in Australia. The compensation offered was identical, but Parker’s right to approve the director and screenplay would have been eliminated or altered by the Big Country proposal. She refused to accept and brought suit to recover the $750,000 for Fox’s breach of the Bloomer Girl contract. Fox’s sole defense in its answer was that it owed no money to Parker because she had deliberately failed to mitigate or reduce her damages by unreasonably refusing to accept the Big Country lead. Parker filed a motion for summary judgment. Fox, in opposition to the motion, claimed, in effect, only that the Big Country offer was not employment different from or inferior to that under the Bloomer Girl contract. The trial court granted Parker a summary judgment and Fox appealed.

DECISION Summary judgment affirmed.

OPINION Burke, J. The familiar rules are that the matter to be determined by the trial court on a motion for summary judgment is whether facts have been pre- sented which give rise to a triable factual issue. The court may not pass upon the issue itself. Summary judg- ment is proper only if the affidavits or declarations in support of the moving party would be sufficient to sus- tain a judgment in his favor and his opponent does not by affidavit show facts sufficient to present a triable issue of fact. The affidavits of the moving party are strictly construed, and doubts as to the propriety of summary judgment should be resolved against granting

the motion. Such summary procedure is drastic and should be used with caution so that it does not become a substitute for the open trial method of determining facts. The moving party cannot depend upon allegations in his own pleadings to cure deficient affidavits, nor can his adversary rely upon his own pleadings in lieu or in support of affidavits in opposition to a motion; how- ever, a party can rely on his adversary’s pleadings to establish facts not contained in his own affidavits. [Cita- tions.] Also, the court may consider facts stipulated to by the parties and facts which are properly the subject of judicial notice. [Citations.]

***

Applying the foregoing rules to the record in the pres- ent case, with all intendments in favor of the party oppos- ing the summary judgment motion—here, defendant—it is clear that the trial court correctly ruled that plaintiff’s failure to accept defendant’s tendered substitute employ- ment could not be applied in mitigation of damages because the offer of the Big Country lead was of employment both different and inferior, and that no fac- tual dispute was presented on that issue. The mere cir- cumstance that Bloomer Girl was to be a musical review calling upon plaintiff’s talents as a dancer as well as an actress, and was to be produced in the City of Los Angeles, whereas, Big Country was a straight dramatic role in a “Western Type” story taking place in an opal mine in Australia, demonstrates the difference in kind between the two employments; the female lead as a dra- matic actress in a western style motion picture can by no stretch of imagination be considered the equivalent of or substantially similar to the lead in a song-and- dance production.

Additionally, the substitute Big Country offer pro- posed to eliminate or impair the director and screenplay approvals accorded to plaintiff under the original Bloomer Girl contract *** and thus constituted an offer of inferior employment. No expertise or judicial notice

58 The Legal Environment of Business Part II

Trial [3-5c] In all federal civil cases at common law involving more than $20.00, the U.S. Constitution guarantees the right to a jury trial. In addition, nearly every state constitu- tion provides a similar right. In addition, federal and state statutes may authorize jury trials in cases not within the constitutional guarantees. Under federal law and in almost all states, jury trials are not available in equity cases. Even in cases in which a jury trial is avail- able, the parties may waive (choose not to have) a trial by jury. When a trial is conducted without a jury, the judge serves as the fact finder and will make separate findings of fact and conclusions of law. When a trial is conducted with a jury, the judge determines issues of law and the jury determines questions of fact.

Jury Selection Assuming a timely demand for a jury has been made, the trial begins with the selection of a jury. The jury selection process involves a voir dire, an examination by the parties’ attorneys (or in some courts by the judge) of the potential jurors. Each party has an unlimited number of challenges for cause, which allow the party to prevent a prospective juror from serving if the juror is biased or cannot be fair and impartial. In addition, each party has a limited number of peremptory challenges for which no cause is required to disqualify a prospective juror. The Supreme Court has held that the U.S. Constitution prohibits discrimination in jury selection on the basis of race or gender.

is required in order to hold that the deprivation or infringement of an employee’s rights held under an orig- inal employment contract converts the available “other employment” relied upon by the employer to mitigate damages, into inferior employment which the employee need not seek or accept. [Citation.]

INTERPRETATION A court will grant sum- mary judgment when there are no issues of fact to be determined by trial.

CRITICAL THINKING QUESTION When should a court grant summary judgment? Explain.

E D M O N S O N V . L E E S V I L L E C O N C R E T E C O M P A N Y , I N C . S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 1 9 9 1

5 0 0 U . S . 6 1 4 , 1 1 1 S . C t . 2 0 7 7 , 1 1 4 L . E d . 2 d 6 6 0

FACTS Thaddeus Donald Edmonson, a construction worker, was injured in a job-site accident at Fort Polk, Louisiana. Edmonson sued Leesville Concrete Company for negligence in the U.S. District Court for the Western District of Louisiana, claiming that a Leesville employee permitted one of the company’s trucks to roll backward and pin him against some construction equipment. Edmonson invoked his Seventh Amendment right to a trial by jury. During voir dire, Leesville used two of its three peremptory challenges authorized by statute to remove black persons from the prospective jury. When Edmonson, who is himself black, requested that the Dis- trict Court require Leesville to articulate a race-neutral explanation for striking the two jurors, the District Court ruled that the precedent on which Edmonson’s request relied applied only to criminal cases and allowed the strikes to stand. A jury of eleven whites and one black brought in a verdict for Edmonson, assessing total damages at $90,000. It also attributed 80 percent of the fault to Edmonson’s contributory negligence and awarded him only $18,000. On appeal, a divided

en banc panel affirmed the judgment of the District Court, concluding that the use of peremptory challenges by private litigants did not constitute state action and, as a result, did not violate constitutional guarantees against racial discrimination. The U.S. Supreme Court granted certiorari.

DECISION Judgment for Edmonson.

OPINION Kennedy, J. We must decide in the case before us whether a private litigant in a civil case may use peremptory challenges to exclude jurors on account of their race. ***

***

*** Although the conduct of private parties lies beyond the Constitution’s scope in most instances, gov- ernmental authority may dominate an activity to such an extent that its participants must be deemed to act with the authority of the government and, as a result, be subject to constitutional constraints. ***

Chapter 3 Civil Dispute Resolution 59

Conduct of Trial After the jury has been selected, both attorneys make an opening statement about the facts that they expect to prove in the trial. The plaintiff and plaintiff’s witnesses then testify on direct examination by the plaintiff’s attorney. Each is subject to cross-examination by the defendant’s attor- ney. Pederson and her witnesses testify that the traffic light at the street intersection where she was struck was green for traffic in the direction in which she was cross- ing but changed to yellow when she was about one- third of the way across the street.

During the trial, the judge rules on the admission and exclusion of evidence on the basis of its relevance and reliability. If the judge does not allow certain

evidence to be introduced or certain testimony to be given, the attorney must make an offer of proof to pre- serve for review on appeal the question of its admissi- bility. The offer of proof consists of oral statements of counsel or witnesses showing for the record the evi- dence that the judge has ruled inadmissible; it is not regarded as evidence and is not heard by the jury.

After cross-examination, followed by redirect exami- nation of each of her witnesses, Pederson rests her case. At this time, Dryden may move for a directed verdict in his favor. A directed verdict is a final binding determi- nation on the merits made by the judge after a trial has begun but before the jury renders a verdict. If the judge concludes that the evidence introduced by Pederson,

*** Our precedents establish that, in determining whether a particular action or course or conduct is gov- ernmental in character, it is relevant to examine the following: the extent to which the actor relies on govern- mental assistance and benefits, [citations]; whether the actor is performing a traditional governmental function, [citations]; and whether the injury caused is aggravated in a unique way by the incidents of governmental authority, [citation]. Based on our application of these three princi- ples to the circumstances here, we hold that the exercise of peremptory challenges by the defendant in the District Court was pursuant to a course of state action.

*** It cannot be disputed that, without the overt, sig- nificant participation of the government, the peremptory challenge system, as well as the jury trial system of which it is a part, simply could not exist. As discussed above, peremptory challenges have no utility outside the jury system, a system which the government alone administers. In the federal system, Congress has estab- lished the qualifications for the jury service, [citation], and has outlined the procedures by which jurors are selected. ***

*** The trial judge exercises substantial control over voir

dire in the federal system. [Citation.] *** Without the direct and indispensable participation of the judge, who beyond all question is a state actor, the peremptory challenge system would serve no purpose. By enforcing a discriminatory peremptory challenge, the court “has not only made itself a party to the [biased act], but has elected to place its power, property and prestige behind the [alleged] discrimination.” [Citation.] ***

*** The peremptory challenge is used in selecting an entity that is a quintessential governmental body, having no attributes of a private actor. The jury exercises the power of the court and of the government that confers

the court’s jurisdiction. *** In the federal system, the Constitution itself commits the trial of facts in a civil cause to the jury. Should either party to a cause invoke its Seventh Amendment right, the jury becomes the prin- cipal fact-finder, charged with weighing the evidence, judging the credibility of witnesses, and reaching a ver- dict. The jury’s factual determinations as a general rule are final. [Citation.] In some civil cases, as we noted ear- lier this Term, the jury can weigh the gravity of a wrong and determine the degree of the government’s interest in punishing and deterring willful misconduct. *** And in all jurisdictions a true verdict will be incorporated in a judgment enforceable by the court. These are traditional functions of government, not of a select, private group beyond the reach of the Constitution.

*** Finally, we note that the injury caused by the discrimi-

nation is made more severe because the government per- mits it to occur within the courthouse itself. Few places are a more real expression of the constitutional authority of the government than a courtroom, where the law itself unfolds. *** To permit racial exclusion in this official forum compounds the racial insult inherent in judging a citizen by the color of his or her skin.

INTERPRETATION The U.S. Constitution imposes restrictions against racial discrimination in the jury selection process.

ETHICAL QUESTION What are ethical grounds for an attorney to exercise a peremptory challenge? Explain.

CRITICAL THINKING QUESTION What grounds should be disallowed in the exercise of peremp- tory challenges? Explain.

60 The Legal Environment of Business Part II

which is assumed for the purposes of the motion to be true, would not be sufficient for the jury to find in favor of the plaintiff, then the judge will grant the directed verdict in favor of the defendant. In some states, the judge will deny the motion for a directed verdict if there is any evidence on which the jury might possibly render a verdict for the plaintiff.

If the judge denies the motion for a directed verdict, however, the defendant then has the opportunity to present evidence. Dryden and his witnesses testify that he was driving his car at a low speed when it struck Pederson and that Dryden at the time had the green light at the intersection. After the defendant has pre- sented his evidence, the plaintiff and the defendant may be permitted to introduce rebuttal evidence. Once both parties have rested (concluded), then either party may move for a directed verdict. By this motion, the party contends that the evidence is so clear that reasonable persons could not differ about the outcome of the case. If the judge grants the motion for a directed verdict, he takes the case away from the jury and enters a judg- ment for the party making the motion.

If these motions are denied, then Pederson’s attorney makes a closing argument to the jury, reviewing the evidence and urging a verdict in favor of Pederson. Then Dryden’s attorney makes a closing argument, summarizing the evidence and urging a verdict in favor of Dryden. Pederson’s attorney is permitted to make a short argument in rebuttal.

Jury Instructions The attorneys previously have given possible written jury instructions on the applica- ble law to the trial judge, who gives to the jury those instructions that he approves and denies those that he considers incorrect. The judge also may give the jury instructions of his own. Jury instructions (called “charges” in some states) advise the jury of the particu- lar rules of law that apply to the facts the jury deter- mines from the evidence.

Verdict The jury then retires to the jury room to deliberate and to reach its verdict in favor of one party or the other. If the jury finds the issues in favor of Dryden, its verdict is that he is not liable. If, however, it finds the issues for Pederson and against Dryden, its verdict will be that the defendant is liable and will spec- ify the amount of the plaintiff’s damages. In this case, the jury found that Pederson’s damages were $35,000. On returning to the jury box, the foreperson either announces the verdict or hands it in written form to the clerk to give to the judge, who reads the verdict in

open court. In some jurisdictions, a special verdict, by which the jury makes specific written findings on each factual issue, is used. The judge then applies the law to these findings and renders a judgment. In the United States the prevailing litigant is ordinarily not entitled to collect attorneys’ fees from the losing party, unless otherwise provided by statute or an enforceable con- tract allocating attorneys’ fees.

Motions Challenging Verdict The unsuccess- ful party may then file a written motion for a new trial or for judgment notwithstanding the verdict. A motion for a new trial may be granted if (1) the judge com- mitted prejudicial error during the trial, (2) the verdict is against the weight of the evidence, (3) the damages are excessive, or (4) the trial was not fair. The judge has the discretion to grant a motion for a new trial (on grounds 1, 3, or 4) even if the verdict is supported by substantial evidence. On the other hand, the motion for judgment notwithstanding the verdict (also called a judgment n.o.v.) must be denied if any sub- stantial evidence supports the verdict. This motion is similar to a motion for a directed verdict, only it is made after the jury’s verdict. To grant the motion for judgment notwithstanding the verdict, the judge must decide that the evidence is so clear that reasonable people could not differ as to the outcome of the case. If a judgment n.o.v. is reversed on appeal, a new trial is not necessary, and the jury’s verdict is entered. If the judge denies the motions for a new trial and for a judgment notwithstanding the verdict, he enters judgment on the verdict for $35,000 in favor of the plaintiff.

Appeal [3-5d] The purpose of an appeal is to determine whether the trial court committed prejudicial error. Most jurisdic- tions permit an appeal only from a final judgment. As a general rule, only errors of law are reviewed by an appellate court. Errors of law include the judge’s deci- sions to admit or exclude evidence; the judge’s instruc- tions to the jury; and the judge’s actions in denying or granting a motion for a demurrer, a summary judg- ment, a directed verdict, or a judgment n.o.v. Appellate courts review errors of law de novo. Errors of fact will be reversed only if they are so clearly erroneous that they are considered to be an error of law.

Let us assume that Dryden directs his attorney to appeal. The attorney files a notice of appeal with the clerk of the trial court within the prescribed time. Later,

Chapter 3 Civil Dispute Resolution 61

Dryden, as appellant, files in the reviewing court the re- cord on appeal, which contains the pleadings, a tran- script of the testimony, rulings by the judge on motions made by the parties, arguments of counsel, jury instruc- tions, the verdict, posttrial motions, and the judgment from which the appeal is taken. In states having an in- termediate court of appeals, such court usually will be the reviewing court. In states having no intermediate court of appeal, a party may appeal directly from the trial court to the state supreme court.

Dryden, as appellant, is required to prepare a con- densation of the record, known as an abstract, or perti- nent excerpts from the record, which he files with the reviewing court together with a brief and argument. His brief contains a statement of the facts, the issues, the rulings by the trial court that Dryden contends are erroneous and prejudicial, grounds for reversal of the judgment, a statement of the applicable law, and argu- ments on his behalf. Pederson, the appellee, files an answering brief and argument. Dryden may, but is not required to, file a reply brief. The case is now ready to be considered by the reviewing court.

The appellate court does not hear any evidence; rather, it decides the case on the record, abstracts, and briefs. After oral argument by the attorneys, if the court elects to hear one, the court takes the case under advisement, or begins deliberations. Then, having made a decision based on majority rule, the appellate court prepares a written opinion containing the rea- sons for its decision, the rules of law that apply, and its judgment. The judgment may affirm the judgment of the trial court, or, if the appellate court finds that reversible error was committed, the judgment may be reversed or modified or returned to the lower court (remanded) for a new trial. In some instances the appellate court will affirm the lower court’s decision in part and will reverse it in part. The losing party may file a petition for rehearing, which is usually denied.

If the reviewing court is an intermediate appellate court, the party losing in that court may decide to seek a reversal of its judgment by filing within a prescribed time a notice of appeal, if the appeal is by right, or a petition for leave to appeal to the state supreme court, if the appeal is by discretion. This petition corresponds to a petition for a writ of certiorari in the U.S. Supreme Court. The party winning in the appellate court may file an answer to the petition for leave to appeal. If the petition is granted, or if the appeal is by right, the re- cord is certified to the Supreme Court, where each party files a new brief and argument. The Supreme Court may hear oral argument or simply review the

record; it then takes the case under advisement. If the Supreme Court concludes that the judgment of the appellate court is correct, it affirms. If it decides other- wise, it reverses the judgment of the appellate court and enters a reversal or an order of remand. The unsuccessful party may again file a petition for a rehearing, which is likely to be denied. Barring the remote possibility of an application for still further review by the U.S. Supreme Court, the case either has reached its termination or, on remand, is about to start its second journey through the courts, beginning, as it did originally, in the trial court.

Enforcement [3-5e] If Dryden does not appeal, or if the reviewing court affirms the judgment if he does appeal, and Dryden does not pay the judgment, the task of enforcement will remain. Pederson must request the clerk to issue a writ of execution demanding payment of the judgment, which is served by the sheriff on the defendant. If the writ is returned “unsatisfied,” that is, if Dryden still does not pay, Pederson may post bond or other security and order a levy on and sale of specific nonexempt property belonging to the defendant, which is then seized by the sheriff, advertised for sale, and sold at a public sale under the writ of execution. If the sale does not produce enough money to pay the judgment, Pederson’s attorney may begin another proceeding in an attempt to locate money or other property belonging to Dryden. In an attempt to collect the judgment, Pederson’s attorney may also proceed by garnishment against Dryden’s employer to collect from his wages or against a bank in which he has an account.

If Pederson cannot satisfy the judgment with Dryden’s property located within Illinois (the state where the judg- ment was obtained), Pederson will have to bring an action on the original judgment in other states where Dryden owns property. Because the U.S. Constitution requires each state to accord judgments of other states full faith and credit, Pederson will be able to obtain a local judgment that may be enforced by the methods described previously.

The various stages in civil procedure are illustrated in Figure 3-7.

ALTERNATIVE DISPUTE RESOLUTION [3-6] Litigation is complex, time consuming, and expensive. Furthermore, court adjudications involve long delays,

62 The Legal Environment of Business Part II

lack special expertise in substantive areas, and provide only a limited range of remedies. Additionally, litigation is structured so that one party takes all with little opportunity for compromise and often causes animosity between the disputants. Consequently, in an attempt to overcome some of the disadvantages of litigation, sev- eral nonjudicial methods of dealing with disputes have developed. The most important of these alternatives to litigation is arbitration. Others include conciliation, mediation, and “mini-trials.”

The various techniques differ in a number of ways, including (1) whether the process is voluntary, (2) whether the process is binding, (3) whether the dis- putants represent themselves or are represented by attorneys, (4) whether the decision is made by the dis- putants or by a third party, (5) whether the procedure used is formal or informal, and (6) whether the basis for the decision is law or some other criterion.

Which method of civil dispute resolution—litigation or one of the nongovernmental methods—is better for a particular dispute depends on several factors, includ- ing the financial circumstances of the disputants, the nature of the relationship (commercial or personal,

ongoing or limited) between them, and the urgency of a quick resolution. Alternative dispute resolution methods are especially suitable in cases in which privacy, speed, preservation of continuing relations, and control over the process—including the flexibility to compromise— are important to the parties. Nevertheless, the disadvan- tages of using alternative dispute mechanisms may make court adjudication more appropriate. For exam- ple, with the exception of arbitration, only courts can compel participation and provide a binding resolution. In addition, only courts can establish precedents and create public duties. Furthermore, the courts provide greater due process protections and uniformity of out- come. Finally, the courts are independent of the parties and are publicly funded.

See Concept Review 3-2 for a comparison of adjudi- cation, arbitration, and mediation/conciliation.

PRACTICAL ADVICE Consider including in your contracts a provision specifying what means of dispute resolution will apply to the contract.

FIGURE 3-7 Stages in Civil Procedure

Determine what facts are in dispute

Complaint Answer Reply

Discovery Conference

Summary Judgment

Jury Selection Opening Statements

Introduction of Evidence Closing Arguments

Judgment on Verdict

Briefs and Transcript Oral Argument

Decision

Execution Garnishment

Discover what evidence there is to prove the

facts in dispute

Determine what facts are proved by the

evidence

Review the lower court’s actions for prejudicial error

Implement the court’s judgment Enforcement

Appeal

Trial

Pretrial

Pleadings

Chapter 3 Civil Dispute Resolution 63

Arbitration [3-6a] In arbitration, the parties select a neutral third person or persons—the arbitrator(s)—who render(s) a binding decision after hearing arguments and reviewing evi- dence. Because the presentation of the case is less for- mal and the rules of evidence are more relaxed, arbitration usually takes less time and costs less than litigation. Moreover, in many arbitration cases, the par- ties are able to select an arbitrator with special exper- tise concerning the subject of the dispute. Thus, the quality of the arbitrator’s decision may be higher than that available through the court system. In addition, arbitration normally is conducted in private, thus avoiding unwanted publicity. Arbitration is commonly used in commercial and labor management disputes.

Types of Arbitration There are two basic types of arbitration—consensual, which is by far the most common, and compulsory. Consensual arbitration occurs whenever the parties to a dispute agree to submit the controversy to arbitration. They may do this in advance by agreeing in their contract that disputes aris- ing out of their contract will be resolved by arbitration. Or they may do so after a dispute arises by then agree- ing to submit the dispute to arbitration. In either instance, such agreements are enforceable under the Fed- eral Arbitration Act (FAA) and state statutes. Forty-nine states have adopted the Uniform Arbitration Act (UAA). (In 2000, the Uniform Law Commission, also known as the National Conference of Commissioners on Uniform

State Laws, promulgated the Revised UAA to provide state legislatures with a more up-to-date statute to resolve disputes through arbitration. To date, at least seventeen states have adopted the Revised UAA.) In compulsory arbitration, which is relatively infrequent, a federal or state statute requires arbitration for specific types of disputes, such as those involving public employ- ees, including police officers, teachers, and firefighters.

Procedure Usually the parties’ agreement to arbi- trate specifies how the arbitrator or arbitrators will be chosen. If it does not, the FAA and state statutes pro- vide methods for selecting arbitrators. Although the requirements for arbitration hearings vary from state to state, they generally consist of opening statements, case presentation, and closing statements. Case presentations may include witnesses, documentation, and site inspec- tions. The parties may cross-examine witnesses and may be represented by attorneys.

The decision of the arbitrator, called an award, is binding on the parties. Nevertheless, it is subject to very limited judicial review. Under the FAA and the Revised UAA these include (1) the award was procured by cor- ruption, fraud, or other undue means; (2) the arbitra- tors were partial or corrupt; (3) the arbitrators were guilty of misconduct prejudicing the rights of a party to the arbitration proceeding; and (4) the arbitrators exceeded their powers. Historically, the courts were unfriendly to arbitration; however, they have dramati- cally changed their attitude and now favor arbitration.

CONCEPT REVIEW 3-2 C O M P A R I S O N O F C O U R T A D J U D I C A T I O N , A R B I T R A T I O N ,

A N D M E D I A T I O N / C O N C I L I A T I O N

Court Adjudication Arbitration Mediation/Conciliation

Binding Yes Yes No

Public proceedings Yes No No

Special expertise No Yes Yes

Publicly funded Yes No No

Precedents established Yes No No

Time consuming Yes No No

Long delays Yes No No

Expensive Yes No No

64 The Legal Environment of Business Part II

Court-Annexed Arbitration A growing num- ber of federal and state courts have adopted court- annexed arbitration in civil cases in which the parties seek limited amounts of damages. The arbitrators are

usually attorneys. Appeal from this type of nonbinding arbitration is by trial de novo. Many states have enacted statutes requiring the arbitration of medical malpractice disputes.

N I T R O - L I F T T E C H N O L O G I E S , L . L . C . V . H O W A R D S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 1 2

5 6 8 U . S . ___ , 1 3 3 S . C t . 5 0 0 , 1 8 4 L . E d . 2 d 3 2 8

FACTS This dispute arises from a contract between Nitro-Lift Technologies, L.L.C., and two of its former employees. Nitro-Lift contracts with operators of oil and gas wells to provide services that enhance produc- tion. The plaintiffs Eddie Lee Howard and Shane D. Schneider entered a confidentiality and noncompetition agreement with Nitro-Lift that contained the following arbitration clause:

Any dispute, difference or unresolved question between Nitro-Lift and the Employee (collectively the “Disputing Parties”) shall be settled by arbitra- tion by a single arbitrator mutually agreeable to the Disputing Parties in an arbitration proceeding conducted in Houston, Texas in accordance with the rules existing at the date hereof of the Ameri- can Arbitration Association.

After working for Nitro-Lift on wells in Oklahoma, Texas, and Arkansas, the plaintiffs quit and began working for one of Nitro-Lift’s competitors. Claiming that the plaintiffs had breached their noncompetition agreements, Nitro-Lift brought an arbitration case. The plaintiffs then filed suit in the District Court of Johnston County, Oklahoma, asking the court to declare the non- competition agreements null and void and to enjoin their enforcement. The court dismissed the complaint, finding that the contracts contained valid arbitration clauses.

The plaintiffs appealed, and the Oklahoma Supreme Court held that despite the “[U.S.] Supreme Court cases on which the employers rely,” the “existence of an arbi- tration agreement in an employment contract does not prohibit judicial review of the underlying agreement.” Finding the arbitration clauses no obstacle to its review, the Oklahoma Supreme Court held that the noncompeti- tion agreements were “void and unenforceable as against Oklahoma’s public policy,” expressed in an Oklahoma statute.

DECISION The judgment of the Supreme Court of Oklahoma is vacated, and the case is remanded.

OPINION Per Curiam. State courts rather than fed- eral courts are most frequently called upon to apply the Federal Arbitration Act (FAA), [citation], including the Act’s national policy favoring arbitration. It is a matter of great importance, therefore, that state supreme courts adhere to a correct interpretation of the legislation. ***

***

The Oklahoma Supreme Court’s decision disregards this Court’s precedents on the FAA. That Act, which “declare[s] a national policy favoring arbitration,” [cita- tion], provides that a “written provision in … a contract evidencing a transaction involving commerce to settle by arbitration a controversy thereafter arising out of such contract or transaction … shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” [Citation.] It is well settled that “the substantive law the Act created [is] applicable in state and federal courts.” [Citations.] And when parties commit to arbitrate contractual dis- putes, it is a mainstay of the Act’s substantive law that attacks on the validity of the contract, as distinct from attacks on the validity of the arbitration clause itself, are to be resolved “by the arbitrator in the first instance, not by a federal or state court.” [Citations.] ***

This principle requires that the decision below be vacated. *** [T]he Oklahoma Supreme Court must abide by the FAA, which is “the supreme Law of the Land,” U.S. Const., Art. VI, cl. 2, and by the opinions of this Court interpreting that law. “It is this Court’s responsi- bility to say what a statute means, and once the Court has spoken, it is the duty of other courts to respect that understanding of the governing rule of law.” [Citation.] Our cases hold that the FAA forecloses precisely this type of “judicial hostility towards arbitration.” [Citation.]

*** Hence, it is for the arbitrator to decide in the first instance whether the covenants not to compete are valid as a matter of applicable state law. [Citation.]

INTERPRETATION When parties commit to arbitrate contractual disputes, the FAA requires that

Chapter 3 Civil Dispute Resolution 65

Conciliation [3-6b] Conciliation is a nonbinding, informal process in which a third party (the conciliator) selected by the disputing par- ties attempts to help them reach a mutually acceptable agreement. The duties of the conciliator include improving communications, explaining issues, scheduling meetings, discussing differences of opinion, and serving as an interme- diary between the parties when they are unwilling to meet.

Mediation [3-6c] Mediation is a process in which a third party (the medi- ator) selected by the disputants helps them to reach a voluntary agreement resolving their disagreement. In addition to employing conciliation techniques to improve communications, the mediator, unlike the conciliator, proposes possible solutions for the parties to consider. Like the conciliator, the mediator does not have the

power to render a binding decision. Because it is a vol- untary process and has lower costs than a formal legal proceeding or arbitration, mediation has become one of the most widespread forms of dispute resolution in the United States. Mediation commonly is used by the judi- cial system in such tribunals as small claims courts, housing courts, family courts, and neighborhood justice centers. In 2001, the Uniform Law Commission promul- gated the Uniform Mediation Act, which was amended in 2003. The Act establishes a privilege of confidentiality for mediators and participants. To date at least eleven states have adopted it.

Sometimes the techniques of arbitration and media- tion are combined in a procedure called “med-arb.” In med-arb, the neutral third party serves first as a mediator and, if all issues are not resolved through such mediation, then serves as an arbitrator authorized to render a binding decision on the remaining issues.

attacks on the validity of the contract, as distinct from attacks on the validity of the arbitration clause itself, are to be resolved by the arbitrator in the first instance, not by a federal or state court.

CRITICAL THINKING QUESTION Why should attacks on the validity of a contract calling for arbitration be treated differently than attacks on the validity of the arbitration clause?

Business Law IN ACTION

In any given year, a large company like DobashiMotors has lots of litigation exposure. In its vehicle manufacturing division it employs thousands of workers, who bring numerous claims arising out of such matters as workplace injuries and alleged employment discrimination. Nationwide it has a network of hundreds of dealers, who may have contract disagreements with Dobashi, some of which inevitably escalate to the point they end up in court.

Naturally the company also regularly contends with payment disputes involving its many service providers and parts suppliers, sometimes initiating suit and other times finding itself on the other side as a defendant. And together with its financing division, Dobashi Motors deals with thousands of buyers and potential buyers, who sue not so infrequently, typically based on state de- ceptive practices statutes or federal laws governing access to credit. Every year, adverse judgments arise from at least some of each of these types of legal disputes. Judg- ments aside, even if Dobashi were to win every case, the company still would spend millions of dollars in attor- neys’ fees and other litigation expenses annually.

Legal disagreement is inherent in a business’s contrac- tual relationships. Recognizing this, Dobashi can choose to include predispute arbitration agreements in its employment contracts, written distribution and vendor arrangements, and financing deals. The regular use of such clauses would divert most of Dobashi’s litigation out of the court system and into what has been acknowl- edged to be a much more inexpensive, faster, more pri- vate, and more flexible dispute resolution environment. Indeed, studies have shown that a company like Dobashi can save 50 percent or more in litigation expenses by choosing arbitration as its primary vehicle for resolving disputes.

Critics contend that arbitration results often are incon- sistent with the law and that they can deprive the parties of certain remedies available only in court. Good drafting can eliminate the latter and, even if the former is true, it will operate rather evenhandedly: Dobashi may lose some cases it would have won in court, and vice versa. In the end, the cost savings are not inconsequential, both in the short term and over time.

66 The Legal Environment of Business Part II

Mini-Trial [3-6d] A mini-trial is a structured settlement process that com- bines elements of negotiation, mediation, and trials. Mini-trials are most commonly used when both dispu- tants are corporations. In a mini-trial, attorneys for the two corporations conduct limited discovery and then present evidence to a panel consisting of managers from each company, as well as to a neutral third party, who may be a retired judge or other attorney. After the law- yers complete their presentations, the managers try to negotiate a settlement without the attorneys. The man- agers may consult the third party on how a court might resolve the issues in dispute.

Summary Jury Trial [3-6e] A summary jury trial is a mock trial in which the parties present their case to a jury. Though not binding, the jury’s verdict does influence the negotiations in which the parties must participate following the mock trial. If the parties do not reach a settlement, they may have a full trial de novo.

Negotiation [3-6f] Negotiation is a consensual bargaining process in which the parties attempt to reach an agreement resolving their dispute. Negotiation differs from other methods of alter- nate dispute resolution in that no third parties are involved.

C H A P T E R S U M M A R Y THE COURT SYSTEM

Federal Courts

District Courts trial courts of general jurisdiction that can hear and decide most legal controversies in the federal system

Courts of Appeals hear appeals from the district courts and review orders of certain administrative agencies

The Supreme Court the nation’s highest court, whose principal function is to review decisions of the federal Courts of Appeals and the highest state courts

Special Courts have jurisdiction over cases in a particular area of federal law and include the U.S. Court of Federal Claims, the U.S. Tax Court, the U.S. Bankruptcy Courts, and the U.S. Court of Appeals for the Federal Circuit

G O I N G G L O B A L What about international dispute resolution?

Laws vary greatly from countryto country: what one nation requires by law, another may forbid. To complicate matters, there is no single authority in international law that can compel countries to act. When the laws of two or more nations conflict, or when one party has violated an agreement and the other party wishes to enforce it or to recover damages, establish- ing who will adjudicate the matter, which laws will be applied, what remedies will be available, or where

the matter should be decided often is very confusing and uncertain. Unlike domestic law, international law generally cannot be enforced. Consequently, international courts do not have compulsory jurisdiction, though they do have authority to resolve an international dispute if the parties to the dispute accept the court’s jurisdiction over the matter.

Accordingly, arbitration is a com- monly used means for resolving international disputes. The United Nations Committee on International

Trade Law (UNCITRAL) and the International Chamber of Commerce have promulgated arbitration rules that have won broad international adherence. The FAA has provisions implementing the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards. A number of states have enacted laws specifically governing international arbitration; some of the statutes have been based on the Model Law on International Arbitration drafted by UNCITRAL.

Chapter 3 Civil Dispute Resolution 67

State Courts

Inferior Trial Courts hear minor criminal cases such as traffic offenses and civil cases involving small amounts of money and conduct preliminary hearings in more serious criminal cases

Trial Courts have general jurisdiction over civil and criminal cases

Special Trial Courts trial courts, such as probate courts and family courts, which have jurisdiction over a particular area of state law

Appellate Courts include one or two levels; the highest court’s decisions are final except in those cases reviewed by the U.S. Supreme Court

JURISDICTION

Subject Matter Jurisdiction

Definition authority of a court to decide a particular kind of case

Federal Jurisdiction • Exclusive Federal Jurisdiction federal courts have sole jurisdiction over federal crimes,

bankruptcy, antitrust, patent, trademark, copyright, and other special cases • Concurrent Federal Jurisdiction authority of more than one court to hear the same case; state

and federal courts have concurrent jurisdiction over (1) federal question cases (cases arising under the Constitution, statutes, or treaties of the United States) which do not involve exclusive federal jurisdiction and (2) diversity of citizenship cases involving more than $75,000

Exclusive State Jurisdiction state courts have exclusive jurisdiction over all matters to which the federal judicial power does not reach

Jurisdiction over the Parties

Definition the power of a court to bind the parties to a suit

In Personam Jurisdiction jurisdiction based on claims against a person, in contrast to jurisdiction over property

In Rem Jurisdiction jurisdiction based on claims against property

Attachment Jurisdiction jurisdiction over a defendant’s property to obtain payment of a claim not related to the property

Venue geographic area in which a lawsuit should be brought

CIVIL DISPUTE RESOLUTION

Civil Procedure

Pleadings series of statements that give notice and establish the issues of fact and law presented and disputed • Complaint initial pleading by the plaintiff stating his case • Summons notice given to inform a person of a lawsuit against her • Answer defendant’s pleading in response to the plaintiff’s complaint • Reply plaintiff’s pleading in response to the defendant’s answer

Pretrial Procedure process requiring the parties to disclose what evidence is available to prove the disputed facts; designed to encourage settlement of cases or to make the trial more efficient • Judgment on Pleadings a final ruling in favor of one party by the judge based on the pleadings • Discovery right of each party to obtain evidence from the other party

68 The Legal Environment of Business Part II

• Pretrial Conference a conference between the judge and the attorneys to simplify the issues in dispute and to attempt to settle the dispute without trial

• Summary Judgment final ruling by the judge in favor of one party based on the evidence disclosed by discovery

Trial determines the facts and the outcome of the case • Jury Selection each party has an unlimited number of challenges for cause and a limited

number of peremptory challenges • Conduct of Trial consists of opening statements by attorneys, direct and cross-examination of

witnesses, and closing arguments • Directed Verdict final ruling by the judge in favor of one party based on the evidence

introduced at trial • Jury Instructions judge gives the jury the particular rules of law that apply to the case • Verdict the jury’s decision based on those facts the jury determines the evidence proves • Motions Challenging Verdict include motions for a new trial and a motion for judgment

notwithstanding the verdict

Appeal determines whether the trial court committed prejudicial error

Enforcement plaintiff with an unpaid judgment may resort to a writ of execution to have the sheriff seize property of the defendants and to garnishment to collect money owed to the defendant by a third party

Alternative Dispute Resolution

Arbitration nonjudicial proceeding in which a neutral third party selected by the disputants renders a binding decision (award)

Conciliation nonbinding process in which a third party acts as an intermediary between the disputing parties

Mediation nonbinding process in which a third party acts as an intermediary between the disputing parties and proposes solutions for them to consider

Mini-Trial nonbinding process in which attorneys for the disputing parties (typically corporations) present evidence to managers of the disputing parties and a neutral third party, after which the managers attempt to negotiate a settlement in consultation with the third party

Summary Jury Trial mock trial followed by negotiations

Negotiation consensual bargaining process in which the parties attempt to reach an agreement resolving their dispute without the involvement of third parties

Q U E S T I O N S

1. On June 15 a newspaper columnist predicted that the coast of State X would be flooded on the following Sep- tember 1. Relying on this pronouncement, Gullible quit his job and sold his property at a loss so as not to be financially ruined. When the flooding did not occur, Gullible sued the columnist in a State X court for dam- ages. The court dismissed the case for failure to state a cause of action under applicable state law. On appeal, the State X Supreme Court upheld the lower court. Three months after this ruling, the State Y Supreme Court heard an appeal in which a lower court had ruled that a reader could sue a columnist for falsely predicting flooding.

a. Must the State Y Supreme Court follow the ruling of the State X Supreme Court as a matter of stare decisis?

b. Should the State Y lower court have followed the rul- ing of the State X Supreme Court until the State Y Supreme Court issued a ruling on the issue?

c. Once the State X Supreme Court issued its ruling, could the U.S. Supreme Court overrule the State X Supreme Court?

d. If the State Y Supreme Court and the State X Supreme Court rule in exactly opposite ways, must the U.S. Supreme Court resolve the conflict between the two courts?

Chapter 3 Civil Dispute Resolution 69

2. State Senator Bowdler convinced the legislature of State Z to pass a law requiring all professors to submit their class notes and transparencies to a board of censors to be sure that no “lewd” materials were presented to students at state universities. Professor Rabelais would like to challenge this law as being violative of his First Amend- ment rights under the U.S. Constitution.

a. May Professor Rabelais challenge this law in State Z courts?

b. May Professor Rabelais challenge this law in a federal district court?

3. While driving his car in Virginia, Carpe Diem, a resident of North Carolina, struck Butt, a resident of Alaska. As a result of the accident, Butt suffered more than $80,000 in medical expenses. Butt would like to know if he per- sonally serves the proper papers to Diem whether he can obtain jurisdiction against Diem for damages in the fol- lowing courts:

a. Alaska state trial court

b. Federal Circuit Court of Appeals for the Ninth Circuit (includes Alaska)

c. Virginia state trial court

d. Virginia federal district court

e. Federal Circuit Court of Appeals for the Fourth Cir- cuit (includes Virginia and North Carolina)

f. Virginia equity court

g. North Carolina state trial court

4. Sam Simpleton, a resident of Kansas, and Nellie Naive, a resident of Missouri, each bought $85,000 in stock at local offices in their home states from Evil Stockbrokers,

Inc. (Evil), a business incorporated in Delaware with its principal place of business in Kansas. Both Simpleton and Naive believe that they were cheated by Evil and would like to sue it for fraud. Assuming that no federal question is at issue, assess the accuracy of the following statements:

a. Simpleton can sue Evil in a Kansas state trial court.

b. Simpleton can sue Evil in a federal district court in Kansas.

c. Naive can sue Evil in a Missouri state trial court.

d. Naive can sue Evil in a federal district court in Missouri.

5. The Supreme Court of State A ruled that, under the law of State A, pit bull owners must either keep their dogs fenced or pay damages to anyone bitten by the dogs. Assess the accuracy of the following statements:

a. It is likely that the U.S. Supreme Court would issue a writ of certiorari in the “pit bull” case.

b. If a case similar to the “pit bull” case were to come before the Supreme Court of State B in the future, the doctrine of stare decisis would leave the court no choice but to rule the same way as the Supreme Court of State A ruled in the “pit bull” case.

6. The Supreme Court of State G decided that the U.S. Con- stitution requires professors to warn students of their right to remain silent before questioning the students about cheating. This ruling directly conflicts with a deci- sion of the Federal Court of Appeals for the circuit that includes State G.

a. Must the Federal Circuit Court of Appeals withdraw its ruling?

b. Must the Supreme Court of State G withdraw its ruling?

C A S E P R O B L E M S

7. Thomas Clements brought an action in a court in Illinois to recover damages for breach of warranty against defend- ant, Signa Corporation. (A warranty is an obligation that the seller of goods assumes with respect to the quality of the goods sold.) Clements had purchased a motorboat from Barney’s Sporting Goods, an Illinois corporation. The boat was manufactured by Signa Corporation, an Indiana corporation with its principal place of business in Decatur, Indiana. Signa has no office in Illinois and no agent authorized to do business on its behalf within Illinois. Clements saw Signa’s boats on display at the Chicago Boat Show. In addition, literature on Signa’s boats was distributed at the Chicago Boat Show. Several boating magazines, delivered to Clements in Illinois, con- tained advertisements for Signa’s boats. Clements had also

seen Signa’s boats on display at Barney’s Sporting Goods Store in Palatine, Illinois, where he eventually purchased the boat. A written warranty issued by Signa was deliv- ered to Clements in Illinois. Although Signa was served with a summons, it failed to enter an appearance in this case. A default order was entered against Signa, and sub- sequently a judgment of $6,220 was entered against Signa. Signa appealed. Decision?

8. Vette sued Aetna under a fire insurance policy. Aetna moved for summary judgment on the basis that the pleadings and discovered evidence showed a lack of an insurable interest in Vette. An “insurable interest” exists when the insured derives a monetary benefit or advant- age from the preservation or continued existence of the

70 The Legal Environment of Business Part II

property or would sustain an economic loss from its destruction. Aetna provided ample evidence to infer that Vette had no insurable interest in the contents of the burned building. Vette also provided sufficient evidence to put in dispute this factual issue. The trial court granted the motion for summary judgment. Vette appealed. Decision?

9. Mark Womer and Brian Perry were members of the U.S. Navy and were stationed in Newport, Rhode Island. On April 10, Womer allowed Perry to borrow his automobile so that Perry could visit his family in New Hampshire. Later that day, while operating Womer’s vehicle, Perry was involved in an accident in Manchester, New Hampshire. As a result of the accident, Tzannetos Tavoularis was injured. Tavoularis brought this action against Womer in a New Hampshire superior court, contending that Womer was negligent in lending the automobile to Perry when he knew or should have known that Perry did not have a valid driver’s license. Womer sought to dismiss the action on the ground that the New Hampshire courts lacked jurisdiction over him, citing the following facts: (a) he did not live in New Hampshire, (b) he had no relatives in New Hampshire, (c) he neither owned property nor pos- sessed investments in New Hampshire, and (d) he had never conducted business in New Hampshire. Did the New Hampshire courts have jurisdiction? Explain.

10. Mariana Deutsch worked as a knitwear mender and attended a school for beauticians. The sink in her apart- ment collapsed on her foot, fracturing her big toe and making it painful for her to stand. She claims that as a consequence of the injury, she was compelled to abandon her plans to become a beautician because that job requires long periods of standing. She also asserts that she was unable to work at her current job for a month. She filed a tort claim against Hewes Street Realty for negligence in failing to maintain the sink properly. She brought the suit in federal district court, claiming dam- ages of $85,000. Her medical expenses and actual loss of salary were less than $7,500; the rest of her alleged dam- ages were for loss of future earnings as a beautician. Hewes Street moved to dismiss the suit on the basis that Deutsch’s claim fell short of the jurisdictional require- ment and therefore the federal court lacked subject mat- ter jurisdiction over her claim. The district court dismissed the suit, and Deutsch appealed. Does the fed- eral court have jurisdiction? Explain.

11. Kenneth Thomas brought suit against his former employer, Kidder, Peabody & Company, and two of its employees, Barclay Perry and James Johnston, in a dis- pute over commissions on sales of securities. When he applied to work at Kidder, Peabody & Company, Thomas had filled out a form, which contained an arbi- tration agreement clause. Thomas had also registered with the New York Stock Exchange (NYSE). Rule 347 of the NYSE provides that any controversy between a registered representative and a member company shall be

settled by arbitration. Kidder, Peabody & Company is a member of the NYSE. Thomas refused to arbitrate, rely- ing on Section 229 of the California Labor Code, which provides that actions for the collection of wages may be maintained “without regard to the existence of any pri- vate agreement to arbitrate.” Perry and Johnston filed a petition in a California state court to compel arbitration under Section 2 of the Federal Arbitration Act, which was enacted pursuant to the Commerce Clause of the U.S. Constitution. Should the petition of Perry and John- son be granted?

12. Steven Gwin bought a lifetime Termite Protection Plan for his home in Alabama from the local office of Allied- Bruce, a franchisee of Terminix International Company. The plan provided that Allied-Bruce would “protect” Gwin’s house against termite infestation, reinspect peri- odically, provide additional treatment if necessary, and repair damage caused by new termite infestations. Termi- nix International guaranteed the fulfillment of these con- tractual provisions. The plan also provided that all disputes arising out of the contract would be settled exclusively by arbitration. Four years later, Gwin had Allied-Bruce reinspect the house in anticipation of selling it. Allied-Bruce gave the house a “clean bill of health.” Gwin then sold the house and transferred the Termite Protection Plan to Dobson. Shortly thereafter, Dobson found the house to be infested with termites. Allied-Bruce attempted to treat and repair the house, using materials from out of state, but these efforts failed to satisfy Dobson. Dobson then sued Gwin, Allied-Bruce, and Terminix International in an Alabama state court. Allied- Bruce and Terminix International asked for a stay of these proceedings until arbitration could be carried out as stipulated in the contract. The trial court refused to grant the stay. The Alabama Supreme Court upheld that ruling, citing a state statute that makes predispute arbi- tration agreements unenforceable. The court found that the Federal Arbitration Act, which preempts conflicting state law, did not apply to this contract because its con- nection to interstate commerce was too slight. Was the Alabama Supreme Court correct? Explain.

13. Llexcyiss Omega and D. Dale York, both residents of Indiana, jointly listed a Porsche automobile for sale on eBay, a popular auction website. The listing stated that the vehicle was located in Indiana and that the winning bidder would be responsible for arranging and paying for delivery of the vehicle. The Attaways, residents of Idaho, entered a bid of $5,000 plus delivery costs. After being notified that they had won the auction, the Attaways submitted payment to Omega and York through PayPal (an online payment service owned by eBay), which charged the amount to the Attaways’ MasterCard account. The Attaways arranged for CarHop USA, a Washington- based auto transporter, to pick up the Porsche in Indiana and deliver it to their Idaho residence. After taking

Chapter 3 Civil Dispute Resolution 71

delivery of the Porsche, the Attaways filed a claim with PayPal, asking for a refund of its payment to Omega and York because the Porsche was “significantly not-as- described” in its eBay listing. PayPal informed the Att- aways via email that their claim was denied. The Attaways

convinced MasterCard to rescind the payment that had been made to Omega and York. Omega and York filed suit against the Attaways in small claims court in Indiana, demanding $5,900 in damages. Explain whether the Indi- ana courts have jurisdiction over the Attaways.

T A K I N G S I D E S

John Connelly suffered personal injuries when a tire manufac- tured by Uniroyal failed while his 1969 Opel Kadett was being operated on a highway in Colorado. Connelly’s father had purchased the automobile from a Buick dealer in Evan- ston, Illinois. The tire bore the name “Uniroyal” and the legend “made in Belgium” and was manufactured by Uni- royal, sold in Belgium to General Motors, and subsequently installed on the Opel when it was assembled at a General Motors plant in Belgium. The automobile was shipped to the United States for distribution by General Motors. It appears that between the years 1968 and 1971 more than 4,000 Opels imported into the United States from Antwerp, Belgium, were delivered to dealers in Illinois each year; that in each of those years between 600 and 1,320 of the Opels delivered to Illinois dealers were equipped with tires manufac- tured by Uniroyal; and that the estimated number of Uniroyal tires mounted on Opels delivered in Illinois within each of

those years ranged from 3,235 to 6,630. Connelly brought suit in Illinois against Uniroyal to recover damages for per- sonal injuries. Uniroyal asserted that it was not subject to the jurisdiction of the Illinois courts because it is not registered to do business and has never had an agent, employee, represen- tative, or salesperson in Illinois; that it has never possessed or controlled any land or maintained any office or telephone list- ing in Illinois; that it has never sold or shipped any products into Illinois, either directly or indirectly; and that it has never advertised in Illinois.

a. What arguments could Connelly make in support of his claim that Illinois courts have jurisdiction over Uniroyal?

b. What arguments could Uniroyal make in support of its claim that Illinois courts do not have jurisdiction over it?

c. Who should prevail? Explain.

72 The Legal Environment of Business Part II

C H A P T E R 4

CONSTITUTIONAL LAW

I have always regarded [the American] Constitution as the most remarkable work known to me in modern times to have been produced by the human intellect, at a single stroke (so to speak), in its application to political affairs.

WILLIAM GLADSTONE, BRITISH PRIME MINISTER (1887)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Explain the basic principles of constitutional law.

2. Describe the sources and extent of the power of the federal and state governments to regulate business and commerce.

3. Distinguish the three levels of scrutiny used by the courts to determine the constitutionality of government action.

4. Explain the effect of the First Amendment on (a) corporate political speech, (b) commercial speech, and (c) defamation.

5. Explain the difference between substantive and procedural due process.

Y ou will recall from Chapter 1 that a constitution is the fundamental law of a particular level of government. It establishes the structure of gov-

ernment and defines the political relationships within it. It also places restrictions on the powers of government and guarantees the rights and liberties of the people. The Constitution of the United States was adopted on September 17, 1787, by representatives of the thir- teen newly created states. Its purpose is stated in the preamble:

We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defense, promote the general Welfare, and secure the Blessings of Liberty to

ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.

Although the framers of the U.S. Constitution stated precisely what rights and authority were vested in the new national government, they considered it unneces- sary to list those liberties the people were to keep for themselves. Nonetheless, during the state conventions ratifying the document, people expressed fear that the federal government might abuse its powers. To calm these concerns, the first Congress approved ten amend- ments to the U.S. Constitution, now known as the Bill of Rights, which were adopted on December 15, 1791.

The Bill of Rights restricts the powers and authority of the federal government and establishes many of the

73

civil and political rights enjoyed in the United States, including the right to due process of law and freedoms of speech, press, religion, assembly, and petition. Though the Bill of Rights does not apply directly to the states, the Supreme Court has held that the Fourteenth Amend- ment incorporates most of the principal guarantees of the Bill of Rights, thus making them applicable to the states.

This chapter concerns constitutional law as it applies to business and commerce. We will begin by surveying some of the basic principles of constitutional law and will then examine the allocation of power between the federal and state governments with respect to the regulation of business. Finally, we will discuss the constitutional restric- tions on the power of government to regulate business.

BASIC PRINCIPLES [4-1] Constitutional law in the United States involves several basic concepts. These fundamental principles, which apply both to the powers of and to the limitations on government, are (1) federalism, (2) federal supremacy and preemption, (3) judicial review, (4) separation of powers, and (5) state action.

Federalism [4-1a] Federalism is the division of governing power between the federal government and the states. The U.S. Consti- tution enumerates the powers of the federal government and specifically reserves to the states or the people the powers not expressly delegated to the federal govern- ment. Accordingly, the federal government is a govern- ment of enumerated, or limited, powers, and a specified power must authorize each of its acts. The doctrine of enumerated powers is not, however, a significant limita- tion on the federal government, because a number of these enumerated powers, in particular the power to regulate interstate and foreign commerce, have been broadly interpreted.

Furthermore, the Constitution grants Congress not only specified powers but also the power “[t]o make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers, and all other Powers vested by this Constitution in the Government of the United States, or in any Department or Officer thereof.” U.S. Constitution, Article I, Section 8, clause 18. In the Supreme Court’s view, the Necessary and Proper Clause enables Congress to legislate in areas not mentioned in the list of enumerated powers as long as such legislation reasonably relates to some enumerated power.

Federal Supremacy and Preemption [4-1b] Although under the U.S. federalist system the states retain significant powers, the Supremacy Clause of the U.S. Constitution provides that, within its own sphere, federal law is supreme and that state law must, in case of conflict, yield. Accordingly, any state constitutional provision or law that conflicts with the U.S. Constitu- tion or valid federal laws or treaties is unconstitutional and may not be given effect.

Under the Supremacy Clause, whenever Congress enacts legislation within its constitutional powers, the fed- eral action preempts (overrides) any conflicting state legis- lation. Even if a state regulation is not in conflict, it must still give way if Congress clearly has intended its action to preempt state legislation. This intent may be stated expressly in the legislation or inferred from the scope of the legislation, the need for uniformity, or the danger of conflict between coexisting federal and state regulation.

When Congress has not intended to displace all state legislation, then nonconflicting state legislation is per- mitted. When Congress has not acted, the fact that it has the power to act does not prevent the states from acting. Until Congress exercises its power to preempt, state regulation is permitted.

W I L L I A M S O N V . M A Z D A M O T O R O F A M E R I C A , I N C . S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 1 1

5 6 2 U . S . 3 2 3 , 1 3 1 S . C t . 1 1 3 1 , 1 7 9 L . E d . 2 d 7 5

FACTS The 1989 version of Federal Motor Vehicle Safety Standard 208 (FMVSS 208) requires, among other things, that auto manufacturers install seatbelts on the rear seats of passenger vehicles. They must install lap-and-shoulder belts on seats next to a vehicle’s doors or frames. But they have a choice about what to install

on rear middle seats or those next to an aisle in a mini- van. There they can install either lap belts or lap-and- shoulder belts.

In 2002, the Williamson family, riding in their 1993 Mazda minivan, was struck head-on by another vehicle. Thanh Williamson was sitting in a rear aisle seat,

74 The Legal Environment of Business Part II

wearing a lap belt; she died in the accident. Delbert and Alexa Williamson were wearing lap-and-shoulder belts; they survived. They, along with Thanh’s estate, brought this suit against Mazda. They claimed that Mazda should have installed lap-and-shoulder belts on rear aisle seats in the minivan and that Thanh died because Mazda equipped her seat with a lap belt instead.

The California trial court dismissed this claim on the basis of the pleadings. The California Court of Appeal affirmed, relying on a U.S. Supreme Court decision, Geier v. American Honda Motor Co. That case held that a different portion of an older version of FMVSS 208—which required installation of passive restraint devices—preempted a state tort suit that sought to hold an auto manufacturer liable for failure to install a par- ticular kind of passive restraint, namely, airbags. The Williamsons sought certiorari, which was granted.

DECISION The judgment of the California Court of Appeal is reversed.

OPINION Breyer, J. Under ordinary conflict pre- emption principles a state law that “stands as an obsta- cle to the accomplishment and execution of the full purposes and objectives” of a federal law is pre-empted. [Citations.] In Geier we found that the state law stood as an “‘obstacle’ to the accomplishment” of a significant federal regulatory objective, namely, the maintenance of manufacturer choice. [Citation.] We must decide whether the same is true here.

*** Like the regulation in Geier, the regulation here

leaves the manufacturer with a choice. And, like the tort suit in Geier, the tort suit here would restrict that choice. But unlike Geier, we do not believe here that choice is a significant regulatory objective.

*** In 1984, DOT [Department of Transportation] rejected a regulation that would have required the use of lap-and-shoulder belts in rear seats [Citation.] None- theless, by 1989 when DOT promulgated the present regulation, it had “concluded that several factors had changed.” [Citation.]

DOT then required manufacturers to install a partic- ular kind of belt, namely, lap-and-shoulder belts, for rear outer seats. In respect to rear inner seats, it retained manufacturer choice as to which kind of belt to install. *** DOT here was not concerned about consumer acceptance; it was convinced that lap-and-shoulder belts would increase safety; it did not fear additional safety risks arising from use of those belts; it had no interest in assuring a mix of devices; and, though it was concerned about additional costs, that concern was diminishing.

***

The more important reason why DOT did not require lap-and-shoulder belts for rear inner seats was that it thought that this requirement would not be cost-effective. The agency explained that it would be sig- nificantly more expensive for manufacturers to install lap-and-shoulder belts in rear middle and aisle seats than in seats next to the car doors. [Citation.] But that fact—the fact that DOT made a negative judgment about cost effectiveness—cannot by itself show that DOT sought to forbid common-law tort suits in which a judge or jury might reach a different conclusion.

For one thing, DOT did not believe that costs would remain frozen. Rather it pointed out that costs were fall- ing as manufacturers were “voluntarily equipping more and more of their vehicles with rear seat lap/shoulder belts.” [Citation.] For another thing, many, perhaps most, federal safety regulations embody some kind of cost-effectiveness judgment. While an agency could base a decision to pre-empt on its cost-effectiveness judgment, we are satisfied that the rulemaking record at issue here discloses no such preemptive intent. And to infer from the mere existence of such a cost-effectiveness judgment that the federal agency intends to bar States from impos- ing stricter standards would treat all such federal stand- ards as if they were maximum standards, eliminating the possibility that the federal agency seeks only to set forth a minimum standard potentially supplemented through state tort law. We cannot reconcile this conse- quence with a statutory saving clause that foresees the likelihood of a continued meaningful role for state tort law. [Citation.]

Finally, the Solicitor General tells us that DOT’s reg- ulation does not pre-empt this tort suit.

*** *** In Geier, the Solicitor General pointed out that

“state tort law does not conflict with a federal ‘mini- mum standard’ merely because state law imposes a more stringent requirement.” [Citation.] And the Solicitor General explained that a standard giving manufacturers “multiple options for the design of” a device would not pre-empt a suit claiming that a manufacturer should have chosen one particular option, where “the Secretary did not determine that the availability of options was necessary to promote safety.” [Citation.] This last state- ment describes the present case.

In Geier, then, the regulation’s history, the agency’s contemporaneous explanation, and its consistently held interpretive views indicated that the regulation sought to maintain manufacturer choice in order to further significant regulatory objectives. Here, these same con- siderations indicate the contrary. We consequently con- clude that, even though the state tort suit may restrict the manufacturer’s choice, it does not “stan[d] as an

Chapter 4 Constitutional Law 75

Judicial Review [4-1c] Judicial review describes the process by which the courts examine government actions to determine whether they conform to the U.S. Constitution. If government action violates the U.S. Constitution, under judicial review the courts will invalidate that action. Judicial review extends to legislation, acts of the executive branch, and the deci- sions of inferior courts; such review scrutinizes actions of both the federal and state governments and applies to both the same standards of constitutionality. The U.S. Supreme Court is the final authority as to the constitu- tionality of any federal and state law.

Separation of Powers [4-1d] Another basic principle on which the U.S. government is founded is that of separation of powers. The U.S. Constitution vests power in three distinct and independ- ent branches of government—the executive, legislative, and judicial branches. The purpose of the doctrine of separation of powers is to prevent any branch of gov- ernment from gaining too much power. The doctrine also permits each branch to function without interfer- ence from any other branch. Basically, the legislative branch is granted the power to make the law, the exec- utive branch to enforce the law, and the judicial branch to interpret the law. This separation of powers is not complete, however. For example, the executive branch

has veto power over legislation enacted by Congress, the legislative branch must approve a great number of executive appointments, and the judicial branch may declare both legislation and executive actions unconstitu- tional. Nevertheless, the U.S. government generally oper- ates under a three-branch scheme that provides for separation of powers and places checks and balances on the power of each branch, as illustrated by Figure 4-1.

State Action [4-1e] Most of the protections provided by the U.S. Constitu- tion and its amendments apply only to government, or state, action. State action includes any actions of the federal and state governments and their subdivisions, such as city or county governments and agencies. Only the Thirteenth Amendment, which abolishes slavery or involuntary servitude, applies to the actions of private individuals. The protections that guard against state action, however, may be extended by statute to apply to private activity.

Additionally, action taken by private citizens may con- stitute state action if the state exercises coercive power over the challenged private action, has encouraged the action significantly, or was substantially involved with the action. For example, the Supreme Court found state action when the Supreme Court of Missouri ordered a lower court to enforce an agreement among white

obstacle to the accomplishment … of the full purposes and objectives” of federal law. [Citation.] Thus, the reg- ulation does not pre-empt this tort action.

INTERPRETATION Providing manufacturers with a choice of belts for rear inner seats is not a significant

objective of the federal regulation, and thus the regulation does not preempt the state tort suit.

CRITICAL THINKING QUESTION How does this decision affect the extent to which manufacturers can rely on federal safety regulations? Explain.

FIGURE 4-1 Separation of Powers: Checks and Balances

Legislative Makes the Law

Judicial Interprets the Law

Appoints federal judges

Veto power

Confirms appointments

Judicial review

Confirms appointments

Judicial review

Executive Enforces the Law

76 The Legal Environment of Business Part II

property owners that prohibited the transfer of their property to nonwhites. Moreover, if “private” individu- als or entities engage in public functions, their actions may be considered state action subject to constitutional limitations. For example, the U.S. Supreme Court held that a company town was subject to the First Amend- ment because the state had allowed the company to

exercise all of the public functions and activities usually conducted by a town government. Since that case, the Supreme Court has been less willing to find state action based upon the performance of public functions by pri- vate entities; the Court now limits such a finding to those functions “traditionally exclusively reserved to the state.”

B R E N T W O O D A C A D E M Y V . T E N N E S S E E S E C O N D A R Y S C H O O L A T H L E T I C A S S O C I A T I O N

S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 0 1

5 3 1 U . S . 2 8 8 , 1 2 1 S . C t . 9 2 4 , 1 4 8 L . E d . 2 d 8 0 7

FACTS The Tennessee Secondary School Athletic Association (Association) is a not-for-profit membership corporation organized to regulate interscholastic sport among the public and private high schools in Tennessee. No school is forced to join, but since there is no other authority regulating interscholastic athletics, it enjoys the memberships of almost all the state’s public high schools (some 290 of them or 84 percent of the Associa- tion’s voting membership), far outnumbering the fifty- five private schools that belong.

The Association’s rulemaking arm is its legislative council, while its board of control deals with administra- tion. The voting membership of each of these nine-person committees is limited under the Association’s bylaws to high school principals, assistant principals, and superin- tendents elected by the member schools, and the public school administrators who so serve typically attend meet- ings during regular school hours. Although the Associa- tion’s staff members are not paid by the state, they are eligible to join the state’s public retirement system for its employees. Member schools pay dues to the Association, though the bulk of its revenue is gate receipts at member teams’ football and basketball tournaments. The constitu- tion, bylaws, and rules of the Association set standards of school membership and the eligibility of students to play in interscholastic games. In 1997, a regulatory enforcement proceeding was brought against Brentwood Academy, a private parochial high school member of the Association. The Association’s board of control found that Brentwood violated a rule prohibiting “undue influ- ence” in recruiting athletes, when it wrote to incoming students and their parents about spring football practice. The Association placed Brentwood’s athletic program on probation for four years, declared its football and boys’ basketball teams ineligible to compete in playoffs for two years, and imposed a $3,000 fine.

Brentwood sued the Association and its executive director, claiming that enforcement of the Rule was state

action and a violation of the First and Fourteenth Amendments. The district court entered summary judg- ment for Brentwood and enjoined the Association from enforcing the Rule. The U.S. Court of Appeals for the Sixth Circuit reversed, saying that the district court was mistaken in seeing a symbiotic relationship between the state and the Association. It emphasized that the Associ- ation was neither engaging in a traditional and exclusive public function nor responding to state compulsion. The U.S. Supreme Court granted certiorari to resolve the conflict.

DECISION The judgment of the Court of Appeals for the Sixth Circuit is reversed, and the case is remanded for further proceedings consistent with this opinion.

OPINION Souter, J. Thus, we say that state action may be found if, though only if, there is such a “close nexus between the State and the challenged action” that seemingly private behavior “may be fairly treated as that of the State itself.” [Citation.]

***

Our cases have identified a host of facts that can bear on the fairness of such an attribution. We have, for example, held that a challenged activity may be state action when it results from the State’s exercise of “coercive power,” [citation], when the State provides “significant encouragement, either overt or covert,” [citation], or when a private actor operates as a “willful participant in joint activity with the State or its agents,” [citation]. We have treated a nominally private entity as a state actor when it is controlled by an “agency of the State,” [citation], when it has been delegated a public function by the State, [citations], when it is “entwined with governmental policies” or when government is “entwined in [its] management or control,” [citation].

***

Chapter 4 Constitutional Law 77

POWERS OF GOVERNMENT [4-2] The U.S. Constitution created a federal government of enumerated powers. Moreover, as the Tenth Amend- ment declares, “[t]he powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.” Consequently, the legislation Congress enacts must be based on a specific power the Constitu- tion grants to the federal government or be reasonably necessary to carry out an enumerated power.

Some government powers may be exercised only by the federal government. These exclusive federal powers include the power to establish laws regarding bank- ruptcy, to establish post offices, to grant patents and copyrights, to coin currency, to wage war, and to enter into treaties. Conversely, both the federal government and the states may exercise concurrent government powers, which include taxation, spending, and police power (regulation of public health, safety, and welfare).

In this part of the chapter, we will examine the sources and extent of the powers of the federal government—as well as the power of the states—to reg- ulate business and commerce.

Federal Commerce Power [4-2a] The U.S. Constitution provides that Congress has the power to regulate commerce with other nations and among the states. This Commerce Clause has two important effects: (1) it provides a broad source of commerce power for the federal government to regulate the economy, and (2) it restricts state regulations that obstruct or unduly burden interstate commerce.

The U.S. Supreme Court interprets the Commerce Clause as granting virtually complete power to Con- gress to regulate the economy and business. More spe- cifically, under the Commerce Clause, Congress has the power to regulate (1) the channels of interstate com- merce, (2) the instrumentalities of interstate commerce,

*** [T]he “necessarily fact-bound inquiry,” [citation], leads to the conclusion of state action here. The nomi- nally private character of the Association is overborne by the pervasive entwinement of public institutions and pub- lic officials in its composition and workings, and there is no substantial reason to claim unfairness in applying con- stitutional standards to it.

The Association is not an organization of natural persons acting on their own, but of schools, and of pub- lic schools to the extent of 84% of the total. Under the Association’s bylaws, each member school is represented by its principal or a faculty member, who has a vote in selecting members of the governing legislative council and board of control from eligible principals, assistant principals and superintendents.

Although the findings and prior opinions in this case include no express conclusion of law that public school officials act within the scope of their duties when they represent their institutions, no other view would be rational, *** . Interscholastic athletics obviously play an integral part in the public education of Tennessee, where nearly every public high school spends money on com- petitions among schools. Since a pickup system of inter- scholastic games would not do, these public teams need some mechanism to produce rules and regulate competi- tion. The mechanism is an organization overwhelmingly composed of public school officials who select represen- tatives (all of them public officials at the time in ques- tion here), who in turn adopt and enforce the rules that make the system work. Thus, by giving these jobs to the

Association, the 290 public schools of Tennessee belong- ing to it can sensibly be seen as exercising their own authority to meet their own responsibilities. *** In sum, to the extent of 84% of its membership, the Association is an organization of public schools represented by their officials acting in their official capacity to provide an integral element of secondary public schooling. There would be no recognizable Association, legal or tangible, without the public school officials, who do not merely control but overwhelmingly perform all but the purely ministerial acts by which the Association exists and functions in practical terms. ***

To complement the entwinement of public school officials with the Association from the bottom up, the State of Tennessee has provided for entwinement from top down. State Board members are assigned ex officio to serve as members of the board of control and legislative council, and the Association’s ministerial employees are treated as state employees to the extent of being eligible for membership in the state retirement system.

INTERPRETATION If an association involves the pervasive entwinement of state school officials in its structure, the association’s regulatory activity will be treated as state action.

CRITICAL THINKING QUESTION Should the actions of private parties be immune from federal constitutional limitations? Explain.

78 The Legal Environment of Business Part II

and (3) those activities having a substantial relation to interstate commerce. A court may invalidate legislation enacted under the Commerce Clause only if it is clear that (1) the activity the legislation regulates does not affect interstate commerce or (2) no reasonable connec- tion exists between the selected regulatory means and the stated ends. For example, activities conducted solely within one state, such as the practice of law or real estate brokerage agreements, are subject to federal anti- trust laws under the power granted by the Commerce Clause if those activities (1) substantially affect inter- state commerce or (2) are in the flow of commerce.

Because of the broad and permissive interpretation of the commerce power, Congress currently regulates a vast range of activities. Many of the activities discussed in this text are regulated by the federal government through its exercise of the commerce power; such activities include federal crimes, consumer warranties and credit transac- tions, electronic funds transfers, trademarks, unfair trade practices, other consumer transactions, residential real estate transactions, consumer and employee safety, labor relations, civil rights in employment, transactions in securities, and environmental protection.

In 2010, Congress enacted the Patient Protection and Affordable Care Act (commonly called “Obamacare”) to increase the number of Americans covered by health in- surance and decrease the cost of health care. One key provision—the individual mandate—requires most Americans to maintain “minimum essential” health insurance coverage or make a “shared responsibility payment” to the federal government. The constitutional- ity of the individual mandate was challenged as beyond the commerce and taxing powers of Congress. In decid- ing the Commerce Clause question, the U.S. Supreme Court explained that the Commerce Clause presupposes the existence of commercial activity to be regulated:

The individual mandate, however, does not regulate exist- ing commercial activity. It instead compels individuals to become active in commerce by purchasing a product, on

the ground that their failure to do so affects interstate commerce. Construing the Commerce Clause to permit Congress to regulate individuals precisely because they are doing nothing would open a new and potentially vast do- main to congressional authority.

Accordingly, in a 5–4 vote the Court held that the individual mandate was not a valid exercise of the com- merce power. National Federation of Independent Busi- ness v. Sebelius, 567 U.S. 1 (2012). The Court’s decision regarding the taxing power of Congress is cov- ered later in this chapter.

State Regulation of Commerce [4-2b] The Commerce Clause, as we have previously discussed, specifically grants to Congress the power to regulate commerce among the states. In addition to acting as a broad source of federal power, the clause also implicitly restricts the states’ power to regulate activities if the result obstructs or unduly burdens interstate commerce.

Regulations The U.S. Supreme Court ultimately decides the extent to which state regulation may affect interstate commerce. In doing so, the Court weighs and balances several factors: (1) the necessity and impor- tance of the state regulation, (2) the burden it imposes on interstate commerce, and (3) the extent to which it discriminates against interstate commerce in favor of local concerns. The application of these factors involves case-by-case analysis. In general, in cases in which a state statute regulates evenhandedly to accomplish a legitimate state interest and its effects on interstate com- merce are only incidental, the Court will uphold the statute unless the burden imposed on interstate com- merce is clearly excessive compared with the local bene- fits. The Court will uphold a discriminatory regulation only if no other reasonable method of achieving a legit- imate local interest exists.

D E P A R T M E N T O F R E V E N U E O F K E N T U C K Y , E T A L . V . D A V I S S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 0 8

5 5 3 U . S . 3 2 8 , 1 2 8 S . C t . 1 8 0 1 , 1 7 0 L . E d . 2 d 6 8 5

FACTS Kentucky, like forty other states, exempts from state income taxes interest on bonds issued by it or its political subdivisions but not on bonds issued by other states and their subdivisions. The differential tax scheme in Kentucky benefits its residents who buy its

bonds by effectively lowering interest rates. After paying state income tax on out-of-state municipal bonds, plaintiffs sued Kentucky for a refund, claiming that Kentucky’s differential tax impermissibly discrimi- nated against interstate commerce. The trial court ruled

Chapter 4 Constitutional Law 79

for Kentucky. The State Court of Appeals reversed, find- ing that Kentucky’s scheme violated the Commerce Clause. The U.S. Supreme Court granted certiorari.

DECISION The judgment is reversed, and the case is remanded.

OPINION Souter, J. The significance of the scheme is immense. Between 1996 and 2002, Kentucky and its subdivisions issued $7.7 billion in long-term bonds to pay for spending on transportation, public safety, educa- tion, utilities, and environmental protection, among other things. [Citation.] Across the Nation during the same period, States issued over $750 billion in long- term bonds, with nearly a third of the money going to education, followed by transportation (13%) and util- ities (11%). [Citation.] Municipal bonds currently finance roughly two-thirds of capital expenditures by state and local governments. [Citation.]

*** The Commerce Clause empowers Congress “[t]o reg-

ulate Commerce … among the several States,” Art. I, §8, cl. 3, and although its terms do not expressly restrain “the several States” in any way, we have sensed a negative implication in the provision since the early days, [citation]. The modern law of what has come to be called the dormant Commerce Clause is driven by concern about “economic protectionism—that is, regula- tory measures designed to benefit in-state economic interests by burdening out-of-state competitors.” [Cita- tion.] The point is to “effectuat[e] the Framers’ purpose to ‘prevent a State from retreating into [the] economic isolation,”’ [citation], “that had plagued relations among the Colonies and later among the States under the Articles of Confederation,” [citation].

*** Under the resulting protocol for dormant Commerce

Clause analysis, we ask whether a challenged law dis- criminates against interstate commerce. [Citation.] A dis- criminatory law is “virtually per se invalid,” [citation], and will survive only if it “advances a legitimate local purpose that cannot be adequately served by reasonable nondiscriminatory alternatives,” [citation.] Absent dis- crimination for the forbidden purpose, however, the law “will be upheld unless the burden imposed on [interstate] commerce is clearly excessive in relation to the putative local benefits.” Pike v. Bruce Church, Inc., [citation]. State laws frequently survive this Pike scrutiny, [citation], though not always, as in Pike itself, [citation].

*** *** In [citation], we explained that a government

function is not susceptible to standard dormant Com- merce Clause scrutiny owing to its likely motivation by

legitimate objectives distinct from the simple economic protectionism the Clause abhors, [citations]. This logic applies with even greater force to laws favoring a State’s municipal bonds, given that the issuance of debt secur- ities to pay for public projects is a quintessentially pub- lic function, with the venerable history we have already sketched, [Citation.]. By issuing bonds, state and local governments “sprea[d] the costs of public projects over time,” [citation], much as one might buy a house with a loan subject to monthly payments. Bonds place the cost of a project on the citizens who benefit from it over the years, *** and they allow for public work beyond what current revenues could support. [Citation.] Bond proceeds are thus the way to shoulder the cardinal civic responsi- bilities listed in [citation]: protecting the health, safety, and welfare of citizens. It should go without saying that the apprehension in [citation] about “unprecedented … interference” with a traditional government function is just as warranted here, where the Davises would have us invalidate a century-old taxing practice, [citation], pres- ently employed by 41 States, [citation], and affirmatively supported by all of them, [citation].

[T]he Kentucky tax scheme parallels the ordinance upheld in [citation]: it “benefit[s] a clearly public [issuer, that is, Kentucky], while treating all private [issuers] exactly the same.” [Citation.]

Kentucky’s tax exemption favors a traditional gov- ernment function without any differential treatment favoring local entities over substantially similar out-of- state interests. This type of law does “not ‘discriminate against interstate commerce’ for purposes of the dor- mant Commerce Clause.” [Citation.]

*** A look at the specific markets in which the exemption’s effects are felt both confirms the conclusion that no traditionally forbidden discrimination is under- way and points to the distinctive character of the tax pol- icy. The market as most broadly conceived is one of issuers and holders of all fixed-income securities, what- ever their source or ultimate destination. In this interstate market, Kentucky treats income from municipal bonds of other States just like income from bonds privately issued in Kentucky or elsewhere; no preference is given to any local issuer, and none to any local holder, beyond what is entailed in the preference Kentucky grants itself when it engages in activities serving public objectives. *** These facts suggest that no State perceives any local advantage or disadvantage beyond the permissible ones open to a government and to those who deal with it when that government itself enters the market. [Citation.]

*** In sum, the differential tax scheme is critical to the

operation of an identifiable segment of the municipal fi- nancial market as it currently functions, and this fact alone demonstrates that the unanimous desire of the

80 The Legal Environment of Business Part II

Taxation The Commerce Clause, in conjunction with the Import-Export Clause, also limits the power of the state to tax. The Import-Export Clause provides: “No State shall, without the Consent of the Congress, lay any Imposts or Duties on Imports or Exports.” U.S. Constitution, Article I, Section 10, clause 2. Together, the Commerce Clause and the Import-Export Clause exempt from state taxation goods that have entered the stream of commerce, whether they are interstate or for- eign and whether they are imports or exports. The pur- pose of this immunity is to protect goods in commerce from both discriminatory and cumulative state taxes. Once the goods enter the stream of interstate or foreign commerce, the power of the state to tax ceases and does not resume until the goods are delivered to the purchaser or the owner terminates the movement of the goods through commerce.

The Due Process Clause of the Fourteenth Amend- ment also restricts the power of states to tax. Under the Due Process Clause, for a state tax to be constitutional, a sufficient nexus must exist between the state and the person, thing, or activity to be taxed.

Federal Fiscal Powers [4-2c] The federal government exerts a dominating influence over the national economy through its control of finan- cial matters. Much of this impact results from the exer- cise of its regulatory powers under the Commerce Clause, as previously discussed. In addition, the govern- ment derives a substantial portion of its influence from powers that are independent of the Commerce Clause. These include (1) the power to tax, (2) the power to spend, (3) the power to borrow and coin money, and (4) the power of eminent domain.

Taxation The federal government’s power to tax, although extremely broad, has three major limitations: (1) direct taxes must be apportioned among the states, (2) all custom duties and excise taxes must be uniform throughout the United States, and (3) no duties may be levied on exports from any state.

Besides raising revenues, taxes also have regulatory and socioeconomic effects. For example, import taxes and custom duties can protect domestic industry from foreign competition. Graduated or progressive tax rates and exemptions may further social policies seek- ing the redistribution of wealth. Tax credits encourage investment in favored enterprises to the disadvantage of unfavored businesses. A tax that does more than just raise revenue will be upheld “so long as the motive of Congress and the effect of its legislative action are to secure revenue for the benefit of the gen- eral government.”

The Patient Protection and Affordable Care Act’s individual mandate provision requires most Americans to maintain “minimum essential” health insurance cover- age or make a “shared responsibility payment” to the federal government. The constitutionality of the individ- ual mandate was challenged as beyond the commerce and taxing powers of Congress. In deciding the taxing power question, in a 5–4 vote the U.S. Supreme Court held that requiring certain individuals to “pay a financial penalty for not obtaining health insurance may reason- ably be characterized as a tax. Because the Constitution permits such a tax, it is not our role to forbid it, or to pass upon its wisdom or fairness.” National Federation of Independent Business v. Sebelius, 567 U.S. 1 (2012).

Spending Power The Constitution authorizes the federal government to pay debts and to spend for the common defense and general welfare of the United States. Like the power to tax, the spending power of Congress is extremely broad; this power will be upheld so long as it does not violate a specific constitutional limitation on federal power.

Furthermore, through its spending power, Congress may accomplish indirectly what it may not do directly. For example, the Supreme Court has held that Congress may condition a state’s receipt of federal highway funds on that state’s mandating twenty-one as the minimum drinking age, even though the Twenty-First Amendment grants the states significant powers with respect to alco- hol consumption within their respective borders. As the

States to preserve the tax feature is a far cry from the private protectionism that has driven the development of the dormant Commerce Clause. ***

INTERPRETATION State law exempting from state income taxes interest on bonds issued by that state or its political subdivisions but not on bonds issued by

other states and their subdivisions does not impermissi- bly discriminate against interstate commerce.

CRITICAL THINKING QUESTION Had the Court invalidated Kentucky’s taxing scheme, what would the impact have been on the states’ ability to finance their operations?

Chapter 4 Constitutional Law 81

Court noted, “Constitutional limitations on Congress when exercising its spending power are less exacting than those on its authority to regulate directly.” Whether directly or indirectly, the power of the federal government to spend money represents an important regulatory force in the economy and significantly affects the general welfare of the United States.

Borrowing and Coining Money The U.S. Constitution also grants Congress the power to borrow money on the credit of the United States and to coin money. These two powers have enabled the federal government to establish a national banking system, the Federal Reserve System, and specialized federal lending programs such as the Federal Land Bank. Through these and other institutions and agencies, the federal government wields extensive control over national fiscal and monetary policies and exerts considerable influence over interest rates, the money supply, and foreign exchange rates.

Eminent Domain The government’s power to take private property for public use, known as the power of eminent domain, is recognized, in the federal Constitution and in the constitutions of the states, as one of the inherent powers of government. At the same time, however, the power is carefully limited. The Fifth Amendment to the federal Constitution contains a

Takings Clause that provides that private property shall not be taken for public use without just compensation. Although this amendment applies only to the federal government, the U.S. Supreme Court has held that the Takings Clause is incorporated through the Fourteenth Amendment and is therefore applicable to the states. Moreover, similar or identical provisions are found in the constitutions of the states.

As the language of the Takings Clause indicates, the taking must be for a public use. Public use has been held to be synonymous with public purpose. Thus, pri- vate entities, such as railroads and housing authorities, may use the government’s power of eminent domain so long as the entity’s use of the property benefits the pub- lic. When the government or a private entity properly takes property under the power of eminent domain, the owners of the property must receive just compensation, which has been interpreted as the fair market value of the property.

The U.S. Supreme Court has held that the Takings Clause requires just compensation only if a government taking actually occurs, not if the government regulation only reduces the value of the property. If, however, a regulation deprives the owner of all economic use of the property, then a taking has occurred. Eminent domain is discussed further in Chapter 49.

Figure 4-2 summarizes the powers granted to the federal government, the states, and the people.

FIGURE 4-2 Powers of Government

People’s Powers

All powers not granted to federal or state government

States’ Powers

Federal Powers Commerce Power Taxation Borrowing Currency* Eminent Domain Civil Rights Bankruptcy* Admiralty*

Powers not granted by the Constitution to the federal government or prohibited to the states

Copyrights* Patents* International Treaties* Waging War* Post* Naturalization* Weights* Measures*

* Exclusive power

82 The Legal Environment of Business Part II

LIMITATIONS ON GOVERNMENT [4-3] As we have discussed, the U.S. Constitution grants certain specified powers to the federal government, while reserving other, unspecified powers to the states. The Constitution and its amendments, how- ever, impose limits on the powers of both the federal government and the states. In this part of the chapter, we will discuss those limitations most applicable to business: (1) the Contract Clause, (2) the First Amendment, (3) due process, and (4) equal protec- tion. The first of these—the Contract Clause—applies only to the actions of state governments, whereas the other three apply to both the federal government and the states.

None of these restrictions operates as an absolute limitation but instead triggers review or scrutiny by the courts to determine whether the government power exercised encroaches impermissibly upon the interest the Constitution protects. The U.S. Supreme Court has used different levels of scrutiny, depending on the inter- est affected and the nature of the government action. Although this differentiation among levels of scrutiny is most fully developed in the area of equal protection, it also occurs in other areas, including substantive due process and protection of free speech.

The least rigorous level of scrutiny is the rational relationship test, which requires that the regulation con- ceivably bear some rational relationship to a legitimate government interest that the regulation will attempt to further. The most exacting level of scrutiny is the strict scrutiny test, which requires that the regulation be nec- essary to promote a compelling government interest. Finally, under the intermediate test, the regulation must have a substantial relationship to an important govern- ment objective. These standards will be explained more fully. See Concept Review 4-1 illustrating these limita- tions on government.

Contract Clause [4-3a] Article I, Section 10, of the Constitution provides: “No State shall … pass any … Law impairing the Obligation of Contracts.” The U.S. Supreme Court has used the Contract Clause to restrict states from retroactively modifying public charters and private contracts. How- ever, the Court, holding that the Contract Clause does not preclude the states from exercising eminent domain or their police powers, has ruled: “No legislature can bargain away the public health or the public morals.” Although the Contract Clause does not apply to the federal government, due process limits the federal gov- ernment’s power to impair contracts.

PRACTICAL ADVICE The federal Constitution protects you from a state law that impairs a preexisting contract.

First Amendment [4-3b] The First Amendment states:

Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.

The First Amendment’s protection of free speech is not absolute. Some forms of speech, such as obscenity, receive no protection. Most forms of speech, however, are pro- tected by the strict or exacting scrutiny standard, which requires the existence of a compelling and legitimate state interest to justify a restriction of speech. If such an interest exists, the legislature must use means that least restrict free speech. We will examine the application of the First Amendment’s guarantee of free speech to (1) corporate po- litical speech, (2) commercial speech, and (3) defamation.

CONCEPT REVIEW 4-1 L I M I T A T I O N S O N G O V E R N M E N T

Test/Interest Equal Protection Substantive Due Process Free Speech

Strict Scrutiny Fundamental Rights Suspect Classifications

Fundamental Rights Protected Noncommercial Speech

Intermediate Gender Legitimacy

Commercial Speech

Rational Relationship Economic Regulation Economic Regulation Nonprotected Speech

Chapter 4 Constitutional Law 83

B R O W N V . E N T E R T A I N M E N T M E R C H A N T S A S S O C I A T I O N S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 1 1

5 6 4 U . S . ___ , 1 3 1 S . C t . 2 7 2 9 , 1 8 0 L . E d . 2 d 7 0 8

FACTS A California statute (the Act) prohibits the sale or rental of violent video games to minors and requires their packaging to be labeled “18.” The Act does “not apply if the violent video game is sold or rented to a minor by the minor’s parent, grandparent, aunt, uncle, or legal guardian.” The Act covers games “in which the range of options available to a player includes killing, maiming, dismembering, or sexually assaulting an image of a human being, if those acts are depicted” in a manner that “[a] reasonable person, con- sidering the game as a whole, would find appeals to a deviant or morbid interest of minors,” that is “patently offensive to prevailing standards in the community as to what is suitable for minors,” and that “causes the game, as a whole, to lack serious literary, artistic, political, or scientific value for minors.” Violation of the Act is pun- ishable by a civil fine of up to $1,000.

The plaintiffs, representing the video-game and soft- ware industries, brought a challenge to the Act in the U.S. District Court for the Northern District of Califor- nia. That court concluded that the Act violated the First Amendment’s freedom of speech clause and permanently enjoined its enforcement. The Court of Appeals affirmed, and the U.S. Supreme Court granted certiorari.

DECISION The judgment of the Court of Appeals is affirmed.

OPINION Scalia, J. California correctly acknowl- edges that video games qualify for First Amendment protection. The Free Speech Clause exists principally to protect discourse on public matters, but we have long recognized that it is difficult to distinguish politics from entertainment, and dangerous to try. *** Like the pro- tected books, plays, and movies that preceded them, video games communicate ideas—and even social mes- sages—through many familiar literary devices (such as characters, dialogue, plot, and music) and through fea- tures distinctive to the medium (such as the player’s interaction with the virtual world). That suffices to con- fer First Amendment protection. ***

The most basic of those principles is this: “[A]s a general matter, … government has no power to restrict expression because of its message, its ideas, its subject matter, or its content.” [Citation.] There are of course exceptions. “‘From 1791 to the present,’ … the First Amendment has ‘permitted restrictions upon the content

of speech in a few limited areas,’ and has never ‘include[d] a freedom to disregard these traditional limitations.”’ [Citations.] These limited areas—such as obscenity, [citation], incitement, [citation], and fighting words, [citation]—represent “well-defined and narrowly limited classes of speech, the prevention and punishment of which have never been thought to raise any Constitu- tional problem,” [citation].

Last Term, in [citation], we held that new categories of unprotected speech may not be added to the list by a legislature that concludes certain speech is too harmful to be tolerated. ***

*** The California Act *** does not adjust the boundaries

of an existing category of unprotected speech to ensure that a definition designed for adults is not uncritically applied to children. *** Instead, it wishes to create a wholly new category of content-based regulation that is permissible only for speech directed at children.

That is unprecedented and mistaken. “[M]inors are entitled to a significant measure of First Amendment protection, and only in relatively narrow and well- defined circumstances may government bar public dis- semination of protected materials to them.” [Citation.] No doubt a State possesses legitimate power to protect children from harm, [citation], but that does not include a free-floating power to restrict the ideas to which chil- dren may be exposed. “Speech that is neither obscene as to youths nor subject to some other legitimate proscrip- tion cannot be suppressed solely to protect the young from ideas or images that a legislative body thinks unsuitable for them.” [Citation.]

*** California claims that video games present spe- cial problems because they are “interactive,” in that the player participates in the violent action on screen and determines its outcome. The latter feature is nothing new *** As for the argument that video games enable participation in the violent action, that seems to us more a matter of degree than of kind. ***

Because the Act imposes a restriction on the content of protected speech, it is invalid unless California can demonstrate that it passes strict scrutiny—that is, unless it is justified by a compelling government interest and is narrowly drawn to serve that interest. [Citation.] The State must specifically identify an “actual problem” in need of solving, [citation], and the curtailment of free speech must be actually necessary to the solution,

84 The Legal Environment of Business Part II

Corporate Political Speech Freedom of speech is indispensable to the discovery and spread of political truth; indeed, “the best test of truth is the power of the thought to get itself accepted in the competition of the market.” To promote this competition of ideas, the First Amendment’s guarantee of free speech applies not only to individuals but also to corporations. Accordingly, cor- porations may not be prohibited from speaking out on political issues. For example, in First National Bank v. Bellotti, 435 U.S. 765 (1978), the U.S. Supreme Court has held unconstitutional a Massachusetts criminal stat- ute that prohibited banks and business corporations from making contributions and expenditures with regard to most referenda issues. The Court held that if speech is otherwise protected, the fact that the speaker is a corpo- ration does not alter the speech’s protected status.

The Supreme Court retreated somewhat from its hold- ing in Bellotti when it upheld a state statute prohibiting corporations, except media corporations, from using gen- eral treasury funds to make independent expenditures in elections for public office but permitting such expenditures

from segregated funds used solely for political purposes. The Court held that the statute did not violate the First Amendment because the burden on corporations’ exercise of political expression was justified by a compelling state interest in preventing corruption in the political arena: “the corrosive and distorting effects of immense aggrega- tions of wealth that are accumulated with the help of the corporate form and that have little or no correlation to the public’s support for the corporation’s political ideas.” The Court held that the statute was sufficiently narrowly tailored because it “is precisely targeted to eliminate the distortion caused by corporate spending while also allow- ing corporations to express their political views” by mak- ing expenditures through segregated funds. Austin v. Michigan Chamber of Commerce, 494 U.S. 652 (1990).

In a recent landmark 5–4 decision, Citizens United v. Federal Election Commission, 558 U.S. 310 (2010), the U.S. Supreme Court explicitly overruled the Austin case. Citizens United involved a First Amendment chal- lenge to a federal law that prohibited corporations and unions from using their general treasury funds to make

[citation]. That is a demanding standard. “It is rare that a regulation restricting speech because of its content will ever be permissible.” [Citation.]

California cannot meet that standard. At the outset, it acknowledges that it cannot show a direct causal link between violent video games and harm to minors. ***

*** California’s effort to regulate violent video games is

the latest episode in a long series of failed attempts to censor violent entertainment for minors. While we have pointed out above that some of the evidence brought forward to support the harmfulness of video games is unpersuasive, we do not mean to demean or disparage the concerns that underlie the attempt to regulate them—concerns that may and doubtless do prompt a good deal of parental oversight. We have no business passing judgment on the view of the California Legisla- ture that violent video games (or, for that matter, any other forms of speech) corrupt the young or harm their moral development. Our task is only to say whether or not such works constitute a “well-defined and narrowly limited clas[s] of speech, the prevention and punishment of which have never been thought to raise any Constitu- tional problem,” [citation] (the answer plainly is no); and if not, whether the regulation of such works is justi- fied by that high degree of necessity we have described as a compelling state interest (it is not). Even where the protection of children is the object, the constitutional limits on governmental action apply.

California’s legislation straddles the fence between (1) addressing a serious social problem and (2) helping concerned parents control their children. Both ends are legitimate, but when they affect First Amendment rights they must be pursued by means that are neither seriously underinclusive nor seriously overinclusive. [Citation.] As a means of protecting children from portrayals of vio- lence, the legislation is seriously underinclusive, not only because it excludes portrayals other than video games, but also because it permits a parental or avuncular veto. And as a means of assisting concerned parents it is seriously overinclusive because it abridges the First Amendment rights of young people whose parents (and aunts and uncles) think violent video games are a harm- less pastime. And the overbreadth in achieving one goal is not cured by the underbreadth in achieving the other. Legislation such as this, which is neither fish nor fowl, cannot survive strict scrutiny.

INTERPRETATION Because video games qual- ify for First Amendment protection and new categories of unprotected speech may not be added, a state must show that a law restricting video game sales to minors (1) is justified by a compelling government interest and (2) is narrowly drawn to serve that interest.

CRITICAL THINKING QUESTION Is there a less restrictive alternative to California’s law that would be at least as effective? Explain.

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independent expenditures for speech defined as an “electioneering communication” or for speech expressly advocating the election or defeat of a candidate. (An electioneering communication is “any broadcast, cable, or satellite communication” that “refers to a clearly identified candidate for Federal office” and is made within thirty days of a primary election.) The Supreme Court invalidated these provisions as conflicting with the First Amendment, holding: “We return to the prin- ciple established in … Bellotti that the Government may not suppress political speech on the basis of the speaker’s corporate identity. No sufficient governmental interest justifies limits on the political speech of non- profit or for-profit corporations.”

The ruling in Citizens United, however, did not apply to the two types of federal statutory limits on direct contributions by individuals to federal candidates and political parties. The first limit, called base limits, restricts how much money an individual may contribute to a particular candidate or committee. The second limit, called aggregate limits, restricts how much money an individual donor may contribute in total to all can- didates or committees during a political cycle. In 2014, the U.S. Supreme Court considered a challenge to the aggregate limits in the case of McCutcheon v. Federal Election Commission, 572 U.S. ___ (2014). In a 5–4 decision, the Supreme Court invalidated the aggregate limits under the First Amendment. This decision did not involve any challenge to the base limits, which have been upheld previously as serving the permissible objec- tive of combatting corruption. In addition, this decision concerned only contributions from individuals; federal law continues to ban direct contributions by corpora- tions and unions.

Commercial Speech Commercial speech is expression related to the economic interests of the speaker and his audience, such as advertisements for a product or service. Since the mid-1970s, U.S. Supreme Court decisions have eliminated the doctrine that com- mercial speech is wholly outside the protection of the First Amendment. Rather, the Court has established the principle that speech proposing a commercial transac- tion is entitled to protection, which, although less than that accorded to political speech, is still extensive. Pro- tection is accorded commercial speech because of the interest such communication holds for the advertiser, consumer, and general public. Advertising and other similar messages convey important information for the proper and efficient distribution of resources in a free market system. At the same time, however, commercial speech is less valuable and less vulnerable than other

varieties of speech and therefore does not merit com- plete First Amendment protection.

In cases determining the protection to be afforded commercial speech, a four-part analysis has developed. First, the court must determine whether the expression is protected by the First Amendment. For commercial speech to come within that provision, such speech, at the least, must concern lawful activity and not be misleading. Second, the court must determine whether the asserted government interest is substantial. If both inquiries yield positive answers, then, third, the court must determine whether the regulation directly advances the government interest asserted and, fourth, whether the regulation is not more extensive than is necessary to serve that inter- est. The Supreme Court recently held that government restrictions of commercial speech need not be absolutely the least severe so long as they are “narrowly tailored” to achieve the government objective.

Because the constitutional protection extended to commercial speech is based on the informational func- tion of advertising, governments may regulate or sup- press commercial messages that do not accurately inform the public about lawful activity. “The govern- ment may ban forms of communication more likely to deceive the public than to inform it, or commercial speech related to illegal activity.” Therefore, govern- ment regulation of false and misleading advertising is permissible under the First Amendment.

Defamation Defamation is a civil wrong or tort that consists of disgracing or diminishing a person’s repu- tation through the communication of a false statement. An example would be the publication of a statement that a person had committed a crime or had a loathsome dis- ease. (Defamation is also discussed in Chapter 7.)

Because defamation involves a communication, it receives the protection extended to speech by the First Amendment. Moreover, the U.S. Supreme Court has ruled that a public official who is defamed in regard to his conduct, fitness, or role as public official may not recover in a defamation action unless the statement was made with actual malice, which requires clear and con- vincing proof that the defendant had knowledge of the falsity of the communication or acted in reckless disre- gard of its truth or falsity. This restriction on the right to recover for defamation is based on “a profound national commitment to the principle that debate on public issues should be uninhibited, robust and wide- open, and that it may well include vehement, caustic, and sometimes unpleasantly sharp attacks on government and public officials.” New York Times Co. v. Sullivan, 376 U.S. 254 (1964). The communication may deal with

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the official’s qualifications for and performance in office, which would likely include most aspects of character and public conduct. In addition, the Supreme Court has extended the same rule to public figures and candidates for public office. (The Supreme Court, however, has not precisely defined the term public figure.)

In a defamation suit brought by a private person (one who is neither a public official nor a public figure), the plain- tiff must prove that the defendant published the defamatory and false comment with either malice or negligence.

Due Process [4-3c] The Fifth and Fourteenth Amendments prohibit the fed- eral and state governments, respectively, from depriving any person of life, liberty, or property without due process of law. Due process has two different aspects: substantive and procedural. As discussed in Chapter 1, substantive law creates, defines, or regulates legal rights, whereas procedural law establishes the rules for enforcing those rights. Accordingly, substantive due process concerns the compatibility of a law or govern- ment action with fundamental constitutional rights such as free speech. In contrast, procedural due process involves the review of the decision-making process that enforces substantive laws and results in depriving a per- son of life, liberty, or property.

Substantive Due Process Substantive due pro- cess, which involves a court’s determination of whether a particular government action is compatible with indi- vidual liberties, addresses the constitutionality of a legal rule, not the fairness of the process by which the rule is applied. Legislation affecting economic and social inter- ests satisfies substantive due process so long as the legislation is rationally related to legitimate government objectives. In cases in which a rule affects individuals’ fundamental rights under the Constitution, however, courts will carefully scrutinize the legislation to deter- mine whether it is necessary to promote a compelling or overriding government interest. For example, the U.S. Supreme Court overturned the federal Defense of Marriage Act (DOMA), which defines marriage as the union of a man and a woman for purposes of federal benefits. DOMA thus denies federal benefits to persons in same-sex marriages made lawful by some of the states. The Supreme Court held that

The federal statute is invalid, for no legitimate purpose overcomes the purpose and effect to disparage and to injure those whom the State, by its marriage laws, sought to protect in personhood and dignity … By seeking to dis- place this protection and treating those persons as living in

marriages less respected than others, the federal statute is in violation of the Fifth Amendment. United States v. Windsor, 570 U.S. ___ (2013).

Moreover, in a 5–4 decision, the U.S. Supreme Court held that the Due Process Clause of the Fourteenth Amend- ment requires a state to license a marriage between two people of the same sex and to recognize a marriage between two people of the same sex when their marriage was law- fully licensed and performed out-of-state. Obergefell v. Hodges, 576 U.S. ___ (2015).

Procedural Due Process Procedural due process pertains to the government decision-making process that results in depriving a person of life, liberty, or property. As the Supreme Court has interpreted procedural due process, the government is required to provide an indi- vidual with a fair procedure if, but only if, the person faces deprivation of life, liberty, or property. When gov- ernment action adversely affects an individual but does not deny life, liberty, or property, the government is not required to give the person any hearing at all.

For the purposes of procedural due process, liberty generally includes the ability of individuals to engage in freedom of action and choice regarding their personal lives. Property includes not only all forms of real and personal property but also certain benefits (entitle- ments) conferred by the government, such as social security payments and food stamps.

When applicable, procedural due process requires that a court use a fair and impartial procedure in resolving the factual and legal basis for a government action that results in a deprivation of life, liberty, or property.

Equal Protection [4-3d] The Fourteenth Amendment provides that “nor shall any State … deny to any person within its jurisdiction the equal protection of the laws.” Although this amendment applies only to the actions of state governments, the Supreme Court has interpreted the Due Process clause of the Fifth Amendment to subject federal actions to the same standards of review. The most important constitu- tional concept protecting individual rights, the guarantee of equal protection basically requires that similarly situ- ated persons be treated similarly by government actions.

For example, in a 5–4 decision, the U.S. Supreme Court held that the Equal Protection Clause of the Four- teenth Amendment requires a state to license a marriage between two people of the same sex and to recognize a marriage between two people of the same sex when their marriage was lawfully licensed and performed out- of-state. Obergefell v. Hodges, 576 U.S. ___ (2015).

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When government action involves classification of people, the equal protection guarantee comes into play. In determining whether government action satisfies the equal protection guarantee, the Supreme Court uses one of three standards of review, depending on the nature of the right involved. The three standards are (1) the rational relationship test, (2) the strict scrutiny test, and (3) the intermediate test.

Rational Relationship Test The rational rela- tionship test, which applies to cases not subject to either the strict scrutiny test or the intermediate test, requires that the classification conceivably bear some rational relationship to a legitimate government interest the clas- sification seeks to further. Under this standard of review, the government action is permitted to attack part of the evil to which the action is addressed. Moreover, there is a strong presumption that the action is constitutional. Therefore, the courts will overturn the government action only if clear and convincing evidence shows that there is no reasonable basis justifying the action.

For example, in United States v. Windsor, 570 U.S. ___ (2013), discussed earlier, the U.S. Supreme Court overturned the federal Defense of Marriage Act (DOMA) also for violating the constitutional guarantee of equal protection. By defining marriage as the union of a man and a woman, DOMA denies federal benefits to persons in same-sex marriages made lawful by some of the states. The Court held that DOMA denies equal protection of the laws, stating:

The class to which DOMA directs its restrictions and restraints are those persons who are joined in same-sex marriages made lawful by the State. DOMA singles out a class of persons deemed by a State entitled to recognition and protection to enhance their own liberty. It imposes a disability on the class by refusing to acknowledge a status the State finds to be dignified and proper. DOMA instructs all federal officials, and indeed all persons with whom same-sex couples interact, including their own children, that their marriage is less worthy than the marriages of others. The federal statute is invalid, for no legitimate pur- pose overcomes the purpose and effect to disparage and to injure those whom the State, by its marriage laws, sought to protect in personhood and dignity. By seeking to dis- place this protection and treating those persons as living in marriages less respected than others, the federal statute is in violation of the Fifth Amendment.

Strict Scrutiny Test The strict scrutiny test is far more exacting than the rational relationship test. Under this test, the courts do not defer to the government;

rather, they independently determine whether a classifica- tion of persons is constitutionally permissible. This deter- mination requires that the classification be necessary to promote a compelling or overriding government interest.

The strict scrutiny test is applied when government action affects fundamental rights or involves suspect classifications. Fundamental rights include most of the provisions of the Bill of Rights and certain other rights, such as interstate travel, voting, and access to criminal justice. Suspect classifications include those made on the basis of race or national origin. A classic and important example of strict scrutiny applied to classifications based upon race is found in the 1954 school desegregation case of Brown v. Board of Education of Topeka, in which the Supreme Court ruled that segregated public school systems violated the equal protection guarantee. Subsequently, the Court has invalidated segregation in public beaches, municipal golf courses, buses, parks, public golf courses, and courtroom seating.

A recent U.S. Supreme Court case again addressed the application of strict scrutiny to public schools. School districts in Seattle, Washington, and metropoli- tan Louisville, Kentucky, had voluntarily adopted stu- dent assignment plans that relied on race to determine which schools certain children may attend. In a 5–4 decision, the Court held that public school systems may not seek to achieve or maintain integration through measures that take explicit account of a student’s race. The Court reaffirmed that when the government dis- tributes burdens or benefits on the basis of individual racial classifications, that action is reviewed under strict scrutiny requiring the most exact connection between justification and classification. Therefore, the school districts must demonstrate that the use of individual racial classifications in their school assignment plans is narrowly tailored to achieve a compelling government interest. In reversing the lower courts’ decisions uphold- ing the schools’ plans, the Court held: “The [school] districts have also failed to show that they considered methods other than explicit racial classifications to achieve their stated goals. Narrow tailoring requires ‘serious, good faith consideration of workable race-neutral alternatives.”’ Parents Involved in Community Schools v. Seattle School District No.1, 551 U.S. 701 (2007).

Moreover, in reviewing the use of race by the Uni- versity of Texas at Austin as one of various factors in its undergraduate admissions process, the U.S. Supreme Court held that strict scrutiny must be applied to any admissions program using racial categories or clas- sifications. In this case, the Supreme Court reaffirmed that “all racial classifications imposed by government ‘must be analyzed by a reviewing court under strict

88 The Legal Environment of Business Part II

scrutiny.’” Fisher v. University of Texas at Austin, 570 U.S. ___ (2013).

In the 2014 case of Schuette v. BAMN, 572 U.S. ___, the U.S. Supreme Court in a 6–2 ruling upheld a Michigan constitutional amendment, approved and enacted by its voters, that bans affirmative action in admissions to the state’s public universities. In holding that the amendment was not invalid under the Equal Protection Clause of the Fourteenth Amendment, the Supreme Court stated:

In Fisher [v. University of Texas at Austin], the Court did not disturb the principle that the consideration of race in

admissions is permissible, provided that certain conditions are met. In this case, as in Fisher, that principle is not chal- lenged. The question here concerns not the permissibility of race-conscious admissions policies under the Constitu- tion but whether, and in what manner, voters in the States may choose to prohibit the consideration of racial prefer- ences in governmental decisions, in particular with respect to school admissions. … This case is not about how the debate about racial preferences should be resolved. It is about who may resolve it. There is no authority in the Constitution of the United States or in this Court’s prece- dents for the Judiciary to set aside Michigan laws that commit this policy determination to the voters.

B R O W N V . B O A R D O F E D U C A T I O N O F T O P E K A S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 1 9 5 4

3 4 7 U . S . 4 8 3 , 7 4 S . C t . 6 8 6 , 9 8 L . E d . 8 7 3

FACTS These were consolidated cases from Kansas, South Carolina, Virginia, and Delaware, each with a dif- ferent set of facts and local conditions but also present- ing a common legal question. Black minors, through their legal representatives, sought court orders to obtain admission to the public schools in their community on a nonsegregated basis. They had been denied admission to schools attended by white children under laws requiring or permitting segregation according to race. The Supreme Court had previously upheld such laws under the “separate but equal” doctrine, which provided that there was equality of treatment of the races through substan- tially equal, though separate, facilities; and the lower courts had found that the white schools and the black schools involved had been or were being equalized with respect to buildings, curricula, qualifications and salaries of teachers, and other “tangible” factors. The black minors contended, however, that segregated public schools were not and could not be made “equal,” and that hence they had been deprived of the equal protection of the laws guaranteed by the Fourteenth Amendment.

DECISION Judgment for plaintiffs.

OPINION Warren, C. J. Today, education is perhaps the most important function of state and local govern- ments. Compulsory school attendance laws and the great expenditures for education both demonstrate our recogni- tion of the importance of education to our democratic so- ciety. It is required in the performance of our most basic public responsibilities, even service in the armed forces. It is the very foundation of good citizenship. Today it is a principal instrument in awakening the child to cultural values, in preparing him for later professional training,

and in helping him to adjust normally to his environment. In these days, it is doubtful that any child may reasonably be expected to succeed in life if he is denied the opportu- nity of an education. Such an opportunity, where the state has undertaken to provide it, is a right which must be made available to all on equal terms.

We come then to the question presented: Does segre- gation of children in public schools solely on the basis of race, even though the physical facilities and other “tangible” factors may be equal, deprive the children of the minority group of equal educational opportunities? We believe that it does.

In Sweatt v. Painter, [citation], in finding that a seg- regated law school for Negroes could not provide them equal educational opportunities, this Court relied in large part on “those qualities which are incapable of objective measurement but which make for greatness in a law school.” In McLaurin v. Oklahoma State Regents, [citation], the Court in requiring that a Negro admitted to a white graduate school be treated like all other students, again resorted to intangible considera- tions: “ *** his ability to study, to engage in discus- sions and exchange views with other students, and, in general, to learn his profession.” Such considerations apply with added force to children in grade and high schools. To separate them from others of similar age and qualifications solely because of their race generates a feeling of inferiority as to their status in the commu- nity that may affect their hearts and minds in a way unlikely ever to be undone. The effect of this separa- tion on their educational opportunities was well stated by a finding in the Kansas case by a court which nevertheless felt compelled to rule against the Negro plaintiffs:

Chapter 4 Constitutional Law 89

Intermediate Test An intermediate test has been applied to government action based on gender and le- gitimacy. Under this test, the classification must have a substantial relationship to an important government objective. The intermediate standard eliminates the strong presumption of constitutionality to which the rational

relationship test adheres. For example, the Supreme Court invalidated an Alabama law that allowed courts to grant alimony awards only from husbands to wives and not from wives to husbands. Similarly, where an Idaho statute gave preference to males over females in qualifying for selection as administrators of estates, the

Segregation of white and colored children in public schools has a detrimental effect upon the colored children. The impact is greater when it has the sanction of the law, for the policy of separating the races is usually interpreted as denoting the inferiority of the Negro group. A sense of inferiority affects the motivation of a child to learn. Segre- gation with the sanction of law, therefore, has a tendency to (retard) the educational and mental development of Negro children and to deprive them of some of the bene- fits they would receive in a racial(ly) integrated school system.

*** We conclude that in the field of public education the

doctrine of “separate but equal” has no place. Separate educational facilities are inherently unequal. Therefore, we hold that the plaintiffs and others similarly situated for whom the actions have been brought are, by reason

of the segregation complained of, deprived of the equal protection of the laws guaranteed by the Fourteenth Amendment. This disposition makes unnecessary any discussion whether such segregation also violates the Due Process Clause of the Fourteenth Amendment.

INTERPRETATION When a governmentally imposed classification involves fundamental rights or suspect classifications, equal protection requires the clas- sification to be necessary to promote a compelling or overriding government interest.

CRITICAL THINKING QUESTION Is the Equal Protection Clause of the U.S. Constitution vio- lated when different public school districts spend signifi- cantly different amounts of money per student? Explain.

Ethical Dilemma Who Is Responsible for Commercial Speech?

FACTS Jane Stewart is an assistant manager of adver- tising for Dazzling Magazine, a fashion magazine aimed primarily at women between the ages of twenty-five and thirty-five. Offering regular columns on health, beauty, fash- ion, and current events, the magazine has a small circulation and handles its advertising internally.

Having experienced declining sales in recent years, the magazine has downsized its operations by eliminating jobs and implementing cost-cutting measures. To prevent fur- ther declines in revenue, Dazzling’s marketing and editorial staffs are attempting to expand the magazine’s appeal to include younger audiences between the ages of sixteen and twenty-four. Jane is in charge of making recommendations to the advertising manager with regard to new advertise- ments. The advertising manager, in turn, makes the final recommendation to the head of the advertising department. Because of the magazine’s overall decline in sales, the advertising unit has come under increased pressure to generate revenue from advertisements. Compensation of advertising unit employees is based in part on the earning of “bonus points” related to first-year revenues from new clients.

Jane has received advertisement offers from two cigarette companies and from one swimsuit manufacturer. Although the cigarette advertisements would generate twice as much revenue as the swimsuit advertisement, Jane is concerned that the cigarette advertisements would lure young women to smoke. She has recommended to her supervisor, Agnes Scott, that the cigarette advertisements be rejected.

Scott adamantly disagrees. She strongly recommends to the head of the advertising department that the cigarette advertisements be accepted.

Social, Policy, and Ethical Considerations 1. What should Jane do? What is best for (a) her company

and (b) society? Should Jane raise her concerns to the department head?

2. Identify the competing social values at stake with regard to cigarette advertising. What role should the govern- ment play in regulating speech that promotes products such as tobacco and alcohol?

3. Should the age of Dazzling’s prospective audience influ- ence the choice of advertisements? Explain.

90 The Legal Environment of Business Part II

Supreme Court invalidated the statute because the preference did not bear a fair and substantial relation- ship to any legitimate legislative objective. Moreover, the Supreme Court invalidated a state university’s (Virginia Military Institute) admission policy excluding women. U.S. v. Virginia, 518 U.S. 515 (1996). On the

other hand, not all legislation based on gender is invalid. For example, the Supreme Court has upheld a California statutory rape law that imposed penalties only on males, as well as the federal military Selective Service Act that exempted women from registering for the draft.

C H A P T E R S U M M A R Y Basic Principles

Federalism the division of governing power between the federal government and the states

Federal Supremacy federal law takes precedence over conflicting state law

Federal Preemption right of federal government to regulate matters within its power to the exclusion of regulation by the states

Judicial Review examination of government actions to determine whether they conform to the U.S. Constitution

Separation of Powers allocation of powers among executive, legislative, and judicial branches of government

State Action actions of governments to which constitutional provisions apply

Powers of Government

Federal Commerce Power exclusive power of federal government to regulate commerce with other nations and among the states

State Regulation of Commerce the Commerce Clause of the Constitution restricts the states’ power to regulate activities if the result obstructs interstate commerce

Federal Fiscal Powers • Taxation and Spending the Constitution grants Congress broad powers to tax and spend; such

powers are important to federal government regulation of the economy • Borrowing and Coining Money enables the federal government to establish a national banking

system and to control national fiscal and monetary policy • Eminent Domain the government’s power to take private property for public use with the

payment of just compensation

Limitations on Government

Contract Clause restricts states from retroactively modifying contracts

Freedom of Speech First Amendment protects most speech by using a strict scrutiny standard • Corporate Political Speech First Amendment protects a corporation’s right to speak out on

political issues • Commercial Speech expression related to the economic interests of the speaker and its

audience; such expression receives a lesser degree of protection • Defamation a tort consisting of a false communication that injures a person’s reputation; such

a communication receives limited constitutional protection

Due Process Fifth and Fourteenth Amendments prohibit the federal and state governments from depriving any person of life, liberty, or property without due process of law • Substantive Due Process determination of whether a particular government action is compatible

with individual liberties • Procedural Due Process requires the government decision-making process to be fair and

impartial if it deprives a person of life, liberty, or property

Chapter 4 Constitutional Law 91

Equal Protection requires that similarly situated persons be treated similarly by government actions • Rational Relationship Test standard of equal-protection review applicable to cases not subject

to either the strict scrutiny test or the intermediate test, such as economic regulation • Strict Scrutiny Test exacting standard of equal-protection review applicable to regulation

affecting a fundamental right or involving a suspect classification • Intermediate Test standard of equal-protection review applicable to regulation based on gender

and legitimacy

Q U E S T I O N S

1. In May, Patricia Allen left her automobile on the shoulder of a road in the city of Erehwon after the car stopped run- ning. A member of the Erehwon city police department found the car later that day and placed on it a sticker stat- ing that unless the car was moved, it would be towed. When after a week the car had not been removed, the police department authorized Baldwin Auto Wrecking Co. to tow it away and to store it on its property. Allen was told by a friend that her car was at Baldwin’s. Allen asked Baldwin to allow her to take possession of her car, but

Baldwin refused to relinquish the car until the $70.00 tow- ing fee was paid. Allen could not afford to pay the fee, and the car remained at Baldwin’s for six weeks. At that time, Baldwin requested the police department for a permit to dispose of the automobile. After the police department tried unsuccessfully to telephone Allen, the department issued the permit. In late July, Baldwin destroyed the auto- mobile. Allen brings an action against the city and Baldwin for damages for loss of the vehicle, arguing that she was denied due process. Decision?

C A S E P R O B L E M S

2. In 1967, large oil reserves were discovered in the Prudhoe Bay area of Alaska. As a result, state revenues increased from $124 million in 1969 to $3.7 billion in 1981. In 1980, the state legislature enacted a dividend program that would distribute annually a portion of these earnings to the state’s adult residents. Under the plan, each citizen eighteen years of age or older receives one unit for each year of residency subsequent to 1959, the year Alaska became a state. The state advanced three purposes justify- ing the distinctions made by the dividend program: (a) creation of a financial incentive for individuals to establish and maintain residence in Alaska; (b) encour- agement of prudent management of the earnings; and (c) apportionment of benefits in recognition of undefined “contributions of various kinds, both tangible and intan- gible, which residents have made during their years of residency.” Crawford, a resident since 1978, brings suit challenging the dividend distribution plan as violative of the equal protection guarantee. Did the dividend program violate the Equal Protection Clause of the Fourteenth Amendment? Explain.

3. Maryland enacted a statute prohibiting any producer or refiner of petroleum products from operating retail serv- ice stations within the state. The statute also required that any producer or refiner discontinue operating its company-owned retail service stations. Approximately 3,800 retail service stations in Maryland sell more than twenty different brands of gasoline. All of this gasoline is brought in from other states, as no petroleum products

are produced or refined in Maryland. Only 5 percent of the total number of retailers are operated by a pro- ducer or refiner. Maryland enacted the statute because a survey conducted by the state comptroller indicated that gasoline stations operated by producers or refiners had received preferential treatment during periods of gasoline shortage. Seven major producers and refiners brought an action challenging the statute on the ground that it discriminated against interstate commerce in viola- tion of the Commerce Clause of the U.S. Constitution. Are they correct? Explain.

4. The Federal Aviation Act provides that “The United States of America is declared to possess and exercise complete and exclusive national sovereignty in the air- space of the United States.” The city of Orion adopted an ordinance that makes it unlawful for jet aircraft to take off from its airport between 11:00 P.M. of one day and 7:00 A.M. of the next day. Jordan Airlines, Inc., is adversely affected by this ordinance and brings suit chal- lenging it under the Supremacy Clause of the U.S. Consti- tution as conflicting with the Federal Aviation Act or preempted by it. Is the ordinance valid? Explain.

5. The Public Service Commission of State X issued a regu- lation completely banning all advertising that “promotes the use of electricity” by any electric utility company in State X. The commission issued the regulation to con- serve energy. Central Electric Corporation of State X challenges the order in the state courts, arguing that the

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commission had restrained commercial speech in viola- tion of the First Amendment. Was its freedom of speech unconstitutionally infringed? Explain.

6. E-Z-Rest Motel is a motel with 216 rooms located in the center of a large city in State Y. It is readily accessible from two interstate highways and three major state highways. The motel solicits patronage from outside State Y through various national advertising media, including magazines of national circulation. It accepts convention trade from out- side State Y, and approximately 75 percent of its registered guests are from out of State Y. An action under the Federal Civil Rights Act of 1964 has been brought against E-Z- Rest Motel alleging that the motel discriminates on the ba- sis of race and color. The motel contends that the statute cannot be applied to it because it is not engaged in inter- state commerce. Can the federal government regulate this activity under the Interstate Commerce Clause? Why?

7. State Z enacted a Private Pension Benefits Protection Act requiring private employers with one hundred or more employees to pay a pension funding charge for terminat- ing a pension plan or closing an office in State Z. Acme Steel Company closed its offices in State Z, whereupon the state assessed the company $185,000 under the vest- ing provisions of the Act. Acme challenged the constitu- tionality of the Act under the Contract Clause of the U.S. Constitution. Was the Act constitutional? Explain.

8. A state statute empowered public school principals to suspend students for up to ten days without any notice or hearing. A student who was suspended for ten days challenges the constitutionality of his suspension on the ground that he was denied due process. Was due process denied? Explain.

9. Iowa enacted a statute prohibiting the use of sixty-five- foot double-trailer-truck combinations. All of the other midwestern and western states permit such trucks to be used on their roads. Despite these restrictions, Iowa’s statute permits cities abutting the state line to enact local ordinances adopting the length limitations of the adjoin- ing state. In cases in which a city has exercised this option, otherwise-oversized trucks are permitted within the city limits and in nearby commercial zones. Consoli- dated Freightways is adversely affected by this statute and brings suit against Iowa, alleging that the statute vio- lates the Commerce Clause. The District Court found that the evidence established that sixty-five-foot doubles were as safe as the shorter truck units. Does the statute violate the Commerce Clause? Explain.

10. Metropolitan Edison Company is a privately owned and operated Pennsylvania corporation subject to extensive regulation by the Pennsylvania Public Utility Commission. Under a provision of its general tariff filed with the com- mission, Edison had the right to discontinue electric service to any customer on reasonable notice of nonpayment of

bills. Catherine Jackson had been receiving electricity from Metropolitan Edison when her account was terminated because of her delinquency in payments. Edison later opened a new account for her residence in the name of James Dodson, another occupant of Jackson’s residence. In August of the following year, Dodson moved away and no further payments were made to the account. Finally, in October, Edison disconnected Jackson’s service without any prior notice. Jackson brought suit claiming that her electric service could not be terminated without notice and a hearing. She further argued that such action, allowed by a provision of Edison’s tariff filed with the commission, constituted “state action” depriving her of property in vio- lation of the Fourteenth Amendment’s guarantee of due process of law. Should Edison’s actions be considered state action? Explain.

11. The McClungs owned Ollie’s Barbecue, a restaurant located a few blocks from the interstate highway in Birmingham, Alabama, with dining accommodations for whites only and a take-out service for blacks. In the year preceding the passage of the Civil Rights Act of 1964, the restaurant had purchased a substantial portion of the food it served from outside the state. The restaurant had refused to serve blacks since its original opening in 1927 and asserted that if it were required to serve blacks it would lose much of its business. The McClungs sought a declara- tory judgment to render unconstitutional the application of the Civil Rights Act to their restaurant because their admitted racial discrimination did not restrict or signifi- cantly impede interstate commerce. Decision?

12. Miss Horowitz was admitted as an advanced medical stu- dent at the University of Missouri-Kansas City. During the spring of her first year, several faculty members expressed dissatisfaction with Miss Horowitz’s clinical performance, noting that it was below that of her peers, that she was er- ratic in attendance at her clinical sessions, and that she lacked a critical concern for personal hygiene. Upon the recommendation of the school’s Council on Evaluation, she was advanced to her second and final year on a pro- bationary basis. After subsequent unfavorable reviews dur- ing her second year and a negative evaluation of her performance by seven practicing physicians, the council recommended that Miss Horowitz be dismissed from the school for her failure to meet academic standards. The de- cision was approved by the dean and later affirmed by the provost after an appeal by Miss Horowitz. She brought suit against the school’s Board of Curators, claiming that her dismissal violated her right to procedural due process under the Fourteenth Amendment and deprived her of “liberty” by substantially impairing her opportunities to continue her medical education or return to employment in a medically related field. Is her claim correct? Explain.

13. Drug compounding is a process by which a pharmacist or doctor combines, mixes, or alters ingredients to create

Chapter 4 Constitutional Law 93

a medication tailored to the needs of an individual patient. Compounding is typically used to prepare medi- cations that are not commercially available, such as medi- cation for a patient who is allergic to an ingredient in a mass-produced product. The Federal Food, Drug, and Cosmetic Act of 1938 (FDCA) regulates drug manufac- turing, marketing, and distribution, providing that no person may sell any new drug unless approved by the Food and Drug Administration (FDA). The Food and Drug Administration Modernization Act of 1997 (FDAMA), which amends the FDCA, exempts compounded drugs from the FDCA’s requirements provided the drugs satisfy a number of restrictions, including that the prescription must be “unsolicited,” and the provider compounding the drug may “not advertise or promote the compound- ing of any particular drug, class of drug, or type of drug.” The provider, however, may “advertise and pro- mote the compounding service.”

A group of licensed pharmacies that specialize in drug compounding challenged the FDAMA’s requirement that they refrain from advertising and promoting their prod- ucts if they wish to continue compounding on the basis that it violates the Free Speech Clause of the First Amendment. What test should the court apply in deter- mining the validity of the FDAMA?

14. A Massachusetts statute established differential methods by which wineries distribute wines in Massachusetts. The statute allows only “small” wineries, defined as those producing 30,000 gallons or less of grape wine a year, to obtain a “small winery shipping license.” This license allows them to sell their wines in Massachusetts in three ways: through shipments made directly to consumers, through wholesaler distribution, and through retail distri- bution. All of Massachusetts’s wineries are “small” wine- ries. Some out-of-state wineries also meet this definition. Wines from “small” Massachusetts wineries compete with wines from “large” wineries, which Massachusetts has defined as those producing more than 30,000 gallons of grape wine annually. These “large” wineries must choose between relying upon wholesalers to distribute

their wines in-state or applying for a “large winery ship- ping license” to sell directly to Massachusetts consumers. They cannot, by law, use both methods to sell their wines in Massachusetts, and they cannot sell wines directly to retailers under either option. No “large” wineries are located inside Massachusetts.

Plaintiffs, a group of California winemakers and Massachusetts residents, assert that the statute was designed with the purpose, and has the effect, of advan- taging Massachusetts wineries to the detriment of those wineries that produce 98 percent of the country’s wine, in violation of the Commerce Clause. Decision?

15. American Express Travel Related Services (“Amex”) sells Amex Travelers Cheques (“TCs”), which are preprinted checks for specified amounts with a unique serial number and no expiration date. Amex is able to sell TCs for their face value because Amex’s contract with TC owners gives Amex the right to retain, use, and invest funds from the sale of TCs until the date the TCs are cashed.

All states have unclaimed property laws requiring abandoned property to be turned over to the state while the original property owner still maintains the right to the property. The purpose of unclaimed property laws is to provide for the safekeeping of abandoned property and then to reunite the abandoned property with its owner. As these laws are applied to TCs, Amex sends the funds held as TCs to the state as unclaimed property with the serial number, amount, and date of sale since the name of TC owner is not known. When one of these TCs is cashed, Amex seeks to reclaim those funds from that state. In New Jersey, the Treasurer returns the funds with interest. Until recently, all states had a fifteen-year abandonment period for travelers checks. In 2010, New Jersey passed Chapter 25, shortening the abandonment period for travelers checks to three years. Amex chal- lenges the constitutionality of the amendment. Explain whether the amendment violates any of the following provisions of the U.S Constitution: (a) Due Process Clause, (b) Contract Clause, (c) Takings Clause, and (d) Commerce Clause.

T A K I N G S I D E S

Alabama was one of only sixteen states that permitted com- mercial hazardous waste landfills. From 1985 through 1989, the tonnage of hazardous waste received per year more than doubled. Of this, up to 90 percent of the hazardous waste was shipped in from other states. In response, Alabama imposed a fee of $97.60 per ton for hazardous waste gener- ated outside Alabama compared with a fee of $25.60 per ton for hazardous wastes generated within Alabama.

Chemical Waste Management, Inc., which operates a com- mercial hazardous waste land disposal facility in Emelle,

Alabama, filed suit asserting that the Alabama law violated the Commerce Clause of the U.S. Constitution.

a. What arguments could Chemical Waste Management, Inc., make in support of its claim that the statute is unconstitu- tional?

b. What arguments could Alabama make to defend the con- stitutionality of the statute?

c. Who should prevail? Explain.

94 The Legal Environment of Business Part II

C H A P T E R 5

ADMINISTRATIVE LAW

In all tyrannical governments, … the right both of making and enforcing the law is vested in … one and the same body of men; and wherever these two powers are united together, there can be no public liberty.

WILLIAM BLACKSTONE, BRITISH JURIST (1775)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Explain the three basic functions of administrative agencies.

2. Distinguish among the three types of rules promulgated by administrative agencies.

3. Explain the difference between formal and informal methods of adjudication.

4. Identify (a) the questions of law determined by a court in conducting a review of a rule or

order of an administrative agency and (b) the three standards of judicial review of factual determinations made by administrative agencies.

5. Describe the limitations imposed on administrative agencies by the legislative branch, the executive branch, and the legally required disclosure of information.

A dministrative law is the branch of public law that is created by administrative agencies in the form of rules, regulations, orders, and decisions

to carry out the regulatory powers and duties of those agencies. Administrative agencies are government enti- ties—other than courts and legislatures—having author- ity to affect the rights of private parties through their operations. Administrative agencies, referred to by names such as commission, board, department, agency, adminis- tration, government corporation, bureau, or office, regu- late a vast array of important matters involving national safety, welfare, and convenience. For instance, federal administrative agencies are charged with being responsible for national security, citizenship and naturalization, law enforcement, taxation, currency, elections, environmental

protection, consumer protection, regulation of transporta- tion, telecommunications, labor relations, trade, com- merce, and securities markets, as well as with providing health and social services.

Because of the increasing complexity of the social, eco- nomic, and industrial life of the nation, the scope of administrative law has expanded enormously. In 1952, Justice Jackson observed that “the rise of administrative bodies has been the most significant legal trend of the last century, and perhaps more values today are affected by their decisions than by those of all the courts, review of administrative decisions apart.” This observation is even truer in the twenty-first century, as evidenced by the great increase in the number and activities of federal govern- ment boards, commissions, and other agencies. Certainly,

95

agencies create more legal rules and adjudicate more controversies than all the nation’s legislatures and courts combined.

State agencies also play a significant role in the func- tioning of our society. Among the more important state boards and commissions are those that supervise and regulate banking, insurance, communications, transpor- tation, public utilities, pollution control, and workers’ compensation.

Much of the federal, state, and local law in this country is established by countless administrative agen- cies. These agencies, which many label the “fourth branch of government,” possess tremendous power and have long been criticized as being “in reality miniature independent governments … which are a haphazard de- posit of irresponsible agencies.” Presidential Task Force Report (1937).

Despite such criticism, these administrative entities clearly play a significant and necessary role in our soci- ety. Administrative agencies relieve legislatures from the impossible burden of fashioning legislation that deals with every detail of a specific problem. As a result, Con- gress can enact legislation, such as the Federal Trade Commission Act, which prohibits unfair and deceptive trade practices, without having to define such a phrase specifically or to anticipate all the particular problems that may arise. Instead, Congress may pass an enabling statute that creates an agency—in this example, the Fed- eral Trade Commission (FTC)—to which it can delegate the power to issue rules, regulations, and guidelines to carry out the statutory mandate. In addition, the estab- lishment of separate, specialized bodies enables adminis- trative agencies to be staffed by individuals with expertise in the field being regulated. Administrative agencies thus can develop the knowledge and devote the time necessary to provide continuous and flexible solu- tions to evolving regulatory problems.

In this chapter, we will discuss federal administrative agencies. Such agencies can be classified as either inde- pendent or executive. Executive agencies are those housed within the executive branch of government, whereas independent agencies are not. Many federal agencies are discussed in other parts of the text. More specifically, the FTC and Department of Justice are dis- cussed in Chapter 42; the FTC, the Consumer Financial Protection Bureau (CFPB), and the Consumer Product Safety Commission (CPSC) in Chapter 44; the Depart- ment of Labor, National Labor Relations Board (NLRB) and Equal Employment Opportunity Commission (EEOC) in Chapter 41; the Securities and Exchange Commission (SEC) in Chapters 39 and 43; and the Envi- ronmental Protection Agency (EPA) in Chapter 45.

OPERATION OF ADMINISTRATIVE AGENCIES [5-1] Most administrative agencies perform three basic func- tions: (1) rulemaking, (2) enforcement, and (3) adjudi- cation of controversies. The term administrative process refers to the entire set of activities in which administra- tive agencies engage while carrying out these functions. Administrative agencies exercise powers that have been allocated by the Constitution to the three separate branches of government. More specifically, an agency exercises legislative power when it makes rules, execu- tive power when it enforces its enabling statute and its rules, and judicial power when it adjudicates disputes. This concentration of power has raised questions regarding the propriety of having the same bodies that establish the rules also act as prosecutors and judges in determining whether those rules have been violated. To address this issue and to bring about certain additional procedural reforms, the Administrative Procedure Act (APA) was enacted in 1946.

Rulemaking [5-1a] Rulemaking is the process by which an administrative agency enacts or promulgates rules of law. Under the APA, a rule is “the whole or a part of an agency statement of general or particular applicability and future effect designed to implement, interpret, or process law or policy.” Once promulgated, rules are applicable to all parties. Moreover, the process of rulemaking notifies all parties that the impending rule is being considered and provides concerned individuals with an opportunity to be heard. Administra- tive agencies promulgate three types of rules: legislative rules, interpretative rules, and procedural rules.

PRACTICAL ADVICE Keep informed of the regulations issued by administrative agencies that affect your business.

Legislative Rules Legislative rules, often called regulations, are in effect “administrative statutes.” Legislative rules are those issued by an agency having the ability, under a legislative delegation of power, to make rules having the force and effect of law. For example, the FTC has rulemaking power with which to elaborate upon its enabling statute’s prohibition of unfair or deceptive acts or practices.

Legislative rules have the force of law if they are con- stitutional, within the power granted to the agency by the legislature, and issued according to proper procedure.

96 The Legal Environment of Business Part II

To be constitutional, regulations must not violate any provisions of the U.S. Constitution, such as due process or equal protection. In addition, they may not involve an unconstitutional delegation of legislative power from the legislature to the agency. To be constitutionally permissi- ble, the enabling statute granting power to an agency must establish reasonable standards to guide the agency in implementing the statute. This requirement has been met by such statutory language as “to prohibit unfair methods of competition”; “fair and equitable”; “public interest, convenience, and necessity”; and other equally broad expressions. In any event, agencies may not exceed the actual authority granted by the enabling statute.

In 2015, the U.S. Supreme Court addressed the validity of the IRS rule making the Patient Protection and Afford- able Care Act’s tax credits available in those states that have a Federal Exchange. In a 6–3 decision, the Court upheld the IRS rule but based its decision on the Court’s own interpretation of the Act without deferring to the agency’s interpretation. The Court stated “Congress passed the Affordable Care Act to improve health insur- ance markets, not to destroy them.”

Legislative rules must be promulgated in accordance with the procedural requirements of the APA, although the enabling statute may impose more stringent require- ments. Most legislative rules are issued in accordance with the informal rulemaking procedures of the APA, which require that the agency provide the following:

1. prior notice of a proposed rule, usually by publica- tion in the Federal Register;

2. an opportunity for interested parties to participate in the rulemaking; and

3. publication of a final draft containing a concise gen- eral statement of the rule’s basis and purpose at least thirty days before its effective date.

In some instances the enabling statute requires that certain rules be made only after the opportunity for an agency hearing. This formal rulemaking procedure is far more complex than the informal procedures and is governed by the same APA provisions that govern adju- dication, discussed later in this chapter. In formal rule- making, the agency must consider the record of the trial-like agency hearing and include a statement of “findings and conclusions, and the reasons or basis therefore, on all the material issues of fact, law, or dis- cretion presented on the record” when making rules.

Some enabling statutes direct that the agency, in mak- ing rules, use certain procedures that are more formal than those in informal rulemaking but do not compel the full hearing that formal rulemaking requires. This in- termediate procedure, known as hybrid rulemaking, results from combining the informal procedures of the APA with the additional procedures specified by the ena- bling statute. For example, an agency may be required to conduct a legislative-type hearing (formal) that per- mits no cross-examination (informal).

In 1990, Congress enacted the Negotiated Rulemak- ing Act to encourage the involvement of affected parties in the initial stages of the policy-making process prior to the publication of notice of a proposed rule. The Act authorizes agencies to use negotiated rulemaking but does not require it. If an agency decides to use negoti- ated rulemaking, the affected parties and the agency develop an agreement and offer it to the agency. If accepted, the agreement becomes a basis for the pro- posed regulation, which is then published for comment.

PRACTICAL ADVICE Participate as early as possible in the rulemaking process of administrative agencies that affect your business.

M A Y O F O U N D A T I O N F O R M E D I C A L E D U C A T I O N A N D R E S E A R C H V . U N I T E D S T A T E S

S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 1 1

5 6 2 U . S . 4 4 , 1 3 1 S . C t . 7 0 4 , 1 7 8 L . E d . 2 d 5 8 8

FACTS Most doctors who graduate from medical school in the United States pursue additional education in a specialty to become board certified to practice in that field (e.g., orthopedics, cardiology, ophthalmology). Plaintiffs Mayo Foundation for Medical Education and Research, Mayo Clinic, and the Regents of the Univer- sity of Minnesota (collectively Mayo) offer medical

residency programs that provide such instruction. Mayo’s residency programs, which usually last three to five years, train doctors primarily through hands-on experience. Residents often spend between fifty and eighty hours a week caring for patients supervised by more senior resi- dents and by faculty members known as attending physi- cians. In 2005, Mayo paid its residents annual “stipends”

Chapter 5 Administrative Law 97

ranging between $41,000 and $56,000 and provided them with health insurance, malpractice insurance, and paid vacation time. Mayo residents also take part in “a formal and structured educational program.” Residents are assigned textbooks and journal articles to read and are expected to attend weekly lectures and other confer- ences. Residents also take written exams and are eval- uated by the attending faculty physicians. The bulk of residents’ time is spent caring for patients.

Through the Social Security Act and related legisla- tion, Congress has created a comprehensive national in- surance system that provides benefits for retired workers, disabled workers, unemployed workers, and their fami- lies. Under the Federal Insurance Contributions Act (FICA), Congress funds Social Security by taxing both employers and employees on the wages employees earn. Congress has defined “wages” to include “all remunera- tion for employment” and “employment” as “any serv- ice, of whatever nature, performed … by an employee for the person employing him.”

In Section 3121(b)(10), Congress excluded from taxa- tion “service performed in the employ of … a school, col- lege, or university … if such service is performed by a student who is enrolled and regularly attending classes at such school, college, or university.” In 2004, the Treasury Department adopted a rule prescribing that an employee’s service is “incident” to his studies only when “[t]he edu- cational aspect of the relationship between the employer and the employee, as compared to the service aspect of the relationship, [is] predominant.” The rule categorically provides that “[t]he services of a full-time employee”—as defined by the employer’s policies, but in any event including any employee normally scheduled to work forty hours or more per week—“are not incident to and for the purpose of pursuing a course of study.” The rule clarifies that the Department’s analysis “is not affected by the fact that the services performed … may have an educational, instructional, or training aspect.” The rule also includes as an example the case of a medical resident whose “normal work schedule calls for [him] to perform services forty or more hours per week” and provides that his ser- vice is “not incident to and for the purpose of pursuing a course of study,” and he accordingly is not an exempt “student” under Section 3121(b)(10).

After the Department promulgated the full-time employee rule, Mayo filed suit asserting that its residents were exempt under §3121(b)(10). The U.S. District Court granted Mayo’s motion for summary judgment. The Government appealed, and the U.S. Court of Appeals reversed. The U.S. Supreme Court granted Mayo’s petition for certiorari.

DECISION The judgment of the U.S. Court of Appeals is affirmed.

OPINION Roberts, C. J. We begin our analysis with the first step of the two-part framework announced in Chevron [USA Inc. v. Natural Resources Defense Coun- cil, Inc.], [citation], and ask whether Congress has “directly addressed the precise question at issue.” We agree with the Court of Appeals that Congress has not done so. The statute does not define the term “student,” and does not otherwise attend to the precise question whether medical residents are subject to FICA. [Citation.]

*** In the typical case, such an ambiguity would lead

us inexorably to Chevron step two, under which we may not disturb an agency rule unless it is “‘arbitrary or capricious in substance, or manifestly contrary to the statute.”’ [Citation.] In this case, however, the parties disagree over the proper framework for evaluating an ambiguous provision of the Internal Revenue Code.

*** The principles underlying our decision in Chevron

apply with full force in the tax context. Chevron recog- nized that “[t]he power of an administrative agency to administer a congressionally created … program neces- sarily requires the formulation of policy and the making of rules to fill any gap left, implicitly or explicitly, by Congress.” [Citation.] *** Filling gaps in the Internal Revenue Code plainly requires the Treasury Department to make interpretive choices for statutory implementa- tion at least as complex as the ones other agencies must make in administering their statutes. [Citation.] We see no reason why our review of tax regulations should not be guided by agency expertise pursuant to Chevron to the same extent as our review of other regulations.

*** We have held that Chevron deference is appropri- ate “when it appears that Congress delegated authority to the agency generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the exercise of that authority.” ***

*** The Department issued the full-time employee rule pursuant to the explicit authorization to “prescribe all needful rules and regulations for the enforcement” of the Internal Revenue Code. [Citation.] ***

*** The full-time employee rule easily satisfies the second

step of Chevron, which asks whether the Department’s rule is a “reasonable interpretation” of the enacted text. [Citation.] To begin, Mayo accepts that “the ‘educa- tional aspect of the relationship between the employer and the employee, as compared to the service aspect of the relationship, [must] be predominant”’ in order for an individual to qualify for the exemption. [Citation.] Mayo objects, however, to the Department’s conclusion that residents who work more than 40 hours per week categorically cannot satisfy that requirement. Because

98 The Legal Environment of Business Part II

Interpretative Rules Interpretative rules are “issued by an agency to advise the public of the agency’s construction of the statutes and rules which it administers.” Attorney General’s Manual on the Administrative Proce- dure Act. Interpretative rules, however, which are exempt from the APA’s procedural requirements of notice and comment, are not automatically binding on the private

parties the agency regulates or on the courts, although they are given substantial weight. As the Supreme Court has stated, “The weight of such [an interpretative rule] in a par- ticular case will depend upon the thoroughness evident in its consideration, the validity of its reasoning, its consis- tency with earlier and later pronouncements, and all those factors which give it power to persuade.”

residents’ employment is itself educational, Mayo argues, the hours a resident spends working make him “more of a student, not less of one.” [Citation.] Mayo contends that the Treasury Department should be required to engage in a case-by-case inquiry into “what [each] employee does [in his service] and why” he does it. [Citation.] Mayo also objects that the Department has drawn an arbitrary distinction between “hands-on training” and “classroom instruction.” [Citation.]

We disagree. Regulation, like legislation, often requires drawing lines. Mayo does not dispute that the Treasury Department reasonably sought a way to distin- guish between workers who study and students who work, [citation]. *** The Department reasonably con- cluded that its full-time employee rule would “improve administrability,” [citation], and it thereby “has avoided the wasteful litigation and continuing uncertainty that would inevitably accompany any purely case-by-case approach” like the one Mayo advocates, [citation].

*** We do not doubt that Mayo’s residents are engaged in

a valuable educational pursuit or that they are students of their craft. The question whether they are “students” for purposes of §3121, however, is a different matter. Because it is one to which Congress has not directly spoken, and because the Treasury Department’s rule is a reasonable construction of what Congress has said, the judgment of the Court of Appeals must be affirmed.

INTERPRETATION Generally, when Congress has not directly addressed the precise question at issue, courts may not disturb an agency rule that attempts to resolve the question, unless it is arbitrary or capricious in substance or manifestly contrary to statute.

CRITICAL THINKING QUESTION Do you agree that the agency’s full-time employee rule is better than a case-by-case approach? Explain.

P E R E Z V . M O R T G A G E B A N K E R S A S S ’ N . S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 1 5

5 7 5 U . S . ____ , 1 3 5 S . C t . 1 1 9 9 , 1 9 1 L . E d . 2 d 1 8 6

FACTS The Fair Labor Standards Act of 1938 (FLSA) establishes a minimum wage and overtime com- pensation for each hour worked in excess of 40 hours in each workweek for many employees. [This statute is discussed in Chapter 41.] Certain classes of employees, however, are exempt from these provisions, including the “administrative” exemption that exempts those “employed in a bona fide executive, administrative, or professional capacity … or in the capacity of outside salesman.” The FLSA grants the Secretary of Labor authority to define the categories of exempt administra- tive employees.

In 1999 and 2001, the Department’s Wage and Hour Division issued letters opining that mortgage-loan offi- cers do not qualify for the administrative exemption and thus FLSA’s minimum wage and maximum hour require- ments applied. In 2004 through notice-and-comment rulemaking, the Secretary issued new regulations that provided several examples of exempt administrative

employees, one of which is “[e]mployees in the financial services industry,” who, depending on the nature of their day-to-day work, “generally meet the duties requirements for the administrative exception.” The financial services example ends with a caveat that “an employee whose primary duty is selling financial prod- ucts does not qualify for the administrative exemption.” Mortgage Bankers Association (MBA), a national trade association representing real estate finance companies, requested a new opinion interpreting the revised regula- tions. In 2006, the Department issued an opinion letter finding that mortgage-loan officers fell within the admin- istrative exemption. In 2010, however, the Wage and Hour Division again altered its interpretation of the FLSA’s administrative exemption as it applied to mort- gage-loan officers, concluding that mortgage-loan offi- cers “have a primary duty of making sales for their employers, and, therefore, do not qualify” for the administrative exemption. The Department accordingly

Chapter 5 Administrative Law 99

withdrew its 2006 opinion letter. Like the 1999, 2001, and 2006 opinion letters, the 2010 Administrator’s Interpretation was issued without notice or an opportu- nity for comment.

MBA filed a complaint in federal District Court chal- lenging the 2010 Administrator’s Interpretation. MBA contended that the 2010 Administrator’s Interpretation was procedurally invalid in light of the D.C. Circuit’s decision in Paralyzed Veterans, which holds that an agency must use notice-and-comment procedures when an agency wishes to issue a new interpretation of a reg- ulation that deviates significantly from a previously adopted interpretation. The District Court granted sum- mary judgment to the Department. On appeal, the D.C. Circuit applied Paralyzed Veterans and reversed. The Department appealed to the U.S. Supreme Court.

DECISION The judgment of the United States Court of Appeals for the District of Columbia Circuit is reversed.

OPINION Sotomayor, J. When a federal adminis- trative agency first issues a rule interpreting one of its regulations, it is generally not required to follow the notice-and-comment rulemaking procedures of the Administrative Procedure Act (APA or Act). [Citation.] The United States Court of Appeals for the District of Columbia Circuit has nevertheless held, in a line of cases beginning with Paralyzed Veterans of Am. v. D.C. Arena L. P., [citation], that an agency must use the APA’s notice-and-comment procedures when it wishes to issue a new interpretation of a regulation that devi- ates significantly from one the agency has previously adopted. The question in these cases is whether the rule announced in Paralyzed Veterans is consistent with the APA. We hold that it is not.

The APA establishes the procedures federal adminis- trative agencies use for “rule making,” defined as the process of “formulating, amending, or repealing a rule.” [Citation.] “Rule,” in turn, is defined broadly to include “statement [s] of general or particular applicability and future effect” that are designed to “implement, interpret, or prescribe law or policy.” [Citation.]

Section 4 of the APA, [citation], prescribes a three-step procedure for so-called “notice-and-comment rule- making.” First, the agency must issue a “[g]eneral notice of proposed rule making,” ordinarily by publication in the Federal Register. [Citation.] Second, if “notice [is] required,” the agency must “give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments.” [Cita- tion.] An agency must consider and respond to significant comments received during the period for public comment. [Citation.] Third, when the agency promulgates the final rule, it must include in the rule’s text “a concise general

statement of [its] basis and purpose.” [Citation.] Rules issued through the notice-and-comment process are often referred to as “legislative rules” because they have the “force and effect of law.” [Citation.]

Not all “rules” must be issued through the notice-and- comment process. Section 4(b)(A) of the APA provides that, unless another statute states otherwise, the notice-and- comment requirement “does not apply” to “interpretative rules, general statements of policy, or rules of agency orga- nization, procedure, or practice.” [Citation.] The term “interpretative rule,” or “interpretive rule,” is not further defined by the APA, *** it suffices to say that the critical feature of interpretive rules is that they are “issued by an agency to advise the public of the agency’s construction of the statutes and rules which it administers.” [Citation.] The absence of a notice-and-comment obligation makes the process of issuing interpretive rules comparatively easier for agencies than issuing legislative rules. But that conven- ience comes at a price: Interpretive rules “do not have the force and effect of law and are not accorded that weight in the adjudicatory process.” [Citation.]

***

*** This exemption of interpretive rules from the notice-and-comment process is categorical, and it is fatal to the rule announced in Paralyzed Veterans.

Rather than examining the exemption for interpre- tive rules contained in §4(b)(A) of the APA, the D.C. Circuit in Paralyzed Veterans focused its attention on §1 of the Act. That section defines “rule making” to include not only the initial issuance of new rules, but also “repeal[s]” or “amend[ments]” of existing rules. [Citation.] Because notice-and-comment requirements may apply even to these later agency actions, the court reasoned, “allow[ing] an agency to make a fundamental change in its interpretation of a substantive regulation without notice and comment” would undermine the APA’s procedural framework. [Citation.]

This reading of the APA conflates the differing pur- poses of §§1 and 4 of the Act. Section 1 defines what a rulemaking is. It does not, however, say what procedures an agency must use when it engages in rulemaking. That is the purpose of §4. And §4 specifically exempts inter- pretive rules from the notice-and-comment requirements that apply to legislative rules. So, the D.C. Circuit cor- rectly read §1 of the APA to mandate that agencies use the same procedures when they amend or repeal a rule as they used to issue the rule in the first instance. See FCC v. Fox Television Stations, Inc., [citation]. [This case appears later in this chapter.] Where the court went wrong was in failing to apply that accurate understand- ing of §1 to the exemption for interpretive rules con- tained in §4: Because an agency is not required to use notice-and-comment procedures to issue an initial

100 The Legal Environment of Business Part II

Procedural Rules Procedural rules are also exempt from the notice and comment requirements of the APA and are not law. These rules establish rules of conduct for practice before the agency, identify an agency’s organization, and describe its method of oper- ation. For example, the SEC’s Rules of Practice deal with matters such as who may appear before the com- mission; business hours and notice of proceedings and hearings; settlements, agreements, and conferences; pre- sentation of evidence and the taking of depositions and interrogatories; and review of hearings.

See Concept Review 5-1.

Enforcement [5-1b] Agencies also investigate conduct to determine whether the enabling statute or the agency’s legislative rules have been violated. In carrying out this executive function, the agencies traditionally have been accorded great dis- cretion, subject to constitutional limitations, to compel the disclosure of information. These limitations require that (1) the investigation is authorized by law and undertaken for a legitimate purpose, (2) the information sought is relevant, (3) the demand for information is suf- ficiently specific and not unreasonably burdensome, and (4) the information sought is not privileged.

interpretive rule, it is also not required to use those pro- cedures when it amends or repeals that interpretive rule.

The straightforward reading of the APA we now adopt harmonizes with longstanding principles of our administrative law jurisprudence. Time and again, we have reiterated that the APA “sets forth the full extent of judicial authority to review executive agency action for procedural correctness.” Fox Television Stations, Inc., [citation]. Beyond the APA’s minimum requirements, courts lack authority “to impose upon [an] agency its own notion of which procedures are ‘best’ or most likely to further some vague, undefined public good.” [Cita- tion.] To do otherwise would violate “the very basic tenet of administrative law that agencies should be free to fashion their own rules of procedure.” [Citation.]

These foundational principles apply with equal force to the APA’s procedures for rulemaking. We explained in [citation] that §4 of the Act “established the maxi- mum procedural requirements which Congress was willing to have the courts impose upon agencies in con- ducting rulemaking procedures.” [Citation.] “Agencies are free to grant additional procedural rights in the exercise of their discretion, but reviewing courts are gen- erally not free to impose them if the agencies have not chosen to grant them.” [Citation.]

The Paralyzed Veterans doctrine creates just such a judge-made procedural right: the right to notice and an

opportunity to comment when an agency changes its interpretation of one of the regulations it enforces. That requirement may be wise policy. Or it may not. Regard- less, imposing such an obligation is the responsibility of Congress or the administrative agencies, not the courts. We trust that Congress weighed the costs and benefits of placing more rigorous procedural restrictions on the issuance of interpretive rules. [Citation.] In the end, Congress decided to adopt standards that permit agen- cies to promulgate freely such rules—whether or not they are consistent with earlier interpretations. That the D.C. Circuit would have struck the balance differently does not permit that court or this one to overturn Con- gress’ contrary judgment. [Citation.]

*** For the foregoing reasons, the judgment of the United

States Court of Appeals for the District of Columbia Circuit is reversed.

INTERPRETATION The APA’s notice-and- comment requirement does not apply to interpretive rules.

CRITICAL THINKING QUESTION Explain whether this ruling permits agencies to avoid the APA’s notice-and-comment provisions by issuing in- terpretive rules instead of legislative rules.

CONCEPT REVIEW 5-1 A D M I N I S T R A T I V E R U L E M A K I N G

Rule Procedure Effect

Legislative Subject to APA Binding

Interpretative Exempt from APA Persuasive

Procedural Exempt from APA Persuasive

Chapter 5 Administrative Law 101

For example, the following explains some of the SEC’s investigative and enforcement functions:

All SEC investigations are conducted privately. Facts are developed to the fullest extent possible through informal inquiry, interviewing witnesses, examining brokerage records, reviewing trading data, and other methods. With a formal order of investigation, the Division’s staff may compel witnesses by subpoena to testify and produce books, records, and other relevant documents. Following an investigation, SEC staff present their findings to the Commission for its review. The Commission can authorize the staff to file a case in federal court or bring an adminis- trative action. In many cases, the Commission and the party charged decide to settle a matter without trial. (SEC, http://www.sec.gov.)

Adjudication [5-1c] After concluding an investigation, the agency may use informal or formal methods to resolve the matter. Because the caseload of administrative agencies is vast, far greater than that of the judicial system, most mat- ters are informally adjudicated. Informal procedures include advising, negotiating, and settling. In 1990 Congress enacted the Administrative Dispute Resolu- tion Act to authorize and encourage federal agencies to use mediation, conciliation, arbitration, and other tech- niques for the prompt and informal resolution of dis- putes. The Act does not, however, require agencies to use alternative dispute resolution, and the affected par- ties must consent to its use.

PRACTICAL ADVICE When available, consider using alternative methods of dispute resolution with administrative agencies.

The formal procedure by which an agency resolves a matter (called adjudication) involves finding facts, applying legal rules to the facts, and formulating orders. An order “means the whole or a part of a final disposition, whether affirmative, negative, injunctive or declaratory in form, of an agency.” Adjudication, which in essence is an administrative trial, is used when the enabling statute so requires.

The procedures employed by the various administra- tive agencies to adjudicate cases are nearly as varied as the agencies themselves. Nevertheless, the APA does establish certain mandatory standards for those federal agencies the Act covers. For example, an agency must give notice of a hearing. The APA also requires that the agency give all interested parties the opportunity to

submit and consider “facts, arguments, offers of settle- ment, or proposals of adjustment.” In many cases this involves testimony and cross-examination of witnesses. If no settlement is reached, then a hearing must be held.

The hearing is presided over by an administrative law judge (ALJ) and is prosecuted by the agency. ALJs are appointed by the agency through a professional merit selection system and may be removed only for good cause. There are more than twice as many ALJs as there are federal judges. Juries are never used. Thus, the agency serves as both the prosecutor and decision maker. To reduce the potential for a conflict of interest, the APA provides for a separation of functions between those agency members engaged in investigation and prosecution and those involved in decision making.

Either party may introduce oral and documentary evidence, and the agency must base all sanctions, rules, and orders upon “consideration of the whole record or those parts cited by a party and supported by and in accordance with the reliable, probative, and substantial evidence.” All decisions must include a statement of findings of fact and conclusions of law and the reasons or basis for them, as well as a statement of the appro- priate rule, order, sanction, or relief.

If such are authorized by law and within its delegated jurisdiction, an agency may impose in its orders sanc- tions such as penalties; fines; the seizing of property; the assessment of damages, restitution, compensation, or fees; and the act of requiring, revoking, or suspending a license. In most instances, orders are final unless appealed, and failure to comply with an order subjects the party to a statutory penalty. If the order is appealed, the governing body of the agency may decide the case de novo. Thus, the agency may hear additional evidence and arguments in deciding whether to revise the findings and conclusions it made in the initial decision.

Although administrative adjudications mirror to a large extent the procedures of judicial trials, there are many differences between the two.

Agency hearings, especially those dealing with rulemaking, often tend to produce evidence of general conditions as distinguished from facts relating solely to the respondent. Administrative agencies in rulemaking and occasionally in formal adversarial adjudications more consciously formu- late policy than do courts. Consequently, administrative adjudications may require that the administrative law judge consider more consciously the impact of his decision upon the public interest as well as upon the particular respondent. … An administrative hearing is tried to an administrative law judge, never to a jury. Since many of the rules governing the admission of proof in judicial trials

102 The Legal Environment of Business Part II

are designed to protect the jury from unreliable and possi- bly confusing evidence, it has long been asserted that such rules need not be applied at all or with the same vigor in proceedings solely before an administrative law judge.… Consequently, the technical common law rules governing the admissibility of evidence have generally been aban- doned by administrative agencies. McCormick on Evi- dence, 4th ed., Section 350, p. 605.

LIMITS ON ADMINISTRATIVE AGENCIES [5-2] An important and fundamental part of administrative law is the limits imposed by judicial review upon the activities of administrative agencies. On matters of pol- icy, however, courts are not supposed to substitute their judgment for the agency’s judgment. Additional limita- tions arise from the legislature and the executive branch, which, unlike the judiciary, may address the wisdom and correctness of an agency’s decision or action. See Figure 5-1, which illustrates the limits on administrative agencies. Moreover, legally required dis- closure of agency actions provides further protection for the public.

Judicial Review [5-2a] As discussed in Chapter 4, judicial review describes the process by which the courts examine government action. Judicial review, which is available unless a stat- ute precludes such review or the agency action is com- mitted to agency discretion by law, acts as a control or check on a particular rule or order of an administrative agency.

General Requirements Parties seeking to chal- lenge agency action must have standing and must have exhausted their administrative remedies. Standing requires that the agency action injure the party in fact and that the party assert an interest that is in the “zone of interests to be protected or regulated by the statute in question.” Judicial review is ordinarily available only for final agency action. Accordingly, if a party seeks review while an agency proceeding is in progress, a court will usually dismiss the action because the party has failed to exhaust his administrative remedies.

PRACTICAL ADVICE Be sure to exhaust all of your administrative remedies before seeking judicial review of action taken by an administrative agency.

FIGURE 5-1 Limits on Administrative Agencies

Judicial Review Excess of authority Proper interpretation of applicable law Violation of constitution Violation of required legal procedure

ADMINISTRATIVE AGENCIES

Legislative Control Power over budget Amendment of enabling statute Elimination of agency Enactment of guidelines

Executive Control Power of appointment Budgetary control Impoundment of monies appropriated Restructuring of executive agencies

Chapter 5 Administrative Law 103

S A C K E T T V . E N V I R O N M E N T A L P R O T E C T I O N A G E N C Y S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 1 2

5 6 6 U . S . ___ , 1 3 2 S . C t . 1 3 6 7 , 1 8 2 L . E d . 2 d 3 6 7

FACTS The Clean Water Act (Act) prohibits “the discharge of any pollutant by any person,” without a permit, into “navigable waters,” which the Act defines as “the waters of the United States.” If the Environmen- tal Protection Agency (EPA) determines that any person is in violation of this restriction, the Act directs the agency either to issue a compliance order or to initiate a civil enforcement action. When the EPA prevails in a civil action, the Act provides for a civil penalty not to exceed $37,500 per day for each violation. According to the government, when the EPA prevails against any per- son who has been issued a compliance order but has failed to comply, that amount is increased to $75,000.

The Sacketts own a two-thirds-acre residential lot in Bonner County, Idaho. Their property lies just north of Priest Lake, but it is separated from the lake by several lots containing permanent structures. In preparation for constructing a house, the Sacketts filled in part of their lot with dirt and rock. Some months later, they received from the EPA a compliance order, which stated that their residential lot contained navigable waters and that their construction project violated the Act by placing fill material on the property. On that basis the order directs them immediately to restore the property pursuant to an EPA work plan and to provide the EPA with access to the site and all records and documents related to the conditions at the site.

The Sacketts, who do not believe that their property is subject to the Act, asked the EPA for a hearing, but that request was denied. They then brought an action in the U.S. District Court for the District of Idaho, seeking declaratory and injunctive relief. Their complaint con- tended that the EPA’s issuance of the compliance order was “arbitrary [and] capricious” under the Administra- tive Procedure Act (APA) and that it deprived them of “life, liberty, or property, without due process of law,” in violation of the Fifth Amendment. The District Court dismissed the claims for want of subject-matter jurisdic- tion. The U.S. Court of Appeals for the Ninth Circuit affirmed, concluding that the Act “preclude[s] pre- enforcement judicial review of compliance orders” and that such preclusion does not violate the Fifth Amend- ment’s due process guarantee. The U.S. Supreme Court granted certiorari.

DECISION The judgment of the U.S. Court of Appeals is reversed, and the case is remanded.

OPINION Scalia, J. The Sacketts brought suit under Chapter 7 of the APA, which provides for judicial review of “final agency action for which there is no other adequate remedy in a court.” [Citation.] We con- sider first whether the compliance order is final agency action. There is no doubt it is agency action, which the APA defines as including even a “failure to act.” [Cita- tion.] But is it final? It has all of the hallmarks of APA finality that our opinions establish. Through the order, the EPA “‘determined’” “‘rights or obligations.’” [Cita- tion.] *** Also, “‘legal consequences … flow’” from issuance of the order. [Citation.] ***

The issuance of the compliance order also marks the “‘consummation’” of the agency’s decisionmaking proc- ess. [Citation.] As the Sacketts learned when they unsuc- cessfully sought a hearing, the “Findings and Conclusions” that the compliance order contained were not subject to further agency review. ***

The APA’s judicial review provision also requires that the person seeking APA review of final agency action have “no other adequate remedy in a court,” [Citation.] In Clean Water Act enforcement cases, judicial review ordinarily comes by way of a civil action brought by the EPA under [citation]. But the Sacketts cannot initiate that process, and each day they wait for the agency to drop the hammer, they accrue *** an additional $75,000 in potential liability. The other possible route to judicial review—applying to the Corps of Engineers for a permit and then filing suit under the APA if a per- mit is denied—will not serve either. ***

Nothing in the Clean Water Act expressly precludes judicial review under the APA or otherwise. *** The APA, we have said, creates a “presumption favoring ju- dicial review of administrative action,” but as with most presumptions, this one “may be overcome by inferences of intent drawn from the statutory scheme as a whole. The Government offers several reasons why the statu- tory scheme of the Clean Water Act precludes review. [The Supreme Court found that these arguments did not support an inference that the Clean Water Act’s statu- tory scheme precluded APA review.]

***

We conclude that the compliance order in this case is final agency action for which there is no adequate remedy other than APA review, and that the Clean Water Act does not preclude that review. We therefore

104 The Legal Environment of Business Part II

In exercising judicial review, the court may decide either to compel agency action unlawfully withheld or to set aside impermissible agency action. In making its determination, the court must review the whole record and may set aside agency action only if the error is prejudicial.

Questions of Law When conducting a review, a court decides all relevant questions of law, interprets con- stitutional and statutory provisions, and determines the meaning or applicability of the terms of an agency action. This review of questions of law includes determin- ing whether the agency has (1) exceeded its authority, (2) properly interpreted the applicable law, (3) violated any constitutional provision, or (4) acted contrary to the procedural requirements of the law.

Questions of Fact When reviewing factual deter- minations, the courts use one of three different standards.

In cases in which informal rulemaking or informal adjudication has occurred, the standard generally is the arbitrary and capricious test, which requires only that the agency had a rational basis for reaching its deci- sion. Where there has been a formal hearing, the sub- stantial evidence test usually applies. It also applies to informal or hybrid rulemaking if the enabling statute so requires. The substantial evidence test requires the con- clusions reached to be supported by “such relevant evi- dence as a reasonable mind might accept as adequate to support a conclusion.” Finally, in rare instances, the reviewing court may apply the unwarranted by the facts standard, which permits the court to try the facts de novo. This strict review is available only when the enabling statute so provides, when the agency has con- ducted an adjudication with inadequate fact-finding procedures, or when issues that were not before the agency are raised in a proceeding to enforce nonadjudi- cative agency action.

reverse the judgment of the Court of Appeals and remand the case for further proceedings consistent with this opinion.

INTERPRETATION The APA provides for ju- dicial review of final agency action for which there is no

other adequate remedy in a court unless another statute precludes judicial review.

CRITICAL THINKING QUESTION Which policy reasons support and which oppose the requirement for final agency action prior to judicial review?

F C C V . F O X T E L E V I S I O N S T A T I O N S , I N C . S u p r e m e C o u r t o f t h e U n i t e d S t a t e s , 2 0 0 9

5 5 6 U . S . 5 0 2 , 1 2 9 S . C t . 1 8 0 0 , 1 7 3 L . E d . 2 d 7 3 8

FACTS Federal law bans the broadcasting of “any … indecent … language,” which includes references to sexual or excretory activity or organs. Congress has given the Federal Communications Commission (FCC) various means of enforcing this indecency ban, including civil fines, license revocations, and the denial of license renewals. The Commission first invoked the statutory ban on indecent broadcasts in 1975, declaring a daytime broadcast of George Carlin’s “Filthy Words” mono- logue actionably indecent. In the ensuing years, the Commission took a cautious, but gradually expanding, approach to enforcing the statutory prohibition against indecent broadcasts. Although the Commission had expanded its enforcement beyond the “repetitive use of specific words or phrases,” it preserved a distinction between literal and nonliteral (or “expletive”) uses of evocative language. The Commission explained that

each literal “description or depiction of sexual or excre- tory functions must be examined in context to determine whether it is patently offensive,” but that “deliberate and repetitive use … is a requisite to a finding of indecency” when a complaint focuses solely on the use of nonliteral expletives. In 2004, the FCC’s Golden Globes Order declared for the first time that an exple- tive (nonliteral) use of the F-Word or the Sh-Word could be actionably indecent, even when the word is used only once. The first order to this effect dealt with an NBC broadcast of the Golden Globe Awards, in which the performer Bono commented, “This is really, really, f * * * ing brilliant.”

This case concerns utterances in two live broadcasts aired by Fox Television Stations, Inc., and its affiliates prior to the Commission’s Golden Globes Order. The first occurred during the 2002 Billboard Music

Chapter 5 Administrative Law 105

Awards, when the singer Cher exclaimed, “I’ve also had critics for the last 40 years saying that I was on my way out every year. Right. So f * * * ‘em.” The second involved a segment of the 2003 Billboard Music Awards, during the presentation of an award by Nicole Richie and Paris Hilton, principals in a Fox television series called “The Simple Life.” Ms. Hilton began their interchange by reminding Ms. Richie to “watch the bad language,” but Ms. Richie proceeded to ask the audience, “Why do they even call it ‘The Simple Life?’ Have you ever tried to get cow s * * * out of a Prada purse? It’s not so f * * * ing simple.” Following each of these broadcasts, the Commission received numerous complaints from parents whose children were exposed to the language.

In 2006, the FCC found both broadcasts to have vio- lated the prohibition against indecency. The FCC’s order stated that the Golden Globes Order eliminated any doubt that fleeting expletives could be actionable; declared that under the new policy, a lack of repetition weighs against a finding of indecency, but is not a safe harbor; and held that both broadcasts met the new test because one involved a literal description of excrement and both invoked the F-Word. The order did not impose sanctions for either broadcast. The Second Cir- cuit set aside the agency action, declining to address the constitutionality of the FCC’s action but finding the FCC’s reasoning inadequate under the Administrative Procedure Act (APA).

DECISION The judgment of the U.S. Court of Appeals for the Second Circuit is reversed, and the case is remanded.

OPINION Scalia, J. The Administrative Procedure Act, [citation], which sets forth the full extent of judicial authority to review executive agency action for proce- dural correctness, [citation], permits (insofar as relevant here) the setting aside of agency action that is “arbitrary” or “capricious,” [citation]. Under what we have called this “narrow” standard of review, we insist that an agency “examine the relevant data and articulate a satisfactory explanation for its action.” Motor Vehicle Mfrs. Assn. of United States, Inc. v. State Farm Mut. Automobile Ins. Co., [citation]. We have made clear, however, that “a court is not to substitute its judgment for that of the agency,” [citation], and should “uphold a decision of less than ideal clarity if the agency’s path may reasonably be discerned,” [citation].

In overturning the Commission’s judgment, the Court of Appeals here relied in part on Circuit precedent requiring a more substantial explanation for agency action that changes prior policy. The Second Circuit has

interpreted the Administrative Procedure Act and our opinion in State Farm as requiring agencies to make clear “‘why the original reasons for adopting the [dis- placed] rule or policy are no longer dispositive’” as well as “‘why the new rule effectuates the statute as well as or better than the old rule.’” [Citation.] ***

We find no basis in the Administrative Procedure Act or in our opinions for a requirement that all agency change be subjected to more searching review. *** The statute makes no distinction, however, between initial agency action and subsequent agency action undoing or revising that action.

To be sure, the requirement that an agency provide reasoned explanation for its action would ordinarily demand that it display awareness that it is changing position. An agency may not, for example, depart from a prior policy sub silentio or simply disregard rules that are still on the books. [Citation.] And of course the agency must show that there are good reasons for the new policy. But it need not demonstrate to a court’s satisfaction that the reasons for the new policy are better than the reasons for the old one; it suffices that the new policy is permissible under the statute, that there are good reasons for it, and that the agency believes it to be better, which the conscious change of course adequately indicates. This means that the agency need not always provide a more detailed justifi- cation than what would suffice for a new policy cre- ated on a blank slate. Sometimes it must—when, for example, its new policy rests upon factual findings that contradict those which underlay its prior policy; or when its prior policy has engendered serious reliance interests that must be taken into account. [Citation.] It would be arbitrary or capricious to ignore such mat- ters. In such cases it is not that further justification is demanded by the mere fact of policy change; but that a reasoned explanation is needed for disregarding facts and circumstances that underlay or were engendered by the prior policy.

Judged under the above described standards, the Commission’s new enforcement policy and its order finding the broadcasts actionably indecent were neither arbitrary nor capricious. First, the Commission forth- rightly acknowledged that its recent actions have broken new ground, taking account of inconsistent “prior Com- mission and staff action” and explicitly disavowing them as “no longer good law.” [Citation.] *** There is no doubt that the Commission knew it was making a change. That is why it declined to assess penalties *** .

Moreover, the agency’s reasons for expanding the scope of its enforcement activity were entirely rational. *** Even isolated utterances can be made in “pander [ing,] … vulgar and shocking” manners, [citation], and

106 The Legal Environment of Business Part II

In deciding this case on remand, the Second Circuit Court of Appeals found the FCC’s policy unconstitu- tionally vague and invalidated it in its entirety. The U.S. Supreme Court vacated the Second Circuit’s deci- sion but ruled against the FCC’s imposing sanctions against Fox. The Supreme Court explained that under the Due Process Clause, laws must give fair notice of conduct that is forbidden or required and laws that are impermissibly vague must be invalidated. The Court held that because the FCC failed to give Fox fair notice prior to the broadcasts in question that fleeting expletives could be found actionably indecent, the FCC’s standards as applied to these broadcasts were vague, and therefore the FCC’s orders must be set aside. The Supreme Court noted that its decision (1) does not address the First Amendment implications of the FCC’s indecency policy, (2) leaves the FCC free to modify its current indecency policy in light of its determination of the public interest and applicable legal requirements, and (3) leaves the courts free to review the current policy or any modified policy in light of its content and application. FCC v. Fox Tele- vision Stations, Inc., 567 U.S. ___, 132 S.Ct. 2307, 183 L.Ed.2d 234 (2012).

Legislative Control [5-2b] The legislature may exercise control over administra- tive agencies in various ways. Through its budgetary power, it may greatly restrict or expand an agency’s operations. Congress may amend an enabling statute to increase, modify, or decrease an agency’s authority. Even more drastically, it may completely eliminate an agency. Or, Congress may establish general guidelines to govern agency action, as it did by enacting the APA. Moreover, it may reverse or change an agency

rule or decision by specific legislation. In addition, each house of Congress has oversight committees that review the operations of administrative agencies. Finally, the Senate has the power of confirmation over some high-level appointments to administrative agencies.

In 1996 Congress enacted the Congressional Review Act, which subjects most rules to a new, extensive form of legislative control. With limited exceptions, the Act requires agencies to submit newly adopted rules to each house of Congress before they can take effect. If the rule is a major rule, it does not become final until Congress has had an opportunity to disapprove it. A major rule is any rule that the Office of Management and Budget (OMB) finds has resulted in or is likely to result in (1) an annual effect on the economy of at least $100 million; (2) a major increase in costs or prices; or (3) a significant adverse effect on competition, employment, investment, productivity, innovation, or international competitiveness of U.S. enterprises. If the rule is not a major rule, it takes effect as it otherwise would have after its submission to Congress; it is subject to possible disapproval by Congress. All rules covered by the Act shall not take effect if Congress adopts a joint resolution of dis- approval. The President may veto the joint resolution, but Congress may then vote to override the veto. A rule that has been disapproved is treated as though it had never taken effect.

Executive Branch Control [5-2c] By virtue of their power to appoint and remove their chief administrators, U.S. Presidents have significant con- trol over the administrative agencies housed within the executive branch. With respect to independent agencies,

can constitute harmful “‘first blow[s]’” to children, [citation]. It is surely rational (if not inescapable) to believe that a safe harbor for single words would “likely lead to more widespread use of the offensive language,” [Citation.]

*** The Second Circuit did not definitively rule on

the constitutionality of the Commission’s orders, but respondents nonetheless ask us to decide their validity under the First Amendment. This Court, however, is one of final review, “not of first view.” [Citation.] *** We see no reason to abandon our usual procedures in a rush

to judgment without a lower court opinion. We decline to address the constitutional questions at this time.

INTERPRETATION For agency action to be upheld on review under the APA’s “arbitrary or capricious” standard, the agency must have examined relevant data and articulated a satisfactory explanation for its action.

CRITICAL THINKING QUESTION What policies support limitations on judicial review of agency action? Were these policies implicated in this case?

Chapter 5 Administrative Law 107

however, the President has less control because commis- sioners serve for a fixed term that is staggered with the President’s term of office. Nevertheless, his power to appoint agency chairs and to fill vacancies confers con- siderable control, as does his power to remove commis- sioners for statutorily defined cause. The President’s central role in the budgeting process of agencies also enables him to exert great control over agency policy and operations. Even more extreme is the President’s power to impound monies appropriated to an agency by Congress. In addition, the President may radically alter, combine, or even abolish agencies of the executive branch unless either house of Congress disapproves such an act within a prescribed time.

Disclosure of Information [5-2d] Requiring administrative agencies to disclose informa- tion about their actions makes them more accountable to the public. Accordingly, Congress has enacted disclo- sure statutes to enhance public and political oversight of agency activities. These statutes include the Freedom of Information Act (FOIA), the Privacy Act, and the Government in the Sunshine Act.

Freedom of Information Act First enacted in 1966, FOIA gives the public access to most records in the files of federal administrative agencies. Once a per- son has requested files, an agency must indicate within ten working days whether it intends to comply with the request and must within a reasonable time respond to the request. The agency may charge a fee for providing the records.

FOIA permits agencies to deny access to nine cate- gories of records: (1) records specifically authorized in the interest of national defense or foreign policy to be kept secret; (2) records that relate solely to the internal personnel rules and practices of an agency; (3) records specifically exempted by statute from dis- closure; (4) trade secrets and commercial or financial information that is privileged or confidential; (5) inter- agency or intra-agency memorandums; (6) personnel and medical files, the disclosure of which would con- stitute a clearly unwarranted invasion of personal privacy; (7) investigatory records compiled for law enforcement purposes; (8) records that relate to the regulation or supervision of financial institutions; and (9) certain geological and geophysical information and data.

The Electronic FOIA Amendments require agencies to provide public access to information in an electronic format. Agencies must, within one year after their crea- tion, make records available by computer telecommuni- cations or other electronic means.

PRACTICAL ADVICE Be aware that the Freedom of Information Act may give the public access to information you provide to administrative agencies.

Privacy Act The Privacy Act protects certain gov- ernment records pertaining to individuals that a fed- eral agency maintains and retrieves by an individual’s name or other personal identifier, including social security number. In general, the Privacy Act prohibits unauthorized disclosures of those records covered by the Act. It also gives individuals the right to review and copy records about themselves, to find out whether these records have been disclosed, and to request corrections or amendments of these records, unless the records are legally exempt. It also requires agencies to maintain in their records only that infor- mation about an individual that is relevant and neces- sary to accomplish an agency function and to collect information to the greatest extent practicable directly from the individual.

Government in the Sunshine Act The Gov- ernment in the Sunshine Act requires meetings of many federal agencies to be open to the public. This Act applies to multimember bodies whose members the President appoints with the advice and consent of the Senate, such as the SEC, the FTC, the Federal Commu- nications Commission, the CPSC, and the Commodity Futures Trading Commission. The Act does not cover executive agencies such as the EPA, the Food and Drug Administration (FDA), and the National Highway Safety Administration (NHTSA).

Agencies generally may close meetings on the same grounds upon which they may refuse disclosure of records under FOIA. In addition, agencies such as the SEC and the Federal Reserve Board may close meetings to protect information the disclosure of which would lead to financial speculation or endanger the stability of financial institutions. The Sunshine Act also permits agencies to close meetings that concern agency partici- pation in pending or anticipated litigation.

108 The Legal Environment of Business Part II

C H A P T E R S U M M A R Y Operation of Administrative Agencies

Rulemaking process by which an administrative agency promulgates rules of law • Legislative Rules substantive rules issued by an administrative agency under the authority

delegated to it by the legislature • Interpretative Rules statements issued by an administrative agency indicating how it construes

the statutes and rules that it administers • Procedural Rules rules issued by an administrative agency establishing its organization, method

of operation, and rules of conduct for practice before the agency

Enforcement process by which agencies determine whether their rules have been violated

Adjudication formal methods by which an agency resolves disputes

Ethical Dilemma Should the Terminally Ill Be Asked to Await FDA Approval

of Last-Chance Treatments?

FACTS Mrs. Barnett is a seventy-three-year-old widow who has just been diagnosed with ovarian cancer. Because of the lack of adequate screening procedures for this type of cancer, Mrs. Barnett’s cancer has long gone undetected and has progressed considerably.

Dr. Jason, Mrs. Barnett’s doctor, will perform immediate surgery, but the surgery will not effectively cure the cancer. He has recommended that she undergo rigorous chemother- apy on a monthly basis for eighteen months following sur- gery. Thereafter, an exploratory operation can be conducted to assess the success of the treatment. The proposed chemo- therapy will cause severe side effects, including nausea, oral lesions, and complete hair loss.

Dr. Jason has informed Mrs. Barnett and her two daugh- ters, June and Sarina, that although chemotherapy will defer their mother’s immediate death, her chances of a recovery are slim. Dr. Jason stated that while, on average, one in three patients undergoing such treatment could expect to recover, he believed Mrs. Barnett’s recovery was highly unlikely. A second opinion from a reputable cancer treat- ment center confirmed Dr. Jason’s diagnosis and recommen- dations for treatment.

Sarina has heard of an experimental cancer drug being tested in Europe. Thus far the results seem promising. Though the drug may be obtained in Europe, it is not yet legal in the United States. The Food and Drug Administra- tion (FDA) has just begun to review the drug, but it will be years before the drug could receive FDA approval.

Sarina is strongly opposed to the painful regimen of chem- otherapy that has been proposed, particularly because the treatment seems futile. She wants to fly to Europe, obtain the experimental drug, and return with it to the United States. Mrs. Barnett is much too ill to travel. June, on the other hand, is opposed to any course of treatment that does not have the approval of the FDA. Mrs. Barnett, who is weak and confused, is looking to her daughters for guidance.

Social, Policy, and Ethical Considerations 1. If Mrs. Barnett were your mother, what recommenda-

tion would you make? Under the circumstances, is it unethical to use a drug that has not been approved by the FDA?

2. As a policy matter, how should the FDA handle drugs for life-threatening diseases?

3. Should individuals be allowed absolute freedom to take risks with drug therapy?

4. Should the FDA apply different drug approval standards with regard to children who suffer from life-threatening diseases?

5. As policy matter, how should the government and non- profit organizations allocate resources among research groups competing for funding? How should the govern- ment, through its administrative agencies, establish pri- orities for funding research on various illnesses?

Chapter 5 Administrative Law 109

Limits on Administrative Agencies

Judicial Review acts as a control or check by a court on a particular rule or order of an administrative agency

Legislative Control includes control over the agency’s budget and enabling statute

Executive Branch Control includes the President’s power to appoint members of the agency

Disclosure of Information congressionally required public disclosure enhances oversight of agency activities

C A S E P R O B L E M S

1. Congress passed the Emergency Price Control Act in the interest of national defense and security. The stated pur- pose of the Act was “to stabilize prices and to prevent speculative, unwarranted and abnormal increases in pri- ces and rents.” The Act established the Office of Price Administration, which was authorized to establish maxi- mum prices and rents that were to be “generally fair and equitable and [were to] effectuate the purposes of this Act.” Stark was convicted for selling beef at prices in excess of those set by the agency. Stark appeals on the ground that the Act unconstitutionally delegated to the agency the legislative power of Congress to control pri- ces. Is Stark correct in this contention?

2. The Secretary of Commerce (Secretary) published a notice in the Federal Register inviting comments regarding flam- mability standards for mattresses. Statistical data were compiled, consultant studies were conducted, and seventy- five groups submitted comments. The Secretary then deter- mined that all mattresses, including crib mattresses, must pass a cigarette test, consisting of bringing a mattress in contact with a burning cigarette. The department’s staff supported this position by stating: “Exemption of youth and crib mattresses is not recommended. While members of these age groups do not smoke, their parents fre- quently do, and the accidental dropping of a lighted ciga- rette on these mattresses while attending to a child is a distinct possibility.” Bunny Bear, Inc., now challenges the cigarette flammability test, asserting that the standard was not shown to be applicable to crib mattresses, as “infants and young children obviously do not smoke.” Bunny Bear argues that the Secretary has not satisfied the burden of proof justifying the inclusion of crib mattresses within this general safety standard. Is Bunny Bear cor- rect? Explain.

3. Reagan National Airport in Washington, D.C., is one of the busiest and most crowded airports in the nation. Accordingly, the Federal Aviation Administration (FAA) has restricted the number of commercial landing and takeoff slots at National to forty per hour. Allocation of the slots among the air carriers serving National had

been by voluntary agreement through an airline schedul- ing committee (ASC). When a new carrier requested twenty slots during peak hours, National’s ASC was unable to agree on a slot allocation schedule. The FAA engaged in informal rulemaking and invited public com- ment as a means to solve the slot allocation dilemma. The FAA then issued Special Federal Aviation Regulation 43 (SFAR 43) based on public comments and a proposal made at the last National ASC meeting, thereby decreas- ing the number of slots held by current carriers and shift- ing some slots to less desirable times. SFAR 43 also granted eighteen slots to New York Air. More specifi- cally, SFAR 43 requires five carriers to give up one or more slots in specific hours during the day, requires twelve carriers to shift one slot to the latest hour of oper- ations, and then reserves and allocates the yielded slots among the new entrants and several other carriers. Northwest Airlines seeks judicial review of SFAR 43, claiming that it is arbitrary, capricious, and not a product of reasoned decision making and that it capriciously favors the Washington–New York market as well as the new carrier. What standard would apply to the agency’s actions? Should Northwest prevail? Explain.

4. Bachowski was defeated in a United Steelworkers of America union election. After exhausting his union rem- edies, Bachowski filed a complaint with Secretary of Labor Dunlop. Bachowski invoked the Labor-Management Reporting and Disclosure Act, which required Dunlop to investigate the complaint and determine whether to bring a court action to set aside the election. Dunlop decided such action was unwarranted. Bachowski then filed an action in a federal district court to order Dunlop to file suit to set aside the election. What standard of review would apply, and what would Bachowski have to prove to prevail under that standard?

5. The Federal Crop Insurance Corporation (FCIC) was created as a wholly government-owned corporation to insure wheat producers against unavoidable crop failure. As required by law, the FCIC published in the Federal Register conditions for crop insurance. Specifically, the

110 The Legal Environment of Business Part II

FCIC published that spring wheat reseeded on winter wheat acreage was ineligible for coverage. When farmer Merrill applied for insurance on his wheat crop, he informed the local FCIC agent that 400 of his 460 acres of spring wheat were reseeded on the winter acreage. The agent advised Merrill that his entire crop was insurable. When drought destroyed Merrill’s wheat, Merrill tried to collect the insurance, but the FCIC refused to pay, assert- ing that Merrill is bound by the notice provided by publi- cation of the regulation in the Federal Register. Is the FCIC correct? Explain.

6. The Department of Energy (DOE) issued a subpoena requesting information regarding purchases, sales, exchanges, and other transactions in crude oil from Phoe- nix Petroleum Company (Phoenix). The aim of the DOE audit was to uncover violations of the Emergency Petro- leum Allocation Act (EPAA). The EPAA contained provi- sions for summary, or expedited, enforcement of DOE decisions. However, after the subpoena was issued but before Phoenix had responded, the EPAA expired. The EPAA provided that

The authority to promulgate and amend any regu- lation, or to issue any order under this Chapter shall expire at midnight September 30, 1981, but such expiration shall not affect any action or pend- ing proceedings, administrative, civil or criminal action or proceeding, whether or not pending, based upon any act committed or liability incurred prior to such expiration date.

Using the summary enforcement provisions of the now-defunct EPAA, the DOE sues to enforce the sub- poena. Phoenix argues that because the EPAA has expired, the DOE lacks the authority either to issue the subpoena or to use the summary enforcement provisions. Is Phoenix correct? Why?

7. Under the Communications Act, the Federal Communica- tions Commission may not impose common carrier obli- gations on cable operators. A common carrier is one that “makes a public offering to provide [communication facilities] whereby all members of the public who choose to employ such facilities may communicate or transmit.” In May 1976, the Commission issued rules requiring cable television systems of a designated size (a) to de- velop a minimum ten-channel capacity by 1986; (b) to make available on a first-come, nondiscriminatory basis certain channels for access by third parties; and (c) to furnish equipment and facilities for such access. The pur- pose of these rules was to ensure public access to the cable systems. Midwest Video Corporation claimed that the access rules exceeded the Commission’s jurisdiction granted it by the Communications Act, because the rules infringe upon the cable systems’ journalistic freedom by in effect treating the cable operators as “common carriers.” The Commission contended that its expansive

mandate under the Communications Act to supervise and regulate broadcasting encompassed the access rules. Did the Commission exceed its authority under the Act?

8. Congress enacted the National Traffic and Motor Vehicle Safety Act of 1966 (the Act) for the purpose of reducing the number of traffic accidents that result in death or personal injury. The Act directs the Secretary of Trans- portation to issue motor vehicle safety standards in order to improve the design and safety features of cars. The Secretary has delegated authority to promulgate safety standards to the National Highway Traffic Safety Admin- istration (NHTSA) under the informal rulemaking proce- dure of the APA. The Act also authorizes judicial review under the provisions of the Administrative Procedure Act (APA) of all orders establishing, amending, or revoking a federal motor vehicle safety standard issued by the NHTSA.

Pursuant to the Act, the NHTSA issued Motor Vehicle Safety Standard 208, which required all cars made after September 1982 to be equipped with passive restraints (either automatic seatbelts or airbags). The cost of imple- menting the standard was estimated to be around $1 bil- lion. However, early in 1981, due to changes in economic circumstances and particularly due to complaints from the automotive industry, the NHTSA rescinded Standard 208. The NHTSA had originally assumed that car manufac- turers would install airbags in 60 percent of new cars and passive seatbelts in 40 percent. However, by 1981 it appeared that manufacturers were planning to install seat- belts in 99 percent of all new cars. Moreover, the majority of passive seatbelts could be easily and permanently detached by consumers. Therefore, the NHTSA felt that Standard 208 would not result in any significant safety benefits. State Farm Mutual Automobile Insurance Com- pany (State Farm) and the National Association of Inde- pendent Insurers (NAII) filed petitions in federal court for review of the NHTSA’s rescission of Standard 208. What standard of review would apply to the rescission? Should it be set aside? Explain.

9. David Diersen filed a complaint against the Chicago Car Exchange (CCE), an automobile dealership, alleging that the CCE fraudulently furnished him an inaccurate odom- eter reading when it sold him a 1968 Dodge Charger, in violation of the Vehicle Information and Cost Savings Act (“the Odometer Act” or “the Act”). The Odometer Act requires all persons transferring a motor vehicle to give an accurate, written odometer reading to the pur- chaser or recipient of the transferred vehicle. Under the Act, those who disclose an inaccurate odometer reading with the intent to defraud are subject to a private cause of action by the purchaser and may be held liable for treble damages or $1,500, whichever is greater. The trial court granted the defendant’s motion for summary judgment, relying upon a regulation promulgated by the National Highway Traffic Safety Administration

Chapter 5 Administrative Law 111

(NHTSA), which purports to exempt vehicles that are at least ten years old (such as the one Diersen purchased from the CCE) from the Act’s odometer disclosure requirements. Diersen then filed a motion for reconsider- ation of the court’s summary judgment order, arguing that the older-car exemption created by the NHTSA lacked any basis in the Act and was therefore invalid. What standard should the court apply in determining the validity of the NHTSA regulation?

10. The Public Company Accounting Oversight Board (PCAOB) was created as part of a series of accounting reforms in the Sarbanes–Oxley Act of 2002. The PCAOB is a Government-created entity with expansive powers to govern an entire industry. Every accounting firm that audits public companies under the securities laws must register with the PCAOB, pay it an annual fee, and com- ply with its rules and oversight. The PCAOB may inspect registered firms, initiate formal investigations, and issue severe sanctions in its disciplinary proceedings. While the Securities and Exchange Commission (SEC) appoints PCAOB members and has oversight of the PCAOB, it cannot remove PCAOB members at will, but only “for good cause shown,” “in accordance with” specified procedures. The SEC Commissioners, in turn, cannot themselves be removed by the President except for “inefficiency, neglect of duty, or malfeasance in office.”

Parties with standing have challenged the constitutional- ity of the Sarbanes–Oxley Act’s creation of the PCAOB because it conferred executive power on PCAOB mem- bers without subjecting them to Presidential control. The basis for the challenge is that PCAOB members were insulated from Presidential control by two layers of ten- ure protection: PCAOB members could only be removed by the SEC for good cause, and the SEC Commissioners could in turn only be removed by the President for good cause. Decision?

11. Present and former law review editors who were research- ing disciplinary systems and procedures at the military service academies for an article were denied access to case summaries of honor and ethics hearings, with personal references or other identifying information deleted, main- tained in the United States Air Force Academy’s Honor and Ethics Code reading files. It was the Academy’s prac- tice to post copies of such summaries on forty squadron bulletin boards throughout the Academy and to distribute copies to Academy faculty and administration officials. The editors brought an action under the Freedom of Infor- mation Act (FOIA) against the Department of the Air Force to compel disclosure of the case summaries. Which exemptions to FOIA are most applicable? Explain whether any of these exemptions would enable the Academy to withhold the requested case summaries.

T A K I N G S I D E S

Section 7(a)(2) of the Endangered Species Act of 1973 (ESA) provides (in relevant part) that

[e]ach Federal agency shall, in consultation with and with the assistance of the Secretary (of the Interior), insure that any action authorized, funded, or carried out by such agency … is not likely to jeopardize the continued existence of any endangered species or threatened species or result in the destruction or adverse modification of habitat of such species which is determined by the Secretary, after consultation as appropriate with affected States, to be critical.

In 1978, the Fish and Wildlife Service and the National Marine Fisheries Service, on behalf of the Secretary of the Interior and the Secretary of Commerce respectively, promul- gated a joint regulation stating that the obligations imposed by Section 7(a)(2) extend to actions taken in foreign nations.

In 1983, the Interior Department proposed a revised joint reg- ulation that would require consultation only for actions taken in the United States or on the high seas. Shortly thereafter, Defenders of Wildlife and other organizations filed an action against the Secretary of the Interior, seeking a declaratory judgment that the new regulation is in error as to the geo- graphic scope of Section 7(a)(2) and an injunction requiring the Secretary to promulgate a new regulation restoring the initial interpretation. The Secretary asserted that the plaintiffs did not have standing to bring this action.

a. What arguments would support the plaintiff’s standing to bring this action?

b. What arguments would support the Secretary’s claim that plaintiffs did not have standing to bring this action?

c. Which side’s arguments are most convincing? Explain.

112 The Legal Environment of Business Part II

C H A P T E R 6

CRIMINAL LAW

These guys commit their crimes with a pencil instead of a gun. MARIO MEROLA (BRONX DISTRICT ATTORNEY), SPEAKING ABOUT CORPORATE CRIME TO THE NEW YORK TIMES (1985)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Describe criminal intent and the various degrees of mental fault.

2. Identify the significant features of white-collar crimes, corporate crimes, and the Racketeer Influenced and Corrupt Organizations Act (RICO).

3. List and define the crimes against business.

4. Describe the defenses of person or property, duress, mistake of fact, and entrapment.

5. List and explain the constitutional amendments affecting criminal procedure.

A s discussed in Chapter 1, the civil law defines duties the violation of which constitutes a wrong against the injured party. The criminal law, on

the other hand, establishes duties the violation of which is a societal wrong against the whole community. Civil law is a part of private law, whereas criminal law is a part of public law. In a civil action, the injured party sues to recover compensation for the damage and injury that he has sustained as a result of the defendant’s wrongful conduct. The party bringing a civil action (the plaintiff) has the burden of proof, which he must sustain by a pre- ponderance (greater weight) of the evidence. The purpose of the civil law is to compensate the aggrieved party.

Criminal law is designed to prevent harm to society by defining criminal conduct and establishing punish- ment for such conduct. In a criminal case, the defend- ant is prosecuted by the government, which must prove the defendant’s guilt beyond a reasonable doubt, a significantly higher burden of proof than that required

in a civil action. Moreover, under our legal system, guilt is never presumed. Indeed, the law presumes the innocence of the accused, and this presumption is un- affected by the defendant’s failure to testify in her own defense. The government still has the burden of affirmatively proving the guilt of the accused beyond a reasonable doubt.

Of course, the same conduct may, and often does, con- stitute both a crime and a tort, which is a civil wrong. (Torts are discussed in Chapters 7 and 8.) But an act may be criminal without being tortious; by the same token, an act may be a tort but not a crime.

Because of the increasing use of criminal sanctions to enforce government regulation of business, criminal law is an essential part of business law. Moreover, businesses sustain considerable loss as victims of criminal actions. Accordingly, this chapter covers the general principles of criminal law and criminal procedure as well as specific crimes and defenses relevant to business.

113

NATURE OF CRIMES [6-1] A crime is any act or omission forbidden by public law in the interest of protecting society and made punish- able by the government in a judicial proceeding brought by it. Punishment for criminal conduct includes fines, imprisonment, probation, and death. In addition, some states and the federal government have enacted victim indemnification statutes, which establish funds, financed by criminal fines, to provide indemnification in limited amounts to victims of criminal activity. Crimes are prohibited and punished on grounds of public policy, which may include the protection and safeguarding of government (as in treason), human life (as in murder), or private property (as in larceny). Additional purposes for criminal law include deter- rence, rehabilitation, and retribution.

Historically, criminal law was primarily common law. In the twenty-first century, however, criminal law is almost exclusively statutory. All states have enacted comprehensive criminal law statutes (or codes) covering most, if not all, of the common law crimes. Since its promulgation in 1962, the American Law Institute’s Model Penal Code has played an important part in the widespread revision and codification of the sub- stantive criminal law of the United States. Moreover, these statutes have made the number of crimes defined in criminal law far greater than the number of crimes defined under common law. Some codes expressly limit crimes to those the code includes, thus abolishing com- mon law crimes. Nonetheless, some states do not define all crimes statutorily; therefore, the courts must rely on common law definitions. Because there are no federal common law crimes, all federal crimes are statutory.

Within recent times the scope of the criminal law has increased greatly. The scope of traditional criminal behavior has been expanded by numerous regulations and laws, pertaining to nearly every phase of modern living, that contain criminal penalties. Typical examples in the field of business law are those laws concerning the licensing and conduct of a business, antitrust laws, and laws governing the sales of securities.

Essential Elements [6-1a] In general, a crime consists of two elements: (1) the wrongful or overt act (actus reus) and (2) the criminal or mental intent (mens rea). For example, to support a larceny conviction, it is not enough to show that the defendant stole another’s goods; it also must be estab- lished that he intended to steal the goods. Conversely, criminal intent without an overt act is not a crime. For

instance, Ann decides to rob the neighborhood grocery store and then really “live it up.” Without more than the thought, Ann has committed no crime.

Actus reus refers to all the nonmental elements of a crime, including the physical act that must be performed, the circumstances under which it must be performed, and the consequences of that act. The actus reus required for specific crimes will be discussed later in this chapter.

Mens rea, or mental fault, refers to the mental ele- ment of a crime. Most common law and some statutory crimes require subjective fault, whereas other crimes require objective fault; some statutory crimes require no fault at all. The Model Penal Code and most modern criminal statutes recognize three possible types of subjective fault: purposeful, knowing, and reckless. A person acts purposely or intentionally if his conscious object is to engage in the prohibited conduct or to cause the prohibited result. Thus, if Arthur, with the desire to kill Donna, shoots his rifle at Donna, who is seemingly out of gunshot range, and in fact does kill her, Arthur had the purpose or intent to kill Donna. If Benjamin, desiring to poison Paula, places a toxic chemical in the water cooler in Paula’s office and unwittingly poisons Gail and Ram, Benjamin will be found to have purposefully killed Gail and Ram, because Benjamin’s intent to kill Paula is transferred to Gail and Ram, regardless of Benjamin’s feelings toward Gail and Ram.

A person acts knowingly if he is aware that his conduct is of a prohibited type or is practically certain to cause a prohibited result. A person acts recklessly if he consciously disregards a substantial and unjustifi- able risk that his conduct is prohibited or that it will cause a prohibited result.

Objective fault involves a gross deviation from the standard of care that a reasonable person would observe under given circumstances. Criminal statutes refer to objective fault by terms such as carelessness or negligence. Such conduct occurs when a person should be aware of a substantial and unjustifiable risk that his conduct is prohibited or will cause a prohibited result. Examples of crimes requiring objective fault are in- voluntary manslaughter (negligently causing the death of another), carelessly driving an automobile, and, in some states, issuing a bad check.

Many regulatory statutes have totally dispensed with the mental element of a crime by imposing criminal liability without fault. Without regard to the care that a person exercises, criminal liability without fault makes it a crime for that person to do a specified act or to bring about a certain result. Statutory crimes imposing

114 The Legal Environment of Business Part II

liability without fault include the sale of adulterated food, the sale of narcotics without a prescription, and the sale of alcoholic beverages to a minor. Most of these crimes involve regulatory statutes dealing with health and safety and impose only fines for violations. See State v. Morse later in this chapter.

See Concept Review 6-1 for an overview of degree of mental fault.

CLASSIFICATION [6-2] Historically, crimes have been classified mala in se (wrongs in themselves or morally wrong, such as mur- der) or mala prohibita (not morally wrong but declared wrongful by law, such as the failure to drive on the right side of the road). From the standpoint of the seriousness of the offense, crimes are also classified as a felony, which is a serious crime (any crime punishable by death or imprisonment in the penitentiary), or as a misdemeanor, which is a less serious crime (any crime punishable by a fine or imprisonment in a local jail).

Vicarious Liability [6-2a] Vicarious liability is liability imposed upon one person for the acts of another. Employers are vicariously liable for the authorized criminal acts of their employees if the employer directed, participated in, or approved of the act. For example, if an employer directs its vice pres- ident of marketing to fix prices with its company’s com- petitors, and the employee does so, both the employer and employee have criminally violated the Sherman Antitrust Act. On the other hand, employers ordinarily are not liable for the unauthorized criminal acts of their employees. As previously discussed, most crimes require

mental fault; this element is not present, so far as crimi- nal responsibility of the employer is concerned, where the employee’s criminal act was not authorized.

Employers, however, may be subject to a criminal penalty for the unauthorized act of an adviser or manager acting in the scope of employment. Moreover, an employer may be criminally liable under a liability without fault statute for certain unauthorized acts of an employee, whether or not the employee is manage- rial. For example, many states have statutes that punish “every person who by himself or his employee or agent sells anything at short weight” or “whoever sells liquor to a minor and any sale by an employee shall be deemed the act of the employer as well.”

PRACTICAL ADVICE Because employers may be criminally liable for the acts of their employees, you should exercise due diligence in adequately checking the backgrounds of prospective employees.

Liability of a Corporation [6-2b] Historically, corporations were not held criminally liable because, under the traditional view, a corporation could not possess the requisite criminal intent and, therefore, was incapable of committing a crime. The dramatic growth in size and importance of corporations changed this view. Under the modern approach, a corporation may be liable for violation of statutes imposing liability without fault. In addition, a corpora- tion may be liable where the offense is perpetrated by a high corporate officer or the board of directors. The Model Penal Code provides that a corporation may be convicted of a criminal offense for the conduct of its employees if

CONCEPT REVIEW 6-1 D E G R E E S O F M E N T A L F A U L T

Type Fault Required Examples

Subjective fault Purposeful Knowing Reckless

Larceny Embezzlement

Objective fault Negligent Careless

Careless driving Issuing bad checks (some states)

Liability without fault None Sale of alcohol to a minor Sale of adulterated food

Chapter 6 Criminal Law 115

1. the legislative purpose of the statute defining the offense is to impose liability on corporations and the conduct is within the scope of the [employee’s] office or employment;

2. the offense consists of an omission to discharge a specific, affirmative duty imposed upon corporations by law; or

3. the offense was authorized, requested, commanded, performed, or recklessly tolerated by the board of direc- tors or by a high managerial agent of the corporation.

Punishment of a corporation for crimes is necessarily by fine, not imprisonment. Nonetheless, individuals bearing responsibility for the criminal act face fines, imprisonment, or both. The Model Penal Code provides that the corpo- rate agent having primary responsibility for the discharge of the duty imposed by law on the corporation is as ac- countable for a reckless omission to perform the required act as though the law imposed the duty directly upon him.

On November 1, 1991 (updated in 2004 and 2010), the Federal Organizational Corporate Sentencing Guide- lines took effect. The overall purpose of the guidelines is to impose sanctions that will provide just punishment and adequate deterrence. The guidelines provide a base fine for each criminal offense, but that fine can be increased or reduced. Factors that can increase a corpo- rate fine include the corporation’s involvement in or tolerance of criminal activity, its prior history, and whether it has obstructed justice. On the other hand, corporations can reduce their punishment by implement- ing an effective compliance and ethics program reason- ably designed to prevent potential legal violations by the corporation and its employees.

An effective compliance and ethics program should include the following:

1. standards and procedures to prevent and detect crimi- nal conduct;

2. responsibility at all levels and adequate resources, and authority for the program;

3. personnel screening related to program goals;

4. training at all levels;

5. auditing, monitoring, and evaluating program effec- tiveness;

6. nonretaliatory internal reporting systems;

7. incentives and discipline to promote compliance; and

8. reasonable steps to respond to and prevent further similar offenses upon detection of a violation.

The 2010 amendments to the guidelines expanded the availability of reduced sentencing for corporations

meeting additional requirements. Under the previous guidelines, convicted corporations could receive a reduced fine for having an effective compliance and ethics program only if no high-level personnel were involved in, or were, willfully ignorant of, the crime. Under the 2010 amendments, a corporation can be eligible for a reduced fine based on an effective com- pliance and ethics program despite the involvement or willful ignorance of high-level personnel if the convicted corporation satisfies four additional criteria:

1. a direct and prompt communication channel exists between compliance personnel and the organization’s governing authority (e.g., the board of directors or the audit committee of the board);

2. the compliance program discovered the criminal offense before discovery outside the company was reasonably likely;

3. the corporation promptly reported the offense to appropriate government authorities; and

4. no individual with operational responsibility for the compliance program participated in, condoned, or was willfully ignorant of the offense.

PRACTICAL ADVICE Companies should ensure that they have a satisfactory corporate compliance program.

WHITE-COLLAR CRIME [6-3] White-collar crime has been defined in various ways. The Justice Department defines it as nonviolent crime involving deceit, corruption, or breach of trust. It in- cludes crimes committed by individuals—such as em- bezzlement and forgery—as well as crimes committed on behalf of a corporation—such as commercial brib- ery, product safety and health crimes, false advertising, and antitrust violations. Regardless of the definition, white-collar crime clearly costs society billions of dol- lars; according to the Federal Bureau of Investigation, white-collar crime is estimated to cost the United States between $300 and $660 billion per year. Historically, prosecution of white-collar crime was deemphasized because such crime was not considered violent. Now, however, many contend that white-collar crime often inflicts violence but does so impersonally. For example, unsafe products cause injury and death to consumers, while unsafe working conditions cause injury and death

116 The Legal Environment of Business Part II

to employees. Indeed, many contend that white-collar criminals should receive stiff prison sentences due to the magnitude of their crimes.

In response to the business scandals involving compa- nies such as Enron, WorldCom, Global Crossing, Adel- phia, and Arthur Andersen, in 2002, Congress passed the Sarbanes-Oxley Act. The Act, according to former President George W. Bush, constitutes “the most far- reaching reforms of American business practices since the time of Franklin Delano Roosevelt [President from 1932 until 1945].” The legislation seeks to prevent such scandals by increasing corporate responsibility, adding new financial disclosure requirements; creating new criminal offenses and increasing the penalties of existing federal crimes; and creating a powerful new five-person Accounting Oversight Board with authority to review and discipline auditors.

The Sarbanes-Oxley Act establishes new criminal penal- ties, including the following: (1) making it a crime to defraud any person or to obtain any money or property

fraudulently in connection with any security of a public company with penalties of a fine and/or up to twenty-five years imprisonment and (2) imposing fines and/or impris- onment of up to twenty years for knowingly altering, destroying, mutilating, or falsifying any document with the intent of impeding a federal investigation. In addition, the Act substantially increases the penalties for existing crimes, including the following: (1) mail and wire fraud (five-year maximum increased to twenty-five-year maxi- mum) and (2) violation of the Securities and Exchange Act (ten-year maximum increased to twenty-year maximum). The Act is discussed further in Chapters 35, 39, and 43.

In December 2008, Bernard L. Madoff admitted to perpetrating a massive Ponzi scheme with estimated losses of $20 billion in principal and approximately $65 billion dollars in paper losses. As a result, in 2010 the Securities and Exchange Commission began reform- ing and improving the way it operates to reduce the chances that such frauds will occur or be undetected in the future.

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FACTS On April 18, 1997, the defendant, Farell, was charged with the theft of a trade secret based upon evidence that he had printed out confidential design specifications for certain computer chips on the last day of his employment as an electrical engineer at Digital Equipment Corporation. As a sentence enhancement, it was further alleged that the loss exceeded $2.5 million and, as a restriction on probation, that the theft was of an amount exceeding $100,000. Defendant pleaded no contest to the theft charge but objected to the potential application of Section 1203.044 to his sentence, which requires a ninety-day county jail sentence as condition of probation for theft of an amount exceeding $50,000. The trial court placed him on probation conditioned on the service of a term in county jail under Section 1203.044.

A hearing was held in the superior court on the lim- ited question of whether the amount of the theft applies to the theft of property other than money, including trade secrets. The court concluded that the provision applies to the theft of all property of a certain value, including trade secrets.

The Court of Appeal reversed, holding that the statute applies only to the theft of what it termed “monetary property.” The California Supreme Court granted the government’s petition for review.

DECISION The judgment of the Court of Appeal is reversed.

OPINION George, C. J. Defendant stands convicted of theft, specifically a violation of [California statute] which provides:

(b) Every person is guilty of theft who, with intent to deprive or withhold the control of a trade secret from its owner, or with an intent to appropriate a trade secret to his or her own use or to the use of another, does any of the following:

(1) Steals, takes, carries away, or uses without authoriza- tion, a “trade secret.” The statute defines the term “trade secret” as follows: “information, including a formula, pat- tern, compilation, program, device, method, technique, or process,” that: (A) Derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use; and (B) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.

[Citation.]

The trial court determined that Section 1203.044 applies to such a theft. This statute, entitled The Economic Crime Law of 1992, requires that a defendant who is convicted of certain theft offenses and is granted probation

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shall be sentenced to at least ninety days in the county jail as a condition of probation. ***

As relevant to the present case, the statute provides: “This section shall apply only to a defendant convicted of a felony for theft of an amount exceeding fifty thou- sand dollars ($50,000) in a single transaction or occur- rence. This section shall not apply unless the fact that the crime involved the theft of an amount exceeding fifty thousand dollars ($50,000) in a single transaction or occurrence is charged in the accusatory pleading and either admitted by the defendant in open court or found to be true by the trier of fact. *** ”

The Court of Appeal determined that Section 1203.044 may not be applied to persons convicted of the theft of trade secrets. It examined the words of the statute and the legislative history of the enactment and, concluding that the statute is at best ambiguous, applied the so-called rule of lenity to give defendant the benefit of the doubt.

Our task is one of statutory interpretation and, “as with any statute, [it] is to ascertain and effectuate legis- lative intent.” [Citations.] We turn first to the words of the statute themselves, recognizing that “they generally provide the most reliable indicator of legislative intent.” [Citation.] We examine the meaning of the phrase “convicted of a felony for theft of an amount exceeding fifty thousand dollars,” keeping in mind that the words must be interpreted in context [Citation.] In outlining the circumstances under which a person given a proba- tionary term for a theft offense must be sentenced to a minimum period in custody does not specify that the theft must involve cash—or that it must involve what is referred to by the Court of Appeal as “monetary prop- erty” and by defendant as a “cash equivalent.”

The crime of theft, of course, is not limited to an unlawful taking of money. *** The crime of theft may involve the theft of trade secrets; indeed, *** the Legis- lature specified that the theft of trade secrets is akin to the theft of any other property. *** In the absence of evidence to the contrary, we may infer that when the Legislature referred in Section 1203.044 to persons “convicted of a felony for theft,” it had in mind the gen- eral definition of theft, including the broad categories of property that may be the subject of theft. ***

***

To interpret Section 1203.044 as limited to the theft of cash or cash equivalents also would be inconsistent with express legislative intent. The Legislature addressed problems of certain white-collar crimes, specifically theft, in enacting Section 1203.044. As the Legislature’s own statement of intent discloses, that body intended to remedy the perceived relative unfairness arising from the light probationary sentences meted out to white-collar criminals, as well as to provide reliable tools to ensure that victims of white-collar criminals receive restitution,

and to provide financial support for investigation and prosecution of white collar crime.

The Legislature declared in enacting Section 1203.044:

[M]ajor economic or “white collar” crime is an increasing threat to California’s economy and the well-being of its citi- zens. The Legislature intends to deter that crime by ensur- ing that every offender, without exception, serves at least some time in jail and by requiring the offenders to divert a portion of their future resources to the payment of restitu- tion to their victims.

White collar criminals granted probation too often com- plete their probation without having compensated their vic- tims or society.

Probation accompanied by a restitution order is often ineffective because county financial officers are often un- aware of the income and assets enjoyed by white collar offenders.… Thus, it is the Legislature’s intent that the financial reporting requirements of this act be utilized to achieve satisfactory disclosure to permit an appropriate res- titution order.

White collar criminal investigations and prosecutions are unusually expensive. These high costs sometimes discourage vigorous enforcement of white collar crime laws by local agencies. Thus, it is necessary to require white collar offenders to assist in funding this enforcement activity. ***

We observe that the term “white-collar crime” is a relatively broad one and is not limited to losses in- volving cash or cash equivalents. It generally is defined as “[a] nonviolent crime usu[ally] involving cheating or dishonesty in commercial matters. Examples include fraud, embezzlement, bribery, and insider trading.” [Citation.] The Legislature has applied the term white- collar crime to fraud and embezzlement, *** a statute that provides for enhanced prison terms for recidivists committing these offenses when the offense involves a pattern of “taking of more than one hundred thousand dollars.” Like the crime of theft, fraud and embezzle- ment are not limited to the unlawful acquisition of cash or cash equivalents. [Citations.] Indeed, fre- quently fraud and embezzlement simply are methods by which a charged theft is accomplished. [Citations.] Because the crime of theft includes a wide range of property and the term white-collar crime has a broad meaning, we find it improbable that the Legislature intended to address only the theft of cash or cash equivalents. *** It is far more reasonable to conclude that the Legislature intended the provision to apply to all thefts of property of a particular value. Any other interpretation would permit many white-collar thieves to continue to receive light probationary sentences and to evade strict restitution requirements. From the usual meaning of the terms used in Section 1202.044, the purpose of the enactment, and the Legislature’s paral- lel use of the same terms in other statutes, one must conclude that Section 1203.044 is not limited to thefts of cash or cash equivalents.

118 The Legal Environment of Business Part II

Computer Crime [6-3a] One special type of white-collar crime is computer crime. Computer crime, or cybercrime, is best categorized based on whether the computer was the instrument or the target of the crime. Examples of cybercrimes using computers as the instrument of the crime include the distribution of child pornography; money laundering; illegal gambling; copyright infringement; illegal communication of trade secrets; and fraud involving credit cards, e-commerce, and securities. Cybercrime with a computer as a target of the crime attacks a computer’s confidentiality, integrity, or availability; examples include theft or destruction of proprietary information, vandalism, denial of service, web- site defacing and interference, and implantation of mali- cious code. Detection of crimes involving computers is extremely difficult. In addition, computer crimes often are not reported because businesses do not want to give the impression that their security is lax. Nonetheless, losses due to computer crimes are estimated to be in the tens of billions of dollars. Moreover, given society’s ever- increasing dependence upon computers, this type of crime will in all likelihood continue to increase.

As a consequence, enterprises are spending large sums of money to increase computer security. In addition, every state has enacted computer crime laws. Originally passed in 1984, the federal Computer Fraud and Abuse Act protects a broad range of computers that facilitate interstate and international commerce and communica- tions. The Act was amended in 1986, 1994, 1996, 2001, 2002, and 2008. The Act makes it a crime with respect to any computer that is used in interstate com- merce or communications (1) to access or damage it without authorization, (2) to access it with the intent to commit fraud, (3) to traffic in passwords for it, and (4) to threaten to cause damage to it with the intent to extort money or anything of value. Furthermore, de- pending on the details of the crime, cybercriminals also may be prosecuted under other federal laws, such as copyright, mail fraud, or wire fraud laws. Spam— unsolicited commercial electronic mail—is currently estimated to account for well over half of all electronic mail. Congress has concluded that spam has become the most prevalent method used for distributing pornog- raphy; perpetrating fraudulent schemes; and introduc- ing viruses, worms, and Trojan horses into personal and business computer systems. In response, Congress

enacted the Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003, or the CAN- SPAM Act of 2003, which went into effect on January 1, 2004. In enacting the statute Congress determined that senders of spam should not mislead recipients as to the source or content of such mail and that recipients of spam have a right to decline to receive additional spam from the same source.

PRACTICAL ADVICE Adequately protect the safety and security of all company electronic data and records.

Racketeer Influenced and Corrupt Organizations Act [6-3b] The Racketeer Influenced and Corrupt Organizations Act (RICO) was enacted in 1970 with the stated pur- pose of terminating the infiltration by organized crime into legitimate business. The Act subjects to severe civil and criminal penalties enterprises that engage in a pattern of racketeering, defined as the commission of two or more predicate acts within a period of ten years. A “predicate act” is any of several criminal offenses listed in RICO. Included are nine major categories of state crimes and more than thirty federal crimes, such as murder, kidnapping, arson, extortion, drug dealing, mail fraud, and bribery. The most controversial issue concerning RICO is its application to businesses that are not engaged in organized crime but that do meet the “pattern of racketeering” test under the Act. Crimi- nal conviction under the law may result in (1) fines of up to $250,000 ($500,000 for an organization) or twice the amount of gross profits or other proceeds from the offense and/or (2) a prison term of up to twenty years or for life if the violation is based on a racketeering activity for which the maximum penalty includes life imprisonment. In addition, businesses forfeit any property obtained due to a RICO violation, and individuals harmed by RICO violations may invoke the statute’s civil remedies, which include treble damage and attorneys’ fees.

Other areas of federal law that impose both civil and criminal penalties include bankruptcy (Chapter 38), anti- trust (Chapter 42), securities regulation (Chapter 43), and environmental regulation (Chapter 45).

INTERPRETATION The requirement imposing a minimum term in county jail applies to the theft of property other than money, including trade secrets.

CRITICAL THINKING QUESTION Should the penalty for theft vary depending on the dollar value of the property taken? Explain.

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CRIMES AGAINST BUSINESS [6-4] Criminal offenses against property greatly affect busi- nesses, amounting to losses worth hundreds of billions of dollars each year. In this section we will discuss the following crimes against property: (1) larceny, (2) em- bezzlement, (3) false pretenses, (4) robbery, (5) bur- glary, (6) extortion and bribery, (7) forgery, and (8) bad checks.

Larceny [6-4a] The crime of larceny is the (1) trespassory (2) taking and (3) carrying away of (or exercising dominion or control over) (4) personal property (5) of another (6) with the intent to deprive the victim permanently of the goods. All six elements must be present for the crime to exist. Thus, if Carol takes Dan’s 1968 automobile without Dan’s permis- sion, intending to use it for a joyride and then return it to Dan, Carol has not committed larceny because she did

A P P L Y I N G T H E L A W

CRIMINAL LAW

Facts Bivens worked as an accounts payable clerk for C&N Construction. Every Wednesday morning, the site foreman would call Bivens and give her the names of the employees working on the job and the number of hours they had worked. Bivens would then convey this informa- tion to a paycheck-processing company, which would return unsigned payroll checks to C&N. After a designated officer of the company signed them, Bivens would forward the checks to the job site for distribution by the foreman. After working for the company for nearly eight years, Bivens began sending false information to the payroll service about employees and hours worked. The resulting checks were typically payable to employees who had worked for C&N in the recent past but who were not active on the current job. Bivens would intercept these “fake” checks after they were signed, forge the payees’ names, and either cash them or deposit them into her bank account. Over a period of seven- teen months, Bivens diverted tens of thousands of dollars to herself by forging more than one hundred fake paychecks. She spent all but a few hundred dollars of the money on meals and entertainment, jewelry, clothing, and shoes. C&N’s vice president ultimately discovered Bivens’s practice, fired her, and notified the authorities of her conduct.

Issue Has Bivens committed the crime of embezzlement?

Rule of Law A crime consists of two elements: (1) actus reus, or a wrongful act, and (2) mens rea, or criminal intent. The crime of embezzlement occurs when a person who is in lawful possession of another’s property intentionally misuses the property or seriously interferes with the owner’s rights in it. Possible defenses to a crime include defense of person or property, duress, and mistake of fact.

Application The actus reus in this case is exercising wrongful dominion and control over the property of another while in legal possession of it. Bivens was lawfully in posses- sion of C&N’s property in the form of the payroll checks. While her job description certainly did not authorize her to keep any of the checks or payroll funds for herself,

Bivens’s position at C&N did require her to record and trans- mit payroll information as well as to handle the checks themselves. While in legal possession of C&N paychecks, Bivens misused or seriously interfered with C&N payroll funds. Without permission or right, she cashed some of the checks and diverted to herself money that belonged to C&N. She has committed the necessary wrongful act.

The next question is whether she had the requisite state of mind. Bivens’s paycheck scheme also reflects mens rea, or subjective fault. Her conduct with regard to the checks was clearly purposeful or intentional. While it might be possible to make an error in transmitting employee names or hours worked occasionally, Bivens could not have negligently transmitted incorrect information about former employees in more than one hundred instances. Moreover, the fact she separated out the fake checks from the genu- ine paychecks, surreptitiously took them from work, falsely endorsed them with the names of the former employee payees, and then cashed them and spent the money indi- cates she intended to steal the funds. This series of events benefiting Bivens could not possibly have happened un- intentionally or through carelessness alone. Therefore the necessary mens rea is present.

Moreover, none of the defenses to a crime is applicable here. Bivens was not acting to protect herself, another per- son, or her property. Nor was she under duress; she was not threatened with immediate, serious bodily harm when she engaged in the paycheck scam. Finally, there is nothing to indicate that Bivens was mistaken about C&N’s owner- ship of the payroll funds, that she was mistaken about the names or hours worked by employees any given week, or that she could have mistakenly thought she was expected to or permitted to falsify payroll records so as to cause pay- checks to be issued to former employees, paychecks which she would then take and cash for herself. Thus, Bivens has no valid legal defense.

Conclusion Bivens’s conduct with regard to these checks constitutes embezzlement.

120 The Legal Environment of Business Part II

not intend to deprive Dan permanently of the automobile. (Carol nevertheless has committed the offense of unauthor- ized use of an automobile, which is a crime in most states.) On the other hand, if Carol left Dan’s 1968 car in a junk- yard after the joyride, Carol most likely would be held to have committed a larceny because of the high risk that Dan would be permanently deprived of the car.

Embezzlement [6-4b] Embezzlement is the fraudulent conversion of another’s property by one who was in lawful possession of it. A conversion is any act that seriously interferes with the owner’s rights in the property; such acts may include exhausting the resources of the property, selling it, giving it away, or refusing to return it to its rightful owner. The key distinction between larceny and embezzlement, therefore, is whether the thief is in lawful possession of the property. Although both situations concern misuse of the property of another, in embezzlement, the thief lawfully possesses the property; in larceny, she does not.

False Pretenses [6-4c] False pretenses is the crime of obtaining title to property of another by making materially false representations

of an existing fact with knowledge of their falsity and with the intent to defraud. Larceny does not cover this situation because here the victim voluntarily transfers the property to the thief. For example, a con artist who goes door to door and collects money by saying he is selling stereo equipment, when he is not, is committing the crime of false pretenses.

Other specialized crimes that are similar to false pretenses include mail, wire, and bank fraud as well as securities fraud. Mail fraud, unlike the crime of false pretenses, does not require the victim to be actually defrauded; it simply requires the defendant to use the mails (or private carrier) to carry out a scheme that attempts to defraud others. Due to its breadth and ease of use, mail fraud has been employed extensively by federal prosecutors. The wire fraud statute prohibits the transmittal by wire, radio, or television in interstate or foreign commerce of any information with the intent to defraud. The federal statute prohibiting bank fraud makes it a crime knowingly to execute or attempt to execute a scheme to defraud a financial institution or to obtain by false pretenses funds under the control or custody of a financial institution. Securities fraud is discussed in Chapter 39.

S T A T E O F S O U T H D A K O T A V . M O R S E S u p r e m e C o u r t o f S o u t h D a k o t a , 2 0 0 8

7 5 3 N . W . 2 d 9 1 5 , 2 0 0 8 S D 6 6

FACTS Janice Heffron orally contracted with her neighbor, Wyatt Morse, to convert her second-floor bedroom into a bathroom in five weeks for $5,000. According to Janice, Morse repeatedly stated that he could do it “easy, quick, cheap.” Janice told her mother, Maxine Heffron, who would finance the project, about Morse’s offer. Maxine and Janice then went to Morse’s home, where he showed them the bathroom he had restored. Janice and Maxine were impressed. Morse also told them that he had plumbing experience, that his work would be above and beyond code, and that the local inspector did not inspect his work because he was so good. Maxine wanted to pay using personal checks to ensure a paper trail, but Morse convinced her to pay him with cash. According to Janice, he wanted to be paid in cash to avoid the Internal Revenue Service. They agreed that Morse would convert the room into a bathroom, install an antique claw-foot tub (one that he would provide

personally), put wainscoting on the walls, install an old tin ceiling like the one in his bathroom, and install crown molding.

Morse began work in January 2006. His efforts con- tinued until the second week of March. He installed plumbing fixtures, and he removed the old water heater and installed a new one. He ran a freeze-proof spigot outside the house. He put in a bathroom vent with an antique vent cover. He custom built a bath- room cabinet at no extra cost to the Heffrons. He mounted wainscoting and crafted a surrounding shelf with rope lighting. He put in a faux tin ceiling, with crown molding and trim. He installed water pipes and a new drain stack. The project took longer and cost more than originally agreed. Morse ran into difficulties when he attempted to install a tankless water heater. He was never able to install the tankless heater and ended up installing a traditional tanked water heater. Morse also experienced problems with some of the

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pipes he installed. Janice told him that they were leak- ing. He repaired them and blamed the leaks on bad batches of solder.

Maxine paid Morse somewhere between $6,000 and $6,500 cash. In March 2006, Morse fell and aggravated his already bad back. Before Janice and Maxine hired him, Morse had told them that he had a back condition. After his fall in March, he came to the job site less and less. Then, after the second week in March he stopped coming entirely. The Heffrons tried contacting him through phone calls, personal visits, and certified mail. He never responded. After Morse abandoned the pro- ject, Janice contacted a licensed plumber, who examined Morse’s work and gave Janice an estimate on the cost of completing the project. The plumber pointed out several deficiencies in Morse’s work. In particular, Morse incorrectly installed the water heater, the pipes for the sink, lavatory, and bathtub. He used S-traps, illegal in South Dakota, and improperly vented the floor drains. Because he installed the water heater incorrectly, carbon monoxide was leaking into Janice’s home. In sum, Morse’s work on the bathroom, in the opinion of the licensed plumber, had no value to the home.

On October 12, 2006, Morse was indicted for grand theft by deception in violation of South Dakota law. A jury returned a guilty verdict. Morse was sentenced to five years in prison. He appeals asserting that the evidence was insufficient to sustain the verdict.

DECISION Judgment reversed.

OPINION Morse argues that the State failed to prove he had the requisite intent to defraud the Heffrons. He does not dispute that the work he did on Janice’s home was faulty and resulted in the Hef- frons having to pay considerably more in repairs. Nonetheless, he claims that his faulty work created a classic breach of contract claim, because when he entered into the agreement to remodel the bathroom, he believed he was capable of doing quality work and fully intended on completing the project. The State, on the other hand, argues that Morse “created and reinforced the false impression in the minds of Jan and Maxine Heffron that he was licensed to, and capable of, installing a second floor bathroom.” More particularly, the State contends that Morse “deceived” the Heffrons on his ability to do the work, “misled” them with his statements that his work would be above code, and “took actions to further reinforce the false impression that he was able to properly install the bathroom.”

Theft by deception is a specific intent crime. [Citation.] Intent to defraud “means to act willfully and with the

specific intent to deceive or cheat, ordinarily for the purpose of either causing some financial loss to another or bringing about some financial gain to one’s self.” [Citation.]

Therefore, Morse must have had the “purpose to deceive.” [Citation.] “It is only where [actors do] not believe what [they] purposely caused [their victims] to believe, and where this can be proved beyond a reasonable doubt, that [these actors] can be convicted of theft.” [Citation.] ***

*** The term, deceive, does not, however, include falsity

as to matters having no pecuniary significance or puffing by statements unlikely to deceive reasonable persons.

Based on our review of the record, in a light most favorable to the verdict, Morse: (1) failed to complete the project in five weeks for $5,000 as promised; (2) performed work that was not “above and beyond code” as promised; (3) lied about obtaining a building permit; (4) lied about the reasons he could not get the tankless water heater installed and why the pipes were leaking; (5) returned the water heater and did not give the $186 refund to Maxine; (6) never provided Janice or Maxine receipts for materials purchased; (7) quit working on the project prematurely and without explanation; and (8) never responded to the Heffrons’ attempts to contact him.

These facts do not prove the elements of theft by deception. There is no evidence that Morse had a purpose to deceive or intended to defraud the Hef- frons when he agreed to remodel Janice’s bathroom. Although his work was not above and beyond code, the State never argued that Morse knew he would do faulty work. Janice and Maxine both testified that Morse took them up to his house and showed him the remodeling that he did to his own bathroom. They both said they were impressed. It cannot be inferred that Morse intended to defraud the Hef- frons because his work product was not up to code. Moreover, the State never argued or presented evi- dence that Morse took Maxine’s money with the intention of never performing under their agreement. *** The parties made their agreement in December 2005, and no one disputes that Morse worked regu- larly on the project from January 2006 until the second week of March. While Morse failed to com- plete the project in five weeks for $5,000 as prom- ised, the State never claimed that he knew it would take longer and charge more, and tricked the Hef- frons into believing him. Neither Janice nor Maxine claimed that Morse deceived them into paying him more money when the project took longer than anticipated. ***

122 The Legal Environment of Business Part II

Robbery [6-4d] Robbery is a larceny with two additional elements: (1) the property is taken directly from the victim or in the immediate presence of the victim and (2) the act is accomplished through either force or the threat of force. The defendant’s force or threat of force need not be against the person from whom the property is taken. For example, a robber threatens Sam that unless Sam opens his employer’s safe, the robber will shoot Maria.

Many statutes distinguish between simple robbery and aggravated robbery. Robbery can be aggravated by any of several factors, including (1) robbery with a deadly weapon, (2) robbery where the robber has the intent to kill or would kill if faced with resistance, (3) robbery that involves serious bodily injury, or (4) rob- bery by two or more persons.

Burglary [6-4e] At common law, burglary was defined as breaking and entering the dwelling of another at night with the intent to commit a felony. Modern statutes differ from the common law definition. Many of them simply re- quire that there be (1) an entry (2) into a building (3) with the intent to commit a felony in the building. Nevertheless, the modern statutes vary so greatly it is nearly impossible to generalize.

Extortion and Bribery [6-4f] Although extortion and bribery are frequently con- fused, they are two distinct crimes. Extortion, or black- mail as it is sometimes called, is generally held to be the making of threats for the purpose of obtaining money or property. For example, Lindsey tells Jason that unless Jason pays her $10,000, she will tell Jason’s customers that Jason was once arrested for disturbing the peace. Lindsey has committed the crime of

extortion. In a few jurisdictions, however, the crime of extortion occurs only if the defendant actually causes the victim to relinquish money or property.

Bribery, on the other hand, is the offer of money or property to a public official to influence the official’s decision. The crime of bribery is committed when the illegal offer is made, whether accepted or not. Thus, if Andrea offered Edward, the mayor of Allentown, a 20 percent interest in Andrea’s planned real estate develop- ment if Edward would use his influence to have the de- velopment proposal approved, Andrea would be guilty of criminal bribery. In contrast, if Edward had threat- ened Andrea that unless he received a 20 percent inter- est in Andrea’s development, he would use his influence to prevent the approval of the development, Edward would be guilty of criminal extortion. Bribery of for- eign officials is covered by the Foreign Corrupt Prac- tices Act, discussed in Chapters 39 and 46.

Some jurisdictions have gone beyond the traditional bribery law to adopt statutes that make commercial bribery illegal. Commercial bribery is the use of bribery to acquire new business, obtain secret information or processes, or obtain kickbacks.

Forgery [6-4g] Forgery is the intentional falsification or false making of a document with the intent to defraud. Accordingly, if William prepares a false certificate of title to a stolen automobile, he is guilty of forgery. Likewise, if an indi- vidual alters some receipts to increase her income tax deductions, she has committed the crime of forgery. The most common type of forgery is the signing of another’s name to a financial document.

Bad Checks [6-4h] All jurisdictions have enacted laws making it a crime to issue bad checks; that is, writing a check when

To sustain a conviction, each element of an offense must be supported by evidence. [Citation.] Theft by deception is a specific intent crime, and therefore, the State was required to prove beyond a reasonable doubt that Morse had the specific intent to defraud the Heffrons when he agreed to remodel the bath- room. Here the evidence offered by the State “is so insubstantial and insufficient, and of such slight probative value, that it is not proper to make a finding beyond a reasonable doubt that [Morse]

committed all of the acts constituting the elements of the offense[.]”

INTERPRETATION An essential element of a crime is the mental intent (mens rea) to commit the crime.

CRITICAL THINKING QUESTION When should circumstantial evidence be permitted to prove a crime has been committed? Explain.

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there is not enough money in the account to cover the check. Most jurisdictions simply require that the check be issued; they do not require that the issuer receive anything in return for the check. Also, though most

jurisdictions require that defendants issue a check with knowledge that they do not have enough money to cover the check, a few jurisdictions require only that there be insufficient funds.

G O I N G G L O B A L What about international bribery?

In 1977, Congress enacted theForeign Corrupt Practices Act (FCPA) prohibiting any U.S. person, and certain foreign issuers of secur- ities, from bribing foreign govern- ment or political officials to assist in obtaining or retaining business. Since 1998, the antibribery provisions also apply to foreign firms and persons who take any act in furtherance of such a corrupt payment while in the United States. The FCPA makes it un- lawful for any U.S. person, and cer- tain foreign issuers of securities, or any of its officers, directors, employ- ees, or agents to offer or give any- thing of value directly or indirectly to any foreign official, political party, or political official for the purpose of (1) influencing any act or decision of that person or party in his or its offi- cial capacity, (2) inducing an act or omission in violation of his or its law- ful duty, or (3) inducing such person or party to use his or its influence to affect a decision of a foreign govern- ment to assist the person in obtain- ing or retaining business. An offer or promise to make a prohibited pay- ment is a violation even if the offer is not accepted or the promise is not

performed. The 1988 amendments to the FCPA explicitly excluded rou- tine government actions not in- volving the discretion of the official, such as obtaining permits or process- ing applications. This exclusion does not cover any decision by a foreign official whether, or on what terms, to award new business or to continue business with a particular party. The amendments also added an affirma- tive defense for payments that are lawful under the written laws or regulations of the foreign official’s country.

Violations can result in fines of up to $2 million for corporations and other business entities; individ- uals may be fined a maximum of $100,000 or imprisoned up to five years, or both. Moreover, under the Alternative Fines Act, the actual fine may be up to twice the benefit that the person sought to obtain by making the corrupt payment. Fines imposed upon individuals may not be paid directly or indirectly by the corporation or other business entity on whose behalf the individ- uals acted. In addition, the courts may impose civil penalties of up to

$16,000, as adjusted for inflation in March 2013.

In 1997 the United States signed the Organisation for Economic Co- operation and Development Conven- tion on Combating Bribery of Foreign Public Officials in International Busi- ness Transactions (OECD Convention). The OECD Convention has been adopted by at least forty nations. In 1998 Congress enacted the Inter- national Anti-Bribery and Fair Com- petition Act of 1998 to conform the FCPA to the OECD Convention. The 1998 Act expands the FCPA to include (1) payments made to “secure any improper advantage” from foreign officials, (2) all foreign persons who commit an act in furtherance of a for- eign bribe while in the United States, and (3) officials of public interna- tional organizations within the defi- nition of a “foreign official.” A public international organization is defined as either an organization designated by executive order pursuant to the International Organizations Immun- ities Act or any other international organization designated by executive order of the President.

L O U I S I A N A V . H A M E D C o u r t o f A p p e a l o f L o u i s i a n a , F o u r t h C i r c u i t , 2 0 1 4

1 4 7 S o . 3 d 1 1 9 1

FACTS The defendant, Zuhair Hamed, was charged with issuing a worthless check in the amount of fifteen hundred dollars or more. On September 18, 2007, Little

Castro, L.L.C. (doing business as Discount City) entered into a credit sales agreement with fuel supplier, Ballard Petroleum, Inc. Ballard Petroleum agreed to provide

124 The Legal Environment of Business Part II

fuel, and Discount City would pay the obligation within ten days from the date of the invoice or next load. Ameer Hamed, the defendant’s son, personally guaran- teed payment on behalf of his establishment, Discount City. The defendant was listed as a contact on the credit application filed by his son.

During October of 2007, Ballard Petroleum made six fuel deliveries in a twelve-day period. However, the checks for those deliveries totaling approximately $126,000 were returned for nonsufficient funds (NSF). On November 1, 2007, the defendant rode with Mr. Jim Ballard, the owner of Ballard Petroleum, to the bank, where the defendant issued Mr. Ballard a cashier’s check in the amount of $126,061.30 to cover the returned checks. On the next day, another NSF check in the amount of $20,597.08 was returned to Ballard Petroleum. The check, dated October 26, 2007, was for a fuel delivery on October 16, 2007.

The defendant was not a member of Silwady’s Group L.L.C., the listed account holder on the check. Also, the defendant was not a member of Little Castro, L.L.C. (Discount City). Thus, the defendant was acting as an agent for these businesses.

In an effort to resolve the matter, Mr. Ballard made several attempts to contact the defendant, but he was unable to reach him. On November 6, 2007, pursuant to instruction from the Worthless Check Division of the District Attorney’s office, Ballard Petroleum sent a certi- fied letter notifying Discount City of the dishonored check. In response to the letter, the defendant acknowl- edged the debt and advised Mr. Ballard that he would reimburse him. By April of 2009, after the District Attorney’s office became involved, the defendant paid $7,000.00 towards the balance. There were no addi- tional payments made, and charges were eventually filed against the defendant in October of 2011.

The defendant pled not guilty at arraignment. After a motions hearing, the trial court found no probable cause to substantiate the charges. The defendant subsequently waived his right to a jury trial and elected to proceed with a bench trial. At the conclusion of trial, the trial court found the defendant guilty as charged. The trial court denied all post-verdict motions, and the defendant was sentenced to four years in the Department of Cor- rections, suspended, with four years of active probation, as well as a $1,000.00 fine, court costs, and restitution costs. After a hearing, the magistrate court ordered the defendant to pay $13,626.08 in restitution. The defend- ant appealed.

DECISION The Court of Appeal reversed the defend- ant’s conviction and sentence, holding that evidence was insufficient.

OPINION Belsome, J. The defendant first argues that the evidence was insufficient for a rational trier of fact to find that the elements of the crime of issuing worthless checks were proven beyond a reasonable doubt.

The court in [citation] recognized the elements required to convict a defendant for issuing a worthless check as follows:

Under [Louisiana Statute], to obtain a conviction for issuing of a worthless check the state is required to prove beyond a reasonable doubt that: (1) defendant issued, in exchange for anything of value, whether the exchange is contemporane- ous or not; (2) a check, draft or order for the payment of money upon any bank or other depository; (3) knowing at the time of the issuing that the account on which drawn has insufficient funds with the financial institution on which the check is drawn to have the instrument paid in full on presentation; and (4) the instrument was issued with intent to defraud.

The proper inquiry under [the Louisiana statute] is whether a defendant knew that he had not sufficient credit with the bank, not whether his actual monetary balance was sufficient to cover a check, draft or order for payment issued by him. [Citation.]

In this case, the knowledge element is lacking. The State points to two facts to support its argument that the knowledge element was met: 1) the multitude of NSF checks written to the victim before and after the date of the check at issue; and 2) the defendant’s ac- knowledgment that he owed the debt and would reim- burse Ballard Petroleum.

First, there is no evidence in the record that the de- fendant knew there were insufficient funds in the bank on August 26, 2007. While Mr. Ballard testified that he went to the bank with the defendant, who issued him a cashier’s check for the returned checks on November 1, 2007; this took place after the checks had already been written. Thus, it does not serve to establish that the de- fendant had knowledge of the insufficient funds at the time the checks were written. Likewise, the defendant’s acknowledgement of the debt after he received the certi- fied letter does not prove the defendant’s knowledge at the time the check was issued.

*** this was not the defendant’s personal (or business) account. Significantly, the account holder, here, was Silwady’s Group, a limited liability company that was not owned by the defendant [but did involve the defendant’s son]. Thus, it is reasonable to conclude that the defendant was merely an agent, who was directed to write checks without knowledge of the status of the account. The fact that he continually attempted to reimburse Ballard Petro- leum supports this conclusion. Under these circumstances, presenting account records alone is insufficient to prove the defendant’s knowledge.

Chapter 6 Criminal Law 125

DEFENSES TO CRIMES [6-5] Even though a defendant is found to have committed a criminal act, he will not be convicted if he has a valid defense. The defenses most relevant to white-collar crimes and crimes against business include defense of property, duress, mistake of fact, and entrapment. In some instances, a defense proves the absence of a re- quired element of the crime; other defenses provide a justification or excuse that bars criminal liability.

Defense of Person or Property [6-5a] Individuals may use reasonable force to protect them- selves, other individuals, and their property. This defense enables a person to commit, without any criminal liabil- ity, what otherwise would be considered the crime of assault, battery, manslaughter, or murder. Under the ma- jority rule, deadly force is never reasonable to protect property because life is deemed more important than the protection of property. For this reason, individuals can- not use a deadly mechanical device, such as a spring gun, to protect their property. If, however, the defender’s use of reasonable force in protecting his property is met with an attack upon his person, he then may use deadly force if the attack threatens him with death or serious bodily harm.

Duress [6-5b] A person who is threatened with immediate, serious bodily harm to himself or another unless he engages in criminal activity has the valid defense of duress (some- times referred to as compulsion or coercion) to criminal conduct other than murder. For example, Ann threat- ens to kill Ben if Ben does not assist her in committing larceny. Ben complies. Because of duress, he would not be guilty of the larceny.

Mistake of Fact [6-5c] If a person reasonably believes the facts surrounding an act to be such that his conduct would not constitute a crime, then the law will treat the facts as he reasonably believes them to be. Accordingly, an honest and reason- able mistake of fact will justify the defendant’s conduct. For example, if Ann gets into a car that she reasonably believes to be hers—the car is the same color, model, and year as hers; is parked in the same parking lot; and is started by her key—she will be relieved of criminal responsibility for taking Ben’s automobile.

Entrapment [6-5d] The defense of entrapment arises when a law enforce- ment official induces a person to commit a crime when that person would not have done so without the persua- sion of the police official. The rationale behind the rule, which applies only to government officials and agents, not to private individuals, is to prevent law enforcement officials from provoking crime and from engaging in improper conduct.

CRIMINAL PROCEDURE [6-6] Each of the states and the federal government have procedures for initiating and coordinating criminal prosecutions. In addition, the first ten amendments to the U.S. Constitution (called the Bill of Rights) guar- antee many defenses and rights of an accused. The Fourth Amendment prohibits unreasonable searches and seizures to obtain incriminating evidence. The Fifth Amendment requires indictment by a grand jury for capital crimes, prevents double jeopardy, protects against self-incrimination, and prohibits deprivation of life or liberty without due process of law. The Sixth

The record fails to provide sufficient evidence for a rational trier of fact to conclude that defendant had the knowledge that Silwady Group did not have sufficient funds with the bank for payment of the check when he signed it. [Citation.] Accordingly, we find that the evi- dence was legally insufficient to convict the defendant of issuing worthless checks. In light of this conclusion, we pretermit any discussion of the defendant’s remain- ing assignments of error.

INTERPRETATION Under the Louisiana statute the offense of issuing a bad check requires that the defend- ant knew that he had not sufficient credit with the bank, not whether his actual monetary balance was sufficient to cover a check, draft or order for payment issued by him.

CRITICAL THINKING QUESTION What elements do you believe are essential to a bad check law? Explain.

126 The Legal Environment of Business Part II

Amendment requires that an accused receive a speedy and public trial by an impartial jury and that he be informed of the nature of the accusation, be con- fronted by the witnesses who testify against him, be given the power to obtain witnesses in his favor, and have the right to competent counsel for his defense. The Eighth Amendment prohibits excessive bail, exces- sive fines, and cruel or unusual punishment.

Most state constitutions have similar provisions to protect the rights of accused persons. In addition, the Fourteenth Amendment prohibits state governments from depriving any person of life, liberty, or property without due process of law. Moreover, the U.S. Supreme Court has held that most of the constitutional protections just discussed apply to the states through the operation of the Fourteenth Amendment.

Although various jurisdictions may differ in actual operational details, their criminal processes have a number of common objectives. The primary purpose of the process in any jurisdiction is the effective enforcement of the criminal law, but this purpose must be accomplished within the limitations imposed by other goals. These goals include advancing an ad- versary system of adjudication, requiring the govern- ment to bear the burden of proof, minimizing both erroneous convictions and the burdens of defense, respecting individual dignity, maintaining the appear- ance of fairness, and achieving equality in the admin- istration of the process.

We will first discuss the steps in a criminal prosecu- tion; we will then focus on the major constitutional pro- tections for the accused in our system of criminal justice.

Steps in Criminal Prosecution [6-6a] Although the particulars of criminal procedure vary from state to state, the following provides a basic overview of the steps in criminal prosecution. After arrest, the accused is booked and appears before the magistrate, commissioner, or justice of the peace, where he is given formal notice of the charges and is advised of his rights and where bail is set. Next, a preliminary hearing is held to determine whether there is probable cause to believe the defendant is the one who committed the crime. The defendant is usually entitled to be represented by counsel.

If the magistrate concludes that there is probable cause, she will bind the case over to the next stage, which is either an indictment or information, depending upon the jurisdiction. The federal system and about one-third of the states require indictments for all felony prosecutions (unless waived by the defendant), while

the other states permit, but do not mandate, indict- ments. A grand jury issues an indictment or true bill if it finds sufficient evidence to justify a trial on the charge brought. The grand jury, which traditionally consists of no fewer than sixteen and no more than twenty-three people, is not bound by the magistrate’s decision at the preliminary hearing. Unlike the prelimi- nary hearing, the grand jury does not hear evidence from the defendant, nor does the defendant appear before the grand jury. In contrast, an information is a formal accusation of a crime brought by a prosecuting officer, not a grand jury. Such a procedure is used in misdemeanor cases and in some felony cases in those states that do not require indictments. The indictment or information at times precedes the actual arrest.

At the arraignment, the defendant is brought before the trial court, where he is informed of the charge against him and where he enters his plea. The arraign- ment must be held promptly after the indictment or in- formation has been filed. If his plea is “not guilty,” the defendant must stand trial. He is entitled to a jury trial for all felonies and for misdemeanors punishable by more than six months’ imprisonment. Most states also permit a defendant to request a jury trial for lesser mis- demeanors. If the defendant chooses, however, he may have his guilt or innocence determined by the court sit- ting without a jury, which is called a “bench trial.”

In the great majority of criminal cases, defendants enter into a plea bargain with the government instead of going to trial. In a 2012 case, the U.S. Supreme Court stated, “Ninety-seven percent of federal convictions and ninety-four percent of state convictions are the result of guilty pleas.”

A criminal trial is similar to a civil trial, but there are some significant differences: (1) the defendant is presumed innocent, (2) the burden of proof on the prosecution is to prove criminal guilt beyond a reasona- ble doubt (proof that is entirely convincing, satisfied to a moral certainty), and (3) the defendant is not required to testify. The trial begins with the selection of the jury and the opening statements by the prosecutor and the attorney for the defense. The prosecution presents evi- dence first; then the defendant presents his evidence. At the conclusion of the testimony, closing statements are made and the jury is instructed as to the applicable law and retires to arrive at a verdict. If the verdict is “not guilty,” the matter ends there. The state has no right to appeal from an acquittal; and the accused, having been placed in “jeopardy,” cannot be tried a second time for the same offense. If the verdict is “guilty,” the judge will enter a judgment of conviction and set the case for

Chapter 6 Criminal Law 127

sentencing. The defendant may make a motion for a new trial, asserting that prejudicial error occurred at his original trial, thus requiring a retrial of the case. He may appeal to a reviewing court, alleging error by the trial court and asking for either his discharge or a remand of the case for a new trial.

Fourth Amendment [6-6b] The Fourth Amendment, which protects all individuals against unreasonable searches and seizures, is designed to guard the privacy and security of individuals against arbitrary invasions by government officials. Although the Fourth Amendment by its terms applies only to acts of the federal government, the Fourteenth Amendment makes it applicable to state government actions as well.

When a violation of the Fourth Amendment has occurred, the general rule prohibits the introduction of the illegally seized evidence at trial. The purpose of this exclusionary rule is to discourage illegal police conduct and to protect individual liberty, not to hinder the search for the truth. Nonetheless, in recent years the Supreme Court has limited the exclusionary rule.

To obtain a warrant to search a particular person, place, or thing, a law enforcement official must dem- onstrate to a magistrate that he has probable cause to believe that the search will reveal evidence of criminal activity. Probable cause means “[t]he task of the issu- ing magistrate is simply to make a practical, common- sense decision whether, given all the circumstances set forth … before him, … there is a fair probability that contraband or evidence of a crime will be found in a particular place.” Illinois v. Gates, 462 U.S. 213 (1983). Even though the Fourth Amendment requires that a search and seizure generally be made after a valid search warrant has been obtained, in some instances a search warrant is not necessary. For exam- ple, it has been held that a warrant is not necessary when (1) there is hot pursuit of a fugitive, (2) the sub- ject of the search voluntarily consents, (3) an emer- gency requires such action, (4) there has been a lawful arrest, (5) evidence of a crime is in plain view of the law enforcement officer, or (6) delay would present a significant obstacle to the investigation.

Fifth Amendment [6-6c] The Fifth Amendment protects persons against self- incrimination, double jeopardy, and being charged with a capital or infamous crime except by grand jury

indictment. The prohibitions against self-incrimination and double jeopardy also apply to the states through the Due Process Clause of the Fourteenth Amendment; however, the grand jury clause does not.

The privilege against self-incrimination extends only to testimonial evidence, not to physical evidence. The Fifth Amendment privilege “protects an accused only from being compelled to testify against himself, or otherwise provide the state with evidence of a testimo- nial or communicative nature.” Therefore, a person can be forced to stand in an identification lineup, provide a handwriting sample, or take a blood test. Significantly, the Fifth Amendment does not protect the records of a business entity, such as a corporation or partnership; it applies only to papers of individuals. Moreover, the Fifth Amendment does not prohibit examination of an individual’s business records as long as the individual is not compelled to testify against himself.

The Fifth Amendment and the Fourteenth Amend- ment also guarantee due process of law, which is basi- cally the requirement of a fair trial. All persons are entitled to have the charges or complaints against them made publicly and in writing, whether in civil or crimi- nal proceedings, and are to be given the opportunity to defend themselves against such charges. In criminal prosecutions, due process includes the right to counsel, to confront and cross-examine adverse witnesses, to testify in one’s own behalf if desired, to produce wit- nesses and offer other evidence, and to be free from any and all prejudicial conduct and statements.

PRACTICAL ADVICE A defendant has the right not to testify against himself, and a jury cannot consider this against him.

Sixth Amendment [6-6d] The Sixth Amendment provides that the federal gov- ernment shall provide the accused with a speedy and public trial by an impartial jury, inform him of the nature and cause of the accusation, confront him with the witnesses against him, have compulsory process for obtaining witnesses in his favor, and allow him to obtain the assistance of counsel for his defense. The Fourteenth Amendment extends these guarantees to the states.

See Concept Review 6-2 for a presentation of the constitutional protections provided the defendant in a criminal action.

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C H A P T E R S U M M A R Y

Nature of Crimes

Definition any act or omission forbidden by public law

Essential Elements • Actus reus wrongful or overt act • Mens rea criminal intent or mental fault • Felony a serious crime • Misdemeanor a less serious crime

Classification

Vicarious Liability liability imposed for acts of his or her employees if the employer directed, participated in, or approved of the acts

Liability of a Corporation under certain circumstances a corporation may be convicted of crimes and punished by fines

White-Collar Crime

Definition nonviolent crime involving deceit, corruption, or breach of trust

Computer Crime use of a computer to commit a crime

Racketeer Influenced and Corrupt Organizations Act federal law intended to stop organized crime from infiltrating legitimate businesses

Crimes Against Business

Larceny trespassory taking and carrying away of personal property of another with the intent to deprive the victim permanently of the property

CONCEPT REVIEW 6-2 C O N S T I T U T I O N A L P R O T E C T I O N F O R T H E C R I M I N A L D E F E N D A N T

Amendment Protection Conferred

Fourth Freedom from unreasonable search and seizure

Fifth Right to due process Right to indictment by grand jury for capital crimes* Freedom from double jeopardy Freedom from self-incrimination

Sixth Right to speedy, public trial by jury Right to be informed of accusations Right to present witnesses Right to competent counsel

Eighth Freedom from excessive bail Freedom from cruel and unusual punishment

* This right has not been applied to the states through the Fourteenth Amendment.

Chapter 6 Criminal Law 129

Embezzlement taking of another’s property by a person who was in lawful possession of the property

False Pretenses obtaining title to property of another by means of representations one knows to be materially false, made with intent to defraud

Robbery committing larceny with the use or threat of force

Burglary under most modern statutes, an entry into a building with the intent to commit a felony

Extortion the making of threats to obtain money or property

Bribery offering money or property to a public official to influence the official’s decision

Forgery intentional falsification of a document in order to defraud

Bad Checks knowingly issuing a check without funds sufficient to cover the check

Defenses to Crimes

Defense of Person or Property individuals may use reasonable force to protect themselves, other individuals, and their property

Duress coercion by threat of serious bodily harm is a defense to criminal conduct other than murder

Mistake of Fact honest and reasonable belief that conduct is not criminal is a defense

Entrapment inducement by a law enforcement official to commit a crime is a defense

Criminal Procedure

Steps in Criminal Prosecution generally include arrest, booking, formal notice of charges, preliminary hearing to determine probable cause, indictment or information, arraignment, and trial

Fourth Amendment protects individuals against unreasonable searches and seizures

Fifth Amendment protects persons against self-incrimination, double jeopardy, and being charged with a capital crime except by grand jury indictment

Sixth Amendment provides the accused with the right to a speedy and public trial, the opportunity to confront witnesses, have compulsory process for obtaining witnesses, and the right to counsel

Q U E S T I O N S

1. Sam said to Carol, “Kim is going to sell me a good used car next Monday and then I’ll deliver it to you in exchange for your computer but I’d like to have the com- puter now.” Relying on this statement, Carol delivered the computer to Sam. Sam knew Kim had no car and would have none in the future, and he had no such arrangement with her. The appointed time of exchange passed, and Sam failed to deliver the car to Carol. Has a crime been committed? Discuss.

2. Sara, a lawyer, drew a deed for Robert by which Robert was to convey land to Rick. The deed was correct in every detail. Robert examined and verbally approved it but did not sign it. Then Sara erased Rick’s name and substituted her own. Robert subsequently signed the deed with all required legal formalities without noticing the change. Was Sara guilty of forgery? Discuss.

3. Ann took Bonnie’s watch without Bonnie knowing of the theft. Bonnie subsequently discovered her loss and was informed that Ann had taken the watch. Bonnie immedi- ately pursued Ann. Ann pointed a loaded pistol at Bon- nie, who, in fear of being shot, allowed Ann to escape. Was Ann guilty of robbery? Of any other crime?

4. Jones and Wilson were on trial, separately, for larceny of a $10,000 bearer bond (payable to the holder of the bond, not a named individual) issued by Brown, Inc. The commonwealth’s evidence showed that the owner of the bond put it in an envelope bearing his name and address and dropped it accidentally in the street; that Jones found the envelope with the bond in it; that Jones could neither read nor write; that Jones presented the envelope and bond to Wilson, an educated man, and asked Wilson what he should do with it; that Wilson told Jones that

130 The Legal Environment of Business Part II

the finder of lost property becomes the owner of it; that Wilson told Jones that the bond was worth $1,000 but that the money could be collected only at the issuer’s home office; that Jones then handed the bond to Wilson, who redeemed it at the corporation’s home office and received $10,000; that Wilson gave Jones $1,000 of the proceeds. What rulings?

5. Truck drivers for a hauling company, while loading a desk, found a $100 bill that had fallen out of the desk. They agreed to get it exchanged for small bills and divide the proceeds. En route to the bank, one of them changed his mind and refused to proceed with the scheme, where- upon the other pulled a knife and demanded the bill. A police officer intervened. What crimes have been committed?

6. Peter, an undercover police agent, was trying to locate a laboratory where it was believed that methamphetamine, or “speed”—a controlled substance—was being manufac- tured illegally. Peter went to Mary’s home and said that he represented a large organization that was interested in obtaining methamphetamine. Peter offered to supply a necessary ingredient for the manufacture of the drug, which was very difficult to obtain, in return for one-half of the drug produced. Mary agreed and processed the chemical given to her by Peter in Peter’s presence. Later Peter returned with a search warrant and arrested Mary. Mary was charged with various narcotics law violations. Mary asserted the defense of entrapment. Should Mary prevail? Why?

7. The police obtained a search warrant based on an affida- vit that contained the following allegations: (a) Donald was seen crossing a state line on four occasions during a five-day period and going to a particular apartment,

(b) telephone records disclosed that the apartment had two telephones, (c) Donald had a reputation as a book- maker and as an associate of gamblers, and (d) the Fed- eral Bureau of Investigation was informed by a “confidential reliable informant” that Donald was con- ducting gambling operations from the apartment. The af- fidavit did not indicate how the informant knew of this information, nor did it contain any information about the reliability of the informant. When a search was made based on the warrant, evidence was obtained that resulted in Donald’s conviction of violating certain gam- bling laws. Donald challenged the constitutionality of the search warrant. Were Donald’s constitutional rights vio- lated? Explain your answer.

8. A national bank was robbed by a man with a small strip of tape on each side of his face. An indictment was returned against David. David was then arrested, and counsel was appointed to represent him. Two weeks later, without notice to David’s lawyer, an agent with the Federal Bureau of Investigation arranged to have the two bank employees observe a lineup, including David and five or six other prisoners. Each person in the lineup wore strips of tape, as had the robber, and each was directed to repeat the words “Put the money in the bag,” as had the robber. Both of the bank employees identified David as the robber. At David’s trial he was again identified by the two, in the courtroom, and the prior lineup identification was elicited on cross-examination by David’s counsel. David’s counsel moved the court to grant a judgment of acquittal or alternatively to strike the courtroom identifications on the ground that the lineup had violated David’s Fifth Amendment privilege against self-incrimination and his Sixth Amendment right to counsel. Decision?

C A S E P R O B L E M S

9. Waronek owned and operated a trucking rig, transporting goods for L.T.L. Perishables, Inc., of St. Paul, Minnesota. He accepted an offer to haul a trailer load of beef from Illini Beef Packers, Inc., in Joslin, Illinois, to Midtown Packing Company in New York City. After his truck was loaded with ninety-five forequarters and ninety-five hind- quarters of beef in Joslin, Waronek drove north to his home in Watertown, Wisconsin, rather than east to New York. While in Watertown, he asked employees of the Royal Meat Company to butcher and prepare four hind- quarters of beef—two for himself and two for his friends. He also offered to sell ten hindquarters to one employee of the company at an alarmingly reduced rate. The suspi- cious employee contacted the authorities, who told him to proceed with the deal. When Waronek arrived in New York with his load short nineteen hindquarters, Waronek

telephoned L.T.L. Perishables in St. Paul. He notified them “that he was short nineteen hindquarters, that he knew where the beef went, and that he would make good on it out of future settlements.” L.T.L. told him to contact the New York police, but he failed to do so. Shortly there- after, he was arrested by the Federal Bureau of Investiga- tion and indicted for the embezzlement of goods moving in interstate commerce. Explain whether Waronek was guilty of the crime of embezzlement.

10. Four separate cases involving similar fact situations were consolidated because they presented the same constitu- tional question. In each case, police officers, detectives, or prosecuting attorneys took a defendant into custody and interrogated him in a police station to obtain a confession. In none of these cases did the officials fully and effectively

Chapter 6 Criminal Law 131

advise the defendant of his rights at the outset of the inter- rogation. The interrogations produced oral admissions of guilt from each defendant, as well as signed statements from three of them, which were used to convict them at their trials. The defendants appealed, arguing that the offi- cials should have warned them of their constitutional rights and the consequences of waiving them before the questioning began. It was contended that to permit any statements obtained without such a warning violated their Fifth Amendment privilege against self-incrimination. Were the defendants’ constitutional rights violated? Discuss.

11. Officer Cyril Rombach of the Burbank Police Department, an experienced and well-trained narcotics officer, applied for a warrant to search several residences and automobiles for cocaine, methaqualone, and other narcotics. Rombach supported his application with information given to another police officer by a confidential informant of unproven reli- ability. He also based the warrant application on his own observations made during an extensive investigation: known drug offenders visiting the residences and leaving with small packages, as well as a suspicious trip to Miami by two of the suspects. A state superior court judge in good faith issued a search warrant to Rombach based on this informa- tion. Rombach’s searches netted large quantities of drugs

and other evidence, which produced indictments of several suspects on charges of conspiracy to possess and distribute cocaine. The defendants moved to suppress the evidence on the grounds that the search warrant was defective in that Rombach had failed to establish the informant’s credi- bility. Should the evidence be excluded, or can it be placed into evidence since the police and courts acted in good faith? Why?

12. On February 10, Kelm secured a loan for $6,000 from Ms. Joan Williams. Kelm told Williams that the loan was to finance a real estate transaction. Five days later, Ms. Williams received a check drawn by Kelm in the amount of $6,000 from Kelm’s attorney. Although the check was dated February 15, Kelm claims that she delivered the check to her attorney on February 10. The following week, Ms. Williams learned the check was uncollectible. Subsequently, Williams received assurances from Kelm but was unsuccessful in her efforts to obtain money from the drawee’s bank. When Williams deposited the check, it was returned with a notation that it should not be pre- sented again and that no account was on file. Bank records show that the account was closed on March 8 and that it had negative balances since February 10. Did Kelm illegally issue a bad check? Explain.

T A K I N G S I D E S

Olivo was in the hardware area of a department store. A security guard saw him look around, take a set of wrenches, and conceal it in his clothing. Olivo looked around once more and proceeded toward an exit, passing several cash registers. The guard stopped him short of the exit.

a. What argument would support the prosecutor in finding Olivo guilty of larceny?

b. What argument would you make as Olivio’s defense counsel for finding him not guilty of larceny?

c. Which side’s argument do you find most convincing? Explain.

132 The Legal Environment of Business Part II

C H A P T E R 7

INTENTIONAL TORTS

Torts are infinitely various, not limited or confined, for there is nothing in nature but may be an instrument for mischief. CHARLES PRATT, QUOTED IN THE GUIDE TO AMERICAN LAW, VOL. 10

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Identify and describe the torts that protect against intentional harm to personal rights.

2. Explain the application of the various privileges to defamation suits and how they are affected by whether the plaintiff is (a) a public figure, (b) a public official, or (c) a private person.

3. Describe and distinguish the four torts comprising invasion of privacy.

4. Identify and describe the torts that protect against harm to property.

5. Distinguish among interference with contractual relations, disparagement, and fraudulent misrepresentation.

A ll forms of civil liability are either (1) voluntar- ily assumed, as by contract, or (2) involuntarily assumed, as imposed by law. Tort liability is

of the second type. Tort law gives persons relief from civil wrongs or injuries to their persons, property, and economic interests. Examples include assault and bat- tery, automobile accidents, professional malpractice, and products liability. This law has three principal objectives: (1) to compensate persons who sustain harm or loss resulting from another’s conduct, (2) to place the cost of that compensation only on those parties who should bear it, and (3) to prevent future harms and losses. Thus, the law of torts reallocates losses caused by human misconduct. In general, a tort is com- mitted when (1) a duty owed by one person to another

(2) is breached, (3) proximately causing (4) injury or damage to the owner of a legally protected interest.

Each person is legally responsible for the damages proximately caused by his tortious conduct. Moreover, as discussed in Chapter 29, businesses that conduct their business activities through employees are also liable for the torts their employees commit in the course of em- ployment. The tort liability of employers makes the study of tort law essential to business managers.

Injuries may be inflicted intentionally, negligently, or without fault (strict liability). We will discuss intentional torts in this chapter and cover negligence and strict lia- bility in Chapter 8.

The same conduct may, and often does, constitute both a crime and a tort. For example, let us assume

133

that Johnson has committed an assault and battery against West. For the commission of this crime, the state may take appropriate action against Johnson. In addition, Johnson has violated West’s right to be secure in his person, and so has committed a tort against West. Regardless of the criminal action brought by the state against Johnson, West may bring a civil tort action against Johnson for damages. But an act may be criminal without being tortious; by the same token, an act may be a tort but not a crime.

In a tort action, the injured party sues to recover compensation for the injury sustained as a result of the defendant’s wrongful conduct. The purpose of tort law, unlike criminal law, is to compensate the injured party, not to punish the wrongdoer. In certain cases,

however, courts may award exemplary or punitive damages, which are damages over and above the amount necessary to compensate the plaintiff. In cases in which the defendant’s tortious conduct has been intentional—or in some states, reckless—and outra- geous, showing malice or a fraudulent or evil motive, most courts permit a jury to award punitive damages. The allowance of punitive damages is designed to pun- ish and make an example of the defendant and thus deter the defendant and others from similar conduct.

PRACTICAL ADVICE When bringing a lawsuit for an intentional tort, consider whether it is appropriate to ask for punitive damages.

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5 4 9 U . S . 3 4 6 , 1 2 7 S . C t . 1 0 5 7 , 1 6 6 L . E d . 2 d 9 4 0

FACTS This lawsuit arises out of the death of Jesse Williams, a heavy cigarette smoker. Williams’ widow rep- resents his estate in this state lawsuit for negligence and deceit against Philip Morris, the manufacturer of Marl- boro, the brand that Williams smoked. A jury found that Williams’ death was caused by smoking, that Williams smoked in significant part because he thought it was safe to do so, and that Philip Morris knowingly and falsely led him to believe that this was so. The jury found that both Philip Morris and Williams were negligent and that Philip Morris had engaged in deceit. In respect to deceit, it awarded compensatory damages of about $821,000 along with $79.5 million in punitive damages.

The trial judge subsequently found the $79.5 million punitive damages award “excessive” and reduced it to $32 million. Both sides appealed. The Oregon Court of Appeals rejected Philip Morris’ arguments and restored the $79.5 million jury award. Subsequently, the Oregon Supreme Court rejected Philip Morris’ arguments that the trial court should have instructed the jury that it could not punish Philip Morris for injury to persons not before the court and that the roughly 100:1 ratio of the $79.5 million punitive damages award to the compensa- tory damages amount was “grossly excessive.”

The U.S. Supreme Court granted Philip Morris certio- rari on its claims that (1) Oregon had unconstitutionally permitted it to be punished for harming nonparty victims and (2) Oregon had in effect disregarded “the constitu- tional requirement that punitive damages be reasonably related to the plaintiff’s harm.”

DECISION The Oregon Supreme Court’s judgment is vacated, and the case is remanded.

OPINION Breyer J. This Court has long made clear that “punitive damages may properly be imposed to fur- ther a State’s legitimate interests in punishing unlawful conduct and deterring its repetition.” [Citations.] At the same time, we have emphasized the need to avoid an arbitrary determination of an award’s amount. Unless a State insists upon proper standards that will cabin the jury’s discretionary authority, its punitive damages sys- tem may deprive a defendant of “fair notice … of the severity of the penalty that a State may impose,” [cita- tion]; it may threaten “arbitrary punishments,” i.e., punishments that reflect not an “application of law” but “a decisionmaker’s caprice,” [citation]; and, where the amounts are sufficiently large, it may impose one State’s (or one jury’s) “policy choice,” say as to the conditions under which (or even whether) certain products can be sold, upon “neighboring States” with different public policies, [citation].

For these and similar reasons, this Court has found that the Constitution imposes certain limits, in respect both to procedures for awarding punitive damages and to amounts forbidden as “grossly excessive.” [Citation] (requiring judicial review of the size of punitive awards); [citation] (review must be de novo); [citation] (excessive- ness decision depends upon the reprehensibility of the defendant’s conduct, whether the award bears a reasona- ble relationship to the actual and potential harm caused

134 The Legal Environment of Business Part II

Tort law is primarily common law, and, as we men- tioned in Chapter 1, the Restatements, prepared by the American Law Institute (ALI), present many important areas of the common law, including torts. You will recall that although they are not law in themselves, the Restatements are highly persuasive in the courts. Since then, the Restatement has served as a vital force in shaping the law of torts. Between 1965 and 1978, the

institute adopted and promulgated a second edition of the Restatement of Torts, which revised and superseded the First Restatement. This text will refer to the second Restatement simply as the Restatement.

In 1996, the ALI approved the development of a new Restatement, called Restatement Third, Torts: Liability for Physical and Emotional Harm, which addresses the general or basic elements of the tort action for liability

by the defendant to the plaintiff, and the difference between the award and sanctions “authorized or imposed in comparable cases”); [citation] (excessiveness more likely where ratio exceeds single digits). Because we shall not decide whether the award here at issue is “grossly excessive,” we need now only consider the Constitution’s procedural limitations.

In our view, the Constitution’s Due Process Clause forbids a State to use a punitive damages award to punish a defendant for injury that it inflicts upon non- parties or those whom they directly represent, i.e., injury that it inflicts upon those who are, essentially, strangers to the litigation.

*** *** [W]e can find no authority supporting the use

of punitive damages awards for the purpose of punish- ing a defendant for harming others. We have said that it may be appropriate to consider the reasonableness of a punitive damages award in light of the potential harm the defendant’s conduct could have caused. But we have made clear that the potential harm at issue was harm potentially caused the plaintiff. [Citation] (“We have been reluctant to identify concrete constitutional limits on the ratio between harm, or potential harm, to the plaintiff and the punitive damages award”) ***

*** Evidence of actual harm to nonparties can help to show that the conduct that harmed the plaintiff also posed a substantial risk of harm to the general public, and so was particularly reprehensible—although counsel may argue in a particular case that conduct resulting in no harm to others nonetheless posed a grave risk to the public, or the converse. Yet for the reasons given above, a jury may not go further than this and use a punitive damages verdict to punish a defendant directly on account of harms it is alleged to have visited on nonparties.

*** We therefore conclude that the Due Process Clause requires States to provide assurance that juries are not asking the wrong question, i.e., seeking, not sim- ply to determine reprehensibility, but also to punish for harm caused strangers.

***

The instruction that Philip Morris said the trial court should have given distinguishes between using harm to others as part of the “reasonable relationship” equation (which it would allow) and using it directly as a basis for punishment. The instruction asked the trial court to tell the jury that “you may consider the extent of harm suffered by others in determining what [the] reasonable relationship is” between Philip Morris’ punishable mis- conduct and harm caused to Jesse Williams, “[but] you are not to punish the defendant for the impact of its alleged misconduct on other persons, who may bring lawsuits of their own in which other juries can resolve their claims.…” [Citation.] And as the Oregon Supreme Court explicitly recognized, Philip Morris argued that the Constitution “prohibits the state, acting through a civil jury, from using punitive damages to punish a defendant for harm to nonparties.” [Citation.]

*** As the preceding discussion makes clear, we believe

that the Oregon Supreme Court applied the wrong con- stitutional standard when considering Philip Morris’ appeal. We remand this case so that the Oregon Supreme Court can apply the standard we have set forth. Because the application of this standard may lead to the need for a new trial, or a change in the level of the punitive damages award, we shall not consider whether the award is constitutionally “grossly excessive.”

INTERPRETATION In most states, a jury may award punitive damages if a defendant’s tortious conduct is intentional and outrageous, but the amount of damages must not be grossly excessive and may not punish the defendant for harm caused to parties other than the plaintiff.

ETHICAL QUESTION Is it ethical to impose punishment in a civil case without the protections pro- vided to defendants in a criminal proceeding? Explain.

CRITICAL THINKING QUESTION Can juries be adequately instructed to make the distinction required by the U.S. Supreme Court? Explain.

Chapter 7 Intentional Torts 135

for accidental personal injury, property damage, and emotional harm but does not cover liability for economic loss. This work replaces comparable provisions in the Restatement Second, Torts. The final work is published in two volumes. Volume 1 was released in 2010 and primarily covers liability for negligence causing physical harm, duty, strict liability, factual cause, and scope of liability (traditionally called proximate cause). Volume 2, published in 2012, covers affirmative duties, emotional harm, land possessors’ liability, and liability of actors who retain independent contractors.

Because this new Restatement applies to noninten- tional torts, it will be covered extensively in the next chapter, and it will be cited as the “Third Restatement.” A few of its provisions, however, do apply to intentional torts and will be included in this chapter. Comment c to Section 5 of the Third Restatement provides that the Second Restatement remains largely authoritative in ex- plaining the details of specific intentional torts and their related defenses. The ALI, however, has begun work on the Restatement Third, Torts: Intentional Torts to Per- sons, which is the latest installment of the ALI’s ongoing revision of the Restatement Second of Torts. This new project will complete the work focusing on recovery for physical and emotional harm to persons.

The Restatement Third, Torts: Economic Torts and Related Wrongs will update coverage on torts that in- volve economic loss or pecuniary harm not resulting from physical harm or physical contact to a person or property. The project will update coverage of economic torts in Restatement Second, Torts and address some

topics not covered in prior Restatements. The ALI began this project in 2004, and after several years of inactivity the project was resumed in 2010. Tentative Draft No. 1 (Chapter 1, Unintentional Infliction of Economic Loss, Sections 1-5) was approved in 2012; Tentative Draft No. 2 (Chapter 1, Unintentional Infliction of Economic Loss, Sections 6-8, and Chapter 2, Liability in Tort for Fraud, Sections 9-15) was approved in 2014.

Intent, as used in tort law, does not require a hostile or evil motive. Rather, it means that the actor desires to cause the consequences of his act or that he believes the consequences are substantially (almost) certain to result from it. (See Figure 7-1, which illustrates intent.) The Third Restatement provides that “[a] person acts with the intent to produce a consequence if: (a) the person acts with the purpose of producing that conse- quence; or (b) the person acts knowing that the conse- quence is substantially certain to result.”

The following examples illustrate the definition of intent: (1) If Mark fires a gun in the middle of the Mojave Desert, he intends to fire the gun; but when the bullet hits Steven, who is in the desert without Mark’s knowledge, Mark does not intend that result. (2) Mark throws a bomb into Steven’s office in order to kill Steven. Mark knows that Carol is in Steven’s office and that the bomb is substantially certain to injure Carol, although Mark has no desire to harm her. Mark is, nonetheless, liable to Carol for any injury caused Carol. Mark’s intent to injure Steven is transferred to Carol.

Infants (persons who have not reached the age of majority, which is eighteen years in almost all states)

FIGURE 7-1 Intent

Does defendant desire to cause consequences?

Yes

No

No

Does defendant believe consequences

are substantially certain to result?

Yes

No Intent

Intent

136 The Legal Environment of Business Part II

are held liable for their intentional torts. The infant’s age and knowledge, however, are critical in determining whether the infant had sufficient intelligence to form the required intent. Incompetents, like infants, are gen- erally held liable for their intentional torts.

Even though the defendant has intentionally in- vaded the interests of the plaintiff, the defendant will not be liable if such conduct was privileged. A defend- ant’s conduct is privileged if it furthers an interest of such social importance that the law grants immunity from tort liability for damage to others. Examples of privilege include self-defense, defense of property, and defense of others. In addition, the plaintiff’s consent to the defendant’s conduct is a defense to intentional torts.

HARM TO THE PERSON [7-1] The law provides protection against harm to the person. Generally, intentional torts to the person entitle the in- jured party to recover damages for bodily harm, emo- tional distress, loss or impairment of earning capacity, and reasonable medical expenses as well as for harm the tortious conduct caused to property or business.

Battery [7-1a] Battery is an intentional infliction of harmful or offen- sive bodily contact. It may consist of contact causing serious injury, such as a gunshot wound or a blow on the head with a club. Or it may involve contact causing little or no physical injury, such as knocking a hat off of a person’s head or flicking a glove in another’s face. Bodily contact is offensive if it would offend a reason- able person’s sense of dignity. Such contact may be accomplished through the use of objects, such as Gus- tav’s throwing a rock at Hester with the intention of hitting her. If the rock hits Hester or any other person, Gustav has committed a battery.

Assault [7-1b] Assault is intentional conduct by one person directed at another that places the other in apprehension of immi- nent (immediate) bodily harm or offensive contact. It is usually committed immediately before a battery, but if the intended battery fails, the assault remains. Assault is essentially a mental rather than a physical intrusion. Accordingly, damages for it may include compensation for fright and humiliation. The person in danger of im- mediate bodily harm must have knowledge of the dan- ger and be apprehensive of its imminent threat to his safety.

False Imprisonment [7-1c] The tort of false imprisonment or false arrest is the act of intentionally confining a person against her will within fixed boundaries if the person is conscious of the confinement or harmed by it. Such restraint may be brought about by physical force, by the threat of physical force, or by force directed against a person’s property. Damages for false imprisonment may include compensation for loss of time, physical discomfort, inconvenience, physical illness, and mental suffering. Merely obstructing a person’s freedom of movement is not false imprisonment so long as a reasonable alterna- tive exit is available.

Merchants occasionally encounter potential liability for false imprisonment when they seek to question a suspected shoplifter. A merchant who detains an inno- cent person may face a lawsuit for false imprisonment. However, most states have statutes protecting the mer- chant, provided she detains the suspect with probable cause, in a reasonable manner, and for not more than a reasonable time.

PRACTICAL ADVICE When detaining a suspected shoplifter, be careful to conform to the limitations of your state’s statutory privilege.

Infliction of Emotional Distress [7-1d] Under the Second and Third Restatements, a person is liable for infliction of emotional distress when that person by extreme and outrageous conduct intention- ally or recklessly causes severe emotional distress to another. The person is liable for that emotional distress and, if the emotional distress causes bodily harm, also for the resulting bodily harm. Recklessness is conduct that evidences a conscious disregard of or an indiffer- ence to the consequences of the act committed. With respect to infliction of emotional distress, the Third Restatement explains that an

actor acts recklessly when the actor knows of the risk of severe emotional disturbance (or knows facts that make the risk obvious) and fails to take a precaution that would elimi- nate or reduce the risk even though the burden is slight rela- tive to the magnitude of the risk, thereby demonstrating the actor’s indifference.

Damages may be recovered for severe emotional distress even in the absence of any physical injury. Liability for infliction of emotional distress, however, arises only when the person seeking recovery has suffered severe emotional disturbance and when a

Chapter 7 Intentional Torts 137

reasonable person in the same circumstances would suffer severe disturbance. Thus, the Third Restate- ment is imposing an objective—not a subjective—test. Accordingly, there is no liability for mental harm suf- fered by an unusually vulnerable plaintiff, unless the defendant knew of the plaintiff’s special vulnerability. Under the “extreme and outrageous” requirement, a person is liable only if the conduct goes beyond the bounds of human decency and would be regarded as

intolerable in a civilized community. Ordinary insults and indignities are not enough for liability to be imposed, even if the person desires to cause emotional disturbance. Examples of this tort include sexual harassment on the job and outrageous and prolonged bullying tactics employed by creditors or collection agencies attempting to collect a debt, or by insurance adjusters trying to force a settlement of an insurance claim.

F E R R E L L V . M I K U L A C o u r t o f A p p e a l s o f G e o r g i a , 2 0 0 8

2 9 5 G a . A p p . 3 2 6 , 6 7 2 S . E . 2 d 7 ; r e c o n s i d e r a t i o n d e n i e d , 2 0 0 8 ; c e r t i o r a r i d e n i e d 2 0 0 9

FACTS On Friday night, August 6, 2006, eighteen- year-old Racquel Ferrell and thirteen-year-old Kristie Ferrell went to Ruby Tuesday. After they ate and paid their bill, the girls left the restaurant, got into their car, and drove out of the parking lot. As they entered the highway, Racquel noticed a black truck following her very closely with its headlights on high. A marked police car by the side of the road pulled onto the high- way between the girls’ car and the following truck and pulled the car over. The officer pulled Racquel out of the car, placed her in handcuffs, and put her in the back seat of his patrol car. Another officer removed Kristie from the car, placed her in handcuffs, and put her in the back of another patrol car.

All of the police officers gathered to talk to the driver of the truck that had been following the Ferrells, who turned out to be a uniformed off-duty police officer working as a security guard for Ruby Tuesday. The offi- cer who arrested Racquel returned to the patrol car where she was being held and told her if she had not paid her Ruby Tuesday bill, she was going to jail. She protested, and the officer conferred again with the other officers, then returned to the car and said, “It was a mistake.” He explained that the manager at the res- taurant had sent the off-duty officer after them because he said the girls had not paid their bill, but they did not fit the description of the two people who had walked out without paying. The officers removed the handcuffs from Racquel and Kristie and returned them to their car. After asking for Racquel’s driver’s license and obtaining information about both girls, the officer told them they were free to go.

Christian Mikula had been an assistant manager for about a month and was the only manager at Ruby Tuesday that night. One of the servers, Robert, reported that his customers at Table 24 had a complaint, so Mikula talked to the couple and told them he would

“take care of the food item in question. The customers were a man and a woman in their late twenties to early thirties. Mikula left the table to discuss the matter with Robert, after which server Aaron told Mikula that the patrons at Table 24 had left without paying. Mikula looked at the table, confirmed they had not left any money for the bill, and went out the main entrance. He saw a car pulling out of the parking lot and said to the off-duty officer, “Hey, I think they just left without paying.” The officer said, “Who, them?” Mikula said, “I think so,” and the officer got up and went to his vehicle.

Mikula knew the officer was going to follow the people in the car and would stop them, but did not ask the officer if he had seen who got into the car. He did not give the officer a description of the people at Table 24 and did not know the race, age, gender, or number of people in the car being followed. He did not know if there were people in any of the other cars in the parking lot. He did not ask any other people in the restaurant if they had seen the people at Table 24 leave the build- ing, which had two exits. He did not know how long the people had been gone before Aaron told him they left or whether another customer had picked up money from Table 24. He could have tried to obtain more information to determine whether the people in the car he pointed out were the people who had been sitting at Table 24, but did not do so.

Racquel Ferrell and the parents of Kristie Ferrell sued Ruby Tuesday, Inc., and its manager, Christian Mikula, for false imprisonment and intentional infliction of emotional distress. The trial court granted the defendants’ motion for summary judgment on all counts. The Ferrells appealed.

DECISION Summary judgment on the claim for intentional infliction of emotional distress is affirmed; summary judgment on the claim for false imprisonment is reversed.

138 The Legal Environment of Business Part II

OPINION Barnes, C. J. In this case, the Ferrells were detained without a warrant, and thus have a claim for false imprisonment *** . [Citation.] “False imprison- ment is the unlawful detention of the person of another, for any length of time, whereby such person is deprived of his personal liberty.” [Citation.] “The only essential elements of the action being the detention and its un- lawfulness, malice and the want of probable cause need not be shown.” [Citations.]

The evidence in this case clearly establishes that the Ferrells were detained. Although “‘imprisonment’ was originally intended to have meant stone walls and iron bars, … under modern tort law an individual may be imprisoned when his movements are restrained in the open street, or in a traveling automobile.” [Citation.] Ruby Tuesday does not argue otherwise, but instead argues that the evidence established sufficient probable cause and the plaintiffs failed to establish that Mikula acted with malice. But malice is not an element of false imprisonment, *** . Further, *** the mere existence of probable cause standing alone has no real defensive bearing on the issue of liability [for false imprisonment]. [Citation.]

***

Arresting or procuring the arrest of a person with- out a warrant constitutes a tort, “unless he can justify under some of the exceptions in which arrest and imprisonment without a warrant are permitted by law, [citations]”. Generally, one “who causes or directs the arrest of another by an officer without a warrant may be held liable for false imprisonment, in the absence of justification, and the burden of proving that such imprisonment lies within an exception rests upon the person … causing the imprisonment.” [Citations.] ***

Accordingly, as the Ferrells have established an unlaw- ful detention, the next issue to consider is whether Mikula “caused” the arrest. Whether a party is potentially liable for false imprisonment by “directly or indirectly urg[ing] a law enforcement official to begin criminal proceedings” or is not liable because he “merely relates facts to an official who then makes an independent decision to arrest” is a factual question for the jury. [Citation.] The party need not expressly request an arrest, but may be liable if his conduct and acts “procured and directed the arrest.” [Citation.]

***

Here, Mikula told the officer that the car leaving the parking lot contained people who left without pay- ing for their food, although he did not know or try to

ascertain who was in the car. He also knew the officer was going to detain the people in the car and could have tried to stop him, but made no attempt to do so. Accordingly, the trial court erred in granting summary judgment to the defendants on the plaintiffs’ false imprisonment claim.

***

The Ferrells also contend that the trial court erred in granting summary judgment to the defendants on their claim for intentional infliction of emotional distress. The elements of a cause of action for intentional infliction of emotional distress are: (1) intentional or reckless con- duct; (2) that is extreme and outrageous; (3) a causal connection between the wrongful conduct and the emo- tional distress; and (4) severe emotional distress. [Cita- tion.] Further,

[l]iability for this tort has been found only where the con- duct has been so outrageous in character, and so extreme in degree, as to go beyond all possible bounds of decency, and to be regarded as atrocious, and utterly intolerable in a civilized community. Generally, the case is one in which the recitation of the facts to an average member of the commu- nity would arouse his resentment against the actor, and lead him to exclaim, “Outrageous!”

[Citation.] In this case, the action upon which the Ferrells base

their emotional distress claim is being stopped by the police, placed in handcuffs, and held in a patrol car for a short period of time before being released. While this incident was unfortunate, the question raised by the evidence was whether the restaurant manager’s actions were negligent, not whether he acted maliciously or his conduct was extreme, atrocious, or utterly intoler- able. Accordingly, the trial court did not err in granting the defendants’ motion for summary judgment on the Ferrells’ claim for intentional infliction of emotional distress.

INTERPRETATION False imprisonment is the unlawful detention of the person of another, for any length of time, whereby such person is deprived of his personal liberty unless there is a legally recognized justi- fication. Liability is imposed under the tort of infliction of emotional distress for intentional or reckless conduct that is extreme and outrageous and that causes severe emotional distress.

CRITICAL THINKING QUESTION Do you agree that the manager’s conduct was negligent at most and thus not reckless?

Chapter 7 Intentional Torts 139

HARM TO THE RIGHT OF DIGNITY [7-2] The law also protects a person against intentional inter- ference with, or harm to, his right of dignity. This pro- tection covers a person’s reputation, privacy, and right to freedom from unjustifiable litigation.

Defamation [7-2a] As discussed in Chapter 4, the tort of defamation is a false communication that injures a person’s reputation by disgracing him and diminishing the respect in which he is held. An example would be the publication of a false statement that a person had committed a crime or had a loathsome disease.

Elements of Defamation The elements of a defamation action are (1) a false and defamatory state- ment concerning another; (2) an unprivileged publica- tion (communication) to a third party; (3) depending on the status of the defendant, negligence or reckless- ness on her part in knowing or failing to ascertain the falsity of the statement; and (4) in some cases, proof of special harm caused by the publication. The burden of proof is on the plaintiff to prove the falsity of the de- famatory statement.

If the defamatory communication is handwritten, type- written, printed, or pictorial or is in any other medium

with similar communicative power, such as a television or radio broadcast, it is designated as libel. If it is spoken or oral, it is designated as slander. In either case, it must be communicated to a person or persons other than the one who is defamed, a process referred to as its publica- tion. Thus, if Maurice writes a defamatory letter about Pierre’s character that he hands or mails to Pierre, this is not a publication because it is intended only for Pierre. The publication must have been intentional or the result of the defendant’s negligence.

Any living person, as well as corporations, partnerships, and unincorporated associations, may be defamed. Unless a statute provides otherwise, no action may be brought for defamation of a deceased person.

A significant trend affecting business has been the bringing of defamation suits against former employers by discharged employees. It has been reported that such suits account for approximately one-third of all defa- mation lawsuits. The following case demonstrates the consequences of failing to be careful in discharging an employee.

PRACTICAL ADVICE Consider whether you should provide employment references for current and former employees, and if you decide to do so, take care in what you say. See the “Business Law in Action” feature on p. 142.

F R A N K B . H A L L & C O . , I N C . V . B U C K C o u r t o f A p p e a l s o f T e x a s , F o u r t e e n t h D i s t r i c t , 1 9 8 4

6 7 8 S . W . 2 d 6 1 2 ; c e r t i o r a r i d e n i e d , 4 7 2 U . S . 1 0 0 9 , 1 0 5 S . C t . 2 7 0 4 , 8 6 L . E d . 2 d 7 2 0 ( 1 9 8 5 )

FACTS On June 1, 1976, Larry W. Buck, an estab- lished salesman in the insurance business, began working for Frank B. Hall & Co. In the course of the ensuing months, Buck brought several major accounts to Hall and produced substantial commission income for the firm. In October 1976, Mendel Kaliff, then president of Frank B. Hall & Co. of Texas, informed Buck that his salary and benefits were being reduced because of his failure to gen- erate sufficient income for the firm. On March 31, 1977, Kaliff and Lester Eckert, Hall’s office manager, fired Buck. Buck was unable to procure subsequent employ- ment with another insurance firm. He hired an investiga- tor, Lloyd Barber, to discover the true reasons for his dismissal and for his inability to find other employment.

Barber contacted Kaliff, Eckert, and Virginia Hilley, a Hall employee, and told them he was an investigator and was seeking information about Buck’s employment with the firm. Barber conducted tape-recorded interviews with

the three in September and October of 1977. Kaliff accused Buck of being disruptive, untrustworthy, para- noid, hostile, and untruthful and of padding his ex- pense account. Eckert referred to Buck as “a zero” and a “classical sociopath” who was ruthless, irrational, and disliked by other employees. Hilley stated that Buck could have been charged with theft for certain materials he brought with him from his former employer to Hall. Buck sued Hall for damages for defamation and was awarded over $1.9 million by a jury—$605,000 for actual damages and $1,300,000 for punitive damages. Hall then brought this appeal.

DECISION Judgment for Buck affirmed.

OPINION Junell, J. Any act wherein the defamatory matter is intentionally or negligently communicated to a third person is a publication. In the case of slander, the

140 The Legal Environment of Business Part II

Defenses to Defamation The defense of privilege is immunity from tort liability granted when the defend- ant’s conduct furthers a societal interest of greater impor- tance than the injury inflicted upon the plaintiff. Three kinds of privileges apply to defamation: absolute, condi- tional, and constitutional.

Absolute privilege, which protects the defendant regardless of his motive or intent, has been confined to those few situations in which public policy clearly favors complete freedom of speech. Such privilege includes (1) statements made by participants in a judi- cial proceeding regarding that proceeding, (2) state- ments made by members of Congress on the floor of

Congress and by members of state and local legislative bodies, (3) statements made by certain executive branch officers while performing their government duties, and (4) statements regarding a third party made between spouses when they are alone.

Qualified or conditional privilege depends on proper use of the privilege. A person has a conditional privilege to publish defamatory matter to protect her own legiti- mate interests or, in some cases, the interests of another. Conditional privilege also extends to many communica- tions in which the publisher and the recipient have a common interest, such as letters of reference. Conditional privilege, however, is forfeited by a publisher who acts in

act is usually the speaking of the words. Restatement (Second) Torts §577 comment a (1977). There is ample support in the record to show that these individuals intentionally communicated disparaging remarks to a third person. The jury was instructed that “Publication means to communicate defamatory words to some third person in such a way that he understands the words to be defamatory. A statement is not published if it was unauthorized, invited or procured by Buck and if Buck knew in advance the contents of the invited communication.” In response to special issues, the jury found that the slanderous statements were made and published to Barber.

*** A defamer cannot escape liability by showing that,

although he desired to defame the plaintiff, he did not desire to defame him to the person to whom he in fact intentionally published the defamatory communication. The publication is complete although the publisher is mistaken as to the identity of the person to whom the publication is made. Restatement (Second) of Torts §577 comment l (1977). Likewise, communication to an agent of the person defamed is a publication, unless the communication is invited by the person defamed or his agent. Restatement §577 comment e. We have already determined that the evidence is sufficient to show that Buck did not know what Kaliff, Eckert or Hilley would say and that he did not procure the defamatory state- ments to create a lawsuit. Thus, the fact that Barber may have been acting at Buck’s request is not fatal to Buck’s cause of action. There is absolutely no proof that Barber induced Kaliff, Eckert or Hilley to make any of the defamatory comments.

*** When an ambiguity exists, a fact issue is presented.

The court, by submission of proper fact issues, should let the jury render its verdict on whether the statements

were fairly susceptible to the construction placed thereon by the plaintiff. [Citation.] Here, the jury found (1) Eckert made a statement calculated to convey that Buck had been terminated because of serious miscon- duct; (2) the statement was slanderous or libelous; (3) the statement was made with malice; (4) the statement was published; and (5) damage directly resulted from the statement. The jury also found the statements were not substantially true. The jury thus determined that these statements, which were capable of a defamatory meaning, were understood as such by Barber.

*** We hold that the evidence supports the award of

actual damages and the amount awarded is not mani- festly unjust. Furthermore, in responding to the issue on exemplary damages, the jury was instructed that exem- plary damages must be based on a finding that Hall “acted with ill will, bad intent, malice or gross disregard to the rights of Buck.” Although there is no fixed ratio between exemplary and actual damages, exemplary dam- ages must be reasonably apportioned to the actual dam- ages sustained. [Citation.] Because of the actual damages [$605,000] and the abundant evidence of malice, we hold that the award of punitive damages [$1,300,000] was not unreasonable. ***

INTERPRETATION The key elements of defa- mation are that the statements made are false, injure the plaintiff’s reputation, and are published.

ETHICAL QUESTION Did Hall’s employees act ethically? Did Buck act ethically in hiring an investi- gator to obtain the information? Explain.

CRITICAL THINKING QUESTION How should a company respond to inquiries for information about former or current employees? Explain.

Chapter 7 Intentional Torts 141

an excessive manner, without probable cause, or for an improper purpose.

The First Amendment to the U.S. Constitution guar- antees freedom of speech and freedom of the press. The U.S. Supreme Court has applied these rights to the law of defamation by extending a form of constitutional privilege to defamatory and false statements about public officials or public figures so long as it is done without malice. For these purposes, malice is not ill will but clear and convincing proof of the publisher’s knowledge of falsity or reckless disregard of the truth. Thus, under constitutional privilege, the public official or public figure must prove that the defendant pub- lished the defamatory and false comment with knowl- edge or in reckless disregard of the comment’s falsity and its defamatory character. However, in a defama- tion suit brought by a private person (one who is nei- ther a public official nor a public figure), the plaintiff must prove that the defendant published the defama- tory and false comment with malice or negligence.

Congress enacted Section 230 of the Communications Decency Act of 1996 (CDA) granting immunity to Inter- net service providers (ISPs) from liability for defamation

when publishing information originating from a third party. A court has interpreted this provision of the CDA as immunizing an ISP that refused to remove or retract an allegedly defamatory posting made on its bulletin board. The immunity granted by the CDA to ISPs has spawned a number of lawsuits urging ISPs to reveal the identities of subscribers who have posted allegedly defamatory statements. To date, ISPs have complied, generating additional litigation by angry ISP patrons attempting to keep their identities protected by asserting that their right to free speech is being compromised.

Because Section 230 of the CDA grants immunity only to ISPs, there is the possibility that employers will be held liable for some online defamatory statements made by an employee. Section 577(2) of the Restatement of Torts provides that a person who intentionally and unreasonably fails to remove defamatory matter that she knows is exhibited on property in her possession or under her control is liable for its continued publication. Therefore, employers in control of e-forums, such as electronic bulletin boards and chat rooms, should act quickly to remove any defamatory statement brought to their attention.

Business Law IN ACTION

If you own or manage a business, you can expectemployees to leave for a variety of reasons. When your present or former employees apply for work else- where, their potential new employers may well call you to verify their employment history and ask your opinion of them as employees. Should you give that information?

Many employers have stopped giving meaningful references for former employees. Some employers verify only employment dates and job titles of former employ- ees. Others give no information at all. The reason? Fear of liability for defamation and of incurring large legal expenses to defend a lawsuit.

Are those fears justified? Does the benefit of minimiz- ing risk outweigh the cost of shutting down a legitimate and valuable information system? Consider the following points:

• A number of the states have enacted statutes that provide varying degrees of protection against liability for defamation to companies that give job references for current or former employees.

• An employer is liable for a false statement only if she was negligent in attempting to establish its truth.

• Employment references enjoy qualified privilege, unless the employer communicates the statements to people

with no need to know their contents or publishes them out of spite.

• Employment references are valuable. Employers who expect to get useful information about job applicants should also be willing to give it.

You can reduce the risk of liability when giving employ- ment references if you …

• Endeavor to ensure that all statements you publish about an employee are true. Your effort can be used as a defense against negligence.

• Make sure you publish statements only to people with a legitimate need to know (i.e., potential employers).

• Regulate the giving of references in your company. Make sure people who work for you understand who may give references and who may not. And make sure they know that no one is ever to publish statements maliciously.

• Ask your existing employees to give you written consent to provide references for them.

Source: Ramona L. Paetzold and Steven L. Wilborn, “Employer (Ir)rationality and the Demise of Employment References,” American Business Law Journal, May 1992, 123–42.

142 The Legal Environment of Business Part II

Invasion of Privacy [7-2b] The invasion of a person’s right to privacy actually con- sists of four distinct torts: (1) appropriation of a person’s name or likeness, (2) unreasonable intrusion on the seclu- sion of another, (3) unreasonable public disclosure of private facts, or (4) unreasonable publicity that places another in a false light in the public eye.

It is entirely possible and not uncommon for a per- son’s right of privacy to be invaded in a manner entailing two or more of these related torts. For example, Bart forces his way into Cindy’s hospital room, takes a photo- graph of Cindy, and publishes it to promote his cure for Cindy’s illness along with false statements about Cindy that would be highly objectionable to a reasonable person. Cindy would be entitled to recover on any or all of the four torts comprising invasion of privacy.

Appropriation The tort of appropriation is the unauthorized use of another person’s name or likeness for one’s own benefit, as, for example, in promoting or advertising a product or service. The tort of appro- priation, which seeks to protect the individual’s right to the exclusive use of his identity, is also known as the “right of publicity.” In the previous example, Bart’s use of Cindy’s photograph to promote Bart’s business constitutes the tort of appropriation. The fol- lowing case involving Vanna White is also an example of appropriation.

PRACTICAL ADVICE When using another person’s identity for your own purposes, be sure to obtain that person’s written consent.

W H I T E V . S A M S U N G E L E C T R O N I C S U . S . C o u r t o f A p p e a l s , N i n t h C i r c u i t , 1 9 9 2

9 7 1 F . 2 d 1 3 9 5 ; c e r t i o r a r i d e n i e d , 5 0 8 U . S . 9 5 1 , 1 1 3 S . C t . 2 4 4 3 , 1 2 4 L . E d . 2 d 6 6 0 ( 1 9 9 3 )

FACTS Plaintiff, Vanna White, is the hostess of Wheel of Fortune, one of the most popular game shows in television history. Samsung Electronics and David Deutsch Associates ran an advertisement for videocas- sette recorders that depicted a robot dressed in a wig, gown, and jewelry chosen to resemble White’s hair and dress. The robot was posed in a stance, for which White is famous, next to a game board, which is instantly rec- ognizable as the Wheel of Fortune game show set. The caption of the ad read: “Longest-running game show. 2012 AD.” Defendants referred to the ad as the “Vanna White” ad. White neither consented to the ads, nor was she paid for them. White sued Samsung and Deutsch under the California common law right of publicity. The district court granted summary judgment against White on this claim.

DECISION Judgment reversed.

OPINION Goodwin, J. White argues that the district court erred in granting summary judgment to defendants on White’s common law right of publicity claim. In East- wood v. Superior Court, [citation], the California court of appeal stated that the common law right of publicity cause of action “may be pleaded by alleging (1) the defendant’s use of the plaintiff’s identity; (2) the appro- priation of plaintiff’s name or likeness to defendant’s advantage, commercially or otherwise; (3) lack of consent, and (4) resulting injury.” [Citation.] The district court

dismissed White’s claim for failure to satisfy Eastwood’s second prong, reasoning that defendants had not appro- priated White’s “name or likeness” with their robot ad. We agree that the robot ad did not make use of White’s name or likeness. However, the common law right of publicity is not so confined.

The Eastwood court did not hold that the right of publicity cause of action could be pleaded only by alleg- ing an appropriation of name or likeness. Eastwood involved an unauthorized use of photographs of Clint Eastwood and of his name. Accordingly, the Eastwood court had no occasion to consider the extent beyond the use of name or likeness to which the right of publicity reaches. That court held only that the right of publicity cause of action “may be” pleaded by alleging, inter alia, appropriation of name or likeness, not that the action may be pleaded only in those terms.

The “name or likeness” formulation referred to in Eastwood originated not as an element of the right of publicity cause of action, but as a description of the types of cases in which the cause of action had been rec- ognized. The source of this formulation is Prosser, Pri- vacy, 48 Cal.L.Rev. 383, 401–07 (1960), one of the earliest and most enduring articulations of the common law right of publicity cause of action. In looking at the case law to that point, Prosser recognized that right of publicity cases involved one of two basic factual scenar- ios: name appropriation, and picture or other likeness appropriation. [Citation.]

Chapter 7 Intentional Torts 143

Even though Prosser focused on appropriations of name or likeness in discussing the right of publicity, he noted that “[i]t is not impossible that there might be appropriation of the plaintiff’s identity, as by imperso- nation, without use of either his name of his likeness, and that this would be an invasion of his right of privacy.” [Citation.] At the time Prosser wrote, he noted however, that “[n]o such case appears to have arisen.” [Citation.]

Since Prosser’s early formulation, the case law has borne out his insight that the right of publicity is not limited to the appropriation of name or likeness. In Motschenbacher v. R.J. Reynolds Tobacco Co., [cita- tion], the defendant had used a photograph of the plaintiff’s race car in a television commercial. Although the plaintiff appeared driving the car in the photograph, his features were not visible. Even though the defendant had not appropriated the plaintiff’s name or likeness, this court held that plaintiff’s California right of public- ity claim should reach the jury.

In Midler, this court held that, even though the defend- ants had not used Midler’s name or likeness, Midler had stated a claim for violation of her California common law right of publicity because “the defendants *** for their own profit in selling their product did appropriate part of her identity” by using a Midler sound-alike. [Citation.]

In Carson v. Here’s Johnny Portable Toilets, Inc., [citation], the defendant had marketed portable toilets under the brand name “Here’s Johnny”—Johnny Car- son’s signature “Tonight Show” introduction—without Carson’s permission. The district court had dismissed Carson’s Michigan common law right of publicity claim because the defendants had not used Carson’s “name or likeness.” [Citation.] In reversing the district court, the sixth circuit found “the district court’s conception of the right of publicity *** too narrow” and held that the right was implicated because the defendant had appropriated Carson’s identity by using, inter alia, the phrase “Here’s Johnny.” [Citation.]

These cases teach not only that the common law right of publicity reaches means of appropriation other than name or likeness, but that the specific means of appropriation are relevant only for determining whether the defendant has in fact appropriated the plaintiff’s identity. The right of publicity does not require that appropriations of identity be accomplished through par- ticular means to be actionable. It is noteworthy that the Midler and Carson defendants not only avoided using the plaintiff’s name or likeness, but they also avoided appropriating the celebrity’s voice, signature, and photo- graph. The photograph in Motschenbacher did include the plaintiff, but because the plaintiff was not visible the driver could have been an actor or dummy and the anal- ysis in the case would have been the same.

Although the defendants in these cases avoided the most obvious means of appropriating the plaintiffs’ identities, each of their actions directly implicated the commercial interests which the right of publicity is designed to protect. As the Carson court explained:

[t]he right of publicity has developed to protect the com- mercial interest of celebrities in their identities. The theory of the right is that a celebrity’s identity can be valuable in the promotion of products, and the celebrity has an interest that may be protected from the unauthorized commercial exploitation of that identity *** If the celebrity’s identity is commercially exploited, there has been an invasion of his right whether or not his “name or likeness” is used.

[Citation.] It is not important how the defendant has appropriated the plaintiff’s identity, but whether the defendant has done so. Motschenbacher, Midler, and Carson teach the impossibility of treating the right of publicity as guarding only against a laundry list of spe- cific means of appropriating identity. A rule which says that the right of publicity can be infringed only through the use of nine different methods of appropriating iden- tity merely challenges the clever advertising strategist to come up with the tenth.

Indeed, if we treated the means of appropriation as dispositive in our analysis of the right of publicity, we would not only weaken the right but effectively eviscer- ate it. The right would fail to protect those plaintiffs most in need of its protection. Advertisers use celebrities to promote their products. The more popular the celeb- rity, the greater the number of people who recognize her, and the greater the visibility for the product. The identities of the most popular celebrities are not only the most attractive for advertisers, but also the easiest to evoke without resorting to obvious means such as name, likeness, or voice.

Consider a hypothetical advertisement which depicts a mechanical robot with male features, an African-American complexion, and a bald head. The robot is wearing black high-top Air Jordan basketball sneakers, and a red basket- ball uniform with black trim, baggy shorts, and the number 23 (though not revealing “Bulls” or “Jordan” let- tering). The ad depicts the robot dunking a basketball one-handed, stiff-armed, legs extended like open scissors, and tongue hanging out. Now envision that this ad is run on television during professional basketball games. Considered individually, the robot’s physical attributes, its dress, and its stance tells us little. Taken together, they lead to the only conclusion that any sports viewer who has registered a discernible pulse in the past five years would reach: the ad is about Michael Jordan.

Viewed separately, the individual aspects of the adver- tisement in the present case say little. Viewed together, they leave little doubt about the celebrity the ad is meant

144 The Legal Environment of Business Part II

Intrusion The tort of intrusion is the unreasonable and highly offensive interference with the solitude or seclu- sion of another. Such unreasonable interference includes improper entry into another’s dwelling, unauthorized eavesdropping on another’s private conversations, and unauthorized examination of another’s private papers and records. The intrusion must be highly offensive or objec- tionable to a reasonable person and must involve private matters. Thus, there is no liability if the defendant exam- ines public records or observes the plaintiff in a public place. This form of invasion of privacy is committed once the intrusion occurs—publicity is not required.

Public Disclosure of Private Facts Under the tort of public disclosure of private facts, liability is imposed for publicity given to private information about another, if the matter made public would be highly offensive and objectionable to a reasonable per- son. Like intrusion, this tort applies only to private, not public, information about an individual; unlike intru- sion, it requires publicity. Under the Restatement, the publicity required differs in degree from “publication” as used in the law of defamation. This tort requires that private facts be communicated to the public at large or that they become public knowledge, whereas publica- tion of a defamatory statement need be made only to a single third party. Thus Kathy, a creditor of Gary, will not invade Gary’s privacy by writing a letter to Gary’s employer informing the employer of Gary’s failure to pay the debt, but Kathy would be liable if she posted in the window of her store a statement that Gary will not pay a debt owed to her. Some courts, however, have allowed recovery where the disclosure was made to only one person. Also, unlike defamation, this tort

applies to truthful private information if the matter published would be offensive and objectionable to a reasonable person of ordinary sensibilities.

False Light The tort of false light imposes liability for highly offensive publicity placing another in a false light if the defendant knew that the matter publicized was false or acted in reckless disregard of the truth. For example, Edgar includes Jason’s name and photograph in a public “rogues’ gallery” of convicted criminals. Be- cause Jason has never been convicted of any crime, Edgar is liable to Jason for placing him in a false light.

As with defamation, the matter must be untrue; unlike defamation, it must be “publicized,” not merely “published.” Although the matter must be objectionable to a reasonable person, it need not be defamatory. In many instances, the same facts will give rise to actions both for defamation and for false light.

Defenses The defenses of absolute, conditional, and constitutional privilege apply to publication of any mat- ter that is an invasion of privacy to the same extent that such defenses apply to defamation.

Misuse of Legal Procedure [7-2c] Three torts comprise the misuse of legal procedure: malicious prosecution, wrongful civil proceedings, and abuse of process. Each protects an individual from being subjected to unjustifiable litigation. Malicious prosecution and wrongful civil proceedings impose liability for damages caused by improperly brought proceedings, including harm to reputation, credit, or standing; emotional distress; and the expenses incurred in defending against the wrongfully brought lawsuit.

to depict. The female shaped robot is wearing a long gown, blond wig, and large jewelry. Vanna White dresses exactly like this at times, but so do many other women. The robot is in the process of turning a block letter on a game-board. Vanna White dresses like this while turning letters on a game-board but perhaps similarly attired Scrabble-playing women do this as well. The robot is standing on what looks to be the Wheel of Fortune game show set. Vanna White dresses like this, turns letters, and does this on the Wheel of Fortune game show. She is the only one. Indeed, defendants themselves referred to their ad as the “Vanna White” ad. We are not surprised.

Television and other media create marketable celebrity identity value. Considerable energy and ingenuity are expended by those who have achieved celebrity value to exploit it for profit. The law protects the celebrity’s sole

right to exploit this value whether the celebrity has achieved her fame out of rare ability, dumb luck, or a combination thereof. We decline Samsung and Deutsch’s invitation to permit the evisceration of the common law right of publicity through means as facile as those in this case. Because White has alleged facts showing that Samsung and Deutsch had appropriated her identity, the district court erred by rejecting, on summary judgment, White’s common law right of publicity claim.

INTERPRETATION The tort of appropriation protects a person’s exclusive right to exploit the value of her identity.

CRITICAL THINKING QUESTION What are the interests protected by this tort?

Chapter 7 Intentional Torts 145

Abuse of process consists of using a legal proceeding (criminal or civil) to accomplish a purpose for which the proceeding is not designed. This misuse of proce- dure applies even when there is probable cause or when the plaintiff or prosecution succeeds in the litigation.

HARM TO PROPERTY [7-3] The law also provides protection against invasions of a person’s interests in property. Intentional harm to prop- erty includes the torts of (1) trespass to real property, (2) nuisance, (3) trespass to personal property, and (4) conversion.

Real Property [7-3a] Real property is land and anything attached to it, such as buildings, trees, and minerals. The law protects the possessor’s rights to the exclusive use and quiet enjoy- ment of the land. Accordingly, damages for harm to land include compensation for the resulting diminution in the value of the land, the loss of use of the land, and the discomfort caused to the possessor of the land.

Trespass A person is liable for trespass to real prop- erty if he intentionally (1) enters or remains on land in the possession of another, (2) causes a thing or a third person to so enter or remain, or (3) fails to remove from the land a thing that he is under a duty to remove. Liability exists even though no actual damage is done to the land.

It is no defense that the intruder acted under the mis- taken belief of law or fact that he was not trespassing. If the intruder intended to be on the particular prop- erty, his reasonable belief that he owned the land or had permission to enter on it is irrelevant. However, an intruder is not liable if his presence on the land of another is not caused by his own actions. For example,

if Shirley is thrown onto Roy’s land by Jimmy, Shirley is not liable to Roy for trespass, although Jimmy is.

A trespass may be committed on, beneath, or above the surface of the land, although the law regards the upper air, above a prescribed minimum altitude for flight, as a public highway. No aerial trespass occurs unless the aircraft enters into the lower reaches of the airspace and substantially interferes with the land- owner’s use and enjoyment.

Nuisance A nuisance is a nontrespassory invasion of another’s interest in the private use and enjoyment of land. In contrast to trespass, nuisance does not require interference with another’s right to exclusive possession of land but imposes liability for significant and un- reasonable harm to another’s use or enjoyment of land. Examples of nuisances include the emission of unpleasant odors, smoke, dust, or gas, as well as the pollution of a stream, pond, or underground water supply.

PRACTICAL ADVICE In using, manufacturing, and disposing of dangerous, noxious, or toxic materials, take care not to create a nuisance.

Personal Property [7-3b] Personal property is any type of property other than an interest in land. The law protects a number of interests in the possession of personal property, including an in- terest in the property’s physical condition and usability, an interest in the retention of possession, and an inter- est in the property’s availability for future use.

Trespass The tort of trespass to personal property consists of the intentional dispossession or unauthor- ized use of the personal property of another. Although the interference with the right to exclusive use and pos- session may be direct or indirect, liability is limited to

CONCEPT REVIEW 7-1 P R I V A C Y

Appropriation Intrusion Public Disclosure False Light

Publicity Yes No Yes Yes

Private Facts No Yes Yes No

Offensiveness No Yes Yes Yes

Falsity No No No Yes

146 The Legal Environment of Business Part II

instances in which the trespasser (1) dispossesses the other of the property; (2) substantially impairs the con- dition, quality, or value of the property; or (3) deprives the possessor of use of the property for a substantial time. For example, Albert parks his car in front of his house. Later, Ronald pushes Albert’s car around the corner. Albert subsequently looks for his car but cannot find it for several hours. Ronald is liable to Albert for trespass.

Conversion The tort of conversion is an intentional exercise of dominion or control over another’s personal property that so seriously interferes with the other’s right of control as justly to require the payment of full value for the property. Thus, all conversions are trespasses, but not all trespasses are conversions. Conversion may con- sist of the intentional destruction of the personal property or the use of the property in an unauthorized manner. For example, Barbara entrusts an automobile to Ken, a dealer, for sale. After he drives the car eight thousand miles on his own business, Ken is liable to Barbara for conversion. On the other hand, in the example in which Ronald pushed Albert’s car around the corner, Ronald would not be liable to Albert for conversion.

HARM TO ECONOMIC INTERESTS [7-4] Economic interests comprise a fourth set of interests the law protects against intentional interference. Economic or pecuniary interests include a person’s existing and pro- spective contractual relations, a person’s business reputa- tion, a person’s name and likeness (previously discussed under appropriation), and a person’s freedom from deception. In this section, we will discuss business torts— those torts that protect a person’s economic interests.

Interference with Contractual Relations [7-4a] Interference with contractual relations involves interfer- ing intentionally and improperly with the performance of a contract by inducing one of the parties not to per- form it. (Contracts are discussed extensively in Part III of this text.) The injured party may recover the eco- nomic loss resulting from the breach of the contract. The law imposes similar liability for intentional and improper interference with another’s prospective con- tractual relation, such as a lease renewal or financing for construction.

In either case, the rule requires that a person act with the purpose or motive of interfering with another’s contract or with the knowledge that such interference is substantially certain to occur as a natural conse- quence of her actions. The interference may occur by prevention through the use of physical force or by threats. Frequently, the interference is accomplished by inducement, such as the offer of a better contract. For instance, Calvin may offer Becky, an employee of Fran under a contract that has two years left, a yearly salary of $5,000 per year more than the contractual arrangement between Becky and Fran. If Calvin is aware of the contract between Becky and Fran and of the fact that his offer to Becky will interfere with that contract, then Calvin is liable to Fran for intentional interference with contractual relations.

PRACTICAL ADVICE Recognize that inducing another person’s employees to breach a valid agreement not to compete or not to disclose confidential information may be improper interference with contractual relations.

T E X A C O , I N C . V . P E N N Z O I L , C O . C o u r t o f A p p e a l s o f T e x a s , F i r s t D i s t r i c t , 1 9 8 7

7 2 9 S . W . 2 d 7 6 8 ; c e r t i o r a r i d e n i e d , 4 8 5 U . S . 9 9 4 , 1 0 8 S . C t . 1 3 0 5 , 9 9 L . E d . 2 d 6 8 6 ( 1 9 8 8 )

FACTS Pennzoil negotiated with Gordon Getty and the J. Paul Getty Museum over the purchase by Pennzoil of all the Getty Oil stock held by each. Gordon Getty, who was also a director of Getty Oil, held about 40.2 percent of the outstanding shares of Getty Oil. The Museum held 11.8 percent. On January 2, a Memoran- dum of Agreement was drafted, setting forth the terms reached by Pennzoil, Gordon Getty, and the Museum. After increasing the offering price to $110 per share

plus a $5 “stub” or bonus, the board of directors of Getty Oil voted on January 3 to accept the Pennzoil deal. Accordingly, on January 4 both Getty Oil and Pennzoil issued press releases, announcing an agreement in principle on the terms of the Memorandum of Agree- ment but at the higher price.

Having learned of the impending sale of Getty Oil stock to Pennzoil, Texaco hurriedly called several in- house meetings, and hired an investment banker as well,

Chapter 7 Intentional Torts 147

Disparagement [7-4b] The tort of disparagement or injurious falsehood imposes liability upon one who publishes a false statement that results in harm to another’s monetary interests if the pub- lisher knows that the statement is false or acts in reckless disregard of its truth or falsity. This tort most commonly

involves intentionally false statements that cast doubt on another’s right of ownership in or on the quality of another’s property or products. Thus Simon, while con- templating the purchase of a stock of merchandise that belongs to Marie, reads an advertisement in a newspaper in which Ernst falsely asserts he owns the merchandise. Ernst has disparaged Marie’s property in the goods.

to determine a feasible price range for acquiring Getty Oil. On January 5, Texaco decided on $125 per share and authorized its officers to take any steps necessary to conclude a deal. Texaco met first with a lawyer for the Museum, then with Gordon Getty. Texaco stressed to Getty that if he hesitated in selling his shares, he might be “locked out” in a minority position. On January 6, the Getty Oil board of directors voted to withdraw from the Pennzoil deal and unanimously voted to accept the $125-per-share Texaco offer. Pennzoil sued and won an award of $7.53 billion in compensatory damages and $3 billion in punitive damages based on tortious inter- ference with a contract. Texaco appealed.

DECISION Judgment of trial court affirmed.

OPINION Warren, J. New York law requires knowl- edge by a defendant of the existence of contractual rights as an element of the tort of inducing a breach of that con- tract. [Citation.] However, the defendant need not have full knowledge of all the detailed terms of the contract. [Citations.]

The element of knowledge by the defendant is a question of fact, and proof may be predicated on circum- stantial evidence. [Citation.] Since there was no direct evi- dence of Texaco’s knowledge of a contract in this case, the question is whether there was legally and factually sufficient circumstantial evidence from which the trier of fact reasonably could have inferred knowledge.

*** We find that an inference could arise that Texaco

had some knowledge of Pennzoil’s agreement with the Getty entities, given the evidence of Texaco’s detailed studies of the Pennzoil plan, its knowledge that some members of the Getty board were not happy with Penn- zoil’s price, and its subsequent formulation of strategy to “stop the [Pennzoil] train” ***

*** A necessary element of the plaintiff’s cause of action

is a showing that the defendant took an active part in persuading a party to a contract to breach it. [Citation.] Merely entering into a contract with a party with the

knowledge of that party’s contractual obligations to someone else is not the same as inducing a breach. [Citation.] It is necessary that there be some act of inter- ference or of persuading a party to breach, for example by offering better terms or other incentives, for tort liability to arise. [Citations.] The issue of whether a defendant affirmatively took steps to induce the breach of an existing contract is a question of fact for the jury. [Citation.]

*** The evidence discussed above on Texaco’s calculated

formulation and implementation of its ideal strategy to acquire Getty is also inconsistent with its contention that it was merely the passive target of Getty’s aggres- sive solicitation campaign and did nothing more than to accept terms that Getty Oil and the Museum had pro- posed. The evidence showed that Texaco knew it had to act quickly, and that it had “24 hours” to “stop the train.” Texaco’s strategy was to approach the Museum first, through its “key person” Lipton, to obtain the Museum’s shares, and then to “talk to Gordon.” It knew that the Trust instrument permitted Gordon Getty to sell the Trust shares only to avoid a loss, and it knew of the trustee’s fear of being left in a powerless minority ownership position at Getty Oil. Texaco notes indicated a deliberate strategy to “create concern that he will take a loss;” “if there’s a tender offer and Gordon doesn’t tender, then he could wind up with paper”; and “pressure.” This evidence contradicts the contention that Texaco passively accepted a deal proposed by the other parties.

INTERPRETATION The tort of interference with contractual relations protects a party to a contract from a third party who intentionally and improperly induces the other contracting party not to perform the contract.

ETHICAL QUESTION Did Getty or Texaco act unethically? Explain.

CRITICAL THINKING QUESTION Does the protection afforded by this tort conflict with soci- ety’s interest in free competition? Explain.

148 The Legal Environment of Business Part II

Absolute, conditional, and constitutional privileges apply to the same extent to the tort of disparagement as they do to defamation. In addition, a competitor has condi- tional privilege to compare her products favorably with those of a rival, even though she does not believe that her products are superior. No privilege applies, however, if the comparison contains false assertions of specific un- favorable facts about the competitor’s property.

The pecuniary loss an injured person may recover is that which directly and immediately results from impair- ment of the marketability of the property disparaged. Damages also may be recovered for expenses necessary to counteract the false publication, including litigation expenses, the cost of notifying customers, and the cost of publishing denials.

PRACTICAL ADVICE When commenting on the products or services offered by a competitor, take care not to make any false statements.

Fraudulent Misrepresentation [7-4c] Fraudulent misrepresentation imposes liability for the monetary loss caused by a justifiable reliance on a mis- representation of fact intentionally made for the purpose of inducing the relying party to act. For example, Smith misrepresents to Jones that a tract of land in Texas is located in an area where oil drilling has recently com- menced. Smith makes this statement knowing it is not true. In reliance upon the statement, Jones purchases the land from Smith. Smith is liable to Jones for intentional or fraudulent misrepresentation. Although fraudulent misrepresentation is a tort action, it is closely connected with contractual negotiations; its relationship to contracts is discussed in Chapter 11.

PRACTICAL ADVICE When describing your products or services, take care not to make any false statements.

CONCEPT REVIEW 7-2 I N T E N T I O N A L T O R T S

Interest Protected Tort

Person Freedom from contact Freedom from apprehension Freedom of movement Freedom from distress

Battery Assault False imprisonment Infliction of emotional distress

Dignity Reputation Privacy

Defamation Appropriation Intrusion Public disclosure of private facts False light

Freedom from wrongful legal actions Misuse of legal procedure

Property Real Trespass

Nuisance Personal Trespass

Conversion

Economic Contracts Goodwill Freedom from deception

Interference with contractual rights Disparagement Fraudulent misrepresentation

Chapter 7 Intentional Torts 149

C H A P T E R S U M M A R Y Harm to the Person

Battery intentional infliction of harmful or offensive bodily contact

Assault intentional infliction of apprehension of immediate bodily harm or offensive contact

False Imprisonment intentional confining of a person against her will

Infliction of Emotional Distress extreme and outrageous conduct intentionally or recklessly causing severe emotional distress

Harm to the Right of Dignity

Defamation false communication that injures a person’s reputation • Libel written or electronically transmitted defamation • Slander spoken defamation

Ethical Dilemma What May One Do to Attract Clients from a Previous Employer?

FACTS Carl Adle and Louise Bart formed a law firm as partners, and Anne Lily, Marvin Thomas, and Tim Jones joined the newly formed firm of Adle & Bart as associates (nonpartner employees). After about five years, Lily, Thomas, and Jones became disenchanted with the law firm and decided to form their own, to be called Lily, Thomas & Jones.

Lily and Thomas suggested to Jones that they contact approximately five hundred of Adle & Bart’s current clients. Lily and Thomas had prepared a model letter to inform clients about the new law firm (Lily, Thomas & Jones) and to encourage them to leave Adle & Bart and to become clients of the new firm. The letter also indicated that Lily, Thomas & Jones would offer legal services far better than those of Adle & Bart: billing rates would be more reasona- ble, service more prompt, and legal representation more effective and successful. The reference to success was aimed, in part, at three large clients who recently lost lawsuits under Adle & Bart representation. Although the losses had not resulted from malpractice or mishandling by Adle & Bart, Lily and Thomas knew that significant amounts of money had been at issue and that the clients were sensitive about the results of the lengthy litigation.

The letter included two postage-paid form letters for the prospective client to sign and mail. One form letter was addressed to Adle & Bart, informing them of the client’s desire to discontinue the client-attorney relationship and requesting the firm to forward all files to Lily, Thomas &

Jones. The other form letter, addressed to Lily, Thomas & Jones, requested representation.

Jones is reluctant about the proposed mailing. Lily and Thomas, in turn, argue that their new firm is not doing as well as they expected. They essentially give Jones an ulti- matum: join in the letter or leave the firm. Jones, who has thoroughly alienated Adle & Bart, does not believe he has any immediate alternative job opportunities.

Social, Policy, and Ethical Considerations 1. Should Jones agree to the proposed mailing? Is it ethical

for those forming the new firm to use a client list of their former employer when seeking clients?

2. What practical steps could Jones take to assist him in his decision?

3. What are the competing social interests at stake in this controversy?

4. How would your answers differ, if at all, if the firms were accounting firms rather than law firms?

5. In what manner, if at all, should the law protect existing businesses from competition? Under what circumstances might competition become unfair, and how should laws be tailored to deter unfair practices?

6. Should Jones be concerned about the comparisons the letter makes between the new firm and Adle & Bart?

150 The Legal Environment of Business Part II

Invasion of Privacy • Appropriation unauthorized use of a person’s identity • Intrusion unreasonable and highly offensive interference with the seclusion of another • Public Disclosure of Private Facts highly offensive publicity of private information • False Light highly offensive and false publicity about another

Misuse of Legal Procedure torts of malicious prosecution, wrongful civil proceeding, and abuse of process that protect an individual from unjustifiable litigation

Harm to Property

Real Property land and anything attached to it • Trespass to Real Property wrongfully entering on land of another • Nuisance a nontrespassory interference with another’s use and enjoyment of land

Personal Property any property other than land • Trespass to Personal Property an intentional taking or use of another’s personal property • Conversion intentional exercise of control over another’s personal property

Harm to Economic Interests

Interference with Contractual Relations intentionally causing one of the parties to a contract not to perform

Disparagement publication of false statements about another’s property or products

Fraudulent Misrepresentation a false statement, made with knowledge of its falsity, intended to induce another to act

Q U E S T I O N S

1. The Penguin intentionally hits Batman with his umbrella. Batman, stunned by the blow, falls backward, knocking Robin down. Robin’s leg is broken in the fall, and he cries out, “Holy broken bat bones! My leg is broken.” Who, if anyone, has liability to Robin? Why?

2. CEO was convinced by his employee, M. Ploy, that a coworker, A. Cused, had been stealing money from the company. At lunch that day in the company cafeteria, CEO discharged Cused from her employment, accused her of stealing from the company, searched through her purse over her objections, and finally forcibly escorted her to his office to await the arrival of the police, whom he had his secretary summon. Cused is indicted for embezzlement but subsequently is acquitted upon estab- lishing her innocence. What rights, if any, does Cused have against CEO?

3. Ralph kisses Edith while she is asleep but does not waken or harm her. Edith sues Ralph for battery. Has a battery been committed?

4. Claude, a creditor seeking to collect a debt, calls on Dianne and demands payment in a rude and insolent

manner. When Dianne says that she cannot pay, Claude calls Dianne a deadbeat and says that he will never trust Dianne again. Is Claude liable to Dianne? If so, for what tort?

5. Lana, a ten-year-old child, is run over by a car negli- gently driven by Mitchell. Lana, at the time of the acci- dent, was acting reasonably and without negligence. Clark, a newspaper reporter, photographs Lana while she is lying in the street in great pain. Two years later, Perry, the publisher of a newspaper, prints Clark’s picture of Lana in his newspaper as a lead to an article concerning the negligence of children. The caption under the picture reads: “They ask to be killed.” Lana, who has recovered from the accident, brings suit against Clark and Perry. What is the result?

6. The Saturday Evening Post featured an article entitled “The Story of a College Football Fix,” characterized in the subtitle as “A Shocking Report of How Wally Butts and Bear Bryant Rigged a Game Last Fall.” Butts was athletic director of the University of Georgia, and Bryant was head coach of the University of Alabama. The article

Chapter 7 Intentional Torts 151

was based on a claim by one George Burnett that he had accidentally overheard a long-distance telephone conversation between Butts and Bryant in the course of which Butts divulged information on plays Georgia would use in the upcoming game against Alabama. The writer assigned to the story by the Post was not a foot- ball expert, did not interview either Butts or Bryant, and did not personally see the notes Burnett had made of the telephone conversation. Butts admitted that he had a long-distance telephone conversation with Bryant but denied that any advance information on prospective football plays was given. Has Butts been defamed by the Post?

7. A patient confined in a hospital, Joan, has a rare disease that is of great interest to the public. Carol, a television reporter, requests Joan to consent to an interview. Joan refuses, but Carol, nonetheless, enters Joan’s room over her objection and photographs her. Joan brings a suit against Carol. Is Carol liable? If so, for what tort?

8. Owner has a place on his land where he piles trash. The pile has been there for three months. John, a neighbor of Owner, without Owner’s consent or knowledge, throws trash onto the trash pile. Owner learns that John has done this and sues him. What tort, if any, has John committed?

9. Chris leaves her car parked in front of a store. There are no signs that say Chris cannot park there. The store- owner, however, needs the car moved to enable a deliv- ery truck to unload. He releases the brake and pushes Chris’s car three or four feet, doing no harm to the car. Chris returns and sees that her car has been moved and is very angry. She threatens to sue the storeowner for trespass to her personal property. Can she recover?

10. Carr borrowed John’s brand-new Ford for the purpose of going to the store. He told John he would be right back. Carr then decided, however, to go to the beach while he had the car. Can John recover from Carr the value of the automobile? If so, for what tort?

C A S E P R O B L E M S

11. Marcia Samms claimed that David Eccles had repeatedly and persistently called her at various hours, including late at night, from May to December, soliciting her to have illicit sexual relations with him. She also claimed that on one occasion Eccles came over to her residence to again solicit sex and indecently exposed himself to her. Mrs. Samms had never encouraged Eccles but had con- tinuously repulsed his “insulting, indecent, and obscene” proposals. She brought suit against Eccles, claiming she suffered great anxiety and fear for her personal safety and severe emotional distress, demanding actual and punitive damages. Can she recover? If so, for what tort?

12. National Bond and Investment Company sent two of its employees to repossess Whithorn’s car after he failed to complete the payments. The two repossessors located Whithorn while he was driving his car. They followed him and hailed him down in order to make the reposses- sion. Whithorn refused to abandon his car and demanded evidence of their authority. The two repossessors became impatient and called a wrecker. They ordered the driver of the wrecker to hook Whithorn’s car and move it down the street while Whithorn was still inside the vehicle. Whithorn started the car and tried to escape, but the wrecker lifted the car off the road and progressed sev- enty-five to one hundred feet until Whithorn managed to stall the wrecker. Has National Bond committed the tort of false imprisonment?

13. William Proxmire, a U.S. senator from Wisconsin, initiated the “Golden Fleece of the Month Award” to publicize what he believed to be wasteful government spending. The

second of these awards was given to the federal agencies that had for seven years funded Dr. Hutchinson’s research on stress levels in animals. The award was made in a speech Proxmire gave in the Senate; the text was also incorporated into an advance press release that was sent to 275 members of the national news media. Proxmire also referred to the research again in two subsequent newsletters sent to one hundred thousand constituents and during a television interview. Hutchinson then brought this action alleging defamation resulting in personal and economic injury. Assuming that Hutchinson proved that the statements were false and defamatory, would he prevail?

14. Capune was attempting a trip from New York to Florida on an eighteen-foot-long paddleboard. The trip was being covered by various media to gain publicity for Capune and certain products he endorsed. Capune approached a pier by water. The pier was owned by Robbins, who had posted signs prohibiting surfing and swimming around the pier. Capune was unaware of these notices and at- tempted to continue his journey by passing under the pier. Robbins ran up yelling and threw two bottles at Capune. Capune was frightened and tried to maneuver his paddle- board to go around the pier. Robbins then threw a third bottle that hit Capune on the head. Capune had to be helped out of the water and taken to the hospital. He suf- fered a physical wound that required twenty-four sutures and, as a result, had to discontinue his trip. Capune brought suit in tort against Robbins. Is Robbins liable? If so, for which tort or torts?

152 The Legal Environment of Business Part II

15. Ralph Nader, who has been a critic of General Motors Corp. for many years, claims that when General Motors learned that Nader was about to publish a book entitled Unsafe at Any Speed, criticizing one of its automobiles, the company decided to conduct a campaign of intimida- tion against him. Specifically, Nader claims that GMC (a) conducted a series of interviews with Nader’s acquaintan- ces, questioning them about his political, social, racial, and religious views; (b) kept him under surveillance in public places for an unreasonable length of time includ- ing close observation of him in a bank; (c) caused him to be accosted by women for the purpose of entrapping him into illicit relationships; (d) made threatening, harassing, and obnoxious telephone calls to him; (e) tapped his tele- phone and eavesdropped by means of mechanical and electronic equipment on his private conversations with others; and (f) conducted a “continuing” and harassing investigation of him. Nader brought suit against GMC for invasion of privacy. Which, if any, of the alleged actions would constitute invasion of privacy?

16. Bill Kinsey was charged with murdering his wife while working for the Peace Corps in Tanzania. After waiting six months in jail, he was acquitted at a trial that attracted wide publicity. Five years later, while a gradu- ate student at Stanford University, Kinsey had a brief affair with Mary Macur. He abruptly ended the affair by telling Macur he would no longer be seeing her because another woman, Sally Allen, was coming from England to live with him. A few months later, Kinsey and Allen moved to Africa and were subsequently married. Soon af- ter Bill ended their affair, Macur began a letter-writing campaign designed to expose Bill and his mistreatment of her. Macur sent several letters to both Bill and Sally Kinsey, their parents, their neighbors, their parents’ neighbors, members of Bill’s dissertation committee, other faculty, and the president of Stanford University. The let- ters contained statements accusing Bill of murdering his first wife, spending six months in jail for the crime, being a rapist, and exhibiting other questionable behavior. The Kinseys brought an action for invasion of privacy, seek- ing damages and a permanent injunction. Will the Kin- seys prevail? If so, for what tort?

17. Plaintiff, John W. Carson, was the host and star of The Tonight Show, a well-known television program broad- cast by the National Broadcasting Company. Carson also appeared as an entertainer in nightclubs and theaters around the country. From the time he began hosting The Tonight Show, he had been introduced on the show each night with the phrase “Here’s Johnny.” The phrase “Here’s Johnny” is still generally associated with Carson by a substantial segment of the television viewing public. To earn additional income, Carson began authorizing use of this phrase by outside business ventures.

Defendant, Here’s Johnny Portable Toilets, Inc., is a Michigan corporation engaged in the business of renting

and selling “Here’s Johnny” portable toilets. Defendant’s founder was aware at the time he formed the corporation that “Here’s Johnny” was the introductory slogan for Carson on The Tonight Show. He indicated that he coupled the phrase with a second one, “The World’s Foremost Commodian,” to make “a good play on a phrase.” Carson brought suit for invasion of privacy. Should Carson recover? If so, for which tort?

18. Lemmie L. Ruffin, Jr., was an Alabama licensed agent for Pacific Mutual Life Insurance and for Union Fidelity Life Insurance Company. Union wrote group health in- surance policies for municipalities, while Pacific did not. Plaintiffs Cleopatra Haslip, Cynthia Craig, Alma M. Cal- houn, and Eddie Hargrove were employees of Roosevelt City, Alabama. Ruffin gave the city a single proposal for health and life insurance for its employees, which the city approved. Both companies provided the coverage; however, Union provided the health insurance and Pacific provided the life insurance. This packaging of coverage by two different and unrelated insurers was not unusual. Union would send its billings for health premiums to Ruffin at Pacific Mutual’s office. The city clerk each month issued a check for those premiums and sent it to Ruffin. Ruffin, however, did not remit to Union the premium payments he received from the city; instead, he misappropriated most of them. When Union did not receive payment from the city, it sent notices of lapsed health coverage to the plaintiffs, who did not know that their health policies had been canceled.

Plaintiff Haslip was subsequently hospitalized, and because the hospital could not confirm her health cover- age, it required her to make a partial payment on her bill. Her physician, when he was not paid, placed her account with a collection agency, which obtained against Haslip a judgment that damaged her credit. Plaintiffs sued Pacific Mutual and Ruffin for fraud. The case was submitted to a jury, which was instructed that if it found liability for fraud, it could award punitive damages. The jury returned verdicts for the plaintiffs and awarded Haslip $1,040,000, of which at least $840,000 was puni- tive damages. The Supreme Court of Alabama affirmed the trial court’s judgment. Pacific Mutual appealed. Decision?

19. Susan Jungclaus Peterson was a twenty-one-year-old student at Moorhead State University who had lived most of her life on her family farm in Minnesota. Though Susan was a dean’s list student her first year, her academic performance declined after she became deeply involved in an international religious cult organization known locally as The Way of Minnesota, Inc. The cult demanded an enormous psychological and monetary commitment from Susan. Near the end of her junior year, her parents became alarmed by the changes in Susan’s physical and mental well-being and concluded that she had been “reduced to a condition of psychological

Chapter 7 Intentional Torts 153

bondage by The Way.” They sought help from Kathy Mills, a self-styled “deprogrammer” of minds brain- washed by cults.

On May 24, Norman Jungclaus, Susan’s father, picked up Susan at Moorhead State. Instead of returning home, they went to the residence of Veronica Morgel, where Kathy Mills attempted to deprogram Susan. For the first few days of her stay, Susan was unwilling to discuss her involvement. She lay curled in a fetal position in her bedroom, plugging her ears and hysterically screaming and crying while her father pleaded with her to listen. By the third day, however, Susan’s demeanor changed completely. She became friendly and vivacious and communicated with her father. Susan also went roller skating and played softball at a nearby park over the following weekend. She spent the next week in Columbus, Ohio, with a former cult member who had shared her experiences of the previous week. While in Columbus, she spoke daily by telephone with her fianc�e, a member of The Way, who begged her to return to the cult. Susan expressed the desire to get her fianc�e out of the organi- zation, but a meeting between them could not be arranged outside the presence of other members of The Way. Her parents attempted to persuade Susan to sign an agreement releasing them from liability for their actions, but Susan refused. After nearly sixteen days of “deprogramming” Susan left the Morgel residence and returned to her fianc�e and The Way. Upon the direction of The Way ministry, she brought an action against her parents for false imprison- ment. Will Susan prevail? Explain.

20. Debra Agis was a waitress in a restaurant owned by the Howard Johnson Company. On May 23, Roger Dionne,

manager of the restaurant, called a meeting of all wait- resses at which he informed them “there was some steal- ing going on.” Dionne also stated that the identity of the party or parties responsible was not known and that he would begin firing all waitresses in alphabetical order until the guilty party or parties were detected. He then fired Debra Agis, who allegedly “became greatly upset, began to cry, sustained emotional distress, mental anguish, and loss of wages and earnings.” Mrs. Agis brought this complaint against the Howard Johnson Company and Roger Dionne, alleging that the defendants acted recklessly and outrageously, intending to cause emotional distress and anguish. The defendants argued that damages for emotional distress are not recoverable unless physical injury occurs as a result of the distress. Will Agis be successful on her complaint?

21. Pro Golf Manufacturing, Inc., is in the business of manu- facturing and repairing golf equipment as well as providing golf instruction. On September 27, the Tribune Review Newspaper Company published a newspaper article stating that several historic buildings, including the building con- taining Pro Golf’s business, were set for demolition. On February 18 of the following year, the Tribune Review published another newspaper article, stating that the build- ing containing Pro Golf’s business had been demolished. However, the building containing Pro Golf’s business had neither been scheduled for demolition, nor had it been demolished. Pro Golf seeks to recover for the financial loss that these false publications caused. Explain which tort offers the best likelihood of recovery and what Pro Golf would have to prove to recover.

T A K I N G S I D E S

Edith Mitchell, accompanied by her thirteen-year-old daugh- ter, went through the checkout at Walmart and purchased several items. As they exited, the Mitchells passed through an electronic antitheft device, which sounded an alarm. Robert Canady, employed by Walmart as a “people greeter” and security guard, forcibly stopped Edith Mitchell at the exit, grabbed her bag, and told her to step back inside. The secu- rity guard never touched Edith or her daughter and never threatened to touch either of them. Nevertheless, Edith Mitch- ell described the security guard’s actions in her affidavit as “gruff, loud, rude behavior.” The security guard removed every item Mitchell had just purchased and ran it through the security gate. One of the items still had a security code unit on it, which an employee admitted could have been

overlooked by the cashier. When the security guard finished examining the contents of Mitchell’s bag, he put it on the checkout counter. This examination of her bag took ten or fifteen minutes. Once her bag had been checked, no employee of Walmart ever told Mitchell she could not leave. Mitchell was never threatened with arrest. Mitchell brought a tort action against Walmart.

a. Explain on which torts should Mitchell base her claim against Walmart?

b. What arguments would support Walmart’s denial of liability for these torts?

c. Which party should prevail? Explain.

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C H A P T E R 8

NEGLIGENCE AND STRICT LIABILITY

Nothing is so easy as to be wise after the event. QUOTED BY BARON BRAMWELL (1859)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. List and describe the three required elements of an action for negligence.

2. Explain the duty of care that is imposed on (a) adults, (b) children, (c) persons with a physical disability, (d) persons with a mental deficiency, (e) persons with superior knowledge, and (f) persons acting in an emergency.

3. Differentiate among the duties that possessors of land owe to trespassers, licensees, and invitees.

4. Identify the defenses that are available to a tort action in negligence and those that are available to a tort action in strict liability.

5. Identify and describe those activities giving rise to a tort action in strict liability.

W hereas intentional torts deal with conduct that has a substantial certainty of causing harm, negligence involves conduct that cre-

ates an unreasonable risk of harm. The basis of liability for negligence is the failure to exercise reasonable care under the circumstances for the safety of another per- son or his property, which failure proximately causes injury to such person or damage to his property, or both. Thus, if the driver of an automobile intentionally runs down a person, she has committed the intentional tort of battery. If, on the other hand, the driver hits and injures a person while driving with no reasonable regard for the safety of others, she is negligent.

Strict liability is not based on the negligence or intent of the defendant but rather on the nature of the activity in which he is engaging. Under this doctrine,

defendants who engage in certain activities, such as keeping animals or carrying on abnormally dangerous conditions, are held liable for injuries they cause, even if they have exercised the utmost care. The law imposes this liability to bring about a just reallocation of loss, given that the defendant engaged in the activity for his own benefit and probably is better prepared than the plaintiff is to manage the risk inherent in the activity through insurance or otherwise.

As mentioned in Chapter 7, the American Law Insti- tute (ALI) has published the Restatement Third, Torts: Liability for Physical and Emotional Harm (the “Third Restatement”). This new Restatement addresses the general or basic elements of the tort action for liability for accidental personal injury, property damage, and emotional harm, but it does not cover liability for

155

economic loss. “Physical harm” is defined as bodily harm (physical injury, illness, disease, and death) or property damage (physical impairment of real property or tangible personal property). The Third Restatement replaces comparable provisions in the Restatement Sec- ond, Torts. However, the Third Restatement does not cover the following matters, which remain governed by the Second Restatement: protection of reputation or privacy, economic loss, or domestic relations; determi- nation of the recoverable damages and their amount; and the standards for liability of professionals for mal- practice. Otherwise, this chapter reflects the Third Restatement’s provisions.

The ALI’s Restatement Third, Torts: Economic Torts and Related Wrongs will update coverage on torts that involve economic loss or pecuniary harm not result- ing from physical harm or physical contact to a person or property. This project will update coverage of eco- nomic torts in Restatement Second, Torts and address some topics not covered in prior Restatements. The ALI began this project in 2004, and after several years of inactivity, the project was resumed in 2010. Tentative Draft No. 1 (Chapter 1, Unintentional Infliction of Eco- nomic Loss, Sections 1–5) was approved in 2012; Tenta- tive Draft No. 2 (Chapter 1, Unintentional Infliction of Economic Loss, Sections 6–8, and Chapter 2, Liability in Tort for Fraud, Sections 9–15) was approved in 2014.

NEGLIGENCE A person acts negligently if the person does not exercise reasonable care under all the circumstances. Moreover, the general rule is that a person is under a duty to all others at all times to exercise reasonable care for the safety of other persons and their property.

As the comments to the Third Restatement explain, an action for negligence consists of five elements, each of which the plaintiff must prove:

1. Duty of care: that a legal duty required the defend- ant to conform to the standard of conduct estab- lished for the protection of others;

2. Breach of duty: that the defendant failed to exercise reasonable care;

3. Factual cause: that the defendant’s failure to exercise reasonable care in fact caused the harm the plaintiff sustained;

4. Harm: that the harm sustained is of a type protected against negligent conduct; and

5. Scope of liability: that the harm sustained is within the “scope of liability,” which historically has been referred to as “proximate cause.”

We will discuss the first two elements in the next section, “Breach of Duty of Care”; we will cover the last three elements in subsequent sections.

BREACH OF DUTY OF CARE [8-1] Negligence consists of conduct that creates an unrea- sonable risk of harm. In determining whether a given risk of harm was unreasonable, the following factors are considered: (1) the foreseeable probability that the person’s conduct will result in harm, (2) the fore- seeable gravity or severity of any harm that may fol- low, and (3) the burden of taking precautions to eliminate or reduce the risk of harm. Thus, the stand- ard of conduct, which is the basis for the law of negligence, is usually determined by a cost-benefit or risk-benefit analysis.

Reasonable Person Standard [8-1a] The duty of care imposed by law is measured by the degree of carefulness that a reasonable person would exercise in a given situation. The reasonable person is a fictitious individual who is always careful and prudent and never negligent. What the judge or jury determines a reasonable person would have done in light of the facts revealed by the evidence in a particular case sets the standard of conduct for that case. The reasonable person standard is thus external and objective.

Children A child is a person below the age of majority, which in almost all states has been lowered from twenty-one to eighteen. The standard of conduct to which a child must conform to avoid being negligent is that of a reasonably careful person of the same age, intelligence, and experience under all the circumstances. The law applies a test that acknowledges these three factors, because children do not have the judgment, in- telligence, knowledge, and experience of adults. More- over, children as a general rule do not engage in activities entailing high risk to others, and their conduct normally does not involve a potential for harm as great as that of adult conduct. A child who engages in a dan- gerous activity that is characteristically undertaken by adults, however, such as flying an airplane or driving a boat or car, is held in almost all states to the standard of care applicable to adults.

156 The Legal Environment of Business Part II

Physical Disability If a person is ill or otherwise physically disabled, the standard of conduct to which he or she must conform to avoid being negligent is that of a reasonably careful person with the same disability. Thus, a blind person must act as a reasonable person who is blind. However, the conduct of a person during a period of sudden incapacitation or loss of conscious- ness resulting from physical illness is negligent only if the sudden incapacitation or loss of consciousness was reasonably foreseeable to the actor. Examples of sud- den incapacitation include heart attack, stroke, epileptic seizure, and diabetes.

Mental Disability A person’s mental or emo- tional disability is not considered in determining whether conduct is negligent unless the person is a child. The defendant is held to the standard of conduct of a reasonable person who is not mentally or emo- tionally disabled, even though the defendant is, in fact, incapable of conforming to the standard. When a per- son’s intoxication is voluntary, it is not considered as an excuse for conduct that is otherwise lacking in reasonable care.

Superior Skill or Knowledge If a person has skills or knowledge beyond those possessed by most others, these skills or knowledge are circumstances to be taken into account in determining whether the person has acted with reasonable care. Thus, persons who are qualified and who practice a profession or trade that requires special skill and expertise are required to use the same care and skill that members of their profession or trade normally possess. This standard applies to such professionals as physicians, dentists, attorneys, pharmacists, architects, accountants, and engineers and to those who perform a skilled trade such as an airline pilot, electrician, carpenter, and plumber. If a member of a profession or skilled trade possesses greater skill than that common to the profes- sion or trade, she is required to exercise that greater degree of skill.

Standard for Emergencies An emergency is a sudden and unexpected event that calls for immediate action and permits no time for deliberation. In deter- mining whether a defendant’s conduct was reasonable, the fact that he was at the time confronted with a sud- den and unexpected emergency is taken into considera- tion. The standard is still that of a reasonable person under the circumstances—the emergency is simply part of the circumstances. If, however, the defendant’s own

negligent or tortious conduct created the emergency, he is liable for the consequences of this conduct even if he acted reasonably in the resulting emergency situation. Moreover, failure to anticipate an emergency may itself constitute negligence.

Violation of Statute The reasonable person standard of conduct may be established by legislation or administrative regulation. Some statutes do so by expressly imposing civil liability on violators. In cases in which a statute does not expressly provide for civil liability, courts may adopt the requirements of the statute as the standard of conduct if the statute is designed to protect against the type of accident the defendant’s conduct causes and the accident victim is within the class of persons the statute is designed to protect.

If the statute is found to apply, the great majority of the courts hold that an unexcused violation is negli- gence per se; that is, the violation conclusively shows negligent conduct (breach of duty of care). In a minor- ity of states, the violation is considered merely to be evidence of negligence. In either event, the plaintiff must also prove legal causation and injury.

For example, a statute enacted to protect employees from injuries requires that all factory elevators be equipped with specified safety devices. Arthur, an employee in Leonard’s factory, and Marian, a business visitor to the factory, are injured when the elevator fails because the safety devices have not been installed. The court may adopt the statute as a standard of conduct as to Arthur, and hold Leonard negligent per se as to Arthur, but not as to Marian, because Arthur, not Marian, is within the class of persons the statute is intended to protect. Marian would have to establish that a reasonable person in the position of Leonard under the circumstances would have installed the safety device. (See Figure 8-1 illustrating negligence and negligence per se.)

On the other hand, compliance with a legislative enactment or administrative regulation does not prevent a finding of negligence if a reasonable person would have taken additional precautions. For instance, driving at the speed limit may not constitute due care when traffic or road conditions require a lower speed. Legis- lative or administrative rules normally establish mini- mum standards.

PRACTICAL ADVICE Assess the potential liability for negligence arising from your activities and obtain adequate liability insurance to cover your exposure.

Chapter 8 Negligence and Strict Liability 157

R Y A N V . F R I E S E N H A H N C o u r t o f A p p e a l s o f T e x a s , 1 9 9 5

9 1 1 S . W . 2 d 1 1 3 ; a f f i r m e d , 4 1 T e x . S u p . J . 2 6 1 , 9 6 0 S . W . 2 d 6 5 6 ( 1 9 9 8 )

FACTS Todd Friesenhahn, son of Nancy and Fred- erick Friesenhahn, held an “open invitation” party at his parents’ home that encouraged guests to “bring your own bottle.” Sabrina Ryan attended the party, became intoxicated, and was involved in a fatal accident after she left the party. Sandra and Stephen Ryan, Sabrina’s parents, sued the Friesenhahns for negligence, alleging that the Friesenhahns were aware of the underage drink- ing at the party and of Sabrina’s condition when she left the party. The trial court granted summary judgment for the Friesenhahns.

DECISION Judgment reversed.

OPINION Rickhoff, J.

NEGLIGENCE PER SE Accepting the petition’s allegations as true, the Friesen- hahns were aware that minors possessed and consumed alcohol on their property and specifically allowed Sabrina to become intoxicated. The Texas Alcoholic

Beverage Code provides that one commits an offense if, with criminal negligence, he “makes available an alco- holic beverage to a minor.” [Citation.] The exception for serving alcohol to a minor applies only to the minor’s adult parent. [Citation.]

An unexcused violation of a statute constitutes negli- gence per se if the injured party is a member of the class protected by the statute. [Citation.] The Alcoholic Bever- age Code was designed to protect the general public and minors in particular and must be liberally construed. [Citation.] We conclude that Sabrina is a member of the class protected by the Code.

In viewing the Ryans’ allegations in the light most favorable to them, we find that they stated a cause of action against the Friesenhahns for the violation of the Alcoholic Beverage Code.

COMMON LAW NEGLIGENCE The elements of negligence include (1) a legal duty owed by one person to another; (2) breach of that duty; and (3) damages proximately caused by the breach. [Citation.] To

FIGURE 8-1 Negligence and Negligence Per Se

Does D’s conduct violate any statute?

No

Yes

Yes

No

Does the statute expressly provide for civil liability?

Yes

D is liable if causation and protected harm

are proven.

Is the statute intended to protect a class of

persons, which includes P, from that

type of hazard and harm?

No No Yes

Was D’s conduct reasonable under the

circumstances?

D is not liable.

158 The Legal Environment of Business Part II

Duty to Act [8-1b] As stated previously, the general rule is that a person is under a duty to all others at all times to exercise rea- sonable care for the safety of the others’ person and property. On the other hand, subject to several excep- tions, a person (Andrea) does not have a duty of care when the other’s (Bennie’s) person or property is at risk for reasons other than the conduct of Andrea. This rule applies even though the person may be in a position to help another in peril. For example, Anthony, an adult standing at the edge of a steep cliff, observes a baby carriage with a crying infant in it slowly heading to- ward the edge and certain doom. Anthony could easily prevent the baby’s fall at no risk to his own safety. Nonetheless, Anthony does nothing, and the baby falls to its death. Anthony is under no legal duty to act and therefore incurs no liability for failing to do so.

Nonetheless, special relations between the parties may impose an affirmative duty of reasonable care on

the defendant to aid or protect the other with respect to risks that arise within the scope of the relationship. Thus, in the previous example, if Anthony were the baby’s parent or babysitter, Anthony would be under a duty to act and therefore would be liable for not taking action. The special relations giving rise to an affirmative duty to aid or protect another include (1) a common carrier with its passengers, (2) an innkeeper with its guest, (3) an employer with its employees, (4) a school with its students, (5) a landlord with its tenants with respect to common areas under the landlord’s control, (6) a business open to the public with its customers, and (7) custodian with those in its custody including parents with their children. The Third Restatement leaves it to the courts whether to recognize additional relationships as sufficient to impose an affirmative duty. Furthermore, state and federal statutes and administra- tive regulations as well as local ordinances may impose an affirmative duty to act for the protection of another.

determine whether a common law duty exists, we must consider several factors, including risk, foreseeability, and likelihood of injury weighed against the social utility of the defendant’s conduct, the magnitude of the burden of guarding against the injury and consequences of placing that burden on the defendant. [Citation.] ***

As the Supreme Court in [citation] explained, there are two practical reasons for not imposing a third-party duty on social hosts who provide alcohol to adult guests: first, the host cannot reasonably know the extent of his guests’ alcohol consumption level; second, the host cannot reason- ably be expected to control his guests’ conduct. [Citation.] The Tyler court in [citation] relied on these principles in holding that a minor “had no common law duty to avoid making alcohol available to an intoxicated guest [another minor] who he knew would be driving.” [Citation.]

We disagree with the Tyler court because the rationale expressed [by the Supreme Court] in [citation] does not apply to the relationship between minors, or adults and minors. The adult social host need not estimate the extent of a minor’s alcohol consumption because serving minors any amount of alcohol is a criminal offense. [Citation.] ***

***

*** [S]erving minors alcohol creates a risk of injury or death. Under the pled facts, a jury could find that the Friesenhahns, as the adult social hosts, allowed open invitations to a beer bust at their house and they could foresee, or reasonably should have foreseen, that the only means of arriving at their property would be by privately operated vehicles; once there, the most likely means of departure would be by the same means. ***

While one adult has no general duty to control the behavior of another adult, one would hope that adults would exercise special diligence in supervising minors—even during a simple swimming pool party involving potentially dangerous but legal activities. We may have no special duty to watch one adult to be sure he can swim, but it would be ill-advised to turn loose young children without insuring they can swim. When the “party” is for the purpose of engaging in dangerous and illicit activity, the consumption of alcohol by minors, adults certainly have a greater duty of care. [Citation.]

*** In view of the legislature’s determination that minors are not competent to understand the effects of alcohol, we find sufficient legislative intent to support our holding that, taken from the pleadings before us, a duty exists between the adult social host and the minor guest. Accordingly, we find that the Ryans’ petition stated a common-law cause of action.

INTERPRETATION A violation of a statute constitutes negligence per se if the injured party is a member of the class protected by the statute.

ETHICAL QUESTION When should a parent be held liable for her child’s negligence? Explain.

CRITICAL THINKING QUESTION Should a court extend social host liability for providing alcohol to an adult guest? Explain?

Chapter 8 Negligence and Strict Liability 159

In addition, when a person’s prior conduct, even though not tortious, creates a continuing risk of physi- cal harm, the person has a duty to exercise reasonable care to prevent or minimize the harm. For example, Alice innocently drives her car into Frank, rendering him unconscious. Alice leaves Frank lying in the middle of the road, where he is run over by a second car driven by Rebecca. Alice is liable to Frank for the addi- tional injuries inflicted by Rebecca. Moreover, a person who begins a rescue by taking charge of another who is imperiled and unable to protect himself incurs a duty to exercise reasonable care under the circumstances. Furthermore, a person who discontinues aid or protec- tion is under a duty of reasonable care not to leave the other in a worse position. For example, Ann finds Ben drunk and stumbling along a dark sidewalk. Ann leads Ben halfway up a steep and unguarded stairway, where she then abandons him. Ben attempts to climb the stairs but trips and falls, suffering serious injury. Ann is liable to Ben for having left him in a worse position. Most states have enacted Good Samaritan statutes to encour- age voluntary emergency care. These statutes vary con- siderably, but they typically limit or disallow liability for some rescuers under specified circumstances.

There are special relationships in which one person has some degree of control over another person, includ- ing (1) a parent with dependent children and (2) an employer with employees when the employment facili- tates the employee’s causing harm to third parties. The

parent and the employer each owe a duty of reasonable care under the circumstances to third persons with regard to foreseeable risks that arise within the scope of the relationship. Depending on the circumstances, reasonable care may require controlling the activities of the other person or merely providing a warning. Generally, the duty of parents is limited to dependent children; thus when children reach majority or are no longer dependent, parents no longer have control and the duty of reasonable care ceases. The duty of employ- ers includes the duty to exercise reasonable care in the hiring, training, supervision, and retention of employ- ees. This duty of employers is independent of the vicari- ous liability of an employer for an employee’s tortious conduct during the course of employment and extends to conduct by the employee that occurs both inside and outside the scope of employment so long as the em- ployment facilitates the employee causing harm to third parties. The Third Restatement provides the following example of an employer’s duty:

Don is employed by Welch Repair Service, which knows that Don had several episodes of assault in his previous employment. Don goes to Traci’s residence, where he had previously been dispatched by Welch, and misrepresents to Traci that he is there on Welch business to check repairs that had previously been made in Traci’s home. After Traci admits Don, he assaults Traci. Welch is subject to a duty under this subsection with regard to Don’s assault on Traci.

S O L D A N O V . O ’ D A N I E L S C a l i f o r n i a C o u r t o f A p p e a l s , F i f t h D i s t r i c t , 1 9 8 3

1 4 1 C a l . A p p . 3 d 4 4 3 , 1 9 0 C a l . R p t r . 3 1 0

FACTS On August 9, the plaintiff’s father, Darrell Soldano, was shot and killed at the Happy Jack Saloon. The defendant owns and operates the Circle Inn, an eating establishment across the street from the Happy Jack Saloon. On the night of the shooting, a patron of the Happy Jack Saloon came into the Circle Inn and informed the Circle Inn bartender that a man had been threatened at Happy Jack’s. The patron requested that the Circle Inn bartender either call the police or allow the patron to use the Circle Inn phone to call the police. The bartender refused either to make the call or to allow the Happy Jack patron to use the phone. The plaintiff alleges that the actions of the Circle Inn em- ployee were a breach of the legal duty that the Circle Inn owed to the decedent. The defendant maintains that there was no legal obligation to take any action, and

therefore there was no duty owed to the decedent. The trial court dismissed the case on the defendant’s motion for summary judgment.

DECISION The appellate court reversed and remanded the case for trial.

OPINION Andreen, J. There is a distinction, well rooted in the common law, between action and non- action. [Citation.] It has found its way into the prestigi- ous Restatement Second of Torts (hereafter cited as “Restatement”), which provides in section 314: “The fact that the actor realizes or should realize that action on his part is necessary for another’s aid or protection does nor of itself impose upon him a duty to take such action.” ***

160 The Legal Environment of Business Part II

*** As noted in [citation], the courts have increased the

instances in which affirmative duties are imposed not by direct rejection of the common law rule, but by expanding the list of special relationships which will justify departure from that rule.

*** Section 314A of the Restatement lists other special rela-

tionships which create a duty to render aid, such as that of a common carrier to its passengers, an innkeeper to his guest, possessors of land who hold it open to the public, or one who has a custodial relationship to another. A duty may be created by an undertaking to give assistance. [Citation.]

Here there was no special relationship between the defendant and the deceased. It would be stretching the concept beyond recognition to assert there was a rela- tionship between the defendant and the patron from Happy Jack’s Saloon who wished to summon aid. But this does not end the matter.

It is time to re-examine the common law rule of non- liability for nonfeasance in the special circumstances of the instant case.

***

We turn now to the concept of duty in a tort case. The [California] Supreme Court has identified certain factors to be considered in determining whether a duty is owed to third persons. These factors include:

the foreseeability of harm to the plaintiff, the degree of cer- tainty that the plaintiff suffered injury, the closeness of the connection between the defendant’s conduct and the injury suffered, the moral blame attached to the defendant’s con- duct, the policy of preventing future harm, the extent of the burden to the defendant and consequences to the commu- nity of imposing a duty to exercise care with resulting liabil- ity for breach, and the availability, cost, and prevalence of insurance for the risk involved. [Citation.]

We examine those factors in reference to this case. (1) The harm to the decedent was abundantly fore- seeable; it was imminent. The employee was expressly told that a man had been threatened. The employee was a bartender. As such he knew it is foreseeable that some people who drink alcohol in the milieu of a bar setting are prone to violence. (2) The certainty of decedent’s injury is undisputed. (3) There is arguably a close con- nection between the employee’s conduct and the injury: the patron wanted to use the phone to summon the police to intervene. The employee’s refusal to allow the use of the phone prevented this anticipated intervention. If permitted to go to trial, the plaintiff may be able to

show that the probable response time of the police would have been shorter than the time between the prohibited telephone call and the fatal shot. (4) The employee’s conduct displayed a disregard for human life that can be characterized as morally wrong: he was cal- lously indifferent to the possibility that Darrell Soldano would die as the result of his refusal to allow a person to use the telephone. Under the circumstances before us the bartender’s burden was minimal and exposed him to no risk: all he had to do was allow the use of the telephone. It would have cost him or his employer noth- ing. It could have saved a life. (5) Finding a duty in these circumstances would promote a policy of prevent- ing future harm. A citizen would not be required to summon the police but would be required, in circum- stances such as those before us, not to impede another who has chosen to summon aid. (6) We have no infor- mation on the question of the availability, cost, and prevalence of insurance for the risk, but note that the liability which is sought to be imposed here is that of employee negligence, which is covered by many insur- ance policies. (7) The extent of the burden on the de- fendant was minimal, as noted.

*** We acknowledge that defendant contracted for the

use of his telephone, and its use is a species of property. But if it exists in a public place as defined above, there is no privacy or ownership interest in it such that the owner should be permitted to interfere with a good faith attempt to use it by a third person to come to the aid of another.

*** We conclude that the bartender owed a duty to the

plaintiff’s decedent to permit the patron from Happy Jack’s to place a call to the police or to place the call himself.

It bears emphasizing that the duty in this case does not require that one must go to the aid of another. That is not the issue here. The employee was not the good sa- maritan intent on aiding another. The patron was.

INTERPRETATION Although a person may not have a duty to help another, in a case such as this, a person has a duty not to hinder others who are trying to help.

CRITICAL THINKING QUESTION Should the courts go beyond the rule of this case and impose an affirmative duty to go to the aid of another person who is in peril if it can be done without endangerment? Explain.

Chapter 8 Negligence and Strict Liability 161

Duties of Possessors of Land [8-1c] The right of possessors of land to use that land for their own benefit and enjoyment is limited by their duty to do so in a reasonable manner. By the use of their land, possessors of land cannot cause unreasonable risks of harm to others. Liability for breach of this obli- gation may arise from conduct in any of the three areas of torts discussed in this and the preceding chapter: intentional harm, negligence, or strict liability. Most of these cases fall within the classification of negligence.

In conducting activities on her land, the possessor of land is required to exercise reasonable care to pro- tect others who are not on her property. For example, a property owner who constructs a factory on her premises must take reasonable care that it is not unrea- sonably dangerous to people off the site. Moreover, a business or other possessor of land that holds its prem- ises open to the public owes those who are lawfully on the premises a duty of reasonable care with regard to risks that arise within the scope of the relationship.

In most states and under the Second Restatement, the duty of a possessor of land to persons who come on the land usually depends on whether those persons are trespassers, licensees, or invitees. In about fifteen states, however, licensees and invitees are owed the same duty. In addition, at least nine states have abandoned these dis- tinctions and simply apply ordinary negligence principles of foreseeable risk and reasonable care to all entrants on the land including trespassers. The Third Restatement has adopted this last—the unitary—approach.

Second Restatement In accordance with the historical—and still majority—approach to the duties of possessors of land, the Second Restatement provides for varying duties depending on the status of the entrant on the land.

A trespasser is a person who enters or remains on the land of another without the possessor’s consent or a legal privilege to do so. The possessor of the land is not liable to adult trespassers for his failure to maintain the land in a reasonably safe condition. Nonetheless, the possessor is not free to inflict intentional injury on a trespasser. Moreover, most courts hold that upon discovery of the presence of trespassers on the land, the lawful possessor is required to exercise reasonable care for their safety in carrying on her activities and to warn the trespassers of potentially dangerous condi- tions that the trespassers are not likely to discover.

A licensee is a person who is privileged to enter or remain on land only by virtue of the lawful possessor’s consent. Licensees include members of the possessor’s household, social guests, and salespersons calling at

private homes. A licensee will become a trespasser, however, if he enters a portion of the land to which he is not invited or remains on the land after his invitation has expired. The possessor owes a higher duty of care to licensees than to trespassers. The possessor must warn the licensee of dangerous activities and conditions (1) of which the possessor has knowledge or reason to know and (2) the licensee does not and is not likely to discover. If he is not warned, the licensee may recover if the activity or dangerous condition resulted from the possessor’s failure to exercise reasonable care to protect him from the danger. To illustrate: Henry invites a friend, Anne, to his place in the country at 8:00 p.m. on a winter evening. Henry knows that a bridge in his driveway is in a dangerous condition that is not noticeable in the dark. Henry does not inform Anne of this fact. The bridge gives way under Anne’s car, caus- ing serious harm to Anne. Henry is liable to Anne.

An invitee is a person invited upon land as a mem- ber of the public or for a business purpose. A public invitee is a person who is invited to enter or remain on land as a member of the public for a purpose for which the land is held open to the public. Such invitees include those who use public parks, beaches, or swim- ming pools, as well as those who use government facili- ties, such as a post office or an office of the recorder of deeds, where business with the public is transacted openly. A business visitor is a person invited to enter or remain on premises for a purpose directly or indi- rectly concerning business dealings with the possessor of the land, such as one who enters a store or a worker who enters a residence to make repairs. With respect to the condition of the premises, the possessor of land is under a duty to exercise reasonable care to protect invitees against dangerous conditions they are unlikely to discover. This liability extends not only to those con- ditions of which the possessor actually knows but also to those of which she would discover by the exercise of reasonable care. For example, David’s store has a large glass front door that is well lighted and plainly visible. Maxine, a customer, mistakes the glass for an open doorway and walks into the glass, injuring herself. David is not liable to Maxine. If, on the other hand, the glass was difficult to see and a person foreseeably might have mistaken the glass for an open doorway, then David would be liable to Maxine if Maxine crashed into the glass while exercising reasonable care.

Third Restatement The status-based duty rules just discussed have been rejected by the Third Restatement, which adopts a unitary duty of reasona- ble care to persons coming onto the land.

162 The Legal Environment of Business Part II

[Except for “flagrant trespassers,”] a land possessor owes a duty of reasonable care to entrants on the land with regard to:

1. conduct by the land possessor that creates risks to entrants on the land;

2. artificial conditions on the land that pose risks to entrants on the land;

3. natural conditions on the land that pose risks to entrants on the land; …

This rule is similar to the duty land possessors owed to invitees under the Second Restatement except that it extends the duty to all who enter the land, including trespassers, with the exception of “flagrant trespassers.” This rule requires a land possessor to use reasonable care to investigate and discover dangerous conditions and to use reasonable care to eliminate or improve those dangerous conditions that are known or should have been discovered by the exercise of rea- sonable care. However, some risks cannot reasonably be discovered, and the land possessor is not subject to liability for those risks. In addition, a land possessor is not liable to an ordinary trespasser whose unforesee- able presence results in an unforeseeable risk.

A different rule applies to “flagrant trespassers.” The Third Restatement requires that a land possessor only (1) refrain from intentional, willful, or wanton con- duct that harms a flagrant trespasser and (2) exercise

reasonable care on behalf of flagrant trespassers who are imperiled and helpless. The Third Restatement does not define “flagrant trespassers” but instead leaves it to each state to determine at what point an ordinary trespasser becomes a “flagrant trespasser.” The comments to the Third Restatement explain:

The idea behind distinguishing particularly egregious tres- passers for different treatment is that their presence on another’s land is so antithetical to the rights of the land possessor to exclusive use and possession of the land that the land possessor should not be subject to liability for failing to exercise the ordinary duty of reasonable care otherwise owed to them as entrants on the land. It stems from the idea that when a trespass is sufficiently offensive to the property rights of the land possessor it is unfair to subject the possessor to liability for mere negligence.

The Third Restatement provides an illustration of a flagrant trespasser: “Herman engaged in a late-night bur- glary of the Jacob liquor store after it had closed. While leaving the store after taking cash from the store’s regis- ter, Herman slipped on a slick spot on the floor, fell, and broke his arm. Herman is a flagrant trespasser.…”

PRACTICAL ADVICE Take care to inspect your premises regularly to detect any dangerous conditions and either remedy the danger or post prominent warnings of any dangerous conditions you discover.

L O V E V . H A R D E E ’ S F O O D S Y S T E M S , I N C . C o u r t o f A p p e a l s o f M i s s o u r i , E a s t e r n D i s t r i c t , D i v i s i o n T w o , 2 0 0 0

1 6 S . W . 3 d 7 3 9

FACTS At about 3:15 p.m. on November 15, 1995, plaintiff, Jason Love, and his mother, Billye Ann Love, went to the Hardee’s Restaurant in Arnold, Missouri, owned by defendant, Hardee’s Food Systems, Inc. There were no other customers in the restaurant between 3:00 p.m. and 4:00 p.m., but two or three workmen were in the back doing construction. The workmen reported that they did not use the restroom and did not see any- one use the restroom. When Jason went to use the rest- room, he slipped on water on the restroom floor. He fell backwards, hit his head, and felt a shooting pain down his right leg. He found himself lying in an area of dirty water, which soaked his clothes. There were no barricades, warning cones, or anything else that would either restrict access to the bathroom or warn of the danger.

Jason stated after the fall that his back and leg were “hurting pretty bad.” His mother reported the fall. The supervisor filled out an accident report form, which reported that the accident occurred at 3:50 p.m. The supervisor testified that the water appeared to have come from someone shaking his hands after washing them. The supervisor could not recall the last time the restroom had been checked. Jason was taken to a hospital emergency room. As a result of his injuries, he underwent two back surgeries, missed substantial time from work, and suffered from continuing pain and limi- tations on his physical activities.

Hardee’s had a policy requiring that the restroom be checked and cleaned every hour by a maintenance person, who was scheduled to work until 3:00 p.m., but normally left at 1:00 p.m. The supervisor could not recall whether the maintenance person left at 1:00 p.m.

Chapter 8 Negligence and Strict Liability 163

or 3:00 p.m. on November 15, and the defendant was unable to produce the time clock report for that day.

It was also a store policy that whenever employees cleaned the tables, they would check the restroom. If an employee had to use the restroom, then that employee was also supposed to check the restroom. The restaurant supervisor did not ask if any employees had been in the restroom, or if they had checked it in the hour prior to the accident, and did not know if the restroom was actually inspected or cleaned at 3:00 p.m. The restaurant had shift inspection checklists on which the manager would report on the cleanliness of the restrooms and whether the floors were clean and dry. However, the checklists for November 15 were thrown away.

Jason Love filed a lawsuit against Hardee’s Food Systems, Inc., to recover damages for negligence. The jury returned a verdict in the plaintiff’s favor in the amount of $125,000.

DECISION The judgment of the trial court is affirmed.

OPINION Crane, J. In order to have made a submis- sible case, plaintiff had to show that defendant knew or, by using ordinary care, could have known of the danger- ous condition and failed to use ordinary care to remove it, barricade it, or warn of it, and plaintiff sustained dam- age as a direct result of such failure. [Citation.]

“In order to establish constructive notice, the condi- tion must have existed for a sufficient length of time or the facts must be such that the defendant should have reasonably known of its presence.” [Citation.] [Prior] cases *** placed great emphasis on the length of time the dangerous condition had been present and held that times of 20 or 30 minutes, absent proof of other circum- stances, were insufficient to establish constructive notice as a matter of law. [Citations.]

*** Defendant’s liability is predicated on the foreseeability

of the risk and the reasonableness of the care taken, which is a question of fact to be determined by the totality of the circumstances, including the nature of the restaurant’s business and the method of its operation. [Citations.]

In this case the accident took place in the restaurant’s restroom which is provided for the use of employees and customers. The cause of the accident was water, which is provided in the restroom. The restaurant owner could reasonably foresee that anyone using the rest- room, customers or employees, would use the tap water provided in the restroom and could spill, drop, or splash

water on the floor. Accordingly, the restaurant owner was under a duty to use due care to guard against dan- ger from water on the floor.

There was substantial evidence to support submissi- bility. *** [The water] was on the floor of the restroom and the supervisor testified it appeared that someone had shaken water from his hands on the floor.

Next, there was evidence from which the jury could infer that, if the water was caused by a non-employee, the water was on the floor for at least 50 minutes, or longer, because there was evidence that no other cus- tomers were in the store to use the restroom after 3:00 P.M. and the workmen on the site advised that they had not used the restroom.

In addition, plaintiff adduced evidence from which the jury could have found that defendants’ employees had the opportunity to observe the hazard. The restroom was to be used by the employees and was supposed to be checked by them when they used it; employees cleaning tables were supposed to check the restroom when they cleaned the tables; and a maintenance man was supposed to check and clean the restroom every hour.

There was evidence from which the jury could have inferred that the maintenance man charged with clean- ing the restroom every hour did not clean the restroom at 3:00 P.M. as scheduled on the day of the accident. There was testimony that the maintenance man usually left at 1:00 P.M. *** This could have created a span of 2 hours and 50 minutes during which there was no em- ployee working at the restaurant whose primary respon- sibility was to clean the restroom. [Citation.]

There was also evidence from which the jury could have inferred that the restroom was not inspected by any employee who had the responsibility to inspect it during that same time period. The supervisor testified that he could not recall the last time the restroom had been checked and did not ask any employees if they had been in the restroom or had checked it in the hour before the accident. ***

INTERPRETATION The owner or possessor of property is liable to an invitee if the owner knew or, by using ordinary care, could have known of the dangerous condition and failed to use ordinary care to remove it, barricade it, or warn of it, and the invitee sustained damage as a direct result of such failure.

CRITICAL THINKING QUESTION Should customers be required to look for dangers?

164 The Legal Environment of Business Part II

Res Ipsa Loquitur [8-1d] A rule of circumstantial evidence has developed that per- mits the jury to infer both negligent conduct and causa- tion from the mere occurrence of certain types of events. This rule, called res ipsa loquitur, meaning “the thing speaks for itself,” applies when the accident causing the plaintiff’s physical harm is a type of accident that ordi- narily happens as a result of the negligence of a class of actors of which the defendant is the relevant member. For example, Camille rents a room in Leo’s motel. Dur- ing the night, a large piece of plaster falls from the ceiling and injures Camille. In the absence of other evidence, the jury may infer that the harm resulted from Leo’s negli- gence in permitting the plaster to become defective. Leo is permitted, however, to introduce evidence to contradict the inference of negligence.

FACTUAL CAUSE [8-2] Liability for the negligent conduct of a defendant requires that the conduct in fact caused harm to the plaintiff. The Third Restatement states: “Tortious con- duct must be a factual cause of physical harm for liabil- ity to be imposed.” A widely applied test for causation in fact is the but-for test: A person’s conduct is a cause of an event if the event would not have occurred but for the person’s negligent conduct. That is, conduct is a factual cause of harm when the harm would not have occurred absent the conduct. For instance, Arnold fails to erect a barrier around an excavation. Doyle is driving a truck when its accelerator becomes stuck. Arnold’s negligence is not a cause in fact of Doyle’s death if the runaway truck would have crashed through the barrier even if it had been erected. Similarly, failure to install a proper fire escape to a hotel is not the cause in fact of the death of a person who is suffocated by the smoke while sleeping in bed during a hotel fire.

If the tortious conduct of Adam is insufficient by itself to cause Paula’s harm, but when Adam’s conduct is combined with the tortious conduct of Barry, the combined conduct is sufficient to cause Paula’s harm, then Adam and Barry are each considered a factual cause of Paula’s harm.

The but-for test, however, is not satisfied when there are two or more causes, each of which is sufficient to bring about the harm in question and each of which is active at the time harm occurs. For example, Wilson and Hart negligently set fires that combine to destroy Ken- nedy’s property. Either fire would have destroyed the property. Under the but-for test, either Wilson or Hart, or both, could argue that the fire caused by the other

would have destroyed the property and that he, therefore, is not liable. The Third Restatement addresses this prob- lem of multiple sufficient causes by providing, “If multi- ple acts exist, each of which alone would have been a factual cause under [the but-for test] of the physical harm at the same time, each act is regarded as a factual cause of the harm.” Under this rule the conduct of both Wilson and Hart would be found to be a factual cause of the destruction of Kennedy’s property.

SCOPE OF LIABILITY (PROXIMATE CAUSE) [8-3] As a matter of social policy, legal responsibility has not followed all the consequences of a negligent act. Tort law does not impose liability on a defendant for all harm factually caused by the defendant’s negligent con- duct. Liability has been limited—to a greater extent than with intentional torts—to those harms that result from the risks that made the defendant’s conduct tor- tious. This “risk standard” limitation on liability also applies to strict liability cases. The Third Restatement provides the following example: Richard, a hunter, fin- ishes his day in the field and stops at a friend’s house while walking home. His friend’s nine-year-old daugh- ter, Kim, greets Richard, who hands his loaded shotgun to her as he enters the house. Kim drops the shotgun, which lands on her toe, breaking it. Although Richard was negligent for giving Kim his shotgun, the risk that made Richard negligent was that Kim might shoot someone with the gun, not that she would drop it and hurt herself (the gun was neither especially heavy nor unwieldy). Kim’s broken toe is outside the scope of Richard’s liability, even though Richard’s tortious conduct was a factual cause of Kim’s harm.

Foreseeability [8-3a] Determining the liability of a negligent defendant for unforeseeable consequences has proved to be trouble- some and controversial. The Second Restatement and many courts have adopted the following position:

1. If the actor’s conduct is a substantial factor in bring- ing about harm to another, the fact that the actor neither foresaw nor should have foreseen the extent of the harm or the manner in which it occurred does not prevent him from being liable.

2. The actor’s conduct may be held not to be a legal cause of harm to another where, after the event and looking back from the harm to the actor’s negligent

Chapter 8 Negligence and Strict Liability 165

conduct, it appears to the court highly extraordinary that it should have brought about the harm.

A comment to the Third Restatement explains that

the foreseeability test for proximate cause is essentially consistent with the standard set forth in this [Restate- ment]. Properly understood, both the risk standard and a foreseeability test exclude liability for harms that were sufficiently unforeseeable at the time of the actor’s tortious conduct that they were not among the risks— potential harms—that made the actor negligent. Negli- gence limits the requirement of reasonable care to those risks that are foreseeable.

For example, Steven, while negligently driving an auto- mobile, collides with a car carrying dynamite. Steven is unaware of the contents of the other car and has no reason to know about them. The collision causes the dynamite to explode, shattering glass in a building a block away. The shattered glass injures Doria, who is inside the build- ing. The explosion also injures Walter, who is walking on the sidewalk near the collision. Steven would be liable to Walter because Steven should have realized that his negligent driving might result in a collision that would endanger pedestrians nearby. Doria’s harm, however, was beyond the risks posed by Steven’s negligent driving and he, accordingly, is not liable to Doria.

P A L S G R A F V . L O N G I S L A N D R A I L R O A D C O . C o u r t o f A p p e a l s o f N e w Y o r k , 1 9 2 8

2 4 8 N . Y . 3 3 9 , 1 6 2 N . E . 9 9

FACTS Palsgraf was on the railroad station platform buying a ticket when a train stopped at the station. As it began to depart, two men ran to catch it. After the first was safely aboard, the second jumped onto the moving car. When he started to fall, a guard on the train reached to grab him and another guard on the platform pushed the man from behind. They helped the man to regain his balance, but in the process they knocked a small package out of his arm. The package, which contained fireworks, fell onto the rails and exploded. The shock from the explosion knocked over a scale resting on the other end of the platform, and it landed on Mrs. Palsgraf. She then brought an action against the Long Island Railroad Company to recover for the injuries she sustained. The railroad appealed from the trial and appellate courts’ deci- sions in favor of Palsgraf.

DECISION Judgment for Palsgraf reversed.

OPINION Cardozo, C. J. The conduct of the defend- ant’s guard, if a wrong in its relation to the holder of the package, was not a wrong in its relation to the plaintiff, standing far away. Relatively to her it was not negligence at all. Nothing in the situation gave notice that the falling package had in it the potency of peril to persons thus removed. Negligence is not actionable unless it involves the invasion of a legally protected interest, the violation of a right. “Proof of negligence in the air, so to speak, will not do.” [Citations.] “Negligence is the absence of care, according to the circumstances.” [Citations.]

***

If no hazard was apparent to the eye of ordinary vig- ilance, an act innocent and harmless, at least to outward seeming, with reference to her, did not take to itself the quality of a tort because it happened to be wrong, though apparently not one involving the risk of bodily insecurity, with reference to some one else. “In every instance, before negligence can be predicated of a given act, back of the act must be sought and found a duty to the individual complaining, the observance of which would have averted or avoided the injury.” [Citations.]

*** A different conclusion will involve us, and swiftly

too, in a maze of contradictions. A guard stumbles over a package which has been left upon a platform. It seems to be a bundle of newspapers. It turns out to be a can of dynamite. To the eye of ordinary vigilance, the bun- dle is abandoned waste, which may be kicked or trod on with impunity. Is a passenger at the other end of the platform protected by the law against the unsuspected hazard concealed beneath the waste? If not, is the result to be any different, so far as the distant passenger is concerned, when the guard stumbles over a valise which a truckman or a porter has left upon the walk? The pas- senger far away, if the victim of a wrong at all, has a cause of action, not derivative, but original and primary. His claim to be protected against invasion of his bodily security is neither greater nor less because the act result- ing in the invasion is a wrong to another far removed. In this case, the rights that are said to have been vio- lated, the interests said to have been invaded, are not even of the same order. The man was not injured in his person nor even put in danger. The purpose of the act,

166 The Legal Environment of Business Part II

Superseding Cause [8-3b] An intervening cause is an event or act that occurs after the defendant’s negligent conduct and with that negli- gence causes the plaintiff’s harm. If the intervening cause is deemed a superseding cause, it relieves the defendant of liability for that harm.

For example, Carol negligently leaves in a public sidewalk a substantial excavation without a fence or warning lights, into which Gary falls at night. Dark- ness is an intervening, but not a superseding, cause of harm to Gary because it is a normal consequence of the situation caused by Carol’s negligence. There- fore, Carol is liable to Gary. In contrast, if Carol neg- ligently leaves an excavation in a public sidewalk into which Barbara intentionally shoves Gary, under the Second Restatement as a matter of law Carol is not liable to Gary because Barbara’s conduct is a super- seding cause that relieves Carol of liability. The Third Restatement rejects this exception to liability, stating,

Whether Gary’s harm is within the scope of Carol’s liability for her negligence is an issue for the factfinder.

The factfinder will have to determine whether the appro- priate characterization of the harm to Gary is falling into an unguarded excavation site or being deliberately pushed into an unguarded excavation site and, if the latter, whether it is among the risks that made Carol negligent.

An intervening cause that is a foreseeable or normal consequence of the defendant’s negligence is not a superseding cause. Thus, a person who negli- gently places another person or his property in im- minent danger is liable for the injury sustained by a third-party rescuer who attempts to aid the imperiled person or his property. The same is true of attempts by the endangered person to escape the peril, as, for example, when a person swerves off the road to avoid a head-on collision with an automobile driven negligently on the wrong side of the road. It is commonly held that a negligent defendant is liable for the results of necessary medical treatment of the injured party, even if the treatment itself is negligent.

as well as its effect, was to make his person safe. If there was wrong to him at all, which may very well be doubted, it was wrong to a property interest only, the safety of his package. Out of this wrong to property, which threatened injury to nothing else, there has passed, we are told, to the plaintiff by derivation or succession a right of action for the invasion of an inter- est of another order, the right to bodily security. The diversity of interests emphasizes the futility of the effort to build the plaintiff’s right upon the basis of a wrong to some one else. *** One who jostles one’s neighbor in a crowd does not invade the rights of others stand- ing at the outer fringe when the unintended contact

casts a bomb upon the ground. The wrongdoer as to them is the man who carries the bomb, not the one who explodes it without suspicion of the danger.

INTERPRETATION Even if the defendant’s negligent conduct in fact caused harm to the plaintiff, the defendant is not liable if the defendant could not have foreseen injuring the plaintiff or a class of persons to which the plaintiff belonged.

CRITICAL THINKING QUESTION Should a person be held liable for all injuries that her negligence in fact causes? Explain.

P E T I T I O N O F K I N S M A N T R A N S I T C O . U n i t e d S t a t e s C o u r t o f A p p e a l s , S e c o n d C i r c u i t , 1 9 6 4

3 3 8 F . 2 d 7 0 8

FACTS The MacGilvray Shiras was a ship owned by the Kinsman Transit Company. During the winter months when Lake Erie was frozen, the ship and others moored at docks on the Buffalo River. As oftentimes happened, one night an ice jam disintegrated upstream, sending large chunks of ice downstream. Chunks of ice began to pile up against the Shiras, which at that time was without power and manned only by a shipman.

The ship broke loose when a negligently constructed “deadman” to which one mooring cable was attached pulled out of the ground. The “deadman” was operated by Continental Grain Company. The ship began moving down the S-shaped river stern first and struck another ship, the Tewksbury. The Tewksbury also broke loose from its mooring, and the two ships floated down the river together. Although the crew manning the Michigan

Chapter 8 Negligence and Strict Liability 167

HARM [8-4] The plaintiff must prove that the defendant’s negligent conduct proximately caused harm to a legally protected

interest. Certain interests receive little or no protection against such conduct, while others receive full protec- tion. The courts determine the extent of protection for a particular interest as a matter of law on the basis of

Avenue Bridge downstream had been notified of the runaway ships, they failed to raise the bridge in time to avoid a collision because of a mix-up in the shift changeover. As a result, both ships crashed into the bridge and were wedged against the bank of the river. The two vessels substantially dammed the flow of the river, causing ice and water to back up and flood in- stallations as far as three miles upstream. The injured parties brought this action for damages against Kins- man, Continental, and the city of Buffalo. The trial court found the three defendants liable, and they appealed from that decree.

DECISION Decree of trial court affirmed as to liability.

OPINION Friendly, J. The very statement of the case suggests the need for considering Palsgraf v. Long Island RR., [citation], and the closely related problem of liability for unforeseeable consequences.

***

We see little similarity between the Palsgraf case and the situation before us. The point of Palsgraf was that the appearance of the newspaper-wrapped pack- age gave no notice that its dislodgement could do any harm save to itself and those nearby, and this impact, perhaps with consequent breakage, and not by ex- plosion. In contrast, a ship insecurely moored in a fast flowing river is a known danger not only to herself but to the owners of all other ships and structures down river, and to persons upon them. No one would dream of saying that a shipowner who “knowingly and wilfully” failed to secure his ship at a pier on such a river “would not have threatened” persons and owners of property down-stream in some manner. The shipowner and the wharfinger in this case having thus owed a duty of care to all within the reach of the ship’s known destructive power, the impossibility of advance identification of the particular person who would be hurt is without legal consequence. [Cita- tions.] Similarly the foreseeable consequences of the City’s failure to raise the bridge were not limited to the Shiras and the Tewksbury. Collision plainly cre- ated a danger that the bridge towers might fall onto adjoining property, and the crash of two uncontrolled lake vessels, one 425 feet and the other 525 feet long, into a bridge over a swift ice-ridden stream, with a

channel only 177 feet wide, could well result in a par- tial damming that would flood property upstream.

*** All the claimants here met the Palsgraf requirement

of being persons to whom the actors owed a “duty of care,” *** . But this does not dispose of the alternative argument that the manner in which several of the claim- ants were harmed, particularly by flood damage, was unforeseeable and that recovery for this may not be had—whether the argument is put in the forthright form that unforeseeable damages are not recoverable or is concealed under a formula of lack of “proximate cause.”

*** Foreseeability of danger is necessary to render con-

duct negligent; where as here the damage was caused by just those forces whose existence required the exercise of greater care than what was taken—the current, the ice, and the physical mass of the Shiras, the incurring of consequences other and greater than foreseen does not make the conduct less culpable or provide a reasoned basis for insulation. [Citation.] The oft encountered argument that failure to limit liability to foreseeable consequences may subject the defendant to a loss wholly out of proportion to his fault seems scarcely consistent with the universally accepted rule that the defendant takes the plaintiff as he finds him and will be responsi- ble for the full extent of the injury even though a latent susceptibility of the plaintiff renders this far more serious than could reasonably have been anticipated. [Citation.]

The weight of authority in this country rejects the limitation of damages to consequences foreseeable at the time of the negligent conduct when the consequences are “direct,” and the damage, although other and greater than expectable, is of the same general sort that was risked.

INTERPRETATION The unforeseeability of the exact manner and extent of a loss will not limit liability where the persons injured and the general nature of the damage were foreseeable.

CRITICAL THINKING QUESTION Com- pare this decision with that in the Palsgraf case and attempt to reconcile the two decisions.

168 The Legal Environment of Business Part II

social policy and expediency. For example, negligent conduct that is the proximate cause of harmful contact with the person of another is actionable. Thus, if Bob while driving his car negligently runs into Julie, a pe- destrian, who is carefully crossing the street, Bob is liable for physical injuries Julie sustains as a result of the collision. On the other hand, if Bob’s careless driv- ing causes the car’s side view mirror to brush Julie’s coat but results in no physical injuries to her or damage to the coat, thus causing only offensive contact with Julie’s person, Bob is not liable because Julie did not sustain harm to a legally protected interest.

The courts traditionally have been reluctant to allow recovery for negligently inflicted emotional distress. This view has gradually changed, and the majority of courts now hold a person liable for negligently causing emotional distress if bodily harm—such as a heart attack—results from the distress. And though, in the majority of states, a defendant is not liable for conduct resulting solely in emotional disturbance, some courts have recently allowed recovery of damages for negli- gently inflicted emotional distress even in the absence of physical harm when a person’s negligent conduct places another in immediate danger of bodily harm. The Third Restatement follows the minority approach: a person whose negligent conduct places another in immediate danger of bodily harm is subject to liability to the other for serious emotional disturbance caused by reaction to the danger even though the negligent conduct did not cause any impact or bodily harm to the other. Furthermore, in a majority of states and under the Third Restatement, liability for negligently inflicted emotional distress arises in the following situa- tion: A negligently causes serious bodily injury to B. If C is a close family member of B and witnesses the injury to B, then A is liable to C for serious emotional disturbance C suffers from witnessing the event.

DEFENSES TO NEGLIGENCE [8-5] Although a plaintiff has established by a preponderance of the evidence all the required elements of a negligence action, he may nevertheless fail to recover damages if the defendant proves a valid defense. As a general rule, any defense to an intentional tort is also available in an action in negligence. In addition, certain defenses are available in negligence cases that are not defenses to intentional torts. These are contributory negligence, comparative negligence, and assumption of risk. (See Figure 8-2 illustrating the defenses to a negligence action.)

Contributory Negligence [8-5a] Contributory negligence is defined as conduct on the part of the plaintiff that falls below the standard to which he should conform for his own protection and that is a legal cause of the plaintiff’s harm. The Third Restate- ment’s definition of negligence as the failure of a person to exercise reasonable care under all the circumstances applies to the contributory negligence of the plaintiff. In those few jurisdictions that have not adopted compara- tive negligence (Alabama, Maryland, North Carolina, Virginia, and Washington, D.C.), the contributory negli- gence of the plaintiff, whether slight or extensive, prevents him from recovering any damages from the defendant.

Notwithstanding the contributory negligence of the plaintiff, if the defendant had a last clear chance to avoid injury to the plaintiff but did not avail himself of such a chance, the contributory negligence of the plaintiff does not bar his recovery of damages.

Comparative Negligence [8-5b] The harshness of the contributory negligence doctrine has caused all but a few states to reject its all-or-nothing rule and to substitute the doctrine of comparative negligence, which is also called comparative fault or comparative responsibility. (In states adopting comparative negligence, the doctrine of last clear chance has been abandoned.)

Approximately a dozen states have judicially or legislatively adopted “pure” comparative negligence systems. (The ALI’s Third Restatement of Torts: Appor- tionment of Liability advocates this form of compara- tive negligence.) Under pure comparative negligence damages are divided between the parties in proportion to the degree of fault or negligence found against them. For instance, Matthew negligently drives his automobile into Nancy, who is crossing against the light. Nancy sustains damages in the amount of $10,000 and sues Matthew. If the trier of fact (the jury or judge, depend- ing on the case) determines that Matthew’s negligence contributed 70 percent to Nancy’s injury and that Nancy’s contributory negligence contributed 30 percent to her injury, then Nancy would recover $7,000.

Most states have adopted the doctrine of “modified” comparative negligence. Under modified comparative negligence the plaintiff recovers as in pure comparative negligence unless her contributory negligence was equal to or greater than that of the defendant, in which case the plaintiff recovers nothing. Thus, in the previous exam- ple, if the trier of fact determined that Matthew’s negli- gence and Nancy’s contributory negligence contributed 40 percent and 60 percent, respectively, to her injury, then Nancy would not recover anything from Matthew.

Chapter 8 Negligence and Strict Liability 169

FIGURE 8-2 Defenses to a Negligence Action

Defendant prevails

No

Did the defendant have the last clear chance?

Defendant loses Yes

No

Is the defendant negligent?

Has the plaintiff assumed the risk?

Is the plaintiff contributorily negligent?

Is there comparative negligence?

Defendant prevails

Defendant prevails

Defendant loses

Damages are apportioned

Yes

No

No

Yes

No

Yes

Yes

M O O R E V . K I T S M I L L E R C o u r t o f A p p e a l s o f T e x a s , T w e l f t h D i s t r i c t , T y l e r , 2 0 0 6

2 0 1 S . W . 3 d 1 4 7 ; r e v i e w d e n i e d ( 2 0 0 6 )

FACTS In the spring of 2001, Kitsmiller purchased a house in Van Zandt County to use as rental property. In mid-June, he hired B & H Shaw Company, Inc. (B & H), to install a replacement septic tank in the backyard. The septic tank was located about two or three feet from a concrete stoop at the back door of the garage. B & H mounded dirt over the septic tank and the lat- eral lines going out from it upon completion. Sometime after B & H installed the septic tank, Kitsmiller smoothed out the mounds of dirt over the septic tank and lateral lines. Kitsmiller then leased the property to Moore and his wife on July 27. Kitsmiller testified that

he viewed the backyard about a week or ten days prior to leasing the property to the Moores and stated that the dirt around the septic system looked firm.

On August 7, the Moores moved in. On August 11, Moore and his wife went into the backyard for the first time, and as he stepped off the stoop, he was unable to see the ground and could only see his wife and the bag of trash in his left arm. His wife testified that the ground looked flat. Moore testified that he had only taken a few steps off the stoop when his left leg sank into a hole, causing him to fall forward into his wife. As he tried to steady himself with his right foot, it hung

170 The Legal Environment of Business Part II

and then sank, causing him to fall backward on his head and back. Moore testified that the injury to his back required surgery and affected his ability to earn a living.

Moore filed suit against Kitsmiller and B & H. He sought damages for past and future pain and suffering, past and future mental anguish, past and future physical impairment, and past and future loss of earning capacity. In their answers to Moore’s suit, both Kitsmiller and B & H pleaded the affirmative defense of contributory negligence.

During the jury trial, Moore testified Kitsmiller should have notified him where the septic tank and lat- eral lines were located and that the dirt should have remained mounded over the tank and lines. Martin, an on-site septic tank complaint investigator for both the Texas Commission on Environmental Quality and Van Zandt County, testified that dirt should have been mounded over the septic tank and lateral lines, so that when the dirt settled, there would be no holes in the ground around the septic tank or lateral lines.

The jury determined that (1) both Kitsmiller and Moore were negligent, but B & H was not; (2) Kitsmil- ler was 51 percent negligent and Moore was 49 percent negligent; and (3) Moore was entitled to $210,000 in damages. On September 29, 2004, the trial court entered a judgment in favor of Moore and against Kits- miller in the amount of $210,000 plus interest and costs. Applying comparative negligence, the trial court entered a modified final judgment on November 1, 2004, awarding Moore $107,100 plus interest and costs based upon Moore’s contributory negligence. Moore appealed all issues involving his contributory negligence.

DECISION The judgment of the trial court is affirmed.

OPINION Worthen, C. J. Moore argues that his wife and Kitsmiller testified that the back yard was flat at the time of the occurrence. He contends that no one could have anticipated any danger from walking into the yard. Therefore, Moore argues that there is no evi- dence in the record to support the jury’s determination that he was contributorily negligent.

Contributory negligence contemplates an injured per- son’s failure to use ordinary care regarding his or her own safety. [Citation.] This affirmative defense requires proof that the plaintiff was negligent and that the plain- tiff’s negligence proximately caused his or her injuries. [Citation.] Negligence requires proof of proximate cause. [Citation.] Proximate cause requires proof of both cause in fact and foreseeability. [Citation.] The test for cause in fact is whether the negligent act or omission was a substantial factor in bringing about an injury without which the harm would not have occurred. [Citation.]

Foreseeability requires that a person of ordinary intelli- gence should have anticipated the danger created by a negligent act or omission. [Citation.]

Because comparative responsibility involves measuring the party’s comparative fault in causing the plaintiff’s injuries, it necessitates a preliminary finding that the plaintiff was in fact contributorily negligent. [Citation.] The standards and tests for determining contributory negligence ordinarily are the same as those for determin- ing negligence, and the rules of law applicable to the former are applicable to the latter. [Citation.] The burden of proof on the whole case is on the plaintiff. [Citation.] However, on special issues tendered by the defendant presenting an affirmative defense such as contributory negligence, the burden of proof is on the defendant to prove the defense by a preponderance of the evidence. [Citation.]

When attacking the legal sufficiency of an adverse finding on an issue on which the party did not have the burden of proof, that party must demonstrate there is no evidence to support the adverse finding. [Citation.] To evaluate the legal sufficiency of the evidence to sup- port a finding, we must determine whether the proffered evidence as a whole rises to a level that would enable reasonable and fair minded people to differ in their conclusions. [Citation.] We sustain a no evidence issue only if there is no more than a scintilla of evidence proving the elements of the claim. [Citation.] In making this determination, we must view the evidence in the light most favorable to the verdict, crediting favorable evidence if reasonable jurors could and disregarding contrary evidence unless reasonable jurors could not. [Citation.] The trier of fact may draw reasonable and logical inferences from the evidence. [Citation.] It is within the province of the jury to draw one reasonable inference from the evidence although another inference could have been made. [Citation.]

*** Moore testified that when he stepped off the stoop

into the back yard for the first time on August 11, 2001, he could only see his wife and the plastic bag of trash he was carrying in his left hand. The jury was allowed to draw an inference from this evidence that Moore was not watching where he was walking. An individual must keep a proper lookout where he is walking, and a jury is allowed to make a reasonable in- ference that failure to do so was the proximate cause of his injuries. [Citation.] It was reasonable for the jury to make an inference from Moore’s testimony that his fail- ure to keep a proper lookout where he was walking contributed to the occurrence.

Moore contends that the only reasonable inference the jury could have made was that, even if he had been watching where he was walking, he would not have

Chapter 8 Negligence and Strict Liability 171

Assumption of Risk [8-5c] A plaintiff who has voluntarily and knowingly assumed the risk of harm arising from the negligent or reckless conduct of the defendant cannot recover for such harm. In express assumption of the risk, the plaintiff expressly agrees to assume the risk of harm from the defendant’s conduct. Usually, but not always, such an agreement is by contract. Courts usually construe these exculpatory contracts strictly and will hold that the plaintiff has assumed the risk only if the terms of the agreement are clear and unequivocal. Moreover, some contracts for assumption of risk are considered unenforceable as a matter of public policy. See Chapter 13.

In implied assumption of the risk, the plaintiff vol- untarily proceeds to encounter a known danger. Thus, a spectator entering a baseball park may be regarded as consenting that the players may proceed with the game without taking precautions to protect him from being hit by the ball. Most states have abolished or modified the defense of implied assumption of risk. Some have abandoned it entirely while others have merged implied assumption of risk into their comparative negligence systems.

Reflecting this general trend, the Third Restatement of Torts: Apportionment of Liability has abandoned the doctrine of implied voluntary assumption of risk: it is no longer a defense that the plaintiff was aware of a risk and voluntarily confronted it. But if a plaintiff’s conduct in the face of a known risk is unreasonable, it might constitute contributory negligence, thereby reducing the plaintiff’s recovery under comparative negligence. This new Restatement limits the defense of assumption of risk to express assumption of risk, which consists of a con- tract between the plaintiff and another person to absolve the other person from liability for future harm. Contrac- tual assumption of risk may occur by written agreement, express oral agreement, or conduct that creates an implied-in-fact contract, as determined by the applicable rules of contract law. Some contractual assumptions of risk, however, are not enforceable under other areas of substantive law or as against public policy.

PRACTICAL ADVICE Consider having customers and clients sign waivers of liability and assumption of risk forms, but realize that many courts limit their effectiveness.

STRICT LIABILITY In some instances a person may be held liable for injuries he has caused even though he has not acted intentionally or negligently. Such liability is called strict liability, absolute liability, or liability without fault. The courts have determined that certain types of other- wise socially desirable activities pose sufficiently high risks of harm regardless of how carefully they are con- ducted, and that therefore those who carry on these activities should bear the cost of any harm that such activities cause. The doctrine of strict liability is not based on any particular fault of the defendant but on the nature of the activity in which he is engaging.

ACTIVITIES GIVING RISE TO STRICT LIABILITY [8-6] This section discusses the following activities that give rise to strict liability: (1) performing abnormally dan- gerous activities and (2) keeping animals. In addition, strict liability is imposed upon other activities. For example, nearly all states have imposed a limited form of strict product liability upon manufacturers and mer- chants who sell goods in a defective condition un- reasonably dangerous to the user or consumer. This topic is covered in Chapter 22.

Abnormally Dangerous Activities [8-6a] A person who carries on an abnormally dangerous activity is subject to strict liability for physical harm

been able to avoid stepping in the holes because they were not visible to the naked eye. The jury could have made that inference, but chose not to do so. Shaw’s testimony that Martin’s photographs showed the depres- sions could have been present at the time of the occur- rence could have led the jury to believe that Moore’s contention was not a reasonable inference. We conclude that the jury made a reasonable inference from the evi- dence in finding Moore contributorily negligent.

INTERPRETATION In cases in which both the plaintiff and defendant are negligent, under comparative negligence the law apportions damages between the par- ties in proportion to the degree of fault or negligence found against them.

CRITICAL THINKING QUESTION Is it fair that the plaintiff recovers damages despite being contributorily negligent? Explain.

172 The Legal Environment of Business Part II

resulting from the activity. The Third Restatement pro- vides that an activity is an abnormally dangerous activ- ity if: “(1) the activity creates a foreseeable and highly significant risk of physical harm even when reasonable care is exercised by all actors; and (2) the activity is not one of common usage.” The court determines whether an activity is abnormally dangerous by applying these factors. Activities to which the rule has been applied include collecting water or sewage in such quantity and location as to make it dangerous, storing explo- sives or flammable liquids in large quantities, blasting or pile driving, crop dusting, drilling for or refining

oil in populated areas, and emitting noxious gases or fumes into a settled community. On the other hand, courts have refused to apply the rule where the activity is a “natural” use of the land, such as drilling for oil in the oil fields of Texas or transmitting gas through a gas pipe or electricity through electric wiring.

PRACTICAL ADVICE Determine if any of your activities involve abnormally dangerous activities for which strict liability is imposed and be sure to obtain adequate insurance.

K L E I N V . P Y R O D Y N E C O R P O R A T I O N S u p r e m e C o u r t o f W a s h i n g t o n , 1 9 9 1

1 1 7 W a s h . 2 d 1 , 8 1 0 P . 2 d 9 1 7 , a s c o r r e c t e d 8 1 7 P . 2 d 1 3 5 9

FACTS Pyrodyne Corporation contracted to conduct the fireworks display at the Western Washington State Fairgrounds in Puyallup, Washington, on July 4, 1987. During the fireworks display, one of the five-inch mor- tars was knocked into a horizontal position. A shell inside ignited and discharged, flying five hundred feet parallel to the earth and exploding near the crowd of onlookers. Danny and Marion Klein were injured by the explosion. Mr. Klein suffered facial burns and serious injuries to his eyes. The parties provided conflicting explanations for the improper discharge, and because all the evidence had exploded, there was no means of prov- ing the cause of the misfire. The Kleins brought suit against Pyrodyne under the theory of strict liability for participating in an abnormally dangerous activity.

DECISION Judgment for the Kleins.

OPINION Guy, J. The modern doctrine of strict liability for abnormally dangerous activities derives from Fletcher v. Rylands, [citation], in which the defendant’s reservoir flooded mine shafts on the plaintiff’s adjoining land. Rylands v. Fletcher has come to stand for the rule that “the defendant will be liable when he damages another by a thing or activity unduly dangerous and inappropriate to the place where it is maintained, in the light of the character of that place and its surroundings.” [Citation.]

The basic principle of Rylands v. Fletcher has been accepted by the Restatement (Second) of Torts (1977). [Citation.] Section 519 of the Restatement provides that any party carrying on an “abnormally dangerous activity” is strictly liable for ensuing damages. The test for what constitutes such an activity is stated in section

520 of the Restatement. Both Restatement sections have been adopted by this court, and determination of whether an activity is an “abnormally dangerous activity” is a question of law. [Citations.]

Section 520 of the Restatement lists six factors that are to be considered in determining whether an activity is “abnormally dangerous.” The factors are as follows: (a) existence of a high degree of risk of some harm to the person, land or chattels of others; (b) likelihood that the harm that results from it will be great; (c) inability to eliminate the risk by the exercise of reasonable care; (d) extent to which the activity is not a matter of com- mon usage; (e) inappropriateness of the activity to the place where it is carried on; and (f) extent to which its value to the community is outweighed by its dangerous attributes. Restatement (Second) of Torts §520 (1977). As we previously recognized in [citation], the comments to section 520 explain how these factors should be eval- uated: Any one of them is not necessarily sufficient of itself in a particular case, and ordinarily several of them will be required for strict liability. On the other hand, it is not necessary that each of them be present, especially if others weigh heavily. Because of the interplay of these various factors, it is not possible to reduce abnormally dangerous activities to any definition. The essential question is whether the risk created is so unusual, either because of its magnitude or because of the circumstan- ces surrounding it, as to justify the imposition of strict liability for the harm that results from it, even though it is carried on with all reasonable care. Restatement (Second) of Torts §520, comment f (1977). Examination of these factors persuades us that fireworks displays are abnormally dangerous activities justifying the imposition of strict liability.

Chapter 8 Negligence and Strict Liability 173

Keeping of Animals [8-6b] Strict liability for harm caused by animals existed at common law and continues today with some modifica- tion. As a general rule, those who possess animals for their own purposes do so at their peril and must pro- tect against harm those animals may cause to people and property.

Trespassing Animals Owners and possessors of animals, except for dogs and cats, are subject to strict liability for any physical harm their animals cause by trespassing on the property of another. There are two exceptions to this rule: (1) keepers of animals are not strictly liable for animals incidentally straying upon land immediately adjacent to a highway on which they are being lawfully driven, although the owner may be liable for negligence if he fails to control them

properly and (2) in some western states, keepers of farm animals, typically cattle, are not strictly liable for harm caused by their trespassing animals that are allowed to graze freely.

Nontrespassing Animals Owners and posses- sors of wild animals are subject to strict liability for physical harm caused by such animals, whether or not they are trespassing. Accordingly the owner or posses- sor is liable even if she has exercised reasonable care in attempting to restrain the wild animal. Wild animals are defined as those that, in the particular region in which they are kept, are known to be likely to inflict serious damage and that cannot be consid- ered safe, no matter how domesticated they are. The Third Restatement has a similar definition: “A wild animal is an animal that belongs to a category of

We find that the factors stated in clauses (a), (b), and (c) are all present in the case of fireworks displays. Any time a person ignites aerial shells or rockets with the intention of sending them aloft to explode in the pres- ence of large crowds of people, a high risk of serious personal injury or property damage is created. That risk arises because of the possibility that a shell or rocket will malfunction or be misdirected. Furthermore, no matter how much care pyrotechnicians exercise, they cannot entirely eliminate the high risk inherent in setting off powerful explosives such as fireworks near crowds.

*** The factor expressed in clause (d) concerns the extent

to which the activity is not a matter “of common usage.” The Restatement explains that “[a]n activity is a matter of common usage if it is customarily carried on by the great mass of mankind or by many people in the community.” Restatement (Second) of Torts §520, comment i (1977). As examples of activities that are not matters of common usage, the Restatement comments offer driving a tank, blasting, the manufacture, storage, transportation, and use of high explosives, and drilling for oil. The deciding characteristic is that few persons engage in these activities. Likewise, relatively few per- sons conduct public fireworks displays. Therefore, pre- senting public fireworks displays is not a matter of common usage.

***

The factor stated in clause (e) requires analysis of the appropriateness of the activity to the place where it was carried on. In this case, the fireworks display was

conducted at the Puyallup Fairgrounds. Although some locations—such as over water—may be safer, the Puyal- lup Fairgrounds is an appropriate place for a fireworks show because the audience can be seated at a reasonable distance from the display. Therefore, the clause (e) fac- tor is not present in this case.

The factor stated in clause (f) requires analysis of the extent to which the value of fireworks to the community outweighs its dangerous attributes. We do not find that this factor is present here. This country has a longstand- ing tradition of fireworks on the 4th of July. That tradi- tion suggests that we as a society have decided that the value of fireworks on the day celebrating our national independence and unity outweighs the risks of injuries and damage.

In sum, we find that setting off public fireworks dis- plays satisfies four of the six conditions under the Restate- ment test; that is, it is an activity that is not “of common usage” and that presents an ineliminably high risk of seri- ous bodily injury or property damage. We therefore hold that conducting public fireworks displays is an abnor- mally dangerous activity justifying the imposition of strict liability.

INTERPRETATION The courts impose strict liability for harm resulting from an abnormally danger- ous activity, as determined in light of the place, time, and manner in which the activity was conducted.

CRITICAL THINKING QUESTION If an activity is abnormally dangerous, should the law abolish it? Explain.

174 The Legal Environment of Business Part II

animals that have not been generally domesticated and that are likely, unless restrained, to cause personal injury.” The court determines whether a category of animals is wild. Animals included in this category are bears, lions, elephants, monkeys, tigers, deer, and raccoons. On the other hand, iguanas, pigeons, and manatees are not considered wild animals because they do not pose a risk of causing substantial personal injury.

Domestic animals are those animals that are tradi- tionally devoted to the service of humankind and that as a class are considered safe. Examples of domestic animals are dogs, cats, horses, cattle, and sheep. Own- ers and possessors of domestic animals are subject to

strict liability if they knew, or had reason to know, of an animal’s dangerous tendencies abnormal for the animal’s category. The animal’s dangerous propensity must be the cause of the harm. For example, a keeper is not liable for a dog that bites a human merely because he knows that the dog has a propensity to fight with other dogs. On the other hand, a person whose 150-pound Old English sheepdog has a propensity to jump enthusiastically on visitors would be liable for any damage caused by the dog’s playfulness. About half of the states statutorily impose strict liability in dog cases even where the owner or possessor does not know, and did not have reason to know, of the dog’s dangerous tendencies.

DEFENSES TO STRICT LIABILITY [8-7] Because the strict liability of one who carries on an abnormally dangerous activity or keeps animals is not

based on his negligence, the ordinary contributory negligence of the plaintiff is not a defense to such liabil- ity. The law in imposing strict liability places the full responsibility for preventing harm on the defendant.

P A L U M B O V . N I K I R K S u p r e m e C o u r t , A p p e l l a t e D i v i s i o n , S e c o n d D e p a r t m e n t , N e w Y o r k , 2 0 0 9

5 9 A . D . 3 d 6 9 1 , 8 7 4 N . Y . S . 2 d 2 2 2 , 2 0 0 9 N . Y . S l i p O p . 0 1 4 5 4

FACTS The plaintiff (Palumbo), a mail carrier, sustained injuries when he allegedly was bitten and attacked by a dog on the front steps of the defendants’ (Nikirk’s) house as he attempted to deliver the mail. The plaintiff, who crossed over the defendants’ lawn and driveway from the house next door, and whose view of the dog was obstructed by a bush, did not see the dog or hear it bark until he opened the lid of the mailbox and was bitten. The plaintiff brought an action to recover damages for personal injuries. The trial court granted the defendants’ motion for summary judgment dismissing the complaint. The plaintiff appealed.

DECISION Summary judgment is affirmed.

OPINION Per curiam. To recover upon a theory of strict liability in tort for a dog bite or attack, a plaintiff must prove that the dog had vicious propensities and that the owner of the dog, or person in control of the premises where the dog was, knew or should have known of such propensities [citations]. “Vicious propen- sities include the ‘propensity to do any act that might endanger the safety of the persons and property of others in a given situation”’ [citations].

Here, the defendants established their prima facie entitlement to judgment as a matter of law by presenting evidence that the dog had never bitten, jumped, or growled at anyone prior to the incident in question, nor had the dog exhibited any other aggressive or vicious behavior [citations]. In opposition, the plaintiff failed to come forward with any proof in evidentiary form that the dog had ever previously bitten anyone or exhibited any vicious propensities. Furthermore, the presence of a “Beware of Dog” sign on the premises, the breed of the dog, and the owner’s testimony that the dog was always on a leash were insufficient to raise a triable issue of fact as to the dog’s vicious propensities in the absence of any evidence that prior to this incident the dog exhib- ited any fierce or hostile tendencies [citations].

INTERPRETATION Owners and possessors of domestic animals are subject to strict liability if they knew, or had reason to know, of the animal’s vicious propensities.

CRITICAL THINKING QUESTION Is the burden on the plaintiff to establish the animal’s prior vicious propensities too difficult to sustain?

Chapter 8 Negligence and Strict Liability 175

Nevertheless, some states apply the doctrine of com- parative negligence to some types of strict liability. The Third Restatement provides that if the plaintiff has been contributorily negligent in failing to take reasona- ble precautions, the plaintiff’s recovery in a strict- liability claim for physical harm caused by abnormally dangerous activities or keeping of animals is reduced in accordance with the share of comparative responsibility assigned to the plaintiff.

Under the Second Restatement of Torts voluntary assumption of risk is a defense to an action based on strict liability. If the owner of an automobile knowingly and voluntarily parks the vehicle in a blasting zone, he may not recover for harm to his automobile. The assumption of risk, however, must be voluntary. Where blasting operations are established, for example, the possessor of nearby land is not required to move away and may recover for harm suffered.

The more recent Third Restatement of Torts: Appor- tionment of Liability has abandoned the doctrine of

implied voluntary assumption of risk in tort actions generally: it is no longer a defense that the plaintiff was aware of a risk and voluntarily confronted it. This new Restatement limits the defense of assumption of risk to express assumption of risk, which consists of a contract between the plaintiff and another person to absolve the other person from liability for future harm.

The Third Restatement: Liability for Physical and Emotional Harm recognizes a limitation on strict liabil- ity for abnormally dangerous activities and keeping of animals when the victim suffers harm as a result of exposure to the animal or activity resulting from the victim’s securing some benefit from that exposure. The Third Restatement gives the following example: “if the plaintiff is a veterinarian or a groomer who accepts an animal such as a dog from the defendant, the plain- tiff is deriving financial benefits from the acceptance of the animal, and is beyond the scope of strict lia- bility, even if the dog can be deemed abnormally dangerous.”

Ethical Dilemma What Are the Obligations of a Bartender to His Patrons?

FACTS John Campbell, age twenty-two, was recently hired as a management trainee for the Stanton Hotel. The Stanton features a health club, swimming pool, ski slopes, and boating facilities. The management trainee program is an eighteen-month program during which the trainees rotate jobs to gain exposure to all phases of hotel operations. There is no formal orientation, and each trainee is randomly assigned to jobs.

John’s first assignment was at the restaurant/bar working with Mr. Arnold, a bartender who was fifty years old and quite experienced. Mr. Arnold commented to John that John was lucky to be working the bar during the skiing season. Mr. Arnold explained that skiers frequently come in from the slopes to warm up. He told John that all tips are shared equally and that the more it snows and the colder it gets, the better the bar business.

One day, John observed that Mr. Arnold was serving drinks to two young men who appeared to be about twenty-two or twenty-three. John overheard the men plan- ning to ski an hour or so more and then drive over to meet friends at a neighboring hotel. One of the men appeared self-contained and unaffected by the drinks. His friend,

however, was gradually getting louder, although he was not making a disturbance.

John noticed that Mr. Arnold had already served three rounds of bourbon to the men. When Mr. Arnold was preparing the fourth round, John said to him, “Don’t you think they’ve had enough? They’re going back on the slopes.” Mr. Arnold replied, “Kid, you’ve got a lot to learn.”

Social, Policy, and Ethical Considerations 1. What action, if any, should John take?

2. What are the potential risks to the two men who are drinking? Are public safety issues involved?

3. What management policies should the hotel institute with regard to its liquor policies and athletic operations?

4. Do the drinking companions bear an ethical responsibil- ity for each other’s drinking?

5. How should society balance the interests of freedom of business and individual conduct (i.e., drinking) with the competing interests of protecting public safety?

176 The Legal Environment of Business Part II

C H A P T E R S U M M A R Y NEGLIGENCE

Breach of Duty of Care

Definition of Negligence conduct that falls below the standard established by law for the protection of others against unreasonable risk of harm

Reasonable Person Standard degree of care that a reasonable person would exercise under all the circumstances • Children must conform to conduct of a reasonable person of the same age, intelligence, and

experience under all the circumstances • Physical Disability a disabled person’s conduct must conform to that of a reasonable person

under the same disability • Mental Disability a mentally disabled person is held to the reasonable person standard of a

reasonable person who is not mentally deficient • Superior Skill or Knowledge if a person has skills or knowledge beyond those possessed by

most others, these skills or knowledge are circumstances to be taken into account in determining whether the person has acted with reasonable care

• Standard for Emergencies the reasonable person standard applies, but an unexpected emergency is considered part of the circumstances

• Violation of Statute if the statute applies, the violation is negligence per se in most states

Duty to Act a person is under a duty to all others at all times to exercise reasonable care for the safety of the others’ person and property; however, except in special circumstances, no one is required to aid another in peril

Duties of Possessors of Land • Second Restatement a land possessor owes the following duties: (1) not to injure

intentionally trespassers, (2) to warn licensees of known dangerous conditions licensees are unlikely to discover for themselves, and (3) to exercise reasonable care to protect invitees against dangerous conditions land possessor should know of but invitees are unlikely to discover

• Third Restatement adopts a unitary duty of reasonable care to all entrants on the land except for flagrant trespassers: a land possessor must use reasonable care to investigate and discover dangerous conditions and must use reasonable care to eliminate or improve those dangerous conditions that are known or should have been discovered by the exercise of reasonable care

Res Ipsa Loquitur permits the jury to infer both negligent conduct and causation

Factual Cause and Scope of Liability

Factual Cause the defendant’s conduct is a factual cause of the harm when the harm would not have occurred absent the conduct Scope of Liability (Proximate Cause) Liability is limited to those harms that result from the risks that made the defendant’s conduct tortious • Foreseeability excludes liability for harms that were sufficiently unforeseeable at the time

of the defendant’s tortious conduct that they were not among the risks that made the defendant negligent

• Superseding Cause an intervening act that relieves the defendant of liability

Chapter 8 Negligence and Strict Liability 177

Harm

Burden of Proof plaintiff must prove that defendant’s negligent conduct caused harm to a legally protected interest

Harm to Legally Protected Interest courts determine which interests are protected from negligent interference

Defenses to Negligence

Contributory Negligence failure of a plaintiff to exercise reasonable care for his own protection, which in a few states prevents the plaintiff from recovering anything

Comparative Negligence damages are divided between the parties in proportion to their degree of negligence; applies in almost all states

Assumption of Risk plaintiff’s express consent to encounter a known danger; some states still apply implied assumption of the risk

STRICT LIABILITY

Activities Giving Rise to Strict Liability

Definition of Strict Liability liability for nonintentional and nonnegligent conduct

Abnormally Dangerous Activity strict liability is imposed for any activity that (1) creates a foreseeable and highly significant risk of harm and (2) is not one of common usage

Keeping of Animals strict liability is imposed for wild animals and usually for trespassing domestic animals

Defenses to Strict Liability

Contributory Negligence is not a defense to strict liability

Comparative Negligence some states apply this doctrine to some strict liability cases

Assumption of Risk express assumption of risk is a defense to an action based upon strict liability; some states apply implied assumption of risk to strict liability cases

Q U E S T I O N S

1. A statute that requires railroads to fence their tracks is construed as intended solely to prevent injuries to ani- mals straying onto the right-of-way. B & A Railroad Company fails to fence its tracks. Two of Calvin’s cows wander onto the track. Nellie is hit by a train. Elsie is poisoned by weeds growing beside the track. For which cow(s), if any, is B & A Railroad Company liable to Calvin? Why?

2. Martha invites John to come to lunch. Martha knows that her private road is dangerous to travel, having been heavily eroded by recent rains. She doesn’t warn John of the condition, reasonably believing that he will notice the deep ruts and exercise sufficient care. John’s attention,

while driving over, is diverted from the road by the screaming of his child, who has been stung by a bee. He fails to notice the condition of the road, hits a rut, and skids into a tree. If John is not contributorily negligent, is Martha liable to John?

3. Nathan is run over by a car and left lying in the street. Sam, seeing Nathan’s helpless state, places him in his car for the purpose of taking him to the hospital. Sam drives negligently into a ditch, causing additional injury to Nathan. Is Sam liable to Nathan?

4. Vance was served liquor while he was an intoxicated patron of the Clear Air Force Station Noncommissioned Officers’ Club. He later injured himself as a result of his

178 The Legal Environment of Business Part II

intoxication. An Alaska state statute makes it a crime to give or to sell liquor to intoxicated persons. Vance has brought an action seeking damages for the injuries he suffered. Could Vance successfully argue that the United States was negligent per se by its employee’s violation of the statute?

5. A statute requires all vessels traveling on the Great Lakes to provide lifeboats. One of Winston Steamship Com- pany’s boats is sent out of port without a lifeboat. Perry, a sailor, falls overboard in a storm so heavy that had there been a lifeboat it could not have been launched. Perry drowns. Is Winston liable to Perry’s estate?

6. Lionel is negligently driving an automobile at excessive speed. Reginald’s negligently driven car crosses the center line of the highway and scrapes the side of Lionel’s car, damaging its fenders. As a result, Lionel loses control of his car, which goes into the ditch, wrecking the car and causing personal injuries to Lionel. What can Lionel recover?

7. Ellen, the owner of a baseball park, is under a duty to the entering public to provide a reasonably sufficient number of screened seats to protect those who desire such protection against the risk of being hit by batted balls. Ellen fails to do so.

a. Frank, a customer entering the park, is unable to find a screened seat and, although fully aware of the risk, sits in an unscreened seat. Frank is struck and injured by a batted ball. Is Ellen liable?

b. Gretchen, Frank’s wife, has just arrived from Germany and is viewing baseball for the first time. Without ask- ing any questions, she follows Frank to a seat. After the batted ball hits Frank, it caroms into Gretchen, injuring her. Is Ellen liable to Gretchen?

8. CC Railroad is negligent in failing to give warning of the approach of its train to a crossing and thereby endangers Larry, a blind man who is about to cross. Mildred, a bystander, in a reasonable effort to save Larry, rushes onto the track to push Larry out of danger. Although Mildred acts as carefully as possible, she is struck and injured by the train.

a. Can Mildred recover from Larry?

b. Can Mildred recover from CC Railroad?

9. Two thugs in an alley in Manhattan held up an unidenti- fied man. When the thieves departed with his possessions, the man quickly gave chase. He had almost caught one when the thief managed to force his way into an empty taxicab stopped at a traffic light. The Peerless Transport Company owned the cab. The thief pointed his gun at the driver’s head and ordered him to drive on. The driver started to follow the directions while closely pursued by a posse of good citizens, but then suddenly jammed on the brakes and jumped out of the car to safety. The thief also jumped out, but the car traveled on, injuring Mrs. Cordas and her two children. The Cordases then brought an action for damages, claiming that the cab driver was negli- gent in jumping to safety and leaving the moving vehicle uncontrolled. Was the cab driver negligent? Explain.

10. Timothy keeps a pet chimpanzee that is thoroughly tamed and accustomed to playing with its owner’s children. The chimpanzee escapes, despite every precaution to keep it on the owner’s premises. It approaches a group of children. Wanda, the mother of one of the children, erroneously thinking the chimpanzee is about to attack the children, rushes to her child’s assistance. In her hurry and excite- ment, she stumbles and falls, breaking her leg. Can Wanda recover from Timothy for her personal injuries?

C A S E P R O B L E M S

11. Hawkins slipped and fell on a puddle of water just inside the automatic door to the H. E. Butt Grocery Company’s store. The water had been tracked into the store by cus- tomers and blown through the door by a strong wind. The store manager was aware of the puddle and had mopped it up several times earlier in the day. Still, no signs had been placed to warn store patrons of the dan- ger. Hawkins brought an action to recover damages for injuries sustained in the fall. Was the store negligent in its conduct?

12. Escola, a waitress, was injured when a bottle of soda exploded in her hand while she was putting it into the restaurant’s cooler. The bottle came from a shipment that had remained under the counter for thirty-six hours after

being delivered by the bottling company. The bottler had subjected the bottle to the method of testing for defects commonly used in the industry, and there is no evidence that Escola or anyone else did anything to damage the bottle between its delivery and the explosion. Escola brought an action against the bottler for damages. Because she is unable to show any specific acts of negli- gence on its part, she seeks to rely on the doctrine of res ipsa loquitur. Should she be able to recover on this theory? Explain.

13. Hunn injured herself when she slipped and fell on a loose plank while walking down some steps. The night before, while entering the hotel, she had noticed that the steps were dangerous, and although she knew from her earlier

Chapter 8 Negligence and Strict Liability 179

stays at the hotel that another exit was available, she chose that morning to leave via the dangerous steps. The hotel was aware of the hazard, as one of three other guests who had fallen that night had reported his acci- dent to the desk clerk then on duty. Still, the hotel did not place cautionary signs on the steps to warn of the danger, and the steps were not roped off or otherwise excluded from use. Hunn brought an action against the hotel for injuries she sustained as a result of her fall. Should she recover? Explain.

14. Fredericks, a hotel owner, had a dog named Sport that he had trained as a watchdog. When Vincent Zarek, a guest at the hotel, leaned over to pet the dog, it bit him. Although Sport had never bitten anyone before, Freder- icks was aware of the dog’s violent tendencies and, there- fore, did not allow it to roam around the hotel alone. Vincent brought an action for injuries sustained when the dog bit him. Is Fredericks liable for the actions of his dog? Explain.

15. Led Foot drives his car carelessly into another car. The second car contains dynamite, a fact that Led had no way of knowing. The collision causes an explosion that shatters a window of a building half a block away on another street. The flying glass inflicts serious cuts on Sally, who is working at a desk near the window. The explosion also harms Vic, who is walking on the side- walk near the point of the collision. Toward whom is Led Foot negligent?

16. A foul ball struck Marie Uzdavines on the head while she was watching the Metropolitan Baseball Club (The Mets) play the Philadelphia Phillies at the Mets’ home stadium in New York. The ball came through a hole in a screen designed to protect spectators sitting behind home plate. The screen contained several holes that had been repaired with baling wire, a lighter weight wire than that used in the original screen. Although the manager of the stadium makes no formal inspections of the screen, his employees do try to repair the holes as they find them. Weather conditions, rust deterioration, and baseballs hitting the screen are the chief causes of these holes. The owner of the stadium, the city of New York, leases the stadium to the Mets and replaces the entire screen every two years. Uzdavines sued the Mets for negligence under the doc- trine of res ipsa loquitur. Is this an appropriate case for res ipsa loquitur? Explain.

17. Two-year-old David Allen was bitten by Joseph White- head’s dog while he was playing on the porch at the Allen residence. Allen suffered facial cuts, a severed mus- cle in his left eye, a hole in his left ear, and scarring over his forehead. Through his father, David sued Whitehead, claiming that, as owner, Whitehead is responsible for his dog’s actions. Whitehead admitted that (a) the dog was large, was mean-looking, and frequently barked at neigh- bors; (b) the dog was allowed to roam wild; and (c) the

dog frequently chased and barked at cars. He stated, however, that (a) the dog was friendly and often played with his and neighbors’ children, (b) he had not received previous complaints about the dog, (c) the dog was nei- ther aggressive nor threatening, and (d) the dog had never bitten anyone before this incident. Is Whitehead liable?

18. Larry VanEgdom, in an intoxicated state, bought alco- holic beverages from the Hudson Municipal Liquor Store in Hudson, South Dakota. An hour later, VanEgdom, while driving a car, struck and killed Guy William Lud- wig, who was stopped on his motorcycle at a stop sign. Lela Walz, as special administrator of Ludwig’s estate, brought an action against the city of Hudson, which operated the liquor store, for the wrongful death of Lud- wig. Walz alleged that the store employee was negligent in selling intoxicating beverages to VanEgdom when he knew or could have observed that VanEgdom was drunk. Decision?

19. Carolyn Falgout accompanied William Wardlaw as a social guest to Wardlaw’s brother’s camp. After both par- ties had consumed intoxicating beverages, Falgout walked onto a pier that was then only partially com- pleted. Wardlaw had requested that she not go on the pier. Falgout said, “Don’t tell me what to do,” and pro- ceeded to walk on the pier. Wardlaw then asked her not to walk past the completed portion of the pier. She ignored his warnings and walked to the pier’s end. When returning to the shore, Falgout got her shoe caught between the boards. She fell, hanging by her foot, with her head and arms in the water. Wardlaw rescued Falg- out, who had seriously injured her knee and leg. She sued Wardlaw for negligence. Decision?

20. Joseph Yania, a coal strip-mine operator, and Boyd Ross visited a coal strip-mining operation owned by John Bigan to discuss a business matter with Bigan. On Bigan’s property there were several cuts and trenches he had dug to remove the coal underneath. While there, Bigan asked the two men to help him pump water from one of these cuts in the earth. This particular cut con- tained water eight to ten feet in depth with sidewalls or embankments sixteen to eighteen feet in height. The two men agreed, and the process began with Ross and Bigan entering the cut and standing at the point where the pump was located. Yania stood at the top of one of the cut’s sidewalls. Apparently, Bigan taunted Yania into jumping into the water from the top of the side- wall—a height of sixteen to eighteen feet. As a result, Yania drowned. His widow brought a negligence action against Bigan. She claims that Bigan was negligent “(1) by urging, enticing, taunting, and inveigling Yania to jump into the water; (2) by failing to warn Yania of a dangerous condition on the land; and (3) by failing to go to Yania’s rescue after he jumped into the water.” Was Bigan negligent?

180 The Legal Environment of Business Part II

21. Old Island Fumigation, Inc., fumigated buildings A and B of a condominium complex using Vikane gas. Build- ings A and B, together with building C, form a U shape; buildings B and C have between them an atrium and were thought to be separated by an impenetrable fire wall. Although Old Island evacuated occupants of buildings A and B before the fumigation, the company advised the occupants of building C that they could remain in their dwellings while the other buildings were treated. Several residents of building C became ill shortly after the Vikane gas was released into the adja- cent buildings. The hospital admission forms indicate that the cause of their illnesses was sulfuryl fluoride

poisoning. Sulfuryl fluoride is the active chemical ingre- dient of Vikane. Several months after this incident, an architect hired by the fumigation company discovered that the fire wall between buildings B and C was defec- tive and contained a four-foot-by-eighteen-inch open space through which the gas had entered building C. The defect was only visible from a vantage point within the crawl space and had been missed by various building inspectors and by the fumigation company itself during an earlier inspection. The occupants of building C who had been injured by the Vikane fumes sued the fumigator. Explain whether the fumigator is strictly liable.

T A K I N G S I D E S

Rebecca S. Dukat arrived at Mockingbird Lanes, a bowling alley in Omaha, Nebraska, at approximately 6:00 p.m. to bowl in her league game. The bowling alley’s parking lot and adjacent sidewalk were covered with snow and ice. Dukat proceeded to walk into the bowling alley on the only side- walk provided in and out of the building. She testified that she noticed the sidewalk was icy. After bowling three games and drinking three beers, Dukat left the bowling alley at approximately 9:00 p.m. She retraced her steps on the same sidewalk, which was still covered with ice and in a condition that, according to Frank Jameson, general manager of Mock- ingbird Lanes, was “unacceptable” if the bowling alley was open to customers. As Dukat proceeded along the sidewalk to

her car, she slipped, attempted to catch herself by reaching to- ward a car, and fell. She suffered a fracture of both bones in her left ankle as well as a ruptured ligament. Dukat sued Mockingbird Lanes, seeking damages for her for personal injuries. Mockingbird denied liability for Dukat’s personal injuries.

a. What arguments would support Dukat’s claim for her personal injuries?

b. What arguments would support Mockingbird’s denial of liability for Dukat’s personal injuries?

c. Which side should prevail? Explain.

Chapter 8 Negligence and Strict Liability 181

PART III C O N T R A C T S

CISG

CHAPTER 9 Introduction to Contracts

CHAPTER 10 Mutual Assent

CHAPTER 11 Conduct Invalidating Assent

CHAPTER 12 Consideration

CHAPTER 13 Illegal Bargains

CHAPTER 14 Contractual Capacity

CHAPTER 15 Contracts in Writing

CHAPTER 16 Third Parties to Contracts

CHAPTER 17 Performance, Breach, and Discharge

CHAPTER 18 Contract Remedies

C H A P T E R 9

INTRODUCTION TO CONTRACTS

A promise is a debt, and I certainly wish to keep all my promises to the letter; I can give no better advice. GEOFFREY CHAUCER, THE MAN OF LAW IN THE CANTERBURY TALES (1387)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Distinguish between contracts that are covered by the Uniform Commercial Code and those covered by the common law.

2. List the essential elements of a contract.

3. Distinguish among (a) express and implied contracts; (b) unilateral and bilateral contracts; (c) valid, void, voidable, and unenforceable

agreements; and (d) executed and executory contracts.

4. Explain the doctrine of promissory estoppel.

5. Identify the three elements of enforceable quasi contract and explain how it differs from a contract.

E very business enterprise, whether large or small, must enter into contracts with its employees, its suppliers of goods and services, and its customers

in order to conduct its business operations. Thus, con- tract law is an important subject for the business man- ager. Contract law is also basic to fields of law treated in other parts of this book, such as agency, partner- ships, corporations, sales of personal property, negotia- ble instruments, and secured transactions.

Even the most common transaction may involve many contracts. For example, in a typical contract for the sale of land, the seller promises to transfer title, or right of ownership, to the land and the buyer promises to pay an agreed-upon purchase price. In addition, the seller may promise to pay certain

taxes, and the buyer may promise to assume a mort- gage on the property or to pay the purchase price to a creditor of the seller. If the parties have lawyers, they very likely have contracts with these lawyers. If the seller deposits the proceeds of the sale in a bank, he enters into a contract with the bank. If the buyer rents the property, he enters into a contract with the tenant. When one of the parties leaves his car in a parking lot to attend to any of these matters, he assumes a contractual relationship with the owner of the lot. In short, nearly every business transaction is based on contract and the expectations the agreed- upon promises create. It is, therefore, essential that you know the legal requirements for making binding contracts.

184

DEVELOPMENT OF THE LAW OF CONTRACTS [9-1] Contract law, like the law as a whole, is not static. It has undergone—and is still undergoing—enormous changes. In the nineteenth century, almost total freedom in forming contracts was the rule. However, contract formation also involved many technicalities, and the courts imposed contract liability only when the parties complied strictly with the required formalities.

During the twentieth century, many of the formal- ities of contract formation were relaxed, and as a result, contractual obligations usually are recognized whenever the parties clearly intend to be bound. In addition, an increasing number of promises are now enforced in certain circumstances, even though such promises do not comply strictly with the basic require- ments of a contract. In brief, the twentieth century left its mark on contract law by limiting the absolute free- dom of contract and, at the same time, by relaxing the requirements of contract formation. Accordingly, we can say that it is considerably easier now both to get into a contract and to get out of one.

Common Law [9-1a] Contracts are primarily governed by state common law. As we mentioned in Chapter 1, the Restatements, prepared by the American Law Institute (ALI), present many important areas of the common law, including contracts. Although the Restatements are not law in themselves, they are highly persuasive in the courts. An orderly presentation of the common law of contracts is found in the Restatements of the Law of Contracts, val- uable authoritative reference works extensively relied on and quoted in reported judicial opinions. Between 1959 and 1981, the ALI adopted and promulgated a second edition of the Restatement of the Law of Con- tracts, which revised and superseded the first Restate- ment of the Law of Contracts. This text will refer to the second Restatement of the Law of Contracts simply as the “Restatement.”

There are two principal types of contracts: (1) busi- ness-to-business contracts (commercial contracts) and (2) business-to-consumer contracts (consumer con- tracts). The common law and the Restatement generally apply the same rules to both commercial and consumer contracts. (The Uniform Commercial Code’s Article 2, discussed in the following paragraphs, for the most part also does not distinguish between sales of goods to con- sumers and sales between commercial parties.)

In 2012 the ALI began a new project: the Restatement of the Law of Consumer Contracts. This new project will focus on the rules of contract law that treat con- sumer contracts differently from commercial contracts. It includes regulatory rules that are prominently applied in consumer protection law. The project will cover com- mon law as well as statutory and regulatory law.

The Uniform Commercial Code [9-1b] The sale of personal property is a large part of com- mercial activity. Article 2 of the Uniform Commercial Code (the Code, or UCC) governs such sales in all states except Louisiana. A sale consists of the passing of title to goods from seller to buyer for a price. A con- tract for sale includes both a present sale of goods and a contract to sell goods at a future time. The Code essentially defines goods as tangible personal property. Personal property is any property other than an interest in real property (land). For example, the purchase of a television set, an automobile, or a textbook is a sale of goods. All such transactions are governed by Article 2 of the Code, but in cases in which the Code has not specifically modified general contract law, the common law of contracts continues to apply. In other words, the law of sales is a specialized part of the general law of contracts, and the law of contracts governs unless specifically displaced by the Code. See Pittsley v. Houser in Chapter 19.

Amendments to Article 2 were promulgated in 2003 to accommodate electronic commerce and to reflect development of business practices, changes in other law, and other practical issues. Because no states had adopted them and prospects for enactment in the near future were bleak, the 2003 amendments to UCC Articles 2 and 2A were withdrawn in 2011. However, at least forty-seven states have adopted the 2001 Revi- sions to Article 1, which applies to all of the articles of the Code.

Types of Contracts Outside the Code [9-1c] General contract law (common law) governs all con- tracts outside the scope of the Code. Such contracts play a significant role in commercial activities. For example, the Code does not apply to employment con- tracts, service contracts, insurance contracts, contracts involving real property (land and anything attached to it, including buildings, as well as any right, privilege, or power in the real property, including leases, mortgages, options, and easements), and contracts for the sale of

Chapter 9 Introduction to Contracts 185

intangibles such as patents and copyrights. These trans- actions continue to be governed by general contract law. Figure 9-1 summarizes the types of law governing contracts.

See Fox v. Mountain West Electric, Inc., later in this chapter.

DEFINITION OF CONTRACT [9-2] Put simply, a contract is a binding agreement that the courts will enforce. The Restatement Second, Con- tracts more precisely defines a contract as “a promise or a set of promises for the breach of which the law

G O I N G G L O B A L What about international contracts?

The legal issues inherent indomestic commercial con- tracts also arise in international con- tracts. Moreover, certain additional issues, such as differences in lan- guage, customs, legal systems, and currency, are peculiar to interna- tional contracts. An international contract should specify its official language and define all of the sig- nificant legal terms it incorporates. In addition, it should specify the acceptable currency (or currencies) and payment method. The con- tract should include a choice of law clause designating what law will govern any breach or dispute re- garding the contract and a choice of forum clause designating whether the parties will resolve disputes through one nation’s court system or through third-party arbitration.

(The United Nations Committee on International Trade Law and the International Chamber of Commerce have promulgated arbitration rules that have won broad international acceptance.) Finally, the contract should include a force majeure (un- avoidable superior force) clause apportioning the liabilities and re- sponsibilities of the parties in the event of an unforeseeable occur- rence, such as a typhoon, tornado, flood, earthquake, nuclear disaster, or war, including civil war.

The United Nations Convention on Contracts for the International Sales of Goods (CISG), which has been ratified by the United States and at least eighty-two other coun- tries, governs all contracts for the international sales of goods between parties located in different nations

that have ratified the CISG. Because treaties are federal law, the CISG supersedes the Uniform Commercial Code in any situation to which either could apply. The CISG includes provi- sions dealing with interpretation, trade usage, contract formation, obligations, and remedies of sellers and buyers, and risk of loss. Parties to an international sales contract may, however, expressly exclude CISG governance from their contract. The CISG specifically excludes sales of (1) goods bought for personal, family, or household use; (2) ships or aircraft; and (3) electricity. In addi- tion, it does not apply to contracts in which the primary obligation of the party furnishing the goods con- sists of supplying labor or services. The CISG is discussed in Chapters 19 through 23.

FIGURE 9-1 Law Governing Contracts

Specific provision of UCC applicable?

General contract law governs

Sale of goods? UCC governs

YesYes

No

No

186 Contracts Part III

gives a remedy, or the performance of which the law in some way recognizes a duty.” A promise manifests or demonstrates the intention to act or to refrain from acting in a specified manner.

Those promises that meet all of the essential require- ments of a binding contract are contractual and will be enforced. All other promises are not contractual, and usually no legal remedy is available for a breach of, or a failure to properly perform, these promises. (The remedies provided for breach of contract—which include compensatory damages, equitable remedies, reliance damages, and restitution—are discussed in Chapter 18.) Thus, a promise may be contractual (and therefore binding) or noncontractual. In other words, all contracts are promises, but not all promises are contracts, as illustrated by Figure 9-2.

REQUIREMENTS OF A CONTRACT [9-3] The four basic requirements of a contract are as follows:

1. Mutual assent. The parties to a contract must mani- fest by words or conduct that they have agreed to enter into a contract. The usual method of showing mutual assent is by offer and acceptance.

2. Consideration. Each party to a contract must inten- tionally exchange a legal benefit or incur a legal det- riment as an inducement to the other party to make a return exchange.

3. Legality of object. The purpose of a contract must not be criminal, tortious, or otherwise against public policy.

4. Capacity. The parties to a contract must have contractual capacity. Certain persons, such as adju- dicated incompetents, have no legal capacity to con- tract, whereas others, such as minors, incompetent persons, and intoxicated persons, have limited capacity to contract. All others have full contractual capacity.

In addition, though in a limited number of instances a contract must be evidenced by a writing to be en- forceable, in most cases an oral contract is binding and enforceable. Moreover, there must be an absence of invalidating conduct, such as duress, undue influence, misrepresentation, or mistake. (See Figure 9-3.) As the Steinberg v. Chicago Medical School case shows, a promise meeting all of these requirements is contrac- tual and legally binding. However, if any requirement is unmet, the promise is noncontractual. (Also see the case of Bouton v. Byers later in this chapter.) These requirements are considered separately in succeeding chapters.

FIGURE 9-2 Contractual and Noncontractual Promises All promises

Non- contractual

promises

Enforceable noncontractual

promises

Contractual promises

Chapter 9 Introduction to Contracts 187

S T E I N B E R G V . C H I C A G O M E D I C A L S C H O O L I l l i n o i s C o u r t o f A p p e a l s , 1 9 7 6

4 1 I l l . A p p . 3 d 8 0 4 , 3 5 4 N . E . 2 d 5 8 6

FACTS Robert Steinberg applied for admission to the Chicago Medical School as a first-year student and paid an application fee of $15. The school, a pri- vate educational institution, rejected his application. Steinberg brought an action against the school, claim-

ing that it did not evaluate his and other applications according to the academic entrance criteria printed in the school’s bulletin. Instead, he argues, the school based its decisions primarily on nonacademic consider- ations, such as family connections between the

FIGURE 9-3 Validity of Agreements

Void

Void or Voidable

Unenforceable

Mutual Assent?

Consideration?

Yes

Capacity?

Yes

Invalidating Conduct?

Yes

Subject Matter Legal?

No

Statute of Frauds Satisfied?

Yes

Valid Contract

Yes

No

No

No

Yes

No

No

188 Contracts Part III

applicant and the school’s faculty and members of its board of trustees and the ability of the applicant or his family to donate large sums of money to the school. Steinberg asserts that by evaluating his application according to these unpublished criteria, the school breached the contract it had created when it accepted his application fee. The trial court granted the defend- ant’s motion to dismiss, and Steinberg appealed.

DECISION Trial court’s dismissal reversed and case remanded.

OPINION Dempsey, J. A contract is an agreement between competent parties, based upon a consideration sufficient in law, to do or not do a particular thing. It is a promise or a set of promises for the breach of which the law gives a remedy, or the performance of which the law in some way recognizes as a duty. [Citation.] A contract’s essential requirements are: competent par- ties, valid subject matter, legal consideration, mutuality of obligation and mutuality of agreement. Generally, parties may contract in any situation where there is no legal prohibition, since the law acts by restraint and not by conferring rights. [Citation.] However, it is basic con- tract law that in order for a contract to be binding the terms of the contract must be reasonably certain and definite. [Citation.]

A contract, in order to be legally binding, must be based on consideration. [Citation.] Consideration has been defined to consist of some right, interest, profit or benefit accruing to one party or some forbearance, disadvantage, detriment, loss or responsibility given, suf- fered, or undertaken by the other. [Citation.] Money is a valuable consideration and its transfer or payment or promises to pay it or the benefit from the right to its use, will support a contract.

In forming a contract, it is required that both parties assent to the same thing in the same sense [citation] and that their minds meet on the essential terms and conditions. [Citation.] Furthermore, the mutual consent essential to the formation of a contract must be gath- ered from the language employed by the parties or manifested by their words or acts. The intention of the parties gives character to the transaction, and if either party contracts in good faith he is entitled to the benefit of his contract no matter what may have been the secret purpose or intention of the other party. [Citation.]

Steinberg contends that the Chicago Medical School’s informational brochure constituted an invitation to

make an offer; that his subsequent application and the submission of his $15 fee to the school amounted to an offer; that the school’s voluntary reception of his fee constituted an acceptance and because of these events a contract was created between the school and himself. He contends that the school was duty bound under the terms of the contract to evaluate his application accord- ing to its stated standards and that the deviation from these standards not only breached the contract, but amounted to an arbitrary selection which constituted a violation of due process and equal protection. He con- cludes that such a breach did in fact take place each and every time during the past ten years that the school evaluated applicants according to their relationship to the school’s faculty members or members of its board of trustees, or in accordance with their ability to make or pledge large sums of money to the school. Finally, he asserts that he is a member and a proper representa- tive of the class that has been damaged by the school’s practice.

The school counters that no contract came into being because informational brochures, such as its bulletin, do not constitute offers, but are construed by the courts to be general proposals to consider, examine and negotiate. The school points out that this doctrine has been speci- fically applied in Illinois to university informational publications.

*** We agree with Steinberg’s position. We believe that

he and the school entered into an enforceable contract; that the school’s obligation under the contract was stated in the school’s bulletin in a definitive manner and that by accepting his application fee—a valuable consideration—the school bound itself to fulfill its promises. Steinberg accepted the school’s promises in good faith and he was entitled to have his application judged according to the school’s stated criteria.

INTERPRETATION An agreement meeting all of the requirements of a contract is binding and legally enforceable.

ETHICAL QUESTION Is it ethical for a school to consider any factors other than an applicant’s merit? Explain.

CRITICAL THINKING QUESTION Should the courts resolve this type of dispute on the basis of contract law? Explain.

Chapter 9 Introduction to Contracts 189

CLASSIFICATION OF CONTRACTS [9-4] Contracts can be classified according to various charac- teristics, such as method of formation, content, and legal effect. The standard classifications are (1) express or implied contracts; (2) bilateral or unilateral contracts; (3) valid, void, voidable, or unenforceable contracts; and (4) executed or executory contracts. These classifications are not mutually exclusive. For example, a contract may be express, bilateral, valid, and executory.

Express and Implied Contracts [9-4a] Parties to a contract may indicate their assent either in words or by conduct implying such willingness. For instance, a regular customer known to have an account at a drugstore might pick up an item at the drugstore,

show it to the clerk, and walk out. This is a perfectly valid contract. The clerk knows from the customer’s conduct that she is buying the item at the specified price and wants it charged to her account. Her actions speak as effectively as words. Such a contract, formed by conduct, is an implied or, more precisely, an implied in fact contract; in contrast, a contract in which the parties manifest assent in words is an express contract. Both are contracts, equally enforceable. The difference between them is merely the manner in which the parties manifest their assent.

PRACTICAL ADVICE Whenever possible, try to use written express contracts that specify all of the important terms rather than using implied in fact contracts.

F O X V . M O U N T A I N W E S T E L E C T R I C , I N C . S u p r e m e C o u r t o f I d a h o , 2 0 0 2

1 3 7 I d a h o 7 0 3 , 5 2 P . 3 d 8 4 8 ; r e h e a r i n g d e n i e d , 2 0 0 2

FACTS Lockheed Martin Idaho Technical Com- pany (LMITCO) requested bids for a comprehensive fire alarm system in its twelve buildings located in Idaho Falls. Mountain West Electric (MWE) was in the business of installing electrical wiring, conduit and related hookups, and attachments. Fox provided serv- ices in designing, drafting, testing, and assisting in the installation of fire alarm systems. The parties decided that it would be better for them to work together with MWE taking the lead on the project. The parties prepared a document defining each of their roles and jointly prepared a bid. MWE was awarded the LMITCO fixed-price contract. In May 1996, Fox began performing various services at the direction of MWE’s manager.

During the course of the project, many changes and modifications to the LMITCO contract were made. MWE and Fox disagreed on the procedure for the com- pensation of the change orders. MWE proposed a flow- down procedure, whereby Fox would receive whatever compensation LMITCO decided to pay MWE. Fox found this unacceptable and suggested a bidding proce- dure to which MWE objected. Fox and MWE could not reach an agreement upon a compensation arrangement with respect to change orders. Fox left the project on December 9, 1996, after delivering the remaining equip- ment and materials to MWE. MWE contracted with Life Safety Systems to complete the LMITCO project.

Fox filed a complaint in July 1998 seeking money owed for materials and services provided to MWE by Fox. MWE answered and counterclaimed seeking mone- tary damages resulting from the alleged breach of the parties’ agreement by Fox. The district court found in favor of MWE holding that an implied in fact contract existed. Fox appealed.

DECISION The decision of the district court is affirmed.

OPINION Walters, J.

IMPLIED-IN-FACT CONTRACT This Court has recognized three types of contractual relationships:

First is the express contract wherein the parties expressly agree regarding a transaction. Secondly, there is the implied in fact contract wherein there is no express agreement, but the conduct of the parties implies an agreement from which an obligation in contract exists. The third category is called an implied in law contract, or quasi contract. However, a contract implied in law is not a contract at all, but an obligation imposed by law for the purpose of bringing about justice and equity without reference to the intent or the agreement of the parties and, in some cases, in spite of an agreement between the

190 Contracts Part III

parties. It is a non-contractual obligation that is to be treated procedurally as if it were a contract, and is often refered (sic) to as quasi contract, unjust enrich- ment, implied in law contract or restitution.

[Citation.] “An implied in fact contract is defined as one where

the terms and existence of the contract are manifested by the conduct of the parties with the request of one party and the performance by the other often being inferred from the circumstances attending the perform- ance.” [Citation.] The implied-in-fact contract is grounded in the parties’ agreement and tacit understand- ing. [Citation.] ***

[UCC §] 1-205(1) defines “course of dealing” as “a sequence of previous conduct between the parties to a particular transaction which is fairly to be regarded as establishing a common basis of understanding for inter- preting their expressions and other conduct.”

*** Although the procedure was the same for each

change order, in that MWE would request a pricing from Fox for the work, which was then presented to LMITCO, each party treated the pricings submitted by Fox for the change orders in a different manner. This treatment is not sufficient to establish a meeting of the minds or to establish a course of dealing when there was no “common basis of understanding for interpret- ing [the parties’] expressions” under [UCC §] 1-205(1).

*** After a review of the record, it appears that the district court’s findings are supported by substantial and competent, albeit conflicting, evidence. ***

Using the district court’s finding that pricings submit- ted by Fox were used by MWE as estimates for the change orders, the conclusion made by the district court that an implied-in-fact contract allowed for the reasona- ble compensation of Fox logically follows and is grounded in the law in Idaho. [Citation.]

This Court holds that the district court did not err in finding that there was an implied-in-fact contract using the industry standard’s flow-down method of compensa- tion for the change orders rather than a series of fixed price contracts between MWE and Fox.

UNIFORM COMMERCIAL CODE Fox contends that the district court erred by failing to consider previous drafts of the proposed contract between the parties to determine the terms of the par- ties’ agreement. Fox argues the predominant factor of this transaction was the fire alarm system, not the meth- odology of how the system was installed, which would focus on the sale of goods and, therefore, the Uniform Commercial Code (“UCC”) should govern. Fox argues that in using the UCC various terms were agreed upon

by the parties in the prior agreement drafts, including terms for the timing of payments, payments to Fox’s suppliers and prerequisites to termination.

MWE contends that the UCC should not be used, de- spite the fact that goods comprised one-half of the con- tract price, because the predominant factor at issue is services and not the sale of goods. MWE points out that the primary issue is the value of Fox’s services under the change orders and the cost of obtaining replacement services after Fox left the job. MWE further argues that the disagreement between the parties over material terms should prevent the court from using UCC gap fillers. Rather, MWE contends the intent and relationship of the parties should be used to resolve the conflict.

This Court in [citation], pointed out “in determining whether the UCC applies in such cases, a majority of courts look at the entire transaction to determine which aspect, the sale of goods or the sale of services, predomi- nates.” [Citation.] It is clear that if the underlying trans- action to the contract involved the sale of goods, the UCC would apply. [Citation.] However, if the contract only involved services, the UCC would not apply. [Cita- tion.] This Court has not directly articulated the stand- ard to be used in mixed sales of goods and services, otherwise known as hybrid transactions.

The Court of Appeals in Pittsley v. Houser, [citation] [see Chapter 19] focused on the applicability of the UCC to hybrid transactions. The court held that the trial court must look at the predominant factor of the transaction to determine if the UCC applies. [Citation.]

The test for inclusion or exclusion is not whether they are mixed, but, granting that they are mixed, whether their predominant factor, their thrust, their pur- pose, reasonably stated, is the rendition of service, with goods incidentally involved (e.g., contract with artist for painting) or is a transaction of sale, with labor inciden- tally involved (e.g., installation of a water heater in a bathroom). This test essentially involves consideration of the contract in its entirety, applying the UCC to the entire contract or not at all.

[Citation.] This Court agrees with the Court of Appeals’ analysis and holds that the predominant factor test should be used to determine whether the UCC applies to transactions involving the sale of both goods and services.

One aspect that the Court of Appeals noted in its opinion in Pittsley, in its determination that the predom- inant factor in that case was the sale of goods, was that the purchaser was more concerned with the goods and less concerned with the installation, either who would provide it or the nature of the work. MWE and Fox decided to work on this project together because of their differing expertise. MWE was in the business of instal- ling electrical wiring, while Fox designed, tested and

Chapter 9 Introduction to Contracts 191

Bilateral and Unilateral Contracts [9-4b] In the typical contractual transaction, each party makes at least one promise. For example, if Adelle says to Byron, “If you promise to mow my lawn, I will pay you $10,” and Byron agrees to mow Adelle’s lawn, Adelle and Byron have made mutual promises, each agreeing to do something in exchange for the promise of the other. When a contract is formed by the exchange of promises, each party is under a duty to the other. This kind of contract is called a bilateral con- tract, because each party is both a promisor (a person making a promise) and a promisee (the person to whom a promise is made).

A B

promises to pay $10

promises to mow lawn

Promisor Promisee

Promisee Promisor

But suppose that only one of the parties makes a promise. Adelle says to Byron, “If you will mow my lawn, I will pay you $10.” A contract will be formed when Byron has finished mowing the lawn and not before. At that time, Adelle becomes contractually obli- gated to pay $10 to Byron. Adelle’s offer was in exchange for Byron’s act of mowing the lawn, not for his promise to mow it. Because Byron never made a promise to mow the lawn, he was under no duty to mow it. This is a unilateral contract because only one of the parties has made a promise.

A B promises to pay $10

mows lawn

Promisor Promisee

Thus, whereas a bilateral contract results from the exchange of a promise for a return promise, a unilat- eral contract results from the exchange of a promise ei- ther for performing an act or for refraining from doing an act. In cases in which it is not clear whether a uni- lateral or bilateral contract has been formed, the courts presume that the parties intended a bilateral contract. Thus, if Adelle says to Byron, “If you will mow my lawn, I will pay you $10,” and Byron replies, “OK, I will mow your lawn,” a bilateral contract is formed.

PRACTICAL ADVICE Because it is uncertain whether the offeree in a unilateral contract will choose to perform, use bilateral contracts wherever possible.

Valid, Void, Voidable, and Unenforceable Contracts [9-4c] By definition a valid contract is one that meets all of the requirements of a binding contract. It is an enforce- able promise or agreement.

A void contract is an agreement that does not meet all of the requirements of a binding contract. Thus, it is no contract at all; it is merely a promise or an agree- ment that has no legal effect. An example of a void agreement is an agreement entered into by a person whom the courts have declared incompetent.

A voidable contract, on the other hand, though defec- tive, is not wholly lacking in legal effect. A voidable con- tract is a contract; however, because of the manner in which the contract was formed or a lack of capacity of a party to it, the law permits one or more of the parties to avoid the legal duties the contract creates. If the con- tract is voided, both of the parties are relieved of their legal duties under the agreement. For instance, through intentional misrepresentation of a material fact (fraud), Thomas induces Regina to enter into a contract. Regina may, upon discovery of the fraud, notify Thomas that

assisted in the installation of fire alarm systems, in addition to ordering specialty equipment for fire alarm projects.

The district court found that the contract at issue in this case contained both goods and services; however, the predominant factor was Fox’s services. The district court found that the goods provided by Fox were merely incidental to the services he provided, and the UCC would provide no assistance in interpreting the parties’ agreement.

This Court holds that the district court did not err in finding that the predominant factor of the underlying

transaction was services and that the UCC did not apply.

INTERPRETATION An implied in fact con- tract is formed by the conduct of the parties; in cases in which a contract provides for both goods and services, the common law applies if the predominant factor of the contract is the provision of services.

CRITICAL THINKING QUESTION Why should the legal rights of contracting parties depend on whether a contract is or is not for the sale of goods?

192 Contracts Part III

by reason of the misrepresentation, she will not perform her promise, and the law will support Regina. Although the contract induced by fraud is not void, it is voidable at the election of Regina, the defrauded party. Thomas, the fraudulent party, may make no such election. If Re- gina elects to avoid the contract, Thomas will be released from his promise under the agreement, although he may be liable for damages under tort law for fraud.

A contract that is neither void nor voidable may nonetheless be unenforceable. An unenforceable con- tract is one for the breach of which the law provides no remedy. For example, a contract may be unenforce- able because of a failure to satisfy the requirements of the statute of frauds, which requires certain kinds of contracts to be evidenced by a writing to be enforcea- ble. Also, the statute of limitations imposes restrictions on the time during which a party has the right to bring a lawsuit for breach of contract. After the statutory time period has passed, a contract is referred to as unenforceable, rather than void or voidable. Figure 9-3 lists the requirements of a binding contract and the consequences of failing to satisfy each requirement.

PRACTICAL ADVICE Be careful to avoid entering into void, voidable, and unenforceable contracts.

Executed and Executory Contracts [9-4d] A contract that has been fully carried out by all of the parties to it is an executed contract. Strictly speaking,

an executed contract is no longer a contract, because all of the duties under it have been performed, but hav- ing a term for such a completed contract is useful. By comparison, the term executory contract applies to con- tracts that are still partially or entirely unperformed by one or more of the parties.

PROMISSORY ESTOPPEL [9-5] As a general rule, promises are not enforceable if they do not meet all the requirements of a contract. Nevertheless, in certain circumstances, the courts enforce noncontractual promises under the doctrine of promissory estoppel to avoid injustice. A noncontrac- tual promise is enforceable when it is made under cir- cumstances that should lead the promisor reasonably to expect that the promisee, in reliance on the promise, would be induced by it to take definite and substantial action or to forbear, and the promisee does take such action or does forbear (see Figure 9-2). For example, Gordon promises Constance not to foreclose for a period of six months on a mortgage Gordon owns on Constance’s land. Constance then expends $100,000 to construct a building on the land. His promise not to foreclose is binding on Gordon under the doctrine of promissory estoppel.

PRACTICAL ADVICE Take care not to make promises on which others may detrimentally rely.

B O U T O N V . B Y E R S C o u r t o f A p p e a l s o f K a n s a s , 2 0 1 4

5 0 K a n . A p p . 2 d 3 5 , 3 2 1 P . 3 d 7 8 0

FACTS Plaintiff Ellen Byers Bouton held a tenure- track teaching position on the Washburn University School of Law faculty and earned about $100,000 a year. In 2011, Bouton brought a promissory estoppel claim against defendant Walter Byers, her father, for breaching a promise she says he made to bequeath valu- able ranchland to her—a promise that induced her to leave the Washburn University faculty in 2005 so she could help him manage his cattle business. Byers denied ever having made that promise to his daughter. In

August 2006, Bouton signed the first of a series of employment contracts with Byers for her services in helping run the ranching business under which she earned a small fraction of what she had been making as a law professor. After a series of disputes between father and daughter, in 2010 Bouton returned to the Wash- burn Law School faculty in a part-time teaching position without any possibility of tenure. In 2011 Byers sold the last of his land holdings—except for 10 acres—for $1.2 million. As a result, Byers no longer owned any land

Chapter 9 Introduction to Contracts 193

that Bouton might inherit. In November 2011, Byers signed a new trust that upon his death would distribute all of his assets to charitable foundations to provide col- lege scholarships. Byers effectively disinherited Bouton.

On December 8, 2011, Bouton filed an action against Byers seeking damages on a promissory estop- pel theory in an amount equal to what she would have earned had she continued at Washburn Law School in the full-time, tenure-track position that she had resigned in 2005. Bouton contended she gave up her teaching position to manage Byers’ ranching operation in reliance on his promise that she would inherit land worth more than $1 million. Byers denied any liability to Bouton and filed a motion for summary judgment. The district court granted the motion, find- ing the evidence failed to show both a definite promise from Byers and reasonable reliance by Bouton. Bouton appealed.

DECISION Reversed and remanded for further pro- ceedings.

OPINION Atcheson, J. Promissory estoppel is an equitable doctrine designed to promote some measure of basic fairness when one party makes a representation or promise in a manner reasonably inducing another party to undertake some obligation or to incur some detri- ment as a result. The party assuming the obligation or detriment may bring an action for relief should the party making the representation or promise fail to fol- low through. The Kansas Supreme Court has recognized promissory estoppel to be applicable when: (1) a promi- sor reasonably expects a promisee to act in reliance on a promise; (2) the promisee, in turn, reasonably so acts; and (3) a court’s refusal to enforce the promise would countenance a substantial injustice. [Citation.] *** Because promissory estoppel rests on fairness, its appli- cation tends to be especially fact driven and, thus, defies any regimented predictive test [Citation.]

Promissory estoppel and contract law are closely related and serve the same fundamental purposes by providing means to enforce one party’s legitimate expectations based on the representations of another party. *** A contract typically depends upon mutual promises that entail an exchange of bargained consider- ation. [Citation.] *** Promissory estoppel commonly applies when a promise reasonably induces a predictable sort of action but without the more formal mutual con- sideration found in contracts. ***

Kansas courts have explained that a party’s reasona- ble reliance on a promise prompting a reasonable change in position effectively replaces the bargained for consideration of a formal contract, thereby creating

what amounts to a contractual relationship. [Citations.] To the extent the promisee relies on equity to specifi- cally enforce the promise or recover damages equivalent to the promised performance, the promise itself must define with sufficient particularity what the promisor was to do. [Citations.] The same required specificity governs contracts. [Citation.] ***

*** The reasonableness of a party’s actions, including reli-

ance on statements of another party, typically reflects a fact question reserved for the factfinder. [Citations.] ***

*** *** Bouton contends she relied on the oral promise

or representation Byers made in March 2005 that she would inherit land worth more than $1 million so she should not worry about the financial impact of leaving the law school faculty. On the summary judgment re- cord, Byers made that statement during a discussion with Bouton and her husband in which they specifically voiced concerns about her resigning that position to work exclusively on ranch business.

In that context, a factfinder could fairly conclude Byers not only might have expected Bouton to act on the promise but intended her to do so. ***

*** the district court held as a matter of law that Bouton’s reliance on the March 2005 promise she attrib- uted to Byers was unreasonable given her “education and the circumstances as a whole.” *** Our view is other- wise to the extent the record evidence as a whole would allow a factfinder to conclude Bouton reasonably relied on Byers’ March 2005 promise that she would inherit property worth at least a $1 million, especially when that representation came in direct response to her trepidation about leaving a job that paid her well. ***

*** The district court erred in granting summary judg-

ment for the reasons it did. Byers submits the remaining elements of promissory

estoppel on which the district court did not rule support summary judgment. Byers identifies those ele- ments as “substantial detriment” to the promisee and “injustice” resulting from a failure to enforce the promise. We disagree with Byers’ assessment. The facts as Bouton portrays them show she left a lucrative job because of Byers’ March 2005 promise to bequeath her land worth more than $1 million. And the evidence shows that once Bouton left the tenure-track teaching position, it was lost to her. Given the nature of the job, she could not later return to the law school faculty and simply pick up where she left off. Bouton’s compensa- tion for the ranch business came nowhere near her teaching income. All of that reasonably could be

194 Contracts Part III

QUASI CONTRACTS OR RESTITUTION [9-6] In addition to express and implied in fact contracts, there are implied in law or quasi contracts, which were not included in the previous classification of con- tracts for the reason that a quasi (meaning “as if”) con- tract is not a contract at all but is based in restitution. Restitution is an obligation imposed by law to avoid injustice. The basic rule of restitution is that a person who is unjustly enriched at the expense of another is subject to liability in restitution, which usually requires the unjustly enriched person to restore the benefit received or pay money in an amount necessary to elimi- nate the unjust enrichment. In 2011, the ALI promul- gated the Restatement (Third) of Restitution and Unjust

Enrichment, which will be referred to as the “Restatement of Restitution.”

Restitution is not a contract because it is based nei- ther on an express nor on an implied promise. Rather, restitution is an independent basis of liability, in addi- tion to contract or tort liability. The comments to the Restatement of Restitution explain

Restitution is the law of nonconsensual and nonbargained benefits in the same way that torts is the law of non- consensual and nonlicensed harms. Both subjects deal with the consequences of transactions in which the parties have not specified for themselves what the consequences of their interaction should be. … [T]he law of restitution identifies those circumstances in which a person is liable for benefits received, measuring liability by the extent of the benefit.

considered a substantial detriment to Bouton. In the same vein, we are unwilling to say that enforcement of Byers’ March 2005 promise would be something less than just *** .

***

The Restatement (Second) of Contracts §90 specifi- cally states relief on a promissory estoppel claim should be tailored to effectuate fair or equitable results. Thus, “[t]he remedy granted for breach [of the promise] may be limited as justice requires.” Restatement (Second) of Contracts §90. ***

Both the Restatement (Second) of Contracts §90 and *** case authority support a restitutionary award to

Bouton if she can otherwise prove her promissory estop- pel claim. ***

INTERPRETATION The courts will enforce a promise that the promisor should reasonably expect to induce detrimental reliance by the promisee if the prom- isee takes such action and justice requires enforcement.

ETHICAL QUESTION Did Byers act ethically? Explain.

CRITICAL THINKING QUESTION What could Bouton have done to better protect her interests? Explain.

CONCEPT REVIEW 9-1 C O N T R A C T S , P R O M I S S O R Y E S T O P P E L , A N D Q U A S I C O N T R A C T S ( R E S T I T U T I O N )

Contract Promissory Estoppel Quasi Contract (Restitution)

Type of Promise Contractual Noncontractual None Void Unenforceable Invalidated

Requirements All of the essential elements of a contract

Detrimental and justifiable reliance

Benefit conferred and knowingly accepted

Remedies Equitable Compensatory Reliance Restitution

Promise enforced to the extent necessary to avoid injustice

Reasonable value of benefit conferred

Chapter 9 Introduction to Contracts 195

For example, Willard by mistake delivers to Roy a plain, unaddressed envelope containing $100 intended for Lucia. Roy is under no contractual obligation to return it, but Willard is permitted to recover the $100 from Roy. The law imposes a quasi-contractual obliga- tion of restitution on Roy to prevent his unjust enrich- ment at the expense of Willard. Such a recovery requires three essential elements: (1) a benefit conferred upon the defendant (Roy) by the plaintiff (Willard), (2) the defendant’s (Roy’s) appreciation or knowledge of the benefit, and (3) acceptance or retention of the bene-

fit by the defendant (Roy) under circumstances making it inequitable for him to retain the benefit without com- pensating the plaintiff for its value.

The law of restitution provides a remedy when the parties enter into a void contract, an unenforceable con- tract, or a voidable contract that is avoided. In such a case, the law of restitution will determine what recovery is permitted for any performance rendered by the parties under the invalid, unenforceable, or invalidated agree- ment. Restitution also provides a remedy for the breach of a contractual obligation as discussed in Chapter 18.

J A S D I P P R O P E R T I E S S C , L L C V . E S T A T E O F R I C H A R D S O N C o u r t o f A p p e a l s o f S o u t h C a r o l i n a , 2 0 1 1

3 9 5 S . C . 6 3 3 , 7 2 0 S . E . 2 d 4 8 5

FACTS On May 5, 2006, Stewart Richardson (Seller) and JASDIP Properties SC, LLC (Buyer) entered into an agreement for the purchase of certain property in George- town, South Carolina. The purchase price for the property was to be $537,000. Buyer paid an initial earnest money deposit of $10,000. The balance was due at the closing on or before July 28, 2006. Thereafter Seller granted Buyer extensions to the closing date in return for addi- tional payments of $175,000 and $25,000, each to be applied to the purchase price. Buyer was unable to close in a timely fashion, and Seller rescinded the contract.

Thereafter, Buyer brought suit against the seller (1) contending that Seller would be unjustly enriched if allowed to keep the money paid despite the rescission of the agreement and (2) requesting $210,000. The $210,000 consisted of the $10,000 earnest money de- posit and $200,000 in subsequent payments. Buyer later filed an amended complaint requesting $205,000, stat- ing that the agreement permitted Seller to retain half of the $10,000 earnest money deposit.

A jury determined that neither party had breached the contract and awarded no damages on that basis. Buyer then requested a ruling by the trial court on its action for unjust enrichment. The trial court denied Buyer’s claim for unjust enrichment. Buyer appealed arguing that all the evidence presented at trial, as well as the jury’s verdict, supports a finding that the agree- ment was rescinded or abandoned and that this requires restitution of $205,000 to Buyer.

DECISION Judgment of the trial court is reversed, and the case is remanded.

OPINION Konduros, J. “Restitution is a remedy designed to prevent unjust enrichment.” [Citation.]

(“Unjust enrichment is an equitable doctrine, akin to restitution, which permits the recovery of that amount the defendant has been unjustly enriched at the expense of the plaintiff.”) “The terms ‘restitution’ and ‘unjust enrichment’ are modern designations for the older doc- trine of quasi-contract.” [Citation.] “[Q]uantum meruit, quasi-contract, and implied by law contract are equiva- lent terms for an equitable remedy.” [Citation.]

“Implied in law or quasi-contract are not considered contracts at all, but are akin to restitution which permits recovery of that amount the defendant has been benefit- ted at the expense of the plaintiff in order to preclude unjust enrichment.” [Citation.] ***

“To recover on a theory of restitution, the plaintiff must show (1) that he conferred a non-gratuitous benefit on the defendant; (2) that the defendant realized some value from the benefit; and (3) that it would be inequit- able for the defendant to retain the benefit without pay- ing the plaintiff for its value.” [Citation.] “Unjust enrichment is usually a prerequisite for enforcement of the doctrine of restitution; if there is no basis for unjust enrichment, there is no basis for restitution.” [Citation.]

Buyer seeks the $175,000 and $25,000 payments as well as the $10,000 in earnest money *** Additionally, in its amended complaint, Buyer states that under the Agree- ment, Seller can only keep half of the $10,000 in earnest money and only requests a total of $205,000. An issue conceded in the trial court cannot be argued on appeal. [Citation.] Therefore, Buyer is bound by that concession and entitled to $5,000 of the earnest money at most.

The $175,000 and $25,000 payments both explicitly stated that they were towards the purchase price. Addi- tionally, Buyer paid $10,000 in an earnest money de- posit. The unappealed finding of the jury was that neither party breached the Agreement. An unchallenged

196 Contracts Part III

C H A P T E R S U M M A R Y Development of the Law of Contracts

Common Law most contracts are primarily governed by state common law, including contracts involving employment, services, insurance, real property (land and anything attached to it), patents, and copyrights

The Uniform Commercial Code (UCC) Article 2 of the UCC governs the sales of goods • Sale the transfer of title from seller to buyer • Goods tangible personal property (personal property is all property other than an interest in

land)

ruling, right or wrong, is the law of the case. [Citation.] Based on the jury’s finding that Buyer did not breach, we find Buyer is entitled to the money paid towards the purchase price as well as half of the earnest money under the theory of restitution. Buyer met the require- ments to recover under the theory of restitution: (1) Buyer paid Seller $205,000 towards the purchase price and the sale did not go through despite the fact that nei- ther party breached; (2) Seller kept the $205,000 although he also retained the Property; and (3) Seller keeping the $205,000 is inequitable because the Seller still has the Property, the jury found neither party breached, and the evidence supports that Buyer intended to go forward with the purchase. Therefore, the trial

court erred in failing to find for Buyer for its claim of unjust enrichment. Accordingly, we reverse the trial court’s determination that Buyer was not entitled to res- titution and award Buyer $205,000.

INTERPRETATION Implied in law or quasi contracts are not considered contracts at all, but are akin to restitution which permits recovery of that amount the defendant has been benefited at the expense of the plaintiff in order to prevent unjust enrichment.

CRITICAL THINKING QUESTION Why does the law allow a recovery in restitution or quasi contract?

Business Law IN ACTION

Armed with a hastily scribbled work order, Jonas,an employee of Triton Painting Service, heads to 109 Millard Road. He works for two full days power cleaning, priming, and painting the exterior of the house. Satisfied with his work, Jonas moves on to his next job. When the homeowners, the Prestons, return from their vacation several days later, they are shocked to see their formerly “Palatial Peach” home painted “Santa Fe Sand.” They are even more surprised when they receive a call from Triton demanding payment for the paint job.

Errors such as this sometimes occur in business. It was the homeowners at 104 Millard Road who had con- tracted to pay Triton $1,200 for an exterior paint job using Santa Fe Sand. But Jonas felt sure enough he had the correct house number, and no one stopped him from doing the work. And even though the Prestons had not chosen the color, they now have a freshly painted house

because of Triton’s error. Should the Prestons have to pay? If so, how much? What does the law say about this?

To begin with, there was no contract between Triton and the Prestons. Therefore Triton cannot sue the Pres- tons for breach of contract. A suit in quasi contract or restitution is Triton’s best bet, but to prevail, Triton must prove unjust enrichment. One factor affecting Triton’s success is whether the Prestons, in good faith, dislike the new color. However, even if they do not dislike Santa Fe Sand, another factor is whether the house needed repainting. It would be unfair to require the Prestons to pay for an unnecessary service. Moreover, because the Prestons were out of town they could not have stopped Jonas from doing the work. Finally, because they received services rather than goods, they cannot now give back the service. Under these circumstances, it is hardly equitable to make the Prestons pay for what was clearly Triton’s mistake.

Chapter 9 Introduction to Contracts 197

Definition of a Contract

Contract binding agreement that the courts will enforce

Breach failure to properly perform a contractual obligation

Requirements of a Contract

Mutual Assent the parties to a contract must manifest by words or conduct that they have agreed to enter into a contract

Consideration each party to a contract must intentionally exchange a legal benefit or incur a legal detriment as an inducement to the other party to make a return exchange

Legality of Object the purpose of a contract must not be criminal, tortious, or otherwise against public policy

Capacity the parties to a contract must have contractual capacity

Classification of Contracts

Express and Implied Contracts • Implied in Fact Contract contract in which the agreement of the parties is inferred from their

conduct • Express Contract an agreement that is stated in words either orally or in writing

Bilateral and Unilateral Contracts • Bilateral Contract contract in which both parties exchange promises • Unilateral Contract contract in which only one party makes a promise

Valid, Void, Voidable, and Unenforceable Contracts • Valid Contract one that meets all of the requirements of a binding contract • Void Contract no contract at all; without legal effect • Voidable Contract contract capable of being made void • Unenforceable Contract contract for the breach of which the law provides no remedy

Executed and Executory Contracts • Executed Contract contract that has been fully performed by all of the parties • Executory Contract contract that has yet to be fully performed

Promissory Estoppel

Definition a doctrine enforcing some noncontractual promises

Requirements a promise made under circumstances that should lead the promisor reasonably to expect that the promise would induce the promisee to take definite and substantial action, and the promisee does take such action

Remedy a court will enforce the promise to the extent necessary to avoid injustice

Quasi Contract or Restitution

Definition an obligation not based upon contract that is imposed by law to avoid injustice; also called an implied in law contract

Requirements a court will impose a quasi contract or restitution when (1) the plaintiff confers a benefit upon the defendant, (2) the defendant knows or appreciates the benefit, and (3) the defendant’s retention of the benefit is inequitable

Remedy the plaintiff recovers the reasonable value of the benefit she conferred upon the defendant

198 Contracts Part III

Q U E S T I O N S

1. Owen telephones an order to Hillary’s store for certain goods, which Hillary delivers to Owen. Nothing is said by either party about price or payment terms. What are the legal obligations of Owen and Hillary?

2. Minth is the owner of the Hiawatha Supper Club, which he leased for two years to Piekarski. During the period of the lease, Piekarski contracted with Puttkammer for the resurfacing of the access and service areas of the supper club. Puttkammer performed the work satisfactorily. Minth knew about the contract and the performance of the work. The work, including labor and materials, had a reasonable value of $2,540, but Puttkammer was never paid because Piekarski went bankrupt. Puttkammer brought an action against Minth to recover the amount owed to him by Pie- karski. Will Puttkammer prevail? Explain.

3. Jonathan writes to Willa, stating, “I’ll pay you $150 if you reseed my lawn.” Willa reseeds Jonathan’s lawn as requested. Has a contract been formed? If so, what kind?

4. Calvin uses fraud to induce Maria to promise to pay money in return for goods he has delivered to her. Has a contract been formed? If so, what kind? What are the rights of Calvin and Maria?

5. Anna is about to buy a house on a hill. Prior to the pur- chase, she obtains a promise from Betty, the owner of the adjacent property, that Betty will not build any structure that would block Anna’s view. In reliance on this prom- ise, Anna buys the house. Is Betty’s promise binding? Why or why not?

C A S E P R O B L E M S

6. Mary Dobos was admitted to Boca Raton Community Hospital in serious condition with an abdominal aneu- rysm. The hospital called upon Nursing Care Services, Inc., to provide around-the-clock nursing services for Mrs. Dobos. She received two weeks of in-hospital care, forty-eight hours of postrelease care, and two weeks of at-home care. The total bill was $3,723.90. Mrs. Dobos refused to pay, and Nursing Care Services, Inc., brought an action to recover. Mrs. Dobos maintained that she was not obligated to render payment in that she never signed a written contract, nor did she orally agree to be liable for the services. The necessity for the services, rea- sonableness of the fee, and competency of the nurses were undisputed. After Mrs. Dobos admitted that she or her daughter authorized the forty-eight hours of postre- lease care, the trial court ordered compensation of $248 for that period. It did not allow payment of the balance, and Nursing Care Services, Inc., appealed. Decision?

7. St. Charles Drilling Co. contracted with Osterholt to install a well and water system that would produce a specified quantity of water. The water system failed to meet its warranted capacity, and Osterholt sued for breach of contract. Does the Uniform Commercial Code apply to this contract?

8. Helvey brought suit against the Wabash County REMC (REMC) for breach of implied and express warranties. He alleged that REMC furnished electricity in excess of 135 volts to Helvey’s home, damaging his 110-volt household appliances. This incident occurred more than four years before Helvey brought this suit. In defense, REMC pleads that the Uniform Commercial Code’s

(UCC’s) Article 2 statute of limitations of four years has passed, thereby barring Helvey’s suit. Helvey argues that providing electrical energy is not a transaction in goods under the UCC but rather a furnishing of services that would make applicable the general contract six-year stat- ute of limitations. Is the contract governed by the UCC? Why?

9. Jack Duran, president of Colorado Carpet Installation, Inc., began negotiations with Fred and Zuma Palermo for the sale and installation of carpeting, carpet padding, tile, and vinyl floor covering in their home. Duran drew up a written proposal that referred to Colorado Carpet as “the seller” and to the Palermos as the “customer.” The proposal listed the quantity, unit cost, and total price of each item to be installed. The total price of the job was $4,777.75. Although labor was expressly included in this figure, Duran estimated the total labor cost at $926. Mrs. Palermo in writing accepted Duran’s written pro- posal soon after he submitted it to her. After Colorado Carpet delivered the tile to the Palermo home, however, Mrs. Palermo had a disagreement with Colorado Car- pet’s tile man and arranged for another contractor to per- form the job. Colorado Carpet brought an action against the Palermos for breach of contract. Does the Uniform Commercial Code apply to this contract?

10. On November 1, the Kansas City Post Office Employees Credit Union merged with the Kansas City Telephone Credit Union to form the Communications Credit Union (Credit Union). Systems Design and Management Infor- mation (SDMI) develops computer software programs for credit unions, using Burroughs (now Unisys) hardware.

Chapter 9 Introduction to Contracts 199

SDMI and Burroughs together offered to sell to Credit Union both a software package, called the Generic Sys- tem, and Burroughs hardware. Later in November, a demonstration of the software was held at SDMI’s offi- ces, and the Credit Union agreed to purchase the Generic System software. This agreement was oral. After Credit Union was converted to the SDMI Generic System, major problems with the system immediately became apparent, so SDMI filed suit against Credit Union to recover the outstanding contract price for the software. Credit Union counterclaimed for damages based upon breach of con- tract and negligent and fraudulent misrepresentation. Does the Uniform Commercial Code apply to this contract?

11. Insul-Mark is the marketing arm of Kor-It Sales, Inc. Kor-It manufactures roofing fasteners, and Insul-Mark distributes them nationwide. In late 1985, Kor-It con- tracted with Modern Materials, Inc., to have large vol- umes of screws coated with a rust-proofing agent. The contract specified that the coated screws must pass a standard industry test and that Kor-It would pay accord- ing to the pound and length of the screws coated. Kor-It had received numerous complaints from customers that the coated screws were rusting, and Modern Materials unsuccessfully attempted to remedy the problem. Kor-It terminated its relationship with Modern Materials and brought suit for the deficient coating. Modern Materials counterclaimed for the labor and materials it had fur- nished to Kor-It. The trial court held that the contract (a) was for performance of a service, (b) not governed by the Uniform Commercial Code, (c) governed by the common law of contracts, and (d) therefore barred by a two-year statute of limitations. Insul-Mark appealed. Decision?

12. Max E. Pass, Jr., and his wife, Martha N. Pass, departed in an aircraft owned and operated by Mr. Pass from Plant City, Florida, bound for Clarksville, Tennessee. Somewhere over Alabama the couple encountered turbu- lence, and Mr. Pass lost control of the aircraft. The plane crashed, killing both Mr. and Mrs. Pass. Approximately four and a half months prior to the flight in which he was killed, Mr. Pass had taken his airplane to Shelby Aviation, an aircraft service company, for inspection and service. In servicing the aircraft, Shelby Aviation replaced both rear wing attach point brackets on the plane. Three and one half years after the crash, Max E. Pass, Sr., fa- ther of Mr. Pass and administrator of his estate, and Shirley Williams, mother of Mrs. Pass and administratrix of her estate, filed suit against Shelby Aviation. The law- suit alleged that the rear wing attach point brackets sold and installed by Shelby Aviation were defective because they lacked the bolts necessary to secure them properly to the airplane. The plaintiffs asserted claims against the defendant for breach of express and implied warranties under Article 2 of the Uniform Commercial Code (UCC), which governs the sale of goods. Shelby Aviation

contended that the transaction with Mr. Pass had been primarily for the sale of services, rather than of goods, and that consequently Article 2 of the UCC did not cover the transaction. Does the UCC apply to this transaction? Explain.

13. In March, William Tackaberry, a real estate agent for the firm of Weichert Co. Realtors (Weichert), informed Thomas Ryan, a local developer, that he knew of prop- erty Ryan might be interested in purchasing. Ryan indi- cated he was interested in knowing more about the property. Tackaberry disclosed the property’s identity and the seller’s proposed price. Tackaberry also stated that the purchaser would have to pay Weichert a 10 per- cent commission. Tackaberry met with the property owner and gathered information concerning the prop- erty’s current leases, income, expenses, and development plans. Tackaberry also collected tax and zoning docu- ments relevant to the property. In a face-to-face meeting on April 4, Tackaberry gave Ryan the data he had gath- ered and presented Ryan with a letter calling for a 10 percent finder’s fee to be paid to Weichert by Ryan upon “successfully completing and closing of title.” Ryan refused to agree to the 10 percent figure during this meet- ing. Tackaberry arranged a meeting, held three days later, where Ryan contracted with the owner to buy the land. Ryan refused, however, to pay the 10 percent find- er’s fee to Weichert. What, if anything, is Weichert enti- tled to recover from Ryan? Explain.

14. Kasch and his brother owned M.W. Kasch Co. Kasch hired Skebba as a sales representative and over the years promoted him first to account manager, then to customer service manager, field sales manager, vice president of sales, senior vice president of sales and purchasing, and finally to vice president of sales. When M.W. Kasch Co. experienced serious financial problems in 2009, Skebba was approached by another company to leave Kasch and work for them. When Skebba told Kasch he was accept- ing the new opportunity, Kasch asked what it would take to get him to stay. Skebba told Kasch that he needed se- curity for his retirement and family and would stay if Kasch agreed to pay Skebba $250,000 if one of these three conditions occurred: (1) the company was sold, (2) Skebba was lawfully terminated, or (3) Skebba retired. Kasch agreed to this proposal and promised to have the agreement drawn up. Skebba turned down the job oppor- tunity and stayed with Kasch from December 2009 through 2015 when the company assets were sold. Over the years, Skebba repeatedly but unsuccessfully asked Kasch for a written summary of this agreement. Eventu- ally, Kasch sold the business, receiving $5.1 million dol- lars for his fifty-one percent share of the business. Upon the sale of the business, Skebba asked Kasch for the $250,000 Kasch had previously promised to him. Kasch refused and denied ever having made such an agreement. Instead, Kasch gave Skebba a severance agreement, which

200 Contracts Part III

had been drafted by Kasch’s lawyers in 2009. This agree- ment promised two years of salary continuation on the sale of the company, but only if Skebba was not hired by the successor company. The severance agreement also required a set-off against the salary continuation of any sums Skebba earned from any activity during the two years of the severance agreement. Skebba sued. Explain (a) whether Skebba should recover for breach of contract; (b) whether Skebba should recover for promissory estop- pel; and (c) what amount, if any, Kebba is entitled to recover.

15. Hannaford is a national grocery chain whose electronic payment processing system was breached by hackers as early as December 7, 2007. The hackers stole up to 4.2 million credit and debit card numbers, expiration dates, and security codes, but did not steal customer names. On February 27, 2008, Visa Inc. notified Hannaford that Hannaford’s system had been breached. Hannaford dis- covered the means of access on March 8, 2008, and con- tained the breach on March 10, 2008. Hannaford gave notice to certain financial institutions on March 10, 2008. On March 17, 2008, “Hannaford publicly announced for the first time that between December 7,

2007 and March 10, 2008, the security of its information technology systems had been breached, leading to the theft of as many as 4.2 million debit card and credit card numbers belonging to individuals who had made pur- chases at more than 270 of its stores.” It also announced “that it had already received reports of approximately 1,800 cases of fraud resulting from the theft of those numbers.” A number of affected customers sued Hanna- ford for breach of implied contract to recover losses arising out of the unauthorized use of their credit and debit card data. Damages sought included the cost of replacement card fees when the issuing bank declined to issue a replacement card to them, fees for accounts overdrawn by fraudulent charges, fees for altering pre- authorized payment arrangements, loss of accumulated reward points, inability to earn reward points during the transition to a new card, emotional distress, time and effort spent reversing unauthorized charges and protect- ing against further fraud, and the cost of purchasing identity theft/card protection insurance and credit moni- toring services. Discuss the validity of their claim that Hannaford had breached an implied contract with its customers.

T A K I N G S I D E S

Richardson hired J. C. Flood Company, a plumbing contrac- tor, to correct a stoppage in the sewer line of her house. The plumbing company’s “snake” device, used to clear the line leading to the main sewer, became caught in the underground line. To release it, the company excavated a portion of the sewer line in Richardson’s backyard. In the process, the com- pany discovered numerous leaks in a rusty, defective water pipe that ran parallel with the sewer line. To meet public reg- ulations, the water pipe, of a type no longer approved for such service, had to be replaced either then or later, when the yard would have to be excavated again. The plumbing com- pany proceeded to repair the water pipe. Though Richardson inspected the company’s work daily and did not express any

objection to the extra work involved in replacing the water pipe, she refused to pay any part of the total bill after the company completed the entire operation. J. C. Flood Com- pany then sued Richardson for the costs of labor and material it had furnished.

a. What arguments would support J. C. Flood’s claim for the costs of labor and material it had furnished?

b. What arguments would support Richardson’s refusal to pay the bill?

c. For what, if anything, should Richardson be liable? Explain.

Chapter 9 Introduction to Contracts 201

C H A P T E R 1 0

MUTUAL ASSENT

It is elementary that for a contract to exist there must be an offer and acceptance. ZELLER V. FIRST NATIONAL BANK & TRUST, TALES, 79 ILL.APP.3D 170, 34 ILL. DEC. 473, 398 N.E.2D 148 (1979)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Identify the three essentials of an offer and explain briefly the requirements associated with each.

2. State the seven ways by which an offer may be terminated other than by acceptance.

3. Compare the traditional and modern theories of definiteness of acceptance of an offer, as

shown by the common law “mirror image” rule and by the rule of the Uniform Commercial Code.

4. Describe the five situations limiting an offeror’s right to revoke her offer.

5. Explain the various rules that determine when an acceptance takes effect.

T hough each of the requirements for forming a contract is essential to its existence, mutual assent is so basic that frequently a contract is

referred to as an agreement between the parties. Enforc- ing the contract means enforcing the agreement; indeed, the agreement between the parties is the very core of the contract. As discussed in Chapter 9, a contractual agree- ment always involves either a promise exchanged for a promise (bilateral contract) or a promise exchanged for a completed act or forbearance to act (unilateral contract).

The way in which parties usually show mutual assent is by offer and acceptance. One party makes a proposal (offer) by words or conduct to the other party, who agrees by words or conduct to the proposal (acceptance).

A contract may be formed by conduct. Thus, though there may be no definite offer and acceptance, or definite

acceptance of an offer, a contract exists if both parties’ actions manifest (indicate) a recognition by each of them of the existence of a contract. To form a contract, the agreement must be objectively manifested. The important thing is what the parties indicate to one another by spoken or written words or by conduct. The law applies an objective standard and, therefore, is concerned only with the assent, agreement, or intention of a party as it reasonably appears from his words or actions. The law of contracts is not concerned with what a party may have actually thought or the meaning that he intended to convey even if his subjective understanding or inten- tion differed from the meaning he objectively indicated by word or conduct. For example, if Joanne seemingly offers to sell to Bruce her Chevrolet automobile but intended to offer and believes that she is offering her Ford automobile and Bruce accepts the offer, reasonably

202

believing it was for the Chevrolet, a contract has been formed for the sale of the Chevrolet. Subjectively, Joanne and Bruce are not in agreement as to the subject matter. Objectively, however, there is agreement, and the objec- tive manifestation is binding.

The Uniform Commercial Code’s (UCC’s or Code’s) treatment of mutual assent is covered in greater detail in Chapter 19.

OFFER An offer is a definite undertaking or proposal made by one person to another indicating a willingness to enter into a contract. The person making the proposal is the offeror. The person to whom it is made is the offeree. When it is received, the offer confers on the offeree the power to create a contract by acceptance, which is an expression of the offeree’s willingness to comply with the terms of the offer. Until the offeree exercises this power, the outstanding offer creates neither rights nor liabilities.

ESSENTIALS OF AN OFFER [10-1] An offer need not take any particular form to have legal effect. To be effective, however, it must (1) be communicated to the offeree, (2) manifest an intent to enter into a contract, and (3) be sufficiently definite and certain. If these essentials are present and the offer has not terminated, the offer gives the offeree the power to form a contract by accepting the offer.

Communication [10-1a] To provide his part of the mutual assent required to form a contract, the offeree must know about the offer; he cannot agree to something about which he has no knowledge. Accordingly, the offeror must communicate the offer in an intended manner. For example, Oscar signs a letter containing an offer to Ellen and leaves it on top of the desk in his office. Later that day, Ellen, without prearrangement, goes to Oscar’s office, discovers that he is away, notices the letter on his desk, reads it, and then writes on it an acceptance that she dates and signs. No contract is formed because the offer never became effective: Ellen became aware of the offer by chance, not by Oscar’s intentional communication of it.

Not only must the offer be communicated to the offeree, but the communication must also be made or authorized by the offeror. If Jones tells Black that

she plans to offer White $600 for a piano and Black promptly informs White of Jones’s intention, no offer has been made. There was no authorized communica- tion of any offer by Jones to White. By the same token, if David should offer to sell to Lou his diamond ring, an acceptance of this offer by Tia would not be effec- tive, as David made no offer to Tia.

An offer need not be stated or communicated by words. Conduct from which a reasonable person may infer a proposal in return for either an act or a promise amounts to an offer.

An offer may be made to the general public. No per- son can accept such an offer, however, until and unless he knows that the offer exists. For example, if a person, without knowing of an advertised reward for informa- tion leading to the return of a lost watch, gives infor- mation leading to the return of the watch, he is not entitled to the reward. His act was not an acceptance of the offer because he could not accept something of which he had no knowledge.

Intent [10-1b] To have legal effect, an offer must manifest an intent to enter into a contract. The intent of an offer is deter- mined objectively from the words or conduct of the parties. The meaning of either party’s manifestation is based on what a reasonable person in the other party’s position would have believed.

Occasionally, a person exercises her sense of humor by speaking or writing words that—taken literally and with- out regard to context or surrounding circumstances— could be construed as an offer. The promise is intended as a joke, however, and the promisee as a reasonable person should understand it to be such. Therefore, it is not an offer. Because the person to whom it is made real- izes or should realize that it is not made in earnest, it should not create a reasonable expectation in his mind. No contractual intent exists on the part of the promisor, and the promisee is or reasonably ought to be aware of that fact. If, however, the intended joke is so real that the promisee as a reasonable person under all the circum- stances believes that the joke is in fact an offer and so believing accepts, the objective standard applies and the parties have entered into a contract.

A promise made under obvious excitement or emo- tional strain is likewise not an offer. For example, Charlotte, after having her month-old Cadillac break down for the third time in two days, screams in dis- gust, “I will sell this car to anyone for $10.00!” Lisa hears Charlotte and hands her a $10.00 bill. Under the circumstances, Charlotte’s statement was not an

Chapter 10 Mutual Assent 203

offer if a reasonable person in Lisa’s position would have recognized it merely as an excited, nonbinding utterance.

It is important to distinguish language that consti- tutes an offer from that which merely solicits or invites offers. Such proposals, although made in earnest, lack the intent to enter into a contract and therefore are not deemed offers. As a result, a purported acceptance does

not bring about a contract but operates only as an offer. Proposals that invite offers include preliminary negotiations, advertisements, and auctions.

PRACTICAL ADVICE Make sure that you indicate by words or conduct what agreement you wish to enter.

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FACTS The Reed Family owns and operates Cata- mount Slate Products, Inc. (Catamount), a slate quarry and mill, on 122 acres in Fair Haven, Vermont. The Sheldons own neighboring property. Since 1997, the parties have been litigating the Reeds’ right to operate their slate busi- ness and to use the access road leading to the quarry. In 2000, the parties agreed to try to resolve their disputes in a state-funded mediation with retired Judge Arthur O’Dea serving as mediator. Prior to the mediation, Judge O’Dea sent each party a Mediation Agreement outlining the rules governing the mediation. Paragraph nine of the Mediation Agreement stated that—

i. all statements, admissions, confessions, acts, or exchanges … are acknowledged by the parties to be offers in negotia- tion of settlement and compromise, and as such inadmissi- ble in evidence, and not binding upon either party unless reduced to a final agreement of settlement. Any final agree- ment of settlement must be in writing and signed by every party sought to be charged.

The mediation was held on September 5, 2000. Judge O’Dea began the session by reaffirming the state- ments made in the Mediation Agreement. After ten hours, the parties purportedly reached an agreement on all major issues. Judge O’Dea then orally summarized the terms of the resolution with the parties and counsel present. The attorneys took notes on the terms of the agreement with the understanding that they would pre- pare the necessary documents for signature in the com- ing days.

The resolution required the Reeds to pay the Sheldons $250 a month for the right to use the access road, with payments to commence on October 1, 2000. The parties also agreed to a series of terms governing the operation of the slate quarry. These terms were to be memorialized in two distinct documents, a Lease Agreement and a Settlement Agreement.

On September 7, 2000, two days after the mediation, the Sheldons’ attorney, Emily Joselson, drafted a letter

outlining the terms of the settlement and sent copies to James Leary, the Reeds’ attorney, and Judge O’Dea. Within a week, Leary responded by letter concurring in some respects and outlining the issues on which the Reeds disagreed with Joselson’s characterization of the settlement.

On October 1, 2000, the Reeds began paying the $250 monthly lease payments, but since the settlement agreement was not final, the parties agreed that the money would go into an escrow account maintained by the Sheldons’ counsel. The check was delivered to the Sheldons’ attorney with a cover memo stating, “This check is forwarded to you with the understanding that the funds will be disbursed to your clients only after settlement agreement becomes final. Of course, if the settlement agreement does not come to fruition, then the funds must be returned to my clients.” The parties continued to exchange letters actively negotiating the remaining details of the Lease and Settlement Agree- ments for the better part of the next five months.

In February 2001, while drafts were still being ex- changed, Christine Stannard, the Reeds’ daughter, saw a deed and map in the Fair Haven Town Clerk’s Office, which led her to believe that the disputed road was not owned by the Sheldons, but was a town highway. The Reeds then refused to proceed any further with negotiat- ing the settlement agreement. A written settlement agree- ment was never signed by either party.

The Sheldons then filed a motion to enforce the set- tlement agreement. The trial court granted the option, finding that the attorneys’ notes taken at the end of the mediation and the unsigned drafts of the Lease and Set- tlement Agreements sufficiently memorialized the agree- ment between the parties and thus constituted an enforceable settlement agreement.

DECISION Judgment of the trial is reversed and remanded.

204 Contracts Part III

OPINION Skoglund, J. The question before us is whether the oral agreement reached at mediation, when combined with the unexecuted documents drafted sub- sequently, constituted a binding, enforceable settlement agreement. Parties are free to enter into a binding con- tract without memorializing their agreement in a fully executed document. [Citation.] In such an instance, the mere intention or discussion to commit their agreement to writing will not prevent the formation of a contract prior to the document’s execution. [Citations.]

“On the other hand, if either party communicates an intent not to be bound until he achieves a fully executed document, no amount of negotiation or oral agreement to specific terms will result in the formation of a binding contract.” [Citation.] The freedom to determine the exact moment in which an agreement becomes binding encourages the parties to negotiate as candidly as possi- ble, secure in the knowledge that they will not be bound until the execution of what both parties consider to be a final, binding agreement.

We look to the intent of the parties to determine the moment of contract formation. [Citation.] Intent to be bound is a question of fact. [Citation.] “To discern that intent a court must look to the words and deeds [of the parties] which constitute objective signs in a given set of circumstances.” [Citation.] In [citation], the Second Circuit articulated four factors to aid in determining whether the parties intended to be bound in the absence of a fully executed document. [Citation.] The court sug- gested that we

consider (1) whether there has been an express reservation of the right not to be bound in the absence of a writing; (2) whether there has been partial performance of the contract; (3) whether all of the terms of the alleged contract have been agreed upon; and (4) whether the agreement at issue is the type of contract that is usually committed to writing. [Citations.]

The language of the parties’ correspondence and other documentary evidence presented reveals an intent by the mediation participants not to be bound prior to the exe- cution of a final document. First, the Mediation Agree- ment Judge O’Dea sent to the parties prior to the mediation clearly contemplates that any settlement agree- ment emanating from the mediation would be binding only after being put in writing and signed. Paragraph nine of the Agreement expressly stated that statements made during mediation would not be “binding upon either party unless reduced to a final agreement of settlement” and that “any final agreement of settlement [would] be in writing and signed by every party sought to be charged.” Further, Judge O’Dea reminded the par- ties of these ground rules at the outset of the mediation.

***

Even more compelling evidence of the Reeds’ lack of intent to be bound in the absence of a writing is the statement in the cover letter accompanying the Reeds’ $250 payments to the Sheldons’ attorney saying, “This check is forwarded to you with the understanding that the funds will be disbursed to your clients only after settlement agreement becomes final. Of course, if the settlement agreement does not come to fruition, then the funds must be returned to my clients.” This factor weighs in favor of finding that the Reeds expressed their right not to be bound until their agreement was reduced to a final writing and executed.

Because there was no evidence presented of partial performance of the settlement agreement, we next con- sider the third factor, whether there was anything left to negotiate. ***

As stated by the Second Circuit in [citation], “the actual drafting of a written instrument will frequently reveal points of disagreement, ambiguity, or omission which must be worked out prior to execution. Details that are unnoticed or passed by in oral discussion will be pinned down when the understanding is reduced to writing” (internal quotations and citations omitted). [Citation.] This case is no exception. A review of the lengthy correspondence in this case makes clear that several points of disagreement and ambiguity arose dur- ing the drafting process. Beyond the location of seismic measurements and the definition of “overblast,” corre- spondence indicates that the parties still had not reached agreement on the term and width of the lease, acceptable decibel levels and notice provisions for blasts, the defini- tion of “truck trips,” and whether all claims would be dismissed without prejudice after the execution of the agreement. Resolution of these issues was clearly impor- tant enough to forestall final execution until the language of the documents could be agreed upon. In such a case, where the parties intend to be bound only upon execu- tion of a final document, for the court to determine that, despite continuing disagreement on substantive terms, the parties reached a binding, enforceable settlement agree- ment undermines their right to enter into the specific set- tlement agreement for which they contracted.

The fourth and final factor, whether the agreement at issue is the type of contract usually put into writing, also weighs in the Reeds’ favor. Being a contract for an inter- est in land, the Lease Agreement is subject to the Statute of Frauds and thus generally must be in writing. ***

*** In conclusion, three of the four factors indicate that

the parties here did not intend to be bound until the execution of a final written document, and therefore we hold that the parties never entered into a binding settlement agreement.

Chapter 10 Mutual Assent 205

Preliminary Negotiations If a communication creates in the mind of a reasonable person in the posi- tion of the offeree an expectation that his acceptance will conclude a contract, then the communication is an offer. If it does not, then the communication is a pre- liminary negotiation. Initial communications between potential parties to a contract often take the form of preliminary negotiations, through which the parties either request or supply the terms of an offer that may or may not be made. A statement that may indicate a willingness to make an offer is not in itself an offer. For instance, if Brown writes to Young, “Will you buy my automobile for $3,000?” and Young replies, “Yes,” there is no contract. Brown has not made an offer to sell her automobile to Young for $3,000. The offeror must demonstrate an intent to enter into a contract, not merely a willingness to enter into a negotiation.

Advertisements Merchants desire to sell their merchandise and thus are interested in informing poten- tial customers about the goods, terms of sale, and price. But if they make widespread promises to sell to each per- son on their mailing list, the number of acceptances and resulting contracts might conceivably exceed their abil- ity to perform. Consequently, a merchant might refrain

from making offers by merely announcing that he has goods for sale, describing the goods, and quoting prices. He is simply inviting his customers and, in the case of published advertisements, the public, to make offers to him to buy his goods. His advertisements, circulars, quotation sheets, and displays of merchandise are not offers because (1) they do not contain a promise and (2) they leave unexpressed many terms that would be neces- sary to the making of a contract. Accordingly, his cus- tomers’ responses are not acceptances because no offer to sell has been made.

Nonetheless, a seller is not free to advertise goods at one price and then raise the price once demand has been stimulated. Although as far as contract law is concerned, the seller has made no offer, such conduct is prohibited by the Federal Trade Commission as well as by legisla- tion in most states. Moreover, in some circumstances a public announcement or advertisement may constitute an offer if the advertisement or announcement contains a definite promise of something in exchange for something else and confers a power of acceptance on a specified person or class of persons. The typical offer of a reward is an example of a definite offer, as is the situation pre- sented in the landmark Lefkowitz v. Great Minneapolis Surplus Store, Inc. case, which follows.

INTERPRETATION The intent of the parties to be bound to a contract is determined by an objective standard of what a reasonable person would have believed based on the words and conduct of the parties.

CRITICAL THINKING QUESTION Does the decision rendered by the court establish a policy that is best for society? Explain.

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FACTS On April 6, 1956, Great Minneapolis Sur- plus Store published an advertisement in a Minneapolis newspaper reporting that “Saturday, 9:00 a.m. sharp; 3 brand new fur coats worth up to $100; first come, first served, $1.00 each.” Lefkowitz was the first to arrive at the store, but the store refused to sell him the fur coats because the “house rule” was that the offers were intended for women only and sales would not be made to men. The following week, Great Minneapolis published a similar advertisement for the sale of two mink scarves and a black lapin stole. Again Lefkowitz was the first to arrive at the store on Saturday morning, and once again the store refused to sell to him, this time

because Lefkowitz knew of the house rule. This appeal was from a judgment awarding the plaintiff the sum of $138.50 as damages for breach of contract.

DECISION Judgment for Lefkowitz affirmed.

OPINION Murphy, J. The defendant *** relies upon authorities which hold that, where an advertiser publishes in a newspaper that he has a certain quantity or quality of goods which he wants to dispose of at certain prices and on certain terms, such advertisements are not offers which become contracts as soon as any person to whose notice they may come signifies his

206 Contracts Part III

Auction Sales The auctioneer at an auction sale does not make offers to sell the property being auc- tioned but invites offers to buy. The classic statement by the auctioneer is, “How much am I offered?” The persons attending the auction may make progressively higher bids for the property, and each bid or statement of a price or a figure is an offer to buy at that figure. If the bid is accepted, customarily indicated by the fall of the hammer in the auctioneer’s hand, a contract results. A bidder is free to withdraw his bid at any time prior to its acceptance. The auctioneer is likewise free to withdraw the goods from sale unless the sale is advertised or announced to be without reserve.

If the auction sale is advertised or announced in explicit terms to be without reserve, the auctioneer may not withdraw an article or lot put up for sale unless no bid is made within a reasonable time. Unless so advertised or announced, the sale is with reserve. A bidder at either type of sale may retract his bid at any time prior to its acceptance by the auctioneer; such retraction, however, does not revive any previous bid.

Definiteness [10-1c] The terms of a contract, all of which are usually con- tained in the offer, must be clear enough to provide a court with a reasonable basis for determining the exis- tence of a breach and for giving an appropriate remedy. It is a fundamental policy that contracts should be

made by the parties, not by the courts; accordingly, remedies for a breach must in turn have their basis in the parties’ contract. Where the parties have intended to form a contract, the courts will attempt to find a ba- sis for granting a remedy. Missing terms may be sup- plied by course of dealing, usage of trade, or inference. Thus, uncertainty as to incidental matters seldom will be fatal so long as the parties intended to form a con- tract. Nevertheless, the more terms the parties leave open, the less likely it is that they have intended to form a contract. Moreover, given the great variety of contracts, stating the terms that are essential to all con- tracts is impossible. In most cases, however, material terms would include the parties, subject matter, price, quantity, quality, and time of performance. (See DiLor- enzo v. Valve & Primer Corporation in Chapter 12.)

Open Terms With respect to agreements for the sale of goods, the UCC provides standards by which the courts may determine omitted terms, provided the par- ties intended to enter into a binding contract. The Code provides missing terms in a number of instances, where, for example, the contract fails to specify the price, the time or place of delivery, or payment terms. The Restate- ment has adopted an approach similar to the Code’s in supplying terms omitted from the parties’ contract.

Under the Code, an offer for the purchase or sale of goods may leave open particulars of performance to be

acceptance by notifying the other that he will take a certain quantity of them. Such advertisements have been construed as an invitation for an offer of sale on the terms stated, which offer, when received, may be accepted or rejected and which, therefore does not be- come a contract of sale until accepted by the seller; and until a contract has been so made, the seller may modify or revoke such prices or terms. [Citations.] ***

On the facts before us we are concerned with whether the advertisement constituted an offer.

***

The test of whether a binding obligation may originate in advertisements addressed to the general public is “whether the facts show that some performance was promised in positive terms in return for something requested.”

***

Whether in any individual instance a newspaper ad- vertisement is an offer rather than an invitation to make an offer depends on the legal intention of the parties and the surrounding circumstances. [Citations.] We are of the view on the facts before us that the offer by the

defendant of the sale *** was clear, definite, and explicit, and left nothing open for negotiation. The plaintiff having successfully managed to be the first one to appear at the seller’s place of business to be served, as requested by the advertisement, and having offered the stated purchase price of the article, he was entitled to performance on the part of the defendant. We think the trial court was correct in holding that there was in the conduct of the parties a sufficient mutuality of obli- gation to constitute a contract of sale.

INTERPRETATION Although advertisements generally do not constitute offers, under some circum- stances they do.

ETHICAL QUESTION Should Lefkowitz be entitled to damages? Why?

CRITICAL THINKING QUESTION Should an advertisement generally be construed as not constitut- ing an offer? Explain.

Chapter 10 Mutual Assent 207

specified by one of the parties. Any such specification must be made in good faith and within limits set by commercial reasonableness. Good faith is defined as honesty in fact and the observance of reasonable com- mercial standards of fair dealing under the 2001 Re- vised UCC Article 1 adopted by at least forty-six states. (Under the original UCC, good faith means honesty in fact in the conduct or transaction concerned.) Commer- cial reasonableness is a standard determined in terms of the business judgment of reasonable persons familiar with the practices customary in the type of transaction involved and in terms of the facts and circumstances of the case. (See DiLorenzo v. Valve & Primer Corpo- ration in Chapter 12.)

PRACTICAL ADVICE To make an offer that will result in an enforceable contract, make sure you include all the necessary terms.

Output and Requirements Contracts An output contract is an agreement of a buyer to purchase a seller’s entire output for a stated period. In compari- son, a requirements contract is an agreement of a seller to supply a buyer with all his requirements for certain goods. Even though the exact quantity of goods is not specified and the seller may have some degree of con- trol over his output and the buyer over his require- ments, under the Code and the Restatement, such agreements are enforceable by the application of an objective standard based on the good faith of both par- ties. Thus, a seller who operated a factory only eight hours a day before the agreement was made cannot op- erate the factory twenty-four hours a day and insist that the buyer take all of the output. Nor can the buyer expand his business abnormally and insist that the seller still supply all of his requirements.

DURATION OF OFFERS [10-2] An offer confers upon the offeree a power of accep- tance, which continues until the offer terminates. The ways in which an offer may be terminated, other than by acceptance, are through (1) lapse of time, (2) revocation, (3) rejection, (4) counteroffer, (5) death or incompetency of the offeror or offeree, (6) destruction of the subject matter to which the offer relates, and (7) subsequent illegality of the type of contract the offer proposes.

Lapse of Time [10-2a] The offeror may specify the time within which the offer is to be accepted, just as he may specify any other term or condition in the offer. Unless otherwise terminated, the offer remains open for the specified time. Upon the expiration of that time, the offer no longer exists and cannot be accepted. Any purported acceptance of an expired offer will serve only as a new offer.

If the offer does not state the time within which the offeree may accept, the offer will terminate after a reasonable time. Determining a “reasonable” time is a question of fact, depending on the nature of the con- tract proposed, the usages of business, and other cir- cumstances of the case (including whether the offer was communicated by electronic means). For instance, an offer to sell a perishable good would be open for a far shorter period of time than an offer to sell undeveloped real estate.

PRACTICAL ADVICE Because of the uncertainty as to what is a “reasonable time,” it is advisable to specify clearly the duration of offers you make.

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FACTS David and Elizabeth Kidd’s dog bit Mikaila Sherrod. Mikaila through her guardian ad litem (GAL) made a claim for damages against the Kidds (defendants). On June 14, 2005, the Kidds offered to settle the claim for $31,837. On July 12, Mikaila through her GAL sued the Kidds. On July 20, the Kidds raised their settlement offer to $32,843. The suit was subject to mandatory arbitration. The parties proceeded to arbitration on

April 28, 2006. On May 5, the arbitrator awarded Mikaila $25,069.47. On May 9, the GAL wrote to the Kidds and purported to accept their last offer of $32,843, made the year before. The GAL on Mikaila’s behalf moved to enforce the settlement agreement. The court concluded the offer was properly accepted because it had not been withdrawn and it entered judgment in the amount of the first written offer.

208 Contracts Part III

Revocation [10-2b] The offeror generally may cancel or revoke an offer (revocation) at any time prior to its acceptance. If the offeror originally promises that the offer will be open for thirty days but wishes to terminate it after five days, he may do so merely by giving the offeree notice that he is withdrawing the offer. This notice may be given by any means of communication and effectively terminates the offer when received by the offeree. A very few states, however, have adopted a rule that treats revocations the same as acceptances, thus making them effective upon dispatch. An offer made to the general public is revoked only by giving to the revocation publicity equivalent to that given the offer.

Notice of revocation may be communicated indi- rectly to the offeree through reliable information from a third person that the offeror has disposed of the property he has offered for sale or has otherwise placed himself in a position indicating an unwillingness or inability to perform the promise contained in the offer. For example, Aaron offers to sell his portable television set to Ted and tells Ted that he has ten days in which to accept. One week later, Ted observes the televi- sion set in Celia’s house and is informed that Celia purchased it from Aaron. The next day, Ted sends to

Aaron an acceptance of the offer. There is no contract because Aaron’s offer was effectively revoked when Ted learned of Aaron’s inability to sell the television set to Ted because he had sold it to Celia.

Certain limitations, however, restrict the offeror’s power to revoke the offer at any time prior to its ac- ceptance. These limitations apply to the following five situations.

Option Contracts An option is a contract by which the offeror is bound to hold open an offer for a specified period of time. It must comply with all of the requirements of a contract, including the offeree’s giving of consideration to the offeror. (Consideration, or the inducement to enter into a contract consisting of an act or promise that has legal value, is discussed in Chapter 12.) For example, if Ellen, in return for the payment of $500 to her by Barry, grants Barry an option, exercisable at any time within thirty days, to buy Blackacre at a price of $80,000, Ellen’s offer is irrevocable. Ellen is legally bound to keep the offer open for thirty days, and any communication by Ellen to Barry giving notice of withdrawal of the offer is inef- fective. Though Barry is not bound to accept the offer, the option contract entitles him to thirty days in which to accept.

DECISION The decision of the trial judge is reversed.

OPINION Sweeney, C. J. An offer to form a con- tract is open only for a reasonable time, unless the offer specifically states how long it is open for acceptance. [Citations.] “[I]n the absence of an acceptance of an offer … within a reasonable time (where no time limit is specified), there is no contract.” [Citation.]

How much time is reasonable is usually a question of fact. [Citation.] But we can decide the limits of a reason- able time if the facts are undisputed. [Citation.] And here the essential facts are not disputed.

A reasonable time “is the time that a reasonable per- son in the exact position of the offeree would believe to be satisfactory to the offeror.” [Citation.]

The purpose of the offeror, to be attained by the making and performance of the contract, will affect the time allowed for acceptance, if it is or should be known to the offeree. In such case there is no power to accept after it is too late to attain that purpose. [Citation.]

A reasonable time for an offeree to accept an offer depends on the “nature of the contract and the

character of the business in which the parties were engaged.” [Citation.]

Implicit in an offer (and an acceptance) to settle a personal injury suit is the party’s intent to avoid a less favorable result at the hands of a jury, a judge or, in this case, an arbitrator. The defendant runs the risk that the award might be more than the offer. The plaintiff, of course, runs the risk that the award might be less than the offer. Both want to avoid that risk. And it is those risks that settlements avoid.

*** *** Here, the value of this claim was set after arbi-

tration. It was certainly subject to appeal but nonethe- less set by a fact finder.

This offer expired when the arbitrator announced the award and was not subject to being accepted.

INTERPRETATION An offer is open for a rea- sonable period of time.

CRITICAL THINKING QUESTION Should the courts consider the social and public policy in a case such as this? Explain.

Chapter 10 Mutual Assent 209

Firm Offers Under the Code The Code pro- vides that a merchant is bound to keep an offer to buy or sell goods open for a stated period (or, if no time is stated, for a reasonable time) not exceeding three months if the merchant gives assurance in a signed writing that the offer will be held open. The Code, therefore, makes a merchant’s firm offer (written prom- ise not to revoke an offer for a stated period of time) enforceable even though no consideration is given to the offeror for that promise (i.e., an option contract does not exist). A merchant is defined as a person (1) who is a dealer in a given type of goods or (2) who by his occupation holds himself out as having knowledge or skill peculiar to the goods or practices involved or (3) who employs an agent or broker whom he holds out as having such knowledge or skill.

Statutory Irrevocability Certain offers, such as bids made to the state, municipality, or other govern- ment body for the construction of a building or some public work, are made irrevocable by statute. Another example is preincorporation stock subscription agree- ments, which are irrevocable for a period of six months under many state corporation statutes.

Irrevocable Offers of Unilateral Con- tracts Where the offer contemplates a unilateral contract—that is, a promise for an act—injustice to the offeree may result if revocation is permitted after the offeree has started to perform the act requested in the offer and has substantially but not completely accomplished it. Such an offer is not accepted and no contract is formed until the offeree has completed the requested act. By simply starting performance, the offeree does not bind himself to complete perform- ance; historically, he did not bind the offeror to keep the offer open, either. Thus, the offeror could revoke the offer at any time before the offeree’s completion of performance. For example, Jordan offers Karlene $300 if Karlene will climb to the top of the flagpole in the center of campus. Karlene starts to climb, but when she is five feet from the top, Jordan yells to her, “I revoke.”

The Restatement deals with this problem by providing that where the performance of the requested act neces- sarily requires the offeree to expend time and effort, the offeror is obligated not to revoke the offer for a reasona- ble time. This obligation arises when the offeree begins performance. If, however, the offeror does not know of the offeree’s performance and has no adequate means of learning of it within a reasonable time, the offeree

must exercise reasonable diligence to notify the offeror of the performance.

PRACTICAL ADVICE When making an offer, be careful to make it irrevocable only if you so desire.

Promissory Estoppel As discussed in the previ- ous chapter, a noncontractual promise may be enforced when it is made under circumstances that should lead the promisor reasonably to expect that the promise will induce the promisee to take action in reliance on it. This doctrine has been used in some cases to prevent an offeror from revoking an offer prior to its acceptance.

Thus, Ramanan Plumbing Co. submits a written offer for plumbing work to be used by Resolute Building Co. as part of Resolute’s bid as a general contractor. Ramanan knows that Resolute is relying on Ramanan’s bid, and in fact Resolute submits Ramanan’s name as the plumbing subcontractor in the bid. Ramanan’s offer is irrevocable until Resolute has a reasonable opportu- nity to notify Ramanan that Resolute’s bid has been accepted.

Rejection [10-2c] An offeree is at liberty to accept or reject the offer as he sees fit. If he decides not to accept it, he is not required to reject it formally but may simply wait until the offer terminates by lapse of time. A rejection of an offer is a manifestation by the offeree of his unwilling- ness to accept. A communicated rejection terminates the power of acceptance. From the effective moment of rejection, which is the receipt of the rejection by the offeror, the offeree may no longer accept the offer. Rejection by the offeree may consist of express lan- guage or may be implied from language or conduct.

Counteroffer [10-2d] A counteroffer is a counterproposal from the offeree to the offeror that indicates a willingness to contract but on terms or conditions different from those contained in the original offer. It is not an unequivocal acceptance of the original offer, and by indicating an unwillingness to agree to the terms of the offer, it generally operates as a rejection. It also operates as a new offer. To illus- trate further, assume that Worthy writes Joanne a letter stating that he will sell to Joanne a secondhand color television set for $300. Joanne replies that she will pay Worthy $250 for the set. This is a counteroffer that,

210 Contracts Part III

on receipt by Worthy, terminates the original offer. Worthy may, if he wishes, accept the counteroffer and thereby create a contract for $250. If, on the other hand, Joanne in her reply states that she wishes to con- sider the $300 offer but is willing to pay $250 at once for the set, she is making a counteroffer that does not terminate Worthy’s original offer. In the first instance, after making the $250 counteroffer, Joanne may not accept the $300 offer. In the second instance, she may do so, because the counteroffer was stated in such a manner as not to indicate an unwillingness to accept the original offer; Joanne therefore did not terminate it. In addition, a mere inquiry about the possibility of obtaining different or new terms is not a counteroffer and does not terminate the original offer.

Another common type of counteroffer is the condi- tional acceptance, which claims to accept the offer but expressly makes the acceptance contingent on the offer- or’s assent to additional or different terms. Nonetheless, it is a counteroffer and generally terminates the original offer. The Code’s treatment of acceptances containing terms that vary from the offer is discussed later in this chapter.

PRACTICAL ADVICE Consider whether you want to make a counterproposal that terminates the original offer or whether you merely wish to discuss alternative possibilities.

A P P L Y I N G T H E L A W

MUTUAL ASSENT

Facts Taylor and Arbuckle formed a partnership for the pur- pose of practicing pediatric medicine together. They found new medical office space to lease and thereafter, among other things, they set about furnishing the waiting room in a way that children would find inviting. In addition to con- tracting with a mural painter, they decided to purchase a high-definition flat-panel television on which they could show children’s programming. On a Monday, Taylor and Arbuckle visited a local retailer with a reputation for competitive pric- ing, called Today’s Electronics. In addition to comparing the pictures on the various models on display, the doctors dis- cussed the pros and cons of LCD (liquid crystal display) versus plasma with the store’s owner, Patel.

While they were able to narrow their options down sig- nificantly, Taylor and Arbuckle nonetheless could not decide on the exact size set to purchase because they had not yet determined the configuration of the seating to be installed in the waiting room. Sensing that the doctors were consid- ering shopping around, Patel offered them a sizeable dis- count: only $549 for the forty-inch LCD screen they had chosen or the fifty-inch plasma model they favored for only $799. As they were leaving the store, Patel gave the doctors his business card, on which he had jotted the model num- bers and discount prices, his signature, and the notation “we assure you this offer is open through Sun., April 27.”

Anxious to have the waiting room completed, Taylor and Arbuckle quickly agreed on a feasible seating arrangement for the waiting room, ordered the necessary furniture, and decided that the fifty-inch television would be too big. On Friday, April 25, Taylor returned to Today’s Electronics. But before she could tell Patel that they had decided on the forty-inch LCD, Patel informed her that he could not honor the discounted prices because he no longer had in stock either model the doctors were considering.

Issue Is Patel free to revoke his offer notwithstanding having agreed to hold it open through the weekend?

Rule of Law The general rule is that an offeror may revoke, or withdraw, an offer any time before it has been accepted. However, there are several limitations on an offer- or’s power to revoke an offer before acceptance. One of these is the Uniform Commercial Code’s (UCC’s) “merchant’s firm offer” rule. Under the UCC, a merchant’s offer to buy or sell goods is irrevocable for the stated period (or, if no period is stated, for a reasonable time) not exceeding three months, when he has signed a writing assuring the offeree that the offer will be kept open for that period. The Code defines a merchant as one who trades in the types of goods in question or who holds himself out, either personally or by way of an agent, to be knowledgeable regarding the goods or practices involved in the transaction.

Application The proposed contract between the doctors and Today’s Electronics is governed by Article 2 of the Code because it involves a sale of goods, in this case a television set. Both Patel and Today’s Electronics are considered mer- chants of televisions under the Code’s definition, because Patel and his store regularly sell electronics, including televi- sion sets. Patel offered to sell to Taylor and Arbuckle either the forty-inch LCD television for $549 or the fifty-inch plasma for $799. By reducing his offer to a signed writing, and by promising in that writing that the stated prices were assured to be open through Sun., April 27, Patel has made a firm offer that he cannot revoke during that six-day period. Whether he still has either model in stock does not affect the irrevocability of the offer.

Conclusion Patel’s offer is irrevocable through Sunday, April 27. Therefore Patel’s attempt to revoke it is ineffective, and Taylor may still accept it.

Chapter 10 Mutual Assent 211

T H O R P R O P E R T I E S V . W I L L S P R I N G H O L D I N G S L L C S u p r e m e C o u r t , A p p e l l a t e D i v i s i o n , F i r s t D e p a r t m e n t , N e w Y o r k , 2 0 1 4

1 1 8 A . D . 3 d 5 0 5 , 9 8 8 N . Y . S . 2 d 4 7

FACTS Plaintiff Thor Properties brought this action for breach of contract to compel specific performance by defendant Willspring Holdings to sell it a mixed-used building in Manhattan. On December 5, 2012, Thor emailed Willspring a letter of intent (LOI) offering to buy the property for $111 million under terms that included Willspring’s transfer of the property free of liens. The December 5th LOI also provided that, unless Willspring countersigned and returned it by December 7, Thor’s offer would “be deemed withdrawn in its entirety.” On December 5, Willspring emailed Thor to reject its offer, noting that Thor’s purchase price fell short of other bids. Willspring also refused to transfer the property free of liens because it demanded Thor assume the existing mortgage on the property. After more negotiations, on December 6 Willspring emailed Thor that Willspring expected a modified LOI to be issued under which Thor would (1) increase its offer to $115 million; (2) agree to assume the mortgage; (3) exe- cute a long-form purchase agreement by December 11, 2012; and (4) close by the end of the year. Later on December 6, Thor emailed a second LOI, which increased the purchase price but did not commit to exe- cuting the purchase agreement by December 11 or clos- ing in 2012, and still required Willspring to deliver the property free of liens. The new LOI also required Will- spring’s countersignature and delivery by December 7. Thereafter, Willspring responded by sending Thor a copy of its December 6th LOI, which Willspring had marked up by hand and signed. Willspring’s response deleted Thor’s requirement that the seller convey title free of liens and added the December 11 deadline for an executed purchase agreement. In addition, the response modified its demand for a closing by year’s end by pro- viding that the closing must occur within 30 days after the purchase agreement was signed but also provided that “[time was of the essence]” for closing.

Minutes later, Willspring’s principal emailed Thor that he was “pleased that we have been able to agree [to] terms.” He cautioned, however, that if there were any “[renegotiating]” then Willspring would “walk away promptly.” About one hour thereafter, however, Thor emailed Willspring that “[w]e will be getting our response to your proposed changes to the LOI shortly.”

While the parties continued discussions on the evening of December 6, on the morning of December 7, Willspring’s principal emailed Thor that “[p]er our conversation last night … I understand our changes to [the December 6th]

LOI are NOT acceptable to Thor as presented. Please send me a revised LOI with your suggested changes so I can have our attorney review them.” Later on December 7, Thor sent Willspring a new or third LOI which changed the terms of the marked-up December 6th LOI by giving Thor a unilateral right to adjourn the closing date by 10 days, despite time being of the essence. The December 7th LOI sent by Thor also extended the deadline for a signed purchase agreement by two days but limited Thor’s assumption of the mortgage to the only exception to Willspring’s obligation to deliver the property free of liens. The December 7th LOI stated that it required Willspring’s countersignature and return by that day. On the afternoon of December 7, Willspring’s principal emailed Thor that the “LOI changes you have put forth… [are] not what we agreed to” because “[w]e were very clear on the need to sign a contract early next week and … to close by year end.” The Willspring principal acknowledged that Thor’s offer expired that day. On December 10, Thor emailed Willspring a copy of the December 6th LOI that Willspring had marked up and signed, which now bore Thor’s initials by Willspring’s handwritten changes purport- edly to show Thor’s acceptance of the agreement that it had previously sought to modify. Willspring, however, con- tracted to sell its property to a third party.

The Supreme Court, New York County granted Willspring’s motion for summary judgment dismissing the complaint. Thor appealed.

DECISION Judgment for Willspring affirmed.

OPINION Sweeny, J.P. The record demonstrates that the parties never came to terms and instead pro- posed a series of offers and counteroffers to which they never mutually agreed. Moreover, Thor’s belated attempt to form a binding contract on December 10 was a nullity. To enter into a contract, a party must clearly and unequivocally accept the offeror’s terms [citations]. If instead the offeree responds by condition- ing acceptance on new or modified terms, that response constitutes both a rejection and a counteroffer which extinguishes the initial offer [citation]. The counteroffer extinguishes the original offer, and thereafter the offeree cannot, as Thor attempted on December 10, unilaterally revive the offer by accepting it [citation].

While oral acceptance of a written offer can form a binding contract for the sale of real property [citation], the record does not support Thor’s claim that it unequivocally accepted the counteroffer that Wellspring

212 Contracts Part III

Death or Incompetency [10-2e] The death or incompetency of either the offeror or the offeree ordinarily terminates an offer. On his death or incompetency, the offeror no longer has the legal capacity to enter into a contract; thus, all outstanding offers are terminated. Death or incompetency of the offeree also terminates the offer, because an ordinary offer is not as- signable (transferable) and may be accepted only by the person to whom it was made. When the offeree dies or ceases to have legal capability to enter into a contract, no one else has the power to accept the offer. Therefore, the offer necessarily terminates.

The death or incompetency of the offeror or offeree, however, does not terminate an offer contained in an option.

Destruction of Subject Matter [10-2f] Destruction of the specific subject matter of an offer ter- minates the offer. Suppose that Sarah, owning a Buick, offers to sell the car to Barbara and allows Barbara five days in which to accept. Three days later the car is destroyed by fire. On the following day, Barbara, with- out knowledge of the destruction of the car, notifies Sarah that she accepts Sarah’s offer. There is no contract. The destruction of the car terminated Sarah’s offer.

Subsequent Illegality [10-2g] One of the essential requirements of a contract, as we previ- ously mentioned, is legality of purpose or subject matter. If performance of a valid contract is subsequently made illegal, the obligations of both parties under the contract

are discharged. Illegality taking effect after the making of an offer but prior to acceptance has the same effect: the offer is legally terminated. For an illustration of the dura- tion of revocable offers, see Figure 10-1.

ACCEPTANCE OF OFFER The acceptance of an offer is essential to the formation of a contract. Once an effective acceptance has been given, the contract is formed. Acceptance of an offer for a bilat- eral contract is some overt act by the offeree that manifests his assent to the terms of the offer, such as speaking or sending a letter, or other explicit or implicit communica- tion to the offeror. If the offer is for a unilateral contract, acceptance is the performance of the requested act with the intention of accepting. For example, if Joy publishes an offer of a reward to anyone who returns the diamond ring that she has lost (an offer to enter into a unilateral con- tract) and Bob, with knowledge of the offer, finds and returns the ring to Joy, Bob has accepted the offer.

COMMUNICATION OF ACCEPTANCE [10-3]

General Rule [10-3a] Because acceptance is the manifestation of the offeree’s assent to the offer, it must necessarily be communicated to the offeror. This is the rule as to all offers to enter

set forth in the mark-up of the December 6th LOI, before that counteroffer terminated. Thor’s email that it would respond to Willspring’s changes to the December 6th LOI indicates that Thor had not accepted those changes and intended further negotiation.

Moreover, Willspring’s email on the morning of December 7 confirms that Thor had rejected Willspring’s counteroffer. At the time, Thor did not claim that an agree- ment had been reached, but instead responded to Will- spring’s email by submitting the December 7th LOI, which it described as another “offer.” The December 7th LOI nei- ther refers to the marked-up December 6th LOI as a binding agreement nor unconditionally accepts the counteroffer embodied in Willspring’s handwritten changes.

Thor claims that on December 6 it orally accepted Willspring’s changes to the December 6th LOI, but asked Willspring to consider some “slight modifications” that Thor would put into writing the next day. However, the changes in the December 7th LOI were not, as Thor claims, “immaterial,” because they afforded Thor

the unilateral right to adjourn the closing. If a real estate contract provides that the time of closing is of the essence, “performance on the specified date is a material element… and failure to perform on that date con- stitutes… a material breach” [citation]. By modifying a material term in Willspring’s counteroffer, Thor rejected it and proposed a counteroffer that Willspring never accepted. Accordingly, the complaint for breach of con- tract was properly dismissed.

INTERPRETATION A counteroffer generally operates as a rejection and thus terminates the power of acceptance.

ETHICAL QUESTION Was the defendant morally obligated to sell the property? Explain.

CRITICAL THINKING QUESTION What could the plaintiffs have done to protect themselves while at the same time seeking different terms?

Chapter 10 Mutual Assent 213

into bilateral contracts. In the case of unilateral offers, however, notice of acceptance to the offeror usually is not required. If, however, the offeree in a unilateral contract has reason to know that the offeror has no adequate means of learning of the offeree’s performance with reasonable promptness and certainty, then the offeree must make reasonable efforts to notify the offeror of acceptance or lose the right to enforce the contract.

Silence as Acceptance [10-3b] An offeree is generally under no legal duty to reply to an offer. Silence or inaction therefore does not indicate acceptance of the offer. By custom, usage, or course of dealing, however, the offeree’s silence or inaction may operate as an acceptance. Thus, the silence or inaction of an offeree who fails to reply to an offer operates as an acceptance and causes a contract to be formed. Through previous dealings, for example, the offeree has given the offeror reason to understand that the offeree will accept all offers unless the offeree sends notice to the contrary. Another example of silence operating as an acceptance occurs when the prospective member of a mail-order club agrees that his failure to return a notification card rejecting offered goods will constitute his acceptance of the club’s offer to sell the goods.

Furthermore, if an offeror sends unordered or unsoli- cited merchandise to a person, stating that the goods may be purchased at a specified price and that the offer will be deemed to have been accepted unless the goods are returned within a stated period of time, the offer is one for

an inverted unilateral contract (i.e., an act for a promise). This practice has led to abuse, however, prompting the federal government as well as most states to enact statutes that provide that in such cases the offeree-recipient of the goods may keep them as a gift and is under no obligation either to return them or to pay for them.

Effective Moment [10-3c] As discussed previously, an offer, a revocation, a rejection, and a counteroffer are effective when they are received. An acceptance is generally effective upon dispatch. This is true unless the offer specifically provides otherwise, the offeree uses an unauthorized means of communica- tion, or the acceptance follows a prior rejection.

Stipulated Provisions in the Offer If the offer specifically stipulates the means of communication to be used by the offeree, the acceptance must conform to that specification. Thus, if an offer states that accep- tance must be made by registered mail, any purported acceptance not made by registered mail would be in- effective. Moreover, the rule that an acceptance is effec- tive when dispatched or sent does not apply in cases in which the offer provides that the acceptance must be received by the offeror. If the offeror states that a reply must be received by a certain date or that he must hear from the offeree or uses other language indicating that the acceptance must be received by him, the effective moment of the acceptance is when the offeror receives it, not when the offeree sends or dispatches it.

FIGURE 10-1 Duration of Revocable Offers

Offer Effective Communicated Intent Definite and certain

OFFER OPEN

Offer Terminated Lapse of time

Revocation Rejection

Counteroffer Death

Incompetency Destruction of subject

Subsequent illegality

No Offer No Offer

214 Contracts Part III

PRACTICAL ADVICE Consider whether you should specify in your offers that acceptances are valid only upon receipt.

Authorized Means Historically, an authorized means of communication was either the means the offeror expressly authorized in the offer or, if none was authorized, the means the offeror used in presenting the offer. If in reply to an offer by mail, the offeree places in the mail a letter of acceptance properly stamped and addressed to the offeror, a contract is formed at the time and place that the offeree mails the letter. This assumes, of course, that the offer was open

at that time and had not been terminated by any of the methods previously discussed. The reason for this rule is that the offeror, by using the mail, impliedly author- ized the offeree to use the same means of communica- tion. It is immaterial if the letter of acceptance goes astray in the mail and is never received.

The Restatement and the Code both now provide that where the language in the offer or the circumstances do not otherwise indicate, an offer to make a contract shall be construed as authorizing acceptance in any reasona- ble manner. Thus, an authorized means is usually any reasonable means of communication. These provisions are intended to allow flexibility of response and the ability to keep pace with new modes of communication.

See Figure 10-2 for an overview of offer and acceptance.

FIGURE 10-2 Mutual Assent

Contract formed

Is acceptance effective?

No contract No

Has a definite and certain offer been communicated?

Has the offer been revoked by the offeror?

Has the offeror received a rejection or counteroffer?

Has lapse of time, death, incompetency,

destruction of subject matter, or subsequent

Illegality occurred?

No offer

Offer terminated

No

No

No

No

Yes

Yes

Yes

Yes

Yes

Chapter 10 Mutual Assent 215

O S P R E Y L . L . C . V . K E L L Y - M O O R E P A I N T C O . , I N C . S u p r e m e C o u r t o f O k l a h o m a , 1 9 9 9

1 9 9 9 O K 5 0 , 9 8 4 P . 2 d 1 9 4

FACTS In 1977, the defendant, Kelly-Moore Paint Company, entered into a fifteen-year commercial lease with the plaintiff, Osprey, for a property in Edmond, Oklahoma. The lease contained two five-year renewal options. The lease required that the lessee give notice of its intent to renew at least six months prior to its ex- piration. It also provided that the renewal “may be delivered either personally or by depositing the same in United States mail, first class postage prepaid, registered or certified mail, return receipt requested.” Upon ex- piration of the original fifteen-year lease, Kelly-Moore timely informed the lessor by certified letter of its intent to extend the lease an additional five years. The first five-year extension was due to expire on August 31, 1997. On the last day of the six-month notification deadline, Kelly-Moore faxed a letter of renewal notice to Osprey’s office at 5:28 p.m. In addition, Kelly-Moore sent a copy of the faxed renewal notice letter by Federal Express that same day. Osprey denies ever receiving the fax, but it admits receiving the Federal Express copy of the notice on the following business day. Osprey rejected the notice, asserting that it was late, and it filed an action to remove the defendant from the premises. After a trial on the merits, the trial court granted judg- ment in favor of Kelly-Moore, finding that the faxed notice was effective. Osprey appealed. The Court of Civil Appeals reversed, determining that the plain lan- guage of the lease required that it be renewed by deliver- ing notice either personally or by mail and that Kelly- Moore had done neither. Kelly-Moore appealed.

DECISION The decision of the Court of Ap- peals is vacated, and the decision of the trial court is affirmed.

OPINION Kauger, J. The precise issue of whether a faxed or facsimile delivery of a written notice to renew a commercial lease is sufficient to exercise timely the renewal option of the lease is one of first impression in Oklahoma. Neither party has cited to a case from another jurisdiction which has decided this question, or to any case which has specifically defined “personal delivery” as including facsimile delivery.

*** Osprey argues that (1) the lease specifically pre-

scribed limited means of acceptance of the option, and

it required that the notice of renewal be delivered either personally or sent by United States mail, registered or certified; (2) Kelly-Moore failed to follow the contrac- tual requirements of the lease when it delivered its notice by fax; and (3) because the terms for extending the lease specified in the contract were not met, the notice was invalid and the lease expired on August 31, 1997. Kelly-Moore counters that (1) the lease by the use of the word “shall” mandates that the notice be written, but the use of the word “may” is permissive; and (2) although the notice provision of the lease permits deliv- ery personally or by United States mail, it does not exclude other modes of delivery or transmission which would include delivery by facsimile. ***

A lease is a contract and in construing a lease, the usual rules for the interpretation of contractual writings apply. ***

Language in a contract is given its plain and ordinary meaning, unless some technical term is used in a manner meant to convey a specific technical concept. A contract term is ambiguous only if it can be interpreted as having two different meanings. *** The lease does not appear to be ambiguous.

“Shall” is ordinarily construed as mandatory and “may” is ordinarily construed as permissive. The con- tract clearly requires that notice “shall” be in writing. The provision for delivery, either personally or by certi- fied or registered mail, uses the permissive “may” and it does not bar other modes of transmission which are just as effective.

The purpose of providing notice by personal delivery or registered mail is to insure the delivery of the notice, and to settle any dispute which might arise between the parties concerning whether the notice was received. A substituted method of notice that performs the same function and serves the same purpose as an authorized method of notice is not defective.

Here, the contract provided that time was of the essence. Although Osprey denies that it ever received the fax, the fax activity report and telephone company records confirm that the fax was transmitted success- fully, and that it was sent to Osprey’s correct facsimile number on the last day of the deadline to extend the lease. The fax provided immediate written communica- tion similar to personal delivery and, like a telegram,

216 Contracts Part III

Unauthorized Means When the method of communication used by the offeree is unauthorized, the traditional rule is that acceptance is effective when and if received by the offeror, provided that it is received within the time during which the authorized means would have arrived. The Restatement goes fur- ther by providing that if these conditions are met, then the effective time for the acceptance is the moment of dispatch.

Acceptance Following a Prior Rejection An acceptance sent after a prior rejection is not effective when sent by the offeree, but only when and if re- ceived by the offeror before he receives the rejection. Thus, when an acceptance follows a prior rejection, the first communication the offeror receives is the effective one. For example, Carlos in New York sends by mail to Paula in San Francisco an offer that is expressly stated to be open for ten days. On the fourth day, Paula sends to Carlos by mail a letter of rejection, which is delivered on the morning of the seventh day. At noon on the fifth day, Paula dispatches an over- night letter of acceptance that Carlos receives before the close of business on the sixth day. A contract was formed when Carlos received Paula’s overnight letter of acceptance, as it was received before the letter of rejection.

Defective Acceptances [10-3d] A late or defective acceptance does not create a con- tract. After the offer has expired, it cannot be accepted. However, a late or defective acceptance does manifest a willingness on the part of the offeree to enter into a contract and therefore constitutes a new offer. To cre- ate a contract based on this offer, the original offeror must accept the new offer by manifesting his assent to it.

VARIANT ACCEPTANCES [10-4] A variant acceptance—one that contains terms different from or additional to those in the offer—receives dis- tinctly different treatment under the common law and under the Code.

Common Law [10-4a] An acceptance must be positive and unequivocal. It may not change, add to, subtract from, or qualify in any way the provisions of the offer. In other words, it must be the mirror image of the offer. Any communi- cation by the offeree that attempts to modify the offer is not an acceptance but a counteroffer, which does not create a contract.

Code [10-4b] The common law mirror image rule, by which the ac- ceptance cannot vary or deviate from the terms of the offer, is modified by the Code. This modification is necessitated by the realities of modern business prac- tices. A vast number of business transactions use standardized business forms. For example, a merchant buyer sends to a merchant seller on the buyer’s order form a purchase order for one thousand cotton shirts at $60.00 per dozen with delivery by October 1 at the buyer’s place of business. On the reverse side of this standard form are twenty-five numbered paragraphs containing provisions generally favorable to the buyer. When the seller receives the buyer’s order, he agrees to the buyer’s quantity, price, and delivery terms and sends to the buyer on his acceptance form an unequiv- ocal acceptance of the offer. However, on the back of his acceptance form, the seller has thirty-two num- bered paragraphs generally favorable to himself and in significant conflict with the provisions on the buyer’s form. Under the common law’s mirror image rule, no

would be timely if it were properly transmitted before the expiration of the deadline to renew. Kelly-Moore’s use of the fax served the same function and the same purpose as the two methods suggested by the lease and it was transmitted before the expiration of the deadline to renew. Under these facts, we hold that the faxed or facsimile delivery of the written notice to renew the commercial lease was sufficient to exercise timely the renewal option of the lease.

INTERPRETATION Where the language in the offer or the circumstances does not otherwise indicate, an offer to make a contract shall be con- strued as authorizing acceptance in any reasonable manner.

CRITICAL THINKING QUESTION Are there instances in which an offeror should require a certain mode for acceptance? When?

Chapter 10 Mutual Assent 217

contract would exist; for the seller has not accepted unequivocally all of the material terms of the buyer’s offer.

The Code attempts to alleviate this battle of the forms by focusing on the intent of the parties. If the offeree does not expressly make her acceptance conditional upon the offeror’s assent to the additional or different terms, a contract is formed. The issue then becomes whether the offeree’s different or additional terms be- come part of the contract. If both offeror and offeree are merchants, such additional terms may become part of the contract provided that they do not materially alter the agreement and are not objected to either in the offer itself or within a reasonable period of time. If either of the parties is not a merchant or if the additional terms materially alter the offer, then the additional terms are merely construed as proposals to the contract. Different terms proposed by the offeree will not become part of the contract unless accepted by the offeror. The courts are divided over what terms to include when the terms differ or conflict. Most courts hold that the offeror’s terms govern; other courts hold that the terms cancel

each other out and look to the Code to provide the missing terms. Some states follow a third alternative and apply the additional terms test to different terms. (See Figure 19-1 in Chapter 19.)

Let us apply the Code to the previous example involving the seller and the buyer: because both parties are merchants and the seller’s acceptance was not conditional upon assent to the seller’s additional or different terms, then (1) the contract will be formed without the seller’s different terms unless the buyer spe- cifically accepts them; (2) the contract will be formed without the seller’s additional terms (unless they are specifically accepted by the buyer) because the addi- tional terms materially alter the offer; or (3) depending upon the jurisdiction, (a) the buyer’s conflicting terms will be included in the contract, (b) the Code will pro- vide the missing terms because the conflicting terms cancel each other out, or (c) the additional terms test is applied.

See Concept Review 10-1 explicating the effective time and effect of communications involved in offers and acceptances.

Business Law IN ACTION

Business-to-consumer, or “B2C,” transactions onthe Internet allow buyers to purchase goods for delivery as quickly as overnight—everything from sports equipment and welding tools to bath towels and fresh cut flowers. And increasingly consumers can buy services in cyberspace, too, like vacation packages and movie theater tickets.

The contracting process is easy. In addition to requiring the purchaser to input data like payment details and ship- ping and billing addresses, Web-based providers use radio buttons or check boxes for the customer to make various selections. In some cases the customer must uncheck or deselect items, and in others, the consumer must affirma- tively click on a button or series of buttons labeled “I agree” or “I accept.” These cybercontracts are sometimes called “clickwrap” or “click on” agreements.

By filling in the required blanks, selecting or deselecting various options, and otherwise completing the transaction, the purchaser is indicating his or her assent to be bound by the seller’s offer. Sales of goods can be relatively simple and straightforward. But services available on the Internet,

particularly those that involve an ongoing relationship between the user and the provider, usually require more complex contract provisions.

Offers for video rental club memberships and software licenses, for example, frequently contain restrictions on use and such other terms as warranty disclaimers and arbi- tration clauses as well as privacy policy disclosures, all writ- ten primarily in legalese and taking up multiple screens of text. The reality is that many buyers simply do not read them. Nonetheless, depending on how the agreement process is set up, these terms are likely binding.

Whether a buyer’s nonverbal assent to these lengthy contract provisions will pass legal muster is dependent on the online contracting process. Even if the buyer does not read the proposed terms, they will be enforced if the buyer has had the opportunity to review them, either by way of an automatic screen or a link. And, equally as im- portant, the cyberoffer’s terms will be binding when the site requires the buyer to actively select them or to click on a button or type words affirmatively indicating his or her assent.

218 Contracts Part III

C H A P T E R S U M M A R Y OFFER

Essentials of an Offer

Definition indication of willingness to enter into a contract

Communication offeree must have knowledge of the offer, and the offer must be made by the offeror or her authorized agent to the offeree

Intent determined by an objective standard of what a reasonable offeree would have believed

Definiteness offer’s terms must be clear enough to provide a court with a basis for giving an appropriate remedy

Duration of Offers

Lapse of Time offer remains open for the time period specified or, if no time is stated, for a reasonable period of time

Revocation generally, an offer may be terminated at any time before it is accepted, subject to the following exceptions • Option Contracts contract that binds offeror to keep an offer open for a specified time • Firm Offer a merchant’s irrevocable offer to sell or buy goods in a signed writing that ensures

that the offer will not be terminated for up to three months • Statutory Irrevocability offer made irrevocable by statute • Irrevocable Offer of Unilateral Contracts a unilateral offer may not be revoked for a

reasonable time after performance is begun • Promissory Estoppel noncontractual promise that binds the promisor because she should

reasonably expect that the promise will induce the promisee (offeree) to take action in reliance on it

Rejection refusal to accept an offer terminates the power of acceptance

Counteroffer counterproposal to an offer that generally terminates the original offer

Death or Incompetency of either the offeror or the offeree terminates the offer

CONCEPT REVIEW 10-1 O F F E R A N D A C C E P T A N C E

Time Effective Effect

Communications by Offeror • Offer Received by offeree Creates power to form a contract • Revocation Received by offeree Terminates power

Communications by Offeree • Rejection Received by offeror Terminates offer • Counteroffer Received by offeror Terminates offer • Acceptance Sent by offeree Forms a contract • Acceptance after prior rejection Received by offeror If received before rejection forms a contract

Chapter 10 Mutual Assent 219

Destruction of Subject Matter of an offer terminates the offer

Subsequent Illegality of the purpose or subject matter of the offer terminates the offer

ACCEPTANCE OF OFFER

Requirements

Definition positive and unequivocal expression of a willingness to enter into a contract on the terms of the offer

Mirror Image Rule except as modified by the Code, an acceptance cannot deviate from the terms of the offer

Communication of Acceptance

General Rule acceptance effective upon dispatch unless the offer specifically provides otherwise or the offeree uses an unauthorized means of communication

Silence as Acceptance generally does not indicate acceptance of the offer

Effective Moment generally upon dispatch • Stipulated Provisions in the Offer the communication of acceptance must conform to the

specifications in the offer • Authorized Means the Restatement and the Code provide that, unless the offer provides

otherwise, acceptance is authorized to be in any reasonable manner • Unauthorized Means acceptance effective when received, provided that it is received within the

time within which the authorized means would have arrived • Acceptance Following a Prior Rejection first communication received by the offeror is effective

Defective Acceptance does not create a contract but serves as a new offer

Variant Acceptance

Common Law

Code

Q U E S T I O N S

1. Ames, seeking business for his lawn maintenance firm, posted the following notice in the meeting room of the Ant- lers, a local lodge: “To the members of the Antlers—Special this month. I will resod your lawn for $4.00 per square foot using Fairway brand sod. This offer expires July 15.”

The notice also included Ames’s name, address, and signature and specified that the acceptance was to be in writing.

Bates, a member of the Antlers, and Cramer, the jani- tor, read the notice and were interested. Bates wrote a letter to Ames saying he would accept the offer if Ames would use Putting Green brand sod. Ames received this letter July 14 and wrote to Bates saying he would not use Putting Green sod. Bates received Ames’s letter on July 16 and promptly wrote Ames that he would accept Fair- way sod. Cramer wrote to Ames on July 10 saying he accepted Ames’s offer.

By July 15, Ames had found more profitable ventures and refused to resod either lawn at the specified price. Bates and Cramer brought an appropriate action against Ames for breach of contract. Decisions as to the respec- tive claims of Bates and Cramer?

2. Justin owned four speedboats named Porpoise, Priscilla, Providence, and Prudence. On April 2, Justin made writ- ten offers to sell the four boats in the order named for $14,200 each to Charles, Diane, Edward, and Fran, respectively, allowing ten days for acceptance. In which, if any, of the following four situations was a contract formed?

a. Five days later, Charles received notice from Justin that he had contracted to sell Porpoise to Mark. The next day, April 8, Charles notified Justin that he accepted Justin’s offer.

220 Contracts Part III

b. On the third day, April 5, Diane mailed a rejection to Justin that reached Justin on the morning of the sixth day. At 10:00 a.m. on the fourth day, Diane sent an acceptance by overnight letter to Justin, who received it at noon the fifth day.

c. Edward, on April 3, replied that he was interested in buying Providence but declared the price appeared slightly excessive and wondered if, perhaps, Justin would be willing to sell the boat for $13,900. Five days later, having received no reply from Justin, Edward accepted Justin’s offer by letter, and enclosed a certified check for $14,200.

d. Fran was accidentally killed in an automobile accident on April 9. The following day, the executor of her estate mailed an acceptance of Justin’s offer to Justin.

3. Alpha Rolling Mill Corporation (Alpha Corporation), by letter dated June 8, offered to sell Brooklyn Railroad Company (Brooklyn Company) two thousand to five thousand tons of fifty-pound iron rails on certain specified terms and added that, if the offer was accepted, Alpha Corporation would expect to be notified prior to June 20. Brooklyn Company, on June 16, by fax, referring to Alpha Corporation’s offer of June 8, directed Alpha Cor- poration to enter an order for one thousand two hundred tons of fifty-pound iron rails on the terms specified. The same day, June 16, Brooklyn Company, by letter to Alpha Corporation, confirmed the fax. On June 18, Alpha Cor- poration, by telephone, declined to fulfill the order. Brook- lyn Company, on June 19, wrote Alpha Corporation: “Please enter an order for two thousand tons of rails as per your letter of the eighth. Please forward written con- tract. Reply.” In reply to Brooklyn Company’s repeated inquiries concerning whether the order for two thousand tons of rails had been entered, Alpha denied the existence of any contract between Brooklyn Company and itself. Thereafter, Brooklyn Company sued Alpha Corporation for breach of contract. Decision?

4. On April 8, Crystal received a telephone call from Akers, a truck dealer, who told Crystal that a new model truck in which Crystal was interested would arrive in one week. Although Akers initially wanted $10,500, the conversation ended after Akers agreed to sell and Crystal agreed to pur- chase the truck for $10,000, with a $1,000 down payment and the balance on delivery. The next day, Crystal sent Akers a check for $1,000, which Akers promptly cashed.

One week later, when Crystal called Akers and inquired about the truck, Akers informed Crystal he had several pros- pects looking at the truck and would not sell for less than $10,500. The following day Akers sent Crystal a properly executed check for $1,000 with the following notation thereon: “Return of down payment on sale of truck.”

After notifying Akers that she will not cash the check, Crystal sues Akers for damages. Should Crystal prevail? Explain.

5. On November 15, Gloria, Inc., a manufacturer of crystal- ware, mailed to Benny Buyer a letter stating that Gloria would sell to Buyer one hundred crystal “A” goblets at $100 per goblet and that “the offer would remain open for fifteen (15) days.” On November 18, Gloria, noticing the sudden rise in the price of crystal “A” goblets, decided to withdraw her offer to Buyer and so notified Buyer. Buyer chose to ignore Gloria’s letter of revocation and gleefully watched as the price of crystal “A” goblets con- tinued to skyrocket. On November 30, Buyer mailed to Gloria a letter accepting Gloria’s offer to sell the goblets. The letter was received by Gloria on December 4. Buyer demands delivery of the goblets. What is the result?

6. On May 1, Melforth Realty Company offered to sell Greenacre to Dallas, Inc., for $1 million. The offer was made by a letter sent by overnight delivery and stated that the offer would expire on May 15. Dallas decided to purchase the property and sent a letter by registered first- class mail to Melforth on May 10 accepting the offer. As a result of unexplained delays in the postal service, the letter was not received by Melforth until May 22. Mel- forth wishes to sell Greenacre to another buyer who is offering $1.2 million for the tract of land. Has a contract resulted between Melforth and Dallas?

7. Rowe advertised in newspapers of wide circulation and otherwise made known that she would pay $5,000 for a complete set, consisting of ten volumes, of certain rare books. Ford, not knowing of the offer, gave Rowe all but one volume of the set of rare books as a Christmas pres- ent. Ford later learned of the offer, obtained the one remaining book, tendered it to Rowe, and demanded the $5,000. Rowe refused to pay. Is Ford entitled to the $5,000?

8. Scott, manufacturer of a carbonated beverage, entered into a contract with Otis, owner of a baseball park, whereby Otis rented to Scott a large signboard on top of the center field wall. The contract provided that Otis should letter the sign as Scott desired and would change the lettering from time to time within forty-eight hours after receipt of written request from Scott. As directed by Scott, the signboard originally stated in large letters that Scott would pay $100 to any ball player hitting a home run over the sign.

In the first game of the season, Hume, the best hitter in the league, hit one home run over the sign. Scott im- mediately served written notice on Otis instructing Otis to replace the offer on the signboard with an offer to pay $50.00 to every pitcher who pitched a no-hit game in the park. A week after receipt of Scott’s letter, Otis had not changed the wording on the sign; and on that day, Perry, a pitcher for a scheduled game, pitched a no-hit game and Todd, one of his teammates, hit a home run over Scott’s sign.

Scott refuses to pay any of the three players. What are the rights of Scott, Hume, Perry, and Todd?

Chapter 10 Mutual Assent 221

9. Barney accepted Clark’s offer to sell to him a portion of Clark’s coin collection. Clark forgot at the time of the offer and acceptance that her prized $20.00 gold piece was included in the portion that she offered to sell to Barney. Clark did not intend to include the gold piece in the sale. Barney, at the time of inspecting the offered por- tion of the collection, and prior to accepting the offer, saw the gold piece. Is Barney entitled to the $20.00 gold piece?

10. Small, admiring Jasper’s watch, asked Jasper where and at what price he had purchased it. Jasper replied, “I bought it at West Watch Shop about two years ago for around $85.00, but I am not certain as to that.” Small then said, “Those fellows at West are good people and always sell good watches. I’ll buy that watch from you.” Jasper replied, “It’s a deal.” The next morning, Small telephoned Jasper and said he had changed his mind and did not wish to buy the watch.

Jasper sued Small for breach of contract. In defense, Small has pleaded that he made no enforceable con- tract with Jasper because (a) the parties did not agree on the price to be paid for the watch and (b) the parties did not agree on the place and time of delivery of the watch to Small. Are either or both of these defenses good?

11. Jeff says to Brenda, “I offer to sell you my PC for $900.” Brenda replies, “If you do not hear otherwise from me by Thursday, I have accepted your offer.” Jeff agrees and does not hear from Brenda by Thursday. Does a contract exist between Jeff and Brenda? Explain.

12. On November 19, Hoover Motor Express Company sent to Clements Paper Company a written offer to purchase certain real estate. Sometime in December, Clements authorized Williams to accept the offer. Williams, how- ever, attempted to bargain with Hoover to obtain a better deal, specifically that Clements would retain easements on the property. In a telephone conversation on January 13 of the following year, Williams first told Hoover of his plan to obtain the easements. Hoover replied, “Well, I don’t know if we are ready. We have not decided; we might not want to go through with it.” On January 20, Clements sent a written acceptance of Hoover’s offer. Hoover refused to buy, claiming it had revoked its offer through the January 13 phone conversation. Clements then brought suit to compel the sale or obtain damages. Did Hoover successfully revoke its offer?

13. Walker leased a small lot to Keith for ten years at $100 a month, with a right for Keith to extend the lease for another ten-year term under the same terms except as to rent. The renewal option provided:

Rental will be fixed in such amount as shall actually be agreed upon by the lessors and the lessee with the monthly rental fixed on the comparative basis of rental values as of the date of the renewal with rental values at this time reflected by the compara- tive business conditions of the two periods.

Keith sought to exercise the renewal right and, when the parties were unable to agree on the rent, brought suit against Walker. Who prevails? Why?

C A S E P R O B L E M S

14. The Brewers contracted to purchase Dower House from McAfee. Then, several weeks before the May 7 settlement date for the purchase of the house, the two parties began to negotiate for the sale of certain items of furniture in the house. On April 30, McAfee sent the Brewers a letter containing a list of the furnishings to be purchased at specific prices; a payment schedule including a $3,000 payment due on acceptance; and a clause reading: “If the above is satisfactory, please sign and return one copy with the first payment.”

On June 3, the Brewers sent a letter to McAfee stating that enclosed was a $3,000 check, that the original con- tract had been misplaced and could another be furnished, that they planned to move into Dower House on June 12, and that they wished that the red desk also be included in the contract. McAfee then sent a letter dated June 8 to the Brewers listing the items of furniture they had purchased.

The Brewers moved into Dower House in the middle of June. Soon after they moved in, they tried to contact McA- fee at his office to tell him that there had been a misunder-

standing relating to their purchase of the listed items. They then refused to pay him any more money, and he brought this action to recover the outstanding balance unless the red desk was also included in the sale. Will McAfee be able to collect the additional money from the Brewers?

15. The Thoelkes were owners of real property located in Florida, which the Morrisons agreed to purchase. The Morrisons signed a contract for the sale of that property and mailed it to the Thoelkes in Texas on November 26. Subsequently, the Thoelkes executed the contract and placed it in the mail addressed to the Morrisons’ attorney in Florida. After the executed contract was mailed but before it was received in Florida, the Thoelkes called the Morrisons’ attorney in Florida and attempted to repudi- ate the contract. Does a contract exist between the Thoelkes and the Morrisons? Discuss.

16. Lucy and Zehmer met while having drinks in a restau- rant. During the course of their conversation, Lucy appa- rently offered to buy Zehmer’s 471.6-acre farm for $50,000 cash. Although Zehmer claims that he thought

222 Contracts Part III

the offer was made in jest, he wrote the following on the back of a pad: “We hereby agree to sell to W. O. Lucy the Ferguson Farm complete for $50,000, title satisfac- tory to buyer.” Zehmer then signed the writing and induced his wife Ida to do the same. She claims, however, that she signed only after Zehmer assured her that it was only a joke. Finally, Zehmer claims that he was “high as a Georgia pine” at the time but admits that he was not too drunk to make a valid contract. Explain whether the contract is enforceable.

17. On July 31, Lee Calan Imports advertised a used Volvo station wagon for sale in the Chicago Sun-Times. As part of the information for the advertisement, Lee Calan Imports instructed the newspaper to print the price of the car as $1,795. However, due to a mistake made by the newspaper, without any fault on the part of Lee Calan Imports, the printed ad listed the price of the car as $1,095. After reading the ad and then examining the car, O’Brien told a Lee Calan Imports salesman that he wanted to purchase the car for the advertised price of $1,095. Calan Imports refuses to sell the car to O’Brien for $1,095. Is there a contract? If so, for what price?

18. On May 20, cattle rancher Oliver visited his neighbor Southworth, telling him, “I know you’re interested in buying the land I’m selling.” Southworth replied, “Yes, I do want to buy that land, especially because it adjoins my property.” Although the two men did not discuss the price, Oliver told Southworth he would determine the value of the property and send that information to South- worth so that he would have “notice” of what Oliver “wanted for the land.” On June 13, Southworth called Oliver to ask if he still planned to sell the land. Oliver answered, “Yes, and I should have the value of the land determined soon.” On June 17, Oliver sent a letter to Southworth listing a price quotation of $324,000. South- worth then responded to Oliver by letter on June 21, stating that he accepted Oliver’s offer. However, on June 24 Oliver wrote back to Southworth saying, “There has never been a firm offer to sell, and there is no enforceable contract between us.” Oliver maintains that a price quo- tation alone is not an offer. Southworth claims a valid contract has been made. Who wins? Discuss.

19. On August 12, Mr. and Mrs. Mitchell, the owners of a small secondhand store, attended Alexander’s Auction,

where they bought a used safe for $50.00. The safe, part of the Sumstad estate, contained a locked inside compartment. Both the auctioneer and the Mitchells knew this fact. Soon after the auction, the Mitchells had the compartment opened by a locksmith, who dis- covered $32,207 inside. The Everett Police Department impounded the money. The city of Everett brought an action against the Sumstad estate and the Mitchells to determine the owner of the money. Who should receive the money? Why?

20. Irwin Schiff is a self-styled “tax rebel” who has made a career, and substantial profit, out of his tax protest activ- ities. On February 7, Schiff appeared live on CBS News Nightwatch, a late-night program with a viewer partici- pation format. During the broadcast Schiff repeated his assertion that nothing in the Internal Revenue Code stated that an individual was legally required to pay fed- eral income tax. Schiff then challenged, “If anybody calls this show—I have the Code—and cites any section of this Code that says an individual is required to file a tax return, I will pay them $100,000.” Call-in telephone numbers were periodically flashed on the screen. John Newman, an attorney, did not see Schiff’s live appear- ance on Nightwatch. Newman did, however, see a two- minute videotaped segment, including Schiff’s challenge, which was rebroadcast several hours later on the CBS Morning News. Newman researched the matter that same day and on the following day, February 9, placed a call using directory assistance to CBS Morning News stating that the call was performance of the consideration requested by Mr. Schiff in exchange for his promise to pay $100,000. When Schiff refused to pay, Newman sued. Should Newman prevail? Explain.

21. The Cornillies listed with a real estate agent a home for sale. Patrick and Anne Giannetti offered $155,000 for the home and submitted a deposit in the amount of $2,500. The Cornillies countered this offer with an offer to sell the house for $160,000. The Giannettis then inquired whether certain equipment and items of furni- ture could be included with the sale of the house. The Cornillies refused to include the questioned items in the sale. The Giannettis then accepted the $160,000 offer but changed the mortgage amount from $124,000 to $128,000. Is there a binding contract? Explain.

T A K I N G S I D E S

Cushing filed an application with the office of the Adjutant General of the State of New Hampshire for the use of the Portsmouth Armory to hold a dance on the evening of April 29. The application, made on behalf of the Portsmouth Area Clamshell Alliance, was received by the Adjutant General’s

office on or about March 30. On March 31 the Adjutant General mailed a signed contract after agreeing to rent the ar- mory for the evening requested. The agreement required ac- ceptance by the renter affixing his signature to the agreement and then returning the copy to the Adjutant General within

Chapter 10 Mutual Assent 223

five days after receipt. Cushing received the contract offer, signed it on behalf of the Alliance, and placed it in the outbox for mailing on April 3. At 6:30 on the evening of April 4, Cushing received a telephone call from the Adjutant General revoking the rental offer. Cushing stated during the conversa- tion that he had already signed and mailed the contract. The Adjutant General sent a written confirmation of the with- drawal on April 5. On April 6 the Adjutant General’s office

received by mail from Cushing the signed contract dated April 3 and postmarked April 5.

a. What are the arguments that a binding contract exists?

b. What are the arguments that a contract does not exist or should not exist?

c. What is the proper outcome? Explain.

224 Contracts Part III

C H A P T E R 1 1

CONDUCT INVALIDATING ASSENT

Fraud—A generic term embracing all multifarious means which human ingenuity can devise, and which are resorted to by one individual to get advantage over another by false suggestion or by suppression of the truth.

JOHNSON V. MCDONALD, 170 OKL. 117, 39 P.2D 150

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Identify the types of duress and describe the legal effect of each.

2. Define undue influence and identify some of the situations giving rise to a confidential relationship.

3. Identify the types of fraud and the elements that must be shown to establish the existence of each.

4. Define the two types of nonfraudulent misrepresentation.

5. Identify and explain the situations involving voidable mistakes.

I n addition to requiring offer and acceptance, the law requires that the agreement be voluntary and know- ing. If these requirements are not met, then the agree-

ment is either voidable or void. This chapter deals with situations in which the consent manifested by one of the parties to the contract is not effective because it was not knowingly and voluntarily given. We consider five such situations in this chapter: duress, undue influence, fraud, nonfraudulent misrepresentation, and mistake.

DURESS [11-1] A person should not be held to an agreement he has not entered voluntarily. Accordingly, the law will not enforce any contract induced by duress, which in

general is any wrongful or unlawful act or threat that overcomes the free will of a party.

Physical Compulsion [11-1a] Duress is of two basic types. The first type, physical duress, occurs when one party compels another to mani- fest assent to a contract through actual physical force, such as pointing a gun at a person or taking a person’s hand and compelling him to sign a written contract. This type of duress, while extremely rare, renders the agree- ment void, and the party exerting the duress is liable in restitution as necessary to avoid unjust enrichment.

Improper Threats [11-1b] The second and more common type of duress involves the use of improper threats or acts, including economic

225

and social coercion, to compel a person to enter into a contract. Though the threat may be explicit or may be inferred from words or conduct, in either case it must leave the victim with no reasonable alternative. This type of duress makes the contract voidable at the option of the coerced party, and the party exerting the duress is liable in restitution as necessary to avoid unjust enrich- ment (see Chapter 18). For example, if Ellen, a landlord, induces Vijay, an infirm, bedridden tenant, to enter into a new lease on the same apartment at a greatly increased rent by wrongfully threatening to terminate Vijay’s lease and evict him, Vijay can escape or avoid the new lease by reason of the duress exerted on him.

The fact that the act or threat would not affect a person of average strength and intelligence is not im- portant if it places fear in the person actually affected and induces her to act against her will. The test is sub- jective, and the question is this: did the threat actually induce assent on the part of the person claiming to be the victim of duress?

Ordinarily, the acts or threats constituting duress are themselves crimes or torts. But this is not true in all

cases. The acts need not be criminal or tortious to be wrongful; they merely need to be contrary to public policy or morally reprehensible. For example, if the threat involves a breach of a contractual duty of good faith and fair dealing, it is improper.

Moreover, it generally has been held that contracts induced by threats of criminal prosecution are voidable, regardless of whether the coerced party had committed an unlawful act. Similarly, threatening the criminal prosecution of a close relative is also duress. To be dis- tinguished from such threats of prosecution are threats that resort to ordinary civil remedies to recover a debt due from another. It is not wrongful to threaten a civil suit against an individual to recover a debt. What is prohibited is threatening to bring a civil suit when bringing such a suit would be abuse of process.

PRACTICAL ADVICE If you entered into a contract due to improper threats, consider whether you wish to void the contract. If you decide to do so, act promptly.

B E R A R D I V . M E A D O W B R O O K M A L L C O M P A N Y S u p r e m e C o u r t o f A p p e a l s o f W e s t V i r g i n i a , 2 0 0 2

2 1 2 W . V a . 3 7 7 , 5 7 2 S . E . 2 d 9 0 0

FACTS Between 1985 and 1987, Jerry A. Berardi, Betty J. Berardi, and Bentley Corporation (the Berardis) leased space for three restaurants from Meadowbrook Mall Company. In 1990, the Berardis were delinquent in their rent. Meadowbrook informed Mr. Berardi that a lawsuit would be filed in Ohio requesting judgment for the total amount owed. Mr. Berardi then entered into a consent judgment with Meadowbrook granting judgment for the full amount owed. Meadowbrook in return promised that no steps to enforce the judgment would be undertaken provided the Berardis continued to operate their three restaurants.

In April 1996, Meadowbrook filed in the Circuit Court of Harrison County, West Virginia, the judgment of the Ohio lawsuits and obtained a lien on a building that was owned by the Berardis, the Goff Building. By so doing, Meadowbrook impeded the then-pending refi- nancing of the building by the Berardis.

In June 1997, the Berardis and Meadowbrook signed a “Settlement Agreement and Release” settling the 1990 Ohio judgments. In this document, the Berardis acknowl- edged the validity of the 1990 Ohio judgments and that the aggregate due under them was $814,375.97. The Berardis agreed to pay Meadowbrook $150,000 on the

date the Goff Building refinancing occurred and to pay Meadowbrook $100,000 plus 8.5 percent interest per year on the third anniversary of the initial $150,000 pay- ment. These payments would discharge the Berardis from all other amounts owed. The payment of the initial $150,000 would also result in Meadowbrook releasing the lien against the Goff Building.

The agreement additionally recited:

Berardis hereby release and forever discharge Mead- owbrook, its employees, agents, successors, and assigns from any and all claims, demands, damages, actions, and causes of action of any kind or nature that have arisen or may arise as a result of the leases.

Nevertheless, on October 2, 2000, the Berardis filed a complaint against Meadowbrook alleging that Mead- owbrook breached the October 1990 agreement by attempting to enforce the 1990 Ohio judgments and that Meadowbrook extorted by duress and coercion the 1997 agreement. Meadowbrook filed a motion to dis- miss under the 1997 settlement. Meadowbrook sought summary judgment, which the circuit court granted. Berardi now appeals.

226 Contracts Part III

DECISION Summary judgment affirmed.

OPINION Per Curiam. “We begin our discussion of this issue by reiterating, at the outset, that settlements are highly regarded and scrupulously enforced, so long as they are legally sound.” [Citation.] “The law favors and encourages the resolution of controversies by con- tracts of compromise and settlement rather than by liti- gation; and it is the policy of the law to uphold and enforce such contracts if they are fairly made and are not in contravention of some law or public policy.” [Citations.] Those who seek to avoid a settlement “face a heavy burden” [citation] and “since … settlement agreements, when properly executed, are legal and bind- ing, this Court will not set aside such agreements on allegations of duress … absent clear and convincing proof of such claims.” [Citation.]

The Berardis contend the 1997 settlement is invalid as it was procured by “economic duress:”

The concept of “economic or business duress” may be generally stated as follows: Where the plaintiff is forced into a transaction as a result of unlawful threats or wrongful, oppressive, or unconscionable conduct on the part of the defendant which leaves the plaintiff no reasonable alternative but to acquiesce, the plaintiff may void the transaction and recover any economic loss.

In [citation], we emphasized that there appears to be general acknowledgment that duress is not shown because one party to the contract has driven a hard bar- gain or that market or other conditions now make the contract more difficult to perform by one of the parties or that financial circumstances may have caused one party to make concessions.

“Duress is not readily accepted as an excuse” to avoid a contract. [Citation.] Thus, to establish economic duress, “in addition to their own statements, the plain- tiffs must produce objective evidence of their duress. The defense of economic duress does not turn only upon the subjective state of mind of the plaintiffs, but it must be reasonable in light of the objective facts presented.” [Citation.]

Mr. Berardi is a sophisticated businessman who has operated a number of commercial enterprises. As of 1997, the Berardis had substantial assets and a consider- able net worth. While economic duress may reach large business entities as well as the “proverbial little old lady in tennis shoes,” [citation], when the parties are sophisticated business entities, releases should be voided only in “extreme and extraordinary cases.” [Citation.] Indeed, “where an experienced businessman takes suffi- cient time, seeks the advice of counsel and understands the content of what he is signing he cannot claim the execution of the release was a product of duress.”

[Citation.] While the presence of counsel will not per se defeat a claim of economic duress, “a court must deter- mine if the attorneys had an opportunity for meaningful input under the circumstances.” [Citation.]

*** No case can be found, we apprehend, where a party who, without force or intimidation and with full knowledge of all the facts of the case, accepts on account of an unlitigated and controverted demand a sum less than what he claims and believes to be due him, and agrees to accept that sum in full satisfac- tion, has been permitted to avoid his act on the ground that this is duress. [Citations.]

*** Finally, we do not believe that any relative economic

inequality between the Berardis and Meadowbrook suf- ficiently factor into the summary judgment calculation. We have recognized that, “‘in most commercial transac- tions it may be assumed that there is some inequality of bargaining power. …”’ [Citation.] Indeed, even when one sophisticated business entity enjoys “a decided eco- nomic advantage” over another such entity, economic duress is extremely circumscribed:

Because an element of economic duress is … present when many contracts are formed or releases given, the ability of a party to disown his obligations under a contract or release on that basis is reserved for extreme and extraordinary cases. Otherwise, the stronger party to a contract or release would rou- tinely be at risk of having its rights under the con- tract or release challenged long after the instrument became effective.

[Citation.] Given the facts, the law’s disfavor of economic

duress, its approbation of settlements, the sophisticated nature of the parties, and the extremely high evidentiary burden the Berardis must overcome, we harbor no sub- stantial doubt nor do we believe the circuit court abused its discretion.

INTERPRETATION Economic duress consists of unlawful threats or wrongful, oppressive, or uncon- scionable conduct by one party that leaves the other party no reasonable alternative but to acquiesce to the terms of a contract.

ETHICAL QUESTION Did Meadowbrook act in a proper manner? Explain.

CRITICAL THINKING QUESTION Did Berardi really have a reasonable alternative to signing the release? Explain.

Chapter 11 Conduct Invalidating Assent 227

UNDUE INFLUENCE [11-2] Undue influence is the unfair persuasion of a person by a party in a dominant position based on a confidential relationship. The law very carefully scrutinizes con- tracts between those in a relationship of trust and con- fidence that is likely to permit one party to take unfair advantage of the other. Examples are the relationships of guardian–ward, trustee–beneficiary, agent–principal, spouses, parent–child, attorney–client, physician–patient, and clergy–parishioner.

A transaction induced by undue influence on the part of the dominant party is voidable, and the domi- nant party is liable in restitution as necessary to avoid unjust enrichment (see Chapter 18). The ultimate ques- tion in undue influence cases is whether the transaction was induced by dominating either the mind or emo- tions or both of a submissive party. The weakness or

dependence of the person persuaded is a strong indica- tor of whether the persuasion may have been unfair. For example, Abigail, a person without business experi- ence, has for years relied on Boris, who is experienced in business, for advice on business matters. Boris, with- out making any false representations of fact, induces Abigail to enter into a contract with Boris’s confeder- ate, Cassius. The contract, however, is disadvantageous to Abigail, as both Boris and Cassius know. The trans- action is voidable on the grounds of undue influence.

PRACTICAL ADVICE If you are in a confidential relationship with another person, when you enter into a contract with that person, make sure that (1) you fully disclose all relevant information about that transaction, (2) the contract is fair, and (3) the other party obtains independent advice about the transaction.

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FACTS Harold and Pearl Neugebauer owned a 159- acre farm they called the “Home Place.” The farm included a house, garage, granary, machine sheds, barns, silos, and a dairy barn. During their marriage, Harold handled all of the legal and financial affairs of the farm and family. In 1980, Harold died, leaving Pearl as the sole owner of the Home Place and another farm prop- erty. Following Harold’s death, Lincoln, the youngest of Harold and Pearl’s seven children, began farming both properties. Lincoln also lived with his mother on the Home Place. In 1984, Lincoln and Dennis, one of Pearl’s other sons, formed L & D Farms partnership to manage the farming operation on Pearl’s land. L & D Farms entered into an oral ten-year lease with Pearl that included an option to purchase the Home Place for $117,000, the appraised value in 1984. In 1985, Pearl moved from the farm to a home in town. In 1989, Lin- coln and Dennis dissolved L & D Farms without exercis- ing the option to purchase the Home Place. After dissolution of the partnership, Lincoln farmed Pearl’s land by himself. He paid annual rent, but Lincoln and Pearl never put their oral farm lease in writing. Pearl trusted Lincoln and left it to him to determine how much rent to pay. Pearl did, however, expect that Lincoln would be “fair.” Pearl never took any steps to determine if the $6,320 annual rent Lincoln was paying was fair.

On several occasions from 2004 to 2008, Lincoln pri- vately consulted with an attorney, Keith Goehring, about

purchasing the Home Place. On December 3, 2008, Lincoln took Pearl to Goehring’s office to discuss the purchase. Pearl, who had only an eighth-grade education, was almost eighty-four years old and was hard of hear- ing. Although Lincoln and Goehring discussed details of Lincoln’s proposed purchase, Pearl said virtually nothing. She later testified that she could not keep up with the conversation and did not understand the terms discussed. A few days later, Pearl and Lincoln executed a contract for deed that had been drafted by Goehring. Goehring had been retained and his fees were paid by Lincoln. Nei- ther Lincoln nor Goehring advised Pearl that Goehring represented only Lincoln, and neither suggested that Pearl could or should retain her own legal counsel.

There is no dispute that the fair market value of the Home Place was $697,000 in 2008 when the contract for deed was executed. Under the terms of the contract, Lincoln was to pay Pearl $117,000, the farm’s 1984 appraised value. The contract price was to be paid over thirty years by making annual payments of $6,902.98. After executing the contract, Lincoln told Pearl not to tell the rest of her children about the agreement. Pearl later became suspicious that something may have been wrong with the contract. In January 2009, Pearl revealed the contract to the rest of her children, and they explained the contract to her. She began to cry and wanted the con- tract torn up. Pearl personally and through her children asked Lincoln to tear up the contract. Lincoln refused.

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Pearl then brought an action for rescission of the contract on the ground of undue influence. The trial court found that Lincoln had exerted undue influence and rescinded the contract. Lincoln appealed.

DECISION Judgment of the trial court is affirmed.

OPINION Zinter, J. The elements [of undue influ- ence] are: (1) a person susceptible to undue influence; (2) another’s opportunity to exert undue influence on that person to effect a wrongful purpose; (3) another’s dispo- sition to do so for an improper purpose; and (4) a result clearly showing the effects of undue influence. [Citation.] The party alleging undue influence must prove these ele- ments by a preponderance of the evidence. [Citation.]

Susceptibility to Undue Influence Lincoln argues that no evidence supported the court’s finding that Pearl was susceptible to undue influence. *** Lincoln contends that in the absence of medical evidence of mental defi- cits, the court erred in finding that Pearl was susceptible to undue influence.

Concededly, “‘physical and mental weakness is always material upon the question of undue influence.’ Obviously, an aged and infirm person with impaired mental faculties would be more susceptible to influence than a mentally alert younger person in good health.” [Citations.] But this Court has not required medical evi- dence to prove susceptibility to undue influence. ***

In this case, there was substantial non-medical evidence demonstrating Pearl’s susceptibility to undue influence. Pearl had an eighth-grade education, and she lacked expe- rience in business and legal transactions. When she signed the contract for deed, Pearl was almost eighty-four and hard of hearing. Pearl and Dennis testified that she had relied on her deceased husband to take care of all their business and legal matters during their marriage. This dependency continued after Harold’s death. Pearl testified that, with the exception of her checking account and monthly expenses, she often asked her children for help with business and financial affairs, which she did not understand. *** We also note that Lincoln admitted Pearl had some mental impairment. He told [Pearl’s daughter] Cheryl that Pearl was “slipping,” meaning that Pearl would say something and a few minutes later repeat her- self because she had forgotten what she had said. ***

Opportunity to Exert Undue Influence Lincoln con- tends that the court’s finding of opportunity to exert undue influence was erroneous because Lincoln and Pearl had no confidential relationship and Pearl had the ability to seek independent advice between the two meetings with Goehring, but chose not to do so. ***

In this case, Pearl testified that Lincoln was her son and someone with whom she had previously lived for

many years: someone she trusted to “do right.” Lincoln conceded that on the date Pearl signed the contract, he knew Pearl trusted him and had confidence that he would treat her fairly in his business dealings with her. This type of trust and confidence by a mother in her son was sufficient to prove opportunity.

*** Disposition to Exert Undue Influence The court’s

finding that Lincoln had a disposition to exert undue influence for an improper purpose was also supported. Lincoln had substantial experience in farmland transac- tions and real estate appreciation. He collaborated with an attorney a number of times over four years to purchase the farm and draft the necessary documents. Yet Lincoln did not have the farm appraised as he had previously done when farming the property with his brother. Instead, Lincoln set the price at a value for which it had appraised twenty-four years earlier, a price that was one-sixth of its then current value. He also took no steps to ensure that his elderly mother understood the contract terms, includ- ing the fact that considering her age and the thirty-year amortization, she would likely never receive a substantial portion of the payments. Finally, neither Lincoln nor his attorney advised Pearl to seek legal representation. ***

Lincoln’s conduct after execution of the contract was also relevant to show disposition to exercise undue influ- ence at the time the contract was executed. [Citation.] Af- ter this contract for deed was executed, Lincoln instructed Pearl not to tell her other children about the contract. ***

The court finally observed that Lincoln historically took advantage of Pearl by paying her less than fair market rent under the oral lease. ***

*** Result Showing Effects of Undue Influence Finally, we

see no clear error in the court finding a result clearly show- ing the effects of undue influence. By executing the contract for deed, Pearl sold her property for $580,000 less than its value. Not only was the contract price of $117,000 substan- tially below the market value of $697,000, the thirty-year payment term would have required Pearl to live to 114 years-of-age to receive the payments.

INTERPRETATION A transaction induced by undue influence on the part of the dominant party is voidable by the unduly influenced party.

ETHICAL QUESTION Did Lincoln act in a proper manner? Explain.

CRITICAL THINKING QUESTION Ex- plain who should have the burden of proof in undue influence cases: the party alleging undue influence or the party alleged to have exerted undue influence.

Chapter 11 Conduct Invalidating Assent 229

FRAUD [11-3] Another factor affecting the validity of consent given by a contracting party is fraud, which prevents assent from being knowingly given. There are two distinct types of fraud: fraud in the execution and fraud in the inducement.

Fraud in the Execution [11-3a] Fraud in the execution, which is extremely rare, con- sists of a misrepresentation that deceives the defrauded person as to the very nature of the contract. Such fraud occurs when a person does not know, or does not have reasonable opportunity to know, the character or essence of a proposed contract because the other party misrepresents its character or essential terms. Fraud in the execution renders the transaction void.

For example, Melody delivers a package to Ray, requests that Ray sign a receipt for it, holds out a simple printed form headed “Receipt,” and indicates the line on which Ray is to sign. This line, which appears to Ray to be the bottom line of the receipt, is actually the signature line of a promissory note cleverly concealed underneath the receipt. Ray signs where directed without knowing that he is signing a note. This is fraud in the execution. The note is void and of no legal effect, for, although the signature is genuine and appears to manifest Ray’s assent to the terms of the note, there is no actual assent. The nature of Melody’s fraud precluded consent to the signing of the note because it prevented Ray from rea- sonably knowing what he was signing.

Fraud in the Inducement [11-3b] Fraud in the inducement, generally referred to as fraud or deceit, is an intentional misrepresentation of material fact by one party to the other, who consents to enter into a contract in justifiable reliance on the misrepresentation. Fraud in the inducement renders the contract voidable by the defrauded party and makes the fraudulent party liable in restitution as necessary to avoid unjust enrich- ment. For example, Alice, in offering to sell her dog to Bob, tells Bob that the dog won first prize in its class in the recent national dog show. In truth, the dog had not even been entered in the show. However, Alice’s state- ment induces Bob to accept the offer and pay a high price for the dog. There is a contract, but it is voidable by Bob because Alice’s fraud induced his assent.

The requisites for fraud in the inducement are as follows:

1. a false representation

2. of a fact

3. that is material and

4. made with knowledge of its falsity and the intention to deceive (scienter) and

5. which representation is justifiably relied on.

The remedies that may be available for fraud in the inducement are rescission, restitution, and damages, as discussed in Chapter 18.

False Representation A basic element of fraud is a false representation or a misrepresentation (i.e., misleading conduct or an assertion not in accord with the facts, made through a positive statement). In con- trast, concealment is an action intended or known to be likely to keep another from learning a fact he other- wise would have learned. Active concealment can form the basis for fraud, as, for example, when a seller puts heavy oil or grease in a car engine to conceal a knock. Truth may be suppressed by concealment as much as by misrepresentation. Expressly denying knowledge of a fact that a party knows to exist is a misrepresentation if it leads the other party to believe that the fact does not exist or cannot be discovered. Moreover, a state- ment of misleading half-truth is considered the equiva- lent of a false representation.

Generally, silence or nondisclosure alone does not amount to fraud when the parties deal at arm’s length. An arm’s-length transaction is one in which the parties owe each other no special duties and each is acting in his or her self-interest. In most business or market transac- tions, the parties deal at arm’s length and generally have no obligation to tell the other party everything they know about the subject of the contract. Thus, it is not fraud when a buyer possesses advantageous information about the seller’s property, information of which he knows the seller to be ignorant, and does not disclose such informa- tion to the seller. A buyer is under no duty to inform the seller of the greater value or other advantages of the property for sale. Assume, for example, that Sid owns a farm that, as a farm, is worth $100,000. Brenda, who knows that there is oil under Sid’s farm, also knows that Sid is ignorant of this fact. Without disclosing this infor- mation to Sid, Brenda makes an offer to Sid to buy the farm for $100,000. Sid accepts the offer, and a contract is duly made. Sid, on later learning the facts, can do noth- ing about the matter, either at law or in equity. As one case puts it, “a purchaser is not bound by our laws to make the man he buys from as wise as himself.”

PRACTICAL ADVICE Consider bargaining with the other party to promise to give you full disclosure.

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Although nondisclosure usually does not constitute a misrepresentation, in certain situations it does. One such situation arises when (1) a person fails to disclose a fact known to him, (2) he knows that the disclosure of that fact would correct a mistake of the other party as to a basic assumption on which that party is making the contract, and (3) nondisclo- sure of the fact amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing. Accordingly, if the property at issue in the contract contains a substantial latent (hidden) defect, one that would not be discovered through an ordinary examination, the seller may be obliged to reveal it. Suppose, for example, that Judith owns a valuable horse, which she knows is suffering from a disease discoverable only by a competent veterinary surgeon. Judith offers to sell this horse to Curt but does not inform him about the condition of her horse. Curt makes a reasonable examination of the horse and, finding it in apparently normal condition, purchases it from Judith. Curt, on later discovering the disease in question, can have the sale set aside. Judith’s silence, under the circumstances, was a mis- representation.

PRACTICAL ADVICE When entering into contract negotiations, first determine what duty of disclosure you owe to the other party.

In other situations, the law also imposes a duty of disclosure. For example, one may have a duty of disclo- sure because of prior representations innocently made before entering into the contract, which are later dis- covered to be untrue. Another instance in which silence may constitute fraud is a transaction involving a fiduci- ary. A fiduciary is a person in a confidential relation- ship who owes a duty of trust, loyalty, and confidence to another. For example, an agent owes a fiduciary duty to his principal, as does a trustee to the benefici- ary of the trust and a partner to her copartners. A fidu- ciary may not deal at arm’s length, as a party in most everyday business or market transactions may, but owes a duty to disclose fully all relevant facts when entering into a transaction with the other party to the relationship.

Fact The basic element of fraud is the misrepresenta- tion of a material fact. A fact is an event that actually took place or a thing that actually exists. Suppose that Dale induces Mike to purchase shares in a company unknown to Mike at a price of $100 per share by

representing that she had paid $150 per share for them during the preceding year, when in fact she had paid only $50.00. This representation of a past event is a misrepresentation of fact.

Actionable fraud rarely can be based on what is merely a statement of opinion. A representation is one of opinion if it expresses only the uncertain belief of the representer as to the existence of a fact or his judg- ment as to quality, value, authenticity, or other matters of judgment.

The line between fact and opinion is not an easy one to draw and in close cases presents an issue for the jury. The solution often will turn on the superior knowledge of the person making the statement and the information available to the other party. Thus, if Dale said to Mike that the shares were “a good invest- ment,” she was merely stating her opinion; and nor- mally Mike ought to regard it as no more than that. Other common examples of opinion are statements of value, such as “This is the best car for the money in town” or “This deluxe model will give you twice the wear of a cheaper model.” Such exaggerations and commendations of articles offered for sale are to be expected from dealers, who are merely puffing their wares with “sales talk.” If the representer is a profes- sional advising a client, the courts are more likely to regard an untrue statement of opinion as actionable. Such a statement expresses the opinion of one holding himself out as having expert knowledge, and the tend- ency is to grant relief to those who have sustained loss by reasonable reliance on expert evaluation, as the next case shows.

Also to be distinguished from a representation of fact is a prediction. Predictions are similar to opinions, as no one can know with certainty what will happen in the future, and normally they are not regarded as factual statements. Likewise, promissory statements ordinarily do not constitute a basis of fraud, because a breach of promise does not necessarily indicate that the promise was fraudulently made. However, a promise that the promisor, at the time of making, had no intention of keeping is a misrepresentation of fact.

Historically, courts held that representations of law were not statements of fact but of opinion. The present trend is to recognize that a statement of law may have the effect of either a statement of fact or a statement of opinion. For example, a statement asserting that a par- ticular statute has been enacted or repealed has the effect of a statement of fact. On the other hand, a state- ment as to the legal consequences of a particular set of facts is a statement of opinion.

Chapter 11 Conduct Invalidating Assent 231

Materiality In addition to the requirement that a misrepresentation be one of fact, it must also be mate- rial. A misrepresentation is material if (1) it would be likely to induce a reasonable person to manifest assent

or (2) the maker knows that it would be likely to induce the recipient to do so. Thus, in the sale of a racehorse, it may not be material whether the horse was ridden in its most recent race by a certain jockey,

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FACTS Tony Y. Maroun (Maroun) was employed by Amkor when he accepted an offer to work for Wyre- less, a start-up company. Wyreless promised Maroun, among other items, the following: (1) annual salary of $300,000; (2) $300,000 bonus for successful organiza- tion of Wyreless Systems, Inc.; (3) 15 percent of the issued equity in Wyreless Systems, Inc.; (4) the equity and “organization bonus” tied to agreeable milestones; (5) full medical benefits; and (6) the position of chief ex- ecutive officer, president, and board member. Maroun began working for Wyreless but was terminated a few months later. Maroun then filed suit alleging he had not received 15 percent of issued equity and had not received $429,145, which represented the remainder of the $600,000. Wyreless filed a motion for summary judgment. The district court granted the motion, and Maroun appealed.

DECISION Judgment of the district court affirmed.

OPINION Trout, J. Maroun argues the district court erred in granting summary judgment in favor of Robinson on the fraud claim. Fraud requires: (1) a state- ment or a representation of fact; (2) its falsity; (3) its materiality; (4) the speaker’s knowledge of its falsity; (5) the speaker’s intent that there be reliance; (6) the hearer’s ignorance of the falsity of the statement; (7) reli- ance by the hearer; (8) justifiable reliance; and (9) result- ant injury. [Citation.] In opposition to the defendants’ motion for summary judgment, Maroun filed an affida- vit that stated Robinson made the following representa- tions to Maroun:

(1) That Wyreless was to be a corporation of consid- erable size, with initial net revenues in excess of sev- eral hundred million dollars.

(2) That Robinson would soon acquire one and one-half million dollars in personal assets, which Robinson would make available to personally guar- anty payment of my compensation from Wyreless.

(3) That he would have no difficulty in obtaining the initial investments required to capitalize Wyreless

as a large, world leading corporation with initial net revenues in excess of several hundred million dollars.

(4) That he had obtained firm commitments from several investors and that investment funds would be received in Wyreless’ bank account in the near future.

“An action for fraud or misrepresentation will not lie for statements of future events.” [Citation.] “[T]here is a general rule in [the] law of deceit that a representation consisting of [a] promise or a statement as to a future event will not serve as [a] basis for fraud.…” [Citation.] Statements numbered one and two both address future events. Robinson allegedly stated Wyreless “was to be” and that he “would soon acquire.” “[T]he representation forming the basis of a claim for fraud must concern past or existing material facts.” [Citation.] Neither of these statements constitutes a statement or a representation of past or existing fact. A “promise or statement that an act will be undertaken, however, is actionable, if it is proven that the speaker made the promise without intending to keep it.” [Citation.] There is no indication in the record that Robinson did not intend to fulfill those representa- tions to Maroun at the time he made the statements.

“Opinions or predictions about the anticipated prof- itability of a business are usually not actionable as fraud.” [Citation.] Statement number three appears to be merely Robinson’s opinion. As to statement number four, no evidence was submitted that Robinson had not received commitments at the time he made the statement to Maroun. Accordingly, the district court’s grant of summary judgment against Maroun on the fraud claim is affirmed.

INTERPRETATION Fraud generally must be based on a material fact and not on predictions or a person’s opinion.

ETHICAL QUESTION Did Wyreless act in an ethical manner?

CRITICAL THINKING QUESTION When should an employer be held to its “promises”?

232 Contracts Part III

but its running time for the race probably would be. The Restatement of Contracts and the Restatement of Restitution provide that a contract justifiably induced by a misrepresentation is voidable if the misrepresenta- tion is either fraudulent or material. Therefore, a fraud-

ulent misrepresentation does not have to be material to obtain rescission, but it must be material to recover damages.

The Reed v. King case presents an unusual factual sit- uation involving the duty to disclose a “material” fact.

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FACTS Dorris Reed bought a house from Robert King for $76,000. King and his real estate agent knew that a woman and her four children had been murdered in the house ten years earlier and allegedly knew that the event had materially affected the market value of the house. They said nothing about the murders to Reed, and King asked a neighbor not to inform her of them. After the sale, neighbors told Reed about the murders and informed her that the house was consequently worth only $65,000. Reed brought an action against King and the real estate agent, alleging fraud and seek- ing rescission and damages. The complaint was dis- missed, and Reed appealed.

DECISION Judgment reversed.

OPINION Blease, J. Does Reed’s pleading state a cause of action? Concealed within this question is the nettlesome problem of the duty of disclosure of blem- ishes on real property which are not physical defects or legal impairments to use.

Reed seeks to state a cause of action sounding in contract, i.e., rescission, or in tort, i.e., deceit. In either event her allegations must reveal a fraud. [Citation.] “The elements of actual fraud, whether as the basis of the remedy in contract or tort, may be stated as follows: There must be (1) a false representation or concealment of a material fact (or, in some cases, an opinion) suscep- tible of knowledge, (2) made with knowledge of its fal- sity or without sufficient knowledge on the subject to warrant a representation, (3) with the intent to induce the person to whom it is made to act upon it; and such person must (4) act in reliance upon the representation (5) to his damage.” ***

The trial court perceived the defect in Reed’s com- plaint to be a failure to allege concealment of a material fact. ***

Concealment is a term of art which includes mere nondisclosure when a party has a duty to disclose. [Citation.] Rest.2d Contracts, §161; Rest.2d Torts, §551 *** Accordingly, the critical question is: does the

seller have a duty to disclose here? Resolution of this question depends on the materiality of the fact of the murders.

In general, a seller of real property has a duty to disclose: “where the seller knows of facts materially affecting the value or desirability of the property which are known or accessible only to him and also knows that such facts are not known to, or within the reach of the diligent attention and observation of the buyer, the seller is under a duty to disclose them to the buyer.” [Citation.] Whether information “is of suffi- cient materiality to affect the value or desirability of the property *** depends on the facts of the particular case.” [Citation.] Materiality “is a question of law, and is part of the concept of right to rely or justifiable reli- ance.” [Citation.] *** Three considerations bear on this legal conclusion: the gravity of the harm inflicted by nondisclosure; the fairness of imposing a duty of discovery on the buyer as an alternative to compelling disclosure, and the impact on the stability of contracts if rescission is permitted.

Numerous cases have found nondisclosure of physi- cal defects and legal impediments to use of real property are material. [Citation.] However, to our knowledge, no prior real estate sale case has faced an issue of nondi- sclosure of the kind presented here.

*** The murder of innocents is highly unusual in its

potential for so disturbing buyers they may be unable to reside in a home where it has occurred. This fact may foreseeably deprive a buyer of the intended use of the purchase. Murder is not such a common occurrence that buyers should be charged with anticipating and discov- ering this disquieting possibility. Accordingly, the fact is not one for which a duty of inquiry and discovery can sensibly be imposed upon the buyer.

*** Whether Reed will be able to prove her allegation

that the decade old multiple murder has a significant effect on market value we cannot determine. If she is

Chapter 11 Conduct Invalidating Assent 233

Knowledge of Falsity and Intention to Deceive To establish fraud, the misrepresentation must have been known by the one making it to be false and must be made with an intent to deceive. This ele- ment of fraud is known as scienter. Knowledge of fal- sity can consist of (1) actual knowledge, (2) lack of belief in the statement’s truthfulness, or (3) reckless indifference as to its truthfulness.

Justifiable Reliance A person is not entitled to relief unless she has justifiably relied on the misrepresen- tation. If the complaining party’s decision was in no way influenced by the misrepresentation, she must abide by the terms of the contract. She is not deceived if she does not rely on the misrepresentation. Justifiable reliance requires that the misrepresentation contribute substantially to the misled party’s decision to enter into the contract. If the complaining party knew or it was obvious that the representation of the defendant was untrue, but she still entered into the contract, she has not justifiably relied on that representation. More- over, where the misrepresentation is fraudulent, the

party who relies on it is entitled to relief even though she does not investigate the statement or is contributorily negligent in relying on it. Not knowing or discovering the facts before making a contract does not make a per- son’s reliance unjustified unless her reliance amounts to a failure to act in good faith and in accordance with rea- sonable standards of fair dealing. Thus, most courts will not allow a person who concocts a deliberate and elabo- rate scheme to defraud—one that the defrauded party should readily detect—to argue that the defrauded party did not justifiably rely upon the misrepresentation.

NONFRAUDULENT MISREPRESENTATION [11-4] Nonfraudulent misrepresentation is a material, false statement that induces another to rely justifiably but is made without scienter. Such representation may occur in one of two ways. Negligent misrepresentation is a false representation that is made without knowledge of its fal- sity and without due care in ascertaining its truthfulness;

able to do so by competent evidence she is entitled to a favorable ruling on the issues of materiality and duty to disclose.

INTERPRETATION A representation is material if it is likely to influence or affect a reasonable person.

ETHICAL QUESTION Should King have revealed the information to Reed? Explain.

CRITICAL THINKING QUESTION What is material information, and how should it be determined?

CONCEPT REVIEW 11-1 M I S R E P R E S E N T A T I O N

Fraudulent Negligent Innocent

False Statement of Fact Yes Yes Yes

Materiality Yes for damages No for rescission

Yes Yes

Fault With knowledge and intent (scienter)

Without knowledge and without due care

Without knowledge but with due care

Reliance Yes Yes Yes

Injury Yes for damages No for rescission

Yes for damages No for rescission

Yes for damages No for rescission

Remedies Damages Rescission

Damages Rescission

Damages Rescission

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such representation renders an agreement voidable. Innocent misrepresentation, which also renders a con- tract voidable, is a false representation made without knowledge of its falsity but with due care. To obtain relief for nonfraudulent misrepresentation, all of the other elements of fraud must be present and the misrep- resentation must be material. The remedies that may be available for nonfraudulent misrepresentation are rescis- sion, restitution, and damages (see Chapter 18).

MISTAKE [11-5] A mistake is a belief that is not in accord with the facts. Where the mistaken facts relate to the basis of the par- ties’ agreement, the law permits the adversely affected party to avoid or reform the contract under certain

circumstances. But because permitting avoidance for mistake undermines the objective approach to mutual assent, the law has experienced considerable difficulty in specifying those circumstances that justify permitting the subjective matter of mistake to invalidate an other- wise objectively satisfactory agreement. As a result, establishing clear rules to govern the effect of mistake has proven elusive.

The Restatement and modern cases treat mistakes of law in existence at the time of making the contract no differently than mistakes of fact. For example, Susan contracts to sell a parcel of land to James with the mu- tual understanding that James will build an apartment house on the land. Both Susan and James believe that such a building is lawful. Unknown to them, however, three days before they entered into their contract, the

A P P L Y I N G T H E L A W

CONDUCT INVALIDATING ASSENT

Facts Gillian bought a two-year-old used car from a luxury automobile dealer for $36,000. At the time of her purchase, the odometer and title documentation both indicated that the car had 21,445 miles on it. But after just a little more than a year, the engine failed, and Gillian had to take the car to a mechanic. The problem was the water pump, which needed to be replaced. Surprised that a water pump should fail in a car with so few miles on it, the mechanic more closely examined the odometer and determined that someone had cleverly tampered with it. According to the mechanic, the car probably had about sixty thousand miles on it when Gillian bought it. At the time Gillian bought the car, the retail value for the same vehicle with sixty thousand miles on it was approximately $30,000.

Gillian decided that under these conditions she no longer wanted the car. She contacted the dealership, which strenu- ously denied having tampered with the odometer. In fact, the dealership’s records reflect that it purchased Gillian’s car at auction for $34,000, after a thorough inspection that revealed no mechanical deficiencies or alteration of the car’s odometer.

Issue Is Gillian’s contract voidable by her?

Rule of Law Innocent misrepresentation renders a con- tract voidable. Innocent misrepresentation is proven when the following elements are established: (1) a false represen- tation, (2) of fact, (3) that is material, (4) made without knowledge of its falsity but with due care, and (5) the repre- sentation is justifiably relied upon.

Application Gillian can prove all five elements of innocent misrepresentation. First, the dealership’s false representation

was that the mileage on the car was 21,445, when the car actually had about sixty thousand miles on it. Second, the mileage of the car at the time of sale is an actual event, not an opinion or prediction. Third, as the mileage of a used car is probably the most critical determinant of its value, this misrepresentation was material to the parties’ agreed sale price, inducing the formation of the contract. Indeed, while Gillian might still have purchased this car with sixty thou- sand miles on it, she most certainly would have done so only at a lower price. Fourth, it is highly unlikely that the dealership was aware of the incorrect odometer reading. We know this because it paid $34,000 for the car, which should have sold for something less than $30,000 in the wholesale market if the true mileage had been known. Moreover, the dealership appears to have conducted appro- priate due diligence to support both its own purchase price and the price at which it offered the car to Gillian. The odometer tampering was cleverly concealed, so much so that neither the dealerships’ inspection before purchase nor Gillian’s mechanic’s initial inspection revealed it. Fifth, Gillian’s reliance on the ostensible odometer reading is justi- fied. The car was only two years old when she bought it, and 21,445 miles is within an average range of mileage for a used car of that age. Unless the car’s physical condi- tion or something in the title paperwork should have alerted her to an inconsistency between the stated mileage and the car’s actual mileage, Gillian was entitled to rely on what appeared to be a correct odometer reading.

Conclusion Because all the elements of innocent misrep- resentation can be shown, Gillian’s contract is voidable by Gillian.

Chapter 11 Conduct Invalidating Assent 235

town in which the land was located had enacted an or- dinance precluding such use of the land. In states that regard mistakes of law and fact in the same light, this mistake of law would be treated as a mistake of fact that would lead to the consequences discussed in the following section.

Mutual Mistake [11-5a] Mutual mistake occurs when both parties are mistaken as to the same set of facts. If the mistake relates to a basic assumption on which the contract is made and has a material effect on the agreed exchange, then it is voidable by the adversely affected party unless he bears the risk of the mistake. In addition, the adversely affected party is entitled to restitution as necessary to avoid unjust enrichment.

Usually, market conditions and the financial situation of the parties are not considered basic assumptions. Thus, if Gail contracts to purchase Pete’s automobile under the belief that she can sell it at a profit to Jesse, she is not excused from liability if she is mistaken in this belief. Nor can she rescind the agreement simply because she was mistaken as to her estimate of what the automo- bile was worth. These are the ordinary risks of business, and courts do not undertake to relieve against them. But suppose that the parties contract upon the assumption that the automobile is a 2010 Cadillac with fifteen thou- sand miles of use, when in fact the engine is that of a cheaper model and has been run in excess of fifty

thousand miles. Here, a court likely would allow a rescission because of mutual mistake of a material fact. In a New Zealand case, the plaintiff purchased a “stud bull” at an auction. There were no express warranties as to “sex, condition, or otherwise.” Actually, the bull was sterile. Rescission was allowed, the court observing that it was a “bull in name only.”

Unilateral Mistake [11-5b] Unilateral mistake occurs when only one of the parties is mistaken. Courts have been hesitant to grant relief for unilateral mistake, even though it relates to a basic assumption on which a party entered into the contract and has a material effect on the agreed exchange. Nevertheless, relief will be granted in cases in which (1) the nonmistaken party knows, or reasonably should know, that such a mistake has been made (palpable unilateral mistake) or (2) the mistake was caused by the fault of the nonmistaken party. For example, sup- pose a building contractor makes a serious error in his computations and consequently submits a job bid that is one-half the amount it should be. If the other party knows that the contractor made such an error, or reasonably should have known it, she cannot, as a gen- eral rule, take advantage of the other’s mistake by accepting the offer. In addition, many courts and the Restatement allow rescission in cases in which the effect of unilateral mistake makes enforcement of the contract unconscionable.

B U R N I N G H A M V . W E S T G A T E R E S O R T S , L T D . C o u r t o f A p p e a l s o f U t a h , 2 0 1 3

3 1 7 P . 3 d 4 4 5 , 2 0 1 3 U T . A p p . 2 4 4 ; r e h e a r i n g d e n i e d F e b r u a r y 6 , 2 0 1 4

FACTS In 2006, Jeff Burningham and Westgate Resorts, Ltd. (Westgate) entered into a real estate pur- chase contract (the REPC) in which Burningham agreed to purchase a Park City, Utah condominium unit from Westgate for $899,000. Pursuant to the REPC, Burning- ham made a 10 percent deposit of $89,900, which was to be retained by Westgate as liquidated damages if Burningham defaulted. As the 2007 closing date approached, real estate market conditions worsened, and Burningham refused to close. A dispute arose between the parties as to whether Burningham was entitled to a refund of the deposit, with Burningham alleging that Westgate had made misrepresentations to fraudulently induce him to enter into the REPC. In September 2010, the parties settled their dispute by executing a second contract (the Agreement) for the sale of the condominium

unit, this time for the reduced purchase price of $462,500. The only deposit contemplated by the Agree- ment was the $89,900 that Burningham had previously paid. The Agreement purported to resolve all outstanding issues between the parties arising under the REPC and stated that it was “wholly integrated and shall supersede any and all previous and current understandings and agreements between the Buyer and Seller.” Unlike the REPC, the Agreement contained a provision (Paragraph 38.1) granting Burningham the right to terminate the Agreement in his sole discretion by giving written notice to Westgate within seven days of the Agreement’s effec- tive date upon which timely notice Burningham would be entitled to repayment of his deposit.

Burningham exercised this termination option by giving timely written notice to Westgate. However,

236 Contracts Part III

Assumption of Risk of Mistake [11-5c] A party who has undertaken to bear the risk of a mistake will not be able to avoid the contract, even though the mistake (which may be either mutual or unilateral) would have otherwise permitted the party to do so. This alloca- tion of risk may occur by agreement of the parties. For instance, a ship at sea may be sold “lost or not lost.” In such case the buyer is liable whether the ship was lost or not lost at the time the contract was made. There is no mistake; instead, there is a conscious allocation of risk.

The risk of mistake also may be allocated by con- scious ignorance when the parties recognize that they

have limited knowledge of the facts. For example, the Supreme Court of Wisconsin refused to set aside the sale of a stone for which the purchaser paid $1.00 but that was subsequently discovered to be an uncut dia- mond valued at $700. The parties did not know at the time of sale what the stone was and knew they did not know. Each consciously assumed the risk that the value might be more or less than the selling price.

PRACTICAL ADVICE If you are unsure about the nature of a contract, consider allocating the risk of the uncertainties in your contract.

Westgate refused to return Burningham’s deposit, con- tending that neither party had intended to provide Bur- ningham the unilateral right to cancel the Agreement and recover the full $89,900 originally deposited under the REPC. Burningham sued Westgate for the return of the deposit, and Westgate brought counterclaims argu- ing mutual mistake. The district court granted sum- mary judgment in favor of Burningham for $89,900. Westgate appealed.

DECISION Judgment affirmed.

OPINION BENCH, Senior Judge. The district court concluded that, pursuant to paragraph 38.1 of the Agree- ment, Burningham timely terminated the Agreement and was entitled to a refund of his $89,900 deposit as a mat- ter of law. Notwithstanding the language of paragraph 38.1, Westgate argues that extrinsic evidence—primarily the declaration of its sales agent [that the parties did not intend to include the provision of a full return of the deposit]—creates material questions of fact on its argu- ments of mutual mistake ***

*** A mutual mistake of fact can provide the basis for equitable rescission or reformation of a contract even when the contract appears on its face to be a “complete and binding integrated agreement.” [Cita- tion.] “A mutual mistake occurs when both parties, at the time of contracting, share a misconception about a basic assumption or vital fact upon which they based their bargain.” [Citation.] Westgate argues that its sales agent’s declaration, viewed in light of the parties’ course of conduct leading up to the Agreement, raises a fact question as to whether the inclusion of paragraph 38.1’s refund language in the Agreement was a mutual mistake.

The sales agent’s declaration summarizes, from West- gate’s perspective, the events leading up to the execution

of the Agreement. The declaration clearly provides evidence that Westgate did not intend for the $89,900 to be refundable, stating that “at no time did Westgate intend for the [$89,900] to be considered a refundable deposit under the [Agreement].” It also provides evi- dence of Westgate’s subjective understanding that Bur- ningham shared its intent, stating that the sales agent “understood these to be Burningham’s intentions based on [the agent’s] discussions and interactions with [Bur- ningham] leading up to the [Agreement].”

What the sales agent’s declaration does not do is pro- vide evidence of Burningham’s intent, as opposed to Westgate’s understanding of that intent. The declaration does not provide the substance of any of the sales agent’s “discussions and interactions” with Burningham that would provide evidence of Burningham’s intent. Instead, the declaration relies on Burningham’s silence, stating that “[a]t no time did Burningham indicate … that he intended the [$89,900] to be a refundable de- posit under the [Agreement] or that he interpreted it to be the ‘deposit’ referenced in Paragraph 38.1 of the [Agreement].”

We agree with the district court that the sales agent’s declaration “does not show that Mr. Burningham was also mistaken on [the deposit] issue.” The declara- tion provides evidence only of unilateral mistake by Westgate, not the mutual mistake required to establish grounds for equitable rescission of the Agreement. We therefore conclude that the declaration did not raise a material question of fact on mutual mistake so as to preclude summary judgment.

INTERPRETATION For a mistake to render a contract voidable, it must be a mutual mistake of fact.

CRITICAL THINKING QUESTION Do you agree with the court’s decision? Why?

Chapter 11 Conduct Invalidating Assent 237

Effect of Fault upon Mistake [11-5d] The Restatement provides that a mistaken party’s fault in not knowing or discovering a fact before making a contract does not prevent him from avoiding the con- tract “unless his fault amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing.” This rule does not, however, apply to a failure to read a contract. As a general proposition, a party is held to what she signs. Her signature authenti- cates the writing, and she cannot repudiate that which she has voluntarily approved. Generally, one who assents to a writing is presumed to know its contents and cannot escape being bound by its terms merely by contending that she did not read them; her assent is deemed to cover unknown as well as known terms.

Mistake in Meaning of Terms [11-5e] Somewhat related to mistakes of fact is the situation in which the parties misunderstand their manifestations of mutual assent. A famous case involving this problem is

Raffles v. Wichelhaus, 2 Hurlstone & Coltman 906 (1864), popularly known as the Peerless case. A contract of purchase was made for 125 bales of cotton to arrive on the Peerless from Bombay. It happened, however, that there were two ships by the name of Peerless each sailing from Bombay, one in October and the other in December. The buyer had in mind the ship that sailed in October, whereas the seller reasonably believed the agreement referred to the Peerless sailing in December. Neither party was at fault, but both believed in good faith that a different ship was intended. The English court held that no contract existed.

The Restatement is in accord: there is no manifesta- tion of mutual assent in cases in which the parties attach materially different meanings to their manifesta- tions and neither party knows or has reason to know the meaning attached by the other. If blame can be ascribed to either party, however, that party will be held responsible. Thus, if the seller knew of the sailing from Bombay of two ships by the name of Peerless, then he would be at fault, and the contract would be for the ship sailing in October as the buyer expected. If neither party is to blame or both are to blame, there is no contract at all; that is, the agreement is void.

CONCEPT REVIEW 11-2 C O N D U C T I N V A L I D A T I N G A S S E N T

Conduct Effect

Duress by physical force Void

Duress by improper threat Voidable

Undue influence Voidable

Fraud in the execution Void

Fraud in the inducement Voidable

C H A P T E R S U M M A R Y Duress

Definition wrongful act or threat that overcomes the free will of a party

Physical Compulsion coercion involving physical force renders the agreement void

Improper Threats improper threats or acts, including economic and social coercion, render the contract voidable

238 Contracts Part III

Undue Influence

Definition taking unfair advantage of a person by reason of a dominant position based on a confidential relationship

Effect renders the contract voidable

Fraud

Fraud in the Execution a misrepresentation that deceives the other party as to the nature of a document evidencing the contract; renders the agreement void

Fraud in the Inducement renders the agreement voidable if the following elements are present: • False Representation positive statement or conduct that misleads • Fact an event that occurred or thing that exists • Materiality of substantial importance • Knowledge of Falsity and Intention to Deceive (called scienter) and includes (1) actual

knowledge, (2) lack of belief in statement’s truthfulness, or (3) reckless indifference to its truthfulness

• Justifiable Reliance a defrauded party is reasonably influenced by the misrepresentation

Nonfraudulent Misrepresentation

Negligent Misrepresentation misrepresentation made without knowledge of its falsity and without due care in ascertaining its truthfulness; renders the contract voidable

Innocent Misrepresentation misrepresentation made without knowledge of its falsity but with due care; renders the contract voidable

Mistake

Definition an understanding that is not in accord with existing fact

Mutual Mistake both parties have a common but erroneous belief forming the basis of the contract; renders the contract voidable by either party

Unilateral Mistake courts are unlikely to grant relief unless the error is known or should be known by the nonmistaken party

Assumption of Risk of Mistake a party may assume the risk of a mistake

Effect of Fault upon Mistake not a bar to avoidance unless the fault amounts to a failure to act in good faith

Q U E S T I O N S

1. Anita and Barry were negotiating, and Anita’s attorney prepared a long and carefully drawn contract that was given to Barry for examination. Five days later and prior to its execution, Barry’s eyes became so infected that it was impossible for him to read. Ten days thereafter and during the continuance of the illness, Anita called Barry and urged him to sign the contract, telling him that time was running out. Barry signed the contract despite the fact he was unable to read it. In a subsequent action by Anita, Barry claimed that the contract was not binding on him because it was impossible for him to read and he

did not know what it contained prior to his signing it. Should Barry be held to the contract?

2. a. William tells Carol that he paid $150,000 for his farm in 2008 and that he believes it is worth twice that at the present time. Relying upon these statements, Carol buys the farm from William for $225,000. William did pay $150,000 for the farm in 2008, but its value has increased only slightly, and it is presently not worth $300,000. On discovering this, Carol offers to reconvey the farm to William and sues for the return of her $225,000. Result?

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b. Modify the facts in (a) by assuming that William had paid $100,000 for the property in 2008. What is the result?

3. On September 1, Adams in Portland, Oregon, wrote a letter to Brown in New York City offering to sell to Brown one thousand tons of chromite at $48.00 per ton, to be shipped by S.S. Malabar sailing from Portland, Oregon, to New York City via the Panama Canal. Upon receiving the letter on September 5, Brown immediately mailed to Adams a letter stating that she accepted the offer. There were two ships by the name of S.S. Malabar sailing from Portland to New York City via the Panama Canal, one sailing in October and the other sailing in December. At the time of mailing her letter of acceptance, Brown knew of both sailings and further knew that Adams knew only of the December sailing. Is there a contract? If so, to which S.S. Malabar does it relate?

4. Adler owes Perreault, a police captain, $500. Adler threatens Perreault that unless Perreault gives him a dis- charge from the debt, Adler will disclose the fact that Perreault has on several occasions become highly intoxi- cated and has been seen in the company of certain disrep- utable persons. Perreault, induced by fear that such a disclosure would cost him his position or in any event lead to social disgrace, gives Adler a release but subse- quently sues to set it aside and recover on his claim. Will Adler be able to enforce the release?

5. Harris owned a farm that was worth about $600 an acre. By false representations of fact, Harris induced Pringle to buy the farm at $1,500 an acre. Shortly after taking pos- session of the farm, Pringle discovered oil under the land. Harris, on learning this, sues to have the sale set aside on the ground that it was voidable because of fraud. Result?

6. On February 2, Phillips induced Mallor to purchase from her fifty shares of stock in the XYZ Corporation for $10,000, representing that the actual book value of each share was $200. A certificate for fifty shares was deliv-

ered to Mallor. On February 16, Mallor discovered that the February 2 book value was only $50.00 per share. Thereafter, Mallor sues Phillips. Will Mallor be successful in a lawsuit against Phillips? Why?

7. Dorothy mistakenly accused Fred’s son, Steven, of negli- gently burning down Dorothy’s barn. Fred believed that his son was guilty of the wrong and that he, Fred, was personally liable for the damage, because Steven was only fifteen years old. Upon demand made by Dorothy, Fred paid Dorothy $25,000 for the damage to Dorothy’s barn. After making this payment, Fred learned that his son had not caused the burning of Dorothy’s barn and was in no way responsible for its burning. Fred then sued Dorothy to recover the $25,000 that he had paid her. Will he be successful?

8. Jones, a farmer, found an odd-looking stone in his fields. He went to Smith, the town jeweler, and asked him what he thought it was. Smith said he did not know but thought it might be a ruby. Jones asked Smith what he would pay for it, and Smith said $200, whereupon Jones sold it to Smith for $200. The stone turned out to be an uncut diamond worth $3,000. Jones brought an action against Smith to recover the stone. On trial, it was proved that Smith actually did not know the stone was a diamond when he bought it, but he thought it might be a ruby. Can Jones void the sale? Explain.

9. Decedent, Joan Jones, a bedridden, lonely woman, eighty-six years old, owned outright Greenacre, her an- cestral estate. Biggers, her physician and friend, visited her weekly and was held in the highest regard by Joan. Joan was extremely fearful of pain and suffering and depended on Biggers to ease her anxiety and pain. Sev- eral months before her death, Joan deeded Greenacre to Biggers for $10,000. The fair market value of Greenacre at this time was $250,000. Joan was survived by two children and six grandchildren. Joan’s children challenged the validity of the deed. Should the deed be declared invalid due to Biggers’ undue influence? Explain.

C A S E P R O B L E M S

10. In February, Gardner, a schoolteacher with no experience in running a tavern, entered into a contract to purchase for $40,000 the Punjab Tavern from Meiling. The con- tract was contingent upon Gardner’s obtaining a five- year lease for the tavern’s premises and a liquor license from the state. Prior to the formation of the contract, Meiling had made no representations to Gardner con- cerning the gross income of the tavern. Approximately three months after the contract was signed, Gardner and Meiling met with an inspector from the Oregon Liquor Control Commission (OLCC) to discuss transfer of the

liquor license. Meiling reported to the agent, in Gardner’s presence, that the tavern’s gross income figures for Febru- ary, March, and April were $5,710, $4,918, and $5,009, respectively. The OLCC granted the required license, the transaction was closed, and Gardner took possession on June 10. After discovering that the tavern’s income was very low and that the tavern had very few female patrons, Gardner contacted Meiling’s bookkeeping service and learned that the actual gross income for those three months had been approximately $1,400 to $2,000. Will a court grant Gardner rescission of the contract? Explain.

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11. Dorothy and John Huffschneider listed their house and lot for sale with C. B. Property. The asking price was $165,000, and the owners told C. B. that the property contained 6.8 acres. Dean Olson, a salesman for C. B., advertised the property in local newspapers as consisting of six acres. James and Jean Holcomb signed a contract to purchase the property through Olson after first inspecting the property with Olson and being assured by Olson that the property was at least 6.6 acres. The Hol- combs never asked for nor received a copy of the survey. In actuality, the lot was only 4.6 acres. Can the Hol- combs rescind the contract? Explain.

12. Christine Boyd was designated as the beneficiary of a life insurance policy issued by Aetna Life Insurance Company on the life of Christine’s husband, Jimmie Boyd. The pol- icy insured against Jimmie’s permanent total disability and provided for a death benefit to be paid on Jimmie’s death. Several years after the policy was issued, Jimmie and Christine separated. Jimmie began to travel exten- sively, and, therefore, Christine was unable to keep track of his whereabouts or his state of health. Jimmie never- theless continued to pay the premiums on the policy until Christine tried to cash in the policy to alleviate her finan- cial distress. A loan previously had been made on the policy, however, leaving its cash surrender value, and thus the amount Christine received, at only $4.19. Shortly thereafter, Christine learned that Jimmie had been permanently and totally disabled before the surrender of the policy. Aetna also was unaware of Jimmie’s condi- tion, and Christine requested the surrendered policy be reinstated and that the disability payments be made. Jim- mie died soon thereafter, and Christine then requested that Aetna pay the death benefit. Decision?

13. Treasure Salvors and the state of Florida entered into a se- ries of four annual contracts governing the salvage of the Nuestra Senora de Atocha. The Atocha is a Spanish gal- leon that sank in 1622, carrying a treasure now worth well over $250 million. Both parties had contracted under the impression that the seabed on which the Atocha lay was land owned by Florida. Treasure Salvors agreed to re- linquish 25 percent of the items recovered in return for the right to salvage on state lands. In accordance with these contracts, Treasure Salvors delivered to Florida its share of the salvaged artifacts. Subsequently the U.S. Supreme Court held that the part of the continental shelf on which the Atocha was resting had never been owned by Florida. Treasure Salvors then brought suit to rescind the contracts and to recover the artifacts it had delivered to the state of Florida. Should Treasure Salvors prevail?

14. Jane Francois married Victor H. Francois. At the time of the marriage, Victor was a fifty-year-old bachelor living with his elderly mother, and Jane was a thirty-year-old, twice-divorced mother of two. Victor had a relatively secure financial portfolio; Jane, on the other hand, brought no money or property to the marriage.

The marriage deteriorated quickly over the next cou- ple of years, with disputes centered on financial matters. During this period, Jane systematically gained a joint interest and took control of most of Victor’s assets. Three years after they married, Jane contracted Harold Mono- son, an attorney, to draw up divorce papers. Victor was unaware of Jane’s decision until he was taken to Mono- son’s office, where Monoson presented for Victor’s signa- ture a “Property Settlement and Separation Agreement.” Monoson told Victor that he would need an attorney, but Jane vetoed Victor’s choice. Monoson then asked another lawyer, Gregory Ball, to come into the office. Ball read the agreement and strenuously advised Victor not to sign it because it would commit him to financial suicide. The agreement transferred most of Victor’s remaining assets to Jane. Victor, however, signed it because Jane and Monoson persuaded him that it was the only way that his marriage could be saved. In Octo- ber of the following year, Jane informed Victor that she had sold most of his former property and that she was leaving him permanently. Can Victor have the agreement set aside as a result of undue influence?

15. Iverson owned Iverson Motor Company, an enterprise engaged in the repair and sale of Oldsmobile, Rambler, and International Harvester Scout automobiles. Forty percent of the business’s sales volume and net earnings came from the Oldsmobile franchise. Whipp contracted to buy Iverson Motors, which Iverson said included the Oldsmobile franchise. After the sale, however, General Motors refused to transfer the franchise to Whipp. Whipp then returned the property to Iverson and brought this action seeking rescission of the contract. Should the contract be rescinded? Explain.

16. On February 10, Mrs. Sunderhaus purchased a diamond ring from Perel & Lowenstein for $6,990. She was told by the company’s salesman that the ring was worth its purchase price, and she also received at that time a written guarantee from the company attesting to the diamond’s value, style, and trade-in value. When Mrs. Sunderhaus went to trade the ring for another, how- ever, she was told by two jewelers that the ring was val- ued at $3,000 and $3,500, respectively. Mrs. Sunderhaus knew little about the value of diamonds and claims to have relied on the oral representation of the Perel & Lowenstein’s salesman and the written representation as to the ring’s value. Mrs. Sunderhaus seeks rescission of the contract or damages in the amount of the sales price over the ring’s value. Will she prevail? Explain.

17. Division West Chinchilla Ranch advertised on television that a five-figure income could be earned by raising chin- chillas with an investment of only $3.75 per animal per year and only thirty minutes of maintenance per day. The minimum investment was $2,150 for one male and six female chinchillas. Division West represented to the plain- tiffs that chinchilla ranching would be easy and that no

Chapter 11 Conduct Invalidating Assent 241

experience was required to make ranching profitable. The plaintiffs, who had no experience raising chinchillas, each invested $2,150 or more to purchase Division’s chinchillas and supplies. After three years without earning a profit, the plaintiffs sued Division West for fraud. Do these facts sustain an action for fraud in the inducement?

18. William Schmalz entered into an employment contract with Hardy Salt Company. The contract granted Schmalz six months’ severance pay for involuntary termination but none for voluntary separation or termination for cause. Schmalz was asked to resign from his employment. He was informed that if he did not resign he would be fired for alleged misconduct. When Schmalz turned in his letter of resignation, he signed a release prohibiting him from suing his former employer as a consequence of his employment. Schmalz consulted an attorney before sign- ing the release and, upon signing it, received $4,583.00 (one month’s salary) in consideration. Schmalz now sues his former employer for the severance pay, claiming that he signed the release under duress. Is Schmalz correct in his assertion?

19. Glen Haumont, who owned an equipment retail business in Broken Bow, Nebraska, owed the Security State Bank more than $628,000 due to improper selling practices as well as business and inventory loans. Several times Glen tried to persuade his parents, Lee and Letha Haumont, to financially back his business debts, but each time they refused. Glen then told his parents that, according to his attorney and the bank, Glen could be prosecuted and sent to jail. Soon afterwards, David Schweitz, the president of the bank, drove out to the elder Haumonts’ farm to con- vince them to sign as guarantors of Glen’s debt. Both Schweitz and Glen stressed to the Haumonts that unless they agreed to guarantee his debt, Glen would go to jail. Letha asked that her attorney be allowed to read over the guarantee agreement, but Schweitz told her that he did not have time to wait and that she must decide right then whether Glen was to go to jail. As a result, the Haumonts signed the agreement, encumbering their previously debt- free family farm for more than $628,000. Should the guarantee agreement be set aside due to duress?

20. Conrad Schaneman was a Russian immigrant who could neither read nor write the English language. In 2011, Con- rad deeded (conveyed) a farm he owned to his eldest son, Laurence, for $23,500, which was the original purchase price of the property in 1981. The value of the farm in 2011 was between $145,000 and $160,000. At the time he executed the deed, Conrad was an eighty-two-year-old invalid, severely ill, and completely dependent on others for his personal needs. He weighed between 325 and 350 pounds, had difficulty breathing, could not walk more than fifteen feet, and needed a special jackhoist to get in and out of the bathtub. Conrad enjoyed a long-standing, confidential relationship with Laurence, who was his prin- cipal adviser and handled Conrad’s business affairs.

Laurence also obtained a power of attorney from Conrad and made himself a joint owner of Conrad’s bank account and $20,000 certificate of deposit. Conrad brought this suit to cancel the deed, claiming it was the result of Laurence’s undue influence. Explain whether the deed was executed as a result of undue influence.

21. At the time of her death Olga Mestrovic was the owner of a large number of works of art created by her late husband, Ivan Mestrovic, an internationally known sculptor and artist whose works were displayed through- out Europe and the United States. By the terms of Olga’s will, all the works of art created by her husband were to be sold and the proceeds distributed to members of the Mestrovic family. Also included in the estate of Olga Mestrovic was certain real property which 1st Source Bank (the Bank), as personal representative of the estate of Olga Mestrovic, agreed to sell to Terrence and Antoi- nette Wilkin. The agreement of purchase and sale made no mention of any works of art, although it did provide for the sale of such personal property as a dishwasher, drapes, and French doors stored in the attic. Immediately after closing on the real estate, the Wilkins complained to the Bank of the clutter left on the premises; the Bank gave the Wilkins an option of cleaning the house them- selves and keeping any personal property they desired, to which the Wilkins agreed. At the time these arrangements were made, neither the Bank nor the Wilkins suspected that any works of art remained on the premises. During cleanup, however, the Wilkins found eight drawings and a sculpture created by Ivan Mestrovic to which the Wilkins claimed ownership based upon their agreement with the Bank that, if they cleaned the real property, they could keep such personal property as they desired. Who is entitled to ownership of the works of art?

22. Frank Berryessa stole funds from his employer, the Eccles Hotel Company. His father, W. S. Berryessa (Berryessa), learned of his son’s trouble and, thinking the amount involved was about $2,000, gave the hotel a promissory note for $2,186 to cover the shortage. In return, the hotel agreed not to publicize the incident or notify the bonding company. (A bonding company is an insurer that is paid a premium for agreeing to reimburse an employer for thefts by an employee.) Before this note became due, however, the hotel discovered that Frank had actually misappropri- ated $6,865. The hotel then notified its bonding company, Great American Indemnity Company, to collect the entire loss. W. S. Berryessa claims that the agent for Great Amer- ican told him that unless he paid them $2,000 in cash and signed a note for the remaining $4,865, Frank would be prosecuted (which note would replace the initial note). Berryessa agreed, signed the note, and gave the agent a cashier’s check for $1,500 and a personal check for $500. He requested that the agent not cash the personal check for about a month. Subsequently, Great American sued Berryessa on the note. He defends against the note on the

242 Contracts Part III

grounds of duress and counterclaims for the return of the $1,500 and the cancellation of the uncashed $500 check. Who should prevail?

23. Ronald D. Johnson is a former employee of International Business Machines Corporation (IBM). As part of a downsizing effort, IBM discharged Johnson. In exchange for an enhanced severance package, Johnson signed a written release and covenant not to sue IBM. IBM’s downsizing plan provided that surplus personnel were eli- gible to receive benefits, including outplacement assis- tance, career counseling, job retraining, and an enhanced separation allowance. These employees were eligible, at IBM’s discretion, to receive a separation allowance of two weeks’ pay. However, employees who signed a release could be eligible for an enhanced severance allow- ance equal to one week’s pay for each six months of accumulated service with a maximum of twenty-six weeks’ pay. Surplus employees could also apply for alter- nate, generally lower-paying, manufacturing positions. Johnson opted for the release and received the maximum twenty-six weeks’ pay. He then alleged, among other claims, that IBM subjected him to economic duress when he signed the release and covenant-not-to-sue, and he sought to rescind both. What will Johnson need to show in order to prove his cause of action?

24. Etta Mae Paulson died on January 31, 2014, leaving four children: Ken, Donald, Barbara, and Larry. She had pur- chased a home in Rainier in 2009, for $21,300. At that time, she had a will that she had executed in 1993, leav- ing all of her property to her four children in equal shares. That will was never changed. After she moved into the house in Rainier, Ken, Ken’s wife, Barbara, and Don helped Etta, who suffered from arthritis in both hands, renal failure, congestive heart failure, and diabe- tes. As a result of these conditions, Etta had trouble get- ting around and, during the last part of her life, she used an electric cart. She was taking several medications, including Prozac, Prednisone, Zantac, and Procardia, and was receiving insulin daily and dialysis an average of three times a week. Although there is no evidence that she was mentally incompetent, the medications and treat- ments made her drowsy, tired, and depressed, and caused mood swings. It is undisputed that she was dependent on the help of others in her daily living.

Larry was not in the Rainier area when his mother moved there and did not visit her. The other children and her neighbor helped her. The other children reroofed the house, picked fruit and stored it, and mowed the lawn; her daughter helped her with her finances and had a joint account with her, which the daughter never used. All of those children visited her frequently, and at least one of them saw her every day. Etta expressed concern about losing the house because of her medical bills and suggested that she put the house in Ken’s name; he and Barbara looked into the situation and concluded that it

was not necessary, and so advised their mother. At some point—it is not clear when—Larry was told by state wel- fare authorities, as Ken and Barbara had learned, that so long as his mother maintained her house as her primary residence and was not receiving Medicaid, she was not in danger of losing her house to the state.

Sometime in early 2013, Larry and his then girlfriend (later his wife) moved in with Etta and took over her care. Larry expressed his concern to his mother that the state might take her house. Not long thereafter, Larry rented a house in Longview in his name and persuaded his mother to move in with him, his girlfriend, and her child. After Etta moved to Longview, she rented her house in Rainier; the rent was used to maintain the house in Longview. At that time, Etta had a savings account with approximately $2,000 in it; Larry held his mother’s power of attorney. At the time of her death in January 2014, that account was exhausted, although her medical expenses were being paid by Medicare. Larry admitted that he used some of that money to buy a bicycle and a guitar. He had also used her credit card, on which there was a substantial balance after her death, which he did not pay. He said that that debt “died with his mother.” On numerous occasions, Larry expressed to his mother his concern that the state would take her house if she kept it in her name. She was fearful of that, in spite of what she had been told by Ken and Barbara. Larry told her that they were wrong and frequently urged her to make up her mind “about the deed.” Etta was hospital- ized three times during 2013. Finally, on September 30, 2013, Larry suggested to his mother that they go to a title company in Rainier to get a deed. Etta signed the deed and gave up all of her rights in the property. Larry then had it recorded. He did not mention it to any of his half-brothers or -sister until two months later when he boasted of it to his half-sister. Is the deed voidable? Explain.

25. In May 1995, Vernon and Janene Lesher agreed to pur- chase an eighteen-acre parcel of real property from the Strids with the intention of using it to raise horses. In purchasing the property, the Leshers relied on their impression that at least four acres of the subject property had a right to irrigation from Slate Creek. The earnest money agreement to the contract provided:

D. Water Rights are being conveyed to Buyer at the close of escrow.… Seller will provide Buyer with a written explanation of the operation of the irrigation system, water right certificates, and in- ventory of irrigation equipment included in sale.

The earnest money agreement also provided:

THE SUBJECT PROPERTY IS BEING SOLD “AS IS” subject to the Buyer’s approval of the tests and conditions as stated herein. Buyer declares that Buyer is not depending on any other statement of

Chapter 11 Conduct Invalidating Assent 243

the Seller or licensees that is not incorporated by reference in this earnest money contract [Bold in original].

Before signing the earnest money agreement, the Strids presented to the Leshers a 1977 Water Resources Depart- ment water rights certificate and a map purporting to show an area of the subject property to be irrigated (“area to be irrigated” map), which indicated that the property carried a four-acre water right. Both parties

believed that the property carried the irrigation rights and that the Leshers needed such rights for their horse farm. The Leshers did not obtain the services of an attor- ney or a water rights examiner before purchasing the property.

After purchasing the property and before establishing a pasture, the Leshers learned that the property did not carry a four-acre water right. Explain whether the Leshers may rescind the contract.

T A K I N G S I D E S

Mrs. Audrey E. Vokes, a widow of fifty-one years and with- out family, purchased fourteen separate dance courses from J. P. Davenport’s Arthur Murray, Inc., School of Dance. The fourteen courses totaled in the aggregate 2,302 hours of dancing lessons at a cost to Mrs. Vokes of $31,090.45. Mrs. Vokes was induced continually to reapply for new courses by representations made by Mr. Davenport that her dancing ability was improving, that she was responding to instruction, that she had excellent potential, and that they were developing her into an accomplished dancer. In fact, she

had no dancing ability or aptitude and had trouble “hearing the musical beat.” Mrs. Vokes brought action to have the contracts set aside.

a. What are the arguments that the contract should be set aside?

b. What are the arguments that the contract should be enforced?

c. What is the proper outcome? Explain.

244 Contracts Part III

C H A P T E R 1 2

CONSIDERATION

Nuda pactio obligationem non parit. (A naked agreement, that is, one without consideration, does not beget an obligation.)

LEGAL MAXIM

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Define consideration and explain what is meant by legal sufficiency.

2. Describe illusory promises, output contracts, requirements contracts, exclusive dealing contracts, and conditional contracts.

3. Explain whether preexisting public and contractual obligations satisfy the legal requirement of consideration.

4. Explain the concept of bargained-for exchange and whether this element is present with past consideration and third-party beneficiaries.

5. Identify and discuss those contracts that are enforceable even though they are not supported by consideration.

C onsideration is the primary—but not the only— basis for the enforcement of promises in our legal system. Consideration is the inducement to

make a promise enforceable. The doctrine of considera- tion ensures that promises are enforced only in cases in which the parties have exchanged something of value in the eye of the law. Gratuitous (gift) promises—those made without consideration—are not legally enforcea- ble, except under certain circumstances, which are dis- cussed later in the chapter.

Consideration, or that which is exchanged for a promise, is present only when the parties intend an exchange. The consideration exchanged for the promise may be an act, a forbearance to act, or a promise to do either of these. Thus, there are two basic elements to consideration: (1) legal sufficiency (something of value

in the eye of the law) and (2) bargained-for exchange. Both must be present to satisfy the requirement of consideration.

LEGAL SUFFICIENCY [12-1] To be legally sufficient, the consideration for the prom- ise must be either a legal detriment to the promisee or a legal benefit to the promisor. In other words, in return for the promise, the promisee must give up something of legal value or the promisor must receive something of legal value.

Legal detriment means (1) the doing of (or the undertaking to do) that which the promisee was under no prior legal obligation to do or (2) the refraining from the doing of (or the undertaking to refrain from

245

doing) that which he was previously under no legal obligation to refrain from doing. On the other hand, legal benefit means the obtaining by the promisor of that which he had no prior legal right to obtain. In most, if not all, cases in which there is legal detriment to the promisee, there is also a legal benefit to the promisor. However, the presence of either is sufficient.

Adequacy [12-1a] Legal sufficiency has nothing to do with adequacy of consideration. The items or actions that the parties agree to exchange do not need to have the same value. Rather, the law will regard the consideration as adequate if the parties have freely agreed to the exchange. The require- ment of legally sufficient consideration, therefore, is not at all concerned with whether the bargain was good or bad or whether one party received dispropor- tionately more or less than what he gave or promised in exchange. (Such facts, however, may be relevant to the availability of certain defenses—such as fraud, duress, or undue influence—or certain remedies—such as specific performance.) The requirement of legally sufficient con- sideration is simply (1) that the parties have agreed to an exchange and (2) that, with respect to each party, the subject matter exchanged, or promised in exchange, either imposed a legal detriment on the promisee or con- ferred a legal benefit on the promisor. If the purported consideration is clearly without value, however, such that the transaction is a sham, many courts would hold that consideration is lacking.

PRACTICAL ADVICE Be sure you are satisfied with your agreed-upon exchange, because courts will not invalidate a contract for absence of adequate consideration.

Unilateral Contracts [12-1b] In a unilateral contract, a promise is exchanged for a completed act or a forbearance to act. Because only one promise exists, only one party, the offeror, makes a promise and is therefore the promisor while the other party, the offeree, is the person receiving the promise and, thus, is the promisee. For example, A promises to pay B $2,000 if B paints A’s house. B paints A’s house.

A B promises to pay $2,000

act of painting house

Promisor Promisee

A’s promise is binding only if it is supported by con- sideration consisting of either a legal detriment to B, the promisee (offeree), or a legal benefit to A, the promisor (offeror). B’s painting the house is a legal detriment to B, the promisee, because she was under no prior legal duty to paint A’s house. Also, B’s painting of A’s house is a legal benefit to A, the promisor, because A had no prior legal right to have his house painted by B.

A unilateral contract also may consist of a promise exchanged for a forbearance. To illustrate, A negli- gently injures B, for which B may recover damages in a tort action. A promises B $5,000 if B forbears from bringing suit. B accepts by not suing.

A B promises to pay $5,000

forbearance from suing

Promisor Promisee

A’s promise to pay B $5,000 is binding because it is supported by consideration; B, the promisee (offeree), has incurred a legal detriment by refraining from bring- ing suit, which he was under no prior legal obligation to refrain from doing. A, the promisor (offeror), has received a legal benefit because she had no prior legal right to B’s forbearance from bringing suit.

Bilateral Contracts [12-1c] In a bilateral contract there is an exchange of promises. Thus, each party is both a promisor and a promisee. For example, if A (the offeror) promises (offers) to pur- chase an automobile from B for $20,000 and B (the offeree) promises to sell the automobile to A for $20,000 (accepts the offer), the following relationship exists:

A B promises to pay $20,000

promises to sell automobile

Promisor

Promisee

Promisee

Promisor

A (offeror) as promisor: A’s promise (the offer) to pay B $20,000 is binding if that promise is supported by legal consideration from B (offeror), which may con- sist of either a legal detriment to B, the promisee, or a legal benefit to A, the promisor. B’s promise to sell A the automobile is a legal detriment to B because he was under no prior legal duty to sell the automobile to A. Moreover, B’s promise is also a legal benefit to A because A had no prior legal right to that automobile.

246 Contracts Part III

Consequently, A’s promise to pay $20,000 to B is sup- ported by consideration and is enforceable.

A B promises to pay $20,000

promises to sell automobile (consideration for A’s promise)

Promisor Promisee

B (offeree) as promisor: For B’s promise (the accep- tance) to sell the automobile to A to be binding, it like- wise must be supported by consideration from A (offeror), which may be either a legal detriment to A, the promisee, or a legal benefit to B, the promisor. A’s prom- ise to pay B $20,000 is a legal detriment to A because he was under no prior legal duty to pay $20,000 to B. At the same time, A’s promise is also a legal benefit to B because B had no prior legal right to the $20,000. Thus, B’s promise to sell the automobile is supported by consid- eration and is enforceable.

A B

(consideration for B’s promise) promises to pay $20,000

promises to sell automobile

Promisee Promisor

To summarize, for A’s promise to B to be binding, it must be supported by legally sufficient considera- tion, which requires that the promise A receives from B in exchange either provides a legal benefit to A or constitutes a legal detriment to B. B’s return promise to A must also be supported by consideration. Thus, in a bilateral contract, each promise is the consi- deration for the other, a relationship that has been referred to as mutuality of obligation. A general con- sequence of mutuality of obligation is that each promi- sor in a bilateral contract must be bound or neither is bound. See Concept Review 12-1 for an overview of

consideration in both unilateral and bilateral con- tracts. Also see the Ethical Dilemma at the end of the chapter for a situation dealing with the disputed enfor- ceability of a promise.

Illusory Promises [12-1d] Words of promise that make the performance of the purported promisor entirely optional do not constitute a promise at all. Consequently, they cannot serve as consideration. In this section, we will distinguish such illusory promises from promises that do impose obliga- tions of performance upon the promisor and thus can be legally sufficient consideration.

An illusory promise is a statement that is in the form of a promise but imposes no obligation upon the maker of the statement. An illusory promise is not considera- tion for a return promise. Thus, a statement committing the promisor to purchase such quantity of goods as he may “desire” or “want” or “wish to buy” is an illusory promise because its performance is entirely optional. For example, if ExxonMobil offers to sell to Gasco as many barrels of oil as Gasco shall choose at $40.00 per barrel, there is no consideration. An offer containing such a promise, although accepted by the offeree, does not create a contract because the promise is illusory— Gasco’s performance is entirely optional, and no con- straint is placed on its freedom. It is not bound to do anything, nor can ExxonMobil reasonably expect it to do anything. Thus, Gasco, by its promise, suffers no legal detriment and confers no legal benefit.

PRACTICAL ADVICE Because an agreement under which one party may perform at his discretion is not a binding contract, be sure that you make a promise and receive a promise that is not optional.

CONCEPT REVIEW 12-1 C O N S I D E R A T I O N I N U N I L A T E R A L A N D B I L A T E R A L C O N T R A C T S

Type of Contract Offer Acceptance Consideration

Unilateral Promise by A Performance of requested act or forbearance by B

Promise by A Performance of requested act or forbearance by B

Bilateral Promise by A Return promise by B to perform requested act or forbearance

Promise by A Return promise by B to perform requested act or forbearance

Chapter 12 Consideration 247

V A N E G A S V . A M E R I C A N E N E R G Y S E R V I C E S S u p r e m e C o u r t o f T e x a s , 2 0 0 9

3 0 2 S . W . 3 d 2 9 9

FACTS American Energy Services (AES or employer) was formed in the summer of 1996. Employees, hired in 1996, allege that in an operational meeting in June 1997, they voiced concerns to John Carnett, a vice president of AES, about the continued viability of the company. The employees allege that, in an effort to provide an incentive for them to stay with the company, Carnett promised the employees, who were at-will employees and therefore free to leave the company at any time, that “in the event of sale or merger of AES, the original [eight] employees remaining with AES at that time would get 5% of the value of any sale or merger of AES.” AES Acquisition, Inc., acquired AES in 2001. Seven of the eight original employees were still with AES at the time of the acquisi- tion. These remaining employees demanded their proceeds, and when the company refused to pay, the employees sued, claiming AES had breached the oral agreement.

AES moved for summary judgment on the ground that the agreement was illusory. The employees argued that the promise represented a unilateral contract, and by remaining employed for the stated period, the employees performed, thereby making the promise en- forceable. The trial court granted AES’s motion for sum- mary judgment, and the employees appealed. The court of appeals affirmed, holding that the alleged unilateral contract failed because it was not supported by at least one nonillusory promise.

DECISION Judgment of the court of appeals reversed, and case remanded.

OPINION Green, J. AES argues, and the court of appeals held, that our holdings in Light dictate the result in this case. [Citation.] In Light, we stated:

Consideration for a promise, by either the employee or the employer in an at-will employment, cannot be depend- ent on a period of continued employment. Such a promise would be illusory because it fails to bind the promisor who always retains the option of discontinuing employ- ment in lieu of performance. When illusory promises are all that support a purported bilateral contract, there is no contract.

*** Light involved an employee’s challenge to a covenant

not to compete. [Citation.] *** We revisited the issue of illusory promises in cove-

nants not to compete in Sheshunoff. *** We reaffirmed

our previous holding in Light that covenants not to compete in bilateral contracts must be supported by “mutual non-illusory promises.” [Citation.]

Citing our holdings in Light and Sheshunoff, the court of appeals [in this case] stated that “[a] unilateral contract may be formed when one of the parties makes only an illusory promise but the other party makes a non-illusory promise. The non-illusory promise can serve as the offer for a unilateral contract, which the promisor who made the illusory promise can accept by performance.” [Citation.] We agree with that statement, but the court of appeals erroneously applied those hold- ings to the current case.

The issue turns on the distinction between bilateral and unilateral contracts. “A bilateral contract is one in which there are mutual promises between two parties to the contract, each party being both a promisor and a promisee.” [Citations.] A unilateral contract, on the other hand, is “created by the promisor promising a benefit if the promisee performs. The contract becomes enforceable when the promisee performs.” [Citation.] Both Sheshunoff and Light concerned bilateral contracts in which employers made promises in exchange for employees’ promises not to compete with their compa- nies after termination. [Citations.] The court of appeals’ explanation of these cases—describing an exchange of promises where one party makes an illusory promise and the other a non-illusory promise—describes the attempted formation of a bilateral contract, not a unilat- eral contract. [Citation.] ***

The court of appeals held that even if AES promised to pay the employees the five percent, that promise was illusory at the time it was made because the employees were at-will, and AES could have fired all of them prior to the acquisition. [Citation.] But whether the promise was illusory at the time it was made is irrelevant; what matters is whether the promise became enforceable by the time of the breach. [Citations.] Almost all unilateral contracts begin as illusory promises. Take, for instance, the classic textbook example of a unilateral contract: “I will pay you $50 if you paint my house.” The offer to pay the individual to paint the house can be withdrawn at any point prior to performance. But once the individ- ual accepts the offer by performing, the promise to pay the $50 becomes binding. The employees allege that AES made an offer to split five percent of the proceeds of the sale or merger of the company among any remaining original employees. Assuming that allegation is true, the

248 Contracts Part III

Output and Requirements Contracts The agreement of a seller to sell her entire production to a particular purchaser is called an output contract. It gives the seller an ensured market for her product. Conversely, a purchaser’s agreement to purchase from a particular seller all the materials of a particular kind that the purchaser needs is called a requirements con- tract. It ensures the buyer of a ready source of inven- tory or supplies. These contracts are not illusory. The buyer under a requirements contract does not promise to buy as much as she desires to buy, but to buy as much as she needs. Similarly, under an output contract, the seller promises to sell to the buyer the seller’s entire production, not merely as much as the seller desires.

Furthermore, the Code imposes a good faith limita- tion upon the quantity to be sold or purchased under an output or requirements contract. Thus, this type of contract involves such actual output or requirements as may occur in good faith, except that no quantity unrea- sonably disproportionate to any stated estimate or, in the absence of a stated estimate, to any normal prior output or requirements may be tendered or demanded. Therefore, after contracting to sell to Adler, Inc., its entire output, Benevito Company cannot increase its production from one eight-hour shift per day to three eight-hour shifts per day.

PRACTICAL ADVICE If you use an output or requirements contract, be sure to act in good faith and do not take unfair advantage of the situation.

Exclusive Dealing Contracts An exclusive dealing agreement is a contract in which a manufacturer of goods grants to a distributor an exclusive right to sell its products in a designated market. Unless otherwise agreed, an implied obligation is imposed on the manufac- turer to use its best efforts to supply the goods and on the distributor to use her best efforts to promote their sale. These implied obligations are sufficient consideration to bind both parties to the exclusive dealing contract.

Conditional Promises A conditional promise is a promise the performance of which depends upon the happening or nonhappening of an event not certain to occur (the condition). A conditional promise is sufficient consideration unless the promisor knows at the time of making the promise that the condition cannot occur.

Thus, if Joanne offers to pay Barry $8,000 for Barry’s automobile, provided that Joanne receives such amount as an inheritance from the estate of her deceased uncle, and Barry accepts the offer, the duty of Joanne to pay $8,000 to Barry is conditioned on her receiving $8,000 from her deceased uncle’s estate. The consideration mov- ing from Barry to Joanne is the transfer of title to the automobile. The consideration moving from Joanne to Barry is the promise of $8,000 subject to the condition.

Preexisting Public Obligations [12-1e] The law does not regard the performance of, or the promise to perform, a preexisting legal duty, public or private, as either a legal detriment or a legal benefit.

seven remaining employees accepted this offer by remain- ing employed for the requested period of time. [Citation.] At that point, AES’s promise became binding. AES then breached its agreement with the employees when it refused to pay the employees their five percent share.

Furthermore, the court of appeals’ holding would potentially jeopardize all pension plans, vacation leave, and other forms of compensation made to at-will employ- ees that are based on a particular term of service. ***

The fact that the employees were at-will and were already being compensated in the form of their salaries in exchange for remaining employed also does not make the promise to pay the bonus any less enforceable.

*** AES allegedly promised to pay any remaining original

employees five percent of the proceeds when AES was sold. Assuming AES did make such an offer, the seven

remaining employees accepted the offer by staying with AES until the sale. Regardless of whether the promise was illusory at the time it was made, the promise became enforceable upon the employees’ performance. The court of appeals erred in holding otherwise. ***

INTERPRETATION An illusory promise is a statement that is in the form of a promise but imposes no obligation upon the maker of the statement.

ETHICAL QUESTION Did AES act ethically by inducing the employees to continue working in return for a promise that AES considered to be not binding? Explain.

CRITICAL THINKING QUESTION Do you agree with this decision? Explain.

Chapter 12 Consideration 249

A public duty does not arise out of a contract; rather, it is imposed on members of society by force of the com- mon law or by statute. Illustrations, as found in the law of torts, include the duty not to commit assault, battery, false imprisonment, or defamation. The criminal law also imposes many public duties. Thus, if Norton promises to pay Holmes, the village ruffian, $100 not to injure him, Norton’s promise is unenforceable because both tort and criminal law impose a preexisting public obligation on Holmes to refrain from such abuse.

Public officials, such as the mayor of a city, members of a city council, police, and firefighters, are under a preexist- ing obligation to perform their duties by virtue of their pub- lic office. See the following case Denney v. Reppert.

The performance of, or the promise to perform, a preexisting contractual duty, a duty the terms of which

are neither doubtful nor the subject of honest dispute, is also legally insufficient consideration because the doing of what one is legally bound to do is neither a detriment to a promisee nor a benefit to the promisor. For example, if Anita employs Ben for one year at a salary of $1,000 per month, and at the end of six months promises Ben that in addition to the salary she will pay Ben $3,000 if Ben remains on the job for the remainder of the period originally agreed on, Anita’s promise is not binding for lack of legally sufficient con- sideration. However, if Ben’s duties were by agreement changed in nature or amount, Anita’s promise would be binding because Ben’s new duties are a legal detri- ment to Ben and a legal benefit to Anita.

The following case deals with both preexisting public and contractual obligations.

D E N N E Y V . R E P P E R T C o u r t o f A p p e a l s o f K e n t u c k y , 1 9 6 8

4 3 2 S . W . 2 d 6 4 7

FACTS In June, three armed men entered and robbed the First State Bank of Eubank, Kentucky, of $30,000. Acting on information supplied by four employees of the bank, Denney, Buis, McCollum, and Snyder, three law enforcement officials apprehended the robbers. Two of the arresting officers, Godby and Simms, were state policemen, and the third, Reppert, was a deputy sheriff in a neighboring county. All seven claimed the reward for the apprehension and conviction of the bank robbers. The trial court held that only Reppert was entitled to the reward, and Denney appealed.

DECISION Judgment affirmed.

OPINION Myre, J. The first question for determi- nation is whether the employees of the robbed bank are eligible to receive or share in the reward. The great weight of authority answers in the negative. ***

To the general rule that, when a reward is offered to the general public for the performance of some specified act, such reward may be claimed by any person who performs such act, is the exception of agents, employees and public officials who are acting within the scope of their employment or official duties. ***

*** At the time of the robbery the claimants Murrell

Denney, Joyce Buis, Rebecca McCollum, and Jewell Snyder were employees of the First State Bank of Eubank. They were under duty to protect and conserve

the resources and moneys of the bank, and safeguard every interest of the institution furnishing them employ- ment. Each of these employees exhibited great courage, and cool bravery, in a time of stress and danger. The community and the county have recompensed them in commendation, admiration and high praise, and the world looks on them as heroes. But in making known the robbery and assisting in acquainting the public and the officers with details of the crime and with identifica- tion of the robbers, they performed a duty to the bank and the public, for which they cannot claim a reward.

State Policemen Garret Godby, Johnny Simms, and [deputy sheriff] Tilford Reppert made the arrest of the bank robbers and captured the stolen money. All par- ticipated in the prosecution. At the time of the arrest, it was the duty of the state policemen to apprehend the criminals. Under the law they cannot claim or share in the reward and they are interposing no claim to it.

This leaves *** Tilford Reppert the sole eligible claimant. The record shows that at the time of the arrest he was a deputy sheriff in Rockcastle County, but the arrest and recovery of the stolen money took place in Pulaski County. He was out of his jurisdiction, and was thus under no legal duty to make the arrest, and is thus eligible to claim and receive the award.

*** It is manifest from the record that Tilford Reppert is

the only claimant qualified and eligible to receive the reward. Therefore, it is the judgment of the circuit court

250 Contracts Part III

Modification of a Preexisting Contract A modification of a preexisting contract occurs when the parties to the contract mutually agree to change one or more of its terms. Under the common law, as shown in the following case, a modification of an existing contract must be supported by mutual consideration to be enforce- able. In other words, the modification must be supported by some new consideration beyond that which is already owed under the original contract. Thus, there must be a separate and distinct modification contract. For example, Diane and Fred agree that Diane shall put in a gravel driveway for Fred at a cost of $2,000. Subsequently, Fred agrees to pay an additional $3,000 if Diane will blacktop the driveway. Because Diane was not bound by the origi- nal contract to provide blacktop, she would incur a legal detriment in doing so and is therefore entitled to the addi- tional $3,000. Similarly, consideration may consist of the promisee’s refraining from exercising a legal right.

The Code has modified the common law rule for contract modification by providing that the parties can effectively modify a contract for the sale of goods with- out new consideration, provided they both intend to modify the contract and act in good faith. Moreover, the Restatement has moved toward this position by providing that a modification of an executory contract is binding if it is fair and equitable in the light of sur- rounding facts that the parties had not anticipated when the contract was made. Figure 12-1 demonstrates when consideration is required to modify an existing contract.

PRACTICAL ADVICE If you modify a contract governed by the common law, be sure to provide additional consideration to make the other party’s new promise enforceable.

that he is entitled to receive payment of the $1,500.00 reward now deposited with the Clerk of this Court.

INTERPRETATION The law does not regard the performance of a preexisting duty as either a legal detriment or a legal benefit.

ETHICAL QUESTION Did the court treat all the parties fairly? Explain.

CRITICAL THINKING QUESTION Do you agree with the preexisting duty rule? Explain.

N E W E N G L A N D R O C K S E R V I C E S , I N C . V . E M P I R E P A V I N G , I N C . A p p e l l a t e C o u r t o f C o n n e c t i c u t , 1 9 9 9

5 3 C o n n . A p p . 7 7 1 , 7 3 1 A . 2 d 7 8 4 ; c e r t i o r a r i d e n i e d , 2 5 0 C o n n . 9 2 1 , 7 3 8 A . 2 d 6 5 8

FACTS On October 26, 1995, the defendant, Empire Paving, Inc., entered into a contract with Rock Services under which Rock Services would provide drilling and blasting services as a subcontractor on the Niles Hill Road sewer project on which Empire was the general contractor and the city of New London was the owner. Rock Services was to be paid an agreed-upon price of $29 per cubic yard with an estimated amount of five thousand cubic yards or on a time and materials basis, whichever was less. From the outset, Rock Ser- vices experienced problems on the job, the primary problem being the presence of a heavy concentration of water on the site. The water problem hindered Rock Services’ ability to complete its work as anticipated. It is the responsibility of the general contractor to control the water on the work site, and on this particular job, Empire failed to control the water on the site properly.

Rock Services attempted alternative methods of dealing with the problem, but was prevented from using them by the city. Thereafter, to complete its work, Rock Services was compelled to use a more costly and time-consuming method.

In late November 1995, Rock Services advised Empire that it would be unable to complete the work as anticipated because of the conditions at the site and requested that Empire agree to amend the contract to allow Rock Services to complete the project on a time and materials basis. On December 8, Empire signed a purchase order that so modified the original agreement. Upon completion of the work, Empire refused to pay Rock Services for the remaining balance due on the time and materials agreement in the amount of $58,686.63, and Rock Services instituted this action. The trial court concluded that the modified agreement was valid and

Chapter 12 Consideration 251

ruled in favor of Rock Services. Empire brings this appeal.

DECISION Judgment in favor of Rock Services affirmed.

OPINION Schaller, J. In concluding that the modifi- cation was valid and enforceable, the trial court deter- mined that the later agreement was supported by sufficient consideration. ***

“The doctrine of consideration is fundamental in the law of contracts, the general rule being that in the absence of consideration an executory promise is unenforceable.” [Citation.] While mutual promises may be sufficient consideration to bind parties to a modifi- cation; [citations] a promise to do that which one is already bound by his contract to do is not sufficient consideration to support an additional promise by the other party to the contract. [Citations.]

A modification of an agreement must be supported by valid consideration and requires a party to do, or promise to do, something further than, or different from, that which he is already bound to do. [Citations.] It is an accepted principle of law in this state that when a party agrees to perform an obligation for another to whom that obligation is already owed, although for lesser remuneration, the second agreement does not con- stitute a valid, binding contract. [Citations.] The basis of the rule is generally made to rest upon the proposi- tion that in such a situation he who promises the addi- tional [work] receives nothing more than that to which he is already entitled and he to whom the promise is made gives nothing that he was not already under legal obligation to give. [Citations.]

Our Supreme Court in [citation], however, articu- lated an exception to the preexisting duty rule:

[W]here a contract must be performed under burden- some conditions not anticipated, and not within the con- templation of the parties at the time when the contract was made, and the promisee measures up to the right standard of honesty and fair dealing, and agrees, in view of the changed conditions, to pay what is then reasonable, just, and fair, such new contract is not without considera- tion within the meaning of that term, either in law or in equity.

*** What unforeseen difficulties and burdens will make a party’s refusal to go forward with his contract equitable, so as to take the case out of the general rule and bring it within the exception, must depend upon the facts of each particular case. They must be substantial, unforeseen, and not within the contemplation of the parties when the contract was made. [Citation.] This

theory of unforeseen circumstances is applicable to the facts of this case.

Empire argues strenuously that the water conditions on the site cannot qualify as a new circumstance that was not anticipated at the time the original contract was signed. ***

Empire’s argument, however, is misplaced. Rock Services does not argue that it was unaware of the water conditions on the site but, rather, that Empire’s failure to control or remove the water on the site constituted the new or changed circumstance. Rock Services argues that Empire’s duty to control or remove the water on the job site arose in accordance with the custom and practice in the industry and, therefore, Empire’s failure to control or remove the water on the site constituted a new circumstance that Rock Services did not anticipate at the time the original contract was signed.

*** In addition to finding that Empire had a duty to

control or remove the water from the job site, the trial court found further that Empire’s failure to control or remove the water from the site made Rock Services’ working conditions sufficiently burdensome to prevent Rock Services from completing the work as anticipated, forcing Rock Services to attempt to use a different method of drilling and ultimately compelling Rock Ser- vices to use the more costly and time consuming method of casing the blasting hole. The trial court fur- ther found that Empire’s failure to control or remove the water on the site constituted a new circumstance not anticipated by the parties at the time the original contract was signed. In addition, the trial court also found that Rock Services’ request for the modification was not wrongful but, rather, was justified under the circumstances and did not constitute duress as a matter of law.

Upon our review of the record, we conclude that the trial court’s findings of fact are supported by the record and are not clearly erroneous. ***

INTERPRETATION The Restatement provides that a modification of an executory contract is binding if it is fair and equitable in the light of surrounding facts that the parties had not anticipated when the contract was made.

CRITICAL THINKING QUESTION Which rule for contract modification do you believe is the best: the common law, the Restatement’s, or the Uni- form Commercial Code’s? Why?

252 Contracts Part III

Substituted Contracts A substituted contract results when the parties to a contract mutually agree to rescind their original contract and enter into a new one. This situation actually involves three separate contracts: the original contract, the contract of rescission, and the substi- tute contract. Substituted contracts are perfectly valid, allowing the parties to effectively discharge the original contract and to impose obligations under the new one. The rescission is binding in that, as long as each party still had rights under the original contract, each has, by giving up those rights, provided consideration to the other.

Settlement of an Undisputed Debt An undisputed debt is an obligation that is not contested as to its existence and its amount. Under the common law, the payment of a lesser sum of money than is owed in consideration of a promise to discharge a fully matured, undisputed debt is legally insufficient to support the promise of discharge. To illustrate, assume that Barbara owes Arnold $100, and in consideration of Barbara’s paying him $50.00, Arnold agrees to discharge the debt.

In a subsequent suit by Arnold against Barbara to recover the remaining $50.00, at common law Arnold is entitled to a judgment for $50.00 on the ground that Arnold’s promise of discharge is not binding, because Barbara’s payment of $50.00 was no legal detriment to the promisee, Barbara, because she was under a preexist- ing legal obligation to pay that much and more. Conse- quently, the consideration for Arnold’s promise of discharge was legally insufficient, and Arnold is not bound by his promise. If, however, Arnold had accepted from Barbara any new or different consideration, such as the sum of $40.00 and a fountain pen worth $10.00 or less, or even the fountain pen with no payment of money, in full satisfaction of the $100 debt, the consid- eration moving from Barbara would be legally sufficient because Barbara was under no legal obligation to give a fountain pen to Arnold. In this example, consideration would also exist if Arnold had agreed to accept $50.00 before the debt became due, in full satisfaction of the debt. Barbara was under no legal obligation to pay any of the debt before its due date. Consequently, Barbara’s

FIGURE 12-1 Modification of a Preexisting Contract

Common Law

Original Contract

Consideration is required

Consideration is required

Consideration is required

Replaces original contract

Replaces original contract

Restatement

UCC

Modifying Contract

Consideration is required

Consideration is required unless modification is

fair and equitable in light of facts not anticipated when contract

was made

No consideration is required if

modification is made in

good faith

Modified Contract

Replaces original contract

+ =

Chapter 12 Consideration 253

early payment would constitute a legal detriment to Barbara as well as a legal benefit to Arnold. The com- mon law is not concerned with the amount of the dis- count, because that is simply a question of adequacy. Likewise, Barbara’s payment of a lesser amount on the due date at an agreed-upon different place of payment would be legally sufficient consideration. The Restate- ment, however, requires that the new consideration “differ[s] from what was required by the duty in a way which reflects more than a pretense of bargain.”

Settlement of a Disputed Debt A disputed debt is an obligation whose existence or amount is con- tested. A promise to settle a validly disputed claim in exchange for an agreed payment or other performance is supported by consideration. Where the dispute is based on contentions without merit or not made in good faith, the debtor’s surrender of such contentions is not a legal detriment to the claimant. The Restatement adopts a dif- ferent position by providing that the settlement of a claim that proves invalid is consideration if at the time of the settlement (1) the claimant honestly believed that the claim was valid or (2) the claim was in fact doubtful because of uncertainty as to the facts or the law.

For example, in situations in which a person has requested professional services from an accountant or a lawyer and no agreement has been made about the amount of the fee to be charged, the client has a legal obligation to pay the reasonable value of the services per- formed. Because no definite amount was agreed on, the client’s obligation is uncertain. When the accountant or lawyer sends the client a bill for services rendered, even though the amount stated in the bill is an estimate of the reasonable value of the services, the debt does not become undisputed until and unless the client agrees to pay the amount of the bill. If the client honestly disputes the amount that is owed and offers in full settlement an amount less than the bill, acceptance of the lesser amount by the accountant or lawyer discharges the debt. Thus, if Andy sends to Bess, an accountant, a check for $120 in full payment of his debt to Bess for services rendered, which services Andy considered worthless but for which Bess billed Andy $600, Bess’s acceptance (cashing) of the check releases Andy from any further liability. Andy has given up his right to dispute the billing further, and Bess has forfeited her right to further collection. Thus, there is mutuality of consideration.

PRACTICAL ADVICE If your contract is validly disputed, carefully consider whether to accept any payment marked “payment in full.”

BARGAINED-FOR EXCHANGE [12-2] The central idea behind consideration is that the parties have intentionally entered into a bargained-for exchange with each other and have each given to the other some- thing in a mutually agreed-upon exchange for his prom- ise or performance. Thus, a promise to give someone a birthday present is without consideration, because the promisor received nothing in exchange for her promise of a present.

PRACTICAL ADVICE Because a promise to make a gift is generally not legally enforceable, obtain delivery of something that shows your control or ownership of the item to make it an executed gift.

Past Consideration [12-2a] Consideration, as previously defined, is the inducement for a promise or performance. The element of exchange is absent where a promise is given for an act already done. Therefore, unbargained-for past events are not con- sideration, despite their designation as past consideration. A promise made on account of something that the prom- isee has already done is not enforceable. For example, Diana installs Tom’s complex new car stereo and speak- ers. Tom subsequently promises to reimburse Diana for her expenses, but his promise is not binding because there is no bargained-for exchange. See DiLorenzo v. Valve and Primer Corporation later in this chapter.

Third Parties [12-2b] Consideration to support a promise may be given to a person other than the promisor if the promisor bar- gains for that exchange. For example, A promises to pay B $15.00 if B delivers a specified book to C.

A

C

B $15

boo k

Promisor

Beneficiary

Promisee

A’s promise is binding because B incurred a legal detriment by delivering the book to C, because B was under no prior legal obligation to do so, and A had no

254 Contracts Part III

prior legal right to have the book given to C. A and B have bargained for A to pay B $15.00 in return for B’s delivering the book to C. A’s promise to pay $15.00 is also consideration for B’s promise to give C the book.

Conversely, consideration may be given by some per- son other than the promisee. For example, A promises to pay B $25.00 in return for D’s promise to give a radio to A. A’s promise to pay $25.00 to B is considera- tion for D’s promise to give a radio to A and vice versa.

CONTRACTS WITHOUT CONSIDERATION [12-3] Certain transactions are enforceable even though they are not supported by consideration.

Promises to Perform Prior Unenforceable Obligations [12-3a] In certain circumstances the courts will enforce new promises to perform an obligation that originally was not enforceable or that has become unenforceable by operation of law. These situations include promises to pay debts barred by the statute of limitations, debts dis- charged in bankruptcy, and voidable obligations. In addition, some courts will enforce promises to pay moral obligations.

Promise to Pay Debt Barred by the Statute of Limitations Every state has a statute of limita- tions stating that legal actions to enforce a debt must be brought within a prescribed period of time after the rights to bring the action arose. Actions not begun within the specified period—such periods vary among the states and also with the nature of the legal action— will be dismissed.

An exception to the past consideration rule extends to promises to pay all or part of a contractual or quasi- contractual debt barred by the statute of limitations. The new promise is binding according to its terms, without consideration, for a second statutory period. Any recov- ery under the new promise is limited to the terms con- tained in the new promise. Most states require that new promises falling under this rule, except those partially paid, must be in writing to be enforceable.

Promise to Pay Debt Discharged in Bank- ruptcy A promise to pay a debt that has been dis- charged in bankruptcy is also enforceable without consideration. The Bankruptcy Code, however, imposes a number of requirements that must be met before such

a promise may be enforced. These requirements are dis- cussed in Chapter 38.

Voidable Promises Another promise that is en- forceable without new consideration is a new promise to perform a voidable obligation that has not previously been avoided. The power of avoidance may be based on lack of capacity, fraud, misrepresentation, duress, undue influence, or mistake. For instance, a promise to perform an antecedent obligation made by a minor upon reach- ing the age of majority is enforceable without new con- sideration. To be enforceable, the promise itself must not be voidable. For example, if the new promise is made without knowledge of the original fraud or by a minor before reaching the age of majority, then the new promise is not enforceable.

Moral Obligation Under the common law and in most states, a promise made to satisfy a preexisting moral obligation is made for past consideration and therefore is unenforceable for lack of consideration. Instances involv- ing such moral obligations include promises to pay another for board and lodging previously furnished to one’s needy relative and promises to pay debts owed by a relative.

The Restatement and a minority of states recognize moral obligations as consideration. The Restatement provides that a promise made for “a benefit previously received by the promisor from the promisee is binding to the extent necessary to prevent injustice.” For instance, under the Restatement, Tim’s subsequent promise to Donna to reimburse her for expenses she incurred in ren- dering emergency services to Tim’s son is binding even though it is not supported by new consideration.

Promissory Estoppel [12-3b] As discussed in Chapter 9, in certain circumstances in which there has been detrimental reliance, the courts enforce noncontractual promises under the doctrine of promissory estoppel. When applicable, the doctrine makes gratuitous promises enforceable to the extent necessary to avoid injustice. The doctrine applies when a promise that the promisor should reasonably expect to induce detrimental reliance does induce such action or forbearance.

Promissory estoppel does not mean that a promise given without consideration is binding simply because it is followed by a change of position on the part of the promisee. Such a change of position in justifiable reli- ance on the promise creates liability if injustice can be avoided only by the enforcement of the promise. For example, Ann promises Larry not to foreclose for a

Chapter 12 Consideration 255

period of six months on a mortgage Ann owns on Larry’s land. Larry then changes his position by spend- ing $100,000 to construct a building on the land. Ann’s promise not to foreclose is binding on her under the doctrine of promissory estoppel.

The most common application of the doctrine of prom- issory estoppel is to charitable subscriptions. Numerous churches, memorials, college buildings, stadiums, hospi- tals, and other structures used for religious, educational, or charitable purposes have been built with the assistance of contributions made through fulfillment of pledges or promises to contribute to particular worthwhile causes.

Although the pledgor regards herself as making a gift for a charitable purpose and gift promises tend not to be enforceable, the courts have generally enforced charitable subscription promises. Although various reasons and theories have been advanced in support of liability, the one most commonly accepted is that the subscription has induced a change of position by the promisee (the church, school, or charitable organization) in reliance on the promise. The Restatement, moreover, has relaxed the reliance requirement for charitable subscriptions so that actual reliance need not be shown; the probability of reli- ance is sufficient.

D I L O R E N Z O V . V A L V E & P R I M E R C O R P O R A T I O N A p p e l l a t e C o u r t o f I l l i n o i s , F i r s t D i s t r i c t , F i f t h D i v i s i o n , 2 0 0 4

8 0 7 N . E . 2 d 6 7 3 , 2 8 3 I l l . D e c . 6 8

FACTS DiLorenzo, a forty-year employee of Valve & Primer, was also an officer, director, and shareholder of one hundred shares of stock. DiLorenzo claims that in 1987 Valve & Primer offered him a ten-year stock option that would allow DiLorenzo to purchase an additional three hundred shares at the fixed price of $250 per share. DiLorenzo claims that in reliance on that employment agreement, he stayed in his job for over nine additional years and did not follow up on any of several recruitment offers from other companies. Valve & Primer claims the 1987 employment agreement between it and DiLorenzo did not contain a stock pur- chase agreement. The only purported proof of the agree- ment is an unsigned copy of board meeting minutes of which DiLorenzo had the only copy.

In January 1996, DiLorenzo entered into a semi- retirement agreement with Valve & Primer, and he attempted to tender his remaining one hundred shares pursuant to a stock redemption agreement. Shortly thereafter, Valve & Primer fired DiLorenzo. DiLorenzo argued before the trial court that, even if the purported agreement was not found to be valid, it should be enforced on promissory estoppel grounds. Valve & Primer moved for summary judgment, which the trial court granted for lack of consideration. The trial court denied the promissory estoppel claim because of insuffi- cient reliance. DiLorenzo appealed.

DECISION The trial court’s grant of Valve & Pri- mer’s motion for summary judgment is affirmed.

OPINION Reid, J. We begin by addressing whether there was consideration for the stock options. “A stock option is the right to buy a share or shares of stock at a

specified price or within a specified period.” [Citation.] In order to evaluate the nature and scope of the stock options issued to DiLorenzo, we must assume, for pur- poses of this portion of our discussion, that DiLorenzo’s corporate minutes are valid.

“A contract, to be valid, must contain offer, accep- tance, and consideration; to be enforceable, the agree- ment must also be sufficiently definite so that its terms are reasonably certain and able to be determined.” [Citation.] “A contract is sufficiently definite and certain to be enforceable if the court is able from its terms and provisions to ascertain what the parties intended, under proper rules of construction and applicable principles of equity.” [Citation.] “A contract may be enforced even though some contract terms may be missing or left to be agreed upon, but if essential terms are so uncertain that there is no basis for deciding whether the agreement has been kept or broken, there is no contract.” [Citation.] A bonus promised to induce an employee to continue his employment is supported by adequate consideration if the employee is not already bound by contract to con- tinue. [Citation.] Because we are assuming the validity of the document issuing the stock options, we now turn to whether the underlying option is supported by valid consideration so as to make it a proper contract.

“Consideration is defined as the bargained-for exchange of promises or performances and may consist of a promise, an act or a forbearance.” [Citation.]

The general principles applicable to option contracts have been long established. An option contract has two elements, an offer to do something, or to forbear, which does not become a contract until accepted; and an agreement to leave the offer open for a specified time, [citation], or for a reasonable time, [citation]. An option contract must be

256 Contracts Part III

supported by sufficient consideration; and if not, it is merely an offer which may be withdrawn at any time prior to a tender of compliance. [Citation.] If a consideration of “one dollar” or some other consideration is stated but which has, in fact, not been paid, the document is merely an offer which may be withdrawn at any time prior to a tender of compliance. The document will amount only to a continuing offer which may be withdrawn by the offeror at any time before acceptance. [Citation.] The consideration to support an option consists of “some right, interest, profit or benefit accruing to one party, or some forbearance, detri- ment, loss or responsibility given, suffered or undertaken by the other’ [citation]; or otherwise stated, “Any act or prom- ise which is of benefit to one party or disadvantage to the other *** .” [Citation.]

“The preexisting duty rule provides that where a party does what it is already legally obligated to do, there is no consideration because there has been no det- riment.” [Citation.]

Focusing on the lack of a detriment to the employee, the trial court found no valid consideration. Based upon our view of the discussion in [citation], the trial court was correct in concluding that the option con- tract is merely an offer which may be withdrawn at any time prior to a tender of compliance. DiLorenzo could have exercised the option the moment it was pur- portedly made, then immediately quit, thereby giving nothing to the employer. Though the exercise of the option would require the transfer of money for the stock, the option itself carries with it no detriment to DiLorenzo. Therefore, there was no consideration for the option.

*** We next address DiLorenzo’s claim that he is entitled

to the value of the shares of stock based upon the theory of promissory estoppel. DiLorenzo argues that the trial court misapplied the law in finding that there was insuffi- cient reliance to support a claim for promissory estoppel. He claims that, once the trial court decided there was insufficient consideration to support the option contract, promissory estoppel should have been applied by the court to enforce the agreement as a matter of equity. DiLorenzo argues that he detrimentally relied upon Valve & Primer’s promise in that he worked at Valve & Primer for an additional period in excess of nine years in reli- ance on the stock option agreement. ***

Valve & Primer responds that the trial court was cor- rect in finding insufficient reliance to support the prom- issory estoppel claim. Valve & Primer argues that the DiLorenzo could not satisfy the detrimental reliance prong of the promissory estoppel elements. Though DiLorenzo claimed he did not act upon offers of employment he claims were made by other companies

during the course of his employment with Valve & Primer, he presented to the trial court nothing but his own testimony in support of his claim. Valve & Primer argues that, since DiLorenzo essentially is claiming his stock option vested immediately, he cannot contend that he detrimentally relied upon the purported agreement in the corporate minutes by turning down those other opportunities. *** For purposes of promissory estoppel, if DiLorenzo’s allegations are taken as true, and the pur- ported option vested immediately, it required nothing of him in order to be exercised other than the payment of $250 per share.

“Promissory estoppel arises when (1) an unambigu- ous promise was made, (2) the defendant relied on the promise, (3) the defendant’s reliance on the promise was reasonable, and (4) the defendant suffered a detriment.” [Citation.] Whether detrimental reliance has occurred is determined according to the specific facts of each case. [Citation.]

While we would accept that, under certain circum- stances, it may be possible for a relinquishment of a job offer to constitute consideration sufficient to sup- port a contract, this is not such a case. There is nothing in the language of the corporate minutes or any other source to be found in this record to suggest that Valve & Primer conditioned the alleged stock option on DiLorenzo’s promise to remain in his employment. While the corporate minutes say the alleged grant of the stock option was intended to “retain and reward,” it contains no mechanism making the retention manda- tory. Since the corporate minutes lack a mandatory obligation on which DiLorenzo could have reasonably detrimentally relied, and he could have elected to buy the shares of stock immediately, DiLorenzo’s decision to remain on the job for the additional period of over nine years must be viewed as a voluntary act. Under those circumstances, promissory estoppel would not apply. It was, therefore, not an abuse of discretion to grant Valve & Primer’s motion for summary judgment on that issue.

INTERPRETATION Past consideration is not legal consideration to support a promise; promissory estoppel requires detrimental reliance.

ETHICAL QUESTION Did the parties act ethically? Explain.

CRITICAL THINKING QUESTION What would have satisfied the consideration requirement in this case?

Chapter 12 Consideration 257

Contracts Under Seal [12-3c] Under the common law, when a person desired to bind himself by bond, deed, or solemn promise, he executed his promise under seal. He did not have to sign the document; rather, his delivery of a document to which he had affixed his seal was sufficient. No consideration for his promise was necessary. In some states a promise under seal is still binding without consideration.

Nevertheless, most states have abolished by statute the distinction between contracts under seal and written unsealed contracts. In these states, the seal is no longer recognized as a substitute for consideration. The Code also has adopted this position, specifically eliminating the use of seals in contracts for the sale of goods.

Promises Made Enforceable by Statute [12-3d] Some gratuitous promises that otherwise would be unenforceable have been made binding by statute. Most significant among these are (1) contract modifications, (2) renunciations, and (3) irrevocable offers.

Contract Modifications As mentioned previ- ously, the Uniform Commercial Code (UCC) has aban- doned the common law rule requiring that a modification

of an existing contract be supported by consideration to be valid. Instead, the Code provides that a contract for the sale of goods can be effectively modified without new consideration, provided the modification is made in good faith.

Renunciations Under the Revised UCC Article 1, a claim or right arising out of an alleged breach may be discharged in whole or in part without consideration by agreement of the aggrieved party in an authenticated record. Under the original Code, any claim or right arising out of an alleged breach of contract can be dis- charged in whole or in part without consideration by a written waiver or renunciation signed and delivered by the aggrieved party. Under both versions of the Code, this provision is subject to the obligation of good faith and, as with all sections of Article 1, applies to a trans- action to the extent that it is governed by one of the other articles of the UCC.

Firm Offers Under the Code, a firm offer, a written offer signed by a merchant offeror to buy or sell goods, is not revocable for lack of consideration during the time within which it is stated to be open, not to exceed three months or, if no time is stated, for a reasonable time. For a summary of consideration, see Figure 12-2.

Business Law IN ACTION

Computer Castle agreed to custom configure sev-enty-five personal computers and deliver them to Delber Data Corp. within ninety days. The price of each computer was $899, and Delber Data also agreed to a “Service-Pak” extended warranty plan for each unit purchased.

Computer Castle’s employees worked diligently to get the order ready and had only five computers left to con- figure when a next-generation operating system hit the market. Prices for computers carrying the old operating system plummeted. Delber Data quickly sought to change its order, but Computer Castle had already built nearly all the computers. Delber admitted it could still use the com- puters with the old operating system but felt that at a minimum Computer Castle should grant a price concession.

The computers Delber Data had agreed to buy could now be sold for only $699 each at most. Not wanting to lose a possible long-term business relationship, Computer

Castle agreed to lower the price of the Delber Data com- puters to $799 each. Computer Castle faxed a short note to Delber confirming the new price. Thus, Delber Data has given no consideration to support the new contract price—indeed Delber is getting the very same computers for less than it originally agreed to pay.

Whether Computer Castle’s price reduction will be en- forceable depends on what law governs the parties’ con- tract. Though Delber did purchase the warranty plan, a service, the contract is clearly one for the sale of goods— the predominant purpose of the contract is the purchase of configured personal computers. The price reduction, then, is a modification of a sales contract and is governed by the Uniform Commercial Code. Despite the lack of con- sideration, the Code permits enforcement of this contract modification, as the change was agreed to by both parties and sought by Delber in good faith, here based on the unanticipated emergence of newer technology.

258 Contracts Part III

FIGURE 12-2 Consideration

No

No

No

No

No

Yes

Yes

Yes

Yes

Yes

A promises B

In exchange for A’s promise, B incurs a legally sufficient consideration by doing an act forbearing from acting promising to do an act promising to forbear

A’s promise is to pay an obligation barred by the statute of limitations discharged in bankruptcy that is voidable

B detrimentally and justifiably relies on A’s promise and A should reasonably have expected such reliance

A’s promise is made under seal and delivered to B

A’s promise is subject to the UCC and is a modification of a sales contract renunciation of a claim firm offer by a merchant

A’s promise is not binding

A’s promise is binding: it is supported by consideration

A’s promise is binding without consideration

A’s promise is binding to the extent necessary to avoid injustice under the doctrine of promissory estoppel

A’s promise is binding in those states that recognize the seal as a substitute for consideration

A’s promise is binding under the UCC

Chapter 12 Consideration 259

C H A P T E R S U M M A R Y Consideration

Definition the inducement to enter into a contract

Elements legal sufficiency and bargained-for exchange

Legal Sufficiency of Consideration

Definition consists of either a benefit to the promisor or a detriment to the promisee • Legal Benefit obtaining something to which one had no prior legal right • Legal Detriment doing an act one is not legally obligated to do or not doing an act that one

has a legal right to do

Adequacy of Consideration not required where the parties have freely agreed to the exchange

Illusory Promise promise that imposes no obligation on the promisor; the following promises are not illusory • Output Contract agreement to sell all of one’s production to a single buyer • Requirements Contract agreement to buy all of one’s needs from a single producer • Exclusive Dealing Contract grant to a franchisee or licensee by a manufacturer of the sole right

to sell goods in a defined market • Conditional Contract a contract in which the obligations are contingent upon the occurrence of

a stated event

Preexisting Public Obligations public duties such as those imposed by tort or criminal law are neither a legal detriment nor a legal benefit

Preexisting Contractual Obligation performance of a preexisting contractual duty is not consideration • Modification of a Preexisting Contract under the common law a modification of a preexisting

contract must be supported by mutual consideration; under the Code a contract can be modified without new consideration

Ethical Dilemma Should a Spouse’s Promise Be Legally Binding?

FACTS Joan Kantor is a social worker for the employ- ees of Surf & Co., a towel manufacturer. Stan Koronetsky, a Surf employee, has confided the following problems to Kantor.

Koronetsky and his wife, Paula, have been married for ten years. Koronetsky states that three years ago his wife was unfaithful and Koronetsky began a divorce proceeding. When Paula Koronetsky promised to refrain from further infi- delity and to attend marital counseling sessions, Koronetsky agreed to stop the divorce proceeding. However, although Stan dropped the divorce proceeding, his wife never attended counseling.

Koronetsky is also upset because he and his wife had agreed that she would attend medical school while he worked to support her. In exchange for his promise to put her through medical school, Paula promised that she would

support him while he obtained his MBA degree. But after Paula became a doctor, she refused to support him; conse- quently, Stan never got his master’s degree.

Social, Policy, and Ethical Considerations 1. What should Joan Kantor do in this situation? What is

the scope of her counseling responsibilities?

2. Should agreements between married parties be enforced in a court of law? If so, what types of agreements should be enforceable?

3. What are the individual interests at stake in this situa- tion? Is it reasonable to assume that spouses make many private agreements and that generally these agreements are made without the intention of their being legally binding?

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• Substituted Contracts the parties agree to rescind their original contract and to enter into a new one; rescission and new contract are supported by consideration

• Settlement of an Undisputed Debt payment of a lesser sum of money to discharge an undisputed debt (one whose existence and amount are not contested) does not constitute legally sufficient consideration

• Settlement of a Disputed Debt payment of a lesser sum of money to discharge a disputed debt (one whose existence or amount is contested) is legally sufficient consideration

Bargained-for Exchange

Definition a mutually agreed-upon exchange

Past Consideration an act done before the contract is made is not consideration

Contracts Without Consideration

Promises to Perform Prior Unenforceable Obligations • Promise to Pay Debt Barred by the Statute of Limitations a new promise by the debtor to pay

the debt renews the running of the statute of limitations for a second statutory period • Promise to Pay Debt Discharged in Bankruptcy may be enforceable without consideration • Voidable Promises a new promise to perform a voidable obligation that has not been

previously avoided is enforceable • Moral Obligation a promise made to satisfy a preexisting moral obligation is generally

unenforceable for lack of consideration

Promissory Estoppel doctrine that prohibits a party from denying his promise when the promisee takes action or forbearance to his detriment reasonably based upon the promise

Contracts Under Seal where still recognized, the seal acts as a substitute for consideration

Promises Made Enforceable by Statute some gratuitous promises have been made enforceable by statute; the Code makes enforceable (1) contract modifications, (2) renunciations, and (3) firm offers

Q U E S T I O N S

1. In consideration of $1,800 paid to him by Joyce, Hill gave Joyce a written option to purchase his house for $180,000 on or before April 1. Prior to April 1, Hill ver- bally agreed to extend the option until July 1. On May 18, Hill, known to Joyce, sold the house to Gray, who was ignorant of the unrecorded option. On May 20, Joyce sent an acceptance to Hill, who received it on May 25. Is there a contract between Joyce and Hill? Explain.

2. a. Ann owed $2,500 to Barry for services Barry rendered to Ann. The debt was due June 30, 2015. In March 2016, the debt was still unpaid. Barry was in urgent need of ready cash and told Ann that if she would pay $1,500 on the debt at once, Barry would release her from the balance. Ann paid $1,500 and stated to Barry that all claims had been paid in full. In August 2016, Barry demanded the unpaid balance and subse- quently sued Ann for $1,000. Result?

b. Modify the facts in (a) by assuming that Barry gave Ann a written receipt stating that all claims had been paid in full. Result?

c. Modify the facts in (a) by assuming that Ann owed Barry the $2,500 on Ann’s purchase of a motorcycle from Barry. Result?

3. a. Judy orally promises her daughter, Liza, that she will give her a tract of land for her home. Liza, as intended by Judy, gives up her homestead and takes possession of the land. Liza lives there for six months and starts construction of a home. Is Judy bound to convey the real estate?

b. Ralph, knowing that his son, Ed, desires to purchase a tract of land, promises to give him the $25,000 he needs for the purchase. Ed, relying on this promise, buys an option on the tract of land. Can Ralph rescind his promise?

4. George owed Keith $800 on a personal loan. Neither the amount of the debt nor George’s liability to pay the $800 was disputed. Keith had also rendered services as a carpenter to George without any agreement as to the price to be paid. When the work was completed, an

Chapter 12 Consideration 261

honest and reasonable difference of opinion developed between George and Keith with respect to the value of Keith’s services. Upon receiving Keith’s bill for the car- pentry services for $600, George mailed in a properly stamped and addressed envelope his check for $800 to Keith. In an accompanying letter, George stated that the enclosed check was in full settlement of both claims. Keith endorsed and cashed the check. Thereafter, Keith unsuccessfully sought to collect from George an alleged unpaid balance of $600. May Keith recover the $600 from George?

5. The Snyder Mfg. Co., being a large user of coal, entered into separate contracts with several coal companies. In each contract, it was agreed that the coal company would supply coal during the year in such amounts as the manufacturing company might desire to order, at a price of $55.00 per ton. In February of that year, the Snyder Company ordered one thousand tons of coal from Union Coal Company, one of the contracting par- ties. Union Coal Company delivered five hundred tons of the order and then notified Snyder Company that no more deliveries would be made and that it denied any obligation under the contract. In an action by Union Coal to collect $55.00 per ton for the five hundred tons of coal delivered, Snyder files a counterclaim, claiming damages of $1,500 for failure to deliver the additional five hundred tons of the order and damages of $4,000 for breach of agreement to deliver coal during the bal- ance of the year. What contract, if any, exists between Snyder and Union?

6. On February 5, Devon entered into a written agreement with Gordon whereby Gordon agreed to drill a well on Devon’s property for the sum of $5,000 and to complete the well on or before April 15. Before entering into the contract, Gordon had made test borings and had satis- fied himself as to the character of the subsurface. After two days of drilling, Gordon struck hard rock. On Feb- ruary 17, Gordon removed his equipment and advised Devon that the project had proved unprofitable and that he would not continue. On March 17, Devon went to Gordon and told Gordon that he would assume the risk of the enterprise and would pay Gordon $100 for each day required to drill the well, as compensation for labor, the use of Gordon’s equipment, and Gordon’s services in supervising the work, provided Gordon would furnish certain special equipment designed to cut through hard rock. Gordon said that the proposal was satisfactory. The work was continued by Gordon and completed in an additional fifty-eight days. Upon com- pletion of the work, Devon failed to pay, and Gordon brought an action to recover $5,800. Devon answered that he had never become obligated to pay $100 a day and filed a counterclaim for damages in the amount of $500 for the month’s delay based on an alleged breach

of contract by Gordon. Explain who will prevail and why.

7. Discuss and explain whether there is valid consideration for each of the following promises:

a. A and B entered into a contract for the purchase and sale of goods. A subsequently promised to pay a higher price for the goods when B refused to deliver at the contract price.

b. A promised in writing to pay a debt, which was due from B to C, on C’s agreement to extend the time of payment for one year.

c. A orally promised to pay $150 to her son, B, solely in consideration of past services rendered to A by B, for which there had been no agreement or request to pay.

8. Alan purchased shoes from Barbara on open account. Barbara sent Alan a bill for $10,000. Alan wrote back that two hundred pairs of the shoes were defective and offered to pay $6,000 and give Barbara his promissory note for $1,000. Barbara accepted the offer, and Alan sent his check for $6,000 and his note in accordance with the agreement. Barbara cashed the check, collected on the note, and one month later sued Alan for $3,000. Is Barbara bound by her acceptance of the offer?

9. Nancy owed Sharon $1,500, but Sharon did not initiate a lawsuit to collect the debt within the time period pre- scribed by the statute of limitations. Nevertheless, Nancy promises Sharon that she will pay the barred debt. There- after, Nancy refuses to pay. Sharon brings suit to collect on this new promise. Is Nancy’s new promise binding? Explain.

10. Anthony lends money to Frank, who dies without having repaid the loan. Frank’s widow, Carol, promises Anthony to repay the loan. Upon Carol’s refusal to pay the loan, Anthony brings suit against Carol for payment. Is Carol bound by her promise to pay the loan?

11. The parties entered into an oral contract in June under which the plaintiff agreed to construct a building for the defendant on a time and materials basis, at a maximum cost of $56,146, plus sales tax and extras ordered by the defendant. When the building was 90 percent com- pleted, the defendant told the plaintiff he was unhappy with the whole job as “the thing just wasn’t being run right.” The parties then, on October 17, signed a writ- ten agreement lowering the maximum cost to $52,000 plus sales tax. The plaintiff thereafter completed the building at a cost of $64,155. The maximum under the June oral agreement, plus extras and sales tax, totaled $61,040. Explain whether the defendant is obligated to pay only the lower maximum fixed by the October 17 agreement.

262 Contracts Part III

C A S E P R O B L E M S

12. Taylor assaulted his wife, who then took refuge in Ms. Harrington’s house. The next day, Mr. Taylor entered the house and began another assault on his wife. Taylor’s wife knocked him down and, while he was lying on the floor, attempted to cut his head open or decapitate him with an ax. Harrington intervened to stop the bloodshed and was hit by the ax as it was descending. The ax fell upon her hand, mutilating it badly, but sparing Taylor his life. After- wards, Taylor orally promised to compensate Harrington for her injury. Is Taylor’s promise enforceable? Explain.

13. Jonnel Enterprises, Inc., contracted to construct a student dormitory at Clarion State College. On May 6, Jonnel entered into a written agreement with Graham and Long as electrical contractors to perform the electrical work and to supply materials for the dormitory. The contract price was $70,544.66. Graham and Long claim that they believed the May 6 agreement obligated them to perform the electrical work on only one wing of the building, but that three or four days after work was started, a second wing of the building was found to be in need of wiring. At that time, Graham and Long informed Jonnel that they would not wire both wings of the building under the present contract, so the parties orally agreed upon a new contract. Under the new contract, Graham and Long were obligated to wire both wings and were to be paid only $65,000, but they were relieved of the obligations to supply entrances and a heating system. Graham and Long resumed their work, and Jonnel made seven of the eight progress payments called for. When Jonnel did not pay the final payment, Graham and Long brought this action. Jonnel claims that the May 6 contract is control- ling. Is Jonnel correct in its assertion? Why?

14. Baker entered into an oral agreement with Healey, the state distributor of Ballantine & Sons’ liquor products, that Ballantine would supply Baker with its products on demand and that Baker would have the exclusive agency for Ballantine within a certain area of Connecticut. Shortly thereafter, the agreement was modified to give Baker the right to terminate at will. Eight months later, Ballantine & Sons revoked its agency. May Baker enforce the oral agreement? Explain.

15. PLM, Inc., entered into an oral agreement with Quaint- ance Associates, an executive “headhunter” service, for the recruitment of qualified candidates to be employed by PLM. As agreed, PLM’s obligation to pay Quaintance did not depend on PLM actually hiring a qualified candi- date presented by Quaintance. After several months Quaintance sent a letter to PLM, admitting that it had so far failed to produce a suitable candidate, but included a bill for $9,806.61, covering fees and expenses. PLM responded that Quaintance’s services were only worth

$6,060.48 and that payment of the lesser amount was the only fair way to handle the dispute. Accordingly, PLM enclosed a check for $6,060.48, writing on the back of the check “IN FULL PAYMENT OF ANY CLAIMS QUAINTANCE HAS AGAINST PLM, INC.” Quaintance cashed the check and then sued PLM for the remaining $3,746.13. Decision?

16. Red Owl Stores told the Hoffman family that upon the payment of approximately $518,000, a grocery store fran- chise would be built for them in a new location. On the advice of Red Owl, the Hoffmans bought a small grocery store in their hometown to get management experience. After the Hoffmans operated at a profit for three months, Red Owl advised them to sell the small grocery, assuring them that Red Owl would find them a larger store else- where. Although selling at that point would cost them much profit, the Hoffmans followed Red Owl’s directions. Additionally, to raise the required money for the deal, the Hoffmans sold their bakery business in their hometown. The Hoffmans also sold their house and moved to a new home in the city where their new store was to be located. Red Owl then informed the Hoffmans that it would take $524,100, not $518,000, to complete the deal. The family scrambled to find the additional funds. However, when told by Red Owl that it would now cost them $534,000 to get their new franchise, the Hoffmans decided to sue instead. Should Red Owl be held to its promises? Explain.

17. The plaintiff, Brenner, entered into a contract with the defendant, Little Red School House, Ltd., which stated that in return for a nonrefundable tuition of $1,080, Brenner’s son could attend the defendant’s school for a year. When Brenner’s ex-wife refused to enroll their son, the plaintiff sought and received a verbal promise of a refund. The defendant now refuses to refund the plain- tiff’s money for lack of consideration. Did mutual consid- eration exist between the parties? Explain.

18. Tender Loving Care, Inc. (TLC), a corporation owned and operated by Virginia Bryant, eventually went out of business. The Secretary of State canceled its corporate charter, and a check drawn on TLC’s account made out to the Department of Human Resources (DHR) to pay state unemployment taxes was returned for insufficient funds. Subsequently, Bryant filed individually for bank- ruptcy, listing the DHR as a creditor. This claim was not allowed, because Bryant was held not to be personally liable on the debts of TLC to the DHR. The DHR later called Bryant to its offices, where she was told that she needed to pay the debt owed to the DHR by TLC. Unable to contact her lawyer, Bryant was persuaded to sign a personal guarantee to cover the debt. Later, when Bryant refused to pay, the DHR filed suit. Decision?

Chapter 12 Consideration 263

19. Ben Collins was a full professor with tenure at Wisconsin State University in 2010. In March 2010, Parsons College, in an attempt to lure Dr. Collins from Wisconsin State, offered him a written contract promising him the rank of full professor with tenure and a salary of $65,000 for the 2010–11 academic year. The contract further provided that the College would increase his salary by $2,000 each year for the next five years. In return, Collins was to teach two trimesters of the academic year beginning in October 2010. In addition, the contract stipulated, by reference to the College’s faculty bylaws, that tenured professors could be dismissed only for just cause and after written charges were filed with the Professional Problems Committee. The two parties signed the contract, and Collins resigned his position at Wisconsin State.

In February 2012, the College tendered a different contract to Collins to cover the following year. This con- tract reduced his salary to $55,000 with no provision for annual increments, but left his rank of full professor intact. It also required that Collins waive any and all rights or claims existing under any previous employment contracts with the College. Collins refused to sign this new contract, and Parsons College soon notified him that he would not be employed the following year. The Col- lege did not give any grounds for his dismissal, nor did it file charges with the Professional Problems Committee. As a result, Collins was forced to take a teaching position at the University of North Dakota at a substantially reduced salary. He sued to recover the difference between the salary Parsons College promised him until 2016 and the amount he earned. Will he prevail? Explain.

20. Rodney and Donna Mathis (Mathis) filed a wrongful death action against St. Alexis Hospital and several physicians, arising out of the death of their mother, Mary Mathis. Several weeks before trial, an expert consulted by Mathis notified the trial court and Mathis’s counsel that, in his opinion, Mary Mathis’s death was not proxi- mately caused by the negligence of the physicians. Shortly thereafter, Mathis voluntarily dismissed the wrongful

death action. Mathis and St. Alexis entered into a cove- nant-not-to-sue in which Mathis agreed not to pursue any claims against St. Alexis or its employees in terms of the medical care of Mary Mathis. St. Alexis, in return, agreed not to seek sanctions, including attorney fees and costs incurred in defense of the previously dismissed wrongful death action. Subsequently, Mathis filed a sec- ond wrongful death action against St. Alexis Hospital, among others. Mathis asked the court to rescind the cov- enant-not-to-sue, arguing that because St. Alexis was not entitled to sanctions in connection with the first wrongful death action, there was no consideration for the cove- nant-not-to-sue. Is this contention correct? Explain.

21. Harold Pearsall and Joe Alexander were friends for more than twenty-five years. About twice a week they would get together after work and proceed to a liquor store, where they would purchase what the two liked to refer as a “package”—a half-pint of vodka, orange juice, two cups, and two lottery tickets. Occasionally, these lottery tickets would yield modest rewards of two or three dollars, which the pair would then “plow back” into the purchase of additional tickets. On December 16, Pearsall and Alexander visited the liquor store twice, buying their normal “package” on both occasions. For the first package, Pearsall went into the store alone, and when he returned to the car, he said to Alexander, in reference to the tickets, “Are you in on it?” Alexander said, “Yes.” When Pearsall asked him for his half of the purchase price, though, Alexander replied that he had no money. When they went to Alexander’s home, Alexander snatched the tickets from Pearsall’s hand and “scratched” them, only to find that they were both worth- less. Later that same evening Alexander returned to the liquor store and bought a second “package.” This time, Pearsall snatched the tickets from Alexander and said that he would “scratch” them. Instead, he gave one to Alexander, and each man scratched one of the tickets. Alexander’s was a $20,000 winner. Alexander cashed the ticket and refused to give Pearsall anything. Can Pearsall recover half of the proceeds from Alexander? Explain.

T A K I N G S I D E S

Anna Feinberg began working for the Pfeiffer Company in 1968 at age seventeen. By 2005, she had attained the posi- tion of bookkeeper, office manager, and assistant treasurer. In appreciation for her skill, dedication, and long years of service, the Pfeiffer board of directors resolved to increase Feinberg’s monthly salary to $4,000 and to create for her a retirement plan. The plan allowed that Feinberg would be given the privilege of retiring from active duty at any time she chose and that she would receive retirement pay of $2,000 per month for life, although the Board expressed the hope that Feinberg would continue to serve the company

for many years. Feinberg, however, chose to retire two years later. The Pfeiffer Company paid Feinberg her retire- ment pay until 2014. The company thereafter discontinued payments.

a. What are the arguments that the company’s promise to pay Feinberg $2,000 per month for life is enforceable?

b. What are the arguments that the company’s promise is not enforceable?

c. What is the proper outcome? Explain.

264 Contracts Part III

C H A P T E R 1 3

ILLEGAL BARGAINS

Pactis privatorum juri publico non derogatur. (Private contracts do not take away from public law.) LEGAL MAXIM

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Identify and explain the types of contracts that may violate a statute and distinguish between the two types of licensing statutes.

2. Describe when a covenant not to compete will be enforced and identify the two situations in which these types of covenants most frequently arise.

3. Explain when exculpatory agreements, agreements involving the commitment of a

tort, and agreements involving public officials will be held to be illegal.

4. Distinguish between procedural and substantive unconscionability.

5. Explain the usual effects of illegality and the major exceptions to this rule.

A legal objective is essential for a promise or

agreement to be binding. When the formation or performance of an agreement is criminal, tor-

tious, or otherwise contrary to public policy, the agree- ment is illegal and unenforceable (as opposed to being void). The law does not provide a remedy for the breach of an unenforceable agreement and thus “leaves the parties where it finds them.” (It is preferable to use the term illegal bargain or illegal agreement rather than illegal contract, because the word contract, by defini- tion, denotes a legal and enforceable agreement.) The illegal bargain is made unenforceable (1) to discourage such undesirable conduct in the future and (2) to avoid the inappropriate use of the judicial process in carrying out the socially undesirable bargain.

In this chapter, we will discuss (1) agreements in vio- lation of a statute, (2) agreements contrary to public policy, and (3) the effect of illegality on agreements.

VIOLATIONS OF STATUTES [13-1] The courts will not enforce an agreement declared illegal by statute. For example, “wagering or gambling contracts” are specifically declared unenforceable in most states. Likewise, an agreement induced by crimi- nal conduct will not be enforced. For example, if Alice enters into an agreement with Brent Co. through the bribing of Brent Co.’s purchasing agent, the agreement would be unenforceable.

265

Licensing Statutes [13-1a] Every jurisdiction has laws requiring a license for those who engage in certain trades, professions, or businesses. Common examples are licensing statutes that apply to lawyers, doctors, dentists, accountants, brokers, plumbers, and contractors. Some licensing statutes mandate schooling and/or examination, while others require only financial responsibility and/or good moral character. Whether a person who has failed to comply with a licensing requirement may recover for services rendered depends on the terms or type of licensing statute.

The statute itself may expressly provide that an unli- censed person engaged in a business or profession for which a license is required shall not recover for services rendered. Where there is no express statutory provision, the courts commonly distinguish between reg- ulatory statutes and those enacted merely to raise reve- nue through the issuance of licenses. If the statute is regulatory, a person cannot recover for professional services unless he has the required license as long as the public policy behind the regulatory purpose clearly out- weighs the person’s interest in being paid for his services.

Some courts balance the penalty suffered by the unli- censed party against the benefit received by the other party. In contrast, if the law is for revenue purposes only, agreements for unlicensed services are enforceable.

A regulatory license is a measure designed to protect the public from unqualified practitioners. Examples are licenses issued under statutes prescribing standards for those who seek to practice law or medicine or, as demonstrated by the following case, to engage in the construction business. A revenue license, on the other hand, does not seek to protect against incompetent or unqualified practitioners but serves simply to raise money. An example is a statute requiring a license of plumbers but not establishing standards of competence for those who practice the trade. The courts regard this as a taxing measure lacking any expression of legisla- tive intent to prevent unlicensed plumbers from enforc- ing their business contracts.

PRACTICAL ADVICE Obtain all necessary licenses before beginning to operate your business.

A L C O A C O N C R E T E & M A S O N R Y V . S T A L K E R B R O S . C o u r t o f S p e c i a l A p p e a l s o f M a r y l a n d , 2 0 1 0

9 9 3 A . 2 d 1 3 6 , 1 9 1 M d . A p p . 5 9 6

FACTS General contractor Stalker Brothers, Inc. (Stalker) from 2004 through 2007 hired a subcontractor Alcoa Concrete and Masonry, Inc. (Alcoa). Alcoa was unlicensed until March 26, 2008. In 2004, all of Alcoa’s invoices were fully and timely paid. When payments in 2005 became less regular, Stalker promised to pay Alcoa when a building owned by Stalker was sold, but full payment was not made. Alcoa continued to perform subcontract work for Stalker based on an agreement that Stalker would pay Alcoa $1,500 per week against invoices for past work and new work. In November 2006, Alcoa performed the cement and masonry work for Stalker on the “Cahill” job. In the summer of 2007, Stalker ceased paying Alcoa entirely.

Alcoa sued Stalker for $53,000 plus interest and attorneys’ fees. Stalker was granted a summary judg- ment on the ground that because Alcoa was not li- censed, the series of subcontracts were illegal and could not be enforced. The circuit court’s decision was based on a line of Maryland cases dealing with licensing,

which is illustrated in the home improvement field principally by Harry Berenter, Inc. v. Berman. If the purpose of a business licensing statute is to raise reve- nue, courts will enforce a contract for compensation for business activity that requires a license, even if made by an unlicensed person. But if the purpose of the licensing requirement is to protect the public, then the Maryland cases relied upon by the circuit court do not enforce contracts made by unlicensed persons who seek compen- sation for business activity for which a license is required.

DECISION The judgment of the circuit court is reversed, and the case remanded.

OPINION Rodowsky, J. At issue is whether a home improvement general contractor is contractually obligated to pay a subcontractor who was not licensed under the Act, either at the time of entering into the subcontract or

266 Contracts Part III

when the subcontract was properly performed, but who was licensed when this suit was brought.

*** Maryland appellate decisions have applied the reve-

nue/regulation rule in a number of contexts. All of the cases under the Act have dealt with the contractor-owner relationship. The members of the public who were pro- tected by the regulatory licensing requirement were the owners of the home. This Court recently again has held, applying Harry Berenter, that a contract between the owner of the improved premises and an unlicensed con- tractor would not be enforced. [Citation.] ***

*** Our review fails to disclose any Maryland appellate

decision directly answering whether the regulatory license rule applied in Harry Berenter, declaring unen- forceable a home improvement contract between an owner and an unlicensed contractor, applies to a sub- contract between a licensed contractor and an unli- censed subcontractor. Harry Berenter does recognize that, pursuant to provisions of the Act ***, the failure to comply with certain formal contractual requirements in a home improvement contract does not invalidate the contract. [Citation.]

*** The authors of Corbin on Contracts, after reviewing

the revenue/regulatory rule, state:

Even when the purpose of a licensing statute is regulatory, courts do not always deny enforcement to the unlicensed party. The statute clearly may protect against fraud and incompetence. Yet, in very many cases the situation involves neither fraud nor incompetence. The unlicensed party may have rendered excellent service or delivered goods of the highest quality. The noncompliance with the statute may be nearly harmless. The real defrauder may be the defendant who will be enriched at the unlicensed party’s expense by a court’s refusal to enforce the contract. Although courts have yearned for a mechanically applicable rule, most have not made one in the present instance. Justice requires that the penalty should fit the crime. Justice and sound policy do not always require the enforcement of licensing statutes by large forfeitures going not to the state but to repudiating defendants.

In most cases, the statute itself does not require such for- feitures. The statute fixes its own penalties, usually a fine or imprisonment of a minor character with a degree of discre- tion in the court. The added penalty of unenforceability of bargains is a judicial creation. In many cases, the court may be wise to apply this additional penalty. When nonenforce- ment causes great and disproportionate hardship, a court must avoid nonenforcement.

***

After the decision in Harry Berenter, in which the Court relied in part on the Restatement of Contracts, the American Law Institute adopted Restatement (Sec- ond) of Contracts (1981). Section 178 states a more flexible approach to enforceability than the rigid reve- nue/regulatory dichotomy. Section 178 reads:

When a Term Is Unenforceable on Grounds of Public Policy

(1) A promise or other term of an agreement is unenforce- able on grounds of public policy if legislation provides that it is unenforceable or the interest in its enforce- ment is clearly outweighed in the circumstances by a public policy against the enforcement of such terms.

(2) In weighing the interest in the enforcement of a term, account is taken of

(a) the parties’ justified expectations,

(b) any forfeiture that would result if enforcement were denied, and

(c) any special public interest in the enforcement of the particular term.

(3) In weighing a public policy against enforcement of a term, account is taken of

(a) the strength of that policy as manifested by legisla- tion or judicial decisions,

(b) the likelihood that a refusal to enforce the term will further that policy.

(c) the seriousness of any misconduct involved and the extent to which it was deliberate, and

(d) the directness of the connection between that mis- conduct and the term.

We find no indication in the Act or in the Maryland cases that a policy of the Act is to protect general con- tractors from unlicensed subcontractors. Consequently, the fact that the Act is a regulatory measure does not bar Alcoa from recovering on its subcontracts with Stalker.

INTERPRETATION A regulatory license is a measure to protect the public from unqualified practi- tioners; the failure to comply with such a regulation pre- vents the noncomplying party from recovering for services rendered if (1) the statute provides that a non- complying agreement is unenforceable or (2) the public policy behind the regulatory purpose clearly outweighs the noncomplying party’s interest in being paid for services rendered.

CRITICAL THINKING QUESTION When should the failure to obtain a license to operate a busi- ness prevent the owner or operator from receiving com- pensation for services?

Chapter 13 Illegal Bargains 267

Gambling Statutes [13-1b] In a wager, the parties stipulate that one shall win and the other lose depending on the outcome of an event in which their only “interest” is the possibility of such gain or loss. All states have legislation on gambling or wager- ing, and U.S. courts generally refuse to recognize the enforceability of a gambling agreement. Thus, if Smith makes a bet with Brown on the outcome of a ball game, the agreement is unenforceable by either party. Some states, however, now permit certain kinds of regulated gambling. Wagering conducted by government agencies, principally state-operated lotteries, has come to consti- tute an increasingly important source of public revenues.

PRACTICAL ADVICE Make sure that your promotions that offer prizes do not fall under state gambling statutes.

Usury Statutes [13-1c] A usury statute is a law establishing a maximum rate of permissible interest for which a lender and borrower of money may contract. Although historically every state had a usury statute, the recent trend is to limit or relax such statutes. Maximum permitted rates vary greatly from state to state and among types of transac- tions. These statutes typically are general in their appli- cation, and certain types of transactions are exempted altogether. For example, many states impose no limit on the rate of interest that may be charged on loans to corporations. Furthermore, some states permit the par- ties to contract for any rate of interest on loans made to individual proprietorships or partnerships for the purpose of carrying on a business. Moreover, there are not many protections remaining for typical consumer transactions, including those involving credit cards. More than half of the states have no interest rate limits on credit card transactions. Furthermore, under federal law, a national bank may charge the interest rate

allowed in the state in which the bank is located to cus- tomers living anywhere in the United States, including states with more restrictive interest caps.

In addition to the exceptions affecting certain desig- nated types of borrowers, a number of states have exempted specific lenders. For example, the majority of states have enacted installment loan laws, which permit eligible lenders a higher return on installment loans than otherwise would be permitted under the applicable general interest statute. These specific lender usury statutes, which have all but eliminated general usury statutes, vary greatly but generally encompass small consumer loans, retail installment sales acts, corporate loans, loans by small lenders, real estate mortgages, and numerous other transactions.

For a transaction to be usurious, courts usually re- quire evidence of the following factors: (1) a loan (2) of money (3) that is repayable absolutely and in all events (4) for which an interest charge is exacted in excess of the interest rate allowed by law. Nevertheless, the law does permit certain expenses or charges in addition to the maximum legal interest, such as payments made by a borrower to the lender for expenses incurred or for services rendered in good faith in making a loan or in obtaining security for its repayment. Permissible expenses commonly incurred by a lender include the costs of examining title, investigating the borrower’s credit rating, drawing necessary documents, and inspect- ing the property. If not excessive, such expenses are not considered in determining the rate of interest under the usury statutes. As shown in the following case, however, payments made to the lender from which he derives an advantage are considered if they exceed the reasonable value of services he actually rendered.

PRACTICAL ADVICE When calculating interest, consider all charges, including service fees, that exceed the actual reasonable expense of making the loan.

D U N N A M V . B U R N S C o u r t o f A p p e a l s o f T e x a s , E l P a s o , 1 9 9 5

9 0 1 S . W . 2 d 6 2 8

FACTS Defendant (Louis Dunnam) and Steve Oualline jointly borrowed $35,000 from plaintiff (Ken Burns) and agreed to repay the principal plus $5,000 six months later. After defendant defaulted on the loan, plaintiff sued to recover. Dunnam

defended by claiming the loan was usurious. The trial court ruled in favor of the plaintiff, and defendant appealed.

DECISION Judgment for defendant.

268 Contracts Part III

The legal effect of a usurious loan varies from state to state. In a few states, the lender forfeits both princi- pal and interest. In some jurisdictions, the lender can recover the principal but forfeits all interest. In other states, only that portion of interest exceeding the per- mitted maximum is forfeited, whereas in still other states, the amount forfeited is a multiple (double or tre- ble) of the interest charged. How the states deal with usurious interest already paid also varies. Some states do not allow the borrower to recover any of the usuri- ous interest she has paid; others allow recovery of such interest or a multiple of it.

VIOLATIONS OF PUBLIC POLICY [13-2] The reach of a statute may extend beyond its language. Sometimes the courts, by analogy, use a statute and the policy it embodies as a guide in determining a person’s rights under a private contract. Conversely, the courts

frequently must express the “public policy” of the state without significant help from statutory sources. This judicially declared public policy is very broad in scope, it often being said that agreements having “a tendency to be injurious to the public or the public good” are contrary to public policy. Contracts raising questions of public policy include agreements that (1) restrain trade, (2) excuse or exculpate a party from liability for his own negligence, (3) are unconscionable, (4) involve tor- tious conduct, (5) tend to corrupt public officials or impair the legislative process, (6) tend to obstruct the administration of justice, or (7) impair family relation- ships. This section will focus on the first five of these types of agreements.

Common Law Restraint of Trade [13-2a] A restraint of trade is any contract or agreement that eliminates or tends to eliminate competition or other- wise obstructs trade or commerce. One type of restraint

OPINION Barajas, J. Appellant claims the trial court erred by refusing to submit his usury defense to the jury. Usury is interest in excess of the amount per- mitted by law. [Citation.] Interest is compensation for the use or forbearance of money. [Citation.] For most transactions between private persons, the maximum allowable rate of interest is 18 percent if the parties agree on a rate of interest [citation], and 6 percent if they do not, [citation]. Usurious contracts are against public policy, [citation] and persons who contract for or collect usurious interest are subject to penalties that may exceed the total value of the contract. [Citation].

We must initially determine whether the $5,000 addi- tional sum contained in the promissory note constitutes interest. Interest need not be denominated interest. [Citation.] When money is advanced in exchange for an obligation to repay the advance plus an additional amount, the added amount is interest that may not exceed the statutory maximum. [Citations.] The fore- going principles instruct that Appellant’s absolute obli- gation to pay $5,000 in addition to the principal renders the additional amount interest.

Appellee [Burns] does not contest that the $5,000 is interest. Neither does he claim that the amount of inter- est was not usurious, although we note that the promis- sory note effectively charges a 28.57 percent interest rate, which exceeds even the highest rate permitted by statute [citation] (permitting 28 percent interest on cer- tain transactions). He argues, rather, that he did not “charge” such interest because the instrument was

drafted by Appellant and because Appellee was actually interested in collecting only the principal amount. In so arguing, Appellee misapprehends the significance of his intent and of the identity of the drafter of the promis- sory note.

A document that contains an absolute obligation to repay a loan together with interest in excess of the amount permitted by statute is usurious on its face. [Citations.] “It is not the lender’s subjective intent to charge usury that makes a loan usurious, but rather his intent to make the bargain that was made.” [Citations.] The specific intent of the lender is immaterial because it is presumed to be reflected in the document he signs. [Citations.] Further, “once the agreed terms have been reduced to writing in the form of a compulsory contract, the test of alleged usury is not concerned with which party might have originated the alleged[ly] usurious provisions.” [Citations.]

*** The drafter of the usurious promissory note is simply irrelevant. *** The instrument embodies a usuri- ous transaction, and Appellee, as the lender, contracted for usurious interest.

INTERPRETATION Usury statutes establish a maximum rate of interest for which a lender may charge a borrower.

CRITICAL THINKING QUESTION Should the law establish maximum rates of interest? If so, in what situations?

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of trade is a covenant not to compete, which is an agreement to refrain from entering into a competing trade, profession, or business.

An agreement to refrain from a particular trade, pro- fession, or business is enforceable if (1) the purpose of the restraint is to protect a property interest of the promisee and (2) the restraint is no more extensive than is reasonably necessary to protect that interest. Restraints typically arise in two situations: (1) the sale of a business and (2) employment contracts.

Sale of a Business As part of an agreement to sell a business, the seller frequently promises not to compete in that particular type of business in a defined area for a stated period of time to protect the business’s goodwill (an asset that the buyer has purchased). The courts will enforce such a covenant (promise) if the restraint is within reasonable limitations. The reason- ableness of the restraint depends on the geographic area the restraint covers, the period for which it is to be effective, and the hardship it imposes on the promisor and the public.

For example, the promise of a person selling a ser- vice station business in Detroit not to enter the service station business in Michigan for the next twenty-five years is unreasonable as to both area and time. The business interest would not include the entire state, so the protection of the purchaser does not require that the seller be prevented from engaging in the service sta- tion business in all of Michigan or perhaps, for that matter, in the entire city of Detroit. Limiting the area to the neighborhood in which the station is located or to a radius of a few miles probably would be adequate protection. However, in the case of a citywide business, such as a laundry or cleaning establishment with neigh- borhood outlets, a covenant restraining competition anywhere in the city might well be reasonable.

The same type of inquiry must be made about time limitations. In the sale of a service station, a twenty-five- year ban on competition from the seller would be unrea- sonable, but a one-year ban probably would not. The courts consider each case on its own facts to determine what is reasonable under the particular circumstances.

Employment Contracts Salespeople, manage- ment personnel, and other employees are frequently required to sign employment contracts prohibiting them from competing with their employers during their employment and for some additional stated pe- riod after their termination. The same is also frequently true among corporations or partnerships involving professionals such as accountants, lawyers, investment

brokers, stockbrokers, or doctors. Though the courts readily enforce a covenant not to compete during the period of employment, they subject the promise not to compete after termination of employment to a test of reasonableness stricter even than that applied to non- competition promises included in a contract for the sale of a business.

A court order enjoining (prohibiting) a former em- ployee from competing in a described territory for a stated period of time is the usual way in which an employer seeks to enforce an employee’s promise not to compete. However, before the courts will grant such injunctions, the employer must demonstrate that the restriction is necessary to protect his legitimate inter- ests, such as trade secrets or customer lists. Because the injunction may have the practical effect of placing the employee out of work, the courts must carefully balance the public policy favoring the employer’s right to protect his business interests against the public policy favoring full opportunity for individuals to gain employment. Some courts, rather than refusing to enforce an unreasonable restraint, will modify the restrictive covenant to make it reasonable under the circumstances.

Thus, one court has held unreasonable a contract covenant requiring a travel agency employee after ter- mination of her employment to not engage in a like business in any capacity in either of two named towns or within a sixty-mile radius of those towns for two years. There was no indication that the employee had enough influence over customers to cause them to move their business to her new agency, nor was it shown that any trade secrets were involved.

Due to the rapid evolution of business practices in the Internet industry, it has been argued that noncom- petition agreements for Internet company employees need their own rules. National Business Services, Inc. v. Wright addressed the geographic scope of an Internet noncompetition agreement, upholding a one-year time restriction and a territorial clause that prevented the employee from taking another Internet-related job anywhere in the United States. The court stated, “Transactions involving the Internet, unlike traditional ‘sales territory’ cases, are not limited by state boundaries.”

PRACTICAL ADVICE If you include a covenant not to compete to protect your property interests, be careful to select a reasonable duration and geographic scope.

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FACTS In June of 1998, Payroll Advance, Inc. entered into an employment contract with Barbara Yates, which contained a covenant not to compete. It is customary for each of Payroll’s branch offices to employ a sole employee at each branch, and that sole employee is the manager of that particular branch. On November 19, 1999, as a condition of her continued employment, Payroll presented Yates with the Employment Agreement which included a provision entitled “NON-COMPETE.” This provision provided:

[Yates] agrees not to compete with [Payroll] as owner, man- ager, partner, stockholder, or employee in any business that is in competition with [Payroll] and within a fifty-mile ra- dius of [Payroll’s] business for a period of two (2) years af- ter termination of employment or [Yates] quits or [Yates] leaves employment of [Payroll].

On November 8, 2007, Yates was fired for cause. Approximately thirty-two days after being terminated, Yates obtained employment with Check Please, one of the Payroll’s competitors. At Check Please, Yates per- formed basically the same duties as she had when employed with Payroll.

On February 7, 2008, Payroll filed a complaint against Yates for (1) injunctive relief to prevent Yates from soliciting its clients for her new employer and to stop her from using client information she purportedly obtained from her time with Payroll and (2) damages for breach of contract for violation of the covenant not to compete together with attorney fees and costs. The trial court found

[n]o evidence exists that, following [Payroll’s] termination of [Yates’] ten year period of employment, [Yates] removed any customer list or other documents from [Payroll’s] place of business [or] … made any personal or other contact with any previous or present customer of [Payroll’s] business or intends to do so.

The trial court further determined that if the cove- nant not to compete were enforced as requested, Yates would be prohibited from engaging in employment with any payday loan business in at least 126 cities situated in Missouri, Arkansas, and Tennessee. Further, Yates could also be prohibited from employment at a bank, savings and loan company, credit union, pawnshop, or title-loan company within Missouri, Arkansas, and Tennessee. Accordingly, the trial court found in favor of Yates holding that the Employment Agreement’s non- compete covenant signed by the parties was not valid in

that it was “unreasonable under the facts and circum- stances of the particular industry, agreement, and geo- graphic location here involved.” Payroll appealed.

DECISION Judgment affirmed.

OPINION Barney, J. “Generally, because covenants not to compete are considered to be restraints on trade, they are presumptively void and are enforceable only to the extent that they are demonstratively reason- able.” [Citations.] “Noncompetition agreements are not favored in the law, and the party attempting to enforce a noncompetition agreement has the burden of demon- strating both the necessity to protect the claimant’s legit- imate interests and that the agreement is reasonable as to time and space.” [Citation.]

There are at least four valid and conflicting concerns at issue in the law of non-compete agreements. First, the employer needs to be able to engage a highly trained work- force to be competitive and profitable, without fear that the employee will use the employer’s business secrets against it or steal the employer’s customers after leaving employment. Second, the employee must be mobile in order to provide for his or her family and to advance his or her career in an ever-changing marketplace. This mobility is de- pendent upon the ability of the employee to take his or her increasing skills and put them to work from one employer to the next. Third, the law favors the freedom of parties to value their respective interests in negotiated contracts. And, fourth, contracts in restraint of trade are unlawful. [Citation.]

“Missouri courts balance these concerns by enforcing non-compete agreements in certain limited circum- stances.” [Citation.] “Non-compete agreements are typi- cally enforceable so long as they are reasonable. In practical terms, a non-compete agreement is reasonable if it is no more restrictive than is necessary to protect the legitimate interests of the employer.” [Citation.] Fur- thermore, “[n]on-compete agreements are enforceable to the extent they can be narrowly tailored geographically and temporally.” [Citation.] Lastly, it is not “necessary for the employer to show that actual damage has occurred, in order to obtain an injunction. The actual damage might be very hard to determine, and this is one reason for granting equitable relief.” [Citation.]

Here, viewing the evidence in a light most favorable to the trial court’s holding, [citation], it is clear the trial court took umbrage with the covenant’s restrictive

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Exculpatory Clauses [13-2b] Some contracts contain an exculpatory clause that excuses one party from liability for her own tortious conduct. Although there is general agreement that ex- culpatory clauses relieving a person from tort liability for harm caused intentionally or recklessly are unen- forceable as violating public policy, exculpatory clauses that excuse a party from liability for harm caused by negligent conduct undergo careful scrutiny by the courts,

which often require that the clause be conspicuously placed in the contract and clearly written. Accordingly, an exculpatory clause on the reverse side of a parking lot claim check, which attempts to relieve the parking lot operator of liability for negligently damaging the cus- tomer’s automobile, generally will be held unenforceable as against public policy.

Where one party’s superior bargaining position has enabled him to impose an exculpatory clause upon the other party, the courts are inclined to nullify the

provisions and geographical limitations on Respondent’s [Yates’] ability to find employment.

*** The question of reasonableness of a restraint is to be

determined according to the facts of the particular case and hence requires a thorough consideration of all sur- rounding circumstances, including the subject matter of the contract, the purpose to be served, the situation of the parties, the extent of the restraint, and the speciali- zation of the business.

*** Here, the covenant not to compete grandly declares

that Respondent cannot “compete with Appellant [Pay- roll] as owner, manager, partner, stockholder, or em- ployee in any business that is in competition with [Appellant] and within a 50 mile radius of [Appellant’s] business.…” (Emphasis added.) There was evidence from Appellant’s representative at trial that Appellant has seventeen branch offices in Missouri and still other locations in Arkansas. If this Court interprets the plain meaning of the covenant not compete as written, the covenant not to compete would prevent Respondent not only from working at a competing business within 50 miles of the branch office in Kennett, Missouri, but Re- spondent would also be barred from working in a com- peting business within 50 miles of any of Appellant’s branch offices. Under this interpretation, Respondent would be greatly limited in the geographic area she could work.

Additionally, the covenant not to compete bars Re- spondent from working at “any business that is in com- petition with [Appellant].” Yet, it fails to set out with precision what is to be considered a competing business and certainly does not specify that it only applies to other payday loan businesses. In that Appellant is in the business of making loans, it could be inferred that in addition to barring Respondent’s employment at a dif- ferent payday loan establishment the covenant not to compete also bars her from being employed anywhere

loans are made including banks, credit unions, savings and loan organizations, title-loan companies, pawn shops, and other financial organizations. Such a restraint on the geographic scope of Respondent’s employment and upon her type of employment is unduly burdensome and unrea- sonable. [Citation.]

*** Appellant’s second point relied on asserts the trial

court erred in denying its petition because [t]he trial court erroneously applied the law in failing to modify the covenant not to compete to a geographic scope it found to be reasonable in that the court found the geo- graphic scope to be unreasonable for the payday loan industry but failed to modify the covenant not to com- pete to reflect a geographic scope that would be reason- able and enforceable.

*** This Court “recognize[s] that an unreasonable restriction against competition in a contract may be modified and enforced to the extent that it is reasonable, regardless of the covenant’s form of wording.” ***

Having reviewed the record in this matter, it appears the record is devoid of a request by Appellant for modi- fication of the covenant not to compete either in its pleadings, at trial, or in its motion for new trial before the trial court. It is settled law that “‘appellate courts are merely courts of review for trial court errors, and there can be no review of matter which has not been presented to or expressly decided by the trial court.”’ [Citation.]

INTERPRETATION Noncompete clauses in employment agreements can be enforced only to the extent necessary to protect the employer’s legitimate interests and only if reasonably limited in duration and geographic scope.

CRITICAL THINKING QUESTION How should courts balance the protection of employers with the freedom of employees to change jobs? Explain.

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provision. Such a situation may arise in residential leases exempting a landlord from liability for his negli- gence. Moreover, an exculpatory clause may be unen- forceable for unconscionability. See Bagley v. Mt. Bachelor later in the chapter.

PRACTICAL ADVICE Because many courts do not favor exculpatory clauses, carefully limit its applicability, make sure that it is clear and understandable, put it in writing, and have it signed.

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FACTS Plaintiff, Tammey J. Anderson, on April 2, 2003, joined the fitness club Curves for Women, which was owned and operated by McOskar Enterprises. As part of the registration requirements, Anderson read an “AGREEMENT AND RELEASE OF LIABILITY,” ini- tialed each of the three paragraphs in the document, and dated and signed it. The first paragraph purported to release Curves from liability for injuries Anderson might sustain in participating in club activities or using club equipment:

In consideration of being allowed to participate in the activities and programs of Curves for Women and to use its facilities, equipment and machinery in addition to the payment of any fee or charge, I do hereby waive, release and forever discharge Curves International Inc., Curves for Women, and their officers, agents, employees, repre- sentatives, executors, and all others (Curves representa- tives) from any and all responsibilities or liabilities from injuries or damages arriving [sic] out of or connected with my attendance at Curves for Women, my participation in all activities, my use of equipment or machinery, or any act or omission, including negligence by Curves representatives.

The second paragraph provided for Anderson’s ac- knowledgment that fitness activities “involve a risk of injury” and her agreement “to expressly assume and accept any and all risks of injury or death.”

After completing the registration, Anderson began a workout under the supervision of a trainer. About fif- teen or twenty minutes later, having used four or five machines, Anderson developed a headache in the back of her head. She contends that she told the trainer, who suggested that the problem was likely just a previous lack of use of certain muscles and that Anderson would be fine. Anderson continued her workout and developed pain in her neck, shoulder, and arm. She informed the trainer but continued to exercise until she completed the program for that session. The pain persisted when Anderson returned home. She then sought medical

attention and, in June 2003, underwent a cervical dis- kectomy. She then filed this lawsuit for damages, alleg- ing that Curves had been negligent in its acts or omissions during her workout at the club. Curves moved for summary judgment on the ground that Anderson had released the club from liability for negli- gence. The district court agreed and granted the motion. Anderson appealed.

DECISION Judgment of the district court is affirmed.

OPINION Shumaker, J. It is settled Minnesota law that, under certain circumstances, “parties to a contract may, without violation of public policy, protect them- selves against liability resulting from their own negli- gence.” Schlobohm v. Spa Petite, Inc., [citation]. The “public interest in freedom of contract is preserved by recognizing [release and exculpatory] clauses as valid.” [Citation.]

Releases of liability are not favored by the law and are strictly construed against the benefited party. [Cita- tion.] “If the clause is either ambiguous in scope or pur- ports to release the benefited party from liability for intentional, willful or wanton acts, it will not be enforced.” [Citation.] Furthermore, even if a release clause is unambiguous in scope and is limited only to negligence, courts must still ascertain whether its enforcement will contravene public policy. On this issue, a two-prong test is applied:

Before enforcing an exculpatory clause, both prongs of the test are examined, to-wit: (1) whether there was a disparity of bargaining power between the parties (in terms of a compulsion to sign a contract containing an unacceptable provision and the lack of ability to negotiate elimination of the unacceptable provision) … and (2) the types of services being offered or provided (taking into consideration whether it is a public or essential service). [Citation.]

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Unconscionable Contracts [13-2c] The Uniform Commercial Code provides that a court may scrutinize every contract for the sale of goods to determine whether in its commercial setting, purpose, and effect the contract is unconscionable, or unfair. The court may refuse to enforce an unconscionable contract or any part of the contract it finds to be unconscionable. The Restatement has a similar provision.

Though neither the Code nor the Restatement defines the word unconscionable, the term is defined in the New Webster’s Dictionary of the English Language (Deluxe Encyclopedic Edition) as “contrary to the dictates of conscience; unscrupulous or unprincipled; exceeding that which is reasonable or customary; inor- dinate, unjustifiable.”

The doctrine of unconscionability has been justified on the basis that it permits the courts to resolve issues of unfairness explicitly in terms of that unfairness without recourse to formalistic rules or legal fictions. In policing contracts for fairness, the courts have again demonstrated their willingness to limit freedom of contract to protect the less advantaged from overreaching by dominant con- tracting parties. The doctrine of unconscionability has evolved through its application by the courts to include both procedural and substantive unconscionability. Procedural unconscionability involves scrutiny for the presence of “bargaining naughtiness.” In other words, was the negotiation process fair? Or were there proce- dural irregularities, such as burying important terms of the agreement in fine print or obscuring the true meaning of the contract with impenetrable legal jargon?

The two-prong test describes what is generally known as a “contract of adhesion,” more particularly explained in Schlobohm:

It is a contract generally not bargained for, but which is imposed on the public for necessary service on a “take it or leave it” basis. Even though a contract is on a printed form and offered on a “take it or leave it” basis, those facts alone do not cause it to be an adhesion contract. There must be a showing that the parties were greatly disparate in bargaining power, that there was no opportunity for nego- tiation and that the services could not be obtained else- where. [Citation.]

*** *** There is nothing in the Curves release that

expressly exonerates the club from liability for any intentional, willful, or wanton act. Thus, we consider whether the release is ambiguous in scope.

*** The vice of ambiguous language is that it fails pre-

cisely and clearly to inform contracting parties of the meaning of their ostensible agreement. Because ambigu- ous language is susceptible of two or more reasonable meanings, each party might carry away from the agree- ment a different and perhaps contradictory understand- ing. In the context of a release in connection with an athletic, health, or fitness activity, the consumer surely is entitled to know precisely what liability is being exoner- ated. A release that is so vague, general, or broad as to fail to specifically designate the particular nature of the liability exonerated is not enforceable. [Citation.]

*** It is clear from this release that Anderson agreed to exonerate Curves from liability for negligence, that being part of the express agreement that Anderson

accepted and it is solely negligence of which Curves is accused.

The unmistakable intent of the parties to the Curves agreement is that Curves at least would not be held liable for acts of negligence. ***

*** Even if a release is unambiguously confined to liabil-

ity for negligence, it still will be unenforceable if it con- travenes public policy. Anderson contends that the Curves contract is one of adhesion characterized by such a disparity in bargaining power that she was compelled to sign it without any ability to negotiate.

*** Even if there was a disparity of bargaining ability

here—which has not been demonstrated—there was no showing that the services provided by Curves are neces- sary and unobtainable elsewhere. ***

The Curves release did not contravene public policy, and we adopt the supreme court’s conclusion in Schlo- bohm: “Here there is no special legal relationship and no overriding public interest which demand that this contract provision, voluntarily entered into by compe- tent parties, should be rendered ineffectual.” [Citation.]

INTERPRETATION An exculpatory clause is valid if it is limited in scope, not ambiguous, and not contrary to public policy.

ETHICAL QUESTION Did Curves act unethi- cally? Explain.

CRITICAL THINKING QUESTION When should an exculpatory clause be held invalid? Explain.

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By comparison, in searching for substantive uncon- scionability, the courts examine the actual terms of a contract for oppressive or grossly unfair provisions such as exorbitant prices or unfair exclusions or limita- tions of contractual remedies. An all-too-common example of such a provision involves a buyer in press- ing need who is in an unequal bargaining position with a seller who consequently obtains an exorbitant price for his product or service. In one case, a price of $749 ($920 if the purchaser wished to pay on credit over time) for a vacuum cleaner that cost the seller $140 was held unconscionable. In another case, the buyers, welfare recipients, purchased by a time payment con- tract a home freezer unit for $900 that, when time credit charges, credit life insurance, credit property in- surance, and sales tax were added, cost $1,235. The purchase resulted from a visit to the buyers’ home by a

salesperson representing Your Shop At Home Service, Inc.; the maximum retail value of the freezer unit at the time of purchase was $300. The court held the contract unconscionable and reformed it by reducing the price to the total payment ($620) the buyers had managed to make.

Some courts hold that for a contract to be unen- forceable, both substantive and procedural unconscion- ability must be present. Nevertheless, they need not exist to the same degree; the more oppressive one is, the less evidence of the other is required.

PRACTICAL ADVICE When negotiating a contract, keep in mind that if your bargaining techniques or the contract terms are oppressive, a court may refuse to enforce the contract in part or in full.

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FACTS Bagley, a highly skilled and experienced snowboarder, purchased a season pass from Mt. Bache- lor. Upon purchasing the season pass, plaintiff executed a written “release and indemnity agreement” that de- fendant required of all its patrons. That season pass agreement provided, in pertinent part:

“In consideration of the use of a Mt. Bachelor pass and/or Mt. Bachelor’s premises, I/we agree to release and indem- nify Mt. Bachelor, Inc., its officers and directors, owners, agents, landowners, affiliated companies, and employees (hereinafter ‘Mt. Bachelor, Inc.’) from any and all claims for property damage, injury, or death which I/we may suf- fer or for which I/we may be liable to others, in any way connected with skiing, snowboarding, or snowriding. This release and indemnity agreement shall apply to any claim even if caused by negligence. The only claims not released are those based upon intentional misconduct.

*** “By my/our signature(s) below, I/we agree that this release

and indemnity agreement will remain in full force and effect and I will be bound by its terms throughout this season and all subsequent seasons for which I/we renew this season pass.”

*** On November 18, 2005, plaintiff began using the pass/

lift ticket, which stated, in part:

“Read this release agreement “In consideration for each lift ride, the ticket user releases

and agrees to hold harmless and indemnify Mt. Bachelor,

Inc., and its employees and agents from all claims for prop- erty damage, injury or death even if caused by negligence. The only claims not released are those based upon inten- tional misconduct.”

Further, the following sign was posted at each of defend- ant’s ski lift terminals:

“YOUR TICKET IS A RELEASE “The back of your ticket contains a release of all claims

against Mt. Bachelor, Inc. and its employees or agents. *** ”

Beginning on November 18, 2005, plaintiff used his season pass to ride defendant’s lifts at least 119 times over the course of twenty-six days that he spent snow- boarding at the ski area. On February 16, 2006, while snowboarding over a human-made jump in defendant’s “air chamber” terrain park, plaintiff sustained serious injuries resulting in his permanent paralysis. Bagley sued Mt. Bachelor ski area for negligence in the design, con- struction, maintenance, and inspection of the jump. The trial court granted operator’s motion for summary judg- ment, which was based on an affirmative defense of release.

In its summary judgment motion, defendant asserted that plaintiff “admittedly understood that he [had] entered into a release agreement and was snowboarding under its terms on the date of [the] accident.” Defendant argued that the release conspicuously and unambigu- ously disclaimed its future liability for negligence, and that the release was neither unconscionable nor contrary to public policy under Oregon law, because “skiers and

Chapter 13 Illegal Bargains 275

snowboarders voluntarily choose to ski and snowboard and ski resorts do not provide essential public services.” In his cross-motion for partial summary judgment, plain- tiff asserted that the release was unenforceable because it was contrary to public policy and was “both substan- tively and procedurally unconscionable.” The trial court rejected plaintiff’s public policy and unconscionability arguments, reasoning that “[s]now riding is not such an essential service which requires someone such as [p]lain- tiff to be forced to sign a release in order to obtain the service.” Accordingly, the trial court granted summary judgment in defendant’s favor and denied plaintiff’s cross-motion for partial summary judgment.

The Court of Appeals affirmed.

DECISION The decision of the Court of Appeals is reversed; the judgment of the trial court is reversed, and the case is remanded to that court for further proceedings.

OPINION Brewer, J. The parties’ dispute in this case involves a topic—the validity of exculpatory agreements— that this court has not comprehensively addressed in deca- des. Although the specific issue on review—the validity of an anticipatory release of a ski area operator’s liability for negligence—is finite and particular, it has broader implica- tions insofar as it lies at the intersection of two traditional common law domains—contract and tort—where, at least in part, the legislature has established statutory rights and duties that affect the reach of otherwise governing com- mon law principles.

It is a truism that a contract validly made between competent parties is not to be set aside lightly. [Cita- tions.] As this court has stated, however, “contract rights are [not] absolute; *** [e]qually fundamental with the private right is that of the public to regulate it in the common interest.” [Citation.]

That “common,” or public, interest is embodied, in part, in the principles of tort law. As a leading treatise explains:

“It is sometimes said that compensation for losses is the pri- mary function of tort law *** [but it] is perhaps more accu- rate to describe the primary function as one of determining when compensation is to be required.”

*** One way in which courts have placed limits on the

freedom of contract is by refusing to enforce agreements that are illegal. [Citations.]

In determining whether an agreement is illegal because it is contrary to public policy, “[t]he test is the evil tendency of the contract and not its actual injury to the public in a particular instance.” [Citation.] The fact that the effect of a contract provision may be harsh as applied to one of the contracting parties does not mean

that the agreement is, for that reason alone, contrary to public policy, particularly where “the contract in ques- tion was freely entered into between parties in equal bargaining positions and did not involve a contract of adhesion, such as some retail installment contracts and insurance policies.” [Citation.]

*** [C]ourts determine whether a contract is illegal by determining whether it violates public policy as expressed in relevant constitutional and statutory provi- sions and in case law, [citation], and by considering whether it is unconscionable. ***

*** [T]his court often has relied on public policy considerations to determine whether a contract or con- tract term is sufficiently unfair or oppressive to be deemed unconscionable. [Citations.]

***

Unconscionability may be procedural or substantive. Procedural unconscionability refers to the conditions of contract formation and focuses on two factors: oppres- sion and surprise. [Citation.] Oppression exists when there is inequality in bargaining power between the par- ties, resulting in no real opportunity to negotiate the terms of the contract and the absence of meaningful choice. [Citations.] Surprise involves whether terms were hidden or obscure from the vantage of the party seeking to avoid them. [Citation.] Generally speaking, factors such as ambiguous contract wording and fine print are the hallmarks of surprise. In contrast, the existence of gross inequality of bargaining power, a take-it-or- leave-it bargaining stance, and the fact that a contract involves a consumer transaction, rather than a commer- cial bargain, can be evidence of oppression.

Substantive unconscionability, on the other hand, gen- erally refers to the terms of the contract, rather than the circumstances of formation, and focuses on whether the substantive terms contravene the public interest or public policy. [Citation.] Both procedural and substantive deficiencies—frequently in combination—can preclude enforcement of a contract or contract term on uncon- scionability grounds. Restatement §208 comment a.

Identifying whether a contract is procedurally uncon- scionable requires consideration of evidence related to the specific circumstances surrounding the formation of the contract at issue. By contrast, the inquiry into sub- stantive unconscionability can be more complicated. To discern whether, in the context of a particular transac- tion, substantive concerns relating to unfairness or oppression are sufficiently important to warrant interfer- ence with the parties’ freedom to contract as they see fit, courts frequently look to legislation for relevant indicia of public policy. When relevant public policy is expressed in a statute, the issue is one of legislative intent. [Citation.] In that situation, the court must examine the

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statutory text and context to determine whether the legislature intended to invalidate the contract term at issue. Id.

Frequently, however, the argument that a contract term is sufficiently unfair or oppressive as to be unen- forceable is grounded in one or more factors that are not expressly codified; in such circumstances, the com- mon law has a significant role to play. ***

This court has considered whether enforcement of an anticipatory release would violate an uncodified public policy in only a few cases. *** [This] court has not declared such releases to be per se invalid, but neither has it concluded that they are always enforceable. Instead, the court has followed a multi-factor approach:

Agreements to exonerate a party from liability or to limit the extent of the party’s liability for tortious conduct are not favorites of the courts but neither are they automati- cally voided. The treatment courts accord such agreements depends upon the subject and terms of the agreement and the relationship of the parties.

[Citation.]

*** *** [R]elevant procedural factors in the determination

of whether enforcement of an anticipatory release would violate public policy or be unconscionable include whether the release was conspicuous and unambiguous; whether there was a substantial disparity in the parties’ bargaining power; whether the contract was offered on a take-it-or-leave-it basis; and whether the contract involved a consumer transaction. Relevant substantive considera- tions include whether enforcement of the release would cause a harsh or inequitable result to befall the releasing party; whether the releasee serves an important public in- terest or function; and whether the release purported to disclaim liability for more serious misconduct than ordi- nary negligence. Nothing in our previous decisions sug- gests that any single factor takes precedence over the others or that the listed factors are exclusive. Rather, they indicate that a determination whether enforcement of an anticipatory release would violate public policy or be unconscionable must be based on the totality of the cir- cumstances of a particular transaction. ***

*** *** [O]ur analysis leads to the conclusion that permit-

ting defendant to exculpate itself from its own negligence would be unconscionable. *** important procedural fac- tors supporting that conclusion include the substantial disparity in the parties’ bargaining power in the particu- lar circumstances of this consumer transaction, and the fact that the release was offered to plaintiff and defend- ant’s other customers on a take-it-or-leave-it basis.

There also are indications that the release is substan- tively unfair and oppressive. First, a harsh and inequitable

result would follow if defendant were immunized from negligence liability, in light of (1) defendant’s superior ability to guard against the risk of harm to its patrons arising from its own negligence in designing, creating, and maintaining its runs, slopes, jumps, and other facili- ties; and (2) defendant’s superior ability to absorb and spread the costs associated with insuring against those risks. Second, because defendant’s business premises are open to the general public virtually without restriction, large numbers of skiers and snowboarders regularly avail themselves of its facilities, and those patrons are subject to risks of harm from conditions on the premises of defendant’s creation, the safety of those patrons is a matter of broad societal concern. The public interest, therefore, is affected by the performance of defendant’s private duties toward them under business premises liability law.

In the ultimate step of our unconscionability analysis, we consider whether those procedural and substantive considerations outweigh defendant’s interest in enforcing the release at issue here. Restatement (Second) of Con- tracts §178 comment b (“[A] decision as to enforceabil- ity is reached only after a careful balancing, in the light of all the circumstances, of the interest in the enforce- ment of the particular promise against the policy against the enforcement of such terms.”). Defendant argues that, in light of the inherent risks of skiing, it is neither unfair nor oppressive for a ski area operator to insist on a release from liability for its own negligence. ***

Defendant’s arguments have some force. After all, skiing and snow boarding are activities whose allure and risks derive from a unique blend of factors that include natural features, artificial constructs, and human engagement. It may be difficult in such circumstances to untangle the causal forces that lead to an injury- producing accident. Moreover, defendant is correct that several relevant factors weigh in favor of enforcing the release. *** [T]he release was conspicuous and unam- biguous, defendant’s alleged misconduct in this case was negligence, not more egregious conduct, and snow- boarding is not a necessity of life.

That said, the release is very broad; it applies on its face to a multitude of conditions and risks, many of which (such as riding on a chairlift) leave defendant’s patrons vulnerable to risks of harm of defendant’s crea- tion. Accepting as true the allegations in plaintiff’s com- plaint, defendant designed, created, and maintained artificial constructs, including the jump on which plain- tiff was injured. Even in the context of expert snow- boarding in defendant’s terrain park, defendant was in a better position than its invitees to guard against risks of harm created by its own conduct.

A final point deserves mention. It is axiomatic that public policy favors the deterrence of negligent conduct.

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Closely akin to the concept of unconscionability is the doctrine of contracts of adhesion. An adhesion con- tract, a standard-form contract prepared by one party, generally involves the preparer offering the other party the contract on a “take-it-or-leave-it” basis. Such con- tracts are not automatically unenforceable but are sub- ject to greater scrutiny for procedural or substantive unconscionability. See the earlier case Anderson v. McOskar Enterprises, Inc., and the Ethical Dilemma at the end of this chapter.

Tortious Conduct [13-2d] An agreement that requires a person to commit a tort is an illegal agreement and thus is unenforceable. The courts will not permit contract law to violate the law of torts. Any agreement attempting to do so is consid- ered contrary to public policy. For example, Ada and Bernard enter into an agreement under which Ada promises Bernard that in return for $5,000, she will disparage the product of Bernard’s competitor, Cone, in order to provide Bernard with a competitive advant- age. Ada’s promise is to commit the tort of disparage- ment and is unenforceable as contrary to public policy.

Corrupting Public Officials [13-2e] Agreements that may adversely affect the public interest through the corruption of public officials or the impair- ment of the legislative process are unenforceable. Exam- ples include using improper means to influence legislation, to secure some official action, or to procure a government contract. Contracts to pay lobbyists for services to obtain or defeat official action by means of persuasive argument are to be distinguished from illegal

influence-peddling agreements. (Chapters 39 and 46 cover the Foreign Corrupt Practices Act, which prohib- its any U.S. person—and certain foreign issuers of securities—from bribing foreign government or political officials to assist in obtaining or retaining business.)

For example, a bargain by a candidate for public office to make a certain appointment following his elec- tion is illegal. In addition, an agreement to pay a public officer something extra for performing his official duty, such as promising a bonus to a police officer for strictly enforcing the traffic laws on her beat, is illegal. The same is true of an agreement in which a citizen prom- ises to perform, or to refrain from performing, duties imposed on her by citizenship. Thus, a promise by Carl to pay $50.00 to Rachel if she will register and vote is opposed to public policy and illegal.

EFFECT OF ILLEGALITY [13-3] With few exceptions, illegal contracts are unenforceable. In most cases, neither party to an illegal agreement can sue the other for breach or recover for any performance rendered. It is often said that where parties are in pari delicto—in equal fault—a court will leave them where it finds them. The law will provide neither with any remedy. This strict rule of unenforceability is subject to certain exceptions, however, which are discussed as follows.

Party Withdrawing Before Performance [13-3a] A party to an illegal agreement may withdraw, before performance, from the transaction and recover

*** As the parties readily agree, the activities at issue in this case involve considerable risks to life and limb. Skiers and snowboarders have important legal induce- ments to exercise reasonable care for their own safety by virtue of their statutory assumption of the inherent risks of skiing. By contrast, without potential exposure to liability for their own negligence, ski area operators would lack a commensurate legal incentive to avoid cre- ating unreasonable risks of harm to their business invit- ees. [Citation.] Where, as here, members of the public are invited to participate without restriction in risky activities on defendant’s business premises (and many do), and where the risks of harm posed by operator neg- ligence are appreciable, such an imbalance in legal incentives is not conducive to the public interest.

Because the factors favoring enforcement of the release are outweighed by the countervailing considerations that

we have identified, we conclude that enforcement of the release at issue in this case would be unconscionable. And, because the release is unenforceable, genuine issues of fact exist that preclude summary judgment in defend- ant’s favor.

INTERPRETATION The doctrine of uncon- scionability includes both procedural and substantive unconscionability and may override an exculpatory clause releasing a party from liability for its own negligence.

ETHICAL QUESTION Did Mt. Bachelor act unethically? Explain.

CRITICAL THINKING QUESTION When should a court modify a challenged clause, and when should it refuse to enforce the entire clause in question?

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whatever she has contributed, if the party has not engaged in serious misconduct. A common example is recovery of money left with a stakeholder for a wager before it is paid to the winner.

Party Protected by Statute [13-3b] Sometimes an agreement is illegal because it violates a statute designed to protect persons from the effects of the prohibited agreement. For example, state and fed- eral statutes prohibiting the sale of unregistered secur- ities are designed primarily to protect investors. In such case, even though there is an unlawful agreement, the statutes usually expressly give the purchaser a right to withdraw from the sale and recover the money paid.

Party Not Equally at Fault [13-3c] Where one of the parties is less at fault than the other, he may be allowed to recover payments made or prop- erty transferred. For example, this exception would apply in cases in which one party induces the other to enter into an illegal bargain through the exercise of fraud, duress, or undue influence.

Excusable Ignorance [13-3d] An agreement that appears to be entirely permissible on its face, nevertheless, may be illegal by reason of facts and circumstances of which one of the parties is com- pletely unaware. For example, a man and woman make

mutual promises to marry, but unknown to the woman, the man is already married. This is an agree- ment to commit the crime of bigamy, and the marriage, if entered into, is void. In such case, the courts permit the party who is ignorant of the illegality to maintain a lawsuit against the other party for damages.

A party also may be excused for ignorance of legisla- tion of a minor character. For instance, Jones and Old South Building Co. enter into a contract to build a fac- tory that contains specifications in violation of the town’s building ordinance. Jones did not know of the violation and had no reason to know. Old South’s promise to build would not be rendered unenforceable on grounds of public policy, and Jones consequently would have a claim against Old South for damages for breach of contract.

Partial Illegality [13-3e] A contract may be partly unlawful and partly lawful. The courts view such a contract in one of two ways. First, the partial illegality may be held to taint the entire contract with illegality, so that it is wholly unen- forceable. Second, the court may determine it possible to separate the illegal from the legal part, in which case the illegal part only will be held unenforceable, whereas the legal part will be enforced. For example, if a con- tract contains an illegal covenant not to compete, the covenant will not be enforced, though the rest of the contract may be.

Business Law IN ACTION

Southwestern Casualty Insurance (SCI) has issuedautomobile insurance policies in the southwestern United States for a number of years. Its standard-form policies historically have covered its policyholders for accidents occurring in Mexico. After reassessing the company’s liabilities, SCI determined that inserting an exclusion for accidents occurring within Mexico’s borders would both assist in keeping premiums in check and con- tribute positively to the company’s bottom line. It there- fore issued a new standard-form policy that was the same in all respects as its old policy, but which now con- tained the Mexico exclusion in a long paragraph of other policy exclusions.

Rather than simply send the new form to its customers along with a premium notice when their policies are up for renewal, SCI must take pains to make its customers aware of the change in coverage. If it does not, there is a good chance in many jurisdictions that SCI will be stopped from enforcing the exclusion, and therefore will

be required to provide coverage according to its custom- ers’ reasonable expectations.

Standard-form insurance policies generally are con- tracts of adhesion. This is because, while some provisions regarding limits and types of coverage may be bargained for, these agreements consist largely of boilerplate provi- sions that are not negotiated and that often are not, nor are they expected to be, read or fully understood by the insured. Standard-form insurance contracts are useful in commerce; by narrowing the consumer’s choice from a limited number of meaningful features rather than an endless combination of possible coverages, they focus the time and effort of the insurer and insured, thereby reducing costs to the benefit of all. The adhesive nature of the agreement, however, imposes an obligation of good faith on the insurer, which has been translated into a rule that insureds do not assent to standard-form terms the insurer has reason to believe that the consumer would not have accepted.

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Restitution [13-3f] The Restatement of Restitution provides that a person who renders performance under an agreement that is illegal or otherwise unenforceable for reasons of public policy may obtain restitution from the other party, as

necessary to prevent unjust enrichment, if the allowance of restitution will not defeat or frustrate the policy of the underlying prohibition. However, a claim in restitu- tion is not allowed if it is foreclosed by the claimant’s inequitable conduct.

C H A P T E R S U M M A R Y Violations of Statutes

General Rule the courts will not enforce agreements declared illegal by statute

Licensing Statutes require formal authorization to engage in certain trades, professions, or businesses • Regulatory License licensing statute that is intended to protect the public against unqualified

persons; an unlicensed person may not recover for services he has performed • Revenue License licensing statute that seeks to raise money; an unlicensed person may recover

for services he has performed

Gambling Statutes prohibit wagers, which are agreements that one party will win and the other party will lose depending on the outcome of an event in which their only interest is the gain or loss

Usury Statutes establish a maximum rate of interest

Violations of Public Policy

Common Law Restraint of Trade unreasonable restraints of trade are not enforceable • Sale of a Business the promise by the seller of a business not to compete in that particular

business in a reasonable geographic area for a reasonable period of time is enforceable • Employment Contracts an employment contract prohibiting an employee from competing with

his employer for a reasonable period following termination is enforceable provided the restriction is necessary to protect legitimate interests of the employer

Exculpatory Clauses the courts generally disapprove of contractual provisions excusing a party from liability for his own tortious conduct

Ethical Dilemma When Is a Bargain Too Hard?

FACTS Between 2011 and 2016, Williams purchased a number of household items on credit from the Penguin Fur- niture Co., a retail furniture store. Penguin retained the right in its contracts to repossess an item if Williams defaulted on an installment payment. Each contract also provided that each installment payment by Williams would be credited pro rata to all outstanding accounts or bills owed to Pen- guin. As a result of this provision, an unpaid balance would remain on every item purchased until the entire balance due on all items, whenever purchased, was paid in full. Williams defaulted on a monthly installment payment in 2016, and

Penguin sought to repossess all the items that Williams had purchased since 2011.

Social, Policy, and Ethical Considerations 1. Is the bargaining power of Penguin too great to assume

that the terms of the agreement resulted from a fair negotiation process?

2. Do the terms of this agreement appear fair and reasona- ble to both parties?

3. Has Penguin acted unethically?

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Unconscionable Contracts unfair or unduly harsh agreements are not enforceable • Procedural Unconscionability unfair or irregular bargaining • Substantive Unconscionability oppressive or grossly unfair contractual terms

Tortious Conduct an agreement that requires a person to commit a tort is unenforceable

Corrupting Public Officials agreements that corrupt public officials are not enforceable

Effect of Illegality

Unenforceability neither party may recover (unenforceable) under an illegal agreement where both parties are in pari delicto (in equal fault)

Exceptions permit one party to recover payments • Party Withdrawing Before Performance • Party Protected by Statute • Party Not Equally at Fault • Excusable Ignorance • Partial Illegality • Restitution

Q U E S T I O N S

1. Johnson and Wilson were the principal shareholders in Matthew Corporation, located in the city of Jonesville, Wisconsin. This corporation was engaged in the business of manufacturing paper novelties, which were sold over a wide area in the Midwest. The corporation was also in the business of binding books. Johnson purchased Wilson’s shares in Matthew Corporation, and in consid- eration thereof, Wilson agreed that for a period of two years he would not (a) manufacture or sell in Wisconsin any paper novelties of any kind that would compete with those sold by Matthew Corporation or (b) engage in the bookbinding business in the city of Jonesville. Discuss the validity and effect, if any, of this agreement.

2. Wilkins, a Texas resident licensed by that state as a certi- fied public accountant (CPA), rendered service in his pro- fessional capacity in Louisiana to Coverton Cosmetics Company. He was not registered as a CPA in Louisiana. His service under his contract with the cosmetics com- pany was not the only occasion on which he had prac- ticed his profession in that state. The company denied liability and refused to pay him, relying on a Louisiana statute declaring it unlawful for any person to perform or offer to perform services as a CPA for compensation until he has been registered by the designated agency of the state and holds an unrevoked registration card. The statute provides that a CPA certificate may be issued without examination to any applicant who holds a valid unrevoked certificate as a CPA under the laws of any other state. The statute provides further that rendering services of the kind performed by Wilkins, without regis- tration, is a misdemeanor punishable by a fine or imprison- ment in the county jail or by both fine and imprisonment. Discuss whether Wilkins would be successful in an action

against Coverton seeking to recover a fee in the amount of $1,500 as the reasonable value of his services.

3. Michael is interested in promoting the passage of a bill in the state legislature. He agrees with Christy, an attorney, to pay Christy for her services in writing the required bill, obtaining its introduction in the legislature, and making an argument for its passage before the legislative committee to which it will be referred. Christy renders these services. Subsequently, on Michael’s refusal to pay Christy, Christy sues Michael for damages for breach of contract. Will Christy prevail? Explain.

4. Anthony promises to pay McCarthy $100,000 if McCarthy reveals to the public that Washington is a communist. Washington is not a communist and never has been. McCarthy successfully persuades the media to report that Washington is a communist and now seeks to recover the $100,000 from Anthony, who refuses to pay. McCarthy initiates a lawsuit against Anthony. What will be the result?

5. The Dear Corporation was engaged in the business of making and selling harvesting machines. It sold every- thing pertaining to its business to the HI Company, agreeing “not again to go into the manufacture of har- vesting machines anywhere in the United States.” The Dear Corporation, which had a national and interna- tional goodwill in its business, now begins the manufac- ture of such machines contrary to its agreement. Should the court stop it from doing so? Explain.

6. Charles Leigh, engaged in the industrial laundry business in Central City, employed Tim Close, previously employed in the home laundry business, as a route

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salesperson. Leigh rents linens and industrial uniforms to commercial customers; the soiled linens and uniforms are picked up at regular intervals by the route drivers and replaced with clean ones. Every employee is assigned a list of customers whom she services. The contract of employment stated that in consideration of being employed, on termination of his employment, Close would not “directly or indirectly engage in the linen sup- ply business or any competitive business within Central City, Illinois, for a period of one year from the date when his employment under this contract ceases.” On May 10 of the following year, Close’s employment was terminated by Leigh for valid reasons. Close then accepted employment with Ajax Linen Service, a direct competitor of Leigh in Central City. He began soliciting former customers he had called on for Leigh and obtained some of them as customers for Ajax. Will Leigh be able to enforce the provisions of the contract?

7. On July 5, 2014, Bill and George entered into a bet on the outcome of the 2014 congressional election. On Janu- ary 28, 2015, Bill, who bet on the winner, approached George, seeking to collect the $3,000 George had wagered. George paid Bill the wager but now seeks to recover the funds from Bill. Result?

8. Carl, a salesperson for Smith, comes to Benson’s home and sells him a complete set of “gourmet cooking utensils” that are worth approximately $300. Benson, an eighty-year-old man who lives alone in a one-room effi- ciency apartment, signs a contract to buy the utensils for $1,450 plus a credit charge of $145 and to make payments

in ten equal monthly installments. Three weeks after Carl leaves with the signed contract, Benson decides he cannot afford the cooking utensils and has no use for them. What can Benson do? Explain.

9. Consider the facts in Question 8 but assume that the price was $350. Assume further that Benson wishes to avoid the contract based on the allegation that Carl befriended and tricked him into the purchase. Discuss.

10. Adrian rents a bicycle from Barbara. The bicycle rental contract Adrian signed provides that Barbara is not liable for any injury to the renter caused by any defect in the bicycle or the negligence of Barbara. Adrian is injured when she is involved in an accident due to Barbara’s improper maintenance of the bicycle. Adrian sues Bar- bara for damages. Will Barbara be protected from liabil- ity by the provision in their contract?

11. Emily was a Java programmer employed with Sun Microsystems in Palo Alto, California. Upon beginning employment, Emily signed a contract that included a noncompetition clause that prevented her from taking another Java programming position with any of five companies Sun listed as “direct competitors” within three months of terminating her employment. Later that year Emily resigned and two months later accepted a position with Hewlett-Packard (HP) in Houston, Texas. HP was listed in Emily’s contract as a “direct competitor,” but she argues that due to the significant geographic distance between both jobs, the contract is not enforceable. Explain whether the contract is enforceable.

C A S E P R O B L E M S

12. Merrill Lynch employed Post and Maney as account executives. Both men elected to be paid a salary and to participate in the firm’s pension and profit-sharing plans rather than take a straight commission. Thirteen years later, Merrill Lynch terminated the employment of both Post and Maney without cause. Both men began working for a competitor of Merrill Lynch. Merrill Lynch then informed them that all of their rights in the company- funded pension plan had been forfeited pursuant to a provision of the plan that permitted forfeiture in the event an employee directly or indirectly competed with the firm. Is Merrill Lynch correct in its assertion?

13. Tovar applied for the position of resident physician in Paxton Community Memorial Hospital. The hospital examined his background and licensing and assured him that he was qualified for the position. Relying upon the hospital’s promise of permanent employment, Tovar resigned from his job and began work at the hospital. He was discharged two weeks later, however, because he did not hold a license to practice medicine in Illinois as

required by state law. He had taken the examination but had never passed it. Tovar claims that the hospital prom- ised him a position of permanent employment and that by discharging him, it breached their employment con- tract. Who is correct? Discuss.

14. Carolyn Murphy, a welfare recipient with very limited education and with four minor children, responded to an advertisement that offered the opportunity to purchase televisions without a deposit or credit history. She entered into a rent- to-own contract for a twenty-five- inch television set that required seventy-eight weekly pay- ments of $16.00 (a total of $1,248, which was two and one-half times the retail value of the set). Under the con- tract, the renter could terminate the agreement by return- ing the television and forfeiting any payments already made. After Murphy had paid $436 on the television, she read a newspaper article criticizing the lease plan. She stopped payment and sued the television company. In response, the television company has attempted to take possession of the set. What will be the outcome?

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15. Albert Bennett, an amateur cyclist, participated in a bicycle race conducted by the United States Cycling Federation. During the race, Bennett was hit by an automobile. He claims that employees of the Federation improperly allowed the car onto the course. The Federation claims that it cannot be held liable to Bennett because Bennett signed a release exculpating the Federation from responsi- bility for any personal injury resulting from his participa- tion in the race. Is the exculpatory clause effective?

16. In February, Brady, a general contractor, signed a written contract with the Fulghums to build for them a house in North Carolina. The contract price of the house was $206,850, and construction was to begin in March of that year. Neither during the contract negotiations nor during the commencement of construction was Brady li- censed as a general contractor as required by North Car- olina law. In fact, Brady did not obtain his license until late October of that year, at which time he had com- pleted more than two-thirds of the construction on the Fulghums’ house. The Fulghums submitted to Brady total payments of $204,000 on the house. Brady sues for $2,850 on the original contract and $29,000 for addi- tions and changes requested by the Fulghums during con- struction. Is Fulghum liable to Brady? Explain.

17. Robert McCart owned and operated an H&R Block tax preparation franchise. When Robert became a district man- ager for H&R Block, he was not allowed to continue oper- ating a franchise. So, in accordance with company policy, he signed over his franchise to his wife June. June signed the new franchise agreement, which included a covenant not to compete for a two-year period within a fifty-mile ra- dius of the franchise territory should the H&R Block fran- chise be terminated, transferred, or otherwise disposed of. June and Robert were both aware of the terms of this agreement, but June chose to terminate her franchise agree- ment anyway. Shortly thereafter, June sent letters to H&R Block customers, criticizing H&R Block’s fees and inform- ing them that she and Robert would establish their own tax preparation services at the same address as the former franchise location. Each letter included a separate letter from Robert detailing the tax services to be offered by the McCarts’ new business. Should H&R Block be able to obtain an injunction against June? Against Robert?

18. Michelle Marvin and actor Lee Marvin began living to- gether, holding themselves out to the general public as man and wife without actually being married. The two orally agreed that while they lived together they would share equally any and all property and earnings accumu- lated as a result of their individual and combined efforts. In addition, Michelle promised to render her services as “companion, homemaker, housekeeper, and cook” to Lee. Shortly thereafter, she gave up her lucrative career as an entertainer to devote her full time to being Lee’s companion, homemaker, housekeeper, and cook. In return he agreed to provide for all of her financial sup- port and needs for the rest of her life. After living

together for six years, Lee compelled Michelle to leave his household but continued to provide for her support. One year later, however, he refused to provide further support. Michelle sued to recover support payments and half of their accumulated property. Lee contends that their agreement is so closely related to the supposed “immoral” character of their relationship that its enforce- ment would violate public policy. The trial court granted Lee’s motion for judgment on the pleadings. Decision?

19. Richard Brobston was hired by Insulation Corporation of America (ICA) in 2005. Initially, he was hired as a terri- tory sales manager but was promoted to national account manager in 2009 and to general manager in 2013. In 2015, ICA was planning to acquire computer-assisted design (CAD) technology to upgrade its product line. Prior to acquiring this technology, ICA required that Brobston and certain other employees sign employment contracts that contained restrictive covenants or be termi- nated and changed their employment status to “at will” employees. These restrictive covenants provided that in the event of Brobston’s termination for any reason, Brob- ston would not reveal any of ICA’s trade secrets or sales information and would not enter into direct competition with ICA within three hundred miles of Allentown, Penn- sylvania, for a period of two years from the date of ter- mination. The purported consideration for Brobston’s agreement was a $2,000 increase in his base salary and proprietary information concerning the CAD system, cus- tomers, and pricing. Brobston signed the proffered employment contract. In October 2015, Brobston became vice president of special products, which included respon- sibility for sales of the CAD system products as well as other products. Over the course of the next year, Brobston failed in several respects to properly perform his employment duties and on August 13, 2016, ICA ter- minated Brobston’s employment. In December 2016, Brobston was hired by a competitor of ICA who was aware of ICA’s restrictive covenants. Can ICA enforce the employment agreement by enjoining Brobston from disclosing proprietary information about ICA and by restraining him from competing with ICA? If so, for what duration and over what geographic area?

20. Henrioulle, an unemployed widower with two children, received public assistance in the form of a rent subsidy. He entered into an apartment lease agreement with Marin Ventures that provided “INDEMNIFICATION: Owner shall not be liable for any damage or injury to the tenant, or any other person, or to any property, occurring on the premises, or any part thereof, and Tenant agrees to hold Owner harmless for any claims for damages no matter how caused.” Henrioulle fractured his wrist when he tripped over a rock on a common stairway in the apartment build- ing. At the time of the accident, the landlord had been having difficulty keeping the common areas of the apart- ment building clean. Will the exculpatory clause effectively bar Henrioulle from recovery? Explain.

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21. Universal City Studios, Inc. (Universal) entered into a gen- eral contract with Turner Construction Company (Turner) for the construction of the Jurassic Park ride. Turner entered into a subcontract with Pacific Custom Pools, Inc. (PCP), for PCP to furnish and install all water treatment work for the project for the contract price of $959,131. PCP performed work on the project from April 2015 until June 2016 for which it was paid $897,719. PCP’s contrac- tor’s license, however, was under suspension from October 12, 2015, to March 14, 2016. In addition, PCP’s license had expired as of January 31, 2016, and it was not renewed until May 5. California Business and Professions Code Section 7031 provides that no contractor may bring an action to recover compensation for the performance of any work requiring a license unless he or she was “a duly licensed contractor at all times during the performance of that [work], regardless of the merits of the cause of action brought by the contractor.” The purpose of this licensing law is to protect the public from incompetence and dis- honesty in those who provide building and construction services. PCP brought suit against Universal and Turner, the defendants, for the remainder of the contract price. Explain who should prevail.

22. Octavio Sanchez worked as a delivery driver at a Domi- no’s Pizza restaurant owned by Western Pizza. He drove

his own car in making deliveries. His hourly wage ranged from the legal minimum wage to approximately $0.50 above minimum wage. Western Pizza reimburses him at a fixed rate of $0.80 per delivery regardless of the num- ber of miles driven or actual expenses incurred. Sanchez brought this class action against Western Pizza, alleging that the flat rate at which drivers were reimbursed for delivery expenses violated wage and hour laws and that the drivers were paid less than the legal minimum wage.

Sanchez and Western Pizza are parties to an undated arbitration agreement. The agreement states that (1) the execution of the agreement “is not a mandatory condi- tion of employment”; (2) any dispute that the parties are unable to resolve informally will be submitted to binding arbitration before an arbitrator approved by both parties and “selected from the then-current Employment Arbitra- tion panel of the Dispute Eradication Services”; (3) the parties waive the right to a jury trial; (4) the arbitration fees will be borne by Western Pizza, and except as other- wise required by law, each party will bear its own attor- ney fees and costs; (5) small claims may be resolved by a summary small claims procedure; and (6) the parties waive the right to bring class arbitration. Should Sanchez be compelled to submit to arbitration to resolve his com- plaint? Explain.

T A K I N G S I D E S

EarthWeb provided online products and services to business professionals in the information technology (IT) industry. EarthWeb operated through a family of websites offering information, products, and services for IT professionals to use for facilitating tasks and solving technology problems in a business setting. EarthWeb obtained this content primarily through licensing agreements with third parties. Schlack began his employment with EarthWeb in its New York City office. His title at EarthWeb was Vice President, Worldwide Content, and he was responsible for the content of all of EarthWeb’s websites. Schlack’s employment contract stated that he was an employee at will and included a section titled “Limited Agreement Not To Compete.” That section provided:

(c) For a period of twelve (12) months after the termi- nation of Schlack’s employment with EarthWeb, Schlack shall not, directly or indirectly:

(1) work as an employee … or in any other … capacity for any person or entity that directly competes with EarthWeb. For the purpose of this section, the

term “directly competing” is defined as a person or entity or division on an entity that is

(i) an online service for Information Professionals whose primary business is to provide Information Tech- nology Professionals with a directory of third party technology, software, and/or developer resources; and/ or an online reference library, and or

(ii) an online store, the primary purpose of which is to sell or distribute third party software or products used for Internet site or software development.

About one year later, Schlack tendered his letter of resig- nation to EarthWeb. Schlack revealed at this time that he had accepted a position with ITworld.com.

a. What arguments would support EarthWeb’s enforcement of the covenant not to compete?

b. What arguments would support Schlack’s argument that the covenant is not enforceable?

c. Which side should prevail? Explain.

284 Contracts Part III

C H A P T E R 1 4

CONTRACTUAL CAPACITY

Youth is a blunder, manhood a struggle, old age a regret. BENJAMIN DISRAELI (1804–1881), CONINGSBY (BOOK III, CH. I)

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Explain how and when a minor may ratify a contract.

2. Describe the liability of a minor who (a) disaffirms a contract or (b) misrepresents his age.

3. Define “necessary” and explain how it affects the contracts of a minor.

4. Distinguish between the legal capacity of a person under guardianship and a mentally incompetent person who is not under guardianship.

5. Explain the rule governing an intoxicated person’s capacity to enter into a contract and contrast this rule with the law governing minors and incompetent persons.

A binding promise or agreement requires that the

parties to the agreement have contractual capacity. Everyone is regarded as having such

capacity unless the law, for public policy reasons, holds that the individual lacks such capacity. We will con- sider this essential ingredient of a contract by discussing those classes and conditions of persons who are legally limited in their capacity to contract: minors, incompe- tent persons, and intoxicated persons.

MINORS [14-1] Almost without exception a minor’s contract, whether executory or executed, is voidable unless the contract has been ratified. A minor, also called an infant, is a person who has not attained the age of legal majority. At common law, a minor was an individual who had

not reached the age of twenty-one years. Today the age of majority has been changed by statute in nearly all jurisdictions, usually to age eighteen.

Thus, the minor is in a favored position by having the option to disaffirm the contract or to enforce it. The adult party to the contract cannot avoid her contract with a minor. Even an “emancipated” minor, one who, because of marriage or other reasons, is no longer subject to strict parental control, may nevertheless avoid contractual liability in most jurisdictions. Consequently, businesspeo- ple deal at their peril with minors and in situations of consequence generally require an adult to cosign or guar- antee the performance of the contract. Nevertheless, most states recognize special categories of contracts that cannot be avoided (such as student loans and contracts for medi- cal care) or that have a lower age for capacity (such as bank accounts, marriage, and insurance contracts).

285

Liability on Contracts [14-1a] A minor’s contract is not entirely void and of no legal effect; rather, as we have said, it is voidable at the minor’s option. The exercise of this power of avoid- ance, called a disaffirmance, releases the minor from any liability on the contract. On the other hand, after the minor comes of age, he may choose to adopt or rat- ify the contract, in which case he surrenders his power of avoidance and becomes bound by his ratification.

Disaffirmance As stated earlier, a minor has the power to avoid liability. The minor or, in some jurisdic- tions, her guardian, may exercise the power to disaf- firm a contract through words or conduct showing an intention not to abide by it.

A minor may disaffirm a contract at any time before reaching the age of majority. Moreover, a minor gener- ally may disaffirm a contract within a reasonable time af- ter coming of age as long as she has not already ratified the contract. A notable exception is that a minor cannot disaffirm a sale of land until after reaching her majority.

In most states, determining a reasonable time depends on circumstances such as the nature of the transaction, whether either party has caused the delay, and the extent to which either party has been injured by the delay. Some states, however, statutorily prescribe a time period, generally one year, in which the minor may disaffirm the contract.

Disaffirmance may be either express or implied. No particular form of language is essential, so long as it shows an intention not to be bound. This intention also may be manifested by acts or by conduct. For example, a minor agrees to sell property to Andy and then sells the property to Betty. The sale to Betty constitutes a disaffirmance of the contract with Andy.

Restitution Disaffirmance of an executory contract releases the minor from any liability on the contractual obligation. In cases in which either or both of the parties have performed partially or fully, however, the issue of restitution arises. A minor who has disaffirmed a con- tract is entitled to restitution from the other party for any benefit the minor has conferred on the other party.

A troublesome yet important problem in this area pertains to the minor’s duty to make restitution to the other party upon disaffirmance. The courts do not agree on this question. The majority hold that the minor must return any property received from the other party to the contract, provided she is in possession of it at the time of disaffirmance. Nothing more is required. Under this approach, if a minor disaffirms the purchase of an automobile and the vehicle has been wrecked, the

minor need only return the wrecked vehicle. Other states require at least the payment of a reasonable amount for the use of the property or of the amount by which the property depreciated while in the hands of the minor. (See the following case Berg v. Traylor.) Some states, however, either by statute or court ruling, recognize a duty on the part of the minor to make restitution—that is, to return an equivalent of what has been received so that the seller will be in approximately the same position he would have occupied had the sale not occurred.

The newly adopted Restatement of Restitution adopts the last position: if the other party has dealt with the minor in good faith on reasonable terms, rescission leaves the minor liable in restitution for benefits the minor received in the transaction. The Restatement of Restitution provides the following example:

Minor purchases a used car from Dealer, paying $5,000 cash and making no misrepresentation of age. Dealer acts in good faith, and the sale is on reasonable terms. Several months later the car develops mechanical problems. Minor continues to drive the car without obtaining the necessary repairs; the car becomes inoperable; Minor repudiates the purchase. Minor is entitled to rescind the transaction on the ground of incapacity. In the two-way restoration consequent on rescission, Minor’s claim is to $5,000 plus interest; Dealer recovers the car, with a credit (against Dealer’s liability to Minor) equal to the car’s depreciation in value while in Minor’s possession.

Finally, can a minor disaffirm and recover property that he has sold to a buyer who in turn has sold it to a good-faith purchaser for value? Traditionally, the minor could avoid the contract and recover the property, even though the third person gave value for it and had no notice of the minority. Thus, in the case of the sale of real estate, a minor could take back a deed of convey- ance even against a third-party good-faith purchaser of the land who did not know of the minority. The Uni- form Commercial Code (UCC), however, has changed this principle in connection with sales of goods by pro- viding that a person with voidable title (e.g., the person buying goods from a minor) has power to transfer valid title to a good-faith purchaser for value. For example, a minor sells his car to an individual who resells it to a used-car dealer, a good-faith purchaser for value. The used-car dealer would acquire legal title even though he bought the car from a seller who had only voidable title.

PRACTICAL ADVICE In all significant contracts entered into with a minor, have an adult cosign or guarantee the written agreement.

286 Contracts Part III

B E R G V . T R A Y L O R C o u r t o f A p p e a l , S e c o n d D i s t r i c t , D i v i s i o n 2 , C a l i f o r n i a , 2 0 0 7

1 4 8 C a l . A p p . 4 t h 8 0 9 , 5 6 C a l . R p t r . 3 d 1 4 0

FACTS Sharyn Berg (Berg), plaintiff, brought this action against Meshiel Cooper Traylor (Meshiel) and her minor son Craig Lamar Traylor (Craig) for unpaid commissions under a contract between Berg, Meshiel, and Craig for Berg to serve as the personal manager of Craig. On January 18, 1999, Berg entered into a two- page “Artist’s Manager’s Agreement” (agreement) with Meshiel and Craig, who was then ten years old. Meshiel signed the agreement and wrote Craig’s name on the signature page where he was designated “Artist.” Craig did not sign the agreement. The agreement provided that Berg was to act as Craig’s exclusive personal man- ager in exchange for a commission of 15 percent of all monies paid to him as an artist during the three-year term of the agreement. The agreement expressly pro- vided that any action Craig “may take in the future per- taining to disaffirmance of this agreement, whether successful or not,” would not affect Meshiel’s liability for any commissions due Berg. The agreement also pro- vided that any disputes concerning payment or interpre- tation of the agreement would be determined by arbitration in accordance with the rules of Judicial Arbi- tration and Mediation Services, Inc. (JAMS).

In June 2001, Craig obtained a role on the Fox Tele- vision Network show Malcolm in the Middle (show). On September 11, 2001, four months prior to the expi- ration of the agreement, Meshiel sent a certified letter to Berg stating that while she and Craig appreciated her advice and guidance, they no longer needed her management services and could no longer afford to pay Berg her 15 percent commission because they owed a “huge amount” of taxes. On September 28, 2001, Berg responded, informing appellants that they were in breach of the agreement.

The arbitration hearing was held in February 2005. The arbitrator awarded Berg commissions and interest of $154,714.15, repayment of personal loans and inter- est of $5,094, and attorneys’ fees and costs of $13,762. He also awarded Berg $405,000 “for future earnings projected on a minimum of six years for national syndi- cation earnings.” The defendants then filed a petition with the state trial court to vacate the arbitration award. Following a hearing, the trial court entered a judgment in favor of Berg against Meshiel and Craig consistent with the arbitrator’s award.

DECISION The decision against Craig is reversed, but the judgment against Meshiel is affirmed.

OPINION Todd, J. Simply stated, one who provides a minor with goods and services does so at her own risk. [Citation.] The agreement here expressly contem- plated this risk, requiring that Meshiel remain obligated for commissions due under the agreement regardless of whether Craig disaffirmed the agreement. Thus, we have no difficulty in reaching the conclusion that Craig is per- mitted to and did disaffirm the agreement and any obli- gations stemming therefrom, while Meshiel remains liable under the agreement and resulting judgment. Where our difficulty lies is in understanding how coun- sel, the arbitrator, and the trial court repeatedly and sys- tematically ignored Craig’s interests in this matter. From the time Meshiel signed the agreement, her interests were not aligned with Craig’s. That no one—counsel, the arbitrator, or the trial court—recognized this conflict and sought appointment of a guardian ad litem for Craig is nothing short of stunning. It is the court’s responsibility to protect the rights of a minor who is a litigant in court. [Citation.]

*** “As a general proposition, parental consent is

required for the provision of services to minors for the simple reason that minors may disaffirm their own contracts to acquire such services.” [Citation.] Accord- ing to Family Code section 6700, “a minor may make a contract in the same manner as an adult, subject to the power of disaffirmance” ***. In turn, Family Code section 6710 states: “Except as otherwise provided by statute, a contract of a minor may be disaffirmed by the minor before majority or within a reasonable time afterwards or, in case of the minor’s death within that period, by the minor’s heirs or personal repre- sentative.” Sound policy considerations support this provision:

The law shields minors from their lack of judgment and ex- perience and under certain conditions vests in them the right to disaffirm their contracts. Although in many instan- ces such disaffirmance may be a hardship upon those who deal with an infant, the right to avoid his contracts is con- ferred by law upon a minor “for his protection against his own improvidence and the designs of others.” It is the pol- icy of the law to protect a minor against himself and his indiscretions and immaturity as well as against the machi- nations of other people and to discourage adults from contracting with an infant. Any loss occasioned by the dis- affirmance of a minor’s contract might have been avoided by declining to enter into the contract. [Citation.]

Chapter 14 Contractual Capacity 287

Ratification A minor has the option of ratifying a contract after reaching the age of majority. Ratification makes the contract binding ab initio (from the begin- ning). That is, the result is the same as if the contract had been valid and binding from its inception. Ratifica- tion, once effected, is final and cannot be withdrawn; furthermore, it must be in total, validating the entire contract. The minor can ratify the contract only as a whole, both as to burdens and benefits. He cannot, for example, ratify so as to retain the consideration received and escape payment or other performance on his part; nor can the minor retain part of the contract and disaffirm another part.

Note that a minor has no power to ratify a contract while still a minor. A ratification based on words or conduct occurring while the minor is still underage is no more effective than his original contractual promise.

The ratification must take place after the individual has acquired contractual capacity by attaining his majority.

Ratification can occur in three ways: (1) through express language, (2) as implied from conduct, and (3) through failure to make a timely disaffirmance. Sup- pose that a minor makes a contract to buy property from an adult. The contract is voidable by the minor, and she can escape liability. But suppose that after reaching her majority she promises to go through with the purchase. The minor has expressly ratified the con- tract she entered when she was a minor. Her promise is binding, and the adult can recover for breach if the minor fails to carry out the terms of the contract.

Ratification also may be implied from a person’s conduct. Suppose that the minor, after attaining major- ity, uses the property involved in the contract, under- takes to sell it to someone else, or performs some other

Berg offers two reasons why the plain language of Family Code section 6710 is inapplicable, neither of which we find persuasive. First, she argues that a minor may not disaffirm an agreement signed by a parent. *** [This is not in accord with the law as stated in numer- ous cases.]

Second, Berg argues that Craig cannot disaffirm the agreement because it was for his and his family’s necessi- ties. Family Code section 6712 provides that a valid con- tract cannot be disaffirmed by a minor if all of the following requirements are met: the contract is to pay the reasonable value of things necessary for the support of the minor or the minor’s family, the things have actually been furnished to the minor or the minor’s family, and the contract is entered into by the minor when not under the care of a parent or guardian able to provide for the minor or the minor’s family. These requirements are not met here. The agreement was not a contract to pay for the necessities of life for Craig or his family. While such necessities have been held to include payment for lodging [citation] and even payment of attorneys’ fees [citation], we cannot conclude that a contract to secure personal management services for the purpose of advancing Craig’s acting career constitutes payment for the type of necessity contemplated by Family Code section 6712. Nor is there any evidence that Meshiel was unable to provide for the family in 1999 at the time of the agree- ment. As such, Family Code section 6712 does not bar the minor’s disaffirmance of the contract.

No specific language is required to communicate an intent to disaffirm. “A contract (or conveyance) of a minor may be avoided by any act or declaration disclos- ing an unequivocal intent to repudiate its binding force and effect.” [Citation.] Express notice to the other party

is unnecessary. [Citation.] We find that the “Notice of Disaffirmance of Arbitration Award by Minor” filed on August 8, 2005 was sufficient to constitute a disaffirm- ance of the agreement by Craig. *** We find that Craig was entitled to and did disaffirm the agreement which, among other things, required him to arbitrate his dis- putes with Berg. On this basis alone, therefore, the judg- ment confirming the arbitration award must be reversed.

*** Appellants do not generally distinguish their argu-

ments between mother and son, apparently assuming that if Craig disaffirms the agreement and judgment, Meshiel would be permitted to escape liability as well. But a disaffirmance of an agreement by a minor does not operate to terminate the contractual obligations of the parent who signed the agreement. [Citation.] The agreement Meshiel signed provided that Craig’s disaf- firmance would not serve to void or avoid Meshiel’s obligations under the agreement and that Meshiel remained liable for commissions due Berg regardless of Craig’s disaffirmance. Accordingly, we find no basis for Meshiel to avoid her independent obligations under the agreement.

INTERPRETATION A minor may disaffirm his contracts during minority and for a reasonable time thereafter; nevertheless, the minor’s right to disaffirm does not extend to an adult party to the agreement.

CRITICAL THINKING QUESTION Under what circumstances should minors be able to disaffirm their contracts and receive their full consideration? Explain.

288 Contracts Part III

act showing an intention to affirm the contract. She may not thereafter disaffirm the contract but is bound by it. Perhaps the most common form of implied ratifi- cation occurs when a minor, after attaining majority, continues to use the property purchased as a minor. This use is obviously inconsistent with the nonexistence

of a contract. Whether the contract is performed or still partly executory, the continued use of the property amounts to a ratification and prevents a disaffirmance by the minor. Simply keeping the goods for an unrea- sonable time after attaining majority has also been con- strued as a ratification.

Business Law IN ACTION

Using his own money, fifteen-year-old Zach bought$160 worth of video games and DVDs at a local electronics warehouse. His parents were furious about the purchase, but initially they did nothing. Several months later Zach’s father learned about the so-called infancy doctrine and insisted that Zach return the games and movies. Zach took the items back to the store and asked for a refund. But the clerk refused, pointing to the store’s “Return Policy,” which permitted returns on opened items like those Zach had bought only within thirty days of purchase and only for the same title when necessary to replace defects. After speaking to the man- ager and getting a similar result, Zach’s father considered filing suit against the store in small claims court. Does a minor’s right of disaffirmation override the store’s return policy in a case like this?

Generally speaking, minors may disaffirm contracts entered into during their minority. In a majority of juris- dictions this is true even if the child or teenager cannot return the consideration he or she received and even if

the minor misrepresented his or her age when entering into the transaction with the adult. However, this rule of incapacity does not excuse minors from paying the rea- sonable value of any necessaries for which they may have contracted. There is little question here that the pur- chases Zach made do not qualify as necessaries, things that supply his basic needs. Therefore, Zach is entitled to disaffirm his contract and receive a refund, although some states perhaps would subject the refund to a deduction of some amount representing depreciation of the items or the use or benefit he received.

Nonetheless, retailers need not fear or refuse transac- tions with minors, especially relatively insignificant ones. Most people will not go to the trouble and expense of bringing litigation to recover a small amount of money. It is also foreseeable that many courts, if given the opportu- nity, would not allow a minor to take unfair advantage of her minority. Moreover, teens make up a growing and lucrative segment of the retail market, with their pur- chases tallying in the billions of dollars each year.

I N R E T H E S C O R E B O A R D , I N C . U n i t e d S t a t e s D i s t r i c t C o u r t , D i s t r i c t o f N e w J e r s e y , 1 9 9 9

2 3 8 B . R . 5 8 5

FACTS During the spring of 1996, Kobe Bryant (Bry- ant), then a seventeen-year-old star high school basketball player, declared his intention to forgo college and enter the 1996 National Basketball Association (NBA) lottery draft. The Score Board Inc., a company in the business of licensing, manufacturing, and distributing sports and entertainment-related memorabilia, entered into negotia- tions with Bryant’s agent, Arn Tellem (Agent) and Bry- ant’s father, former NBA star Joe “Jelly Bean” Bryant, to sign Bryant to a contract. In early July 1996, Score Board sent Bryant a signed written licensing agreement (agree- ment). The agreement granted Score Board the right to produce licensed products, such as trading cards, with Bryant’s image. Bryant was obligated to make two per- sonal appearances on behalf of Score Board and provide

between a minimum of 15,000 and a maximum of 32,500 autographs. Bryant was to receive a $2 stipend for each autograph, after the first 7,500. Under the agree- ment, Bryant could receive a maximum of $75,000 for the autographs. In addition to being compensated for the autographs, Bryant was entitled to receive a base com- pensation of $10,000.

Bryant rejected this proposed agreement, and on July 11, 1996, while still a minor, made a counteroffer (counteroffer), signed it, and returned it to Score Board. The counteroffer made several changes to Score Board’s agreement, including the number of autographs. Score Board claimed that they signed the counteroffer and placed it into its files. The copy signed by Score Board was subsequently misplaced and has never been produced

Chapter 14 Contractual Capacity 289

Liability for Necessaries [14-1b] Contractual incapacity does not excuse a minor from an obligation to pay for necessaries, those things—such as food, shelter, medicine, and clothing—that suitably and reasonably supply his personal needs. Even here, however, the minor is not contractually liable for the agreed price but for the reasonable value of the items furnished. Recovery is based on quasi-contract. Thus, if a clothier sells a minor a suit that the minor needs, the clothier can successfully sue the minor. The clothier’s recovery, however, is limited to the reasonable value of the suit only, even if this amount is much less than the

agreed-upon selling price. In addition, a minor is not liable for anything on the ground that the item is a necessary, unless it has been actually furnished to him and used or consumed by him. In other words, a minor may disaffirm his executory contracts for necessaries and refuse to accept such clothing, lodging, or other items.

Defining “necessaries” is a difficult task. In general, the states regard as necessary those things that the minor needs to maintain himself in his particular station in life. Items necessary for subsistence and health, such as food, lodging, clothing, medicine, and

by Score Board during these proceedings. Rather, Score Board has produced a copy signed only by Bryant.

On August 23, 1996, Bryant turned eighteen. Three days later, Bryant deposited the check for $10,000 into his account. Bryant subsequently performed his contrac- tual duties for about a year and a half. By late 1997, Bryant grew reluctant to sign any more autographs under the agreement and his Agent came to the conclu- sion that a fully executed contract did not exist. By this time, Agent became concerned with Score Board’s finan- cial condition because it failed to make certain payments to several other players. Score Board claims that the true motivation for Bryant’s reluctance stems from his per- ception that he was becoming a “star” player and that his autograph was “worth” more than $2.

On March 17, 1998, Score Board mistakenly sent Bry- ant a check for $1,130 as compensation for unpaid auto- graphs. Bryant was actually entitled to $10,130, and the check for $1,130 was based on a miscalculation.

On March 18, 1998, Score Board filed a voluntary Chapter 11 bankruptcy petition. On March 23, 1998, Agent returned the $1,130 check. Included with the check was a letter that directed Score Board to “imme- diately cease and desist from any use of” Kobe Bryant’s name, likeness, or other publicity rights. Subsequently, Score Board began to sell its assets, including numerous executory contracts with major athletes, including Bry- ant. Bryant argued that Score Board could not do this, because he believed that a contract never existed. In the alternative, if a contract had been created, Bryant con- tended that it was voidable because it had been entered into while he was a minor. The Bankruptcy Court ruled in favor of Score Board. Bryant appealed.

DECISION Judgment affirmed.

OPINION Irenas, J. Bryant challenges the Bank- ruptcy Court’s finding that he ratified the agreement upon attaining majority. Contracts made during minority are

voidable at the minor’s election within a reasonable time after the minor attains the age of majority. [Citations.]

The right to disaffirm a contract is subject to the infant’s conduct which, upon reaching the age of major- ity, may amount to ratification. [Citation.] “Any con- duct on the part of the former infant which evidences his decision that the transaction shall not be impeached is sufficient for this purpose.” [Citation.]

On August 23, 1996, Bryant reached the age of ma- jority, approximately six weeks after the execution of the agreement. On August 26, 1996, Bryant deposited the $10,000 check sent to him from Debtor (Score Board). Bryant also performed his contractual duties by signing autographs.

The Bankruptcy Court did not presume ratification from inaction as Bryant asserts. It is clear that Bryant ratified the contract from the facts, because Bryant con- sciously performed his contractual duties.

Bryant asserts that he acted at the insistence of his Agent, who believed that he was obligated to perform by contract. Yet, neither Bryant nor his Agent disputed the existence of a contract until the March 23, 1998, letter by Tellem (Agent). That Bryant may have relied on his Agent is irrelevant to this Court’s inquiry and is proper evidence only in a suit against the Agent. To the contrary, by admitting that he acted because he was under the belief that a contract existed, Bryant confirms the existence of the contract. Moreover, it was Bryant who deposited the check, signed the autographs, and made personal appearances.

INTERPRETATION Ratification of a contract may be implied from a person’s conduct after the person attains his majority.

CRITICAL THINKING QUESTION What criteria should a court employ in determining what is a reasonable period of time for disaffirmance by a person who has attained majority?

290 Contracts Part III

medical services, are included. But other less essen- tial items, such as textbooks, school instruction, and legal advice, may be included as well. Furthermore, some states enlarge the concept of necessaries to include articles of property and services that a minor needs to earn the money required to provide the necessities of life for himself and his dependents. Nevertheless, many states limit necessaries to items that are not provided to the minor. Thus, if a minor’s guardian provides her with an adequate wardrobe, a

blouse the minor purchased would not be considered a necessary.

Ordinarily, luxury items, such as cameras, tape recorders, stereo equipment, television sets, and motor- boats, do not qualify as necessaries. The question con- cerning whether automobiles and trucks are necessaries has caused considerable controversy, but some courts have recognized that under certain circumstances, an automobile may be a necessary where it is used by the minor for his business activities.

Z E L N I C K V . A D A M S S u p r e m e C o u r t o f V i r g i n i a , 2 0 0 2

2 6 3 V a . 6 0 1 , 5 6 1 S . E . 2 d 7 1 1

FACTS Jonathan Ray Adams (Jonathan) was born on April 5, 1980, the son of Mildred A. Adams (Adams or mother) and Cecil D. Hylton, Jr. (Hylton or father). Jonathan’s parents were never married. Nevertheless, the Florida courts did determine Hylton’s paternity of Jonathan. Jonathan’s grandfather, Cecil D. Hylton, Sr. (Hylton Sr.), died in 1989 and had established certain trusts under his will, which provided that the trustees had sole discretion to determine who qualified as “issue” under the will.

In 1996, Adams met with an attorney, Robert J. Zel- nick (Zelnick), about protecting Jonathan’s interest as a beneficiary of the trusts after she had unsuccessfully attempted to get Jonathan recognized as an heir. Adams explained that she could not afford to pay Zelnick’s hourly fee and requested legal services on her son’s behalf on a contingency fee basis. Zelnick subsequently informed Adams that he had examined a copy of the will and that he was willing to accept the case. Adams went to Zelnick’s office the next day, where Zelnick explained that the gross amount of the estate was very large. Adams signed a retainer agreement (the contract) for Zelnick’s firm to represent Jonathan on a one-third contingency fee.

In May 1997, Zelnick initiated a legal action on Jon- athan’s behalf. A consent decree was entered on January 23, 1998, which ordered that Jonathan was “declared to be the grandchild and issue of Cecil D. Hylton” and was entitled to all benefits under the Will and Trusts of Cecil D. Hylton.

In March 1998, Jonathan’s father brought suit against Adams and Zelnick, on Jonathan’s behalf, to have the contract with Zelnick declared void. Upon reaching the age of majority, Jonathan filed a petition to intervene, in which he disaffirmed the contract. Jonathan filed a motion for summary judgment asserting that the contract was “void as a matter of law” because it was not a

contract for necessaries. Jonathan argued that the 1997 suit was unnecessary due to the Florida paternity decree which conclusively established Hylton’s paternity.

The trial court granted Jonathan’s motion for sum- mary judgment and ruled that the contingency fee agree- ment was not binding on Jonathan because he was “in his minority” when the contract was executed. This appeal followed.

DECISION Judgment reversed and remanded.

OPINION Lemons, J. In this appeal, we consider whether a contract for legal services entered into on behalf of a minor is voidable upon a plea of infancy or subject to enforcement as an implied contract for neces- saries and, if enforceable, the basis for determining value of services rendered.

Under well- and long-established Virginia law, a con- tract with an infant is not void, only voidable by the infant upon attaining the age of majority. [Citation.] This oft-cited rule is subject to the relief provided by the doctrine of necessaries which received thorough analysis in the case of Bear’s Adm’x v. Bear, [citation].

In Bear, we explained that when a court is faced with a defense of infancy, the court has the initial duty to determine, as a matter of law, whether the “things suppli- ed” to the infant under a contract may fall within the general class of necessaries. [Citation.] The court must further decide whether there is sufficient evidence to allow the finder of fact to determine whether the “things supplied” were in fact necessary in the instant case. If either of these preliminary inquiries is answered in the negative, the party who provided the goods or services to the infant under the disaffirmed contract cannot recover. If the preliminary inquiries are answered in the affirmative, then the finder of fact must decide, under all the circumstances, whether the “things supplied” were

Chapter 14 Contractual Capacity 291

actually necessary to the “position and condition of the infant.” If so, the party who provided the goods or serv- ices to the infant is entitled to the “reasonable value” of the things furnished. In contracts for necessaries, an infant is not bound on the express contract, but rather is bound under an implied contract to pay what the goods or services furnished were reasonably worth. [Citation.]

“Things supplied,” which fall into the class of necessa- ries, include “board, clothing and education.” [Citation.] Things that are “necessary to [an infant’s] subsistence and comfort, and to enable [an infant] to live according to his real position in society” are also considered part of the class of necessaries. [Citation.] ***

Certainly, the provision of legal services may fall within the class of necessaries for which a contract by or on behalf of an infant may not be avoided or disaffirmed on the grounds of infancy. Generally, contracts for legal services related to prosecuting personal injury actions, and protecting an infant’s personal liberty, security, or reputation are considered contracts for necessaries. [Cita- tion.] “Whether attorney’s services are to be considered necessaries or not depends on whether or not there is a necessity therefor. If such necessity exists, the infant may be bound.… If there is no necessity for services, there can be no recovery” for the services. [Citation.]

*** Other states have also broadened the definition of

“necessaries” to include contracts for legal services for the protection of an infant’s property rights. ***

In determining whether the doctrine of necessaries may be applied to defeat an attempt to avoid or disaf- firm a contract on the grounds of infancy, the trial court must first determine as a matter of law whether the class of “things supplied” falls within the “general classes of necessaries.” We hold that a contract for legal services falls within this class. However, the inquiry does not end with this determination. The ultimate determination is an issue of fact. The trier of fact must conclude that “under all the circumstances, the things furnished were actually necessary to the position and condition of the infant … and whether the infant was already sufficiently supplied.” [Citation.] If the contract does not fall within the “general classes of necessaries,” the trial court must, as a matter of law, sustain the plea of infancy and permit the avoidance of the contract. Similarly, if the contract does fall within the “general classes of neces- saries,” but upon consideration of all of the circumstan- ces, the trier of fact determines that the provision of the particular services or things was not actually necessary, the plea of infancy must be sustained. Where there is a successful avoidance of the contract, the trial court may not circumvent the successful plea of infancy by affording a recovery to the claimant on the theory of quantum

meruit. However, if the plea of infancy is not sustained, the claimant is not entitled to enforcement of the express contract. Rather, as we have previously held, “even in contracts for necessaries, the infant is not bound on the express contract but on the implied contract to pay what they are reasonably worth.” [Citation.]

*** Upon review of the record, we hold that the *** rea-

son stated by the trial court for holding that the necessa- ries doctrine did not apply, namely that the contract “was conducted while he was in his minority and he’s not bound by that,” is an error of law. We hold that a contract for legal services is within the “general classes of necessaries” that may defeat a plea of infancy. ***

*** The trial court’s determination that the necessaries

doctrine did not apply was made upon motion for sum- mary judgment filed by Jonathan. Nowhere in Jona- than’s motion for summary judgment is the issue raised that the services were unnecessary at the time rendered *** . Although Jonathan argues that the services were not necessary at all because he alleges that the Florida litiga- tion resolved the question of his inclusion as a beneficiary under the will of Hylton Sr., the timing of the services was not even mentioned as an issue, much less as a reason for granting summary judgment. ***

Because the trial court erred in its determination, on this record, on summary judgment, that the doctrine of necessaries did not apply, we will reverse the judgment of the trial court and remand for further proceedings, including the taking of evidence on the issue of the fac- tual determination of necessity “under all of the circum- stances.” Consistent with this opinion, should the trial court upon remand hold that the doctrine of necessaries does not apply because the evidence adduced does not support the claim, the contract is avoided and no award shall be made.

Should the trial court upon remand hold that the evi- dence is sufficient to defeat Jonathan’s plea of infancy, the trial court shall receive evidence of the reasonable value of the services rendered. ***

INTERPRETATION Contractual incapacity does not excuse a minor from an obligation to pay the reasonable value of a necessary.

ETHICAL QUESTION Did Jonathan act ethi- cally? Explain.

CRITICAL THINKING QUESTION What factors should a court use in determining whether goods or services are necessary? Explain.

292 Contracts Part III

Liability for Misrepresentation of Age [14-1c] The states do not agree whether a minor who fraudu- lently misrepresents her age when entering into a con- tract has the power to disaffirm. Suppose a contracting minor says that she is eighteen years of age (or twenty- one, if that is the year of attaining majority) and actually looks at least that age. By the prevailing view in this country, despite her misrepresentation, the minor may nevertheless disaffirm the contract. Some states, however, prohibit disaffirmance if a minor misrepresented

her age to an adult who, in good faith, reasonably relied on the misrepresentation. As shown in the case of Keser v. Chagnon, other states not following the majority rule either (1) require the minor to restore the other party to the position he occupied before making the contract or (2) allow the defrauded party to recover damages against the minor in tort.

PRACTICAL ADVICE In all significant contracts, if you have doubts about the age of your customers, have them prove that they are of legal age.

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1 5 9 C o l o . 2 0 9 , 4 1 0 P . 2 d 6 3 7

FACTS On June 11, 1964, Chagnon bought a 1959 Ford Edsel from Keser for $995. Chagnon, who was then a twenty-year-old minor, obtained the contract by falsely advising to Keser that he was over twenty-one years old, the age of majority. On September 25, 1964, two months and four days after his twenty-first birth- day, Chagnon disaffirmed the contract and, ten days later, returned the Edsel to Keser. He then brought suit to recover the money he had paid for the automobile. Keser counterclaimed that he suffered damages as the direct result of Chagnon’s false representation of his age. A trial was had to the court, sitting without a jury, all of which culminated in a judgment in favor of Chagnon against Keser in the sum of $655.78. This particular sum was arrived at by the trial court in the following manner: the trial court found that Chagnon initially purchased the Edsel for the sum of $995 and that he was entitled to the return of his $995; and then, by way of setoff, the trial court subtracted from the $995 the sum of $339.22, apparently representing the difference between the purchase price paid for the vehicle and the reasonable value of the Edsel on October 5, 1964, the date when the Edsel was returned to Keser.

DECISION Judgment affirmed except as to the cal- culation of damages for misrepresentation.

OPINION McWilliams, J. Before considering each of these several matters, it is deemed helpful to allude briefly to some of the general principles pertaining to the long-standing policy of the law to protect a minor from at least some of his childish foibles by affording

him the right, under certain circumstances, to avoid his contract, not only during his minority but also within a reasonable time after reaching his majority. In [citation] we held that when a minor elects to disaf- firm and avoid his contract, the “contract” becomes invalid ab initio and that the parties thereto then revert to the same position as if the contract had never been made. In that case we went on to declare that when a minor thus sought to avoid his contract and had in his possession the specific property received by him in the transaction, he was in such circumstance required to return the same as a prerequisite to any avoidance.

In [citation] it is said that a minor failing to disaf- firm within a “reasonable time” after reaching his ma- jority loses the right to do so and that just what constitutes a “reasonable time” is ordinarily a question of fact. As regards the necessity for restoration of con- sideration, in [citation] it is stated that the minor after disaffirming is “usually required *** to return the con- sideration, if he can, or the part remaining in his pos- session or control.”

*** Keser’s *** contention that Chagnon upon attaining

his majority ratified the contract by his failure to disaf- firm within a reasonable time after becoming twenty- one and by his retention and use of the Edsel prior to its return to the seller is equally untenable. In this con- nection it is pointed out that Chagnon did not notify Keser of his desire to disaffirm until sixty-six days after he became twenty-one and that he did not return the Edsel until ten days after his notice to disaffirm, during all of which time Chagnon had the possession and use

Chapter 14 Contractual Capacity 293

Liability for Tort Connected with Contract [14-1d] It is well settled that minors are generally liable for their torts. There is, however, a legal doctrine that if a tort and a contract are so “interwoven” that the court must enforce the contract to enforce the tort action, the minor is not liable in tort. Thus, a minor who rents an automobile from an adult enters into a con- tractual relationship obliging him to exercise reasona- ble care to protect the property from injury. By negligently damaging the automobile, he breaches that contractual undertaking. But his contractual immunity protects him from an action by the adult based on the contract. By the majority view, the adult cannot suc- cessfully sue the minor for damages on a tort theory. For, it is reasoned, a tort recovery would, in effect, be an enforcement of the contract and would defeat the protection that contract law gives the minor. Should the minor depart, however, from the terms of the agreement (e.g., by using a rental automobile for an unauthorized purpose) and in so doing negligently cause damage to the automobile, most courts would hold that the tort is independent and that the adult can collect from the minor.

INCOMPETENT PERSONS [14-2] In this section, we will discuss the contract status of mentally incompetent persons who are under court- appointed guardianship and persons with mental inca- pacity who are not adjudicated incompetents.

Person Under Guardianship [14-2a] If a person is under guardianship by court order, her contracts are void and of no legal effect. A court appoints a guardian, generally under the terms of a statute, to control and preserve the property of a per- son (the ward or adjudicated incompetent) whose impaired capacity prevents her from managing her own property. Nonetheless, a party dealing with an individ- ual under guardianship may be able to recover the fair value of any necessaries provided to the incompetent. Moreover, the contracts of the ward may be ratified by her guardian during the period of guardianship or by the ward on termination of the guardianship.

Mental Illness or Defect [14-2b] Because a contract is a consensual transaction, the par- ties to a valid contract must have a certain level of

of the vehicle in question. As already noted, when an infant attains his majority he has a reasonable time within which he may thereafter disaffirm a contract entered into during his minority. And this rule is not as strict where, as here, we are dealing with an executed contract. There is no hard and fast rule as to just what constitutes a “reasonable” time within which the infant may disaffirm. *** Suffice it to say, that under the cir- cumstances disclosed by the record we are not prepared to hold that as a matter of law Chagnon ratified the contract either by his actions or by his alleged failure to disaffirm within a reasonable time after reaching his majority. ***

Finally, error is predicated upon the trial court’s find- ing in connection with Keser’s setoff for the damage occasioned him by Chagnon’s admitted false representa- tion of his age. In this regard the trial court apparently found that the reasonable value of the Edsel when it was returned to Keser by Chagnon was $655.78, and accordingly went on to allow Keser a setoff in the amount of $339.22, this latter sum representing the dif- ference between the purchase price, $995, and the value

of the vehicle on the date it was returned. Finding, then, that Chagnon was entitled to the return of the $995 which he had theretofore paid Keser for the Edsel, the trial court then subtracted therefrom Keser’s setoff in the amount of $339.22, and accordingly entered judg- ment for Chagnon against Keser in the sum of $655.78. Whether it was by accident or design we know not, but $655.78 is apparently the exact amount which Chagnon “owed” the Public Finance Corporation on his note with that company.

INTERPRETATION States vary on the rights of a minor and a defrauded party when a minor fraudulently misrepresents her age when entering into a contract.

ETHICAL QUESTION If a minor misrepre- sents his age, should he forfeit the right to avoid the con- tract? Explain.

CRITICAL THINKING QUESTION What rule would you apply in this case? Explain.

294 Contracts Part III

mental capacity. If a person lacks such mental capacity, or is mentally incompetent, the agreement is voidable.

Under the traditional cognitive ability test, a person is mentally incompetent if he is unable to comprehend the subject of the contract, its nature, and its probable con- sequences. Though he need not be proved permanently incompetent to avoid the contract, his mental defect must be something more than a weakness of intellect or a lack of average intelligence. In short, a person is com- petent unless he is unable to understand the nature and effect of his actions, in which case he may disaffirm the contract even if the other party did not know or had no reason to know of the incompetent’s mental condition.

A second type of mental incompetence recognized by the Restatement of Contracts and some states is a men- tal condition that impairs a person’s ability to act in a reasonable manner. In other words, the person under- stands what he is doing but cannot control his behavior in order to act in a reasonable and rational way.

The newly adopted Restatement of Restitution provides that a transfer by a person lacking mental capacity is subject to rescission unless ratified. Upon disaffirmance by the mentally incompetent person, the other party to the contract is liable in restitution as necessary to avoid unjust enrichment. If the other party has dealt with the mentally incompetent person in good faith on reasonable terms, rescission leaves the mentally incompetent person liable in restitution for benefits the mentally incompetent person received in the transaction.

Like minors and persons under guardianship, an incompetent person is liable on the principle of quasi- contract for necessaries furnished him, the amount of recovery being the reasonable value of the goods or services. Moreover, an incompetent person may ratify or disaffirm voidable contracts during a lucid period or when he becomes competent.

PRACTICAL ADVICE If you have doubts about the capacity of the other party to a contract, have an individual with full legal capacity cosign the contract.

Intoxicated Persons [14-3c] A person may avoid any contract that he enters into if the other party has reason to know that the person, because of his intoxication, is unable to understand the nature and consequences of his actions or unable to act in a reasonable manner. Such con- tracts, as in the case that follows, are voidable, although they may be ratified when the intoxicated person regains his capacity. Slight intoxication will not destroy one’s contractual capacity; on the other hand, to make a contract voidable, a person need not be so drunk that he is totally without reason or understanding.

The effect that the courts allow intoxication to have on contractual capacity is similar to the effect they allow contracts that are voidable because of incompe- tency, although the courts are even more strict with intoxication due to its voluntary nature. Most courts, therefore, require that, to avoid a contract, the intoxi- cated person on regaining his capacity must act promptly to disaffirm and generally must offer to restore the consideration he has received. Individuals who are taking prescribed medication or who are invol- untarily intoxicated are treated the same as those who are incompetent under the cognitive ability test. As with incompetent persons, intoxicated persons are liable in quasi-contract for necessaries furnished during their incapacity.

Figure 14-1 summarizes the voidability of contracts made by persons with contractual incapacity.

FIGURE 14-1 Incapacity: Minors, Nonadjudicated Incompetents, and Intoxicated

Incapacity terminates

Contract may not be ratified May expressly or impliedly ratify contract

Contract may be disaffirmed Contract may be disaffirmed

Contract ratified by nondisaffirmance

INCAPACITY FULL CAPACITY

Reasonable time

Chapter 14 Contractual Capacity 295

F I R S T S T A T E B A N K O F S I N A I V . H Y L A N D S u p r e m e C o u r t o f S o u t h D a k o t a , 1 9 8 7

3 9 9 N . W . 2 d 8 9 4

FACTS Randy Hyland, unable to pay two promis- sory notes due September 19, 1981, negotiated with The First State Bank of Sinai (Bank) for an extension. The Bank agreed on the condition that Randy’s father, Mer- vin, act as cosigner. Mervin, a good customer of the Bank, had executed and paid on time over sixty promis- sory notes within a seven-year period. Accordingly, the Bank drafted a new promissory note with an April 20, 1982, due date, which Randy took home for Mervin to sign. On April 20, 1982, the new note was unpaid. Randy, on May 5, 1982, brought the Bank a check signed by Mervin to cover the interest owed on the unpaid note and asked for another extension. The Bank agreed to a second extension, again on the condition that Mervin act as cosigner. Mervin, however, refused to sign the last note, and Randy subsequently declared bankruptcy. The Bank sued Mervin on December 19, 1982. Mervin responded that he was not liable since he had been incapacitated by liquor at the time he signed the note. He had been drinking heavily throughout this period and in fact had been involuntarily committed to an alcoholism treatment hospital twice during the time of these events. In between commitments, however, Mervin had executed and paid his own promissory note with the Bank and had transacted business in connec- tion with his farm. The trial court held that Mervin’s contract as cosigner was void due to alcohol-related incapacity, and the Bank appealed.

DECISION Judgment for the Bank.

OPINION Henderson, J. Historically, the void con- tract concept has been applied to nullify agreements made by mental incompetents who have contracted *** after a judicial determination of incapacity had been entered. [Citations.] ***

Mervin had numerous and prolonged problems stem- ming from his inability to handle alcohol. However, he was not judicially declared incompetent during the note’s signing.

*** Contractual obligations incurred by intoxicated per-

sons may be voidable. [Citation.] Voidable contracts (contracts other than those entered into following a

judicial determination of incapacity) *** may be re- scinded by the previously disabled party. [Citation.] However, disaffirmance must be prompt, upon the re- covery of the intoxicated party’s mental abilities, and upon his notice of the agreement, if he had forgotten it. [Citation.] ***

A voidable contract may also be ratified by the party who had contracted while disabled. Upon ratification, the contract becomes a fully valid legal obligation. [Cita- tion.] Ratification can either be express or implied by conduct. [Citations.] In addition, failure of a party to disaffirm a contract over a period of time may, by itself, ripen into a ratification, especially if rescission will result in prejudice to the other party. [Citations.]

Mervin received both verbal notice from Randy and written notice from Bank on or about April 27, 1982, that the note was overdue. On May 5, 1982, Mervin paid the interest owing with a check which Randy deliv- ered to Bank. This by itself could amount to ratification through conduct. If Mervin wished to avoid the con- tract, he should have then exercised his right of rescis- sion. We find it impossible to believe that Mervin paid almost $900 in interest without, in his own mind, accepting responsibility for the note. His assertion that paying interest on the note relieved his obligation is equally untenable in light of his numerous past experi- ences with promissory notes.

*** We conclude that Mervin’s obligation to Bank was

not void. *** Mervin’s obligation on the note was void- able and his subsequent failure to disaffirm (lack of re- scission) and his payment of interest (ratification) then transformed the voidable contract into one that is fully binding upon him.

INTERPRETATION An intoxicated party rati- fies a contract by not disaffirming it when she is not intoxicated and learns of its existence and by making interest payments on it when she is not intoxicated.

CRITICAL THINKING QUESTION When should a person be allowed to invalidate an agreement because of intoxication? Explain.

296 Contracts Part III

C H A P T E R S U M M A R Y Minors

Definition person who is under the age of majority (usually eighteen years)

Liability on Contracts minor’s contracts are voidable at the minor’s option • Disaffirmance avoidance of the contract; may be done during minority and for a reasonable

time after reaching majority • Restitution a minor who has disaffirmed a contract is entitled to restitution from the other

party for any benefit the minor has conferred on the other party; the courts differ regarding the obligation of the minor to make restitution to the other party

• Ratification affirmation of the entire contract; may be done upon reaching majority

Liability for Necessaries a minor is liable for the reasonable value of necessary items (those that reasonably supply a person’s needs)

Liability for Misrepresentation of Age prevailing view is that a minor may disaffirm the contract

Liability for Tort Connected with Contract a minor is not liable in tort if a tort and a contract are so intertwined that to enforce the tort the court must enforce the contract

Incompetent and Intoxicated Persons

Person Under Guardianship a contract made by a mentally incompetent person placed under guardianship by court order is void

Mental Illness or Defect a contract entered into by a nonadjudicated mentally incompetent person (one who is unable to understand the nature and consequences of his acts) is voidable

Intoxicated Persons a contract entered into by an intoxicated person (one who cannot understand the nature and consequence of her actions) is voidable

Ethical Dilemma Should a Merchant Sell to One Who Lacks Capacity?

FACTS Alice Richards is a salesclerk for an exclusive department store in Connecticut. She was working in the children’s clothing department when an elderly woman, Carrie Johnson, entered the area and began to browse. Because part of her compensation is based on commissions and it had been a slow season, Richards was eager to help her. However, when Richards asked Johnson if she needed any help, Johnson replied, “No, I’m just looking for a new pocketbook.” When Richards attempted to direct Johnson to the pocketbooks, Johnson did not appear to respond. Puzzled, Richards began to wonder whether the woman was mentally alert.

Johnson picked out infant’s clothing and accessories worth approximately $250. At the cashier’s counter she exclaimed how lovely everything was and explained that the jumpers and bath toys would go well with the other new clothes she had purchased for her son, who would soon be back from a cruise in the Bahamas.

Worried that the woman did not know what she was purchasing, Richards asked her manager for assistance. The manager said that the sale should be completed, as long as the store’s credit policies were satisfied.

Social, Policy, and Ethical Considerations 1. What would you do?

2. What responsibility does a retail store have in stopping a sale where a reasonable person would assume that the customer lacks capacity? What business policies are appropriate?

3. What are the dangers in assuming a protective position? How can a retailer avoid discrimination and extend appropriate protection?

4. What alternatives does a family have when an elderly member begins to lose capacity?

Chapter 14 Contractual Capacity 297

Q U E S T I O N S

1. Mark, a minor, operates a one-man automobile repair shop. Rose, having heard of Mark’s good work on other cars, takes her car to Mark’s shop for a thorough engine overhaul. Mark, while overhauling Rose’s engine, care- lessly fits an unsuitable piston ring on one of the pistons, with the result that Rose’s engine is seriously damaged. Mark offers to return the sum that Rose paid him for his work, but refuses to pay for the damage. Rose sues Mark in tort for the damage to her engine. Can Rose recover from Mark in tort for the damage to her engine? Why?

2. Explain the outcome of each of the following transac- tions.

a. On March 20, Andy Small turned seventeen years old, but he appeared to be at least twenty-one. On April 1, he moved into a rooming house in Chicago and orally agreed to pay the landlady $800 a month for room and board, payable at the end of each month. On April 30, he refused to pay his landlady for his room and board for the month of April.

b. On April 4, he went to Honest Hal’s Carfeteria and signed a contract to buy a used car on credit with a small down payment. He made no representation as to his age, but Honest Hal represented the car to be in top condition, which it subsequently turned out not to be. On April 25, he returned the car to Honest Hal and demanded a refund of his down payment.

c. On April 7, Andy sold and conveyed to Adam Smith a parcel of real estate that he owned. On April 28, he demanded that Adam Smith reconvey the land although the purchase price, which Andy received in cash, had been spent in riotous living.

3. Jones, a minor, owned a 2014 automobile. She traded it to Stone for a 2015 car. Jones went on a three-week trip and found that the 2015 car was not as good as the 2014 car. She asked Stone to return the 2014 car but was told that it had been sold to Tate, who did not know that the car had been obtained by Stone from a minor. Jones thereupon sued Tate for the return of the 2014 car. Is Jones entitled to regain ownership of the 2014 car? Explain.

4. On May 7, Roy, a minor, a resident of Smithton, pur- chased an automobile from Royal Motors, Inc., for $12,750 in cash. On the same day, he bought a motor scooter from Marks, also a minor, for $1,750 and paid him in full. On June 5, two days before attaining his ma- jority, Roy disaffirmed the contracts and offered to return the car and the motor scooter to the respective sellers. Royal Motors and Marks each refused the offers. On June 16, Roy brought separate appropriate actions against Royal Motors and Marks to recover the purchase

price of the car and the motor scooter. By agreement on July 30, Royal Motors accepted the automobile. Royal then filed a counterclaim against Roy for the reasonable rental value of the car between June 5 and July 30. The car was not damaged during this period. Royal knew that Roy lived twenty-five miles from his place of employment in Smithton and that he probably used the car, as he did, for transportation. What is the decision as to

a. Roy’s action against Royal Motors, Inc., and its coun- terclaim against Roy; and

b. Roy’s action against Marks?

5. On October 1, George Jones entered into a contract with Johnson Motor Company, a dealer in automobiles, to buy a car for $10,600. He paid $1,100 down and agreed to make monthly payments thereafter of $325 each. Although he made the first payment on November 1, he failed to make any more payments. Jones was seventeen years old at the time he made the contract, but he repre- sented to the company that he was twenty-one years old because he was afraid the company would not sell the car to him if it knew his real age. His appearance was that of a man of twenty-one years of age. On December 15, the company repossessed the car under the terms provided in the contract. At that time, the car had been damaged and was in need of repairs. On December 20, George Jones became of age and at once disaffirmed the contract and demanded the return of the $1,425 paid on the contract. When the company refused to do so, Jones brought an action to recover the $1,425, and the company set up a counterclaim of $1,500 for expenses it incurred in repairing the car. Who will pre- vail? Why?

6. Rebecca entered into a written contract to sell certain real estate to Mary, a minor, for $80,000, payable $4,000 on the execution of the contract and $800 on the first day of each month thereafter until paid. Mary paid the $4,000 down payment and eight monthly installments before attaining her majority. Thereafter, Mary made two additional monthly payments and caused the con- tract to be recorded in the county where the real estate was located. Mary was then advised by her lawyer that the contract was voidable. After being so advised, Mary immediately tendered the contract to Rebecca, together with a deed reconveying all of Mary’s interest in the property to Rebecca. Also, Mary demanded that Rebecca return the money paid under the contract. Rebecca refused the tender and declined to repay any portion of the money paid to her by Mary. Can Mary cancel the contract and recover the amount paid to Rebecca? Explain.

298 Contracts Part III

7. Anita sold and delivered an automobile to Marvin, a minor. Marvin, during his minority, returned the auto- mobile to Anita, saying that he disaffirmed the sale. Anita accepted the automobile and said she would return the purchase price to Marvin the next day. Later in the day, Marvin changed his mind, took the automobile without Anita’s knowledge, and sold it to Chris. Anita had not returned the purchase price when Marvin took the car. On what theory, if any, can Anita recover from Marvin? Explain.

8. Ira, who in 2013 had been found not guilty of a criminal offense because of insanity, was released from a hospital for the criminally insane during the summer of 2014 and since that time has been a reputable and well-respected

citizen and businessperson. On February 1, 2015, Ira and Shirley entered into a contract in which Ira would sell his farm to Shirley for $300,000. Ira now seeks to void the contract. Shirley insists that Ira is fully competent and has no right to avoid the contract. Who will prevail? Why?

9. Daniel, while under the influence of alcohol to the extent that he did not know the nature and consequences of his acts, agreed to sell his 2013 automobile to Belinda for $13,000. The next morning when Belinda went to Dan- iel’s house with the $13,000 in cash, Daniel stated that he did not remember the transaction but that “a deal is a deal.” One week after completing the sale, Daniel decides that he wishes to avoid the contract. What is the result?

C A S E P R O B L E M S

10. Langstraat, age seventeen, owned a motorcycle that he insured against liability with Midwest Mutual Insurance Company. He signed a notice of rejection attached to the policy indicating that he did not desire to purchase unin- sured motorists’ coverage from the insurance company. Later he was involved in an accident with another motor- cycle owned and operated by a party who was uninsured. Langstraat now seeks to recover from the insurance com- pany, asserting that his rejection was not valid because he is a minor. Can Langstraat recover from Midwest? Explain.

11. G.A.S. married his wife, S.I.S., on January 19, 1998. He began to have mental health problems in 2011; that year, he was hospitalized at the Delaware State Hospital for eight weeks. Similar illnesses occurred in 2013 and in the early part of 2015, with G.A.S. suffering from symptoms such as paranoia and loss of a sense of reality. In early 2016, G.A.S. was still committed to the Delaware State Hospital, attending a regular job during the day and returning to the hospital at night. G.A.S., however, was never adjudicated to be incompetent by any court. Dur- ing this time, he entered into a separation agreement pre- pared by his wife’s attorney which was grossly unfair to G.A.S. However, G.A.S. never spoke with the attorney about the contents of the agreement, nor did he read it prior to signing. Moreover, G.A.S. was not independently represented by counsel when he executed this agreement. Can G.A.S. disaffirm the separation agreement? Explain.

12. L. D. Robertson bought a pickup truck from King and Julian, who did business as the Julian Pontiac Company. At the time of purchase, Robertson was seventeen years old, living at home with his parents and driving his father’s truck around the county to different construction jobs. According to the sales contract, he traded in a pas- senger car for the truck and was given $723 credit toward the truck’s $1,743 purchase price, agreeing to pay the re-

mainder in monthly installments. After he paid the first month’s installment, the truck caught fire and was ren- dered useless. The insurance agent, upon finding that Rob- ertson was a minor, refused to deal with him. Consequently, Robertson sued to exercise his right as a minor to rescind the contract and to recover the purchase price he had already paid ($723 credit for the car traded in plus the one month’s installment). The defendants argue that Robertson, even as a minor, cannot rescind the con- tract because it was for a necessary item. Are they correct?

13. A fifteen-year-old minor was employed by Midway Toyota, Inc. On August 18, 2014, the minor, while engaged in lifting heavy objects, injured his lower back. In October 2014 he underwent surgery to remove a herniated disk. Midway Toyota paid him the appropriate amount of temporary total disability payments ($153.36 per week) from August 18, 2014, through November 15, 2015. In February 2016 a final settlement was reached for 150 weeks of permanent partial disability benefits totaling $18,403.40. Tom Mazurek represented Midway Toyota in the negotiations leading up to the agreement and negoti- ated directly with the minor and his mother, Hermoine Parrent. The final settlement agreement was signed by the minor only. Mrs. Parrent was present at the time and did not object to the signing, but neither she nor anyone else of “legal guardian status” cosigned the agreement. The minor later sought to disaffirm the agreement and reopen his workers’ compensation case. The workers’ compensa- tion court denied his petition, holding that Mrs. Parrent “participated fully in consideration of the offered final set- tlement and … ratified and approved it on behalf of her ward … to the same legal effect as if she had actually signed [it].…” The minor appealed. Decision?

14. Rose, a minor, bought a new Buick Riviera from Sheehan Buick. Seven months later, while still a minor, he attempted to disaffirm the purchase. Sheehan Buick

Chapter 14 Contractual Capacity 299

refused to accept the return of the car or to refund the purchase price. Rose, at the time of the purchase, gave all the appearance of being of legal age. The car had been used by him to carry on his school, business, and social activities. Can Rose successfully disaffirm the contract?

15. Haydocy Pontiac sold Jennifer Lee a used automobile for $7,500, of which $6,750 was financed with a note and security agreement. At the time of the sale, Lee, age twenty, represented to Haydocy that she was twenty-one years old, the age of majority then, and capable of con- tracting. After receiving the car, Lee allowed John Rob- erts to take possession of it. Roberts took the car and has not returned. Lee has failed to make any further pay- ments on the car. Haydocy has sued to recover on the note, but Lee disaffirms the contract, claiming that she was too young to enter into a valid contract. Can Hayd- ocy recover the money from Lee? Explain.

16. Carol White ordered a $225 pair of contact lenses through an optometrist. White, an emancipated minor, paid $100 by check and agreed to pay the remaining $125 at a later time. The doctor ordered the lenses, incurring a debt of $110. After the lenses were ordered, White called to cancel her order and stopped payment on the $100 check. The lenses could be used by no one but White. The doctor sued White for the value of the lenses. Will the doctor be able to recover the money from White? Explain.

17. Halbman, a minor, purchased a used car from Lemke for $11,250. Under the terms of the contract, Halbman would pay $1,000 down and the balance in $250 weekly installments. Halbman purchased the car as a way to get around and have some fun. Upon making the down pay- ment, Halbman received possession of the car, but Lemke retained the title until the balance was paid. After Halb- man had made his first four payments, a connecting rod in the car’s engine broke. Lemke denied responsibility but offered to help Halbman repair the engine if Halbman would provide the parts. Halbman, however, placed the car in a garage where the repairs cost $1,637.40. Halb- man never paid the repair bill.

Hoping to avoid any liability for the vehicle, Lemke transferred title to Halbman even though Halbman never paid the balance owed. Halbman returned the title with a letter disaffirming the contract and demanded return of the money paid. Lemke refused. As the repair bill remained unpaid, the garage removed the car’s engine and transmission and towed the body to Halbman’s father’s house. Vandalism during the period of storage rendered the car unsalvageable. Several times Halbman requested Lemke to remove the car. Lemke refused. Halbman sued Lemke for the return of his consideration,

and Lemke countersued for the amount still owed on the contract. Decision?

18. On April 29, Kirsten Fletcher and John E. Marshall III jointly signed a lease to rent an apartment for the term beginning on July 1 and ending on June 30 of the follow- ing year, for a monthly rent of $525 per month. At the time the lease was signed, Marshall was not yet eighteen years of age. Marshall turned eighteen on May 30. The couple moved into the apartment. About two months later, Marshall moved out to attend college, but Fletcher remained. She paid the rent herself for the remaining ten months of the lease and then sought contribution for Marshall’s share of the rent plus court costs in the amount of $2,500. Can Fletcher collect from Marshall?

19. Rogers was a nineteen-year-old (the age of majority then being twenty-one) high school graduate pursuing a civil engineering degree when he learned that his wife was expecting a child. As a result, he quit school and sought assistance from Gastonia Personnel Corporation in find- ing a job. Rogers signed a contract with the employment agency providing that he would pay the agency a service charge if it obtained suitable employment for him. The employment agency found him such a job, but Rogers refused to pay the service charge, asserting that he was a minor when he signed the contract. Gastonia sued to recover the agreed-upon service charge from Rogers. Should Rogers be liable under his contract? If so, for how much?

20. On September 29, just under two weeks before his 18th birthday, Bagley, a highly skilled and experienced snow- boarder, purchased a season pass from Mt. Bachelor ski facility. Upon purchasing the season pass, he executed a release agreement as required by Mt. Bachelor. The sig- nificant portions of the release agreement were also printed on the pass. Beginning on November 18, after his 18th birthday, Bagley used his season pass to ride Mt. Bachelor’s lifts at least 119 times over the course of twenty-six days spent snowboarding at the ski area. However, on February 16 of the following year, while snowboarding over a manmade jump in Mt. Bachelor’s “air chamber” terrain park, Bagley sustained serious inju- ries resulting in permanent paralysis. Bagley sued Mt. Bachelor for negligence, claiming that he had timely dis- affirmed the release agreement by notifying Mt. Bachelor of the injury. Mt. Bachelor argued that Bagley had mani- fested his intent to ratify (a) by failing to disaffirm the voidable release agreement within a reasonable period of time after reaching the age of majority and (b) by accept- ing the benefits of that agreement. Explain whether Bag- ley has ratified the contract.

300 Contracts Part III

T A K I N G S I D E S

Joseph Eugene Dodson, age sixteen, purchased a used pickup truck from Burns and Mary Shrader. The Shraders owned and operated Shrader’s Auto Sales. Dodson paid $14,900 in cash for the truck. At the time of sale, the Shraders did not question Dodson’s age, but thought he was eighteen or nineteen. Dodson made no misrepresentation concerning his age. Nine months af- ter the date of purchase, the truck began to develop mechanical problems. A mechanic diagnosed the problem as a burnt valve but could not be certain. Dodson, who could not afford the repairs, continued to drive the truck until one month later, when

the engine “blew up.” Dodson parked the vehicle in the front yard of his parents’ home and contacted the Shraders to rescind the purchase of the truck and to request a full refund.

a. What arguments would support Dodson’s termination of the contract?

b. What arguments would support Shrader’s position that the contract is not voidable?

c. Which side should prevail? Explain.

Chapter 14 Contractual Capacity 301

C H A P T E R 1 5

CONTRACTS IN WRITING

To break an oral agreement which is not legally binding is morally wrong. THE TALMUD

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Identify and explain the five types of contracts covered by the general contract statute of frauds and the contracts covered by the Uniform Commercial Code (UCC) statute of frauds provision.

2. Describe the writings that are required to satisfy the general contract and the UCC statute of frauds provisions.

3. Identify and describe the other methods of complying with the general contract and the UCC statute of frauds provisions.

4. Explain the parol evidence rule and identify the situations to which the rule does not apply.

5. Discuss the rules that aid in the interpretation of a contract.

A n oral contract, that is, one not in writing, is in every way as enforceable as a written contract unless otherwise provided by statute. Although

most contracts do not need to be in writing to be en- forceable, it is highly desirable that significant contracts be written. Written contracts avoid many problems that proving the terms of oral contracts inevitably involve. The process of setting down the contractual terms in a written document also tends to clarify the terms and bring to light problems the parties might not otherwise foresee. Moreover, the terms of a written contract do not change over time, whereas the parties’ recollections of the terms might.

When the parties do reduce their agreement to a complete and final written expression, the law (under the parol evidence rule) honors this document by not

allowing the parties to introduce any evidence in a law- suit that would alter, modify, or vary the terms of the written contract. Nevertheless, the parties may differ as to the proper or intended meaning of language con- tained in the written agreement where such language is ambiguous or susceptible to different interpretations. To determine the proper meaning requires an interpre- tation, or construction, of the contract. The rules of construction permit the parties to introduce evidence to resolve ambiguity and to show the meaning of the lan- guage employed and the sense in which both parties used it.

In this chapter, we will examine (1) the types of con- tracts that must be in writing to be enforceable, (2) the parol evidence rule, and (3) the rules of contractual interpretation.

302

STATUTE OF FRAUDS The statute of frauds requires that certain designated types of contracts be evidenced by a writing to be enforceable. Many more types of contracts are not sub- ject to the statute of frauds than are subject to it. Most oral contracts, as previously indicated, are as enforceable and valid as written contracts. If, however, a given contract subject to the statute of frauds is said to be within the statute, to be enforceable it must com- ply with the requirements of the statute. All other types of contracts are said to be “not within” or “outside” the statute and need not comply with its requirements to be enforceable.

The statute of frauds has no relation whatever to any kind of fraud practiced in the making of contracts. The rules relating to such fraud are rules of common law and are discussed in Chapter 11. The purpose of the statute is to prevent fraud in the proof of certain oral contracts by perjured testimony in court. This pur- pose is accomplished by requiring certain contracts to be proved by a signed writing. On the other hand, the statute does not prevent the performance of oral con- tracts if the parties are willing to perform. In brief, the statute relates only to the proof or evidence of a con- tract. It has nothing to do with the circumstances sur- rounding the making of a contract or with the validity of a contract.

PRACTICAL ADVICE Significant contracts should be memorialized in a writing signed by both parties.

CONTRACTS WITHIN THE STATUTE OF FRAUDS [15-1] The following five kinds of contracts are within the statute of frauds as most states have adopted it. Com- pliance requires a writing signed by the party to be charged (the party against whom the contract is to be enforced).

1. Promises to answer for the duty of another

2. Promises of an executor or administrator to answer personally for a duty of the decedent whose funds he is administering

3. Agreements upon consideration of marriage

4. Agreements for the transfer of an interest in land

5. Agreements not to be performed within one year

A sixth type of contract within the original English statute of frauds applied to contracts for the sale of goods. The Uniform Commercial Code (UCC) now governs the enforceability of contracts of this kind.

The various provisions of the statute of frauds apply independently. Accordingly, a contract for the sale of an interest in land also may be a contract in considera- tion of marriage, a contract not to be performed in one year, and a contract for the sale of goods.

In addition to those contracts specified in the original statute, most states require that other contracts be evi- denced by a writing as well—for example, a contract to make a will, to authorize an agent to sell real estate, or to pay a commission to a real estate broker. In addition, UCC Article 9 requires that contracts creating certain types of security interests be in writing. On the other hand, UCC Revised Article 8, which all states have adopted, provides that the statute of frauds does not apply to contracts for the sale of securities. Finally, Article 1 of the UCC requires that contracts for the sale of other personal property for more than $5,000 be in writing. The 2001 Revisions to Article 1, however, has deleted this requirement.

Electronic Records [15-1a] One significant impediment to e-commerce has been the questionable enforceability of contracts entered into through electronic means such as the Internet or email because of the writing requirements under contract and sales law (statute of frauds). In response, the Uniform Electronic Transactions Act (UETA) was promulgated by the National Conference of Commissioners on Uni- form State Laws (NCCUSL) in July 1999 and has been adopted by at least forty-seven states. UETA applies only to transactions between parties each of which has agreed to conduct transactions by electronic means. It gives full effect to electronic contracts, encouraging their widespread use, and develops a uniform legal framework for their implementation. UETA protects electronic sig- natures and contracts from being denied enforcement because of the statute of frauds. Section 7 of UETA accomplishes this by providing the following:

1. A record or signature may not be denied legal effect or enforceability solely because it is in electronic form.

2. A contract may not be denied legal effect or enforce- ability solely because an electronic record was used in its formation.

3. If a law requires a record to be in writing, an elec- tronic record satisfies the law.

4. If a law requires a signature, an electronic signature satisfies the law.

Chapter 15 Contracts in Writing 303

Section 14 of UETA further validates contracts formed by machines functioning as electronic agents for parties to a transaction: “A contract may be formed by the interaction of electronic agents of the parties, even if no individual was aware of or reviewed the electronic agents’ actions or the resulting terms and agreements.” The Act excludes from its coverage wills, codicils, and testamentary trusts as well as all Articles of the UCC except Articles 2 and 2A.

In addition, Congress in 2000 enacted the Electronic Signatures in Global and National Commerce (E-Sign). The Act, which uses language very similar to that of UETA, makes electronic records and signatures valid and enforceable across the United States for many types of transactions in or affecting interstate or foreign com- merce. E-Sign does not generally preempt UETA. E-Sign does not require any person to agree to use or accept electronic records or electronic signatures. The Act defines transactions quite broadly to include the sale, lease, exchange, and licensing of personal property and services, as well as the sale, lease, exchange, or other dis- position of any interest in real property. E-Sign defines an electronic record as “a contract or other record cre- ated, generated, sent, communicated, received, or stored by electronic means.” It defines an electronic signature as “an electronic sound, symbol, or process, attached to or logically associated with a contract or other record and executed or adopted by a person with the intent to sign the record.” Like UETA, E-Sign ensures that Inter- net and e-mail agreements will not be unenforceable because of the statute of frauds by providing that

1. a signature, contract, or other record relating to such transaction may not be denied legal effect, validity, or enforceability solely because it is in electronic form; and

2. a contract relating to such transaction may not be denied legal effect, validity, or enforceability solely because an electronic signature or electronic record was used in its formation.

To protect consumers, E-Sign provides that they must consent electronically to conducting transactions with electronic records after being informed of the types of hardware and software required. Prior to consent, consumers must also receive a “clear and conspicuous” statement informing consumers of their right to (1) have the record provided on paper or in nonelectronic form; (2) after consenting to electronic records, receive paper copies of the electronic record; and (3) withdraw consent to receiving electronic records.

As defined by E-Sign, an electronic agent is a com- puter program or other automated means used inde- pendently to initiate an action or respond to electronic records or performances in whole or in part without

review or action by an individual at the time of the action or response. The Act validates contracts or other records relating to a transaction in or affecting inter- state or foreign commerce formed by electronic agents so long as the action of each electronic agent is legally attributable to the person to be bound.

E-Sign specifically excludes certain transactions, including (1) wills, codicils, and testamentary trusts; (2) adoptions, divorces, and other matters of family law; and (3) the UCC other than sales and leases of goods.

Suretyship Provision [15-1b] The suretyship provision applies to a contractual prom- ise by a surety (promisor) to a creditor (promisee) to perform the duties or obligations of a third person (prin- cipal debtor) if the principal debtor does not perform. Thus, if a mother tells a merchant to extend $1,000 worth of credit to her son and says, “If he doesn’t pay, I will,” the promise is a suretyship and must be evi- denced by a writing (or have a sufficient electronic re- cord) to be enforceable. The factual situation can be reduced to the simple idea that “If X doesn’t pay, I will.” The promise is said to be a collateral promise, in that the promisor is not primarily liable. The mother does not promise to pay in any event; her promise is to pay only if the one primarily obligated, the son, defaults.

Son

Mother

Merchant (1) $1,000 Debt

Credit

Principal Debtor

(2) Pa

y $ 1,0

00 De

bt

if P rin

cip al D

eb tor

do es

no t

Promisor/Surety

Promisee/Creditor

Thus, a suretyship involves three parties and two contracts. The primary contract, between the principal debtor and the creditor, creates the indebtedness. The collateral contract is made by the third person (surety) directly with the creditor, whereby the surety promises to pay the debt to the creditor in case the principal debtor fails to do so. For a complete discussion of sure- tyship, see Chapter 37. See Rosewood Care Center, Inc. v. Caterpillar, Inc., later in this chapter.

Original Promise If the promisor makes an original promise by undertaking to become primarily liable, then the statute of frauds does not apply. For example, a father tells a merchant to deliver certain

304 Contracts Part III

items to his daughter and says, “I will pay $400 for them.” The father is not promising to answer for the debt of another; rather, he is making the debt his own. It is to the father, and to the father alone, that the mer- chant extends credit; to the father alone the creditor may look for payment. The statute of frauds does not apply, and the promise may be oral.

del ive

rs i tem

s

Father

Daughter

Merchant pays $400

Promisor

Beneficiary

Promisee

PRACTICAL ADVICE When entering into a contract with two parties promising you that they will perform, make them both original promisors and avoid having a surety. In any event, if the contract is for a significant amount of money, have both parties sign a written agreement.

Main Purpose Doctrine The courts have devel- oped an exception to the suretyship provision called the “main purpose doctrine” or “leading object rule.” In cases in which the main purpose of the promisor is to obtain an economic benefit for herself that she did not previously have, then the promise comes within the exception and is outside the statute. The expected benefit to the surety “must be such as to justify the conclusion that his main purpose in making the prom- ise is to advance his own interest.” The fact that the surety received consideration for his promise or that he might receive a slight and indirect advantage is insufficient to bring the promise within the main pur- pose doctrine.

Suppose that a supply company has refused to fur- nish materials on the credit of a building contractor. Faced with a possible slowdown in the construction of his building, the owner of the land promises the sup- plier that if the supplier will extend credit to the con- tractor, the owner will pay if the contractor does not. Here, the purpose of the promisor was to serve an economic interest of his own, even though the perform- ance of the promise would discharge the duty of another. The intent to benefit the contractor was at most incidental, and courts will enforce oral promises of this type.

G O I N G G L O B A L What about electronic commerce and electronic signatures

in international contracts?

The United Nations Commis-sion on International Trade Law (UNCITRAL) was established by the U.N. General Assembly to fur- ther the progressive harmonization and unification of the law of inter- national trade. The Commission is composed of sixty member states elected by the General Assembly and is structured to be representa- tive of the world’s various geo- graphic regions and its principal economic and legal systems. One of its primary functions is to develop

conventions, model laws, and rules that are acceptable worldwide.

The UNCITRAL Model Law on Electronic Commerce, adopted in 1996, is intended to facilitate the use of modern means of communications and storage of information. Legisla- tion based on it has been adopted in more than fifty nations and, in the United States, it has influenced the Uniform Electronic Transactions Act, promulgated by the Uniform Law Commission (ULC) in 1999 and adopted by nearly all of the states.

In 2001 the UNCITRAL Model Law on Electronic Signatures was adopted to bring additional legal certainty regarding the use of electronic signatures. Following a technology-neutral approach, the Act establishes a presumption that electronic signatures, which meet certain criteria of technical reli- ability, shall be treated as equiva- lent to handwritten signatures. Legislation based on it has been adopted in at least twenty-five nations.

Chapter 15 Contracts in Writing 305

R O S E W O O D C A R E C E N T E R , I N C . , V . C A T E R P I L L A R , I N C . S u p r e m e C o u r t o f I l l i n o i s , 2 0 0 7

2 2 6 I l l . 2 d 5 5 9 , 8 7 7 N . E . 2 d 1 0 9 1 , 3 1 5 I l l . D e c . 7 6 2

FACTS On January 3, 2002, Caterpillar contacted HSM Management Services (HSM), the management agent for Plaintiff, Rosewood Care Center, Inc. (Rose- wood), a skilled nursing facility. Caterpillar requested that Rosewood admit Betty Jo Cook, an employee of Caterpil- lar, on a “managed care basis (fixed rate).” HSM advised Caterpillar that Rosewood would not admit Cook on those terms. Shortly thereafter, on January 10, Dr. Norma Just, Caterpillar’s employee in charge of medical care relating to workers’ compensation claims, contacted HSM. Just told HSM that Cook had sustained a work- related injury and was receiving medical care at Caterpil- lar’s expense under the workers’ compensation laws. Just requested that Cook be admitted to Rosewood for skilled nursing care and therapy and stated that the cost of Cook’s care would be 100 percent covered and paid directly by Caterpillar to Rosewood with a zero deducti- ble and no maximum limit. Just further advised HSM that Cook had been precertified for four weeks of care. Just asked that Rosewood send the bills for Cook’s care to Caterpillar’s workers’ compensation division. On January 20, “Sue” from Dr. Just’s office telephoned HSM and confirmed approval for Cook’s transfer from the hospital to Rosewood. On January 30, Sue reconfirmed, via tele- phone, Caterpillar’s authorization for Cook’s care and treatment in accordance with the January 10 agreement, except that Sue now advised HSM that Cook was precer- tified for two weeks of care instead of the original four weeks. On January 30, Cook was admitted to Rosewood. Upon her admission, Cook signed a document entitled “Assignment of Insurance Benefits” as required by law. In this document, Cook assigned any insurance benefits she might receive to Rosewood and acknowledged her liability for any unpaid services. Caterpillar, through its health care management company, continued to orally “authorize” care for Cook and did so on February 8, February 25, March 11, March 21, April 8, April 18, May 16, and June 4. Cook remained at Rosewood until June 13, 2002. The total of Rosewood’s charges for Cook’s care amounted to $181,857. Caterpillar never objected to the bills being sent to it for Cook’s care, nor did it ever advise Rosewood that treatment was not authorized. However, Caterpillar ultimately refused to pay for services rendered to Cook.

The plaintiff filed an action against Caterpillar, seek- ing reimbursement for the services provided to Cook while she was a patient at Rosewood. In response, Caterpillar moved to dismiss the complaint, arguing that the alleged promise to pay for Cook’s care was not

enforceable because it was not in writing as required by the statute of frauds. The trial court granted Cater- pillar’s motion for summary judgment, and Rosewood appealed. The appellate court reversed and remanded.

DECISION Judgment of the appellate court affirmed and remanded.

OPINION Burke, J. In general, the statute of frauds provides that a promise to pay the debt of another, i.e., a suretyship agreement, is unenforceable unless it is in writing. ***

*** The plain object of the statute is to require higher and more certain evidence to charge a party, where he does not receive the substantial benefit of the transaction, and where another is primarily liable to pay the debt or discharge the duty; and thereby to afford greater security against the set- ting up of fraudulent demands, where the party sought to be charged is another than the real debtor, and whose debt or duty, on performance of the alleged contract by such third person, would be discharged. [Citation.] ***

II. “MAIN PURPOSE” OR “LEADING OBJECT” RULE *** According to Rosewood, Caterpillar’s promise falls outside the statute of frauds pursuant to the “main purpose” or “leading object” rule. Under this rule, when the “main purpose” or “leading object” of the promi- sor/ surety is to subserve or advance its own pecuniary or business interests, the promise does not fall within the statute. [Citation.] As section 11 of the Restatement (Third) of Suretyship & Guaranty states:

A contract that all or part of the duty of the principal obli- gor to the obligee shall be satisfied by the secondary obligor is not within the Statute of Frauds as a promise to answer for the duty of another if the consideration for the promise is in fact or apparently desired by the secondary obligor mainly for its own economic benefit, rather than the benefit of the principal obligor. [Citation.]

The reason for the “main purpose” or “leading object” rule has been explained:

Where the secondary obligor’s main purpose is its own pe- cuniary or business advantage, the gratuitous or sentimental element often present in suretyship is eliminated, the likeli- hood of disproportion in the values exchanged between sec- ondary obligor and obligee is reduced, and the commercial context commonly provides evidentiary safeguards. Thus, there is less need for cautionary or evidentiary formality than in other secondary obligations. [Citations.]

***

306 Contracts Part III

Promise Made to Debtor The suretyship provi- sion has been interpreted not to include promises made to a debtor. For example, D owes a debt to C. S prom- ises D to pay D’s debt. Because the promise of S was made to the debtor (D), not the creditor (C), the prom- ise is enforceable even if it is oral.

D C debt

Promisee/ Debtor Creditor

S Promisor

promises to pay debt

Executor-Administrator Provision [15-1c] The executor-administrator provision applies to the promises of an executor of a decedent’s will, or to

those of the administrator of the estate if there is no will, to answer personally for a duty of the decedent. An executor or administrator is a person appointed by a court to carry out, subject to order of court, the administration of the estate of a deceased person. If the will of a decedent nominates a certain person as execu- tor, the court usually appoints that person. (For a more detailed discussion of executors, administrators, and the differences between the two, see Chapter 50.) If an executor or administrator promises to answer person- ally for a duty of the decedent, the promise is unen- forceable unless it is in writing or in proper electronic form. For example, Edgar, who is Donna’s son and executor of Donna’s will, recognizes that Donna’s estate will not have enough funds to pay all of the decedent’s debts. He orally promises Clark, one of Donna’s creditors, that he will personally pay all of his mother’s debts in full. Edgar’s oral promise is not en- forceable. This provision does not apply, however, to promises to pay debts of the deceased out of assets of the estate.

The executor-administrator provision is thus a spe- cific application of the suretyship provision. Accord- ingly, the exceptions to the suretyship provision also apply to this provision.

It is clear *** that the “main purpose” or “leading object” rule, as set out in the Restatements, has been a part of Illinois law since 1873. We note that the majority of jurisdictions have adopted this rule as well. [Citations.]

Applying this rule in the case at bar, Caterpillar denies that the “main purpose” for its alleged promise to Rose- wood was to promote its own interest. Caterpillar also denies that it received any benefit from the agreement. Alternatively, Caterpillar argues that we should remand this cause for further proceedings to determine the “main purpose” or “leading object” of its promise.

Whether the “main purpose” or “leading object” of the promisor is to promote a pecuniary or business advantage to it is generally a question for the trier of fact. [Citation.] ***

Here, a decision on what was Caterpillar’s “main purpose” or “leading object” in making the promise can- not be made based on the allegations in the complaint. *** The determination must be made by the trier of fact based on evidence to be presented by the parties. ***

III. WHETHER A SURETYSHIP WAS CREATED IN THIS CASE *** Rosewood argues that no suretyship was created by Caterpillar’s promise. According to Rosewood, Caterpillar contracted directly with Rosewood, became liable for its

own commitment, and received benefits as a result. A suretyship exists when one person undertakes an obli- gation of another person who is also under an obligation or duty to the creditor/obligee. [Citation.] Specifically, “[a] contract is not within the Statute of Frauds as a con- tract to answer for the duty of another unless the prom- isee is an obligee of the other’s duty, the promisor is a surety for the other, and the promisee knows or has rea- son to know of the suretyship relation.” [Citation.] ***

The question of whether Caterpillar’s promise was a suretyship or not, like the question regarding Caterpil- lar’s “main purpose” or “leading object,” cannot be determined on the basis of allegations in Rosewood’s complaint. This question is a factual one to be made based on evidence to be presented by the parties. Accordingly, this issue must also be resolved by the cir- cuit court on remand.

INTERPRETATION When the “main purpose” or “leading object” of the surety is to advance its own pecuniary or business interests, the promise does not fall within the statute.

CRITICAL THINKING QUESTION Should the contracts of a surety have to be in writing? Explain.

Chapter 15 Contracts in Writing 307

Marriage Provision [15-1d] The notable feature of the marriage provision is that it does not apply to mutual promises to marry. Rather, the provision applies only if a promise to marry is made in consideration for some promise other than a mutual promise to marry. Therefore, this provision covers Adams’s promise to convey title to a certain farm to Barnes if Barnes accepts Adams’s proposal of marriage.

Land Contract Provision [15-1e] The land contract provision covers promises to transfer any interest in land, which includes any right, privilege, power, or immunity in real property. Thus, all promises to transfer, buy, or pay for an interest in land, includ- ing ownership interests, leases, mortgages, options, and easements, are within the provision.

The land contract provision does not include con- tracts to transfer an interest in personal property. It also does not cover short-term leases, which by statute in most states are those for one year or less; contracts to build a building on a piece of land; contracts to do work on the land; or contracts to insure a building.

An oral contract for the transfer of an interest in land may be enforced if the party seeking enforcement has so changed his position in reasonable reliance on the contract that a court can prevent injustice only by enforcing the contract. In applying this part perform- ance exception, many states require that the transferee has paid a portion or all of the purchase price and ei- ther has taken possession of the real estate or has started to make valuable improvements on the land. Payment of part or all of the price is not sufficient in itself to make the contract enforceable under this excep- tion. For example, Jane orally agrees to sell land to Jack for $30,000. With Jane’s consent, Jack takes pos- session of the land, pays Jane $10,000, builds a house on the land, and occupies it. Several years later, Jane

repudiates the contract. The courts will enforce the con- tract against Jane.

An oral promise by a purchaser is also enforceable if the seller fully performs by conveying the property to the purchaser.

One-Year Provision [15-1f] The statute of frauds requires that all contracts that cannot be fully performed within one year of the making of the contract be in writing or in proper elec- tronic form.

The Possibility Test To determine whether a contract falls within the one-year provision, the courts ask whether it is possible for the performance of the contract to be completed within a year. Under the majority rule, the possibility test does not ask whether the agreement is likely to be performed within one year from the date it was formed; nor does it ask whether the parties think that performance will occur within the year. The enforceability of the contract depends not on probabilities or on actual subsequent events but on whether the terms of the contract make it possible for performance to occur within one year. For example, an oral contract between Alice and Bill for Alice to build a bridge, which should reasonably take three years, is generally enforceable if it is possi- ble, although extremely unlikely and difficult, for Alice to perform the contract in one year. Similarly, if Alice agrees to employ Bill for life, this contract is also not within the statute of frauds. It is possible that Bill may die within the year, in which case the contract would be completely performed. The contract is therefore one that is fully performable within a year. Contracts of indefinite duration are likewise excluded from the provision. On the other hand, an oral contract to employ another person for thirteen months could not possibly be performed within a year and is therefore unenforceable.

M A C K A Y V . F O U R R I V E R S P A C K I N G C O . S u p r e m e C o u r t o f I d a h o , 2 0 0 8

1 7 9 P . 3 d 1 0 6 4

FACTS Four Rivers operates an onion packing plant near Weiser, Idaho. Randy Smith, the general manager of Four Rivers, hired Stuart Mackay as a field man during the summer of 1999 to secure onion contracts. Four

Rivers began experiencing financial difficulties in late 1999. All employees, including Mackay, were laid off at this time because one of the owners of Four Rivers filed suit to prevent the company from conducting business.

308 Contracts Part III

When the lawsuit was resolved, Smith rehired Mackay as a field man. According to Mackay, Four Rivers offered him a long-term employment contract in March of 2000 to continue working as a field man up to the time of his retirement. Mackay claims he accepted the long-term offer of employment and advised Four Rivers that he may not retire for approximately ten years, at around age sixty-two. Four Rivers denies extending such an offer to Mackay. In 2001, Mackay asked Four Rivers for a written contract of employment. He refused to sign the agreement that was prepared because it gave Four Rivers the right to terminate his employment at any time. On March 7, 2003, Smith terminated Mackay’s employment relationship without notice. Smith claims that Mackay’s performance was not satisfactory because he was not obtaining the quantity of onions necessary to keep Four Rivers’ packing plant operational, resulting in the closure of the packing plant in February 2003. Four Rivers claims its employees, including Mackay, were laid off at this time. Mackay claims that Four Rivers closed due to the price of onions at the time. Mackay applied for unemployment benefits in 2003, stating in his application that he was laid off due to company financial difficulties. Smith states he offered to rehire Mackay in a different position later that year, and Mackay declined.

Mackay sued Four Rivers on August 24, 2004, claiming that Four Rivers breached his oral long-term employment contract. Four Rivers answered by alleg- ing that a contract such as that claimed by Mackay is unenforceable under the Idaho Statute of Frauds because the agreement could not be performed within one year of its making and therefore Mackay was an “at will” employee. Four Rivers moved for sum- mary judgment in October 2006, and the district court granted its motion.

DECISION The decision of the trial court is vacated, and the case is remanded.

OPINION Jones, J. The parties disagree regarding the proper application of Idaho’s Statute of Frauds. According to Mackay, the longstanding rule in Idaho is that where an agreement depends upon a condition which may ripen within a year, even though it may not mature until much later, the agreement does not fall within the Statute. Since the alleged contract here con- tains a term that it will last until Mackay retires, and Mackay could have retired within the first year, the oral contract does not violate the Statute. ***

Four Rivers denies entering into a long-term contract of employment, and *** claims the contract violates [the] Idaho [Statute of Frauds] relying on Burton v. Atomic Workers Fed. Credit Union [citation]. ***

Idaho’s Statute of Frauds provision *** provides that “an agreement that by its terms is not to be performed within a year from the making thereof” is invalid, unless the same or some note or memorandum thereof, be in writing and subscribed by the party charged, or by his agent. [Citation.] *** Under the prevailing interpreta- tion, the enforceability of a contract under the one-year provision does not turn on the actual course of subse- quent events, nor on the expectations of the parties as to the probabilities. [Citation.] Contracts of uncertain duration are simply excluded, and the provision covers only those contracts whose performance cannot possibly be completed within a year. [Citation.]

Leading treatises follow this general rule. It is well settled that the oral contracts invalidated by the Statute because they are not to be performed within a year include only those which cannot be performed within that period. [Citation.] A promise which is not likely to be performed within a year, and which in fact is not performed within a year, is not within the Statute, if at the time the contract is made there is a possibility in law and in fact that full performance such as the par- ties intended may be completed before the expiration of a year. [Citation.] The question is not what the probable, or expected, or actual, performance of the contract was, but whether the contract, according to the reasonable interpretation of its terms, required that it could not be performed within the year. [Citation.] Further, a promise which is performable at or until the happening of any specified contingency which may or may not occur within a year is not within the Statute. [Citation.]

Idaho cases are in accord. A contract which is capa- ble of being performed and might have been fully performed and terminated within a year does not fall within the Statute. [Citation.] Where the termination of a contract is dependent upon the happening of a contin- gency which may occur within a year, although it may not happen until the expiration of a year, the contract is not within the Statute, since it may be performed within a year. [Citations.]

In this case, the district court applied the Burton decision and found that the alleged oral contract could not, by its terms, be completed within a year. In Burton, the plaintiff alleged there was an implied contract, which guaranteed her employment until she reached retirement, at age 65. *** This case differs. In this case, Mackay alleges the term of the contract is until retire- ment. *** Unlike the contract in Burton, which speci- fied “until age 65,” the alleged contract term in this case is indefinite. Thus, the district court erred when it held Burton applied to preclude enforcement of the con- tract alleged in this case.

Chapter 15 Contracts in Writing 309

Computation of Time The year runs from the time the agreement is made, not from the time when the performance is to begin. For example, on January 1, 2015, A hires B to work for eleven months starting on May 1, 2015, under the terms of an oral contract. That contract will be fully performed on March 31, 2016, which is more than one year after January 1, 2015, the date the contract was made. Consequently, the contract is within the statute of frauds and unen- forceable because it is oral.

Jan. 1, 2015

May 1, 2015

Jan. 1, 2016

A and B enter into oral contract

B commences performance

Oral contract must be completed to be enforceable

B finishes performanceMarch 31, 2016

Similarly, a contract for a year’s performance that is to begin three days after the date of the making of the contract is within the statute and, if oral, is unenforceable. If, however, the performance is to begin the day following the making or, under the terms of the agreement, could have begun the follow- ing day, it is not within the statute and need not be in writing.

Full Performance by One Party Where a contract has been fully performed by one party, most courts hold that the promise of the other party is enforceable even though by its terms its performance

was not possible within one year. For example, Jane borrows $4,800 from Tom. Jane orally promises to pay Tom $4,800 in three annual installments of $1,600. Jane’s promise is enforceable, despite the one-year pro- vision, because Tom has fully performed by making the loan.

Sale of Goods [15-1g] The English statute of frauds, which applied to con- tracts for the sale of goods, has been used as a proto- type for the UCC, Article 2, statute of frauds provision. The UCC provides that a contract for the sale of goods for the price of $500 or more is not enforceable unless there is some writing or record sufficient to indicate that a contract for sale has been made between the parties. The Code defines goods as movable personal property.

Admission The Code permits an oral contract for the sale of goods to be enforced against a party who, in his pleading, testimony, or otherwise, admits in court that a contract was made; but the Code limits enforce- ment to the quantity of goods he admits. Moreover, some courts hold that, by performing over a period of time, for example, a party may implicitly admit the existence of a contract. Some courts now apply this exception to other statute of frauds provisions.

Specially Manufactured Goods The Code permits enforcement of an oral contract for goods spe- cially manufactured for a buyer, but only if evidence indicates that the goods were made for the buyer and the seller can show that he has made a substantial begin- ning of their manufacture before receiving any notice of repudiation. If the goods, although manufactured on special order, may be readily resold in the ordinary course of the seller’s business, this exception does not apply.

Rather, this case falls under the general rule cited in numerous Idaho cases and in the Restatement (Second) of Contracts. For the purposes of summary judgment, we must take as true Mackay’s allegation that the con- tract was to last “until retirement.” Since Mackay could have retired within one year under the terms of the alleged contract, this contract is outside Idaho’s Statute of Frauds provision. *** Since the event at issue here— Mackay’s retirement—could possibly have occurred

within one year, the Statute does not bar evidence of such contract.

INTERPRETATION If it is possible to perform fully a contract within one year, the contract does not fall within the statute of frauds.

CRITICAL THINKING QUESTION Do you agree with the one-year provision? Explain.

310 Contracts Part III

K A L A S V . C O O K A p p e l l a t e C o u r t o f C o n n e c t i c u t , 2 0 0 2

7 0 C o n n . A p p . 4 7 7 , 8 0 0 A . 2 d 5 5 3 , 4 7 U C C R e p . S e r v . 2 d 1 3 0 7

FACTS The plaintiff, Barbara H. Kalas, doing busi- ness as Clinton Press, operated a printing press and, for several decades, provided written materials, including books and pamphlets, for Adelma G. Simmons. Sim- mons ordered these materials for use and sale at her farm, known as Caprilands Herb Farm (Caprilands). The defendant has not suggested that these materials could have been sold on the open market. Due to lim- ited space at Caprilands, the plaintiff and Simmons agreed that the written materials would remain stored at the plaintiff’s print shop until Simmons decided that delivery was necessary. The materials were delivered either routinely or upon request by Simmons and were paid for according to the invoice from plaintiff.

In early 1997, the plaintiff decided to close her busi- ness. The plaintiff and Simmons agreed that the materi- als printed for Caprilands and stored at the plaintiff’s print shop would be delivered and paid for upon deliv- ery. On December 3, 1997, Simmons died. The plaintiff submitted a claim against the estate for $24,599.38 for unpaid deliveries to Caprilands. (The defendant, Edward W. Cook, is the executor of the estate of Simmons.) The defendant denied these allegations and raised a defense under the statute of frauds.

The trial ruled that as a contract for the sale of goods, its enforcement was not precluded by the Uniform Commer- cial Code (UCC) statute of frauds provision. Accordingly, the court rendered a judgment in favor of the plaintiff in the amount of $24,599.38. The defendant appealed.

DECISION Judgment affirmed.

OPINION Peters, J. On appeal, the defendant argues that the oral contract was invalid *** because a writing was required by §2-201. ***

Contracts for the sale of goods *** are governed by §2-201. [Citations.]

Under §2-201, oral agreements for the sale of goods at a price of $500 or more are presumptively unenforce- able. [Citations.] The applicable provisions in this case, however, are other subsections of §2-201.

Under §2-201(3)(a), an oral contract for the sale of goods is enforceable if the goods in question are “specially manufactured.” In determining whether the specially manufactured goods exception applies, courts generally apply a four part standard:

(1) the goods must be specially made for the buyer; (2) the goods must be unsuitable for sale to others in the ordinary course of the seller’s business; (3) the seller must have sub- stantially begun to have manufactured the goods or to have a commitment for their procurement; and (4) the manufac- ture or commitment must have been commenced under cir- cumstances reasonably indicating that the goods are for the buyer and prior to the seller’s receipt of notification of con- tractual repudiation. [Citation.]

In applying this standard, “courts have traditionally looked to the goods themselves. The term ‘specially manu- factured,’ therefore, refers to the nature of the particular goods in question and not to whether the goods were made in an unusual, as opposed to the regular, business operation or manufacturing process of the seller.” [Citations.]

Printed material, particularly that, as in this case, names the buyer, has been deemed by both state and federal courts to fall within the exception set out for specially manufactured goods. [Citations.]

It is inherent in the court’s findings that the printed materials in the present case were specially manufac- tured goods. The materials were printed specifically for Caprilands. The materials included brochures and labels with the Caprilands name, as well as books that were written and designed by Simmons. The plaintiff testified that the books were printed, as Simmons had requested, in a rustic style with typed inserts and hand- drawn pictures. Therefore, none of these materials was suitable for sale to others. It is undisputed that, at the time of breach of the alleged contract, goods printed for Simmons already had been produced.

We conclude that, in light of the nature of the goods at issue *** this case falls within the exception for spe- cially manufactured goods. To be enforceable, the agree- ment for their production was, therefore, not required to be in writing under §2-201(3)(a).

INTERPRETATION An oral contract for the sale of goods is enforceable if the goods in question are specially manufactured.

ETHICAL QUESTION Did the executor of Simmons’ estate act ethically? Explain.

CRITICAL THINKING QUESTION Do you agree with the court’s decision? Explain.

Chapter 15 Contracts in Writing 311

Delivery or Payment and Acceptance Un- der the Code, delivery and acceptance of part of the goods, or payment and acceptance of part of the price, validate the contract, but only for the goods that have been accepted or for which payment has been accepted. To illustrate, Liz orally agrees to buy one thousand watches from David for $15,000. David delivers three hundred watches to Liz, who receives and accepts the watches. The oral contract is enforceable to the extent of three hundred watches ($4,500)—those received and accepted—but is unenforceable to the extent of seven hundred watches ($10,500).

A summary of the contracts within, and the excep- tions to, the statute of frauds is provided in Concept Review 15-1.

Modification or Rescission of Contracts Within the Statute of Frauds [15-1h] Oral contracts modifying previously existing contracts are unenforceable if the resulting contract is within the statute of frauds. The reverse is also true: an oral modi- fication of a prior contract is enforceable if the new contract is not within the statute of frauds.

Thus, examples of unenforceable oral contracts in- clude an oral promise to guarantee the additional duties

of another, an oral agreement to substitute different land for that described in the original contract, and an oral agreement to extend an employee’s contract for six months to a total of two years. On the other hand, an oral agreement to modify an employee’s contract from two years to six months at a higher salary is not within the statute of frauds and is enforceable.

Under the UCC, the decisive point is the contract price after modification. If the parties enter into an oral contract to sell for $450 a motorcycle to be delivered to the buyer and later, prior to delivery, orally agree that the seller shall paint the motorcycle and install new tires and that the buyer shall pay a price of $550, the modified contract is unenforceable. Conversely, if the parties have a written contract for the sale of two hundred bushels of wheat at a price of $4.00 per bushel and later orally agree to decrease the quantity to one hundred bushels at the same price per bushel, the agreement as modified is for a total price of $400 and thus is enforceable.

An oral rescission is effective and discharges all unperformed duties under the original contract. For example, Jones and Brown enter into a written contract of employment for a two-year term. Later they orally agree to rescind the contract. The oral agreement is effective, and the written contract is rescinded. Where land has been transferred, however, an agreement to

CONCEPT REVIEW 15-1 T H E S T A T U T E O F F R A U D S

Contracts Within the Statute of Frauds Exceptions

Suretyship—a promise to answer for the duty of another l Main purpose rule l Original promise l Promise made to debtor

Executor-Administrator—a promise to answer personally for debt of decedent

l Main purpose rule l Original promise l Promise made to debtor

Agreements made upon consideration of marriage l Mutual promises to marry

Agreements for the transfer of an interest in land l Part performance plus detrimental reliance l Seller conveys property

Agreements not to be performed within one year l Full performance by one party l Possibility of performance within one year

Sale of goods for $500 or more l Admission l Specially manufactured goods l Delivery or payment and acceptance

312 Contracts Part III

rescind the transaction is a contract to retransfer the land and is within the statute of frauds.

PRACTICAL ADVICE When significantly modifying an existing common law contract, make sure that consideration is given and that the modification is in writing and signed by both parties.

COMPLIANCE WITH THE STATUTE OF FRAUDS [15-2] Even a contract within the statute of frauds will be enforced if it is contained in a writing, memorandum, or record sufficient to satisfy the statute’s requirements. As long as the writing or record meets those require- ments, it need not be in any specific form, nor be an attempt by the parties to enter into a binding contract, nor represent their entire agreement.

General Contract Provisions [15-2a] The English statute of frauds and most modern statutes of frauds require that the agreement be evidenced by a writing or record to be enforceable. The statute’s pur- pose in requiring a writing or record is to ensure that the parties have actually entered into a contract. It is, therefore, not necessary that the writing or record be in existence when the parties initiate litigation; it is suffi- cient to show that the memorandum existed at one time. The note, memorandum, or record, which may be formal or informal, must

1. specify the parties to the contract,

2. specify with reasonable certainty the subject matter and the essential terms of the unperformed pro- mises, and

3. be signed by the party to be charged or by her agent.

The memorandum may be such that the parties them- selves view it as having no legal significance whatever.

For example, a personal letter between the parties, an interdepartmental communication, an advertisement, or the record books of a business may serve as a memoran- dum. The writing need not have been delivered to the party who seeks to take advantage of it, and it may even contain a repudiation of the oral agreement. For exam- ple, Sid and Gail enter into an oral agreement that Sid will sell Blackacre to Gail for $5,000. Sid subsequently receives a better offer and sends Gail a signed letter, which begins by reciting all the material terms of the oral agreement. The letter concludes: “Because my agree- ment to sell Blackacre to you for $5,000 was oral, I am not bound by my promise. I have since received a better offer and will accept that one.” Sid’s letter constitutes a sufficient memorandum for Gail to enforce Sid’s promise to sell Blackacre. Because Gail did not sign the memo- randum, however, the writing does not bind her. Thus, a contract may be enforceable against only one of the parties.

The “signature” may be initials or may even be type- written or printed, as long as the party intended it to authenticate the writing or record. Furthermore, the sig- nature need not be at the bottom of the page or at the customary place for a signature.

The memorandum may consist of several papers or documents, none of which would be sufficient by itself. The several memoranda, however, must together satisfy all of the requirements of a writing to comply with the statute of frauds and must clearly indicate that they relate to the same transaction. The latter requirement can be satisfied if (1) the writings are physically con- nected, (2) the writings refer to each other, or (3) an examination of the writings shows them to be in refer- ence to each other.

PRACTICAL ADVICE To avoid becoming solely liable by signing a contract before the other party signs, include a provision to the effect that no party is bound to the contract until all parties sign the contract.

D A H A N V . W E I S S S u p r e m e C o u r t , A p p e l l a t e D i v i s i o n , S e c o n d D e p a r t m e n t , N e w Y o r k , 2 0 1 4

1 2 0 A . D . 3 d 5 4 0 , 9 9 1 N . Y . S . 2 d 1 1 9

FACTS The defendant Michelle Weiss is the princi- pal of the defendant Gateever, LLC. In August 2009, Gateever purchased seven properties in Far Rockaway, Queens, from the Alaska Group, Inc. The plaintiff,

Sharon Dahan, he held a mortgage in the sum of $650,000 on the seven properties pursuant to an oral loan agreement with the Alaska Group. The plaintiff claims that as part of the purchase price for the

Chapter 15 Contracts in Writing 313

Sale of Goods [15-2b] The statute of frauds provision under Article 2 (Sales) of the UCC is more liberal. For a sale of goods, the Code requires merely a writing or record (1) sufficient to indicate that a contract has been made between the parties, (2) signed by the party against whom enforce- ment is sought or by her authorized agent or broker, and (3) specifying the quantity of goods or securities to be sold. The writing or record is sufficient even if it omits or incorrectly states an agreed-upon term; how- ever, if the quantity term is misstated, the contract can be enforced only to the extent of the quantity stated in the writing or record.

As with general contracts, several related documents may satisfy the writing requirement. Moreover, the “signature” may be by initials or even typewritten or

printed, so long as the party intended to authenticate the writing or record.

In addition, between merchants, if one party, within a reasonable time after entering into the oral contract, sends a written confirmation of the contract for a sale of goods to the other party and the written confirma- tion is sufficient against the sender, it is also sufficient against the recipient of the confirmation unless the re- cipient gives written notice of his objection within ten days after receiving the confirmation. This means that if these requirements have been met, the recipient of the writing or record is in the same position he would have assumed by signing it, and the confirmation, therefore, is enforceable against him.

For example, Brown Co. and ANM Industries enter into an oral contract that provides that ANM will

properties, the defendants orally agreed to assume the mortgage held by him and repay the debt within four months. The plaintiff demanded payment from the defendants. When the defendants refused to pay, the plaintiff brought this action.

The defendants then moved to dismiss the complaint asserting that the plaintiff’s claim to recover damages for breach of contract was barred by the statute of frauds. The plaintiff argued that handwritten statements from the closing and certain email messages, all of which had been attached to the complaint as exhibits, were sufficient evidence of a binding written agreement to satisfy the statute of frauds. The trial court denied the plaintiff’s motion and granted the defendants’ motion to dismiss. The plaintiff appealed.

DECISION Decision of the trial court is affirmed.

OPINION Eng, P. J. To satisfy the statute of frauds, a memorandum, subscribed by the party to be charged, must designate the parties, identify and describe the sub- ject matter, and state all of the essential terms of a com- plete agreement, [citations]. A writing is not a sufficient memorandum unless the “full intention of the parties can be ascertained from it alone, without recourse to parol evidence” [citations]. However, “the statutorily required writing need not be contained in one single document, but rather may be furnished by ‘piecing together other, related writings’” [citation].

*** to the extent that the allegations set forth in the complaint can be liberally construed to allege the exis- tence of an agreement by which the defendants were to

repay the Alaska Group’s debt to the plaintiff as part of the purchase price, it is *** barred by the statute of frauds because an agreement to answer for the debt of another must be in writing [citation]. Contrary to the plaintiff’s contention, the various writings attached to the complaint, taken together, were insufficient to me- morialize the existence of an agreement by which the defendants were to repay the Alaska Group’s debt to the plaintiff. Indeed, an email message dated September 1, 2009, indicated that Weiss was not willing to guaran- tee repayment of the plaintiff’s $650,000 loan to the Alaska Group, and that the material terms of the agree- ment were not settled. The additional email messages submitted by the plaintiff also failed to express the full intention of the parties [citations]. The email messages, at best, showed that there were negotiations for an agreement [citation]. Accordingly, the [trial court] prop- erly granted the defendants’ *** motion to dismiss the complaint.

INTERPRETATION A writing is not a suffi- cient memorandum unless the full intention of the par- ties can be ascertained from it alone, although the required writing need not be contained in one single document but rather may consist of several related documents that clearly indicate they relate to the same transaction.

CRITICAL THINKING QUESTION Should the statute of frauds prevent a party from using oral testi- mony to prove the existence of an oral agreement? Explain.

314 Contracts Part III

deliver twelve thousand shirts to Brown at $6.00 per shirt. Brown sends a letter to ANM acknowledging the agreement. The letter is signed by Brown’s president, contains the quantity term but not the price, and is mailed to ANM’s vice president for sales. Brown is bound by the contract once its authorized agent signs the letter, while ANM cannot raise the defense of the statute of frauds ten days after receiving the letter if it does not object within that time.

PRACTICAL ADVICE Merchants should examine written confirmations carefully and promptly to make certain that they are accurate.

EFFECT OF NONCOMPLIANCE [15-3] Under both the statute of frauds and the Code, the basic legal effect is the same: a contracting party has a defense to an action by the other party for enforce- ment of an unenforceable oral contract—that is, an oral contract that falls within the statute and does not comply with its requirements. For example, if Kirk- land, a painter, and Riggsbee, a homeowner, make an oral contract under which Riggsbee is to give Kirkland a certain tract of land in return for the painting of Riggsbee’s house, the contract is unenforceable under the statute of frauds. It is a contract for the sale of an interest in land. Either party can repudiate and

has a defense to an action by the other to enforce the contract.

Full Performance [15-3a] After all the promises of an oral contract have been performed by all the parties, the statute of frauds no longer applies. Accordingly, neither party may ask the court to rescind the executed oral contract on the basis that it did not meet the statute’s requirements. Thus, the statute applies to executory contracts only.

Restitution [15-3b] A party to a contract that is unenforceable because of the statute of frauds may have, nonetheless, acted in reliance upon the contract. In such a case, the party may recover in restitution the benefits he conferred upon the other in relying upon the unenforceable con- tract. Most courts require, however, that the party seeking restitution not be in default.

The Restatement of Restitution provides that a per- son who renders performance under an agreement that cannot be enforced by reason of the failure to satisfy the statute of frauds has a claim in restitution to pre- vent unjust enrichment. In such a case, that party may recover in restitution the benefits he directly conferred on the other as the performance required or invited by the unenforceable contract.

Thus, if Matthew makes an oral contract to furnish services to Rachel that are not to be performed within

Business Law IN ACTION

When should a writing or record be used tomemorialize a contract? The statute of frauds identifies those categories of contracts that must be evi- denced by a writing or record to be enforced, but it does not prevent us from using written contracts when they are not legally called for, nor does it preclude us from entering into an agreement without one.

Any time there is a doubt about the other party’s abil- ity to perform or a likelihood of future dispute over terms, the parties should have a writing—however brief or informal. For example, one should consider putting in writing service contracts that will be completed in less than a year, such as construction contracts, professional contracts, and other contracts for personal service, even though they typically do not fall within the statute of frauds.

On the other hand, there are times when insisting on a writing might actually undermine an agreement. The most common reason for disregarding the statute of frauds is business expediency. Even though goods valued at greater than $500 may be involved, the seller may not want to “bother” with the formality of a writing, and there may be a buyer who is equally motivated to consummate the transaction. Waiting for a written agreement might mean losing out on the deal. In such a case, however, both par- ties must understand that if the other party fails to per- form, the agreement will be unenforceable.

Commerce is dynamic: depending on the type of agree- ment involved, it can be fast paced and fluid or it can be deliberate and painstaking. Understanding the statute of frauds is important, but one may also wish to consider other factors in deciding whether to put a contract in writing.

Chapter 15 Contracts in Writing 315

a year and Rachel discharges Matthew after three months, Matthew may recover in restitution the value of the services rendered during the three months. Simi- larly, Lenny enters into an oral contract to sell land to Elaine, and Elaine pays a portion of the price as a down payment. Lenny subsequently repudiates the oral contract. Elaine may recover in restitution the portion of the price she paid.

Promissory Estoppel [15-3c] A growing number of courts have used the doctrine of promissory estoppel to displace the requirement of a writing by enforcing oral contracts within the statute of frauds in cases in which the party seeking enforcement has reasonably and foreseeably relied upon a promise in such a way that the court can avoid injustice only by enforcing the promise. The remedy granted is limited, as justice requires, and depends on such factors as the availability of other remedies; the foreseeability, reason- ableness, and substantiality of the reliance; and the extent to which reliance corroborates evidence of the promise. The use of promissory estoppel, however, to avoid the writing requirement of the statute of frauds has gained little acceptance in cases involving the sale of goods.

PAROL EVIDENCE RULE A contract reduced to writing and signed by the par- ties is frequently the result of many conversations, conferences, proposals, counterproposals, letters, and memoranda; sometimes it is also the product of nego- tiations conducted, or partly conducted, by agents of the parties. At some stage in the negotiations, the par- ties or their agents may have reached tentative agree- ments that were superseded (or regarded as such by one of the parties) by subsequent negotiations. Offers may have been made and withdrawn, either expressly or by implication, or forgotten in the give-and-take of negotiations. Ultimately, though, the parties prepare and sign a final draft of the written contract, which may or may not include all of the points that they dis- cussed and agreed on in the course of the negotiations. By signing the agreement, despite its potential omis- sions, the parties have declared it to be their contract, and the terms as contained in it represent the contract they have made. As a rule of substantive law, neither party is later permitted to show that the contract they made is different from the terms and provisions

that appear in the written agreement. This rule, which also applies to wills and deeds, is called the “parol evidence” rule.

THE RULE [15-4] When the parties express their contract in a writing that is intended to be the complete and final expression of their rights and duties, the parol evidence rule excludes prior oral or written negotiations or agree- ments of the parties or their contemporaneous oral agreements that vary or change an integrated written contract. The word parol literally means “speech” or “words.” The term parol evidence refers to any evi- dence, whether oral or in writing, that is outside the written contract and not incorporated into it either directly or by reference.

The parol evidence rule applies only to an integrated contract, that is, one contained in a certain writing or writings to which the parties have assented as being the statement of the complete and exclusive agreement or contract between them. When there is such an integra- tion of a contract, the courts will not permit parol evi- dence of any prior or contemporaneous agreement to vary, change, alter, or modify any of the terms or pro- visions of the written contract.

The reason for the rule is that the parties, by reduc- ing their entire agreement to writing, are regarded as having intended the writing that they signed to include the whole of their agreement. The terms and provisions contained in the writing are there because the parties intended them to be in their contract. Conversely, the courts regard the parties as having omitted intentionally any provision not in the writing. The rule, by excluding evidence that would tend to change, alter, vary, or modify the terms of the written agreement, safeguards the contract as made by the parties. The rule, which applies to all integrated written contracts, deals with what terms are part of the contract. The rule differs from the statute of frauds, which governs what con- tracts must be evidenced by a writing to be enforceable. Does the parol evidence rule or the statute of frauds apply to the situation presented in the Ethical Dilemma at the end of this chapter?

PRACTICAL ADVICE If your contract is intended to be the complete and final agreement, make sure that all terms are included and state your intention that the writing is complete and final. If you do not intend the writing to be complete or final, make sure that you so indicate in the writing itself.

316 Contracts Part III

J E N K I N S V . E C K E R D C O R P O R A T I O N D i s t r i c t C o u r t o f A p p e a l o f F l o r i d a , F i r s t D i s t r i c t , 2 0 0 5

9 1 3 S o . 2 d 4 3

FACTS In January 1991, Sandhill entered into a lease agreement with K & B Florida Corporation (K & B), a pharmaceutical retailer, providing for the rental of a par- cel of real property located in the Gulf Breeze Shopping Center in Gulf Breeze, Florida. Shortly before the execu- tion of the K & B Lease, Sandhill had leased space in the shopping center to Delchamps, Inc., a regional supermar- ket chain, as the “anchor” tenant in the shopping center. Article 2B of the K & B Lease referred to the Delchamps lease and provided:

ARTICLE 2 B. Lessor represents to Lessee that Lessor has entered

into leases with the following named concerns: with Del- champs, Inc. (Delchamps) for a minimum of 45,000 square feet for supermarket grocery store and that Lessor will construct and offer for lease individual retail shops for a minimum of 21,000 square feet for various retail uses, all located and dimensioned shown on the attached Plot Plan, … The continued leasing and payment of rent for their store in the Shopping Center by Delchamps is part of the consideration to induce Lessee to lease and pay rent for its store, … Accordingly, should Delchamps fail or cease to lease and pay rent for its store in the Shopping Center dur- ing the Lease Term as hereinafter set out, Lessee shall have the right and privilege of: (a) canceling this Lease and of terminating all of its obligations hereunder at any time thereafter upon written notice by Lessee to Lessor, and such cancellation and termination shall be effective ninety (90) days after the mailing of such written notice; …

The K & B Lease contained an integration clause which provided that “[t]his lease contains all of the agreements made between the parties hereto and may not be modified orally or in any manner other than by an agreement in writing.” The Delchamps’ lease included an assignment provision which granted Delchamps “the right, at any time after the commencement of the term hereof, to assign this lease.”

In September 1997, Jitney Jungle Stores of America, Inc. (Jitney Jungle), another grocery store operator, acquired Delchamps and continued the operation of the Delchamps’ grocery store in the shopping center. In 1998, Eckerd acquired the K & B drugstore. The K & B Lease was assigned to Eckerd, which began operating an Eckerd drugstore in the leased premises. In October 1999, Jitney Jungle filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. Thereafter, an order was entered in the bankruptcy proceeding approv- ing Delchamps’ assignment of its lease in the shopping

center to Bruno’s Supermarkets, Inc. (Bruno’s). Since the assignment, Bruno’s has occupied the leased premises under the assigned Delchamps’ lease and has operated a Bruno’s grocery store. Sandhill did not provide notice to, or obtain consent from, Eckerd of this assignment. On June 22, 2001, Eckerd notified Sandhill that, because Delchamps had ceased to lease and pay rent for its store in the shopping center, pursuant to the K & B Lease, Eckerd was canceling its lease effective September 20, 2001. Sandhill filed suit against Eckerd for an alleged breach of the shopping center lease. At trial, Sandhill sought to introduce testimony relating to its negotiations of the K & B Lease to explain the parties’ intent in draft- ing the allegedly ambiguous language in article 2B. The trial court prohibited the introduction of this evidence under the parol evidence rule. The district court entered a judgment in favor of Eckerd. This appeal was filed.

DECISION Judgment affirmed.

OPINION Van Nortwick, J. It is a fundamental rule of contract interpretation that a contract which is clear, complete, and unambiguous does not require judicial construction. [Citations.]

*** In the case on appeal, the trial court concluded, and

we agree, that article 2B of the K & B Lease clearly and unambiguously gave the lessee the option to cancel the lease if Delchamps ceased to lease and pay rent for the use of its store. As is clear from article 2B itself, the subject language was an inducement for the drugstore tenant to lease in the shopping center. ***

*** Sandhill argues that the trial court erred in applying

the parol evidence rule and refusing to allow the intro- duction of extrinsic evidence in interpreting article 2B of the K & B Lease. Sandhill correctly acknowledges that, if a contract provision is “clear and unambiguous,” a court may not consider extrinsic or “parol” evidence to change the plain meaning set forth in the contract. [Citation.] Sandhill contends that parol evidence was ad- missible below since the lease is incomplete and contains a latent ambiguity. [Citations.] A latent ambiguity arises when a contract on its face appears clear and unambigu- ous, but fails to specify the rights or duties of the parties in certain situations. [Citation.] Sandhill submits that, while the reference in article 2B of the K & B Lease to

Chapter 15 Contracts in Writing 317

SITUATIONS TO WHICH THE RULE DOES NOT APPLY [15-5] The parol evidence rule, in spite of its name, is not an exclusionary rule of evidence; nor is it a rule of con- struction or interpretation. Rather, it is a rule of sub- stantive law that defines the limits of a contract. Bearing this in mind, as well as the reason underlying the rule, you will readily understand that the rule does not apply to any of the following situations (see Figure 15-1 for an overview of the parol evidence rule):

1. A contract that is partly written and partly oral— that is, a contract in which the parties do not intend the writing to be their entire agreement.

2. A clerical or typographical error that obviously does not represent the agreement of the parties. Where, for example, a written contract for the services of a skilled mining engineer provides that his rate of com- pensation is to be $8.00 per day, a court of equity would permit reformation (correction) of the con- tract to correct the mistake if both parties intended the rate to be $800 per day.

3. The lack of contractual capacity of one of the parties through, for instance, minority, intoxication, or men- tal incompetency. Such evidence would not tend to

vary, change, or alter any of the terms of the written agreement but rather would show that the written agreement was voidable or void.

4. A defense of fraud, misrepresentation, duress, undue influence, mistake, illegality, lack of consideration, or other invalidating cause. Evidence establishing any of these defenses would not purport to vary, change, or alter any of the terms of the written agreement but rather would show such agreement to be voidable, void, or unenforceable.

5. A condition precedent to which the parties agreed orally at the time of the execution of the written agreement and to which the entire agreement was made subject. Such evidence does not tend to vary, alter, or change any of the terms of the agreement; rather, it shows whether the entire unchanged writ- ten agreement ever became effective.

6. A subsequent mutual rescission or modification of the written contract. Parol evidence of a later agree- ment does not tend to show that the integrated writ- ing did not represent the contract between the parties at the time the writing was made.

7. Parol evidence is admissible to explain ambiguous terms in the contract. To enforce a contract, it is necessary to understand its intended meaning.

the Delchamps lease may be “unambiguous” when read literally, this reference was not “clear” or “complete” with regard to the operation of the lease should the Delchamps lease be assigned. We cannot agree.

The operation of the parol evidence rule encourages parties to embody their complete agreement in a written contract and fosters reliance upon the written contract. “The parol evidence rule serves as a shield to protect a valid, complete and unambiguous written instrument from any verbal assault that would contradict, add to, or sub- tract from it, or affect its construction.” [Citation.] The parol evidence rule presumes that the written agreement that is sought to be modified or explained is an integrated agreement; that is, it represents the complete and exclusive instrument setting forth the parties’ intended agreement. [Citation.] The concept of integration is based on a pre- sumption that the parties to a written contract intended that writing “to be the sole expositor of their agreement.” [Citation.] The terms of an integrated written contract can be varied by extrinsic evidence only to the extent that the terms are ambiguous and are given meaning by the extrinsic evidence. [Citation.]

Here, *** the K & B Lease contains a so-called merger or integration clause. Although the existence of

a merger clause does not per se establish that the inte- gration of the agreement is total, [citation], a merger clause is a highly persuasive statement that the parties intended the agreement to be totally integrated and gen- erally works to prevent a party from introducing parol evidence to vary or contradict the written terms. *** Here, we find that the K & B Lease is an integrated agreement complete in all essential terms.

Further, Article 2B is not in the least unclear or incomplete. It contains no latent or patent ambiguity. Although article 2B does not mention assignment by Delchamps, it unambiguously grants the lessee the right to terminate the K & B Lease if Delchamps ceases to lease and pay rent for its store in the shopping center for any reason. *** Accordingly, the trial court cor- rectly ruled that it could not admit extrinsic evidence.

INTERPRETATION The parol evidence rule encourages parties to embody their complete agreement in an integrated written contract and fosters reliance upon the written contract.

CRITICAL THINKING QUESTION Do you agree with the parol evidence rule? Explain.

318 Contracts Part III

Nevertheless, such interpretation is not to alter, change, or vary the terms of the contract.

8. A separate contract; the rule does not prevent a party from proving the existence of a separate, dis- tinct contract between the same parties.

SUPPLEMENTAL EVIDENCE [15-6] Although a written agreement cannot be contradicted by evidence of a prior agreement or of a contemporane- ous agreement, under the Restatement and the Code,

FIGURE 15-1 Parol Evidence Rule

Parol Evidence Rule Applies: Evidence Is Not Admissible

No

Yes Parol Evidence Rule

Does Not Apply: Evidence Is Admissible

Yes

No

Yes

Yes

Evidence proves fraud, misrepresentation, undue influence, mistake, duress,

incapacity, illegality, or unconscionability?

Evidence of a condition precedent?

Evidence explains an ambiguity?

Evidence of a clerical error?

No

No

No

No

No

No

Yes

Yes

Yes

Yes

Written contract?

Integrated contract?

Evidence varies contract?

Evidence prior or contemporaneous?

Chapter 15 Contracts in Writing 319

a written contract may be explained or supplemented by (1) course of dealing between the parties; (2) usage of trade; (3) course of performance; or (4) evidence of consistent additional terms, unless the writing was intended by the parties to be a complete and exclusive statement of their agreement.

A course of dealing is a sequence of previous con- duct between the parties that a court may fairly regard as having established a common basis of understanding for interpreting their expressions and other conduct.

A usage of trade is a practice or method of dealing regularly observed and followed in a place, vocation, or trade.

Course of performance refers to the manner in which and the extent to which the respective parties to a con- tract have accepted without objection successive tenders of performance by the other party.

The Restatement and the Code permit supplemental consistent evidence to be introduced into a court pro- ceeding. Such evidence, however, is admissible only if it does not contradict a term or terms of the original agreement and probably would not have been included in the original contract.

INTERPRETATION OF CONTRACTS

Although parol evidence may not change the written words or language in which the parties embodied their agreement or contract, the ascertainment (determina- tion) of the meaning to be given to the written language is outside the scope of the parol evidence rule. Though the written words embody the terms of the contract, these words are but symbols; and, if their meaning is ambiguous, the courts may clarify this meaning by applying rules of interpretation or construction and by using extrinsic (external) evidence where necessary.

The Restatement defines interpretation as the ascertain- ment of the meaning of a promise or agreement or of a term of the promise or agreement. Where the language in a contract is unambiguous, a court will not accept extrinsic evidence tending to show a meaning different from that which the words clearly convey. To perform its function of interpreting and construing written contracts and docu- ments, the court adopts rules of interpretation to apply a legal standard to the words contained in the agreement. These are among the rules that aid interpretation:

1. Words and other conduct are interpreted in the light of all the circumstances, and if the principal purpose of the parties is ascertainable, it is given great weight.

2. A writing is interpreted as a whole, and all writ- ings that are part of the same transaction are inter- preted together.

3. Unless the parties manifest a different intention, language that has a commonly accepted meaning is interpreted in accordance with that meaning.

4. Unless a different intention is manifested, technical terms and words of art are given their technical meanings.

5. Wherever reasonable, the parties’ manifestations of intention regarding a promise or agreement are interpreted as consistent with each other and with any relevant course of performance, course of deal- ing, or usage of trade.

6. An interpretation that gives a reasonable, lawful, and effective meaning to all the terms is preferred over an interpretation that leaves a part unreason- able, unlawful, or of no effect.

7. Specific and exact terms are given greater weight than general language.

8. Separately negotiated or added terms are given greater weight than standardized terms or other terms not separately negotiated.

9. Express terms, course of performance, course of dealing, and usage of trade are weighted in that order.

10. Where a term or promise has several possible meanings, it will be interpreted against the party who supplied the contract or the term.

11. Where written provisions are inconsistent with typed or printed provisions, the written provision is given preference. Likewise, typed provisions are given preference to printed provisions.

12. If the amount payable is set forth in both figures and words and the amounts differ, the words con- trol the figures.

We may observe that through the application of the parol evidence rule (where properly applicable) and the previous rules of interpretation and construction, the law not only enforces a contract but also, in so doing, exercises great care both that the contract being enforced is the one the parties made and that the sense and meaning of the parties’ intentions are carefully ascertained and given effect.

PRACTICAL ADVICE Take care to ensure that your contracts are complete and understandable, especially if you drafted the contract.

320 Contracts Part III

C H A P T E R S U M M A R Y STATUTE OF FRAUDS

Contracts Within the Statute of Frauds

Rule contracts within the statute of frauds must be evidenced by a writing to be enforceable

Electronic Records full effect is given to electronic contracts and signatures

Suretyship Provision applies to promises to pay the debt of another • Promise Must Be Collateral promisor must be secondarily, not primarily, liable • Original Promise • Main Purpose Doctrine if primary object is to provide an economic benefit to the surety, then

the promise is not within the statute • Promise Made to Debtor

Executor-Administrator Provision applies to promises to answer personally for a duty of the decedent

Marriage Provision applies to promises in consideration of marriage but not to mutual promises to marry

Land Contract Provision applies to promises to transfer any right, privilege, power, or immunity in real property

Ethical Dilemma What’s (Wrong) in a Contract?

FACTS Rick Davidson was an All-American point guard on Donaldson University’s varsity basketball team. He was a four-year starter and, through the cooperation of several accommodating professors, was able to graduate on time—with one small catch: he really couldn’t read or write. But his classroom experiences helped convince him that he could handle any situation, and when he was drafted in the first round by a National Basketball Association (NBA) team, he decided to act as his own agent.

During the negotiations, John Stock, general manager for the team, made Rick an offer of $2.4 million to play for the team for three years. After seeing that other first-round draft choices were receiving closer to $3 million for the same three years, Rick made it known to Stock that the team’s offer was unacceptable. Stock told Rick that because of the salary cap (each NBA team has a limit on the total amount of salaries it can pay its players), he would be willing to raise the offer to $2.8 million but that the extra $400,000 could not be written into the contract. This would be an oral agreement that would avoid disclosing the salary cap violation to the league. After considering the offer, Rick signed the contract for $2.4 million for three years’ service, and he and Stock shook hands on the deal for the

additional $400,000 for the same three years. The contract stated that it was the complete and final agreement between the parties.

After Rick’s first year, it was obvious to the team that Rick was not worth the money, and Stock decided not to pay him the first year’s portion of the extra $400,000. Stock claimed that because this agreement was not in writing, it was not enforceable.

Social, Policy, and Ethical Considerations 1. What would you do?

2. Is the team legally obligated to pay the additional $400,000? Is it ethically obligated to do so?

3. What policy interests are served by the team’s decision not to pay Rick the extra money? Would the fact that NBA policy makes it impossible for a player to leave a team and play for another NBA team change your answer?

4. What responsibility does the university bear in this situation?

5. What is the nature of Rick’s responsibility with respect to these facts? What should he do?

Chapter 15 Contracts in Writing 321

One-Year Provision applies to contracts that cannot be performed within one year • The Possibility Test the criterion is whether it is possible, not likely, for the agreement to be

performed within one year • Computation of Time the year runs from the time the agreement is made • Full Performance by One Party makes the promise of the other party enforceable under

majority view

Sale of Goods a contract for the sale of goods for the price of $500 or more must be evidenced by a writing or record to be enforceable • Admission an admission in pleadings, testimony, or otherwise in court makes the contract

enforceable for the quantity of goods admitted • Specially Manufactured Goods an oral contract for specially manufactured goods is enforceable • Delivery or Payment and Acceptance validates the contract only for the goods that have been

accepted or for which payment has been accepted

Modification or Rescission of Contracts Within the Statute of Frauds oral contracts modifying existing contracts are unenforceable if the resulting contract is within the statute of frauds

Methods of Compliance

General Contract Provisions the writing(s) or record must • specify the parties to the contract • specify the subject matter and essential terms • be signed by the party to be charged or by her agent

Sale of Goods provides a general method of compliance for all parties and an additional one for merchants • Writing(s) or Record must (1) be sufficient to indicate that a contract has been made between

the parties, (2) be signed by the party against whom enforcement is sought or by her authorized agent, and (3) specify the quantity of goods to be sold

• Written Confirmation between merchants, a written confirmation that is sufficient against the sender is also sufficient against the recipient unless the recipient gives written notice of his objection within ten days

Effect of Noncompliance

Oral Contract Within Statute of Frauds is unenforceable

Full Performance statute does not apply to executed contracts

Restitution when a contract is unenforceable because of the statute of frauds, a party may recover in restitution the benefits conferred on the other party in performance of the contract

Promissory Estoppel oral contracts will be enforced in cases in which the party seeking enforcement has reasonably and justifiably relied on the promise and the court can avoid injustice only by enforcement

PAROL EVIDENCE RULE AND INTERPRETATION OF CONTRACTS

The Parol Evidence Rule

Statement of Rule when parties express a contract in a writing that they intend to be the final expression of their rights and duties, evidence of their prior oral or written negotiations or agreements of their contemporaneous oral agreements that vary or change the written contract are not admissible

Situations to Which the Rule Does Not Apply • a contract that is not an integrated document • correction of a typographical error • showing that a contract was void or voidable

322 Contracts Part III

• showing whether a condition has in fact occurred • showing a subsequent mutual rescission or modification of the contract

Supplemental Evidence may be admitted • Course of Dealing previous conduct between the parties • Usage of Trade practice engaged in by the trade or industry • Course of Performance conduct between the parties concerning performance of the particular

contract • Supplemental Consistent Evidence

INTERPRETATION OF CONTRACTS

Definition the ascertainment of the meaning of a promise or agreement or a term of the promise or agreement

Rules of Interpretation include • all the circumstances are considered and the principal purpose of the parties is given great weight • a writing is interpreted as a whole • commonly accepted meanings are used unless the parties manifest a different intention • technical terms are given their technical meaning • wherever possible, the intentions of the parties are interpreted as consistent with each other and

with course of performance, course of dealing, or usage of trade • specific terms are given greater weight than general language • separately negotiated terms are given greater weight than standardized terms or those not

separately negotiated • the order for interpretation is express terms, course of performance, course of dealing, and

usage of trade • where a term has several possible meanings, the term will be interpreted against the party who

supplied the contract or term • written provisions are given preference over typed or printed provisions and typed provisions

are given preference over printed provisions • if an amount is set forth in both words and figures and they differ, words control the figures

Q U E S T I O N S

1. Rafferty was the principal shareholder in Continental Corporation, and as a result, he received the lion’s share of Continental Corporation’s dividends. Continental Cor- poration was anxious to close an important deal for iron ore products to use in its business. A written contract was on the desk of Stage Corporation for the sale of the iron ore to Continental Corporation. Stage Corporation, however, was cautious about signing the contract, and it did not sign until Rafferty called Stage Corporation on the telephone and stated that if Continental Corporation did not pay for the ore, he would pay. Business reversals struck Continental Corporation, and it failed. Stage Corporation sued Rafferty. What defense, if any, has Rafferty?

2. Green was the owner of a large department store. On Wednesday, January 26, he talked to Smith and said, “I will hire you to act as sales manager in my store for one year at a salary of $48,000. You are to begin work next Monday.” Smith accepted and started work on Monday,

January 31. At the end of three months, Green discharged Smith. On May 15, Smith brought an action against Green to recover the unpaid portion of the $48,000 sal- ary. Is Smith’s employment contract enforceable?

3. Rowe was admitted to the hospital suffering from a criti- cal illness. He was given emergency treatment and later underwent surgery. On at least four occasions, Rowe’s two sons discussed with the hospital the payment for services to be rendered by the hospital. The first of these four conversations took place the day after Rowe was admitted. The sons informed the treating physician that their father had no financial means but that they them- selves would pay for such services. During the other con- versations, the sons authorized whatever treatment their father needed, assuring the hospital that they would pay for the services. After Rowe’s discharge, the hospital brought this action against the sons to recover the unpaid bill for the services rendered to their father. Are the sons’ promises to the hospital enforceable? Explain.

Chapter 15 Contracts in Writing 323

4. Ames, Bell, Cain, and Dole each orally ordered LCD (liquid crystal display) televisions from Marvel Electron- ics Company, which accepted the orders. Ames’s televi- sion was to be encased in a specially designed ebony cabinet. Bell, Cain, and Dole ordered standard televi- sions described as “Alpha Omega Theatre.” The price of Ames’s television was $1,800, and the televisions ordered by Bell, Cain, and Dole were $700 each. Bell paid the company $75.00 to apply on his purchase; Ames, Cain, and Dole paid nothing. The next day, Marvel sent Ames, Bell, Cain, and Dole written confirmations captioned “Purchase Memorandum,” numbered 12345, 12346, 12347, and 12348, respectively, containing the essential terms of the oral agreements. Each memorandum was sent in duplicate with the request that one copy be signed and returned to the company. None of the four purchasers returned a signed copy. Ames promptly called the company and repudiated the oral contract, which it received before beginning manufacture of the set for Ames or making commitments to carry out the con- tract. Cain sent the company a letter reading in part, “Referring to your Contract No. 12347, please be advised I have canceled this contract. Yours truly, (Signed) Cain.” The four televisions were duly tendered by Marvel to Ames, Bell, Cain, and Dole, all of whom refused to accept delivery. Marvel brings four separate actions against Ames, Bell, Cain, and Dole for breach of contract. Decide each claim.

5. Moriarity and Holmes enter into an oral contract by which Moriarity promises to sell and Holmes promises to buy Blackacre for $10,000. Moriarity repudiates the con- tract by writing a letter to Holmes in which she states accurately the terms of the bargain, but adds “our agree- ment was oral. It, therefore, is not binding upon me, and I shall not carry it out.” Thereafter, Holmes sues Moriar- ity for specific performance of the contract. Moriarity interposes the defense of the statute of frauds, arguing that the contract is within the statute and hence unen- forceable. What will be the result? Discuss.

6. On March 1, Lucas called Craig on the telephone and offered to pay him $90,000 for a house and lot that Craig owned. Craig accepted the offer immediately on the telephone. Later in the same day, Lucas told Anna- belle that if she would marry him, he would convey to her the property then owned by Craig that was the sub- ject of the earlier agreement. On March 2 Lucas called Penelope and offered her $16,000 if she would work for him for the year commencing March 15, and she agreed. Lucas and Annabelle were married on June 25. By this time, Craig had refused to convey the house to Lucas. Thereafter, Lucas renounced his promise to convey the property to Annabelle. Penelope, who had been working for Lucas, was discharged without cause on July 5; Annabelle left Lucas and instituted divorce proceedings in July.

What rights, if any, has

a. Lucas against Craig for his failure to convey the property;

b. Annabelle against Lucas for failure to convey the house to her; and

c. Penelope against Lucas for discharging her before the end of the agreed term of employment?

7. Blair orally promises Clay to sell him five crops of pota- toes to be grown on Blackacre, a farm in Idaho, and Clay promises to pay a stated price for them on delivery. Is the contract enforceable?

8. Rachel leased an apartment to Bertha for a one-year term beginning May 1, at $800 a month, “payable in advance on the first day of each and every month of said term.” At the time the lease was signed, Bertha told Rachel that she received her salary on the tenth of the month, and that she would be unable to pay the rent before that date each month. Rachel replied that would be satisfactory. On June 2, Bertha not having paid the June rent, Rachel sued Bertha for the rent. At the trial, Bertha offered to prove the oral agreement as to the date of payment each month. Explain whether Rachel should succeed.

9. Ann bought a car from the Used Car Agency (Used) under a written contract. She purchased the car in reli- ance on Used’s agent’s oral representations that it had never been in a wreck and could be driven at least two thousand miles without adding oil. Thereafter, Ann dis- covered that the car had, in fact, been previously wrecked and rebuilt, that it used excessive quantities of oil, and that Used’s agent was aware of these facts when the car was sold. Ann brought an action to rescind the contract and recover the purchase price. Used objected to the introduction of oral testimony concerning representations of its agent, contending that the written contract alone governed the rights of the parties. Should Ann succeed?

10. In a contract drawn up by Goldberg Company, it agreed to sell and Edwards Contracting Company agreed to buy wood shingles at $650. After the shingles were delivered and used, Goldberg Company billed Edwards Company at $650 per bunch of nine hundred shingles. Edwards Company refused to pay because it thought the contract meant $650 per thousand shingles. Goldberg Company brought action to re- cover on the basis of $650 per bunch. The evidence showed that there was no applicable custom or usage in the trade and that each party held its belief in good faith. Decision?

11. Amos orally agrees to hire Elizabeth for an eight-month trial period. Elizabeth performs the job magnificently, and after several weeks Amos orally offers Elizabeth a six- month extension at a salary increase of 20 percent. Eliza- beth accepts the offer. At the end of the eight-month trial period, Amos discharges Elizabeth, who brings suit against Amos for breach of contract. Is Amos liable? Why?

324 Contracts Part III

C A S E P R O B L E M S

12. Halsey, a widower, was living without family or house- keeper in his house in Howell, New York. Burns and his wife claim that Halsey invited them to give up their house and business in Andover, New York, to live in his house and care for him. In return, they allege, he promised them the house and its furniture upon his death. Acting upon this proposal, the Burnses left Andover, moved into Halsey’s house, and cared for him until he died five months later. No deed, will, or memorandum exists to authenticate Hal- sey’s promise. McCormick, the administrator of the estate, claims the oral promise is unenforceable under the statute of frauds. Explain whether McCormick is correct.

13. Ethel Greenberg acquired the ownership of the Carlyle Hotel on Miami Beach but had little experience in the hotel business. She asked Miller to participate in and counsel her operation of the hotel, which he did. He claims that because his efforts produced a substantial profit, Ethel made an oral agreement for the continuation of his services. Miller alleges that in return for his ser- vices, Ethel promised to marry him and to share the net income resulting from the operation of the hotel. Miller maintains that he rendered his services to Ethel in reli- ance upon her promises and that the couple planned to wed in the fall. Ethel, due to physical illness, decided not to marry. Miller sued for damages for Ethel’s breach of agreement. Is the oral contract enforceable? Discuss.

14. Dean was hired on February 12 as a sales manager of the Co-op Dairy for a minimum period of one year with the dairy agreeing to pay his moving expenses. By Febru- ary 26, Dean had signed a lease, moved his family from Oklahoma to Arizona, and reported for work. After he worked for a few days, he was fired. Dean then brought this action against the dairy for his salary for the year, less what he was paid. The dairy argues that the statute of frauds bars enforcement of the oral contract because the contract was not to be performed within one year. Is the dairy correct in its assertion?

15. Yokel, a grower of soybeans, had sold soybeans to Camp- bell Grain and Seed Company and other grain companies in the past. Campbell entered into an oral contract with Yokel to purchase soybeans from him. Promptly after entering into the oral contract, Campbell signed and mailed to Yokel a written confirmation of the oral agree- ment. Yokel received the written confirmation but did not sign it or object to its content. Campbell now brings this action against Yokel for breach of contract upon Yokel’s failure to deliver the soybeans. Is the agreement binding?

16. Presti claims that he reached an oral agreement with Wilson by telephone in October to buy a horse for $60,000. Presti asserts that he sent Wilson a bill of sale and a postdated check, which Wilson retained. Presti also

claims that Wilson told him that for tax reasons he wished not to consummate the transaction until January 1 of the following year. The check was neither deposited nor negotiated. Wilson denies that he ever agreed to sell the horse or that he received the check and bill of sale from Presti. Presti’s claim is supported by a copy of his check stub and by the affidavit of his executive assistant, who says that he monitored the telephone call and pre- pared and mailed both the bill of sale and the check. Wilson argues that the statute of frauds governs this transaction and that because there was no writing, the contract claim is barred. Is Wilson correct? Explain.

17. Louie E. Brown worked for the Phelps Dodge Corporation under an oral contract for approximately twenty-three years. In 2015, he was suspended from work for unau- thorized possession of company property. In 2016, Phelps Dodge fired Brown after discovering that he was using company property without permission and building a trailer on company time. Brown sued Phelps Dodge for benefits under an unemployment benefit plan. According to the plan, “in order to be eligible for unemployment benefits, a laid-off employee must: (1) Have completed 2 or more years of continuous service with the company, and (2) Have been laid off from work because the com- pany had determined that work was not available for him.” The trial court held that the wording of the second condition was ambiguous and should be construed against Phelps Dodge, the party who chose the wording. A read- ing of the entire contract, however, indicates that the plan was not intended to apply to someone who was fired for cause. What is the correct interpretation of this contract?

18. Katz offered to purchase land from Joiner, and after nego- tiating the terms, Joiner accepted. On October 13, over the telephone, both parties agreed to extend the time pe- riod for completing and mailing the written contract until October 20. Although the original paperwork deadline in the offer was October 14, Katz stated he had inserted that provision “for my purpose only.” All other provisions of the contract remained unchanged. Accordingly, Joiner completed the contract and mailed it on October 20. Immediately after, however, Joiner sent Katz an overnight letter stating that “I have signed and returned contract, but have changed my mind. Do not wish to sell property.” Joiner now claims an oral modification of a contract within the statute of frauds is unenforceable. Katz counters that the modification is not material and therefore does not affect the underlying contract. Explain who is correct.

19. When Mr. McClam died, he left the family farm, heavily mortgaged, to his wife and children. To save the farm from foreclosure, Mrs. McClam planned to use insurance proceeds and her savings to pay off the debts. She was

Chapter 15 Contracts in Writing 325

unwilling to do so, however, unless she had full ownership of the property. Mrs. McClam wrote her daughter, stating that the daughter should deed over her interest in the fam- ily farm to her mother. Mrs. McClam promised that upon her death all the children would inherit the farm from their mother equally. The letter further explained that if foreclosure occurred, each child would receive very little, but if they complied with their mother’s plan, each would eventually receive a valuable property interest upon her death. Finally, the letter stated that all the other children had agreed to this plan. The daughter also agreed. Years later, Mrs. McClam tried to convey the farm to her son Donald. The daughter challenged, arguing that the mother was contractually bound to convey the land equally to all children. Donald says this was an oral agreement to sell land and is unenforceable. The daughter says the letter sat- isfies the statute of frauds, making the contract enforcea- ble. Who gets the farm? Explain.

20. Butler Brothers Building Company sublet all of the work in a highway construction contract to Ganley Brothers, Inc. Soon thereafter, Ganley brought this action against Butler for fraud in the inducement of the contract. The contract, however, provided: “The contractor [Ganley] has examined the said contracts …, knows all the require- ments, and is not relying upon any statement made by the company in respect thereto.” Can Ganley introduce into evidence the oral representations made by Butler?

21. Alice solicited an offer from Robett Manufacturing Com- pany to manufacture certain clothing that Alice intended to supply to the government. Alice contends that in a tele- phone conversation, Robett made an oral offer that she immediately accepted. She then received the following letter from Robett, which, she claims, confirmed their agreement:

Confirming our telephone conversation, we are pleased to offer the 3,500 shirts at $14.00 each and the trousers at $13.80 each with delivery approxi- mately ninety days after receipt of order. We will try to cut this to sixty days if at all possible.

This, of course, is quoted f.o.b. Atlanta and the order will not be subject to cancellation, domestic pack only. Thanking you for the opportunity to offer these garments, we are

Very truly yours, ROBETT MANUFACTURING CO., INC.

Explain whether the agreement is enforceable against Robett.

22. Enrique Gittes was a financial consultant for NCC, an English holding company that invested capital in other businesses in return for a stake in those businesses. One of NCC’s investments was a substantial holding in Simplicity Pattern Company. Gittes’s consulting contract was subsequently transferred to Simplicity, and Gittes was elected to the Simplicity board of directors.

When NCC fell into serious financial straits, it became imperative that it sell its interest in Simplicity. Accord- ingly, a buyer was found. The buyer insisted that before closing the deal all current Simplicity directors, including Gittes, must resign. Gittes, however, refused to resign. Edward Cook, the largest shareholder of NCC and the one with the most to lose if the Simplicity sale was not completed, orally offered Gittes a five-year, $50,000-per- year consulting contract with Cook International if Gittes would resign from the Simplicity board.

Gittes and Cook never executed a formal contract. However, Cook International did issue two writings—a prospectus and a memo—that mentioned the employment of Gittes for five years at $50,000 per year. Neither writ- ing described the nature of Gittes’s job or any of his duties. In fact, Gittes was given no responsibilities and was never paid. Gittes sued to enforce the employment contract. Cook International contended that the statute of frauds made the oral contract unenforceable. Decision?

23. Shane Quadri contacted Don Hoffman, an employee of Al J. Hoffman & Co. (Hoffman Agency), to procure car in- surance. Later, Quadri’s car was stolen. Quadri contacted Hoffman, who arranged with Budget Rent-a-Car for a rental car for Quadri until his car was recovered. Hoffman authorized Budget Rent-a-Car to bill the Hoffman Agency. Later, when the stolen car was recovered, Hoffman tele- phoned Goodyear and arranged to have four new tires put on Quadri’s car to replace those damaged during the theft. Budget and Goodyear sued Hoffman for payment of the car rental and tires. Is Hoffman liable on his oral promise to pay for the car rental and the four new tires?

24. On July 5, 2006, Richard Price signed a written employ- ment contract as a new salesman with the Mercury Sup- ply Company. The contract was of indefinite duration and could be terminated by either party for any reason upon fifteen days’ notice. Between 2006 and 2014, Price was promoted several times. In 2008, Price was made vice president of sales. In September of 2014, however, Price was told that his performance was not satisfactory and that if he did not improve he would be fired. In February of 2015, Price received notice of termination. Price claims that in 2011 he entered into a valid oral employment contract with Mercury Supply Company in which he was made vice president of sales for life or until he should retire. Is the alleged oral contract barred by the one-year provision of the statute of frauds?

25. Thomson Printing Company is a buyer and seller of used machinery. On April 10, the president of the company, James Thomson, went to the surplus machinery depart- ment of B.F. Goodrich Company in Akron, Ohio, to examine some used equipment that was for sale. Thomson discussed the sale, including a price of $9,000, with Ingram Meyers, a Goodrich employee and agent. Four days later, on April 14, Thomson sent a purchase order to confirm the oral contract for purchase of the machinery

326 Contracts Part III

and a partial payment of $1,000 to Goodrich in Akron. The purchase order contained Thomson Printing’s name, address, and telephone number, as well as certain informa- tion about the purchase, but did not specifically mention Meyers or the surplus equipment department. Goodrich sent copies of the documents to a number of its divisions, but Meyers never learned of the confirmation until weeks later, by which time the equipment had been sold to another party. Thomson Printing brought suit against Goodrich for breach of contract. Goodrich claimed that no contract had existed and that at any rate the alleged oral contract could not be enforced because of the statute of frauds. Is the contract enforceable? Why?

26. Plaintiffs leased commercial space from the defendant to open a florist shop. After the lease was executed, the plaintiffs learned that they could not place a freestanding sign along the highway to advertise their business because the Deschutes County Code allowed only one freestanding sign on the property, and the defendant al- ready had one in place. The plaintiffs filed this action, alleging that defendant had breached the lease by failing to provide them with space in which they could erect a freestanding sign. Paragraph 16 of the lease provides as follows: “Tenant shall not erect or install any signs … visible from outside the leased premises with out [sic] the previous written consent of the Landlord.” Explain whether this evidence is admissible.

27. Jesse Carter and Jesse Thomas had an auto accident with a driver insured by Allstate. Carter and Thomas hired an attorney, Joseph Onwuteaka, to represent them. Mr. Onwuteaka sent a demand letter for settlement of the plaintiffs’ claims to Allstate’s adjustor, Ms. Gracie Weatherly. Mr. Onwuteaka claims Ms. Weatherly made, and he orally accepted, settlement terms on behalf of the plaintiffs. When Allstate did not honor the agreements, Carter and Thomas filed a suit for breach of contract. Discuss the enforceability of the oral agreement.

28. Mary Iacono and Carolyn Lyons had been friends for almost thirty-five years. Mary suffers from advanced rheu- matoid arthritis and is in a wheelchair. Carolyn invited Mary to join her on a trip to Las Vegas, Nevada, for which Carolyn paid. Mary contended that she was invited to Las Vegas by Carolyn because Carolyn thought Mary was lucky. Sometime before the trip, Mary had a dream about winning on a Las Vegas slot machine. Mary’s dream convinced her to go to Las Vegas, and she accepted Carolyn’s offer to split “50–50” any gambling winnings. Carolyn provided Mary with money for gambling. Mary and Carolyn started to gamble but after losing $47.00, Carolyn wanted to leave to see a show. Mary begged Car- olyn to stay, and Carolyn agreed on the condition that Carolyn put the coins into the machines because doing so took Mary too long. Mary agreed and led Carolyn to a dollar slot machine that looked like the machine in her dream. The machine did not pay on the first try. Mary then said, “Just one more time,” and Carolyn looked at Mary and said, “This one’s for you, Puddin.” They hit the jackpot, winning $1,908,064 to be paid over a period of twenty years. Carolyn refused to share the winnings with Mary. Is Mary entitled to one-half of the proceeds? Explain.

29. On February 9, George Jackson and his neighbors, Karen and Steve Devenyn, drafted and signed a document that purports to convey a seventy-nine-acre parcel of land owned by Jackson. By the terms of the agreement, Jackson wished to reserve a 1.3-acre portion of the par- cel. Although the agreement contained a drawing and dimensions of the conveyance, it did not contain a spe- cific description of the parcel. Jackson died on May 8, and his estate refused to honor the agreement. The Devenyns then filed a petition with the probate court to order a conveyance. Based on the parol evidence rule, the estate of Jackson objected to the admission of the wit- nesses’ testimony that they could point out the specific area based on conversations with Jackson. Explain whether the oral evidence is admissible.

T A K I N G S I D E S

Stuart Studio, an art studio, prepared a new catalog for the National School of Heavy Equipment, a school run by Gilbert and Donald Shaw. When the artwork was virtually finished, Gilbert Shaw requested Stuart Studio to purchase and supervise the printing of twenty-five thousand catalogs. Shaw told the art studio that payment of the printing costs would be made within ten days after billing and that if the “National School would not pay the full total that he would stand good for the entire bill.” Shaw was chairman of the board of directors of the school, and he owned 100 percent of its voting stock and

49 percent of its nonvoting stock. The school became bank- rupt, and Stuart Studio was unable to recover the sum from the school. Stuart Studio then brought an action against Shaw on the basis of his promise to pay the bill.

a. What are the arguments that Shaw is not liable on his promise?

b. What are the arguments that Shaw is liable on his promise?

c. Is Shaw obligated to pay the debt in question? Explain.

Chapter 15 Contracts in Writing 327

C H A P T E R 1 6

THIRD PARTIES TO CONTRACTS

The establishment of [the third-party beneficiary] doctrine … is a victory of practical utility over theory, of equity over technical subtlety.

BRANTLY ON CONTRACTS, 2ND EDITION

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Distinguish between an assignment of rights and a delegation of duties.

2. Identify (a) the requirements of an assignment of contract rights and (b) those rights that are not assignable.

3. Identify those situations in which a delegation of duties is not permitted.

4. Distinguish between an intended beneficiary and an incidental beneficiary.

5. Explain when the rights of an intended beneficiary vest.

I n prior chapters, we considered situations that essentially involved only two parties. In this chapter, we deal with the rights and duties of third parties,

namely, persons who are not parties to the contract but who have a right to or an obligation for its performance. These rights and duties arise either by (1) an assign- ment of the rights of a party to the contract, (2) a delega- tion of the duties of a party to the contract, or (3) the express terms of a contract entered into for the benefit of a third person. In an assignment or delegation, the third party’s rights or duties arise after the original con- tract is made, whereas in the third situation, the third- party beneficiary’s rights arise at the time the contract is formed. We will consider these three situations in that order.

ASSIGNMENT OF RIGHTS [16-1] Every contract creates both rights and duties. A person who owes a duty under a contract is an obligor, while a person to whom a contractual duty is owed is an obligee. For instance, Ann promises to sell to Bart an automobile for which Bart promises to pay $10,000 by monthly installments over the next three years. Ann’s right under the contract is to receive payment from Bart, whereas Ann’s duty is to deliver the automobile. Bart’s right is to receive the automobile; his duty is to pay for it.

A B automobile

$10,000

Obligor Obligee

Obligee Obligor

328

An assignment of rights is the voluntary transfer to a third party of the rights arising from the contract. In the previous example, if Ann were to transfer her right under the contract (the installment payments due from Bart) to Clark for $8,500 in cash, this would constitute a valid assignment of rights. In this case, Ann would be the assignor, Clark would be the assignee, and Bart would be the obligor.

A

C

B automobile

$10 ,00

0

Assignor

Assignee

Obligor

assigns right to $10,000

$8,500

An effective assignment terminates the assignor’s right to receive performance by the obligor. After an assignment, only the assignee has a right to the obligor’s performance.

On the other hand, if Ann and Doris agree that Doris should deliver the automobile to Bart, this would constitute a delegation, not an assignment, of duties between Ann and Doris. A delegation of duties is a transfer to a third party of a contractual obligation. In this instance, Ann would be the delegator, Doris would be the delegatee, and Bart would be the obligee.

Requirements of an Assignment [16-1a] The Restatement defines an assignment of a right as a manifestation of the assignor’s intention to transfer the right so that the assignor’s right to the performance of the obligor is extinguished either in whole or in part and the assignee acquires a right to such performance. No special form or particular words are necessary to create an assignment. Any words that fairly indicate an

intention to make the assignee the owner of the right are sufficient.

Unless otherwise provided by statute, an assignment may be oral. The Uniform Commercial Code (UCC) imposes a writing requirement on all assignments beyond $5,000. The 2001 Revision to Article 1, however, has deleted this requirement. In addition, Article 9 requires certain assignments to be in writing.

Consideration is not required for an effective assign- ment. Consequently, gratuitous assignments are valid and enforceable. By giving value, or consideration, for the assignment, the assignee indicates his assent to the assign- ment as part of the bargained-for exchange. On the other hand, when the assignment is gratuitous, the assignee’s assent is not always required. Any assignee who has not assented to an assignment, however, may disclaim the assignment within a reasonable time after learning of its existence and terms.

Revocability of Assignments When the as- signee gives consideration in exchange for an assign- ment, a contract exists between the assignor and the assignee. Consequently, the assignor may not revoke the assignment without the assignee’s assent. In contrast, a gratuitous assignment is revocable by the assignor and is terminated by the assignor’s death, incapacity, or subse- quent assignment of the right, unless the assignor has made an effective delivery of the assignment to the assignee, as in the case of Speelman v. Pascal. Such delivery can be accomplished by transferring a deed or other document evidencing the right, such as a stock certificate or savings passbook. Delivery also may consist of physically delivering a signed, written assignment of the contract right. A gratuitous assignment is also made irrevocable if, before the attempted revocation, the do- nee-assignee receives payment of the claim from the obli- gor, obtains a judgment against the obligor, or obtains a new contract with the obligor.

PRACTICAL ADVICE Be sure to make irrevocable assignments of only those rights you wish to transfer.

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FACTS In 1952, the estate of George Bernard Shaw granted to Gabriel Pascal Enterprises, Limited, the exclusive rights to produce a musical play and a motion

picture based on Shaw’s play Pygmalion. The agreement contained a provision terminating the license if Gabriel Pascal Enterprises did not arrange for well-known

Chapter 16 Third Parties to Contracts 329

Partial Assignments A partial assignment is a transfer of a portion of the contractual rights to one or more assignees, as in Speelman v. Pascal. The obligor, however, may require all the parties entitled to the prom- ised performance to litigate the matter in one action, thus ensuring that all parties are present and avoiding the undue hardship of multiple lawsuits. For example, Jack owes Richard $2,500. Richard assigns $1,000 to Mildred. Neither Richard nor Mildred can maintain an action against Jack if Jack objects, unless the other is joined in the proceeding against Jack.

Rights That Are Assignable [16-1b] As a general rule, most contract rights, including rights under an option contract, are assignable. The most com- mon contractual right that may be assigned is the right to the payment of money. A contract right to other property, such as land or goods, is likewise assignable.

Rights That Are Not Assignable [16-1c] To protect the obligor or the public interest, some contract rights are not assignable. These nonassignable contract rights include those that (1) materially increase the duty, risk, or burden upon the obligor; (2) transfer

highly personal contract rights; (3) are expressly pro- hibited by the contract; or (4) are prohibited by law.

Assignments That Materially Increase the Duty, Risk, or Burden An assignment is ineffec- tive if performance by the obligor to the assignee would differ materially from the obligor’s performance to the assignor, that is, if the assignment would significantly change the nature or extent of the obligor’s duty. Thus, an automobile liability insurance policy issued to Alex is not assignable by Alex to Betty. The risk assumed by the insurance company was liability for Alex’s negligent operation of the automobile. Liability for Betty’s opera- tion of the same automobile would be a risk entirely different from the one the insurance company had assumed. Similarly, Candice would not be allowed to assign to Eunice, the owner of a twenty-five-room man- sion, Candice’s contractual right to have David paint her small, two-bedroom house. Clearly, such an assignment would materially increase David’s duty of performance. By comparison, the right to receive monthly payments under a contract may be assigned, for mailing the check to the assignee costs no more than mailing it to the assignor. Moreover, if a contract explicitly provides that it may be assigned, then rights under it are assignable even if the assignment would change the duty, risk, or burden of performance on the obligor.

composers, such as Lerner and Loewe, to write the mu- sical and produce it within a specified period of time. George Pascal, owner of 98 percent of Gabriel Pascal Enterprises’ stock, attempted to meet these requirements but died in July 1954 before negotiations had been com- pleted. In February 1954, however, while the license had two years yet to run, Pascal had sent a letter to Kingman, his executive secretary, granting to her certain percentages of his share of the profits from the expected stage and screen productions of Pygmalion. Subse- quently, Pascal’s estate arranged for the writing and production of the highly successful My Fair Lady, based on Shaw’s Pygmalion. Kingman then sued to enforce Pascal’s gift assignment of the future royalties. The trial court entered judgment for Kingman.

DECISION Judgment for Kingman affirmed.

OPINION Desmond, C. J. The only real question is as to whether the 1954 letter *** operated to transfer to plaintiff an enforceable right to the described percentages of the royalties to accrue to Pascal on the production of a stage or film version of a musical play based on

Pygmalion. We see no reason why this letter does not have that effect. It is true that at the time of the delivery of the letter there was no musical stage or film play in existence but Pascal, who owned and was conducting negotiations to realize on the stage and film rights, could grant to another a share of the moneys to accrue from the use of those rights by others. There are many instan- ces of courts enforcing assignments of rights to sums which were expected thereafter to become due to the assignor. *** In every such case the question must be as to whether there was a completed delivery of a kind appropriate to the subject property. *** In our present case there was nothing left for Pascal to do in order to make an irrevocable transfer to plaintiff of part of Pascal’s right to receive royalties from the productions.

INTERPRETATION A gratuitous assignment becomes irrevocable upon the assignor’s making an effective delivery of the assignment to the assignee.

CRITICAL THINKING QUESTION Should the law enforce assignments of contractual rights not in existence at the time of the assignment? Explain.

330 Contracts Part III

Assignments of Personal Rights When the rights under a contract are highly personal, in that they are limited to the person of the obligee, such rights are not assignable. An extreme example of such a contract is an agreement of two persons to marry one another. The prospective groom obviously may not transfer the prospective bride’s promise to marry to some third

party. A more typical example of a contract involving personal rights would be a contract between a teacher and a school. The teacher could not assign her right to a faculty position to another teacher. Similarly, a stu- dent who is awarded a scholarship cannot assign his right to some other person. The Magness case involves another example.

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9 7 2 F . 2 d 6 8 9

FACTS The Dayton Country Club Company (the Club) offers many social activities to its members. The privilege to play golf at the Club, however, is reserved to a special membership category for which additional fees are charged. The Club chooses golfing memberships from a waiting list of members according to detailed rules, regulations, and procedures. Magness and Red- man were golfing members of the Club. Upon their fil- ing for bankruptcy, their trustee sought to assign by sale their golf rights to (1) other members on the waiting list, (2) other members not on the waiting list, or (3) the general public, provided the purchaser first acquired membership in the Club. The bankruptcy court found that the Club’s rules governing golf membership were essentially anti-assignment provisions and therefore the estate could not assign rights contained in the member- ship agreement. On appeal to the district court, the bankruptcy court’s ruling was affirmed. The district court added that this case was not a lease but rather a “non-commercial dispute over the possession of a valua- ble membership in a recreational and social club.”

DECISION Judgment affirmed.

OPINION Joiner, J. *** [T]he contracts involve complex issues and multiple parties: the members of the club, in having an orderly procedure for the selection of full golfing members; the club itself, in demonstrating to all who would become members that there is a pre- dictable and orderly method of filling vacancies in the golfing roster; and more particularly, persons on the waiting list who have deposited substantial sums of money based on an expectation and a developed proce- dure that in due course they, in turn, would become full golfing members.

If the trustee is permitted to assume and assign the full golf membership, the club would be required to

reach its agreement with the persons on the waiting list, each of whom has contractual rights with the club. It would require the club to accept performance from and render performance to a person other than the debtor.

*** The contracts creating the complex relationships

among the parties and others are not in any way com- mercial. They create personal relationships among indi- viduals who play golf, who are waiting to play golf, who eat together, swim and play together. They are per- sonal contracts and Ohio law does not permit the assignment of personal contracts. [Citation.]

So-called personal contracts, or contracts in which the personality of one of the parties is material, are not assignable. Whether the personality of one or both par- ties is material depends on the intention of the parties, as shown by the language which they have used, and upon the nature of the contract.

Therefore, we believe that the trustee’s motion to assign the full golf membership should be denied. We reach this conclusion because the arrangements for fill- ing vacancies proscribe assignment, the club did not consent to the assignment and sale, and applicable law excuses the club from accepting performance from or rendering performance to a person other than the debtor.

INTERPRETATION When rights under a con- tract are personal, they may not be assigned.

ETHICAL QUESTION Is the court’s decision fair to the creditors of Magness and Redman? Explain.

CRITICAL THINKING QUESTION Which type of contracts should not be assignable because of their personal nature? Explain.

Chapter 16 Third Parties to Contracts 331

Express Prohibition Against Assignment Though contract terms prohibiting assignment of rights under the contract are strictly construed, most courts interpret a general prohibition against assignments as a mere promise not to assign. As a consequence, the gen- eral prohibition, if violated, gives the obligor a right to damages for breach of the terms forbidding assignment but does not render the assignment ineffective.

The Restatement provides that unless circumstances indicate the contrary, a contract term prohibiting assignment of the contract bars only the delegation to the assignee (delegatee) of the assignor’s (delegator’s) duty of performance, not the assignment of rights. Thus, Norman and Lucy contract for the sale of land by Lucy to Norman for $300,000 and provide in their contract that Norman may not assign the contract. Norman pays Lucy $300,000, thereby fulfilling his duty of performance under the contract. Norman then assigns his rights to George, who consequently is enti- tled to receive the land from Lucy (the obligor) despite the contractual prohibition of assignment.

Article 2 of the Code provides that a right to dam- ages for breach of the whole contract or a right arising out of the assignor’s due performance of his entire obligation can be assigned despite a contractual provi- sion to the contrary. Article 2 also provides that unless circumstances indicate the contrary, a contract term prohibiting assignment of the contract bars only the delegation to the assignee (delegatee) of the assignor’s (delegator’s) duty of performance, not the assign- ment of rights. Article 9 of the Code makes generally ineffective any term in a security agreement restricting the assignment of a security interest in any right to payment for goods sold or leased or for services rendered.

PRACTICAL ADVICE Consider including in your contract a provision prohibiting the assignment of any contractual rights without your written consent and making ineffective any such assignment.

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5 9 1 S o . 2 d 9 5 3 ; r e h e a r i n g d e n i e d , 1 9 9 2

FACTS Colonial Palms Plaza, Inc. (Landlord) entered into a lease agreement with Abby’s Cakes On Dixie, Inc. (Tenant). The lease included a provision in which Landlord agreed to pay Tenant a construction allowance of up to $11,250 after Tenant completed cer- tain improvements. Prior to completion of the improve- ments, Tenant assigned its right to receive the first $8,000 of the construction allowance to Robert Aldana in return for a loan of $8,000 to finance the construc- tion. Aldana sent notice of the assignment to Landlord. When Tenant completed the improvements, Landlord ignored the assignment and paid Tenant the construc- tion allowance. Aldana sued Landlord for the money due pursuant to the assignment. Landlord relied on an anti-assignment clause in the lease to argue that the assignment was void. That clause states in part:

TENANT agrees not to assign, mortgage, pledge, or encum- ber this Lease, in whole or in part, to sublet in whole or any part of the DEMISED PREMISES … without first obtaining the prior, specific written consent of the LAND- LORD at LANDLORD’S sole discretion…. Any such assignment … without such consent shall be void.

The trial court granted Landlord summary judgment.

DECISION Summary judgment reversed and case remanded.

OPINION Per Curiam. Assignee argues *** that under ordinary contract principles, the lease provision at issue here does not prevent the assignment of the right to receive contractual payments. We agree.

*** [T]he lease provides that “TENANT agrees not to assign *** this Lease, in whole or in part. ***” Ten- ant did not assign the lease, but instead assigned a right to receive the construction allowance.

The law in this area is summarized in Restatement (Second) of Contracts, §322(1), as follows:

(1) Unless the circumstances indicate the contrary, a con- tract term prohibiting assignment of “the contract” bars only the delegation to an assignee of the performance by the assignor of a duty or condition.

As a rule of construction, in other words, a prohibi- tion against assignment of the contract (or in this case, the lease) will prevent assignment of contractual duties, but does not prevent assignment of the right to receive payments due—unless the circumstances indicate the contrary. [Citations.]

332 Contracts Part III

Assignments Prohibited by Law Various federal and state statutes, as well as public policy, pro- hibit or regulate the assignment of certain types of con- tract rights. For instance, assignments of future wages are subject to such statutes, some of which prohibit these assignments altogether, whereas others require the assignments to be in writing and subject them to certain restrictions. Moreover, an assignment that violates pub- lic policy will be unenforceable even in the absence of a prohibiting statute.

Rights of the Assignee [16-1d] Obtains Rights of Assignor The general rule is that an assignee stands in the shoes of the assignor. She acquires the rights of the assignor but no new or additional rights, and she takes with the assigned rights all of the defenses, defects, and infirmities to which they would be subject in an action against the obligor by the assignor. Thus, in an action brought by the assignee against the obligor, the obligor may plead fraud, du- ress, undue influence, failure of consideration, breach

of contract, or any other defense arising out of the orig- inal contract against the assignor. The obligor may also assert rights of setoff or counterclaim arising out of entirely separate matters that he may have against the assignor, as long as they arose before he had notice of the assignment.

The Code permits the buyer under a contract of sale to agree as part of the contract that he will not assert against an assignee any claim or defense that the buyer may have against the seller if the assignee takes the assignment for value, in good faith, and without notice of conflicting claims or of certain defenses. Such a provision in an agreement renders the seller’s rights more marketable. The Federal Trade Commission, however, has invalidated such waiver of defense provisions in consumer credit transactions. This rule is discussed more fully in Chapter 25. Article 9 reflects this rule by essentially rendering waiver-of- defense clauses ineffective in consumer transactions. Most states also have statutes protecting buyers in consumer transactions by prohibiting waiver of defenses.

Landlord was given notice of the assignment. Deliv- ery of the notice of the assignment to the debtor fixes accountability of the debtor to the assignee. [Citation.] Therefore, Landlord was bound by the assignment. [Citation.] The trial court improperly granted final sum- mary judgment in favor of Landlord and the judgment must be reversed.

INTERPRETATION Unless circumstances indi- cate the contrary, a contract term prohibiting assignment

of the contract bars only delegation of the assignor’s con- tractual duties.

ETHICAL QUESTION If the landlord had in- advertently ignored the notice of assignment, would the outcome of the case have been fair? Explain.

CRITICAL THINKING QUESTION Should the courts honor contractual prohibitions of assignments by rendering such assignments ineffective? Explain.

M O U N T A I N P E A K S F I N A N C I A L S E R V I C E S , I N C . V . R O T H - S T E F F E N C o u r t o f A p p e a l s o f M i n n e s o t a , 2 0 1 0

7 7 8 N . W . 2 d 3 8 0

FACTS In May 1998, Catherine Roth-Steffen grad- uated from law school with over $100,000 in school loans from more than a dozen lenders. Of this total, Roth-Steffen received $20,350 from the Missouri Higher Education Loan Authority (MOHELA) CASH Loan pro- gram. As of November 5, 1998, Roth-Steffen had incurred interest on these loans (MOHELA loan) in the amount of $3,043.28. Roth-Steffen listed the balance of $23,401.28 in a loan consolidation application she sub- mitted in December 1998. She requested that the MOHELA loan not be consolidated with her other loans.

In February 2003, MOHELA assigned ownership of the MOHELA loan to Guarantee National Insurance Company (GNIC), which, in turn, assigned the loan for collection to respondent Mountain Peaks Financial Ser- vices, Inc. (Mountain Peaks). Mountain Peaks com- menced a collection action claiming that it holds the MOHELA loan and that it is entitled to judgment in the amount of the outstanding balance, $23,120.52, and additional interest at the rate of 2.54% from July 19, 2007. In response, Roth-Steffen asserted that the action is barred by Minnesota’s six-year statute of limitations

Chapter 16 Third Parties to Contracts 333

Notice The obligor need not receive notice for an assignment to be valid. Giving notice of assignment is advisable, however, because an assignee will lose his rights against the obligor if the obligor, without notice of the assignment, pays the assignor. Compelling an obligor to pay a claim a second time, when she was

unaware that a new party was entitled to payment, would be unfair. For example, Donald owes Gary $1,000 due on September 1. Gary assigns the debt to Paula on August 1, but neither Gary nor Paula informs Donald. On September 1, Donald pays Gary. Donald is fully discharged from his obligation, whereas Gary is

for collection on promissory notes. The district court granted summary judgment in favor of Mountain Peaks, determining that Mountain Peaks (1) owns Roth- Steffen’s loan, (2) is a valid assignee of MOHELA’s right, and (3) under the federal Higher Education Act is not to be subject to any state statutes of limitation.

DECISION Summary judgment is affirmed.

OPINION Bjorkman, J. Enacted in 1965, the Higher Education Act was the first comprehensive gov- ernment program designed to provide scholarships, grants, workstudy funding, and loans for students to attend college. [Citations.] Pursuant to the act, the fed- eral government makes loans and guarantees loans made by private lenders. [Citation.] In 1991, in response to rising loan defaults and an unfavorable legal ruling, Congress adopted the Higher Education Technical Amendments. [Citation.]

The amendments eliminate all statutes of limitation on actions to recover on defaulted student loans for cer- tain classes of lenders. [Citation.] These lenders are defined in section 1091a:

***

(B) a guaranty agency that has an agreement with the Secretary under section 1078(c) of this title that is seeking the repayment of the amount due from a borrower on a loan made under part B of this subchapter after such guaranty agency reimburses the previous holder of the loan for its loss on account of the default of the borrower;

*** [Citation.] For convenience, we refer to the entities described in this statute as “named lenders.”

Mountain Peaks argues that it is exempt from Minnesota’s statutes of limitation because it is a valid as- signee of MOHELA, a lender that has an agreement with the Secretary of Education under [section] 1091a(a)(2)(B). Roth-Steffen acknowledges that MOHELA is a named lender but argues that because Congress did not expressly identify assignees as named lenders, section 1091a does not preempt state statutes of limitation for claims asserted by assignees of named lenders.

***

Section 1091a does not, by its terms, extend its statutes-of-limitation exemption to assignees of named lenders. Nor does the statute expressly preclude applica- tion of the exemption to assignees. ***

*** But courts interpreting federal statutes must also pre-

sume that Congress intended to preserve the common law. ***

The common law of most states, including Minne- sota, has long recognized that “[a]n assignment operates to place the assignee in the shoes of the assignor, and provides the assignee with the same legal rights as the assignor had before assignment.” [Citations]; see gener- ally Restatement (Second) of Contracts §317 (1981) (Assignment of a Right). Contractual rights and duties are generally assignable, including the rights to receive payment on debts, obtain nonmonetary performance, and recover damages. Restatement (Second) of Con- tracts §316 (1981). But an assignor may not transfer rights that are personal, such as recovery for personal injuries or performance under contracts that involve per- sonal trust or confidences. [Citation]; see generally Restatement (Second) of Contracts §317 cmt. c. Under the common law, a contractual right to recover student- loan debt is assignable and does not fall within the per- sonal-rights exclusion to the assignment rule.

*** *** Because Congress legislated with a full knowl-

edge of the common law of assignment, all contractual rights of the named lenders, including the protection from state statutes of limitations, should transfer to their assignees. This interpretation of section 1091a both pre- serves the common law and furthers the stated purpose of the statute. [Citation.]

INTERPRETATION An assignment places the assignee in the shoes of the assignor and provides the assignee with the same legal rights as the assignor had before the assignment.

CRITICAL THINKING QUESTION If assignees of student loans were made subject to state statutes of limitations, what would be the probable effect on the availability of student loans? Explain.

334 Contracts Part III

liable for $1,000 to Paula. On the other hand, if Paula had given notice of the assignment to Donald before September 1 and Donald had paid Gary nevertheless, Paula would then have the right to recover the $1,000 from either Donald or Gary. Furthermore, notice cuts off any defenses based on subsequent agreements between the obligor and assignor and, as already indi- cated, subsequent setoffs and counterclaims of the obli- gor that may arise out of entirely separate matters.

PRACTICAL ADVICE Upon receiving an assignment of a contractual right, promptly notify the obligor of the assignment.

Implied Warranties of Assignor [16-1e] An implied warranty is an obligation imposed by law upon the transferor of property or contract rights. In the absence of an express intention to the contrary, an assignor who receives value makes the following implied warranties to the assignee with respect to the assigned right:

1. that he will do nothing to defeat or impair the assignment;

2. that the assigned right actually exists and is subject to no limitations or defenses other than those stated or apparent at the time of the assignment;

3. that any writing that evidences the right and that is delivered to the assignee or exhibited to him as an inducement to accept the assignment is genuine and what it purports to be; and

4. that the assignor has no knowledge of any fact that would impair the value of the assignment.

Thus, Eric has a right against Julia and assigns it for value to Gwen. Later, Eric gives Julia a release. Gwen may recover damages from Eric for breach of the first implied warranty.

Express Warranties of Assignor [16-1f] An express warranty is an explicitly made contractual promise regarding the property or contract rights trans- ferred. The assignor is further bound by any specific express warranties he makes to the assignee about the right assigned. Unless he explicitly states as much, how- ever, the assignor does not guarantee that the obligor will pay the assigned debt or otherwise perform.

PRACTICAL ADVICE Consider obtaining from the assignor an express warranty stating that the contractual right is assignable and guaranteeing that the obligor will perform the assigned obligation.

Successive Assignments of the Same Right [16-1g] The owner of a right could conceivably make successive assignments of the same claim to different persons. Although this action is morally and legally inappropri- ate, it raises the question of what rights successive assignees have. Assume, for example, that B owes A $1,000. On June 1, A for value assigns the debt to C. Thereafter, on June 15, A assigns it to D, who in good faith gives value and has no knowledge of the prior assignment by A to C. If the assignment is subject to Article 9, then the article’s priority rules will control, as discussed in Chapter 37. Otherwise, the priority is determined by the common law. The majority rule in the United States is that the first assignee in point of time (C) prevails over later assignees. By way of con- trast, in England and in a minority of the states, the first assignee to notify the obligor prevails.

The Restatement adopts a third view. A prior as- signee is entitled to the assigned right and its proceeds to the exclusion of a subsequent assignee, except where the prior assignment is revocable or voidable by the as- signor or the subsequent assignee in good faith and without knowledge of the prior assignment gives value and obtains one of the following: (1) payment or satis- faction of the obligor’s duty, (2) a judgment against the obligor, (3) a new contract with the obligor, or (4) pos- session of a writing of a type customarily accepted as a symbol or evidence of the right assigned.

DELEGATION OF DUTIES [16-2] As we indicated, contractual duties are not assignable, but their performance generally may be delegated to a third person. A delegation of duties is a transfer of a contractual obligation to a third party. For example, A promises to sell B a new automobile, for which B promises to pay $10,000 by monthly installments over the next three years. If A and D agree that D should deliver the automobile to B, this would not constitute an assignment but would be a delegation of duties between A and D. In this instance, A would be the delegator, D would be the delegatee, and B would be the obligee. A delegation of duty does not extinguish

Chapter 16 Third Parties to Contracts 335

the delegator’s obligation to perform because A remains liable to B. When the delegatee accepts, or assumes, the delegated duty, both the delegator and delegatee are liable for performance of the contractual duty to the obligee.

A

D

B automobile

au tom

ob ile

Delegator

Delegatee

Obligee

delegates duty to deliver

automobile

Delegable Duties [16-2a] Though contractual duties generally are delegable, a delegation will not be permitted if

1. the nature of the duties is personal in that the obli- gee has a substantial interest in having the delegator perform the contract;

2. the performance is expressly made nondelegable; or

3. the delegation is prohibited by statute or public policy.

The courts will examine a delegation more closely than an assignment because a delegation compels the nondelegating party to the contract (the obligee) to receive performance from a party with whom she has not dealt.

For example, a schoolteacher may not delegate her performance to another teacher, even if the substitute is equally competent, for this contract is personal in nature. On the other hand, under a contract in which performance by a party involves no special skill and in which no personal trust or confidence is involved, the party may delegate performance of his duty. For example, the duty to pay money, to deliver fungible goods such as corn, or to mow a lawn is usually delegable.

PRACTICAL ADVICE When it is important that the other party to a contract personally perform his contractual obligations, consider including a term in the contract prohibiting any delegation of duties without written consent.

Duties of the Parties [16-2b] Even when permitted, a delegation of a duty to a third person leaves the delegator bound to perform. If the delegator desires to be discharged of the duty, she may enter into an agreement by which she obtains the con- sent of the obligee to substitute a third person (the del- egatee) in her place. This is a novation, whereby the delegator is discharged and the third party becomes directly bound on his promise to the obligee.

Though a delegation authorizes a third party to per- form a duty for the delegator, the delegatee becomes liable for performance only if he assents to perform the delegated duties. Thus, if Frank owes a duty to Grace and Frank delegates that duty to Henry, Henry is not obligated to either Frank or Grace to perform the duty unless Henry agrees to do so. If, however, Henry prom- ises either Frank (the delegator) or Grace (the obligee) that he will perform Frank’s duty, Henry is said to have assumed the delegated duty and becomes liable for nonperformance to both Frank and Grace. Accord- ingly, when there is both a delegation of duties and an assumption of the delegated duties, both the delegator and the delegatee are liable to the obligee for proper performance of the original contractual duty. The del- egatee’s promise to perform creates contract rights in the obligee, who may bring an action against the deleg- atee as a third-party beneficiary of the contract between the delegator and the delegatee. (Third-party contracts are discussed in the next section in this chapter.)

The question of whether a party has assumed contrac- tual duties frequently arises in the following ambiguous situation: Marty and Carol agree to an assignment of Marty’s contract with Bob. The Restatement and the Code clearly resolve this ambiguity by providing that unless the language or circumstances indicate the contrary, an assignment of “the contract” or of “all my rights under the contract” or an assignment in similar general terms is an assignment of rights and a delegation of per- formance of the duties of the assignor, and its acceptance by the assignee constitutes a promise to perform those duties. For example, Cooper Oil Company has a contract to deliver oil to Halsey. Cooper makes a written assign- ment to Lowell Oil Company “of all Cooper’s rights under the contract.” Lowell is under a duty to Halsey to deliver the oil called for by the contract, and Cooper is liable to Halsey if Lowell does not perform. You should also recall that the Restatement and the Code provide that a clause prohibiting an assignment of “the contract” is to be construed as barring only the delegation to the assignee (delegatee) of the assignor’s (delegator’s) performance, unless the circumstances indicate the contrary.

336 Contracts Part III

F E D E R A L I N S . C O . V . W I N T E R S S u p r e m e C o u r t o f T e n n e s s e e , 2 0 1 1

3 5 4 S . W . 3 d 2 8 7

FACTS Winters Roofing Company, entered into a contract to replace a roof on the home of Robert and Joanie Emerson. Without informing the Emersons, he subcontracted the job to Terry Monk. A few months after the work was completed, the roof began to leak and developed several areas of standing water. When the Emersons notified him of these issues, Winters agreed to take care of the problems and subcontracted the repair work to Bruce Jacobs. While performing the work, Jacobs caused a fire, resulting in an $871,069.73 insurance claim by the homeowners. After paying the Emersons’ claim, their insurer, Federal Insurance Com- pany, acquired the homeowners’ rights and claims aris- ing out of the fire. The plaintiff insurance company sued Winters in contract. Winters filed a motion for summary judgment, asserting that because he had sub- contracted the work, he could not be liable. The trial court granted the motion. The Court of Appeals reversed, holding that Winters had a nondelegable con- tractual duty to perform the roofing services in a care- ful, skillful, and workmanlike manner. The Tennessee Supreme Court granted Winter’s application for per- mission to appeal.

DECISION The judgment of the Court of Appeals is affirmed; case is remanded to the trial court.

OPINION Wade, J. In a breach of contract action, claimants must prove the existence of a valid and en- forceable contract, a deficiency in the performance amounting to a breach, and damages caused by the breach. [Citation.] In addition to the explicit terms, con- tracts may be accompanied by implied duties, which can result in a breach. [Citations.] ***

*** Here, the Plaintiff has alleged that the “[D]efendant

breached its contractual duties by failing to complete the contract work … skillfully, carefully, diligently, [and] in a workmanlike manner….” (Emphasis added). In our view, the contract placed upon the Defendant the implied duty to skillfully, carefully, and diligently install and repair the Emersons’ roof in a workmanlike manner.

The question that remains is whether the duty of the Defendant to replace the roof skillfully, carefully, dili- gently, and in a workmanlike manner could be delegated to a subcontractor. That is, may a contractor who has

such a duty escape liability by subcontracting with a third party who breaches these implied responsibilities? ***

The Restatement (Second) of Contracts specifically addresses this issue, explaining that “neither delegation of performance nor a contract to assume the duty [under a contract] … discharges any duty or liability of the delegating obligor.” Restatement (Second) of Con- tracts §318(3) (1981). ***

*** To be clear, this principle does not mean that the

performance of service contracts cannot be delegated. Generally, a contractor may delegate the performance of the contract, in whole or in part, to a third party. Restatement (Second) of Contracts §318(1) (1981). The delegation of performance, however, does not relieve the contractor from the duties implicit in the original con- tract. [Citation.] Stated definitively, “‘[o]ne who con- tracts to perform an undertaking is liable to his promise[e] for the [acts] of an independent contractor to whom he delegates performance.’” [Citation.]

*** Here, the Emersons contracted with the Defendant

for the installation of a roof. When it became apparent that the new roof leaked and required repairs, the Emer- sons contacted the Defendant, who agreed to fix the problems. Without the knowledge of the Emersons, the Defendant hired a subcontractor to perform the repair work, whose use of a propane torch in repairing the roof resulted in a fire that caused substantial damage. Because the Defendant had the implied duty under con- tract to install the roof carefully, skillfully, diligently, and in a workmanlike manner, and, further, because the delegation of the responsibility to perform the services did not operate to release him from liability, the Defend- ant, based on his contract with the Emersons, may be held liable for the damages caused by the acts of Jacobs, the subcontractor. ***

INTERPRETATION A delegation of a duty to a third person leaves the delegator bound to perform and liable for any breach of contract.

CRITICAL THINKING QUESTION Why should the law not permit a contracting party unilaterally to relieve itself of liability by delegating its duty of per- formance to a third person?

Chapter 16 Third Parties to Contracts 337

THIRD-PARTY BENEFICIARY CONTRACTS [16-3] A contract in which a party (the promisor) promises to render a certain performance not to the other party (the promisee) but to a third person (the beneficiary) is called a third-party beneficiary contract. The third per- son is merely a beneficiary of the contract, not a party to it. The law divides such contracts into two types: (1) intended beneficiary contracts and (2) incidental beneficiary contracts. An intended beneficiary is in- tended by the two parties to the contract (the promisor and promisee) to receive a benefit from the perform- ance of their agreement. Accordingly, the courts gener- ally permit intended beneficiaries to enforce third-party contracts. For example, Abbot promises Baldwin to deliver an automobile to Carson if Baldwin promises to pay $10,000. Carson is the intended beneficiary.

A

C

B $10,000

automobile

Promisor

Intended Beneficiary

Promisee

In an incidental beneficiary contract the third party is not intended to receive a benefit under the contract. Accordingly, courts do not enforce the third party’s right to the benefits of the contract. For example, Abbot promises to purchase and deliver to Baldwin an automobile for $10,000. In all probability Abbot would

A P P L Y I N G T H E L A W

THIRD PARTIES TO CONTRACTS

Facts Monica signed a twelve-month lease with Grand- ridge Apartments in Grand City. But after only two months she received a promotion that required her to move to Lakeville, three hundred miles away. Mindful of her lease obligation, she found an acquaintance, Troy, to rent the apartment for the remaining ten months. Troy promised Monica he would pay the rent directly to the landlord each month and would clean the place up before moving out at the end of the lease term.

After moving in, Troy personally delivered a check for the rent to the landlord each month until four months later when he lost his job, at which point he stopped paying rent altogether. The landlord evicted Troy and, as he was unable to find another suitable tenant, he sued Monica for the rent owed on the remainder of the lease. Monica claimed the landlord should have sued Troy.

Issue Is Monica liable for the remaining lease payments?

Rule of Law Performance of a contract obligation gener- ally may be delegated to a third person who is willing to assume the liability. However, such a delegation by the obli- gor does not extinguish the obligor-delegator’s duty to per- form the contract. If the delegator wishes to be discharged from the contract prospectively, she should enter into a new agreement with the obligee, in which the obligee consents

to the substitution of a third party (the delegatee) in the delegator’s place. This is called a novation.

Application The lease is a contract obligation. Monica is the obligor, and the landlord is the obligee. Here, Monica delegated her performance under the lease to Troy. Troy assumed liability for the lease payments by agreeing to pay the rent. However, even though a valid delegation has been made, Monica is not relieved of her duty to pay the rent. Instead, both Troy and Monica are now obligated to the landlord for the remaining lease term.

Had Monica entered into a novation with the landlord, only Troy would be liable for the remaining rent. But the facts do not support finding a novation. Troy made the rent payments directly to the landlord, who ultimately evicted Troy from the apartment. Therefore, the landlord was aware that Troy had taken possession of the apartment and that Troy may have taken on some responsibility for rent pay- ments. At most, the landlord tacitly consented to the infor- mal assignment and delegation of the lease to Troy. However, the landlord never agreed to substitute Troy for Monica and thereby to release Monica from her legal obli- gations under the lease.

Conclusion In a suit by the landlord, Monica is responsi- ble for the remaining rent payments.

338 Contracts Part III

acquire the automobile from Davis. Davis would be an incidental beneficiary and would have no enforceable rights against either Abbot or Baldwin.

A

D

B $10,000

automobile

Promisor

Incidental Beneficiary

Promisee

Intended Beneficiary [16-3a] Unless otherwise agreed between the promisor and promisee, a beneficiary of a promise is an intended ben- eficiary if the parties intended this to be the result of their agreement. Thus, there are two types of intended beneficiaries: (1) donee beneficiaries and (2) creditor beneficiaries.

Donee Beneficiary A third party is an intended donee beneficiary if the promisee’s purpose in bargain- ing for and obtaining the contract with the promisor was to make a gift of the promised performance to the beneficiary. The ordinary life insurance policy illus- trates this type of intended beneficiary third-party contract. The insured (the promisee) makes a contract with an insurance company (the promisor), which promises, in consideration of premiums paid to it by the insured, to pay upon the death of the insured a stated sum of money to the named beneficiary (gener- ally a relative or close friend), who is an intended donee beneficiary.

Insurance Co.

Beneficiary

Insured premium

proceeds

Promisor

Intended Donee

Promisee

gift

Creditor Beneficiary A third person is an intended creditor beneficiary if the promisee intends the performance of the promise to satisfy a legal duty owed to the beneficiary, who is a creditor of the promisee. The contract involves consideration moving from the promisee to the promisor in exchange for the promis- or’s engaging to pay a debt or to discharge an obliga- tion the promisee owes to the third person.

To illustrate: in the contract for the sale by Wesley of his business to Susan, she promises Wesley that she will pay all of his outstanding business debts, as listed in the contract. Wesley’s creditors are intended creditor beneficiaries.

A

C

B $

performance

Promisor

Intended Creditor Beneficiary

Promisee

prior duty owed

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FACTS On April 26, 1984, Mary Stine (Stine) loaned her daughter (Mary Ellen) and son-in-law Wil- liam Stewart $100,000 to purchase a home. In return, the Stewarts jointly executed a promissory note for

$100,000, payable on demand to Stine. The Stewarts did not give a security interest or mortgage to secure the note. The Stewarts eventually paid $50,000 on the note, leaving $50,000, plus unpaid interest, due.

Chapter 16 Third Parties to Contracts 339

The Stewarts divorced on October 2, 1992. The cou- ple executed an Agreement Incident to Divorce, which disposed of marital property, including the home (the agreement identifies the home as the Lago Vista prop- erty). The agreement provided that if Stewart sold the home, he agreed that “any monies owing to [Stine] are to be paid in the current principal sum of $50,000.00.” The agreement further states:

The parties agree that with regard to the note to Mary Nelle Stine, after application of the proceeds of the [Lago Vista property], if there are any amounts owing to [Stine] the remaining balance owing to her will be appropriated 50% to NANCY KAREN STEWART and 50% to WILLIAM DEAN STEWART, JR. and said 50% from each party will be due and payable upon the determination that the proceeds from the sale of said residence are not sufficient to repay said $50,000.00 in full.

Stine did not sign the agreement. On November 17, 1995, Stewart sold the Lago Vista

property for $125,000, leaving $6,820.21 in net pro- ceeds. Stewart did not pay these proceeds to Stine and did not make any further payments on the $50,000 prin- cipal. Consequently, on July 27, 1998, Stine sued Stewart for breaching the agreement.

The trial court concluded that Stine was an intended third-party beneficiary of the agreement and that Stewart breached the agreement when he refused to pay Stine. The trial court awarded Stine $28,410 in damages from Stewart. The court of appeals reversed the judgment, con- cluding that Stine was neither an intended third-party donee beneficiary of the agreement nor an intended third- party creditor beneficiary of the agreement.

DECISION The court of appeals’ judgment is reversed and case remanded.

OPINION Per Curiam. A third party may recover on a contract made between other parties only if the parties intended to secure a benefit to that third party, and only if the contracting parties entered into the contract directly for the third party’s benefit. [Citation.] A third party does not have a right to enforce the contract if she received only an incidental benefit. [Citation.] “A court will not create a third-party beneficiary contract by implication.” [Citation.] Rather, an agreement must clearly and fully express an intent to confer a direct benefit to the third party. [Citation.] To determine the parties’ intent, courts must examine the entire agreement when interpreting a contract and give effect to all the contract’s provisions so that none are rendered meaningless. [Citation.]

To qualify as an intended third-party beneficiary, a party must show that she is either a “donee” or “creditor” beneficiary of the contract. [Citation.] An

agreement benefits a “donee” beneficiary if, under the contract, “the performance promised will, when ren- dered, come to him as a pure donation.” [Citations.] In contrast, an agreement benefits a “creditor” beneficiary if, under the agreement, “that performance will come to him in satisfaction of a legal duty owed to him by the promisee.” [Citations.] This duty may be an indebted- ness, contractual obligation or other legally enforceable commitment owed to the third party. [Citation.]

*** We agree with the court of appeals’ determination that

Stine was not an intended third-party donee beneficiary of the agreement. [Citation.] But, we conclude that Stine is a third-party creditor beneficiary. The agreement expressly provides that the Stewarts intended to satisfy an obliga- tion to repay Stine the $50,000 that the Stewarts owed her. Specifically, the agreement refers to the monies owed to Stine as “the current principal sum of $50,000.” Then, the agreement states that Stewart agreed to pay the prop- erty sale net proceeds “with regard to the note” to Stine.

The agreement further provides that, if the property sale net proceeds did not cover the amount owed to Stine, the remainder would be immediately due and pay- able from the Stewarts, with each owing one half. Thus, the agreement expressly requires the Stewarts to satisfy their existing obligation to pay Stine. [Citation.]

*** Furthermore, contrary to Stewart’s argument, a third-

party beneficiary does not have to show that the signatories executed the contract Solely to benefit her as a noncontract- ing party. Rather, the focus is on whether the contracting parties intended, at least in part, to discharge an obligation owed to the third party. [Citation.] Here, the entire agree- ment is obviously not for Stine’s sole benefit. However, certain provisions in the agreement expressly state the Stewarts’ intent to pay Stine the money due to her.

*** The agreement’s language clearly shows that Stewart

intended to secure a benefit to Stine as a third-party cred- itor beneficiary. The agreement also acknowledges the existence of a legal obligation owed to Stine and thus revives it as an enforceable obligation. Consequently, Stewart breached the agreement when he refused to pay Stine the money owed to her as the agreement requires.

INTERPRETATION An intended third-party beneficiary of a contract may enforce that contract.

CRITICAL THINKING QUESTION Why did the court conclude that Stine was not an intended third-party donee beneficiary?

340 Contracts Part III

Rights of Intended Beneficiary Though an intended creditor beneficiary may sue either or both parties, an intended donee beneficiary may enforce the contract against the promisor only. He cannot maintain an action against the promisee, as the promisee was under no legal obligation to him.

Vesting of Rights A contract for the benefit of an intended beneficiary confers upon that beneficiary rights that the beneficiary may enforce. Until these rights vest (take effect), however, the promisor and promisee may, by later agreement, vary or completely discharge them. There is considerable variation among the states as to when vest- ing occurs. Some states hold that vesting takes place immediately upon the making of the contract. In other states, vesting occurs when the third party learns of the contract and assents to it. In another group of states, vesting requires the third party to change his position in reliance upon the promise made for his benefit. The Restatement has adopted the following position: if the contract between the promisor and promisee provides that its terms may not be varied without the consent of the beneficiary, such a provision will be upheld. If there is no such provision, the parties to the contract may rescind or vary the contract unless the intended beneficiary (1) has brought an action on the promise, (2) has changed her position in reliance on it, or (3) has assented to the prom- ise at the request of the promisor or promisee.

On the other hand, the promisor and promisee may provide that the benefits will never vest. For example, Mildred purchases an insurance policy on her own life, naming her husband as beneficiary. The policy, as such policies commonly do, reserves to Mildred the right to change her beneficiary or even to cancel the policy entirely.

PRACTICAL ADVICE To avoid uncertainty, consider specifying in the contract whether there are any third-party beneficiaries and, if so, who they are, what their rights are, and when their rights vest.

Defenses Against Beneficiary In an action by the intended beneficiary to enforce the promise, the promisor may assert any defense that would be available to her if the action had been brought by the promisee. The rights of the third party are based upon the promisor’s contract with the promisee. Thus, the promisor may assert the absence of mutual assent or consideration, lack of capacity, fraud, mistake, and the like against the intended beneficiary. Once an intended beneficiary’s rights have vested, how- ever, the promisor may not assert the defense of con- tractual modification or rescission entered into with the promisee.

Incidental Beneficiary [16-3b] An incidental third-party beneficiary is a person to whom the parties to a contract did not intend a bene- fit but who nevertheless would derive some benefit by its performance. For instance, a contract to raze an old, unsightly building and to replace it with a costly modern house would benefit the owner of the adjoin- ing property by increasing his property’s value. He would have no rights under the contract, however, as the benefit to him would be unintended and incidental.

A third person who may benefit incidentally by the performance of a contract to which he is not a party has no rights under the contract, as neither the promisee nor the promisor intended that the third person benefit. Assume that for a stated considera- tion Charles promises Madeline that he will purchase and deliver to Madeline a new Sony television of the latest model. Madeline pays in advance for the televi- sion. Charles does not deliver the television to Made- line. Reiner, the local exclusive Sony dealer, has no rights under the contract, although performance by Charles would produce a sale from which Reiner would derive a benefit, for Reiner is only an inciden- tal beneficiary.

C H A P T E R S U M M A R Y Assignment of Rights

Definition of Assignment voluntary transfer to a third party of the rights arising from a contract so that the assignor’s right to performance is extinguished • Assignor party making an assignment • Assignee party to whom contract rights are assigned • Obligor party owing a duty to the assignor under the original contract • Obligee party to whom a duty of performance is owed under a contract

Chapter 16 Third Parties to Contracts 341

Requirements of an Assignment include intent but not consideration • Revocability of Assignment when the assignee gives consideration, the assignor may not revoke

the assignment without the assignee’s consent • Partial Assignment transfer of a portion of contractual rights to one or more assignees

Assignability most contract rights are assignable except • Assignments that materially increase the duty, risk, or burden upon the obligor • Assignments of personal rights • Assignments expressly forbidden by the contract • Assignments prohibited by law

Rights of Assignee the assignee stands in the shoes of the assignor • Defenses of Obligor may be asserted against the assignee • Notice is not required but is advisable

Implied Warranties obligation imposed by law upon the assignor of a contract right

Express Warranty explicitly made contractual promise regarding contract rights transferred

Successive Assignments of the Same Right the majority rule is that the first assignee in point of time prevails over later assignees; minority rule is that the first assignee to notify the obligor prevails

Delegation of Duties

Definition of Delegation transfer to a third party of a contractual obligation • Delegator party delegating his duty to a third party • Delegatee third party to whom the delegator’s duty is delegated • Obligee party to whom a duty of performance is owed by the delegator and delegate

Delegable Duties most contract duties may be delegated except • Duties that are personal • Duties that are expressly nondelegable • Duties whose delegation is prohibited by statute or public policy

Duties of the Parties • Delegation delegator is still bound to perform original obligation • Novation Contract a substituted contract to which the promisee is a party, which substitutes

a new promisor for an existing promisor, who is consequently no longer liable on the original contract and is not liable as a delegator

Third-Party Beneficiary Contracts

Definition a third-party beneficiary contract is one in which one party promises to render a performance to a third person (the beneficiary)

Intended Beneficiaries third parties intended by the two contracting parties to receive a benefit from their contract • Donee Beneficiary a third party intended to receive a benefit from the contract as a gift • Creditor Beneficiary a third person intended to receive a benefit from the contract to satisfy a

legal duty owed to him • Rights of Intended Beneficiary an intended donee beneficiary may enforce the contract against

the promisor; an intended creditor beneficiary may enforce the contract against either or both the promisor and the promisee

• Vesting of Rights if the beneficiary’s rights vest, the promisor and promisee may not thereafter vary or discharge these vested rights

• Defenses Against Beneficiary in an action by the intended beneficiary to enforce the promise, the promisor may assert any defense that would be available to her if the action had been brought by the promisee

Incidental Beneficiary third party whom the two parties to the contract have no intention of benefiting by their contract and who acquires no rights under the contract

342 Contracts Part III

Q U E S T I O N S

1. On December 1, Euphonia, a famous singer, contracted with Boito to sing at Boito’s theater on December 31 for a fee of $45,000 to be paid immediately after the performance.

a. Euphonia, for value received, assigns this fee to Carter.

b. Euphonia, for value received, assigns this contract to sing to Dumont, an equally famous singer.

c. Boito sells his theater to Edmund and assigns his con- tract with Euphonia to Edmund.

State the effect of each of these assignments.

2. The Smooth Paving Company entered into a paving con- tract with the city of Chicago. The contract contained the clause “contractor shall be liable for all damages to buildings resulting from the work performed.” In the process of construction, one of the bulldozers of the Smooth Paving Company struck and broke a gas main, causing an explosion and a fire that destroyed the house of John Puff. Puff brought an action for breach of the paving contract against the Smooth Paving Company to recover damages for the loss of his house. Can Puff recover under this contract? Explain.

3. Anne, who was unemployed, registered with the Speedy Employment Agency. A contract was then made under which Anne, in consideration of such position as the agency would obtain for her, agreed to pay the agency one half of her first month’s salary. The contract also contained an assignment by Anne to the agency of one half of her first month’s salary. Two weeks later, the agency obtained a permanent position for Anne with the Bostwick Co. at a monthly salary of $1,900. The agency also notified Bostwick Co. of the assignment by Anne. At the end of the first month, Bostwick Co. paid Anne her salary in full. Anne then quit and disappeared. The agency now sues Bostwick Co. for $950 under the assignment. Who will prevail? Explain.

4. Georgia purchased an option on Greenacre from Pamela for $10,000. The option contract contained a provision by which Georgia promised not to assign the option con- tract without Pamela’s permission. Georgia, without Pamela’s permission, assigned the contract to Michael. Michael now seeks to exercise the option, and Pamela refuses to sell Greenacre to him. Must Pamela sell the land to Michael?

5. Julia contracts to sell to Hayden, an ice cream manufac- turer, the amount of ice Hayden may need in his business for the ensuing three years to the extent of not more than 250 tons a week at a stated price per ton. Hayden makes a corresponding promise to Julia to buy such an amount of ice. Hayden sells his ice cream plant to Reed and

assigns to Reed all Hayden’s rights under the contract with Julia. On learning of the sale, Julia refuses to fur- nish ice to Reed. Can Reed successfully collect damages from Julia? Explain.

6. Brown enters into a written contract with Ideal Insurance Company under which, in consideration of Brown’s pay- ment of her premiums, the insurance company promises to pay Williams College the face amount of the policy, $100,000, on Brown’s death. Brown pays the premiums until her death. Thereafter, Williams College makes demand for the $100,000, which the insurance company refuses to pay on the ground that Williams College was not a party to the contract. Can Williams successfully enforce the contract?

7. Grant and Debbie enter into a contract binding Grant personally to do some delicate cabinetwork. Grant assigns his rights and delegates performance of his duties to Clarence.

a. On being informed of this, Debbie agrees with Clar- ence, in consideration of Clarence’s promise to do the work, that Debbie will accept Clarence’s work, if properly done, instead of the performance promised by Grant. Later, without cause, Debbie refuses to allow Clarence to proceed with the work, though Clarence is ready to do so, and makes demand on Grant that Grant perform. Grant refuses. Can Clarence recover damages from Debbie? Can Debbie recover from Grant?

b. Instead, assume that Debbie refuses to permit Clarence to do the work, employs another carpenter, and brings an action against Grant, claiming as damages the dif- ference between the contract price and the cost to employ the other carpenter. Explain whether Debbie will prevail.

8. Rebecca owes Lewis $2,500 due on November 1. On August 15, Lewis assigns this right for value received to Julia, who gives notice on September 10 of the assign- ment to Rebecca. On August 25, Lewis assigns the same right to Wayne, who in good faith gives value and has no prior knowledge of the assignment by Lewis to Julia. Wayne gives Rebecca notice of the assignment on August 30. What are the rights and obligations of Rebecca, Lewis, Julia, and Wayne?

9. Lisa hired Jay in the spring, as she had for many years, to set out in beds the flowers Lisa had grown in her greenhouses during the winter. The work was to be done in Lisa’s absence for $300. Jay became ill the day after Lisa departed and requested his friend, Curtis, to set out the flowers, promising to pay Curtis $250 when Jay received his payment. Curtis agreed. On completion of

Chapter 16 Third Parties to Contracts 343

the planting, an agent of Lisa’s, who had authority to dispense the money, paid Jay, and Jay paid Curtis. Within two days, it became obvious that the planting was a disaster. Because he did not operate Lisa’s auto- matic watering system properly, everything set out by Curtis died of water rot. May Lisa recover damages from Curtis? May Lisa recover damages from Jay, and, if so, does Jay have an action against Curtis?

10. Caleb, operator of a window-washing business, dictated a letter to his secretary addressed to Apartments, Inc., stating, “I will wash the windows of your apartment buildings at $4.10 per window to be paid on completion of the work.” The secretary typed the letter, signed

Caleb’s name, and mailed it to Apartments, Inc. Apart- ments, Inc., replied, “Accept your offer.”

Caleb wrote back, “I will wash them during the week starting July 10 and direct you to pay the money you will owe me to my son, Bernie. I am giving it to him as a wedding present.” Caleb sent a signed copy of the letter to Bernie.

Caleb washed the windows during the time stated and demanded payment to him of $8,200 (2,000 win- dows at $4.10 each), informing Apartments, Inc., that he had changed his mind about having the money paid to Bernie.

What are the rights of the parties?

C A S E P R O B L E M S

11. Members of Local 100, Transport Workers Union of America (TWU), engaged in an eleven-day mass transit strike that paralyzed the life and commerce of the city of New York. Jackson, Lewis, Schnitzler & Krupman, a Manhattan law firm, brought a class action suit against the TWU for the direct and foreseeable damages it suf- fered as a result of the union’s illegal strike. The law firm sought to recover as a third-party beneficiary of the col- lective bargaining agreement between the union and New York City. The agreement contains a no-strike clause and states that the TWU agreed to cooperate with the city to provide a safe, efficient, and dependable mass transit sys- tem. The law firm argues that its members are a part of the general public that depends on the mass transit sys- tem to go to and from work. Therefore, they are in the class of persons for whose benefit the union has promised to provide dependable transportation service. Are the members of the class action suit entitled to recover? Explain.

12. Northwest Airlines leased space in the terminal building at the Portland Airport from the Port of Portland. Cro- setti entered into a contract with the Port to furnish jani- torial services for the building, which required Crosetti to keep the floor clean, to indemnify the Port against loss due to claims or lawsuits based upon Crosetti’s failure to perform, and to provide public liability insurance for the Port and Crosetti. A patron of the building who was injured by a fall caused by a foreign substance on the floor at Northwest’s ticket counter brought suit for dam- ages against Northwest, the Port, and Crosetti. Upon set- tlement of this suit, Northwest sued Crosetti to recover the amount of its contribution to the settlement and other expenses on the grounds that Northwest was a third- party beneficiary of Crosetti’s contract with the Port to keep the floors clean and, therefore, within the protection of Crosetti’s indemnification agreement. Will Northwest prevail? Why?

13. Tompkins-Beckwith, as the contractor on a construction project, entered into a subcontract with a division of Air Metal Industries. Air Metal procured American Fire and Casualty Company to be surety on certain bonds in connection with contracts it was performing for Tompkins-Beckwith and others. As security for these bonds, on January 3, Air Metal executed an assignment to American Fire of all accounts receivable under the Tompkins-Beckwith subcontract. On November 26 of that year, Boulevard National Bank lent money to Air Metal. To secure the loans, Air Metal purported to assign to the bank certain accounts receivable it had under its subcontract with Tompkins-Beckwith.

In June of the following year, Air Metal defaulted on various contracts bonded by American Fire. On July 1, American Fire served formal notice on Tompkins- Beckwith of Air Metal’s assignment. Tompkins-Beckwith acknowledged the assignment and agreed to pay. In August, Boulevard National Bank notified Tompkins- Beckwith of its assignment. Tompkins-Beckwith refused to recognize the bank’s claim and, instead, paid all remaining funds that had accrued to Air Metal to Ameri- can Fire. The bank then sued to enforce its claim under Air Metal’s assignment. Is the assignment effective? Why?

14. The International Association of Machinists (the union) was the bargaining agent for the employees of Powder Power Tool Corporation. On August 24, the union and the corporation executed a collective bargaining agreement pro- viding for retroactively increased wage rates for the corpo- ration’s employees effective as of the previous April 1. Three employees who were working for Powder before and for several months after April 1, but who were not employed by the corporation when the agreement was exe- cuted on August 24, were paid to the time their employ- ment terminated at the old wage scale. The three employees assigned their claims to Springer, who brought this action against the corporation for the extra wages. Decision?

344 Contracts Part III

15. In March, Adrian Saylor sold government bonds owned exclusively by him and with $6,450 of the proceeds opened a savings account in a bank in the name of “Mr. or Mrs. Adrian M. Saylor.” In June of the follow- ing year, Saylor deposited the additional sum of $2,132 of his own money in the account. There were no other deposits and no withdrawals prior to the death of Saylor in May a year later. Is the balance of the account on Saylor’s death payable wholly to Adrian Saylor’s estate, wholly to his widow, or half to each?

16. Linda King was found liable to Charlotte Clement as the result of an automobile accident. King, who was insol- vent at the time, declared bankruptcy and directed her attorney, Prestwich, to list Clement as an unsecured cred- itor. The attorney failed to carry out this duty, and con- sequently King sued him for legal malpractice. When Clement pursued her judgment against King, she received a written assignment of King’s legal malpractice claim against Prestwich. Clement has attempted to bring the claim, but Prestwich alleges that a claim for legal mal- practice is not assignable. Decision?

17. Rensselaer Water Company contracted with the city of Rensselaer to provide water to the city for use in homes, public buildings, industry, and fire hydrants. During the term of the contract, a building caught fire. The fire spread to a nearby warehouse and destroyed it and its contents. The water company knew of the fire but failed to supply adequate water pressure at the fire hydrant to extinguish the fire. The warehouse owner sued the water company for failure to fulfill its contract with the city. Can the owner of the warehouse enforce the contract? Explain.

18. McDonald’s has an undeviating policy of retaining absolute control over who receives new franchises. McDonald’s granted to Copeland a franchise in Omaha, Nebraska. In a separate letter, it also granted him a right of first refusal for future franchises to be developed in the Omaha-Council Bluffs area. Copeland then sold all rights in his six McDonald’s franchises to Schupack. When McDonald’s offered a new franchise in the Omaha area to someone other than Schupack, he attempted to exercise the right of first refusal. McDonald’s would not recognize the right in Schupack, claiming that it was per- sonal to Copeland and, therefore, nonassignable without its consent. Schupack brought an action for specific per- formance, requiring McDonald’s to accord him the right of first refusal. Is Schupack correct in his contention?

19. While under contract to play professional basketball for the Philadelphia 76ers, Billy Cunningham, an outstanding player, negotiated a three-year contract with the Carolina Cougars, another professional basketball team. The con- tract with the Cougars was to begin at the expiration of the contract with the 76ers. In addition to a signing bonus of $125,000, Cunningham was to receive under

the new contract a salary of $100,000 for the first year, $110,000 for the second, and $120,000 for the third. The contract also stated that Cunningham “had special, exceptional and unique knowledge, skill and ability as a basketball player” and that Cunningham therefore agreed the Cougars could enjoin him from playing basketball for any other team for the term of the contract. In addition, the contract contained a clause prohibiting its assignment to another club without Cunningham’s consent. In 1971, the ownership of the Cougars changed, and Cunning- ham’s contract was assigned to Munchak Corporation, the new owners, without his consent. When Cunningham refused to play for the Cougars, Munchak Corporation sought to enjoin his playing for any other team. Cun- ningham asserts that his contract was not assignable. Was the contract assignable? Explain.

20. Pauline Brown was shot and seriously injured by an unknown assailant in the parking lot of National Super- markets. Pauline and George Brown brought a negligence action against National; Sentry Security Agency; and T. G. Watkins, a security guard and Sentry employee. The Browns maintained that the defendants have a legal duty to protect National’s customers, both in the store and in the parking lot, and that this duty was breached. The defendants denied this allegation. What will the Browns have to prove to prevail? Explain.

21. Potomac Electric Power Company (PEPCO) is an electric utility serving the metropolitan Washington, D.C., area. Panda-Brandywine, L.P. (Panda) is a “qualified facility” under the Public Utility Regulatory Policies Act of 1978. In August, 1991, PEPCO and Panda entered into a power purchase agreement (PPA) calling for (1) the con- struction by Panda of a new 230-megawatt cogenerating power plant in Prince George’s County, Maryland; (2) connection of the facility to PEPCO’s high-voltage transmission system by transmission facilities to be built by Panda but later transferred without cost to PEPCO; and (3) upon commencement of the commercial opera- tion of the plant, for PEPCO to purchase the power gen- erated by that plant for a period of twenty-five years. The plant was built at a cost of $215 million. The PPA is 113 pages in length, is single-spaced, and is both detailed and complex. It gave PEPCO substantial authority to review; influence; and, in some instances, determine im- portant aspects of both the construction and operation of the Panda facility. Section 19.1 of the PPA provided that the agreement was not assignable and not delegable with- out the written consent of the other party, which consent could not be unreasonably withheld. In 1999, Maryland enacted legislation calling for the restructuring of the electric industry in an effort to promote competition in the generation and delivery of electricity. PEPCO’s pro- posed restructuring involved a complete divestiture of its electric generating assets and its various PPAs, to be accomplished by an auction. The sale to the winning

Chapter 16 Third Parties to Contracts 345

bidder was to be accomplished by an Asset Purchase and Sale Agreement (APSA) that included the PPA to which PEPCO and Panda were parties. Under the APSA the buyer was authorized to take all actions that PEPCO could lawfully take under the PPA with Panda. On June 7, 2000, Southern Energy, Inc. (SEI) was declared the winning bidder. On September 27, 2000, the Public Ser- vice Commission (PSC) entered an order declaring, among other things, that the provisions in the APSA did

not constitute an assignment or transfer within the mean- ing of Section 19.1 of the Panda PPA, that PEPCO was not assigning “significant obligations and rights under the PPA,” that Panda would not be harmed by the trans- action, and that the APSA did not “fundamentally alter” the contract between Panda and PEPCO. The PSC thus concluded that Panda’s consent to the proposed APSA was not required. Panda disagreed. Is Panda correct? Explain.

T A K I N G S I D E S

Pizza of Gaithersburg and The Pizza Shops (Pizza Shops) contracted with Virginia Coffee Service (Virginia) to install vending machines in each of their restaurants. One year later, the Macke Company (a provider of vending machines) purchased Virginia’s assets, and the vending machine con- tracts were assigned to Macke. Pizza Shops had dealt with Macke before but had chosen Virginia because they preferred the way it conducted its business. When Pizza Shops attempted to terminate their contracts for vending

services, Macke brought suit for damages for breach of contract.

a. What arguments would support Pizza Shops’ termination of the contracts?

b. What arguments would support Macke’s suit for breach of contract?

c. Which side should prevail? Explain.

346 Contracts Part III

C H A P T E R 1 7

PERFORMANCE, BREACH, AND DISCHARGE

Because contracting parties ordinarily expect that they will perform their obligations, they are usually more explicit in defining those obligations than in stating the consequences of their nonperformance.

RESTATEMENT OF CONTRACTS, INTRODUCTORY NOTE

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Identify and distinguish among the various types of conditions.

2. Distinguish between full performance and tender of performance.

3. Explain the difference between material breach and substantial performance.

4. Distinguish among a mutual rescission, substituted contract, accord and satisfaction, and novation.

5. Identify and explain the ways discharge may be brought about by operation of law.

T he subject of discharge of contracts concerns the termination of contractual duties. In earlier chapters we saw how parties may become con-

tractually bound by their promises. It is also important to know how a person may become unbound from a contract. Although contractual promises are made for a purpose and the parties reasonably expect this purpose to be fulfilled by performance, performance of a con- tractual duty is only one method of discharge.

Whatever causes a binding promise to cease to be binding is a discharge of the contract. In general, there are four kinds of discharge: (1) performance by the par- ties, (2) material breach by one or both of the parties, (3) agreement of the parties, and (4) operation of law. Moreover, many contractual promises are not absolute

promises to perform but are conditional—that is, they depend on the happening or nonhappening of a specific event. After we discuss the subject of conditions, we will cover the four kinds of discharge.

CONDITIONS [17-1] A condition is an event whose happening or nonhap- pening affects a duty of performance under a contract. Some conditions must be satisfied before any duty to perform arises; others terminate the duty to perform; still others either limit or modify the duty to perform. A con- dition is inserted in a contract to protect and benefit the promisor. The more conditions to which a promise is

347

subject, the less content the promise has. For example, a promise to pay $8,000, provided that such sum is real- ized from the sale of an automobile, provided that the automobile is sold within sixty days, and provided that the automobile, which has been stolen, can be found, is clearly different from, and worth considerably less than, an unconditional promise by the same promisor to pay $8,000.

A fundamental difference exists between the breach or nonperformance of a contractual promise and the failure or nonhappening of a condition. A breach of contract subjects the promisor to liability. It may or may not, depending on its materiality, excuse the non- breaching party’s nonperformance of his duty under the contract. The happening or nonhappening of a con- dition, on the other hand, either prevents a party from acquiring a right or deprives him of a right but subjects neither party to any liability.

Conditions may be classified by how they are imposed: express conditions, implied-in-fact conditions, or implied-in-law conditions (also called constructive conditions). They also may be classified by when they affect a duty of performance: conditions concurrent, conditions precedent, or conditions subsequent. These two ways of classifying conditions are not mutually exclusive; for example, a condition may be constructive and concurrent or express and precedent.

PRACTICAL ADVICE Consider using conditions to place the risk of the nonoccurrence of critical, uncertain events on the other party to the contract.

Express Conditions [17-1a] An express condition is explicitly set forth in language. No particular form of words is necessary to create an express condition, as long as the event to which the per- formance of the promise is made subject is clearly ex- pressed. An express condition is usually preceded by words such as “provided that,” “on condition that,” “if,” “subject to,” “while,” “after,” “upon,” or “as soon as.”

The basic rule applied to express conditions is that they must be fully and literally performed before the condi- tional duty to perform arises. However, when application of the full and literal performance test would result in a forfeiture, the courts usually apply to the completed por- tion of the condition a substantial satisfaction test, as dis- cussed in this chapter under “Substantial Performance.”

Satisfaction of a Contracting Party The parties to a contract may agree that performance by one of them shall be to the satisfaction of the other, who will not be obligated to perform unless he is satisfied. This is an express condition to the duty to perform. Assume that tailor Ken contracts to make a suit of clothes to Dick’s satisfaction and that Dick promises to pay Ken $850 for the suit if he is satisfied with it when com- pleted. Ken completes the suit using materials ordered by Dick. The suit fits Dick beautifully, but Dick tells Ken that he is not satisfied with it and refuses to accept or pay for it. Ken is not entitled to recover $850 or any amount from Dick because the express condition did not happen. This is so if Dick’s dissatisfaction is honest and in good faith, even if it is unreasonable. Where satisfac- tion relates to a matter of personal taste, opinion, or judgment, the law applies the subjective satisfaction standard, and the condition has not occurred if the promisor is in good faith dissatisfied.

If the contract does not clearly indicate that satisfac- tion is subjective or if the performance contracted for relates to mechanical fitness or utility, the law assumes an objective satisfaction standard. For example, the objec- tive standard of satisfaction would apply to the sale of a building or standard goods. In such cases, the question would not be whether the promisor was actually satisfied with the performance by the other party but whether, as a reasonable person, he ought to be satisfied.

PRACTICAL ADVICE In your contracts based on satisfaction, specify which standard— subjective satisfaction or objective satisfaction—should apply to each contractual duty of performance.

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FACTS Optus Software, Inc. (Optus), a small com- puter software company, hired Michael Silvestri as its director of support services at an annual salary

of $70,000. Silvestri was responsible for supervising technical customer support services. Silvestri’s two-year employment contract began on January 4, 1999, and

348 Contracts Part III

contained a satisfaction clause that reserved to the com- pany the right to terminate his employment for “failure or refusal to perform faithfully, diligently or completely his duties … to the satisfaction” of the company. Termi- nation under that clause relieved the company of any further payment obligation to Silvestri.

During the first six months of his employment Silves- tri enjoyed the full support of Joseph Avellino, the CEO of Optus. Avellino’s attitude started to change during the summer months of 1999, when several clients and resellers communicated to Avellino their disappointment with the performance and attitude of the support serv- ices staff generally, and several complaints targeted Sil- vestri specifically. Avellino informed Silvestri of those criticisms. On September 17, 1999, Avellino terminated Silvestri under the satisfaction clause.

Silvestri filed an action for breach of contract. Silvestri did not assert that there was any reason for his termina- tion other than Avellino’s genuine dissatisfaction with his performance. Rather, Silvestri challenged the reasonable- ness of that dissatisfaction. He portrayed Avellino as a meddling micromanager who overreacted to any customer criticism and thus could not reasonably be satisfied.

The trial court granted summary judgment in favor of Optus. The Appellate Division reversed, holding that an employer must meet an objective, reasonable-person test when invoking a satisfaction clause permitting ter- mination of employment. The Supreme Court of New Jersey granted review.

DECISION The judgment of the Appellate Division is reversed, and the case remanded for entry of summary judgment in favor of Optus.

OPINION LaVecchia, J. Agreements containing a promise to perform in a manner satisfactory to another *** are a common form of enforceable contract. [Cita- tion.] Such “satisfaction” contracts are generally divided into two categories for purposes of review: (1) contracts that involve matters of personal taste, sensibility, judg- ment, or convenience; and (2) contracts that contain a requirement of satisfaction as to mechanical fitness, utility, or marketability. [Citation.] The standard for evaluating satisfaction depends on the type of contract. Satisfaction contracts of the first type are interpreted on a subjective basis, with satisfaction dependent on the personal, honest evaluation of the party to be satisfied. [Citation.] Absent language to the contrary, however, contracts of the sec- ond type—involving operative fitness or mechanical util- ity—are subject to an objective test of reasonableness, because in those cases the extent and quality of perform- ance can be measured by objective tests. [Citation.]; Restatement (Second) of Contracts §228; [citation].

A subjective standard typically is applied to satisfac- tion clauses in employment contracts because “there is greater reason and a greater tendency to interpret [the contract] as involving personal satisfaction,” rather than the satisfaction of a hypothetical “reasonable” person. [Citations.]

In the case of a high-level business manager, a subjec- tive test is particularly appropriate to the flexibility needed by the owners and higher-level officers operating a competitive enterprise. [Citation.] When a manager has been hired to share responsibility for the success of a business entity, an employer is entitled to be highly personal and idiosyncratic in judging the employee’s satisfactory performance in advancing the enterprise. [Citations.]

The subjective standard obliges the employer to act “honestly in accordance with his duty of good faith and fair dealing,” [citation], but genuine dissatisfaction of the employer, honestly held, is sufficient for discharge. [Citation.]

Although broadly discretionary, a satisfaction-clause employment relationship is not to be confused with an employment-at-will relationship in which an employer is entitled to terminate an employee for any reason, or no reason, unless prohibited by law or public policy. [Cita- tion.] In a satisfaction clause employment setting, there must be honest dissatisfaction with the employee’s per- formance. *** If *** the employer’s dissatisfaction is honest and genuine, even if idiosyncratic, its reasonable- ness is not subject to second guessing under a reasonable- person standard. ***

*** We hold that a subjective test of performance gov-

erns the employer’s resort to a satisfaction clause in an employment contract unless there is some language in the contract to suggest that the parties intended an objective standard. There is no such language here. ***

Turning then to application of the subjective test in this setting, *** we conclude that the entry of summary judgment in favor of defendants was appropriate. The only issue available to Silvestri is whether the dissatisfac- tion with his performance was genuine, and he has failed to make a prima facie showing that it was not.

INTERPRETATION A subjective test of perform- ance governs an employer’s use of a satisfaction clause in an employment contract unless language in the contract suggests that the parties intended an objective standard.

CRITICAL THINKING QUESTION Could an employee discharged under a satisfaction clause dem- onstrate that the employer was not honestly dissatisfied? Explain.

Chapter 17 Performance, Breach, and Discharge 349

Satisfaction of a Third Party A contract may condition the duty of one contracting party to accept and pay for the performance of the other con- tracting party upon the approval of a third party who is not a party to the contract. For example, building contracts commonly provide that before the owner is required to pay, the builder shall furnish the architect’s certificate stating that the building has been constructed according to the plans and specifications on which the builder and the owner agreed. Although the price is being paid for the building, not for the certificate, the owner must have both the building and the certificate before she will be obliged to pay. The duty of payment was made expressly conditional on the presentation of the certificate.

Implied-in-Fact Conditions [17-1b] Implied-in-fact conditions are similar to express condi- tions in that they must fully and literally occur and in that they are understood by the parties to be part of the agreement. They differ in that they are not stated in express language; rather, they are necessarily inferred from the terms of the contract, the nature of the trans- action, or the conduct of the parties. Thus, if Edna, for $1,750, contracts to paint Sy’s house any color Sy desires, it is necessarily implied in fact that Sy will inform Edna of the desired color before Edna begins to paint. The notification of choice of color is an implied- in-fact condition, an operative event that must occur before Edna is subject to the duty of painting the house.

Implied-in-Law Conditions [17-1c] An implied-in-law condition, or a constructive condi- tion, is imposed by law to accomplish a just and fair result. It differs from an express condition and an implied-in-fact condition in two ways: (1) it is not con- tained in the language of the contract or necessarily inferred from the contract and (2) it need only be sub- stantially performed. For example, Fernando contracts to sell a certain tract of land to Marie for $18,000, but the contract is silent as to the time of delivery of the deed and payment of the price. According to the law, the contract implies that payment and delivery of the deed are not independent of each other. The courts will treat the promises as mutually dependent and therefore will hold that a delivery or tender of the deed by Fer- nando to Marie is a condition to the duty of Marie to pay the price. Conversely, payment or tender of $18,000 by Marie to Fernando is a condition to the duty of Fernando to deliver the deed to Marie.

Concurrent Conditions [17-1d] Concurrent conditions occur when the mutual duties of performance are to take place simultaneously. As we indicated in the discussion of implied-in-law conditions, in the absence of agreement to the contrary, the law assumes that the respective performances under a con- tract are concurrent conditions.

Condition Precedent [17-1e] A condition precedent is an event that must occur before performance is due under a contract. In other words, the immediate duty of one party to perform is subject to the condition that some event must first occur. For instance, Steve is to deliver shoes to Nancy on June 1, and Nancy is to pay for the shoes on July 15. Steve’s delivery of the shoes is a condition precedent to Nancy’s performance. Similarly, if Rachel promises to buy Justin’s land for $50,000, provided Rachel can obtain financing in the amount of $40,000 at 10 percent or less for thirty years within sixty days of signing the contract, Rachel’s obtaining the specified financing is a condition precedent to her duty. If the condition is satisfied, Rachel is bound to perform; if it is not met, she is not bound to perform. Rachel, however, is under an implied-in-law duty to use her best efforts to obtain financing under these terms.

Condition Subsequent [17-1f] A condition subsequent is an event that terminates an existing duty. For example, when goods are sold under terms of “sale or return,” the buyer has the right to return the goods to the seller within a stated period but is under an immediate duty to pay the price unless the parties have agreed on credit. The duty to pay the price is terminated by a return of the goods, which operates as a condition subsequent. Conditions subsequent occur very infrequently in contract law; conditions precedent are quite common.

DISCHARGE BY PERFORMANCE [17-2] Discharge is the termination of a contractual duty. Per- formance is the fulfillment of a contractual obligation. Discharge by performance is undoubtedly the most fre- quent method of discharging a contractual duty. If a promisor exactly performs his duty under the contract, the promisor is no longer subject to that duty.

Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement. As discussed in Chapter 19, the Uniform Commercial Code imposes a comparable duty.

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Tender is an offer by one party—who is ready, willing, and able to perform—to the other party to perform his obligation according to the terms of the contract. Under a bilateral contract, the refusal or rejection of a tender, or offer of performance, by one party may be treated as a repudiation, excusing or discharging the tendering party from further duty of performance under the contract.

DISCHARGE BY BREACH [17-3] A breach of a contract is a wrongful failure to perform its terms. Breach of contract always gives rise to a cause of action for damages by the aggrieved (injured) party. It may, however, have a more important effect: an uncured (uncorrected) material breach by one party operates as an excuse for nonperformance by the other party and discharges the aggrieved party from any fur- ther duty under the contract. If, on the other hand, the breach is not material, the aggrieved party is not dis- charged from the contract, although she may recover money damages. Under the Code’s perfect tender rule, which applies only to sales transactions, any deviation discharges the aggrieved party.

Material Breach [17-3a] An unjustified failure to perform substantially the obli- gations promised in a contract is a material breach. The key is whether the aggrieved party obtained sub- stantially what he had bargained for, despite the breach, or whether the breach significantly impaired his rights under the contract. A material breach dis- charges the aggrieved party from his duty of perform- ance. For instance, Joe orders a custom-made, tailored suit from Peggy to be made of wool, but Peggy makes the suit of cotton instead. Assuming that the labor com- ponent of this contract predominates and thus the con- tract is not considered a sale of goods, Peggy has materially breached the contract. Consequently, Joe is discharged from his duty to pay for the suit, and he may also recover money damages from Peggy for her breach.

Although there are no clear-cut rules as to what con- stitutes a material breach, several basic principles apply. First, partial performance is a material breach of a con- tract if it omits some essential part of the contract. Sec- ond, the courts will consider a breach material if it is quantitatively or qualitatively serious. Third, an inten- tional breach of contract is generally held to be mate- rial. Fourth, a failure to perform a promise promptly is a material breach if time is of the essence; that is, if the parties have clearly indicated that a failure to perform by a stated time is material; otherwise, the aggrieved

party may recover damages only for loss caused by the delay. Fifth, the parties to a contract may, within limits, specify what breaches are to be considered material.

PRACTICAL ADVICE If the timely performance of a contractual duty is important, use a “time-is-of-the-essence” clause to make failure to perform promptly a material breach.

Prevention of Performance One party’s sub- stantial interference with, or prevention of, performance by the other generally constitutes a material breach that discharges the other party to the contract. For instance, Dale prevents an architect from giving Lucy a certificate that is a condition to Dale’s liability to pay Lucy a certain sum of money. Dale may not then use Lucy’s fail- ure to produce a certificate as an excuse for nonpayment. Likewise, if Matthew has contracted to grow a certain crop for Richard and Richard plows the field and destroys the seedlings Matthew has planted, his interfer- ence with Matthew’s performance discharges Matthew from his duty under the contract. It does not, however, discharge Richard from his duty under the contract.

Perfect Tender Rule The Code greatly alters the common law doctrine of material breach by adopt- ing what is known as the perfect tender rule. The perfect tender rule, which will be discussed more fully in Chapter 20, essentially provides that any deviation from the promised performance in a sales contract under the Code constitutes a material breach of the contract and discharges the aggrieved party from his duty of performance.

Substantial Performance [17-3b] Substantial performance is performance that, though incomplete, does not defeat the purpose of the contract. If a party substantially, but not completely, performs her obligations under a contract, the common law generally will allow her to obtain the other party’s performance, less any damages the partial performance caused. If no harm has been caused, the breaching party will obtain the other party’s full contractual performance. Thus, in the specially ordered suit illustration, if Peggy, the tailor, used the correct fabric but improperly used black but- tons instead of blue, she would be permitted to collect from Joe the contract price of the suit less the damage, if any, caused to Joe by the substitution of the wrongly colored buttons. The doctrine of substantial performance assumes particular importance in the construction indus- try in cases in which a structure is built on the aggrieved

Chapter 17 Performance, Breach, and Discharge 351

party’s land. Consider the following: Adam builds a $300,000 house for Betty but deviates from the specifi- cations, causing Betty $10,000 in damages. If the courts considered this a material breach, Betty would not have to pay for the house that is now on her land, a result that would clearly constitute an unjust forfeiture on Adam’s part. Therefore, because Adam’s performance has been substantial, the courts would probably not deem the breach material, and he would be able to col- lect $290,000 from Betty.

Anticipatory Repudiation [17-3c] A breach of contract, as discussed, is a failure to per- form the terms of a contract. Although it is logically and physically impossible to fail to perform a duty before the date on which that performance is due, a party may announce before the due date that she will not perform, or she may commit an act that makes her unable to per- form. Either act is a repudiation of the contract, which notifies the other party that a breach is imminent. Such repudiation before the date fixed by the contract for per-

formance is called an anticipatory repudiation. The courts, as shown in the leading case that follows, view it as a breach that discharges the nonrepudiating party’s duty to perform and permits her to bring suit immedi- ately. Nonetheless, the nonbreaching party may wait until the time the performance is due to see whether the repudiator will retract his repudiation and perform his contractual duties. To be effective, the retraction must come to the attention of the injured party before she materially changes her position in reliance on the repudi- ation or before she indicates to the other party that she considers the repudiation to be final. If the retraction is effective and the repudiator does perform, then there is a discharge by performance; if the repudiator does not perform, there is a material breach.

PRACTICAL ADVICE If the other party to a contract commits an anticipatory breach, carefully consider whether it is better to sue immediately or to wait until the time performance is due.

A P P L Y I N G T H E L A W

PERFORMANCE, BREACH, AND DISCHARGE

Facts Davis manages commercial real estate. In April, Davis contracted with Bidley to acquire and plant impatiens in the flowerbeds outside fourteen office properties that Davis manages. Bidley verbally agreed to buy and plant the impa- tiens by May 31, for a total of $10,000. Bidley purchased the necessary plants from Ackerman, who delivered them to Bidley on May 26. Bidley completed the planting at thirteen of the office buildings by May 29, but because another job took much longer than anticipated, Bidley was unable to finish planting the flowers outside the fourteenth office building until June 1. When he received Bidley’s invoice, Davis refused to pay any of the $10,000.

Issue Has Bidley committed a material breach of the contract so as to discharge Davis’s performance under the contract?

Rule of Law Breach of contract is defined as a wrongful failure to perform. An uncured material breach discharges the aggrieved party’s performance, serving as an excuse for the aggrieved party’s nonperformance of his obligations under the contract. A breach is material if it significantly impairs the aggrieved party’s contract rights. When a breach relates to timing of performance, failure to promptly per- form a contract as promised is considered a material breach only if the parties have agreed that “time is of the essence,” in other words that the failure to perform on time is mate- rial. If, on the other hand, the aggrieved party does get

substantially that for which he bargained, the breach is not material. In such a case the aggrieved party is not dis- charged from the contract but has a right to collect dam- ages for the injury sustained as a result of the breach.

Application Bidley failed to plant all of the flowers by May 31 as he promised. Therefore, he has breached the contract. However, Bidley’s breach is not material. There is no indication that the parties agreed that time was of the essence or that there was any compelling reason the plants had to be in the ground by May 31. They simply agreed on May 31 as the date for performance.

Furthermore, Davis has gotten substantially that for which he bargained. In fact, as of May 31, Bidley had com- pleted the planting at thirteen of the office buildings and had commenced the work at the fourteenth. One day later, the entire job was done. Given that Bidley’s late perform- ance did not significantly impair Davis’s rights under the contract, the breach is not material. Therefore, Davis is enti- tled only to recover any damages he can prove were suf- fered as a result of Bidley’s late performance.

Conclusion Bidley’s breach is not material. Davis is not discharged from performance and must pay the $10,000 owed under the contract, less the value of any damages caused by the one-day delay in planting flowers at one office building.

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Unauthorized Material Alteration of Written Contract [17-3d] An unauthorized alteration or change of any of the ma- terial terms or provisions of a written contract or docu- ment is a discharge of the entire contract. An alteration is material if it would vary any party’s legal relations with the maker of the alteration or would adversely affect that party’s legal relations with a third person. To constitute a discharge, the alteration must be mate- rial and fraudulent and must be the act of either a party to the contract or someone acting on his behalf.

An unauthorized change in the terms of a written con- tract by a person who is not a party to the contract does not discharge the contract.

DISCHARGE BY AGREEMENT OF THE PARTIES [17-4] By agreement, the parties to a contract may discharge each other from performance under the contract. They may do this by rescission, substituted contract, accord and satisfaction, or novation.

H O C H S T E R V . D E L A T O U R Q u e e n ’ s B e n c h o f E n g l a n d , 1 8 5 3

2 E l l i s a n d B l a c k b u r n R e p o r t s 6 7 8

FACTS On April 12, 1852, Hochster contracted with De La Tour to serve as a guide for De La Tour on his three- month trip to Europe, beginning on June 1 at an agreed- upon salary. On May 11, De La Tour notified Hochster that he would not need Hochster’s services. He also refused to pay Hochster any compensation. Hochster brought this action to recover damages for breach of contract.

DECISION Judgment for Hochster.

OPINION Lord Campbell, C. J. On this motion *** the question arises, Whether, if there be an agree- ment between A. and B., whereby B. engages to employ A. on and from a future day for a given period of time, to travel with him into a foreign country as a [guide], and to start with him in that capacity on that day, A. being to receive a monthly salary during the continuance of such service, B. may, before the day, refuse to per- form the agreement and break and renounce it, so as to entitle A. before the day to commence an action against B. to recover damages for breach of the agreement; A. having been ready and willing to perform it, till it was broken and renounced by B.

*** If the plaintiff has no remedy for breach of the con-

tract unless he treats the contract as in force, and acts upon it down to the 1st June, 1852, it follows that, till then, he must enter into no employment which will inter- fere with his promise “to start with the defendant on such travels on the day and year,” and that he must then be properly equipped in all respects as a [guide] for a three months’ tour on the continent of Europe. But it is surely much more rational, and more for the benefit of

both parties, that, after the renunciation of the agreement by the defendant, the plaintiff should be at liberty to con- sider himself absolved from any future performance of it, retaining his right to sue for any damage he has suffered from the breach of it. Thus, instead of remaining idle and laying out money in preparations which must be use- less, he is at liberty to seek service under another employer, which would go in mitigation of the damages to which he would otherwise be entitled for a breach of the contract. It seems strange that the defendant, after renouncing the contract, and absolutely declaring that he will never act under it, should be permitted to object that faith is given to his assertion, and that an opportunity is not left to him of changing his mind.

*** The man who wrongfully renounces a contract into

which he has deliberately entered cannot justly complain if he is immediately sued for a compensation in damage by the man whom he has injured: and it seems reasonable to allow an option to the injured party, either to sue immedi- ately, or to wait till the time when the act was to be done, still holding it as prospectively binding for the exercise of the option, which may be advantageous to the innocent party, and cannot be prejudicial to the wrongdoer.

INTERPRETATION An anticipatory breach discharges the injured party and entitles her to bring suit immediately.

CRITICAL THINKING QUESTION What policy reasons support an injured party’s right to bring suit immediately upon an anticipatory repudiation? Explain.

Chapter 17 Performance, Breach, and Discharge 353

Mutual Rescission [17-4a] A mutual rescission is an agreement between the parties to terminate their respective duties under the contract. It is, literally, a contract to end a contract; and it must contain all of the essentials of a contract. In rescinding an execu- tory, bilateral contract, each party furnishes consideration in giving up his rights under the contract in exchange for the other party’s doing the same. If one party has already fully performed, however, a mutual rescission is not bind- ing at common law because of lack of consideration.

Substituted Contracts [17-4b] A substituted contract is a new contract accepted by both parties in satisfaction of the parties’ duties under

the original contract. A substituted contract immedi- ately discharges the original contract and imposes new obligations under its own terms.

Accord and Satisfaction [17-4c] An accord is a contract by which an obligee promises to accept a stated performance in satisfaction of the obligor’s existing contractual duty. The performance of the accord, called a satisfaction, discharges the original duty. Thus, if Dan owes Sara $500, and the parties agree that Dan will paint Sara’s house in satisfaction of the debt, the agreement is an executory accord. When Dan performs the accord by painting Sara’s house, he will by satisfaction discharge the $500 debt.

M C D O W E L L W E L D I N G & P I P E F I T T I N G , I N C . V . U N I T E D S T A T E S G Y P S U M C O .

S u p r e m e C o u r t o f O r e g o n , 2 0 0 8

3 4 5 O r . 2 7 2 , 1 9 3 P . 3 d 9

FACTS Defendant United States Gypsum (U.S. Gyp- sum) hired BE & K as general contractor on a new plant U.S. Gypsum was building in Columbia County. BE & K subcontracted with the plaintiff (McDowell Welding & Pipefitting, Inc.) to perform work on the project. During construction, the defendants asked the plaintiff to perform additional tasks, over and above the plaintiff’s contractual obligations, and the defend- ants promised to pay the plaintiff for the additional work. After the plaintiff completed its work on the pro- ject, the parties disagreed over the amount that the defendants owed for the additional work.

The plaintiff filed an action against the defendants, alleging breach of contract. All of the plaintiff’s claims arose out of the modification to the construction con- tract. BE & K asserted an affirmative defense alleging that the plaintiff had agreed to settle its claims for a total payment of $896,000.

The trial court granted BE & K’s motion to try its counterclaim before trying the plaintiff’s claims against it. The plaintiff then filed a demand for a jury trial, which BE & K moved to strike, arguing that because its counterclaim was equitable, the plaintiff had no right to a jury trial on the counterclaim. The trial court granted BE & K’s motion to strike the plaintiff’s jury trial demand and, sitting as the trier of fact, found that the plaintiff had accepted the defendants’ offer to settle its claims in return for the defendants’ promise to pay the plaintiff $800,000. Although the defendants alleged that they promised to pay the plaintiff $896,000 in return

for the plaintiff’s promise to release its claims against them, the trial court found that the defendants had promised to pay only $800,000.

Based on its resolution of the defendants’ counter- claim, the trial court entered a limited judgment direct- ing the defendants to tender $800,000 to the court clerk and directing the plaintiff, after the defendants tendered that sum, to execute releases of its claims against the defendants. The plaintiff appealed, claiming a state con- stitutional right to a jury trial on the factual issues that the defendant’s counterclaim had raised. A divided Court of Appeals affirmed the trial court’s judgment. The Oregon Supreme Court allowed the plaintiff’s peti- tion for review.

DECISION Judgment of the Court of Appeals is affirmed in part, reversed in part, and remanded.

OPINION Kistler, J. As we discuss more fully below, a settlement agreement may take one of three forms: an executory accord, an accord and satisfaction, or a substituted contract. As we also discuss below, when the Oregon Constitution was adopted, only a court of equity would enforce an executory accord. The law courts would not enforce executory accords because they suspended the underlying obligation; they did not discharge it. By contrast, an accord and satisfaction and a substituted contract discharged the underlying obliga- tion, albeit for different reasons, and both were enforce- able in the law courts. It follows that the question

354 Contracts Part III

Novation [17-4d] A novation is a substituted contract that involves an agreement among three parties to substitute a new promisee for the existing promisee or to replace the existing promisor with a new one. A novation dis- charges the old obligation by creating a new contract in which there is either a new promisee or a new prom- isor. Thus, if B owes A $500 and A, B, and C agree that C will pay the debt and B will be discharged, the novation is the substitution of the new promisor C for

B. Alternatively, if the three parties agree that B will pay $500 to C instead of to A, the novation is the sub- stitution of a new promisee (C for A). In each instance, the debt B owes A is discharged.

DISCHARGE BY OPERATION OF LAW [17-5] In this chapter, we have considered various ways by which contractual duties may be discharged. In all of

whether the agreement that gave rise to defendants’ counterclaim would have been cognizable in law or equity turns, at least initially, on whether it is an execu- tory accord, an accord and satisfaction, or a substituted contract. We first describe the distinctions among those types of settlement agreements before considering which type of settlement agreement defendants alleged.

An executory accord is “an agreement for the future discharge of an existing claim by a substituted perform- ance.” [Citation.] Usually, an executory accord is a bilat- eral agreement; the debtor promises to pay an amount in return for the creditor’s promise to release the underlying claim. When the parties enter into an executory accord, the underlying claim “is not [discharged] until the new agreement is performed. The right to enforce the original claim is merely suspended, and is revived by the debtor’s breach of the new agreement.” [Citation.]

Because an executory accord does not discharge the underlying claim but merely suspends it, the law courts refused to allow it to be pleaded as a bar to the underly- ing claim. [Citations.] Once the promised performance occurs, the accord has been executed or satisfied and the underlying claim is discharged, resulting in an accord and satisfaction. [Citation.] [Court’s footnote: An accord and satisfaction may occur in one of two ways: “The two parties may first make an accord executory, that is, a contract for the future discharge of the existing claim by a substituted performance still to be rendered. When this executory contract is fully performed as agreed, there is said to be an accord and satisfaction, and the previously existing claim is discharged. It is quite possible, however, for the parties to make an accord and satisfaction with- out any preliminary accord executory or any other execu- tory contract of any kind. [For example, a] debtor may offer the substituted performance in satisfaction of his debt and the creditor may receive it, without any binding promise being made by either party.” [Citation.]] Because an accord and satisfaction discharges the underlying claim, that defense is legal, not equitable. [Citation.]

Finally, the parties may enter into a substituted con- tract; that is, the parties may agree to substitute the new

agreement for the underlying obligation. [Citation.] A substituted contract differs from an executory accord in that the parties intend that entering into the new agreement will immediately discharge the underlying obligation. [Citations.] A substituted contract discharges the underlying obligation and could be asserted as a bar to an action at law. [Citation.]

With that background in mind, we turn to the ques- tion whether defendants pleaded an executory accord, an accord and satisfaction, or a substituted contract. Here, defendants alleged that they agreed to pay plaintiff $896,000 in exchange for a release of plaintiff’s claims against them. Defendants did not allege that they had paid plaintiff the promised sum—an allegation necessary for an accord and satisfaction. [Citations.] Nor did they allege that, by entering into the settlement agreement, they extinguished the underlying obligation—an allega- tion necessary to allege a substituted contract. [Citations.] Rather, defendants alleged that plaintiff agreed to release its claims only after defendants made the promised pay- ment. In short, defendants alleged an executory accord.

*** [The Oregon constitutional right to a jury trial in

civil cases does not extend to the defendants’ counter- claim of an executory accord. We affirm the Court of Appeals decision on the plaintiff’s jury trial claim but reverse its decision on a subsidiary issue regarding pre- judgment interest.]

INTERPRETATION When a debtor and a creditor enter into an executory accord, the underlying claim is not discharged until the new agreement is per- formed; the right to enforce the original claim is merely suspended and is revived by the debtor’s breach of the new agreement.

CRITICAL THINKING QUESTION In settling a contract dispute, what are the advantages and disadvantages of using an executory accord compared with using a substituted contract?

Chapter 17 Performance, Breach, and Discharge 355

these cases, the discharge resulted from the action of one or both of the parties to the contract. In this sec- tion, we will examine discharge brought about by the operation of law.

Impossibility [17-5a] If a particular contracting party is unable to perform because of financial inability or lack of competence, for instance, this subjective impossibility does not excuse the promisor from liability for breach of contract, as the next case shows. Historically, the common law excused a party from contractual duties only for objective impossibility, that is, for situations in which no one could render performance. Thus, the death or illness of a person who has contracted to render per- sonal services is a discharge of his contractual duty.

Furthermore, the contract is discharged if, for example, a jockey contracts to ride a certain horse in the Kentucky Derby and the horse dies prior to the derby, for it is objectively impossible for this or any other jockey to perform the contract. Also, if Ken contracts to lease to Karlene a certain ballroom for a party on a scheduled future date, destruction of the ballroom by fire without Ken’s fault before the scheduled event discharges the contract. Destruction of the subject matter or of the agreed-upon means of performance of a contract, with- out the fault of the promisor, is excusable impossibility.

PRACTICAL ADVICE Use a clause in your contract specifying which events will excuse the nonperformance of the contract.

Subsequent Illegality If the performance of a contract that was legal when formed becomes illegal or impractical because of a subsequently enacted law, the duty of performance is discharged. For example, Linda contracts to sell and deliver to Carlos ten cases of a certain whiskey each month for one year. A sub- sequent prohibition law makes the manufacture, trans- portation, or sale of intoxicating liquor unlawful. The

contractual duties that Linda has yet to perform are discharged.

Frustration of Purpose Where, after a contract is made, a party’s principal purpose is substantially frustrated without his fault by the occurrence of an event whose nonoccurrence was a basic assumption on which the contract was made, his remaining duties to

C H R I S T Y V . P I L K I N T O N S u p r e m e C o u r t o f A r k a n s a s , 1 9 5 4

2 2 4 A r k . 4 0 7 , 2 7 3 S . W . 2 d 5 3 3

FACTS The Christys entered into a written contract to purchase an apartment house from Pilkinton for $30,000. Pilkinton tendered a deed to the property and demanded payment of the unpaid balance of $29,000 due on the purchase price. As a result of a decline in the Christy’s used car business, the Christys did not possess and could not borrow the unpaid balance and, thus, asserted that it was impossible for them to perform their contract. This suit was brought by Pilkinton to enforce the sale of the apartment house.

DECISION Judgment for Pilkinton.

OPINION Smith, J. Proof of this kind [an inability to pay the purchase price] does not establish the type of impossibility that constitutes a defense. There is a familiar distinction between objective impossibility, which amounts to saying, “The thing cannot be done,”

and subjective impossibility—“I cannot do it.” [Cita- tions.] The latter, which is well illustrated by a promis- or’s financial inability to pay, does not discharge the contractual duty and is therefore not a bar to a [judg- ment in favor of the plaintiff].

INTERPRETATION Subjective impossibility (the promisor, but not all promisors, cannot perform) does not discharge the promisor’s contractual duty.

ETHICAL QUESTION Is it fair to make con- tracting parties strictly liable for breach of contract? Explain.

CRITICAL THINKING QUESTION What type of fact situation would have excused the Christys’ duty to perform? Explain.

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render performance are discharged, unless the party has assumed the risk. This rule developed from the so- called coronation cases. When, on the death of his mother, Queen Victoria, Edward VII became King of England, impressive coronation ceremonies were planned, including a procession along a designated route through London. Owners and lessees of buildings along the route made contracts to permit the use of rooms on the day scheduled for the procession. The king became ill, however, and the procession did not take place. Consequently, the rooms were not used. Numerous suits were filed, some by landowners seeking to hold the would-be viewers liable on their promises and some by the would-be viewers seeking to recover money they had paid in advance for the rooms. Though the principle involved was novel, from these cases evolved the frustration of purpose doctrine, under which a contract is discharged if supervening circum- stances make impossible the fulfillment of the purpose that both parties had in mind, unless one of the parties has contractually assumed that risk.

Commercial Impracticability The Restate- ment and Code have relaxed the traditional test of objective impossibility by providing that performance need not be actually or literally impossible; rather, com- mercial impracticability, or unforeseen and unjust hard- ship, will excuse nonperformance. This does not mean mere hardship or an unexpectedly increased cost of per- formance. A party will be discharged from performing her duty only when her performance is made impracti- cable by a supervening event not caused by her own fault. Moreover, the nonoccurrence of the subsequent event must have been a “basic assumption” made by both parties when entering into the contract, neither party having assumed the risk that the event would occur.

PRACTICAL ADVICE Clearly state the basic assumptions of your contract and which risks are assumed by each of the parties.

N O R T H E R N C O R P O R A T I O N V . C H U G A C H E L E C T R I C A L A S S O C I A T I O N S u p r e m e C o u r t o f A l a s k a , 1 9 7 4

5 1 8 P . 2 d 7 6

FACTS Northern Corporation (Northern) entered into a contract with Chugach Electrical Association (Chu- gach) in August 1966 to repair and upgrade the upstream face of Cooper Lake Dam in Alaska. The contract required Northern to obtain rock from a quarry site at the opposite end of the lake and to transport the rock to the dam during the winter across the ice on the lake. In December 1966, Northern cleared a road on the ice to permit deeper freezing, but thereafter water overflowed on the ice, preventing use of the road. Northern com- plained of the unsafe conditions of the lake ice, but Chu- gach insisted on performance. In March 1967, one of Northern’s loaded trucks broke through the ice and sank. Northern continued to encounter difficulties and ceased operations with the approval of Chugach. However, on January 8, 1968, Chugach notified Northern that it would be in default unless all rock was hauled by April 1. After two more trucks broke through the ice, causing the deaths of the drivers, Northern ceased operations and notified Chugach that it would make no more attempts to haul across the lake. Northern advised Chugach that it considered the contract terminated for impossibility of performance and commenced suit to recover the cost incurred in attempting to complete the contract. The trial court found for Northern.

DECISION Judgment for Northern affirmed.

OPINION Boochever, J. The focal question is whether the *** contract was impossible of perform- ance. The September 27, 1966 directive specified that the rock was to be transported “across Cooper Lake to the dam site when such lake is frozen to a sufficient depth to permit heavy vehicle traffic thereon,” and *** specified that the hauling to the dam site would be done during the winter of 1966–67. It is therefore clear that the parties contemplated that the rock would be trans- ported across the frozen lake by truck. Northern’s repeated efforts to perform the contract by this method during the winter of 1966–67 and subsequently in Feb- ruary 1968, culminating in the tragic loss of life, abun- dantly support the trial court’s finding that the contract was impossible of performance by this method.

Chugach contends, however, that Northern was never- theless bound to perform, and that it could have used means other than hauling by truck across the ice to trans- port the rock. The answer to Chugach’s contention is that *** the parties contemplated that the rock would be hauled by truck once the ice froze to a sufficient depth to support the weight of the vehicles. The specification of this particular method of performance presupposed the

Chapter 17 Performance, Breach, and Discharge 357

Availability of Restitution In cases in which impossibility, subsequent illegality, frustration, or impracticability apply, contract law permits the avoid- ance of a contract obligation. If the contract is wholly executory, discharge of the contract obligations resolves the legal issues. However, if the contract has been partially or wholly performed, the legal issues include not only the enforceability of the contract but also restitution. The Restatement of Restitution provides that a person who renders more advanced performance under a contract that is discharged for impossibility, subsequent illegality, frustration, or impracticability is entitled to restitution to prevent unjust enrichment of the other party. Thus, for exam- ple, if the seller has performed prior to receiving pay- ment, the seller would have a claim in restitution. On the other hand, if the buyer has paid part or all of the price in advance, the buyer would be entitled to restitution.

Bankruptcy [17-5b] Bankruptcy is a discharge of a contractual duty by operation of law available to a debtor who, by compli- ance with the requirements of the Bankruptcy Code, obtains an order of discharge by the bankruptcy court. It applies only to obligations that the Bankruptcy Code provides are dischargeable in bankruptcy. (The subject of bankruptcy is discussed in Chapter 38.)

Statute of Limitations [17-5c] At common law a plaintiff was not subject to any time li- mitation within which to bring an action. Now, however, all states have statutes providing such a limitation. The majority of courts hold that the running of the period of the statute of limitations does not operate to discharge the obligation but only to bar the creditor’s right to bring an action.

For a summary of discharge of contracts, see Figure 17-1.

existence of ice frozen to the requisite depth. Since this expectation of the parties was never fulfilled, and since the provisions relating to the means of performance were clearly material, Northern’s duty to perform was dis- charged by reason of impossibility.

There is an additional reason for our holding that Northern’s duty to perform was discharged because of impossibility. It is true that in order for a defendant to prevail under the original common law doctrine of impossibility he had to show that no one else could have performed the contract. However, this harsh rule has gradually been eroded, and the Restatement of Contracts has departed from the early common law rule by recog- nizing the principle of “commercial impracticability.” Under this doctrine, a party is discharged from his con- tract obligations, even if it is technically possible to per- form them, if the costs of performance would be so disproportionate to that reasonably contemplated by the parties as to make the contract totally impractical in a commercial sense. *** Removed from the strictures of the common law, “impossibility” in its modern context has become a coat of many colors, including among its hues the point argued here—namely, impossibility predi- cated upon “commercial impracticability.” This con- cept—which finds expression both in case law *** and in other authorities *** is grounded upon the assumption that in legal contemplation something is impracticable when it can only be done at an excessive and unreason- able cost.

*** The doctrine ultimately represents the ever-shift- ing line, drawn by courts hopefully responsive to com- mercial practices and mores, at which the community’s interest in having contracts enforced according to their terms is out-weighed by the commercial senselessness of requiring performance. ***

In the case before us the detailed opinion of the trial court clearly indicates that the appropriate standard was followed. There is ample evidence to support its findings that “[t]he ice haul method of transporting riprap ulti- mately selected was within the contemplation of the par- ties and was part of the basis of the agreement which ultimately resulted in amendment No. 1 in October 1966,” and that that method was not commercially fea- sible within the financial parameters of the contract. We affirm the court’s conclusion that the contract was impossible of performance.

INTERPRETATION Commercial impracti- cability (unforeseen and unjust hardship) will excuse performance.

ETHICAL QUESTION Did Chugach act ethi- cally in insisting on performance by Northern in face of dangerous conditions? Explain.

CRITICAL THINKING QUESTION Do you think that the court used the proper standard in this case? Explain.

358 Contracts Part III

C H A P T E R S U M M A R Y Conditions

Definition of a Condition an event whose happening or nonhappening affects a duty of performance

Express Condition contingency explicitly set forth in language • Satisfaction express condition making performance contingent on one party’s approval of the

other’s performance • Subjective Satisfaction approval based on a party’s honestly held opinion • Objective Satisfaction approval based on whether a reasonable person would be satisfied • Satisfaction of a Third Party a contract may condition the duty of one contracting party to

accept and pay for the performance of the other contracting party upon the approval of a third party who is not a party to the contract

Implied-in-Fact Condition contingency understood by the parties to be part of the agreement, though not expressed

Implied-in-Law Condition contingency not contained in the language of the contract but imposed by law; also called a constructive condition

Concurrent Conditions conditions that are to take place at the same time

Condition Precedent an event that must or must not occur before performance is due

Condition Subsequent an event that terminates a duty of performance

FIGURE 17-1 Discharge of Contracts

A Discharged

B Discharged

A Enters

into Contract

with B

A and B Discharged

• A fully performs • B materially breaches • A and B agree to substitute C for A (novation) • A discharged in bankruptcy

• Failure of a condition • Mutual rescission of the contract • Substituted contract • Accord and satisfaction • Subsequent illegality of the contract • Impossibility of performance

• B fully performs • A materially breaches • A and B agree to substitute C for B (novation) • B discharged in bankruptcy

Chapter 17 Performance, Breach, and Discharge 359

Discharge by Performance

Discharge termination of a contractual duty

Performance fulfillment of a contractual obligation resulting in a discharge

Tender party’s offer to perform her obligation according to the terms of the cotract

Discharge by Breach

Definition of Breach a wrongful failure to perform the terms of a contract that gives rise to a right to damages by the injured party

Material Breach nonperformance that significantly impairs the injured party’s rights under the contract and discharges the injured party from any further duty under the contract • Prevention of Performance one party’s substantial interference with or prevention of performance

by the other constitutes a material breach and discharges the other party to the contract • Perfect Tender Rule standard under the Uniform Commercial Code that a seller’s performance

under a sales contract must strictly comply with contractual duties and that any deviation discharges the injured party

Substantial Performance performance that is incomplete but that does not defeat the purpose of the contract; does not discharge the injured party but entitles him to damages

Anticipatory Repudiation an inability or refusal to perform, before performance is due, that is treated as a breach, allowing the nonrepudiating party to bring suit immediately

Unauthorized Material Alteration of Written Contract a material and fraudulent alteration of a written contract by a party to the contract discharges the entire contract

Discharge by Agreement of the Parties

Mutual Rescission an agreement between the parties to terminate their respective duties under the contract

Substituted Contract a new contract accepted by both parties in satisfaction of the parties’ duties under the original contract

Accord and Satisfaction substituted duty under a contract (accord) and the discharge of the prior contractual obligation by performance of the new duty (satisfaction)

Novation a substituted contract involving a new third-party promisor or promisee

Discharge by Operation of Law

Impossibility performance of contract cannot be done • Subjective Impossibility the promisor—but not all promisors—cannot perform; does not

discharge the promisor • Objective Impossibility no promisor is able to perform; generally discharges the promisor • Subsequent Illegality if performance becomes illegal or impractical as a result of a change in

the law, the duty of performance is discharged • Frustration of Purpose principal purpose of a contract cannot be fulfilled because of a

subsequent event • Commercial Impracticability where performance can be accomplished only under unforeseen

and unjust hardship, the contract is discharged under the Code and the Restatement • Availability of Restitution a person who renders more advanced performance under a contract

that is discharged for impossibility, subsequent illegality, frustration, or impracticability is entitled to restitution to prevent unjust enrichment of the other party

Bankruptcy discharge available to a debtor who obtains an order of discharge by the bankruptcy court

Statute of Limitations after the statute of limitations has run, the debt is not discharged, but the creditor cannot maintain an action against the debtor

360 Contracts Part III

Q U E S T I O N S

1. A-1 Roofing Co. entered into a written contract with Jaffe to put a new roof on the latter’s residence for $1,800, using a specified type of roofing, and to complete the job without unreasonable delay. A-1 undertook the work within a week thereafter, and when all the roofing material was at the site and the labor 50 percent completed, the premises were totally destroyed by fire caused by lightning. A-1 submitted a bill to Jaffe for $1,200 for materials furnished and labor performed up to the time of the destruction of the premises. Jaffe refused to pay the bill, and A-1 now seeks payment from Jaffe. Should A-1 prevail? Explain.

2. By contract dated January 5, Rebecca agreed to sell to Nancy, and Nancy agreed to buy from Rebecca, a certain parcel of land then zoned commercial. The specific intent of Nancy, which was known to Rebecca, was to erect a manufacturing plant on the land; and the contract stated that the agreement was conditioned on Nancy’s ability to construct such a plant on the land. The closing date for the transaction was set for April 1. On February 15, the city council rezoned the land from commercial to residen- tial, which precluded the erection of the plant. As the closing date drew near, Nancy made it known to Rebecca that she did not intend to go through with the purchase because the land could no longer be used as intended. On April 1, Rebecca tendered the deed to Nancy, who refused to pay Rebecca the agreed purchase price. Rebecca brought an action against Nancy for breach of contract. Can Rebecca enforce the contract?

3. The Perfection Produce Company entered into a written contract with Hiram Hodges for the purchase of three hundred tons of potatoes to be grown on Hodges’s farm in Maine at a stipulated price per ton. Though the land would ordinarily produce one thousand tons and although the planting and cultivation were properly done, Hodges was able to deliver only one hundred tons because an unprecedented drought caused a partial crop failure. Perfection accepted the one hundred tons but paid only 80 percent of the stipulated price per ton. Hodges sued the produce company to recover the unpaid balance of the agreed price for the one hundred tons of potatoes accepted by Perfection. Perfection counter- claimed against Hodges for his failure to deliver the addi- tional two hundred tons. Who will prevail? Why?

4. On November 23, Sally agreed to sell to Bart her Buick automobile for $7,000, delivery and payment to be made on December 1. On November 26, Bart informed Sally that he wished to rescind the contract and would pay Sally $350 if Sally agreed. Sally agreed and took the $350 in cash. On December 1, Bart tendered to Sally $6,650 and demanded that Sally deliver the automobile. Sally refused, and Bart initiated a lawsuit. May Bart enforce the original contract?

5. Webster, Inc., dealt in automobile accessories at whole- sale. Although it manufactured a few items in its own factory, among them windshield wipers, Webster pur- chased most of its inventory from a large number of other manufacturers. In January, Webster entered into a written contract to sell Hunter two thousand windshield wipers for $1,900, delivery to be made June 1. In April, Webster’s factory burned to the ground and Webster failed to make delivery on June 1. Hunter, forced to buy windshield wipers elsewhere at a higher price, is now try- ing to recover damages from Webster. Will Hunter be successful in its claim?

6. Erwick Construction Company contracted to build a house for Charles. The specifications called for the use of Karlene Pipe for all plumbing. Erwick, nevertheless, got a better price on Boynton Pipe and substituted the equally good Boynton Pipe for Karlene Pipe. Charles’s inspection revealed the change, and Charles now refuses to make the final payment. The contract price was for $200,000, and the final payment is $20,000. Erwick now brings suit seeking the $20,000. Will Erwick succeed in its claim?

7. Green owed White $3,500, which was due and payable on June 1. White owed Brown $3,500, which was due and payable on August 1. On May 25, White received a letter signed by Green stating, “If you will cancel my debt to you, in the amount of $3,500, I will pay, on the due date, the debt you owe Brown, in the amount of $3,500.” On May 28, Green received a letter signed by White stat- ing, “I received your letter and agree to the proposals recited therein. You may consider your debt to me can- celed as of the date of this letter.” On June 1, White, needing money to pay his income taxes, made a demand upon Green to pay him the $3,500 due on that date. Is Green obligated to pay the money demanded by White?

8. By written contract, Ames agreed to build a house on Bowen’s lot for $145,000, commencing within ninety days of the date of the contract. Prior to the date for be- ginning construction, Ames informed Bowen that he was repudiating the contract and would not perform. Bowen refused to accept the repudiation and demanded fulfill- ment of the contract. Eighty days after the date of the contract, Bowen entered into a new contract with Curd for $142,000. The next day, without knowledge or notice of Bowen’s contract with Curd, Ames began construc- tion. Bowen ordered Ames from the premises and refused to allow him to continue. Will Ames be able to collect damages from Bowen? Explain.

9. Judy agreed in writing to work for Northern Enterprises, Inc., for three years as superintendent of Northern’s man- ufacturing establishment and to devote herself entirely to the business, giving it her full time, attention, and skill,

Chapter 17 Performance, Breach, and Discharge 361

for which she was to receive $72,000 per annum in monthly installments of $6,000. Judy worked and was paid for the first twelve months, when, through no fault of her own or Northern’s, she was arrested and impris- oned for one month. It became imperative for Northern to employ another, and it treated the contract with Judy as breached and abandoned, refusing to permit Judy to resume work on her release from jail. What rights, if any, does Judy have under the contract?

10. The Park Plaza Hotel awarded its valet and laundry con- cession to Larson for a three-year term. The contract contained the following provision: “It is distinctly under- stood and agreed that the services to be rendered by Lar- son shall meet with the approval of the Park Plaza Hotel, which shall be the sole judge of the sufficiency and pro- priety of the services.” After seven months, the hotel gave a month’s notice to discontinue services based on the fail- ure of the services to meet its approval. Larson brought an action against the hotel, alleging that its dissatisfaction was unreasonable. The hotel defended on the ground that subjective or personal satisfaction may be the sole justifi- cation for termination of the contract. Who is correct? Explain.

11. Schlosser entered into an agreement to purchase a coop- erative apartment from Flynn Company. The written agreement contained the following provision: “This entire agreement is conditioned on Purchaser’s being approved for occupancy by the board of directors of the Coopera- tive. In the event approval of the Purchaser shall be denied, this agreement shall thereafter be of no further force or effect.” When Schlosser unilaterally revoked her “offer,” Flynn sued for breach of contract. Schlosser claims the approval provision was a condition precedent to the existence of a binding contract and, thus, she was free to revoke. Decision?

12. Jacobs, owner of a farm, entered into a contract with Earl Walker in which Walker agreed to paint the build- ings on the farm. As authorized by Jacobs, Walker acquired the paint from Jones with the bill to be sent to Jacobs. Before the work was completed, however, Jacobs without good cause ordered Walker to stop. Walker made offers to complete the job, but Jacobs declined to permit Walker to fulfill his contract. Jacobs refused to pay Jones for the paint Walker had acquired for the job. Explain whether Jones and Walker would be successful in an action against Jacobs for breach of contract.

C A S E P R O B L E M S

13. Barta entered into a written contract to buy the K&K Pharmacy, located in a local shopping center. Included in the contract was a provision stating “this Agreement shall be contingent upon Buyer’s ability to obtain a new lease from Landlord for the premises presently occupied by Seller. In the event Buyer is unable to obtain a lease satisfactory to Buyer, this Agreement shall be null and void.” Barta planned to sell “high-traffic” grocery items, such as bread, milk, and coffee, to attract customers to his drugstore. A grocery store in the shopping center, however, already held the exclusive right to sell grocery items. Barta, therefore, could not obtain a leasing agree- ment meeting his approval. Barta refused to close the sale. In a suit by K&K Pharmacy against Barta for breach of contract, who will prevail? Explain.

14. Victor Packing Co. (Victor) contracted to supply Sun Maid Raisin Growers 1,800 tons of raisins from the cur- rent year’s crop. After delivering 1,190 tons of raisins by August, Victor refused to supply any more. Although Victor had until the end of the crop season to ship the remaining 610 tons of raisins, Sun Maid treated Victor’s repeated refusals to ship any more raisins as a repudia- tion of the contract. To prevent breaching its own con- tracts, Sun Maid went into the marketplace to “cover” and bought the raisins needed. Unfortunately, between the time Victor refused delivery and Sun Maid entered the market, disastrous rains had caused the price of

raisins to skyrocket. May Sun Maid recover from Victor the difference between the contract price and the market price before the end of the current crop year?

15. On August 20, Hildebrand entered into a written con- tract with the city of Douglasville whereby he was to serve as community development project engineer for three years at a monthly fee of $1,583.33. This salary fig- ure could be changed without affecting the other terms of the contract. One of the provisions for termination of the contract was written notice by either party to the other at any time at least ninety days prior to the intended date of termination. The contract listed a substantial number of services and duties Hildebrand was to perform for the city; among the lesser duties were (a) keeping the com- munity development director (Hildebrand’s supervisor) informed at all times of his whereabouts and how he could be contacted and (b) attending meetings at which his presence was requested. Two years later, by which time Hildebrand’s fee had risen to $1,915.83 per month, the city fired Hildebrand effective immediately, citing “certain material breaches … of the … agreement.” The city specifically charged that he did not attend the neces- sary meetings although requested to do so and seldom if ever kept his supervisor informed of his whereabouts and how he could be contacted. Will Hildebrand prevail in a suit against the mayor and city for the amount of $5,747.49 for breach of his employment contract because

362 Contracts Part III

of the city’s failure to give him ninety days’ notice prior to termination?

16. Walker & Co. contracted to provide a sign for Harrison to place above his dry cleaning business. According to the contract, Harrison would lease the sign from Walker, making monthly payments for thirty-six months. In return, Walker agreed to maintain and service the sign at its own expense. Walker installed the sign in July, and Harrison made the first rental payment. Shortly there- after, someone hit the sign with a tomato. Harrison also claims he discovered rust on its chrome and little spider webs in its corners. Harrison repeatedly called Walker for the maintenance work promised under the contract, but Walker did not respond immediately. Harrison then notified Walker that due to Walker’s failure to perform the maintenance services, he held Walker in material breach of the contract. A week later, Walker sent out a crew, which did all of the requested maintenance services. Has Walker committed a material breach of contract? Explain.

17. In May, Watts was awarded a construction contract, based on its low bid, by the Cullman County Commis- sion. The contract provided that it would not become effective until approved by the state director of the Farm- ers Home Administration (now part of the U.S. Depart- ment of Agriculture Rural Development Office). In September, construction still had not been authorized and Watts wrote to the County Commission requesting a 5 percent price increase to reflect seasonal and inflationary price increases. The County Commission countered with an offer of 3.5 percent. Watts then wrote the commis- sion, insisting on a 5 percent increase and stating that if this was not agreeable, it was withdrawing its original bid. The commission obtained another company to per- form the project, and on October 14, informed Watts that it had accepted the withdrawal of the bid. Watts sued for breach of contract. Explain whether Watts will prevail and why or why not.

18. K & G Construction Co. was the owner of and the gen- eral contractor for a housing subdivision project. Harris contracted with the company to do excavating and earth- moving work on the project. Certain provisions of the contract stated that (a) K & G was to make monthly progress payments to Harris, (b) no such payments were to be made until Harris obtained liability insurance, and (c) all of Harris’s work on the project must be performed in a workmanlike manner. On August 9, a bulldozer operator, working for Harris, drove too close to one of K & G’s houses, causing the collapse of a wall and other damage. When Harris and his insurance carrier denied liability and refused to pay for the damage, K & G refused to make the August monthly progress payment. Harris, nonetheless, continued to work on the project until mid-September, when the excavator ceased its oper- ations due to K & G’s refusal to make the progress

payment. K & G had another excavator finish the job at an added cost of $450. It then sued Harris for the bull- dozer damage, alleging negligence, and for the $450 dam- ages for breach of contract. Harris claims that K & G defaulted first, having no legal right to refuse the August progress payment. Did K & G default first? Explain.

19. Mountain Restaurant Corporation (Mountain) leased commercial space in the ParkCenter Mall to operate a restaurant called Zac’s Grill. The lease specified that the lessee shall “at all times have a nonexclusive and nonre- vocable right, together with the other tenants and occu- pants of … the shopping center, to use the parking area … for itself, its customers and employees.” Zac’s Grill was to be a fast-food restaurant where tables were anticipated to “turn over” twice during lunch. Zac’s operated suc- cessfully until parking close to the restaurant became restricted. Two other restaurants opened and began com- peting for parking spaces, and the parking lot would become full between 12:00 and 12:30 P.M. Parking, however, was always available at other areas of the mall. Business declined for Zac’s, which fell behind on the rent due to ParkCenter until finally the restaurant closed. Mountain claims that it was discharged from its obliga- tions under the lease because of material breach. Is Mountain correct? Explain.

20. In late 2012 or early 2013, the plaintiff, Lan England, agreed to sell 258,363 shares of stock to the defendant, Eugene Horbach, for $2.75 per share, for a total price of $710,498.25. Although the purchase money was to be paid in the first quarter of 2013, the defendant made per- iodic payments on the stock at least through September 2013. The parties met in May of 2014 to finalize the transaction. At this time, the plaintiff believed that the defendant owed at least $25,000 of the original pur- chase price. The defendant did not dispute that amount. The parties then reached a second agreement whereby the defendant agreed to pay to the plaintiff an additional $25,000 and to hold in trust 2 percent of the stock for the plaintiff. In return, the plaintiff agreed to transfer the stock and to forgo his right to sue the defendant for breach of the original agreement.

In December 2015, the plaintiff made a demand for the 2 percent stock, but the defendant refused, contending that the 2 percent agreement was meant only to secure his payment of the additional $25,000. The plaintiff sued for breach of the 2 percent agreement. Prior to trial, the defendant discovered additional business records docu- menting that he had, before entering into the second agreement, actually overpaid the plaintiff for the purchase of the stock. The defendant asserts the plaintiff could not enforce the second agreement as an accord and satisfaction because (a) it was not supported by consideration and (b) it was based upon a mutual mistake that the defendant owed additional money on the original agreement. Is the defendant correct in his assertions? Explain.

Chapter 17 Performance, Breach, and Discharge 363

21. An artist once produced a painting now called The Plains of Meudon. For a while, the parties in this case thought that the artist was Theodore Rousseau, a prominent member of the Barbizon school, and that the painting was quite valuable. With this idea in mind, the Kohlers consigned the painting to Leslie Hindman, Inc. (Hindman), an auction house. Among other things, the consignment agreement between the Kohlers and Hindman defined the scope of Hindman, Inc.’s authority as agent. First, Hindman was obliged to sell the painting according to the conditions of sale spelled out in the auction catalog. Those conditions provided that neither the consignors nor Hindman made any warranties of authenticity. Second, the consignment agreement gave Hindman extensive and exclusive discretionary authority to rescind sales if in its “sole discretion” it determined that the sale subjected the company or the Kohlers to any liability under a warranty of authenticity.

Despite having some doubts about its authenticity, Thune was still interested in the painting but wanted to have it authenticated before committing to its purchase. Unable to obtain an authoritative opinion about its authenticity before the auction, Leslie Hindman and Thune made a verbal agreement that Thune could return the painting within approximately thirty days of the auction if he was the successful bidder and if an expert then determined that Rousseau had not painted it. Neither Leslie Hindman nor anyone else at Hindman told the Kohlers about the ques- tions concerning the painting or about the side agreement between Thune and Hindman. At the auction, Thune pre- vailed in the bidding with a high bid of $90,000, and he took possession of the painting without paying. He then sent it to an expert in Paris who decided that it was not a Rous- seau. Thune returned the painting to Hindman within the agreed-upon period. Explain whether the Kohlers would be successful in a lawsuit against either Hindman or Thune.

T A K I N G S I D E S

Associated Builders, Inc., provided labor and materials to William M. Coggins and Benjamin W. Coggins, doing busi- ness as Ben & Bill’s Chocolate Emporium, to complete a structure on Main Street in Bar Harbor, Maine. After a dis- pute arose regarding compensation, Associated and the Cog- ginses executed an agreement stating that there existed an outstanding balance of $70,000 and setting forth the follow- ing terms of repayment:

It is agreed that, two payments will be made by the Cogginses to Associated Builders as follows: Twenty Five Thousand Dollars ($25,000.00) on or before June 1, 2013, and Twenty Five Thousand Dollars ($25,000.00) on or before June 1, 2014. No interest will be charged or paid providing payments are made as agreed. If the payments are not made as agreed then interest shall accrue at 10% per annum figured from

the date of default. It is further agreed that Associated Builders will forfeit the balance of Twenty Thousand Dollars and No Cents ($20,000.00) providing the above payments are made as agreed.

The Cogginses made their first payment in accordance with the agreement. The second payment, however, was delivered three days late on June 4, 2014. Claiming a breach of the contract, Associated contended that the remainder of the original bal- ance of $20,000, plus interest and cost, were now due.

a. What arguments would support Associated’s claim for $20,000?

b. What arguments would support the claim by the Cog- ginses that they were not liable for $20,000?

c. For what damages, if any, are the Cogginses liable? Explain.

364 Contracts Part III

C H A P T E R 1 8

CONTRACT REMEDIES

The traditional goal of the law of contract remedies has not been the compulsion of the promisor to perform his promise but compensation of the promisee for the loss resulting from breach.

RESTATEMENT OF CONTRACTS

C H A P T E R O U T C O M E S After reading and studying this chapter, you should be able to:

1. Explain how compensatory damages and reliance damages are computed.

2. Define (a) nominal damages, (b) incidental damages, (c) consequential damages, (d) foreseeability of damages, (e) punitive damages, (f) liquidated damages, and (g) mitigation of damages.

3. Define the various types of equitable relief and explain when the courts will grant such relief.

4. Explain how restitutionary damages are computed and identify the situations in which restitution is available as a contractual remedy.

5. Identify and explain the limitations on contractual remedies.

W hen one party to a contract breaches the contract by failing to perform his contrac- tual duties, the law provides a remedy for

the injured party. Although the primary objective of contract remedies is to compensate the injured party for the loss resulting from the breach, it is impossible for any remedy to equal the promised performance. The relief a court can give an injured party is what it regards as an equivalent of the promised performance.

PRACTICAL ADVICE Consider including in your contracts a provision for the recovery of attorneys’ fees in the event of breach of contract.

In this chapter, we will examine the most common remedies available for breach of contract: (1) monetary

damages, (2) the equitable remedies of specific perform- ance and injunction, and (3) restitution. Article 2 of the Uniform Commercial Code (UCC), which provides spe- cialized remedies that we will discuss in Chapter 23, governs the sale of goods. Contract remedies are avail- able to protect one or more of the following interests of the injured parties:

1. their expectation interest, which is their interest in having the benefit of their bargain by being put in a position as good as the one they would have been in had the contract been performed;

2. their reliance interest, which is their interest in being reimbursed for loss caused by reliance on the con- tract by being put in a position as good as the one they would have been in had the contract not been made; or

365

3. their restitution interest, which is their interest in having restored to them any benefit that they had conferred on the other party.

The contract remedies of compensatory damages, specific performance, and injunction protect the expec- tation interest. The contractual remedy of reliance dam- ages protects the reliance interest, while the contractual remedy of restitution protects the restitution interest.

PRACTICAL ADVICE Consider including in your contracts a provision for the arbitration of contract disputes.

MONETARY DAMAGES [18-1] A judgment awarding monetary damages is the most frequently granted judicial remedy for breach of con- tract. Monetary damages, however, will be awarded only for losses that are foreseeable, established with reasonable certainty, and not avoidable. The equitable remedies discussed in this chapter are discretionary and are available only if monetary damages are inadequate.

Compensatory Damages [18-1a] The right to recover compensatory damages for breach of contract is always available to the injured party. The purpose in allowing compensatory damages is to place the injured party in a position as good as the one he would have been in had the other party performed under the contract. This involves compensating the injured party for the dollar value of the benefits he would have received had the contract been performed less any savings he experienced by not having to per- form his own obligations under the contract. These damages are intended to protect the injured party’s expectation interest, which is the value he expected to derive from the contract. Thus, the amount of compen- satory damages is the loss of value to the injured party caused by the other party’s failure to perform or by the other party’s deficient performance minus the loss or cost avoided by the injured party plus incidental dam- ages plus consequential damages.

Loss of Value In general, loss of value is the dif- ference between the value of the promised performance of the breaching party and the value of the actual per- formance rendered by the breaching party. If no per- formance is rendered at all, the loss of value is the value of the promised performance. If defective or

partial performance is rendered, the loss of value is the difference between the value that the full performance would have had and the value of the performance actually rendered. Thus, when there has been a breach of warranty, the injured party may recover the differ- ence between the value the goods would have had, had they been as warranted, and the value of the goods in the condition in which the buyer actually received them. To illustrate, Jacob sells an automobile to Juliet, expressly warranting that it will get forty-five miles per gallon; but the automobile gets only twenty miles per gallon. The automobile would have been worth $24,000 if as warranted, but it is worth only $20,000 as delivered. Juliet would recover $4,000 in damages for loss of value.

Cost Avoided The recovery by the injured party is reduced, however, by any cost or loss she has avoided by not having to perform. For example, Clinton agrees to build a hotel for Debra for $11 million by September 1. Clinton breaches by not completing construction until October 1. As a consequence, Debra loses revenues for one month in the amount of $400,000 but saves operat- ing expenses of $60,000. Therefore, she may recover damages for $340,000. Similarly, in a contract in which the injured party has not fully performed, the injured party’s recovery is reduced by the value to the injured party of the performance the injured party promised but did not render. For example, Victor agrees to convey land to Joan in return for Joan’s promise to work for Victor for two years. Joan repudiates the contract before Victor has conveyed the land to Joan. Victor’s recovery for loss from Joan is reduced by the value to Victor of the land.

Incidental Damages Incidental damages are damages that arise directly out of the breach, such as costs incurred to acquire the nondelivered performance from some other source. For example, Agnes employs Benton for nine months for $40,000 to supervise con- struction of a factory. She then fires Benton without cause after three weeks. Benton, who spends $850 in reasonable fees attempting to find comparable employ- ment, may recover $850 in incidental damages in addi- tion to any other actual loss he has suffered.

Consequential Damages Consequential dam- ages are damages not arising directly out of a breach but arising as a foreseeable result of the breach. Conse- quential damages include lost profits and injury to per- son or property. Thus, if Tracy leases to Sean a defective machine that causes $40,000 in property damage and

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$120,000 in personal injuries, Sean may recover, in addition to damages for loss of value and incidental damages, $160,000 as consequential damages.

PRACTICAL ADVICE If you are the provider of goods or services, consider including a contractual provision for the limitation or exclusion of consequential damages. If you are the purchaser of goods or services, avoid such limitations.

Reliance Damages [18-1b] Instead of seeking compensatory damages, a party injured by total breach or repudiation may seek reim- bursement for foreseeable loss caused by her reliance on the contract as measured by the cost or the value of the injured party’s performance. The purpose of reliance damages is to place the injured party in a posi- tion as good as the position she would have been in had the contract not been made. The Restatement of Restitu- tion provides that reliance damages for cost of perform- ance include the injured party’s uncompensated expenses incurred in preparing to perform, in actually performing, or in forgoing opportunities to enter into other con- tracts. Recovery based on cost of performance, however, is reduced by any loss the breaching party can prove with reasonable certainty that the injured party would have suffered had the contract been performed. Alterna- tively, reliance damages may be the market value of the injured party’s uncompensated contractual performance,

not exceeding the contract price of such performance. Limiting damages for the value of performance to the contract price prevents injured parties from choosing reliance damages to escape from an unfavorable bargain. In addition to recovering the cost or value of her performance, the injured party may also recover for any other loss, including incidental or consequential loss, caused by the breach.

An injured party may prefer damages for reliance to compensatory damages when she is unable to establish her lost profits with reasonable certainty. For example, Donald agrees to sell his retail store to Gary, who spends $750,000 in acquiring inventory and fixtures. Donald then repudiates the contract, and Gary sells the inventory and fixtures for $735,000. Because neither party can establish with reasonable certainty what profit Gary would have made, Gary may recover from Donald as damages the loss of $15,000 he sustained on the sale of the inventory and fixtures plus any other costs he incurred in entering into the contract.

Nominal Damages [18-1c] An action to recover damages for breach of contract may be maintained even though the plaintiff has not sustained or cannot prove any injury or loss resulting from the breach. In such case he will be permitted to recover nominal damages—a small sum fixed without regard to the amount of loss. Such a judgment may also include an award of court costs.

Business Law IN ACTION

When contracting parties litigate over a breach,does the losing party have to pay the winner’s attorneys’ fees? These fees may appear to qualify as con- sequential damages, direct consequences of the breach of contract. However, courts in this country follow what is known as the “American Rule,” which provides that each party pays its own attorneys’ fees, regardless of who wins. This rule holds true unless there is an applica- ble statute or express contract clause to the contrary. (Some states have statutes that specifically provide for an award of reasonable attorneys’ fees and costs to the pre- vailing party in certain suits arising out of contract.)

Even though the general rule is that attorneys’ fees are not awarded in breach of contract suits, proactive contracting parties can expressly provide in their contract that the losing party will pay the reasonable attorneys’

fees of the prevailing party. Many written contracts, particularly those that are drafted by lawyers, contain so-called attorneys’ fees provisions. An example of the language used follows: “In the event of any dispute aris- ing out of the performance or breach of this agreement, the prevailing party will be entitled to an award of rea- sonable attorneys’ fees.” Then if the parties end up liti- gating over the contract, the judge will be able to make the nonbreaching party whole by requiring the losing party to pay the winner’s reasonable attorneys’ fees, in addition to any other damages or relief granted.

However, absent an attorneys’ fees clause in the par- ties’ written agreement and without an attorneys’ fees statute in place, the general rule applies and attorneys’ fees will not be considered part of a litigating party’s damages.

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Damages for Misrepresentation [18-1d] The basic remedy for misrepresentation is rescission (avoidance) of the contract. When appropriate, restitu- tion will also be required. At common law, an alter- native remedy to rescission is a suit for damages. The Code liberalizes the common law by not restricting a defrauded party to an election of remedies. That is, the injured party may both rescind the contract by restoring the other party to the status quo and recover damages or obtain any other remedy available under the Code. In most states, the measure of damages for misrepresentation depends on whether the misrepresen- tation was fraudulent or nonfraudulent.

Fraud A party who has been induced by fraud to enter into a contract may recover general damages in a tort action. A minority of states allow the injured party to recover, under the “out-of-pocket” rule, gen- eral damages equal to the difference between the value of what she has received and the value of what she has given for it. The great majority of states, however, permit the intentionally defrauded party to recover, under the “benefit-of-the-bargain” rule, general dam- ages that are equal to the difference between the value of what she has received and the value of the fraudu- lent party’s performance as represented. The Restate- ment of Torts provides the fraudulently injured party with the option of either out-of-pocket or benefit-of- the-bargain damages. To illustrate, Emily intentionally misrepresents the capabilities of a printing press and thereby induces Melissa to purchase the machine for $20,000. Though the value of the press as delivered is $14,000, the machine would be worth $24,000 if it performed as represented. Under the out-of-pocket rule, Melissa would recover $6,000, whereas under the benefit-of-the-bargain rule, she would recover $10,000. In addition to a recovery of general damages under one of the measures just discussed, consequen- tial damages may be recovered to the extent they are proved with reasonable certainty and to the extent they do not duplicate general damages. Moreover, where the fraud is gross, oppressive, or aggravated, punitive damages are permitted. See Merritt v. Craig later in this chapter.

Nonfraudulent Misrepresentation When the misrepresentation is negligent, the deceived party may recover general damages (under the out-of-pocket meas- ure) and consequential damages. Furthermore, some states permit the recovery of general damages under the

benefit-of-the-bargain measure. When the misrepresen- tation is neither fraudulent nor negligent, however, the Restatement of Torts limits damages to the out-of- pocket measure.

Punitive Damages [18-1e] Punitive damages are monetary damages in addition to compensatory damages awarded to a plaintiff in cer- tain situations involving willful, wanton, or malicious conduct. Their purpose is to punish the defendant and thus discourage him, and others, from similar wrong- ful conduct. The purpose of allowing contract dam- ages, on the other hand, is to compensate the plaintiff for the loss sustained because of the defendant’s breach of contract. Accordingly, the Restatement pro- vides that punitive damages are not recoverable for a breach of contract unless the conduct constituting the breach is also a tort for which the plaintiff may recover punitive damages. See Merritt v. Craig later in this chapter.

Liquidated Damages [18-1f] A contract may contain a liquidated damages provi- sion by which the parties agree in advance to the dam- ages to be paid in event of a breach. Such a provision will be enforced if it amounts to a reasonable forecast of the loss that may or does result from the breach. If, however, the sum agreed on as liquidated damages bears no reasonable relationship to the amount of probable loss, it is unenforceable as a penalty. (A pen- alty is a contractual provision designed to deter a party from breaching her contract and to punish her for doing so.) Such equivalence is required because the objective of contract remedies is compensatory, not punitive. By examining the substance of the provision, the nature of the contract, and the extent of probable harm that a breach may reasonably be expected to cause the promisee, the courts will determine whether the agreed amount is proper as liquidated damages or unenforceable as a penalty. If a liquidated damages provision is not enforceable, the injured party never- theless is entitled to the ordinary remedies for breach of contract.

PRACTICAL ADVICE Consider including a contractual provision for reasonable liquidated damages, especially where damages will be difficult to prove.

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FACTS Arrowhead School District No. 75 is located in Park County, Montana, and consists of one school, Arrowhead School (School). For the 1997–98 school year, the School employed eleven full-time teachers and several part-time teachers. During that school year, the School employed James Klyap as a new teacher instructing math, language arts, and physical education for the sixth, sev- enth, and eighth grades. In addition, Klyap helped start a sports program and coached flag football, basketball, and volleyball. In June 1998, the School offered Klyap a contract for the 1998–99 school year, which he accepted. This contract provided for a $20,500 salary and included a liquidated damages clause. The clause calculated liqui- dated damages as a percentage of annual salary deter- mined by the date of breach; a breach of contract after July 20, 1998, required payment of 20 percent of salary as damages. Klyap also signed a notice indicating he accepted responsibility for familiarizing himself with the information in the teacher’s handbook, which also included the liquidated damages clause. On August 12, Klyap informed the School that he would not be returning for the 1998-99 school year even though classes were scheduled to start on August 26. The School then sought to enforce the liquidated damages clause in Klyap’s teach- ing contract for the stipulated amount of $4,100.

After Klyap resigned, the School attempted to find another teacher to take Klyap’s place. Although at the time Klyap was offered his contract the School had eighty potential applicants, only two viable applicants remained available. Right before classes started, the School was able to hire one of those applicants, a less- experienced teacher, at a salary of $19,500.

After a bench trial, the District Court determined the clause was enforceable because the damages suffered by the School were impractical and extremely difficult to fix. After concluding that the School took appropriate steps to mitigate its damages, the court awarded judg- ment in favor of the School in the amount of $4,100. Klyap appealed.

DECISION Judgment affirmed.

OPINION Nelson, J. The fundamental tenet of modern contract law is freedom of contract; parties are free to mutually agree to terms governing their private conduct as long as those terms do not conflict with

public laws. [Citation.] This tenet presumes that parties are in the best position to make decisions in their own interest. Normally, in the course of contract interpreta- tion by a court, the court simply gives effect to the agreement between the parties in order to enforce the private law of the contract. [Citation.] When one party breaches the contract, judicial enforcement of the con- tract ensures the nonbreaching party receives expectancy damages, compensation equal to what that party would receive if the contract were performed. [Citations.] By only awarding expectancy damages rather than addi- tional damages intended to punish the breaching party for failure to perform the contract, court enforcement of private contracts supports the theory of efficient breach. In other words, if it is more efficient for a party to breach a contract and pay expectancy damages in order to enter a superior contract, courts will not interfere by requiring the breaching party to pay more than was due under their contract. [Citation.]

Liquidated damages are, in theory, an extension of these principles. Rather than wait until the occurrence of breach, the parties to a contract are free to agree in advance on a specific damage amount to be paid upon breach. [Citation.] This amount is intended to predeter- mine expectancy damages. Ideally, this predetermination is intended to make the agreement between the parties more efficient. Rather than requiring a post-breach in- quiry into damages between the parties, the breaching party simply pays the nonbreaching party the stipulated amount. Further, in this way, liquidated damages clauses allow parties to estimate damages that are impractical or difficult to prove, as courts cannot enforce expectancy damages without sufficient proof.

*** In order to determine whether a clause should be

declared a penalty, courts attempt to measure the rea- sonableness of a liquidated damages clause. *** [T]he threshold indicator of reasonableness is whether the sit- uation involves damages of a type that are impractical or extremely difficult to prove. ***

According to RESTATEMENT § 356 and other trea- tises, damages must be reasonable in relation to the damages the parties anticipated when the contract was executed or in relation to actual damages resulting from the breach.

***

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Limitations on Damages [18-1g] To accomplish the basic purposes of contract remedies, the limitations of foreseeability, certainty, and mitiga- tion have been imposed upon monetary damages. These limitations are intended to ensure that damages can be taken into account at the time of contracting, that they are compensatory and not speculative, and that they do not include loss that could have been avoided by rea- sonable efforts.

Foreseeability of Damages Contracting parties are generally expected to consider foreseeable risks at the time they enter into the contract. Therefore, compen- satory or reliance damages are recoverable only for loss that the party in breach had reason to foresee as a prob- able result of a breach when the contract was made. The breaching party is not liable for loss that was not fore- seeable at the time of entering into the contract. The test of foreseeable damages is objective, based on what the breaching party had reason to foresee. Loss may be deemed foreseeable as a probable result of a breach because it followed from the breach (1) in the ordinary course of events or (2) as a result of special circumstan- ces, beyond the ordinary course of events, about which the party in breach had reason to know.

A leading case on the subject of foreseeability of dam- ages is Hadley v. Baxendale, decided in England in 1854. In this case, the plaintiffs operated a flour mill at Glouces- ter. Their mill was compelled to cease operating because of a broken crankshaft attached to the steam engine that furnished power to the mill. It was necessary to send the broken shaft to a foundry located at Greenwich so that a new shaft could be made. The plaintiffs delivered the bro- ken shaft to the defendants, who were common carriers, for immediate transportation from Gloucester to Green- wich, but did not inform the defendants that operation of the mill had ceased because of the nonfunctioning crank- shaft. The defendants received the shaft and promised to deliver the shaft for repairs the following day. The defendants, however, did not make delivery as promised; as a result, the mill did not resume operations for several days, causing the plaintiffs to lose profitable sales. The defendants contended that the loss of profits was too remote, and therefore unforeseeable, to be recoverable. Nonetheless, the jury, in awarding damages to the plain- tiffs, was permitted to take into consideration the loss of these profits. The appellate court reversed the decision and ordered a new trial on the ground that the plaintiffs had never communicated to the defendants the special cir- cumstances that caused the loss of profits, namely, the

*** Liquidated damages in a personal service con- tract induce performance by an employee by predeter- mining compensation to an employer if the employee leaves. However, the employer clearly prefers perform- ance by the specific employee because that employee was chosen for hire. *** Further, because personal ser- vice contracts are not enforceable by specific perform- ance, [citation], liquidated damages are an appropriate way for employers to protect their interests. ***

*** After reviewing the facts of this case, we hold that

while the 20% liquidated damages clause is definitely harsher than most, it is still within Klyap’s reasonable expectations and is not unduly oppressive. First, as the School pointed out during testimony, at such a small school teachers are chosen in part depending on how their skills complement those of the other teachers. Therefore, finding someone who would provide services equivalent to Klyap at such a late date would be virtu- ally impossible. This difficulty was born out when only two applicants remained available and the School hired a teacher who was less experienced than Klyap. ***

Second, besides the loss of equivalent services, the School lost time for preparation for other activities in order to attempt to find equivalent services. As the Dis- trict Court noted, the School had to spend additional

time setting up an interview committee and conducting interviews. Further, the new teacher missed all the staff development training earlier that year so individual training was required. And finally, because Klyap was essential to the sports program, the School had to spend additional time reorganizing the sports program as one sport had to be eliminated with Klyap’s loss. ***

*** Therefore, because as a teacher Klyap would know

teachers are typically employed for an entire school year and would know how difficult it is to replace equivalent services at such a small rural school, it was within Klyap’s reasonable expectations to agree to a contract with a 20% of salary liquidated damages provision for a departure so close to the start of the school year.

*** Accordingly, we hold the District Court correctly determined that the liquidated damages provision was enforceable.

INTERPRETATION A liquidated damages pro- vision is enforceable if it is a reasonable forecast of the harm caused by the breach.

CRITICAL THINKING QUESTION What limitations, if any, should the law impose upon liqui- dated damages? Explain.

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continued stoppage of the mill while awaiting the return of the repaired crankshaft. A common carrier, the court reasoned, would not reasonably have foreseen that the plaintiffs’ mill would be shut down as a result of delay in transporting the broken crankshaft. On the other hand, if the defendants in Hadley v. Baxendale had been informed that the shaft was necessary for the operation of the mill, or otherwise had reason to know this fact, they would be liable for the plaintiffs’ loss of profit during that period of the shutdown caused by their delay. Under these circumstances, the loss would be the “foreseeable” and “natural” result of the breach.

Should a plaintiff’s expected profit be extraordinarily large, the general rule is that the breaching party will be liable for such special loss only if he had reason to know of it. In any event, the plaintiff may recover for any ordi- nary loss resulting from the breach. Thus, if Madeline breaches a contract with Jane, causing Jane, due to special circumstances, $10,000 in damages when ordinarily such a breach would result in only $6,000 in damages, Madeline would be liable to Jane for $6,000, not $10,000, provided that Madeline was unaware of the special cir- cumstances causing Jane the unusually large loss.

PRACTICAL ADVICE Be sure to inform the other party to the contract of any “special circumstances” beyond the ordinary course of events that could result from a breach of contract.

Certainty of Damages Damages are not recov- erable for loss beyond an amount that the injured party can establish with reasonable certainty. If the injured party cannot prove a particular element of her loss with reasonable certainty, she nevertheless will be entitled to recover the portion of her loss that she can prove with reasonable certainty. The certainty requirement creates the greatest challenge for plaintiffs seeking the recovery of consequential damages for lost profits on related transactions. Similar difficulty arises in proving lost profits caused by breach of a contract to produce a sporting event or to publish a new book, for example.

Mitigation of Damages Under the doctrine of mitigation of damages, the injured party may not recover damages for loss that he could have avoided with reasonable effort and without undue risk, burden, or humiliation. Thus, if Earl is under a contract to man- ufacture goods for Karl and Karl repudiates the contract after Earl has begun performance, Earl will not be allowed to recover for losses he sustains by continuing to manufacture the goods, if to do so would increase the amount of damages. The amount of loss that reason- ably could have been avoided is deducted from the amount that otherwise would be recoverable as dam- ages. On the other hand, if the goods were almost com- pleted when Karl repudiated the contract, completing the goods might reduce the damages, because the fin- ished goods may be resalable whereas the unfinished goods may not.

Similarly, if Harvey contracts to work for Olivia for one year for a weekly salary and after two months is wrongfully discharged by Olivia, Harvey must use rea- sonable efforts to mitigate his damages by seeking other employment. If, after such effort, he cannot obtain other employment of the same general character, he is entitled to recover full pay for the contract period dur- ing which he is unemployed. He is not obliged to accept a radically different type of employment or to accept work at a distant place. For example, a person employed as a schoolteacher or accountant who is wrongfully discharged is not obliged to accept employ- ment as a chauffeur or truck driver. If Harvey does not seek other employment, then if Olivia proves with rea- sonable certainty that employment of the same general character was available, Harvey’s damages are reduced by the amount he could have earned. The next case involving Shirley MacLaine turns on whether acting in a Western is employment equivalent to singing and dancing in a musical.

PRACTICAL ADVICE If the other party to the contract breaches, be sure to make reasonable efforts to avoid or mitigate damages.

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FACTS Shirley MacLaine Parker, a well-known ac- tress, contracted with Twentieth Century Fox Film Cor- poration (Fox) in August 1965 to play the female lead in Fox’s upcoming production of Bloomer Girl, a motion

picture musical that was to be filmed in California. The contract provided that Fox would pay Parker a minimum “guaranteed compensation” of $750,000 for fourteen weeks of Parker’s services, beginning May 23, 1966. By

Chapter 18 Contract Remedies 371

REMEDIES IN EQUITY [18-2] At times, damages will not adequately compensate an injured party. In these cases, equitable relief in the form of specific performance or an injunction may be avail- able to protect the injured party’s interest. Such remedies are not a matter of right but rest in the discretion of the court. Consequently, they will not be granted when there is an adequate remedy at law; when it is impossible to enforce them, as when the seller has already transferred the subject matter of the contract to an innocent third

person; when the terms of the contract are unfair; when the consideration is grossly inadequate; when the con- tract is tainted with fraud, duress, undue influence, mis- take, or unfair practices; or when the relief would cause the defendant unreasonable hardship. On the other hand, a court may grant specific performance or an injunction despite a provision for liquidated damages. Moreover, a court will grant specific performance or an injunction even though a term of the contract prohibits equitable relief, if denying such relief would cause the injured party unreasonable hardship.

letter dated April 4, 1966, Fox notified Parker of its intention not to produce the film and, instead, offered to employ Parker in the female lead of another film entitled Big Country, Big Man, a dramatic Western to be filmed in Australia. The compensation offered and most of the other provisions in the substitute contract were identical to the Bloomer Girl provisions, except that Parker’s right to approve the director and screenplay would have been eliminated or reduced under the Big Country contract. Parker refused to accept and brought suit against Fox to recover $750,000 for breach of the Bloomer Girl con- tract. Fox contended that it owed no money to Parker because she had deliberately failed to mitigate or reduce her damages by unreasonably refusing to accept the Big Country lead. The trial court granted Parker a summary judgment. (The court’s opinion with respect to the rules for determining whether to grant summary judgment appears in Chapter 3.)

DECISION Judgment for Parker affirmed.

OPINION Burke, J. The general rule is that the measure of recovery by a wrongfully discharged em- ployee is the amount of salary agreed upon for the period of service, less the amount which the employer affirmatively proves the employee has earned or with reasonable effort might have earned from other employ- ment. [Citations.] However, before projected earnings from other employment opportunities not sought or accepted by the discharged employee can be applied in mitigation, the employer must show that the other employment was comparable, or substantially similar, to that of which the employee has been deprived; the employee’s rejection of or failure to seek other avail- able employment of a different or inferior kind may not be resorted to in order to mitigate damages. [Citations.]

*** Applying the foregoing rules to the record in the present

case, with all intendments in favor of the party opposing

the summary judgment motion—here, defendant—it is clear that the trial court correctly ruled that plaintiff’s fail- ure to accept defendant’s tendered substitute employment could not be applied in mitigation of damages because the offer of the Big Country lead was of employment both dif- ferent and inferior, and that no factual dispute was pre- sented on that issue. The mere circumstance that Bloomer Girl was to be a musical review calling upon plaintiff’s tal- ents as a dancer as well as an actress, and was to be pro- duced in the City of Los Angeles, whereas Big Country was a straight dramatic role in a “Western Type” story taking place in an opal mine in Australia, demonstrates the difference in kind between the two employments; the female lead as a dramatic actress in a western style motion picture can by no stretch of the imagination be considered the equivalent of or substantially similar to the lead in a song-and-dance production.

Additionally, the substitute Big Country offer pro- posed to eliminate or impair the director and screenplay approvals accorded to plaintiff under the original Bloomer Girl contract *** and thus constituted an offer of inferior employment. No expertise or judicial notice is required in order to hold that the deprivation or infringement of an employee’s rights held under an orig- inal employment contract converts the available “other employment” relied upon by the employer to mitigate damages, into inferior employment which the employee need not seek or accept. [Citation.]

INTERPRETATION An injured party’s dam- ages may not be reduced by mitigation for her failure to accept or seek other employment of a different or infe- rior kind.

ETHICAL QUESTION Was it fair for Twenti- eth Century Fox Film Corporation to expect Parker to act in the substitute film? Explain.

CRITICAL THINKING QUESTION Why should an injured party be required to mitigate damages?

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Another equitable remedy is reformation, a process whereby the court “rewrites” or “corrects” a written contract to make it conform to the true agreement of the parties. The purpose of reformation is not to make a new contract for the parties but to express adequately the contract they have made for themselves. The rem- edy of reformation is granted when the parties agree on a contract but write it in a way that inaccurately reflects their actual agreement. For example, Acme In- surance Co. and Bell agree that for good consideration, Acme will issue an annuity paying $500 per month. Because of a clerical error, the annuity policy is issued for $50 per month. A court of equity, upon satisfactory proof of the mistake, will reform the policy to pro- vide for the correct amount—$500 per month. In addi- tion, as discussed in Chapter 13, in cases in which a covenant not to compete is unreasonable, some courts will reform the agreement to make it reasonable and enforceable.

Specific Performance [18-2a] Specific performance is the equitable remedy that com- pels the defaulting party to perform her contractual obligations. As with all equitable remedies, it is avail- able only when there is no adequate remedy at law. Ordinarily, for instance, in a case in which a seller breaches a contract for the sale of personal property, the buyer has a sufficient remedy at law. When, how- ever, the personal property contracted for is rare or unique, this remedy is inadequate. Examples of such property would include a famous painting or statue, an

original manuscript or a rare edition of a book, a pat- ent, a copyright, shares of stock in a closely held corpo- ration, or an heirloom. Articles of this kind cannot be purchased elsewhere. Accordingly, on breach by the seller of the contract for the sale of any such article, money damages will not adequately compensate the buyer. Consequently, the buyer may avail herself of the equitable remedy of specific performance.

Although courts of equity will grant specific per- formance in connection with contracts for the sale of personal property only in exceptional circumstances, they will always grant it in case of breach of contract for the sale of real property. The reason for this is that every parcel of land is regarded as unique. Conse- quently, if the seller refuses to convey title to the real estate contracted for, the buyer may seek the aid of a court of equity to compel the seller to convey the title. Most courts of equity will likewise compel the buyer in a real estate contract to perform at the suit of the seller.

Courts of equity will not grant specific performance of contracts for personal services. In the first place, there is the practical difficulty, if not impossibility, of enforc- ing such a decree. In the second place, it is against the policy of the courts to force one person to work for or to serve another against his will, even though the person has contracted to do so. Such enforcement would closely resemble involuntary servitude. For example, if Carmen, an accomplished concert pianist, agrees to appear at a certain time and place to play a specified program for Rudolf, a court would not issue a decree of specific per- formance upon her refusal to appear.

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FACTS On September 15, 2011, Gerald Collins granted Garrett Prestenbach a one-year option to pur- chase about 150 acres of Collins’s farm and pasture land for $500,000. Prestenbach agreed to make a $25,000 down payment on the property and finance the remaining $475,000 through a combination of a $225,000 USDA loan and $250,000 financing agree- ment with Collins.

The option contract included the following details: (1) a recital of $100 consideration; (2) a township-and- range description of the property; (3) a reference to the buyer’s intent to obtain a USDA loan; (4) the total

purchase price; and (5) a recital that the option was irrevocable for the first three months and, after three months, the option could be revoked by giving ten days’ written notice. The parties also agreed that Col- lins would allow the USDA to inspect the property before closing.

About a month after granting Prestenbach the option to purchase his land, another buyer offered to buy Col- lins’s property immediately. Collins attempted to per- suade Prestenbach to give up his option so he could sell to the other party, but Prestenbach refused and quickly recorded the option contract to prevent the sale.

Chapter 18 Contract Remedies 373

By early December, relations between Collins and Prestenbach had deteriorated. On December 8, 2011, Collins’s attorney sent Prestenbach a letter attempting to terminate the one-year option. Prestenbach responded on December 16, 2011, by hand-delivering a letter exer- cising his option to purchase. At that time, the USDA loan process was nearly complete, and on December 22, 2011, the USDA conditionally approved Prestenbach’s loan.

Prestenbach tried to set a closing date for the loan, but Collins refused to move forward with the closing. Claiming that the option to purchase had been termi- nated, Collins denied the USDA’s request to inspect the property. He then filed an action against Prestenbach to establish ownership of the property. In response, Pre- stenbach filed an answer and a counterclaim for specific performance, stating he was “ready, willing, and able” to close the deal. Both parties filed motions for sum- mary judgment. The chancellor granted Collins’s motion for summary judgment and denied Prestenbach’s motion, finding that Prestenbach was not entitled to spe- cific performance because, at the time he exercised his option, he could not pay the entire $500,000 purchase price. Prestenbach appealed.

The Court of Appeals affirmed the chancellor’s judg- ment finding that Prestenbach was not entitled to “specific performance of [the] option contract,” because when he exercised his option, he “indisputably lacked the financing to purchase the property.” [Citation.] The Supreme Court of Mississippi then granted Presten- bach’s writ of certiorari.

DECISION The judgment of the Court of Appeals is reversed; case is remanded to the chancery court with instructions to render judgment for Prestenbach and to set a reasonable closing date.

OPINION Dickinson, P. J. The real-property option contract before us clearly provided how the option was to be exercised, and that a closing of the transaction would take place at some point following the exercise of the option. It further provided that “the purchase price shall be paid at the time of recording of [the] deed,” and that taxes and other assessments would be prorated “as of the date of the closing of the transaction.” So, while the contract required Prestenbach to pay the pur- chase price at “the closing of the transaction,” nothing in the contract suggests that he was required to pay—or demonstrate his ability to pay—the purchase price prior to closing.

While an option contract is not a contract to sell, it morphs into a sales contract when the option holder exercises the option. [Citations.] When the option holder

exercises the option “the option-giver has no choice but to sell when the option is accepted according to its terms.” [Citation.] A valid and enforceable option con- tract requires: (1) an adequate description of the prop- erty, (2) consideration, and (3) a date when the option must be exercised. [Citation.] ***

When the option holder exercises the option to pur- chase, the option holder “is entitled to specific per- formance of the optionor’s duty to convey, so long as the holder is willing to pay the option price.” [Cita- tion.] If an option subject to financing does not specify when the sale must take place, “the court may decree a reasonable time [for performance].” [Citations.] And where the parties fail to include a closing date for the resulting sale, the closing date is “to be within a rea- sonable time from the date of exercising the option.” [Citation.]

In this case, Collins and Prestenbach created a valid and enforceable option to purchase real property and Prestenbach timely exercised this option. When Presten- bach exercised his option to purchase, the option con- tract became an enforceable contract to sell and Prestenbach had the right to specifically enforce that contract. In the absence of a definite closing date in the option contract, it must be presumed that the parties intended that the sale would take place within a reason- able time after Prestenbach exercised his option to pur- chase. And Prestenbach was required to present himself at the closing with the purchase price as specified in the contract.

Absent language in the contract to the contrary, an option holder has no obligation or duty to show an ability to pay the entire sales price before the closing. Instead, by exercising the option, the option holder becomes bound to purchase the property at the closing, according to the terms of the contract. Prestenbach was entitled to set a closing date within a reasonable time following his exercise of the option. He attempted to do so, but Collins refused to cooperate. Thus, Prestenbach is entitled to specific performance, and the chancellor erred in denying Prestenbach’s motion for summary judgment.

INTERPRETATION When an option holder exercises the option to purchase, the option holder/ purchaser is entitled to specific performance of the sell- er’s duty to convey, so long as the purchaser is willing to pay the option price.

CRITICAL THINKING QUESTION What remedies are available to the seller if the option holder/ purchaser is unable to obtain financing and therefore cannot pay the purchase price?

374 Contracts Part III

Injunction [18-2b] An injunction, as used as a contract remedy, is a formal court order enjoining (commanding) a person to refrain from doing a specific act or to cease engaging in specific conduct. A court of equity, at its discretion, may grant an injunction against breach of a contractual duty when dam- ages for a breach would be inadequate. For example, Clint enters into a written contract to give Janice the right of first refusal on a tract of land owned by Clint. Clint, how- ever, subsequently offers the land to Blake without first offering it to Janice. A court of equity may properly enjoin Clint from selling the land to Blake. Similarly, valid cove- nants not to compete may be enforced by an injunction.

An employee’s promise of exclusive personal services may be enforced by an injunction against serving another employer as long as the probable result will not deprive

the employee of other reasonable means of making a liv- ing. Suppose, for example, that Allan makes a contract with Marlene, a famous singer, under which Marlene agrees to sing at Allan’s theater on certain dates for an agreed-upon fee. Before the date of the first performance, Marlene makes a contract with Craig to sing for Craig at his theater on the same dates. Although, as we have dis- cussed, Allan cannot obtain specific performance of his contract by Marlene, a court of equity will, on suit by Allan against Marlene, issue an injunction against her, ordering her not to sing for Craig. This is the situation in the case of Madison Square Garden Corp., Ill. v. Carnera.

In cases in which the services contracted for are not unusual or extraordinary in character, the injured party cannot obtain injunctive relief. His only remedy is an action at law for damages.

M A D I S O N S Q U A R E G A R D E N C O R P . , I L L . V . C A R N E R A U n i t e d S t a t e s C o u r t o f A p p e a l s , S e c o n d C i r c u i t , 1 9 3 1

5 2 F . 2 d 4 7

FACTS Carnera (defendant) agreed with Madison Square Garden (plaintiff) to render services as a boxer in his next contest with the winner of the Schmeling-Stri- bling contest for the heavyweight championship title. The contract also provided that prior to the match Carnera would not engage in any major boxing contest without the permission of Madison Square Garden. Without obtaining such permission, Carnera contracted to engage in a major boxing contest with Sharkey. Madison Square Garden brought suit requesting an injunction against Carnera’s performing his contract to box Sharkey. The trial court granted a preliminary injunction.

DECISION Order for Madison Square Garden affirmed.

OPINION Chase, J. The District Court has found on affidavits which adequately show it that the defend- ant’s services are unique and extraordinary. A negative covenant in a contract for such personal services is en- forceable by injunction where the damages for a breach are incapable of ascertainment. [Citations.]

The defendant points to what is claimed to be lack of consideration for his negative promise, in that the contract is inequitable and contains no agreement to employ him. It is true that there is no promise in so many words to employ the defendant to box in a contest with Stribling or Schmeling, but the agreement read as a whole binds the plaintiff to do just that, providing either Stribling or

Schmeling becomes the contestant as the result of the match between them and can be induced to box the de- fendant. The defendant has agreed to “render services as a boxer” for the plaintiff exclusively, and the plaintiff has agreed to pay him a definite percentage of the gate receipts as his compensation for so doing. The promise to employ the defendant to enable him to earn the compensation agreed upon is implied to the same force and effect as though expressly stated. *** [Citations.]

As we have seen, the contract is valid and enforceable. It contains a restrictive covenant which may be given effect. Whether a preliminary injunction shall be issued under such circumstances rests in the sound discretion of the court. [Citations.] The District Court, in its discretion, did issue the preliminary injunction and required the plaintiff as a condition upon its issuance to secure its own perform- ance of the contract in suit with a bond for $25,000 and to give a bond in the sum of $35,000 to pay the defendant such damages as he may sustain by reason of the injunc- tion. Such an order is clearly not an abuse of discretion.

INTERPRETATION When damages are not ade- quate, an injunction may be used to enforce an agree- ment to perform exclusive services that are unusual and extraordinary.

CRITICAL THINKING QUESTION Should money damages have been an adequate remedy in this case? Explain.

Chapter 18 Contract Remedies 375

RESTITUTION [18-3] One of the remedies that may be available to a party to a contract is restitution. Restitution is the act of return- ing to the aggrieved party the consideration, or its value, that he gave to the other party. The purpose of restitution is to restore the injured party to the position he was in before the contract was made. Therefore, the party seeking restitution must return what has been received from the other party.

Restitution is available in several contractual situa- tions: (1) for a party injured by breach, as an alterna- tive remedy; (2) for a party in default; (3) for a party who may not enforce a contract because of the statute of frauds; and (4) for a party wishing to rescind (avoid) a voidable contract.

Party Injured by Breach [18-3a] The Restatement of Restitution provides that a party is entitled to restitution if the other party totally breaches the contract by nonperformance or repudiation. For example, Benedict agrees to sell land to Beatrice for $60,000. After Beatrice makes a partial payment of $15,000, Benedict wrongfully refuses to transfer title. As an alternative to damages or specific performance, Beatrice may recover the $15,000 in restitution. The Restatement of Restitution provides, however, that res- titution as a remedy for breach of contract is not avail- able against a defendant whose defaulted obligation is exclusively an obligation to pay money. Thus, restitu- tion as an alternative contract remedy is available to a prepaying buyer but not to a credit seller.

Party in Default [18-3b] The Restatement of Restitution provides that a partly performing party whose material breach prevents a recovery on the contract has a claim in restitution against the recipient of performance, as necessary to prevent unjust enrichment. Thus, if a party, after hav- ing partly performed, commits a breach by nonper- formance or repudiation that discharges the other party’s duty to perform, the party in default is entitled to restitution for any benefit she has conferred in excess of the loss she has caused by the breach. For example, Nathan agrees to sell land to Milly for $160,000, and Milly makes a partial payment of $15,000. Milly then repudiates the contract. Nathan sells the land to Mur- ray in good faith for $155,000. Milly may recover from Nathan in restitution the part payment of the $15,000 less the $5,000 damages Nathan sustained because of Milly’s breach, which equals $10,000.

Statute of Frauds [18-3c] The Restatement of Restitution provides that a person who renders performance under an agreement that cannot be enforced by reason of the failure to satisfy the statute of frauds has a claim in restitution to prevent unjust enrich- ment. In such a case, that party may recover in restitution the benefits he directly conferred on the other as the per- formance required or invited by the unenforceable con- tract. Thus, if Wilton makes an oral contract to furnish services to Rochelle that are not to be performed within a year and Rochelle discharges Wilton after three months, Wilton may recover in restitution the value of the services rendered during the three months. Similarly, Sanford enters into an oral contract to sell land to Betty, and Betty pays a portion of the price as a down payment. Sanford subsequently repudiates the oral contract. Betty may recover in restitution the portion of the price she paid.

Voidable Contracts [18-3d] A party who has rescinded or avoided a contract for lack of capacity, duress, undue influence, fraud in the inducement, nonfraudulent misrepresentation, or mistake is entitled to restitution for any benefit he has conferred on the other party. Generally, the party seeking restitu- tion must return any benefit that he has received under the agreement; however, as we found in our discussion of contractual capacity (Chapter 14), this is not always the case. The Restatement of Restitution provides

Rescission requires a mutual restoration and accounting in which each party (a) restores property received from the other, to the extent such restoration is feasible, (b) accounts for addi- tional benefits obtained at the expense of the other as a result of the transaction and its subsequent avoidance, as necessary to prevent unjust enrichment, and (c) compensates the other for loss from related expenditure as justice may require.

For example, Samuel fraudulently induces Jessica to sell land for $160,000. Samuel pays the purchase price, and Jessica conveys the land. Jessica then discovers the fraud. Jessica may disaffirm the contract and recover the land as restitution, but she must return the $160,000 purchase price to Samuel.

Figure 18-1 summarizes the remedies for breach of contract.

LIMITATIONS ON REMEDIES [18-4]

Election of Remedies [18-4a] If a party injured by a breach of contract has more than one remedy available, her manifestation of a

376 Contracts Part III

choice of one remedy, such as bringing suit, does not prevent seeking another unless the remedies are inconsis- tent and the other party materially changes his position in reliance on the manifestation. For example, a party who seeks specific performance, an injunction, or restitu- tion may be entitled to incidental damages, such as those brought about by delay in performance. Damages for total breach, however, are inconsistent with the remedies of specific performance, injunction, and restitution. Like- wise, the remedy of specific performance or an injunc- tion is inconsistent with that of restitution.

With respect to contracts for the sale of goods, the Code rejects any doctrine of election of remedies. Thus, the remedies it provides, which are essentially cumulative, include all of the remedies available for breach. Under the Code, whether one remedy prevents the use of another depends on the facts of the individ- ual case.

Loss of Power of Avoidance [18-4b] A party with a power of avoidance for lack of capacity, duress, undue influence, fraud, misrepresentation, or mistake may lose that power if (1) she affirms the con- tract, (2) she delays unreasonably in exercising the power of disaffirmance, or (3) the rights of third parties intervene.

Affirmance A party who has the power to avoid a contract for lack of capacity, duress, undue influence,

fraud in the inducement, nonfraudulent misrepresenta- tion, or mistake will lose that power by affirming the contract. Affirmance occurs when the party, with full knowledge of the facts, either declares the inten- tion to proceed with the contract or takes some other action from which such intention may reasonably be inferred. Thus, suppose that Pam was induced to pur- chase a ring from Sally through Sally’s fraudulent misrepresentation. If, after learning the truth, Pam undertakes to sell the ring to Janet or does something else that is consistent only with her ownership of the ring, she may no longer rescind the transaction with Sally. In the case of incapacity, duress, or undue influence, affirmance is effective only after the circum- stances that made the contract voidable cease to exist. In cases in which there has been fraudulent misrepre- sentation, the defrauded party may affirm only after he knows of the misrepresentation; if the misrepresen- tation is nonfraudulent or a mistake is involved, af- firmance may occur only after the defrauded party knows or should know of the misrepresentation or mistake.

PRACTICAL ADVICE If you have the power to avoid a contract, do not affirm the contract unless you are sure you wish to relinquish your right to rescind the contract.

FIGURE 18-1 Contract Remedies

No

Yes

Yes

No

Has the contract been breached?

Are legal remedies adequate?

No

Yes

Is there a provision for reasonable

liquidated damages?

Compensatory Damages

Reliance Damages Restitution

No Remedy

Equitable Remedies May be Available

Recovery of Liquidated Damages

Chapter 18 Contract Remedies 377

M E R R I T T V . C R A I G C o u r t o f S p e c i a l A p p e a l s o f M a r y l a n d , 2 0 0 0

1 3 0 M d . A p p . 3 5 0 , 7 4 6 A . 2 d 9 2 3 ; c e r t i o r a r i d e n i e d , 3 5 9 M d . 2 9 , 7 5 3 A . 2 d 2 ( 2 0 0 0 )

FACTS In the fall of 1995, during their search for a new residence, the plaintiffs, Benjamin and Julie Merritt, advised the defendant, Virginia Craig, that they were interested in purchasing Craig’s property contingent upon a satisfactory home inspection. On November 5, 1995, the plaintiffs, their inspector, and the defendant’s husband Mark Craig conducted an inspection of the cistern and water supply pipes in the basement. The examination revealed that the cistern had been used to store a water supply reserve, but was not currently utilized. There were also two water lines that entered into the basement. One of the lines came from an eight-hundred-foot well that was located on the property, and the other line came from a well located on the adjacent property. The well located on the adjacent property supplied water to both the residence and a guesthouse owned by Craig. The exis- tence of the adjacent well was not disclosed to the plaintiffs.

On December 2, 1995, plaintiffs and Craig executed a contract of sale for the property, along with a “Disclosure Statement” signed by Craig and acknowl- edged by the plaintiffs affirming that there were no problems with the water supply to the house. Between November 5, 1995, and June 1996, Craig caused the water line from the guesthouse to the house purchased by the plaintiffs to be cut, and the cistern reactivated to store water from the existing well. On May 18, 1996, Craig’s husband advised Dennis Hannibal, one of the real estate agents involved in the deal, that he had spent $4,196.79 to upgrade the water system on the property. On June 14, 1996, the plaintiffs and Craig closed the sale of the property. Later that afternoon, Craig’s hus- band, without the plaintiffs’ knowledge, excavated the inside wall of the house and installed a cap to stop a leaking condition on the water line that he had previ- ously cut.

Upon taking possession of the house the plaintiffs noticed that the water supply in their well had depleted. The plaintiffs met with Craig to discuss a solution to the water failure problem, agreeing with Craig to con- duct a flow test to the existing well and to contribute money for the construction of a new well. On October 29, 1996, the well was drilled and produced only one- half gallon of water per minute. Subsequently plaintiffs paid for the drilling of a second well on their pro- perty, but it failed to produce water. In January 1997,

appellants contacted a plumber, who confirmed that the line from the guesthouse well had been cut flush with the inside surface of the basement wall and cemented closed. Plaintiffs continued to do further work on the house in an effort to cure the water problem. The plain- tiffs brought suit against Craig, seeking rescission of the deed to the property and contract of sale, along with compensatory and punitive damages. The trial judge dis- missed plaintiffs’ claim for rescission on the ground that they had effectively waived their right to rescission. The jury returned a verdict in favor of the plaintiffs, awarding compensatory damages in the amount of $42,264.76 and punitive damages in the amount of $150,000. The plain- tiffs appealed the trial court’s judgment denying their right to rescind the contract. The defendant cross- appealed on the award of punitive damages.

DECISION Judgment of the trial court reversed, and the case is remanded.

OPINION Davis, J. Under Maryland law, when a party to a contract discovers that he or she has been defrauded, the party defrauded has either “a right to retain the contract and collect damages for its breach, or a right to rescind the contract and recover his or her own expenditures,” not both. [Citations.] “These rights [are] inconsistent and mutually exclusive, and the dis- covery put[s] the purchaser to a prompt election.” [Cita- tion.] “A plaintiff seeking rescission must demonstrate that he [or she] acted promptly after discovery of the ground for rescission,” otherwise the right to rescind is waived. [Citations.] ***

In [this] case *** , appellants [plaintiffs] claim that they were entitled to a rescission of the subject contract of sale and deed and incidental damages. Appellants also claim that they were entitled to compensatory and punitive damages arising from Craig’s actions. Appel- lants, however, may not successfully rescind the con- tract while simultaneously recovering compensatory and punitive damages. Restitution is “a party’s unilateral unmaking of a contract for a legally sufficient reason, such as the other party’s material breach” and it in effect “restores the parties to their pre-contractual posi- tion.” [Citation.] The restoration of the parties to their original position is incompatible with the circumstance when the complaining party is, at once, relieved of all

378 Contracts Part III

Delay The power of avoidance may be lost if the party who has the power to do so does not rescind within a reasonable time after the circumstances that made the contract voidable have ceased to exist. Determining a reasonable time depends on all the circumstances, including the extent to which the

delay enables the party with the power of avoidance to speculate at the other party’s risk. To illustrate, a defrauded purchaser of stock cannot wait unduly to see whether the market price or value of the stock appreciates sufficiently to justify retaining the stock.

obligations under the contract while simultaneously securing the windfall of compensatory and punitive damages beyond incidental expenses.

*** In sum, although whether appellants promptly repudi-

ated the contract was not squarely before the court, we are not persuaded by appellees’ assertion that appellants did not seek rescission in a timely fashion. We hold that, under the facts of this case, appellants must elect the form of relief, i.e., damages or rescission, *** . ***

*** We hold that *** the appellants are entitled to be

awarded punitive damages resulting from Craig’s actions. A “[p]laintiff seeking to recover punitive dam- ages must allege in detail in the complaint the facts that indicate the entertainment by defendant of evil motive or intent.” [Citation.] The Court of Appeals has held that “punitive damages may only be awarded in such cases where ‘the plaintiff has established that the defendant’s conduct was characterized by evil motive, intent to injure, ill will or fraud *** ’”. [Citation.] In cases of fraud that arise out of a contractual relation- ship, the plaintiff would have to establish actual malice to recover punitive damages. [Citation.] Finally, we have stated that “actual or express malice requires an intentional or willful act (or omission) *** and ‘has been characterized as the performance of an act with- out legal justification or excuse, but with an evil or rancorous motive influenced by hate, the purpose being to deliberately and willfully injure the plaintiff.’” [Citation.]

*** The jury believed that the representations made by

Craig were undertaken with actual knowledge that the representations were false and with the intention to deceive appellants. The Court of Appeals, in [citation], held that a person’s actual knowledge that the statement is false, coupled with his or her intent to deceive the plaintiffs by means of that statement, constitutes the actual malice required to support an award for punitive damages. [Citation.] Moreover, the record reflects that

the jury could reasonably infer Craig’s intention to defraud appellants by her representation in the Disclosure Statement that there were no problems with the water supply, and by subsequently making substantial changes in the water system by cutting off a water line which sup- plied water to appellants’ residence immediately after appellants’ inspector examined the system. Therefore, we hold that the circuit court was not in error in finding facts from the record sufficient to support an award of punitive damages.

Craig also challenges the punitive damages award on the basis that the amount of the award was exces- sive. ***

In the case at hand, the trial judge undertook the appropriate review of the jury’s award. It is clear from the court’s comments at the hearing that the court’s decision not to disturb the jury’s verdict was based on the evidence presented at trial and was not excessive under the criteria set forth in [citation]. Craig’s conduct toward appellants was reprehensible and fully war- ranted punitive damages. Her conduct in willfully mis- representing the condition of the water system in the Disclosure Statement, coupled with her actions and those of her husband in interfering and diverting the water flow subsequent to the inspection and sale of the property, constitute egregious conduct. As a result of Craig’s conduct, appellants were forced to employ extreme water conservation practices due to an insuffi- cient water supply and they attempted to ameliorate the problem by having two new wells drilled on the prop- erty which proved to be unproductive. Moreover, the lack of water supply to appellants’ property clearly reduced its market value. ***

INTERPRETATION A defrauded party may re- scind a contract induced by fraud but may lose that power if he affirms the contract or delays unreasonably in exercising the power of rescission.

CRITICAL THINKING QUESTION What is the policy reason for requiring a defrauded party to elect between rescission and damages? Explain.

Chapter 18 Contract Remedies 379

PRACTICAL ADVICE If you have the power to avoid a contract, be sure to rescind within a reasonable time, or you will forfeit your right to do so.

Rights of Third Parties The intervening rights of third parties further limit the power of avoidance and the accompanying right to restitution. If A trans- fers property to B in a transaction that is voidable by A, and B sells the property to C (a good faith purchaser for value) before A exercises the power of avoidance, A will lose the right to recover the property.

Thus, if a third party (C), who is a good faith pur- chaser for value, acquires an interest in the subject matter of the contract before A has elected to rescind, no rescission is permitted. Because the transaction is voidable, B acquires a voidable title to the property. Upon a sale of the property by B to C, who is a pur- chaser in good faith and for value, C obtains good title and is allowed to retain the property. Because both A and C are innocent, the law will not disturb the title held by C, the good faith purchaser. In this case, as in

all cases in which rescission is not available, A’s only recourse is against B.

A

C

B property

voidable

May not recover property

Good faith purchaser

property$

The one notable exception to this rule is the situa- tion involving a sale, other than a sale of goods, by a minor who subsequently wishes to avoid the transac- tion, in which the property has been retransferred to a good faith purchaser. Under this special rule, a good faith purchaser is deprived of the protection generally provided such third parties. Therefore, the third party in a transaction not involving goods, real property being the primary example, is no more protected from the minor’s disaffirmance than is the person dealing directly with the minor.

C H A P T E R S U M M A R Y Monetary Damages

Compensatory Damages contract damages placing the injured party in a position as good as the one he would have held had the other party performed; equals loss of value minus loss avoided by injured party plus incidental damages plus consequential damages • Loss of Value value of promised performance minus value of actual performance • Cost Avoided loss or costs the injured party avoids by not having to perform • Incidental Damages damages arising directly out of a breach of contract • Consequential Damages damages not arising directly out of a breach but arising as a

foreseeable result of the breach

Reliance Damages contract damages placing the injured party in as good a position as she would have been in had the contract not been made

Nominal Damages a small sum awarded when a contract has been breached but the loss is negligible or unproved

Damages for Misrepresentation • Out-of-Pocket Damages difference between the value given and the value received • Benefit-of-the-Bargain Damages difference between the value of the fraudulent party’s

performance as represented and the value the defrauded party received

Punitive Damages are generally not recoverable for breach of contract

Liquidated Damages reasonable damages agreed to in advance by the parties to a contract

Limitations on Damages • Foreseeability of Damages potential loss that the party now in default had reason to know of

when the contract was made

380 Contracts Part III

• Certainty of Damages damages are not recoverable beyond an amount that can be established with reasonable certainty

• Mitigation of Damages injured party may not recover damages for loss he could have avoided by reasonable effort

Remedies in Equity

Availability only in cases in which there is no adequate remedy at law

Types • Specific Performance court decree ordering the breaching party to render promised performance • Injunction court order prohibiting a party from doing a specific act • Reformation court order correcting a written contract to conform with the intent of the

contracting parties

Restitution

Definition of Restitution restoration of the injured party to the position she was in before the contract was made

Availability • Party Injured by Breach if the other party totally breaches the contract by nonperformance or

repudiation • Party in Default for any benefit conferred in excess of the loss caused by the party in default’s

breach • Statute of Frauds where a contract is unenforceable because of the statute of frauds, a party

may recover the benefits conferred on the other party in performance of the contract • Voidable Contracts a party who has rightfully avoided a contract is entitled to restitution for

any benefit conferred on the other party but generally must return any benefit that he has received under the contract

Limitations on Remedies

Election of Remedies if remedies are not inconsistent, a party injured by a breach of contract may seek more than one remedy

Loss of Power of Avoidance a party with the power to avoid a contract may lose that power by • Affirming the contract • Delaying unreasonably in exercising the power of avoidance • Being subordinated to the intervening rights of third parties

Q U E S T I O N S

1. Edward, a candy manufacturer, contracted to buy one thousand barrels of sugar from Marcia. Marcia failed to deliver, and Edward was unable to buy any sugar in the market. As a direct consequence he was unable to make candies to fulfill unusually lucrative contracts for the Christmas trade. (a) What damages is Edward entitled to recover? (b) Would it make any difference if Marcia had been told by Edward that he wanted the sugar to make candies for the Christmas trade and that he had accepted lucrative contracts for delivery for the Christmas trade?

2. Daniel agreed that he would erect an apartment building for Steven for $12 million and that Daniel would suffer a deduction of $12,000 per day for every day of delay. Daniel was twenty days late in finishing the job, losing

ten days because of a strike and ten days because the material suppliers were late in furnishing him with materi- als. Daniel claims that he is entitled to payment in full (a) because the agreement as to $12,000 a day is a penalty and (b) because Steven has not shown that he has sus- tained any damage. Discuss each contention and decide.

3. Sharon contracted with Jane, a shirtmaker, for one thou- sand shirts for men. Jane manufactured and delivered five hundred shirts, for which Sharon paid. At the same time, Sharon notified Jane that she could not use or dispose of the other five hundred shirts and directed Jane not to man- ufacture any more under the contract. Nevertheless, Jane made up the other five hundred shirts and tendered them to Sharon. Sharon refused to accept the shirts. Jane then

Chapter 18 Contract Remedies 381

sued for the purchase price. Is she entitled to the purchase price? If not, is she entitled to any damages? Explain.

4. Stuart contracts to act in a comedy for Charlotte and to comply with all theater regulations for four seasons. Char- lotte promises to pay Stuart $1,800 for each performance and to allow Stuart one benefit performance each season. It is expressly agreed “Stuart shall not be employed in any other production for the period of the contract.” Stuart and Charlotte, during the first year of the contract, have a terrible quarrel. Thereafter, Stuart signs a contract to per- form in Elaine’s production and ceases performing for Charlotte. Charlotte seeks (a) to prevent Stuart from per- forming for Elaine and (b) to require Stuart to perform his contract with Charlotte. What result?

5. Louis leased a building to Pam for five years at a rental of $1,000 per month. Pam was to deposit $10,000 as security for performance of all her promises in the lease, which was to be retained by Louis in case of any breach on Pam’s part. Pam defaulted in the payment of rent for the last two months of the lease. Louis refused to return any of the deposit, claiming it as liquidated damages. Pam sued Louis to recover $8,000 (the $10,000 deposit less the amount of rent due Louis for the last two months). What amount of damages should Pam be allowed to col- lect from Louis? Explain.

6. In which of the following situations is specific perform- ance available as a remedy?

a. Mary and Anne enter into a written agreement under which Mary agrees to sell and Anne agrees to buy for $100 per share one hundred shares of the three hun- dred shares outstanding of the capital stock of the In- finitesimal Steel Corporation, whose shares are not listed on any exchange and are closely held. Mary refuses to deliver when tendered the $10,000.

b. Modifying (a), assume that the subject matter of the agreement is stock of the U.S. Steel Corporation, which is traded on the New York Stock Exchange.

c. Modifying (a), assume that the subject matter of the agreement is undeveloped farmland of little commer- cial value.

7. On March 1, Joseph sold to Sandra fifty acres of land in Oregon that Joseph at the time represented to be fine black loam, high, dry, and free of stumps. Sandra paid Joseph the agreed price of $140,000 and took from Joseph a deed to the land. Sandra subsequently discov- ered that the land was low, swampy, and not entirely free of stumps. Sandra, nevertheless, undertook to convert the greater part of the land into cranberry bogs. After one year of cranberry culture, Sandra became entirely dissatis- fied, tendered the land back to Joseph, and demanded from Joseph the return of the $140,000. On Joseph’s refusal to repay the money, Sandra brought an action at law against him to recover the $140,000. What judgment?

8. James contracts to make repairs to Betty’s building in return for Betty’s promise to pay $12,000 on completion of the repairs. After partially completing the repairs, James is unable to continue. Betty refuses to pay James and hires another builder, who completes the repairs for $5,000. The building’s value to Betty has increased by $10,000 as a result of the repairs by James, but Betty has lost $500 in rents because of the delay caused by James’s breach. James sues Betty. How much, if any, may James recover in restitution from Betty?

9. Linda induced Sally to enter into a purchase of a home theater receiver by intentionally misrepresenting the power output to be seventy-five watts at rated distortion, when in fact it delivered only forty watts. Sally paid $450 for the receiver. Receivers producing forty watts generally sell for $200, whereas receivers producing seventy-five watts generally sell for $550. Sally decides to keep the receiver and sue for damages. How much may Sally recover in damages from Linda?

10. Virginia induced Charles to sell Charles’s boat to Vir- ginia by misrepresentation of material fact on which Charles reasonably relied. Virginia promptly sold the boat to Donald, who paid fair value for it and knew nothing concerning the transaction between Virginia and Charles. Upon discovering the misrepresentation, Charles seeks to recover the boat. What are Charles’s rights against Virginia and Donald?

C A S E P R O B L E M S

11. Felch was employed as a member of the faculty of Findlay College under a contract that permitted dismissal only for cause. He was dismissed by action of the President and Board of Trustees, which did not comply with a contrac- tual provision for dismissal that requires a hearing. Felch requested the court to grant specific performance of the contract and require Findlay College to continue Felch as a member of the faculty and to pay him the salary agreed upon. Is Felch entitled to specific performance? Explain.

12. Copenhaver, the owner of a laundry business, contracted with Berryman, the owner of a large apartment complex, to allow Copenhaver to own and operate the laundry facilities within the apartment complex. Berryman termi- nated the five-year contract with Copenhaver with forty- seven months remaining. Within six months, Copenhaver placed the equipment into use in other locations and gen- erated at least as much income as he would have earned at Berryman’s apartment complex. He then filed suit,

382 Contracts Part III

claiming that he was entitled to conduct the laundry operations for an additional forty-seven months and that, through such operations, he would have earned a profit of $13,886.58, after deducting Berryman’s share of the gross receipts and other operating expenses. Decision?

13. Billy Williams Builders and Developers (Williams) entered into a contract with Hillerich under which Williams agreed to sell to Hillerich a certain lot and to construct on it a house according to submitted plans and specifica- tions. The house built by Williams was defectively con- structed. Hillerich brought suit for specific performance of the contract and for damages resulting from the defec- tive construction and delay in performance. Williams argued that Hillerich was not entitled to have both spe- cific performance and damages for breach of the contract because the remedies were inconsistent and Hillerich had to elect one or the other. Explain whether Williams is correct in this assertion.

14. Developers under a plan approved by the city of Rye had constructed six luxury cooperative apartment buildings and were to construct six more. To obtain certificates of occupancy for the six completed buildings, the developers were required to post a bond with the city to assure com- pletion of the remaining buildings. The developers posted a $100,000 bond upon which Public Service Mutual In- surance Company, as guarantor or surety, agreed to pay $200 for each day after the contractual deadline that the remaining buildings were not completed. After the con- tractual deadline, more than five hundred days passed without completion of the buildings. The city claims that its inspectors and employees will be required to devote more time to the project than anticipated because it has taken extra years to complete. It also claims that it will lose tax revenues for the years the buildings are not com- pleted. Should the city prevail in its suit against the devel- opers and the insurance company to recover $100,000 on the bond? Explain.

15. Kerr Steamship Company sent a telegram at a cost of $26.78 to the Philippines through the Radio Corporation of America. The telegram, which contained instructions in unintelligible code for loading cargo on one of Kerr’s ships, was mislaid and never delivered. Consequently, the ship was improperly loaded and the cargo was lost. Kerr sued the Radio Corporation for the $6,675.29 in profits the company lost on the cargo because of the Radio Cor- poration’s failure to deliver the telegram. Should Kerr be allowed to recover damages from Radio? Explain.

16. El Dorado Tire Company fired Bill Ballard, a sales execu- tive. Ballard had a five-year contract with El Dorado but was fired after only two years of employment. Ballard sued El Dorado for breach of contract. El Dorado claimed that any damages due to breach of the contract should be mitigated because of Ballard’s failure to seek other employment after he was fired. El Dorado did not

provide any proof showing the availability of comparable employment. Explain whether El Dorado is correct in its contention.

17. California and Hawaiian Sugar Company (C and H) is an agricultural cooperative in the business of growing sugarcane in Hawaii and transporting the raw sugar to its refinery in California for processing. Because of the seasonal nature of the sugarcane crop, availability of ships to transport the raw sugar immediately after har- vest is imperative. After losing the services of the ship- ping company it had previously used, C and H decided to build its own ship, a Macababoo, which had two components, a tug and a barge. C and H contracted with Halter Marine to build the tug and with Sun Ship to build the barge. In finalizing the contract for construction of the barge, both C and H and Sun Ship were repre- sented by senior management and by legal counsel. The resulting contract called for a liquidated damages payment of $17,000 per day that delivery of the completed barge was delayed. Delivery of both the barge and the tug was significantly delayed. Sun Ship paid the $17,000 per day liquidated damages amount and then sued to recover it, claiming that without the liquidated damages provision, C and H’s legal remedy for money damages would have been significantly less than that paid by Sun Ship pursuant to the liquidated damages provision. Decision?

18. Bettye Gregg offered to purchase a house from Head & Seeman, Inc. (seller). Though she represented in writing that she had between $15,000 and $20,000 in equity in another home that she would pay to the seller after she sold the other home, she knew that she did not have such equity. In reliance upon these intentionally fraudulent rep- resentations, the seller accepted Gregg’s offer and the par- ties entered into a land contract. After taking occupancy, Gregg failed to make any of the contract payments. The seller’s investigations then revealed the fraud. Head & Seeman then brought suit seeking rescission of the con- tract, return of the real estate, and restitution. Restitution was sought for the rental value for the five months of lost use of the property and the seller’s out-of-pocket expenses made in reliance upon the bargain. Gregg contends that under the election of remedies doctrine, the seller cannot both rescind the contract and recover damages for its breach. Is Gregg correct? Explain.

19. Watson agreed to buy Ingram’s house for $355,000. The contract provided that Watson deposit $15,000 as ear- nest money and that “in the event of default by the Buyer, earnest money shall be forfeited to Seller as liqui- dated damages, unless Seller elects to seek actual damages or specific performance.” Because Watson did not timely comply with all of the terms of the contract, nine months after the Watson sale was to occur, Ingram sold the house to a third party for $355,000. Is Ingram entitled to Watson’s $15,000 earnest money as liquidated damages? Explain.

Chapter 18 Contract Remedies 383

20. Real Estate Analytics, LLC (REA), a limited liability company, became interested in Theodore Tee Vallas’s 14.13-acre Lanikai Lane property located in Carlsbad, California. REA’s primary goal in purchasing the prop- erty was to make a profit for its investors and the com- pany. In March, REA and Vallas entered into a written agreement for Vallas to sell the property to REA. Under the agreement, the sales price was $8.5 million, with

REA to pay an immediate $100,000 deposit, and then pay $2.9 million at closing. In return, Vallas agreed to finance the remaining $5.5 million, with the unpaid balance to be paid over a five-year period. On June 14, Vallas cancelled the contract. The next day REA brought a breach of contract action seeking specific per- formance. Explain whether REA is entitled to specific performance.

T A K I N G S I D E S

Sanders agreed in writing to write, direct, and produce a motion picture on the subject of lithography (a method for printing using stone or metal) for the Tamarind Lithography Workshop. After the completion of this film, Four Stones for Kanemitsu, litigation arose concerning the parties’ rights and obligations under their agreement. Tamarind and Sanders resolved this dispute by a written settlement agreement that provided for Tamarind to give Sanders a screen credit stating: “A Film by Terry Sanders.” Tamarind did not comply with this agreement and failed to include the agreed-upon screen credit for Sanders. Sanders sued Tamarind seeking damages

for breach of the settlement agreement and specific perform- ance to compel Tamarind’s compliance with its obligation to provide the screen credit.

a. What arguments would support Sanders’s claim for spe- cific performance in addition to damages?

b. What arguments would support Tamarind’s claim that Sanders was not entitled to specific performance in addi- tion to damages?

c. Which side’s arguments are most convincing? Explain.

384 Contracts Part III

PART IV S A L E S

CISG

CHAPTER 19 Introduction to Sales and Leases

CHAPTER 20 Performance

CHAPTER 21 Transfer of Title and Risk of Loss

CHAPTER 22 Product Liability: Warranties and Strict Liability

CHAPTER 23 Sales Remedies

C H A P T E R 1 9

INTRODUCTION TO SALES AND LEASES

The propensity to truck, barter, and exchange one thing for another … is common to all men, and to be found in no other race of animals.

ADAM SMITH (1723–1790), THE WEALTH OF NATIONS (1776)

C H A P T E R O U T C O M E S After reading this chapter you should be able to:

1. Distinguish a sale from a lease and describe the governing law for both.

2. Identify and explain the fundamental principles of Article 2 and Article 2A of the Uniform Commercial Code (UCC).

3. Compare and contrast the manifestation of mutual assent under the common law and under Article 2.

4. Determine how Article 2 deals with (a) the necessity of consideration to modify a contract and (b) irrevocable offers.

5. Describe the UCC’s approach to requiring that certain contracts be in writing and identify the alternative methods of compliance under the Code.

S ales are the most common and important of all commercial transactions. In an exchange economy such as ours, sales are the essential means by

which the various units of production exchange their outputs, thereby providing the opportunity for speciali- zation and enhanced productivity. An advanced, com- plex, industrialized economy with highly coordinated manufacturing and distribution systems requires a reli- able mechanism for ensuring that future exchanges can be entered into today and fulfilled later. Because practi- cally everyone in our economy is a purchaser of both durable and consumable goods, the manufacture and dis- tribution of goods involve numerous sales transactions.

The critical role of the law of sales is to establish a framework in which these present and future exchanges may take place in a predictable, certain, and orderly fash- ion with a minimum of transaction costs. Article 2 of the Uniform Commercial Code (the Code, or UCC) governs such sales in all states except Louisiana.

Leases of personal property are also of great eco- nomic significance. Leases range from a consumer rent- ing an automobile or a lawn mower to a Fortune 500 corporation leasing heavy industrial machinery. Despite the frequent and widespread use of personal property leases, the law governing these transactions had been patched together from the common law of personal

386

property, real estate leasing law, and Articles 2 and 9 of the UCC. Although containing several applicable provisions, the UCC did not directly relate to leases.

To fill this void, the drafters of the Code approved Article 2A—Leases in 1987 and subsequently amended the Article in 1990. An analogue of Article 2, the new Article adopts many of the rules contained in Article 2. Article 2A is an attempt to codify in one statute all the rules governing the leasing of personal property. South Dakota has enacted the 1987 version of Article 2A while the District of Columbia and all the other states except Louisiana have adopted the 1990 version.

Amendments to UCC Articles 2 and 2A were promul- gated in 2003 to accommodate electronic commerce and to reflect development of business practices, changes in other law, and interpretive difficulties of practical signifi- cance. Because no states had adopted them and pros- pects for enactment in the near future were bleak, the 2003 amendments to UCC Articles 2 and 2A were with- drawn in 2011. However, at least forty-seven states have adopted the 2001 Revisions to Article 1, which applies to all of the articles of the Code.

This part of the book covers sales and leases of goods. All chapters in this part will cover Article 2A in addition to Article 2 by stating “Article 2A” wherever Article 2A’s provision is either identical to or essentially the same as the Article 2 provision. When Article 2A significantly deviates from Article 2, both rules will be discussed. In this chapter, we will discuss the nature and formation of sales and lease contracts and the fun- damental principles of sales and leases of goods.

NATURE OF SALES AND LEASES

The law of sales, which governs contracts involving the sale of goods, is a specialized branch of both the law of contracts (discussed in Chapters 9–18) and the law of personal property (discussed in Chapter 47). This section will cover the definition of sales and leases and the funda- mental principles of Article 2 and Article 2A of the UCC.

DEFINITIONS [19-1]

Goods [19-1a] Goods are essentially defined as movable, tangible, per- sonal property. For example, the sale of a bicycle, stereo set, or this textbook is considered a sale of

goods. Goods also include the unborn young of ani- mals, growing crops, and, if removed by the seller, tim- ber, minerals, or a building attached to real property. Under Article 2A, minerals cannot be leased prior to their extraction.

Sale [19-1b] The Code defines a sale as the transfer of title to goods from seller to buyer for a price. The price can be money, other goods, real estate, or services.

Lease [19-1c] Article 2A defines a lease of goods as a “transfer of the right to possession and use of goods for a term in return for consideration, but … retention or creation of a security interest is not a lease.” A transaction within this definition of a lease is governed by Article 2A, but if the transaction is a security interest disguised as a lease, it is governed by Article 9. Categorizing a trans- action as a lease has significant implications not only for the parties to the lease but for third parties as well. If the transaction is deemed to be a lease, the residual interest in the goods belongs to the lessor, who need not file publicly to protect this interest. On the other hand, if the transaction is a security interest, then the provisions of Article 9 regarding enforceability, perfec- tion, priority, and remedies apply. UCC Section 1- 201(37) and Revised Section 1-203 provide rules that govern the determination of whether a transaction in the form of a lease creates a security interest.

Consumer Leases Article 2A affords special treatment for consumer leases. The definition of a con- sumer lease requires that (1) the transaction meet the definition of a lease under Article 2A; (2) the lessor be regularly engaged in the business of leasing or selling goods; (3) the lessee be an individual, not an organiza- tion; (4) the lessee take the lease interest primarily for a personal, family, or household purpose; and (5) the total payments under the lease do not exceed $25,000. Although consumer protection for lease transactions is primarily left to other state and federal law, Article 2A does contain a number of provisions that apply to con- sumer leases and that may not be varied by agreement of the parties.

Finance Leases A finance lease is a special type of lease transaction generally involving three parties instead of two. Whereas in the typical lease situation the lessor also supplies the goods, in a finance lease arrangement, the lessor and the supplier are separate

Chapter 19 Introduction to Sales and Leases 387

parties. The lessor’s primary function in a finance lease is to provide financing to the lessee for a lease of goods provided by the supplier. For example, under a finance lease arrangement, a manufacturer supplies goods pur- suant to the lessee’s instructions or specifications. The party functioning as the lessor will then either purchase those goods from the supplier or act as the prime lessee

in leasing them from the supplier. In turn, the lessor will lease or sublease the goods to the lessee. Because the finance lessor functions merely as a source of credit, she typically will have no special expertise as to the goods. Due to the limited role the finance lessor usually plays, Article 2A treats finance leases differently from ordinary leases.

C A R T E R V . T O K A I F I N A N C I A L S E R V I C E S , I N C . C o u r t o f A p p e a l s o f G e o r g i a , 1 9 9 8

2 3 1 G a . A p p . 7 5 5 , 5 0 0 S . E . 2 d 6 3 8

FACTS On January 3, 1996, Tokai’s (now part of De Lage Landen Leasing and Trade Finance) predeces- sor in interest, Mitel Financial, entered into a “Master Equipment Lease Agreement” (Agreement) with Applied Radiological Control, Inc. (ARC) for the lease of certain telephone equipment valued at $42,000. Randy P. Carter of ARC personally guaranteed ARC’s obligations under the Agreement. ARC made four rental payments and then defaulted on its obligations. Thereafter, Tokai repossessed the telephone equipment and sold it for $5,900. Tokai then brought this suit against Carter, and the trial court awarded Tokai $56,765.74. Carter appeals.

DECISION Judgment reversed.

OPINION Blackburn, J. 1. As an initial matter, we note that Paragraph 13 of the Agreement states that each lease contemplated therein is a finance lease as defined by Article 2A of the UCC.

A “finance lease” involves three parties—the lessee/business, the finance lessor, and the equipment supplier. The lessee/ business selects the equipment and negotiates particularized modifications with the equipment supplier. Instead of pur- chasing the equipment from the supplier, the lessee/business has a finance lessor purchase the selected equipment, and then leases the equipment from the finance lessor. [Citation.]

Carter contends, nonetheless, that the true intent of the parties was to enter into a security agreement.

Whether a transaction creates a lease or security interest is determined by the facts of each case; however, a transaction creates a security interest if the consideration the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease not subject to termination by the lessee, and (a) [t]he original term of the lease is equal to or greater than the remaining economic life of the goods, (b) [t]he lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods, (c) [t]he lessee has an option to renew the lease for the remaining economic life of

the goods for no additional consideration or nominal addi- tional consideration upon compliance with the lease agree- ment, or (d) [t]he lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement. [UCC §] 1-201(37).

Here, the Agreement’s initial term was for five years, ARC was not required to renew the lease or purchase the telephone equipment at the end of the term, and ARC did not have the option to renew the lease or pur- chase the property at the end of the term for nominal consideration. Therefore, the Agreement does not fit within the definition of a secured transaction provided by [UCC §] 1-201(37).

Furthermore,

it is commonly held that the “best test” for determining the intent of an agreement which provides for an option to buy is a comparison of the option price with the market value of the equipment at the time the option is to be exercised. *** If, upon compliance with the terms of the “lease,” the lessee has an option to become the owner of the property for no additional or for a nominal consideration, the lease is deemed to be intended for security. [Citations.]

ARC was given the option to purchase the telephone equipment in this case at the end of the lease term for its fair market value. “Additional consideration is not nominal if *** when the option to become the owner of the goods is granted to the lessee the price is stated to be the fair market value of the goods determined at the time the option is to be performed.” [UCC Section 1-201(37)(x).] Accordingly, the agreement in this case must be considered a true lease, not a secured transaction. As a result, the procedural safeguards of Article 9 of the UCC are inappli- cable to the matter at hand, and Carter’s claims under this enumeration must fail. [Citations.]

*** In Georgia, all lease contracts for “goods,” including

finance leases, first made or first effective on or after July 1, 1993, are governed by Article 2A of the Uniform

388 Sales Part IV

Governing Law [19-1d] Although sales transactions are governed by Article 2 of the Code, general contract law continues to apply in cases in which the Code has not specifically modified such law. Nevertheless, although principles of common law and equity may supplement provisions of the Code, they may not be used to supplant its provisions. Thus, the law of sales is a specialized part of the general law of contracts, and the law of contracts continues to gov- ern unless specifically displaced by the Code.

General contract law also continues to govern all contracts outside the scope of the Code. Transactions not within the scope of Article 2 include employment contracts; service contracts; insurance contracts; con- tracts involving real property; and contracts for the sale of intangibles such as stocks, bonds, patents, and copyrights. For an illustration of the law govern- ing contracts, see Figure 9-1. In determining whether a

contract containing both a sale of goods and a service is a UCC contract or general contract, the majority of states follow the predominant purpose test. This test, as in Pittsley v. Houser, which follows, and in Fox v. Mountain West Electric, Inc., in Chapter 9, holds that if the predominant purpose of the whole transaction is a sale of goods, Article 2 applies to the entire transac- tion. If, on the other hand, the predominant purpose is the nongood or service portion, Article 2 does not apply. A few states apply Article 2 only to the goods part of a transaction and general contract law to the nongoods or service part of the transaction.

PRACTICAL ADVICE Because it is unclear which law will govern certain contracts, be careful to specify the particulars of your agreement in your written contract.

Commercial Code. [Citations.] The Agreement was entered into by the parties on January 3, 1996; there- fore, it is subject to Article 2A of the UCC.

INTERPRETATION A lease will be governed by Article 2A unless, in compliance with the terms of the “lease,” the lessee has the option to become the

owner of the property for no additional or for a nomi- nal consideration, in which case, the lease is deemed to be intended for security and governed by Article 9.

CRITICAL THINKING QUESTION Why might the parties attempt to disguise a security agree- ment as a lease?

G O I N G G L O B A L What law governs international sales?

The United Nations Conventionon Contracts for the Interna- tional Sale of Goods (CISG), which has been ratified by the United States and at least eighty-two other countries, governs all contracts for the international sales of goods between parties located in different nations that have ratified the CISG. Because treaties are federal law, the CISG supersedes the UCC in any sit- uation to which either could apply. The CISG includes provisions dealing with interpretation, trade usage, contract formation, obligations and

remedies of sellers and buyers, and risk of loss. Parties to an interna- tional sales contract may, however, expressly exclude CISG governance from their contract. The CISG spe- cifically excludes sales of (1) goods bought for personal, family, or household use; (2) ships or aircraft; and (3) electricity. In addition, it does not apply to contracts in which the primary obligation of the party furnishing the goods consists of sup- plying labor or services. The chapters on Sales (19 through 23) include the comparable provisions of the CISG.

Although Article 2 governs sales, the drafters of the article have invited the courts to extend Code principles to nonsale transactions in goods. To date, a number of courts have accepted this invitation and have applied Code provisions by analogy to other transactions in goods not expressly included within the Act, most frequently to leases and bailments. The Code has also greatly influenced the revision of the Restatement, Second, Contracts, which, as previously discussed, has great effect upon all contracts.

Chapter 19 Introduction to Sales and Leases 389

P I T T S L E Y V . H O U S E R I d a h o C o u r t o f A p p e a l s , 1 9 9 4

8 7 5 P . 2 d 2 3 2

FACTS Jane Pittsley contracted with Donald Houser, who was doing business as Hilton Contract Co. (Hilton), to install carpet in her home. The total con- tract price was $4,402. From this sum, Hilton paid the installers $700 to put the carpet in Pittsley’s home. Fol- lowing installation, Pittsley complained to Hilton that the installation was defective in several respects. Hilton attempted to fix the installation but was unable to sat- isfy Pittsley. Eventually, Pittsley refused any further efforts to fix the carpet. She sued for rescission of the contract and return of the $3,500 she had previously paid on the contract plus incidental damages. Hilton counterclaimed for the balance due on the contract. The magistrate determined that the breach was not so mate- rial as to justify rescission of the contract and awarded Pittsley $250 in repair costs plus $150 in expenses. The magistrate also awarded Hilton the balance of $902 remaining on the contract. Pittsley appealed to the dis- trict court, which reversed and remanded the case to the magistrate for additional findings of fact and to apply the Uniform Commercial Code (UCC) to the transac- tion. Hilton appeals this ruling, asserting that applica- tion of the UCC is inappropriate because the only defects alleged were in the installation of the carpet, not in the carpet itself.

DECISION The judgment of the magistrate is vacated and the case remanded.

OPINION Swanstrom, J. The single question upon which this appeal depends is whether the UCC is appli- cable to the subject transaction. If the underlying trans- action involved the sale of “goods,” then the UCC would apply. If the transaction did not involve goods, but rather was for services, then application of the UCC would be erroneous.

Idaho Code §2–105(l) defines “goods” as “all things (including specially manufactured goods) which are movable at the time of identification to the contract for sale. *** ” Although there is little dispute that carpets are “goods,” the transaction in this case also involved installation, a service. Such hybrid transactions, involv- ing both goods and services, raise difficult questions about the applicability of the UCC. Two lines of author- ity have emerged to deal with such situations.

The first line of authority, and the majority position, utilizes the “predominant factor” test. The Ninth Cir- cuit, applying the Idaho Uniform Commercial Code to

the subject transaction, restated the predominant factor test as:

The test for inclusion or exclusion is not whether they are mixed, but, granting that they are mixed, whether their predominant factor, their thrust, their purpose, reasonably stated, is the rendition of service, with goods incidentally involved (e.g., contract with artist for painting) or is a trans- action of sale, with labor incidentally involved (e.g., installa- tion of a water heater in a bathroom).

[Citations.] This test essentially involves consideration of the contract in its entirety, applying the UCC to the entire contract or not at all.

The second line of authority, which Hilton urges us to adopt, allows the contract to be severed into different parts, applying the UCC to the goods involved in the contract, but not to the nongoods involved, including services as well as other nongoods assets and property. Thus, an action focusing on defects or problems with the goods themselves would be covered by the UCC, while a suit based on the service provided or some other non- goods aspect would not be covered by the UCC. ***

We believe the predominant factor test is the more pru- dent rule. Severing contracts into various parts, attempting to label each as goods or nongoods and applying different law to each separate part clearly contravenes the UCC’s declared purpose “to simplify, clarify and modernize the law governing commercial transactions.” §1–102(2)(a). As the Supreme Court of Tennessee suggested in [citation], such a rule would, in many contexts, present “difficult and in some instances insurmountable problems of proof in seg- regating assets and determining their respective values at the time of the original contract and at the time of resale, in order to apply two different measures of damages.”

Applying the predominant factor test to the case before us, we conclude that the UCC was applicable to the sub- ject transaction. The record indicates that the contract between the parties called for “165 yds Masterpiece No. 2122–Installed” for a price of $4319.50. There was an additional charge for removing the existing carpet. The re- cord indicates that Hilton paid the installers $700 for the work done in laying Pittsley’s carpet. It appears that Pitts- ley entered into this contract for the purpose of obtaining carpet of a certain quality and color. It does not appear that the installation, either who would provide it or the nature of the work, was a factor in inducing Pittsley to choose Hilton as the carpet supplier. On these facts, we conclude that the sale of the carpet was the predominant factor in the contract, with the installation being merely

390 Sales Part IV

Although lease transactions are governed by Article 2A of the Code, general contract law continues to apply in cases in which the Code has not specifically modified such law. In other words, the law of leases is a specialized part of the general law of contracts, and the law of contracts continues to govern unless specifi- cally displaced by the Code.

FUNDAMENTAL PRINCIPLES OF ARTICLE 2 AND ARTICLE 2A [19-2] The purpose of Article 2 is to modernize, clarify, sim- plify, and make uniform the law of sales. Furthermore, the article is to be interpreted according to these princi- ples and not according to some abstraction such as the passage of title. The Code

is drawn to provide flexibility so that, since it is intended to be a semi-permanent piece of legislation, it will provide its own machinery for expansion of commercial practices. It is intended to make it possible for the law embodied in this Act to be developed by the courts in the light of unforeseen and new circumstances and practices. However, the proper construction of the Act requires that its inter- pretation and application be limited to its reason. (General Provisions in Comment to Section 1-102)

This open-ended drafting includes the following fun- damental concepts.

CISG The CISG governs only the formation of the contract of sales and the rights and obligations of the seller and buyer arising from such contract. It does not cover the validity of the contract or any of its provisions. In addition, one of the purposes of the CISG is to promote uniformity of the law of sales.

Good Faith [19-2a] All parties who enter into a contract or duty within the scope of the Code must perform their obligations in good faith. The original Code defines good faith as

“honesty in fact in the conduct or transaction con- cerned.” For a merchant, good faith also requires the observance of reasonable commercial standards of fair dealing in the trade. Revised UCC Section 1–201(20) provides that “good faith means honesty in fact and the observance of reasonable commercial standards of fair dealing,” thus adopting the broader definition of good faith and making it applicable to both merchants and nonmerchants. For instance, if the parties agree that the seller is to set the price term, the seller must establish the price in good faith.

CISG The CISG is also designed to promote the observation of good faith in international trade.

Unconscionability [19-2b] The courts may scrutinize every contract of sale to determine whether in its commercial setting, purpose, and effect it is unconscionable. The reviewing court may refuse to enforce a contract (or any part of it) found to be unconscionable or may limit its application to prevent an unconscionable result. The Code does not define unconscionable; however, the term is defined in the New Webster’s Dictionary (Deluxe Encyclopedic Edition) as “contrary to the dictates of conscience; unscrupulous or unprincipled; exceeding that which is reasonable or customary; inordinate, unjustifiable.”

The Code denies or limits enforcement of an uncon- scionable contract for the sale of goods to promote fairness and decency and to correct harshness or oppression in contracts resulting from the unequal bar- gaining positions of the parties.

The doctrine of unconscionability permits the courts to resolve issues of unfairness explicitly on that basis without recourse to formalistic rules or legal fictions. In policing contracts for fairness, the courts have demon- strated their willingness to limit freedom of contract to protect the less advantaged from the overreaching of dominant contracting parties.

The doctrine of unconscionability has evolved through its application by the courts to include both

incidental to the purchase. Therefore, in failing to con- sider the UCC, the magistrate did not apply the correct legal principles to the facts as found.

INTERPRETATION If the predominant pur- pose of the whole transaction is a sale of goods, then

Article 2 applies to the whole transaction; if the pre- dominant purpose is the nongood or service component, then Article 2 does not apply.

CRITICAL THINKING QUESTION Which test do you prefer? Explain.

Chapter 19 Introduction to Sales and Leases 391

procedural and substantive unconscionability. Proce- dural unconscionability involves scrutiny for the pres- ence of “bargaining naughtiness.” In other words, was the negotiation process fair? Or were there procedural irregularities such as burying important terms of the agreement in fine print or obscuring the true meaning of the contract with impenetrable legal jargon?

In the search for substantive unconscionability, the court examines the actual terms of the contract, seeking oppressive or grossly unfair provisions such as an exor- bitant price or an unfair exclusion or limitation of con- tractual remedies. An all-too-common example involves a necessitous buyer in an unequal bargaining position with a seller who consequently has obtained an exorbi- tant price for his product or service.

See Bagley v. Mt. Bachelor, Inc., in Chapter 13. As to all leases, Article 2A provides that a court

faced with an unconscionable contract or clause may refuse to enforce either the entire contract or just the unconscionable clause or may limit the application of the unconscionable clause to avoid an unconscionable result. This is similar to Article 2’s treatment of uncon- scionable clauses in sales contracts. A lessee under a

consumer lease, however, is provided with additional protection against unconscionability. In the case of a consumer lease, if a court as a matter of law finds that any part of the lease contract has been induced by unconscionable conduct, the court is expressly empow- ered to grant appropriate relief. The same is true when unconscionable conduct occurs in the collection of a claim arising from a consumer lease contract. The explicit availability of relief for consumers subjected to unconscionable conduct (procedural unconscionability)— in addition to a provision regarding unconscionable contracts (substantive unconscionability)—represents a departure from Article 2. An additional remedy that Article 2A provides for consumers is the award of attorneys’ fees. If the court finds unconscionability with respect to a consumer lease, it shall award reasonable attorneys’ fees to the lessee.

PRACTICAL ADVICE Refrain from entering into contracts with provisions that are oppressively harsh or that were negotiated under unfair circumstances.

C O N S T R U C T I O N A S S O C I A T E S , I N C . V . F A R G O W A T E R E Q U I P M E N T C O . N o r t h D a k o t a S u p r e m e C o u r t , 1 9 8 9

4 4 6 N . W . 2 d 2 3 7

FACTS Construction Associates (CA) was the suc- cessful bidder to construct a water supply line for the city of Breckenridge, Minnesota. CA purchased a large amount of polyvinyl chloride pipe manufactured by the Johns-Manville Sales Corporation (J-M) to construct the pipeline. CA, however, did not have any direct contact with J-M; instead, it purchased the pipe through a sup- ply company (Fargo Water Equipment). J-M shipped the pipe directly to the work site and included with each shipment an installation guide written for those who actually directed the installation of the pipe. On page three of the installation guide, J-M expressly warranted the pipe to be free from defects in workmanship and materials. In addition, J-M set forth a limitation of liability clause, which stated there would be no liability except for breach of the express warranty and that J-M would be responsible only for resupplying a like quan- tity of nondefective pipe. J-M stated that it would not be liable for any incidental, consequential, or other damages.

Eventually the Breckenridge pipeline developed more than seventy leaks. The only way these leaks could be repaired was to remove the defective joints and replace

them with stainless steel sleeves. After incurring more than $140,000 in repairs to the pipeline, CA sued J-M and Fargo. CA won a jury award of more than $140,000 in damages from J-M. J-M appealed, claiming that the limitation of liability clause should be enforced.

DECISION Judgment for CA affirmed.

OPINION Ericksted, J. [UCC §2–719] specifically allows the parties to an agreement to limit the remedies available upon breach and to exclude consequential damages:

*** By its terms §2–302 [unconscionable contract or

clause] applies to any clause of the contract. Courts thus have construed §§2–302 and 2–719 together in holding that a general limitation of remedies clause, including those limiting liability to repair or replacement, may be subject to unconscionability analysis under the Code. [Citations.]

The determination whether a particular contractual provision is unconscionable is a question of law for the court. [Citations.] The court is to look at the contract

392 Sales Part IV

Expansion of Commercial Practices [19-2c] An underlying policy of the Code is “to permit the con- tinued expansion of commercial practices through cus- tom, usage and agreement of the parties.” In particular, the Code emphasizes the course of dealing and the usage of trade in interpreting agreements.

A course of dealing is a sequence of previous con- duct between the parties that may fairly be regarded as establishing a common basis of understanding for inter- preting their expressions and agreement.

A usage of trade is a practice or method of dealing regularly observed and followed in a place, vocation, or trade. To illustrate: Connie contracts to sell Ward one thousand feet of San Domingo mahogany. By

from the perspective of the time it was entered into, without the benefit of hindsight. ***

Courts and commentators have generally viewed the Code’s unconscionability provisions within a two-pronged framework: procedural unconscionability, which encom- passes factors relating to unfair surprise, oppression, and inequality of bargaining power, and substantive unconscionability, which focuses upon the harshness or onesidedness of the contractual provision in question. [Citations.]

PROCEDURAL UNCONSCIONABILITY We initially note that this case presents a commercial, rather than a consumer, transaction. Although courts have generally been more reluctant to find unconscionability in purely commercial settings, [citation], under appropriate circumstances a contractual provision may be found unconscionable even in a commercial setting. [Citations.]

*** The circumstances presented in this case demonstrate

a substantial inequality in bargaining power between J-M and Construction Associates. Construction Associ- ates is a relatively small local construction firm, while J-M is part of an enormous, highly diversified, interna- tional conglomerate. The limitation of remedies and exclusion of damages were part of a pre-printed installa- tion guide included with all shipments of J-M Pipe. J-M has continually stressed on appeal that those limitations and exclusions are included in all of its brochures and guides. It is obvious that there is no room for bargain- ing or negotiation as to the warranty provisions.

We also note that the facts in this case demonstrate an actual lack of negotiation coupled with elements of unfair surprise. ***

The limitations and exclusions clause in this case can hardly be described as “bargained for.” The clauses were included on page three of a pre-printed installation guide expressly directed to the worker in the field, rather than to officers of Construction Associates. Con- struction Associates was not apprised at the time of con- tracting that their remedies under the Code were being limited or excluded. It would be within J-M’s control to do so by, for example, requiring its dealers to accept orders for pipe only upon a J-M form which included

the limitations and exclusions and which required the purchaser’s signature. Clearly an element of procedural unconscionability is present where through a pre-printed guide which was not provided to Construction Associ- ates (and then only to field workers) until long after the sales contract had been finalized.

SUBSTANTIVE UNCONSCIONABILITY Substantive unconscionability focuses upon the harsh- ness of the particular contractual terms:

*** The clause at issue here would limit Construction

Associates’ remedy for J-M’s breach to a like quantity of replacement pipe, with no recovery of consequential dam- ages. Construction Associates argues, with support in the evidence, that replacement pipe is not used when making repairs to leaking joints on a completed underground water pipeline. Because the accepted method of repair is to cut out the leaking joint and repair it with a stainless steel sleeve, Construction Associates argues, the replace- ment pipe would be useless in effecting repairs upon the line. The trial court determined that J-M’s limited remedy “amount[ed] to nothing whatsoever.” ***

Numerous courts, in a variety of commercial and consumer contexts, have held limitations and exclusions unconscionable when they leave the non-breaching party with no effective remedy. [Citations.] This is particularly true where the defect in the product is latent, so that the buyer is unable to discover the defect until additional damages are incurred. [Citations.]. In this case, Con- struction Associates did not discover the defects until the pipe was assembled and placed underground.

INTERPRETATION A court can override a term of a contract if it finds that term to be unconscionable or the result of an unconscionable negotiation process.

ETHICAL QUESTION Is unconscionable con- duct always unethical? Explain.

CRITICAL THINKING QUESTION How active should courts be in finding contracts or clauses to be unconscionable? Explain.

Chapter 19 Introduction to Sales and Leases 393

usage of dealers in mahogany, known to Connie and Ward, good-figured mahogany of a certain density is known as San Domingo mahogany, though it does not come from San Domingo. Unless otherwise agreed, the usage is part of the contract.

CISG The parties are bound by any usage or practices that they have agreed to or established between themselves. In addition, the parties are considered, unless otherwise agreed, to be bound by any usage of international trade that is widely known and regularly observed in the particular trade.

Sales By and Between Merchants [19-2d] The Code establishes some separate rules that apply to transactions between merchants or to transactions involv- ing a merchant as a party. A merchant is defined as a person (1) who is a dealer in a particular type of goods, (2) who by his occupation holds himself out as having knowledge or skill peculiar to certain goods or practices, or (3) who employs an agent or broker whom he holds out as having such knowledge or skill. (Article 2A.) These rules exact higher standards of conduct from merchants because of their knowledge of trade and commerce and because merchants as a class generally set these standards for themselves. The more significant of these merchant provisions are good faith, confirmation of oral contracts, firm offers, “battle of the forms,” warranty of title, war- ranty of merchantability, sales on approval, retention of possession of goods by seller, entrusting of goods, risk of loss, and duties after rightful rejection.

Liberal Administration of Remedies [19-2e] The Code provides that its remedies shall be liberally administered to place the aggrieved party in a position as good as the one she would have held, had the defaulting party fully performed. The Code does make it clear, however, that remedies are limited to compen- sation and may not include consequential or punitive damages, unless specifically provided by the Code. According to its provisions, for cases in which the Code itself does not expressly provide a remedy for a right or obligation, the courts should provide an appropriate remedy. Remedies are discussed in Chapter 23.

Freedom of Contract [19-2f] Most of the Code’s provisions are not mandatory but permit the parties by agreement to vary or displace

them altogether. However, the obligations of good faith, diligence, reasonableness, and care may not be disclaimed by agreement, although the parties may by agreement determine the standards by which to meas- ure the performance of these obligations, as long as the standards are not obviously unreasonable.

Validation and Preservation of Sales Contracts [19-2g] One of the requirements of commercial law is the establishment of rules that determine when an agree- ment is valid. The Code approaches this requirement by reducing formal requisites to the bare minimum and by attempting to preserve agreements whenever the par- ties manifest an intent to enter into a contract.

FORMATION OF SALES AND LEASE CONTRACTS

As we have stated previously, the Code’s basic approach to validation is to recognize contracts whenever the par- ties manifest such an intent. This is so whether or not the parties can identify the precise moment at which they formed the contract. (Article 2A.)

MANIFESTATION OF MUTUAL ASSENT [19-3] For a contract to exist, there must be an objective man- ifestation of mutual assent: an offer and an acceptance. In this section, we will examine the UCC rules that affect offers and acceptances.

Definiteness of an Offer [19-3a] At common law, the terms of a contract were required to be definite and complete. The Code has rejected the strict approach of the common law by recognizing an agreement as valid, despite missing terms, if there is any reasonably certain basis for granting a remedy. Accord- ingly, the Code provides that even though a contract may omit one or more terms, the contract need not fail for indefiniteness. (Article 2A.) The Code provides stand- ards by which the courts may ascertain and supply omit- ted essential terms, provided the parties intended to enter into a binding agreement. Nevertheless, the more terms the parties leave open, the less likely their intent to enter into a binding contract. Article 2A generally does not provide the same gap-filling provisions.

394 Sales Part IV

CISG An offer to contract is sufficiently definite if it indicates the goods and fixes or makes provision, expressly or implicitly, for determining price and quality.

Open Price The parties may enter into a contract for the sale of goods even though they have reached no agreement on the price. In such a case, the price is rea- sonable at the time for delivery. A contract has an open price term if the agreement (1) says nothing as to price; (2) provides that the parties shall agree later as to the price and they fail to so agree; or (3) fixes the price in terms of some agreed market or other standard, as set by a third person or agency, and the price is not so set. An agreement that the price is to be fixed by the seller or buyer means that it must be fixed in good faith.

Open Quantity: Output and Requirements Contracts As we discussed in Chapters 10 and 12, an output contract is the agreement of a buyer to purchase the entire output of a seller for a stated period, whereas a requirements contract is an agreement of a seller to supply a buyer with all her requirements for certain goods. Even though the exact quantity of goods is not specified and even though the seller may have some control over his output and the buyer over her requirements, such agree- ments are enforceable through the application of an objec- tive standard based on the good faith of both parties. Moreover, the parties may not produce or request quanti- ties disproportionate to any stated estimate of need or pro- duction or to prior output or requirements.

Irrevocable Offer An offeror generally may with- draw an offer at any time prior to its acceptance. To be effective, the notice revoking the offer must reach the offeree before he has accepted.

An option is a contract by which the offeror is bound to hold open an offer for a specified time. It must comply with all of the requirements of a contract, including consideration. Option contracts apply to all types of contracts, including sales of goods.

The Code has made certain offers—called firm offers—irrevocable without the offeree giving any con- sideration for the promise to keep the offer open. The Code provides that a merchant is bound to keep an offer open for a maximum of three months if the merchant gives assurance in a signed writing that it will be held open. (Article 2A.) The Code, therefore, makes a mer- chant’s written promise not to revoke an offer for a stated period of time enforceable even though no consid- eration is given the merchant–offeror for that promise.

CISG An offer may not be revoked if it indicates, whether by stating a fixed time for acceptance or otherwise, that it is irrevocable; it need not be in writing.

Variant Acceptances [19-3b] The common law mirror image rule, by which the ac- ceptance cannot vary or deviate from the terms of the offer, has been modified by the Code. This modification has been necessitated by the realities of modern business practices, notably by the fact that a vast number of busi- nesses use standardized business forms. For example, a buyer sends to the seller on the buyer’s order form a purchase order for 1,000 dozen cotton shirts at $60.00 per dozen with delivery by October 1 at the buyer’s place of business. On the reverse side of this standard form are twenty-five numbered paragraphs containing provisions generally favorable to the buyer. When the seller receives the buyer’s order and agrees to the buyer’s quantity, price, and delivery terms, he sends to the buyer an unequivocal acceptance of the offer on his acceptance form. On the back of his acceptance form, however, the seller has thirty-two numbered paragraphs generally favorable to himself and in significant conflict with the provisions in the buyer’s form. Under the common law’s mirror image rule, no contract would exist, for the seller has not accepted unequivocally all of the material terms of the buyer’s offer.

The Code attempts to reconcile this battle of the forms by focusing on the intent of the parties. If the offeree expressly makes his acceptance conditional upon assent to the additional or different terms, no contract is formed. If, however, the offeree does not expressly require such a condition, a contract is formed. The issue then becomes whether the offeree’s different or addi- tional terms become part of the contract. If both offeror and offeree are merchants, additional terms (terms the offeree proposed for the contract for the first time) will become part of the contract if they do not materially al- ter the agreement and are not objected to either in the offer itself or within a reasonable time. If either of the parties is not a merchant, or if the terms materially alter the offer, the additional terms are merely construed as proposals for addition to the contract. Different terms (terms that contradict or conflict with terms of the offer) proposed by the offeree generally will not become part of the contract unless specifically accepted by the offeror.

The courts are divided over what terms are included when the terms conflict. The majority of courts hold that the terms cancel each other out and look to the

Chapter 19 Introduction to Sales and Leases 395

Code to provide the missing terms; other courts hold that the offeror’s terms govern. Some states follow a third alternative and apply the additional terms test to different terms. See Figure 19-1 for a summary of the battle of the forms.

Applying Section 2–207 to the previous example: Because both parties are merchants and the seller did

not condition acceptance upon the buyer’s assent to the additional or different terms, (1) the contract will be formed without the seller’s different terms unless the buyer specifically accepts them; (2) the contract will be formed without the seller’s additional terms unless (a) the buyer specifically accepts or (b) the additional terms do not materially alter the offer and the buyer

FIGURE 19-1 Battle of the Forms

Yes

No

Yes

No

No

Is acceptance identical to offer?

Yes

No

Is acceptance expressly conditional upon assent to additional or different

terms?

Contract formed (1) different terms cancel each other out, or (2) offeror’s terms control, or (3) additional term test applied

No

Does acceptance include different terms?

Does acceptance include additional terms?

Yes No

Yes

Are both parties merchants?

Does offer limit acceptance to its terms?

No

Do additional terms materially alter the offer?

Contract formed with additional terms

Has offeror assented to the additional terms?

Has the offeror objected to the additional terms?

Contact formed based on offeror’s terms

Contract formed based on offeror’s terms

without additional terms

No contract formed Yes

No

Yes

Yes

Yes

No

396 Sales Part IV

does not object to them; and (3) depending on the juris- diction, (a) the conflicting terms cancel each other out and the Code provides the missing terms, (b) the buyer’s conflicting terms are included in the contract, or (c) the additional terms test is applied.

CISG A reply to an offer that contains additions, limitations, or other modifications is a counteroffer that rejects the original offer. Nevertheless, a purported acceptance that contains additional or different terms acts as an acceptance if the terms do not materially alter the contract unless the offeror objects to the change. Changes in price, payment, quality, quantity, place and time of delivery, terms of delivery, liability of the parties, and settlement of a dispute are always considered to be material alterations.

Finally, subsection (3) of 2–207 deals with those sit- uations in which the writings do not form a contract, but the conduct of the parties recognizes the existence of one. For instance, Ernest makes an offer to Gwen, who replies with a conditional acceptance. Although no contract has been formed, Gwen ships the ordered goods and Ernest accepts the goods. Subsection (3) pro- vides that in this instance the contract consists of the written terms to which both parties agreed together with supplementary provisions of the Code.

PRACTICAL ADVICE In negotiating a contract, try to be the offeror and consider providing in your offer that your terms control and that any new or different terms will be made part of the contract only if you specifically agree to them in a signed writing.

C O M M E R C E & I N D U S T R Y I N S U R A N C E C O M P A N Y V . B A Y E R C O R P O R A T I O N S u p r e m e J u d i c i a l C o u r t o f M a s s a c h u s e t t s , 2 0 0 1

4 3 3 M a s s . 3 8 8 , 7 4 2 N . E . 2 d 5 6 7 , 4 4 U C C R e p . S e r v . 2 d 5 0

FACTS On December 11, 1995, an explosion and fire destroyed several of Malden Mills’s buildings at its manufacturing facility. Malden Mills and its property insurers, the plaintiffs Commerce & Industry Insurance Company and Federal Insurance Company, brought suit in the Superior Court against numerous defendants, including Bayer Corporation. In their complaint, the plaintiffs allege that the cause of the fire was the igni- tion, by static electrical discharge, of nylon tow (also known as bulk nylon fiber), which was sold by Bayer to Malden Mills.

Malden Mills initiated purchases of nylon tow from Bayer either by sending its standard form purchase order to Bayer, or by placing a telephone order to Bayer, followed by a standard form purchase order. Each of Malden Mills’s purchase orders contained, on the reverse side, as one of its “terms and conditions,” an arbitration provision.

Another “term and condition” appearing in para- graph one on the reverse side of each purchase order provides:

This purchase order represents the entire agreement between both parties, not withstanding any Seller’s order form, and this document cannot be modified except in writ- ing and signed by an authorized representative of the buyer.

In response, Bayer transmitted Malden Mills’s pur- chase orders to the manufacturer with instructions, in

most instances, that the nylon tow was to be shipped directly to Malden Mills. Thereafter, Bayer prepared and sent Malden Mills an invoice. Each of the Bayer invoices contained the following language on its face, located at the bottom of the form in capital letters:

TERMS AND CONDITIONS: NOTWITHSTANDING ANY CONTRARY OR INCONSISTENT CONDITIONS THAT MAY BE EMBODIED IN YOUR PURCHASE ORDER, YOUR ORDER IS ACCEPTED SUBJECT TO THE PRICES, TERMS AND CONDITIONS OF THE MUTUALLY EXECUTED CONTRACT BETWEEN US, OR, IF NO SUCH CONTRACT EXISTS, YOUR ORDER IS ACCEPTED SUBJECT TO OUR REGULAR SCHED- ULED PRICE AND TERMS IN EFFECT AT TIME OF SHIPMENT AND SUBJECT TO THE TERMS AND CON- DITIONS PRINTED ON THE REVERSE SIDE HEREOF.

The following “condition” appears on the reverse side of each invoice:

This document is not an Expression of Acceptance or a Confirmation document as contemplated in Section 2-207 of the Uniform Commercial Code. The acceptance of any order entered by [Malden Mills] is expressly conditioned on [Malden Mills’s] assent to any additional or conflicting terms contained herein.

Based on the arbitration provision in Malden Mills’s purchase orders, Bayer demanded that Malden Mills arbitrate its claims against Bayer. After Malden Mills

Chapter 19 Introduction to Sales and Leases 397

refused, Bayer moved to compel arbitration. The court ruled in favor of Malden Mills.

DECISION The order denying the motion to com- pel arbitration is affirmed.

OPINION Greaney, J. This case presents a dispute arising from what has been styled a typical “battle of the forms” sale, in which a buyer and a seller each attempt to consummate a commercial transaction through the exchange of self-serving preprinted forms that clash, and contradict each other, on both material and minor terms. [Citation.] Here, Malden Mills’s form, a purchase order, contains an arbitration provision, and Bayer’s form, a seller’s invoice, is silent on how the parties will resolve any disputes. Oddly enough, the buyer, Malden Mills, the party proposing the arbitration provision, and its insurers, now seek to avoid an arbitral forum.

Section 2-207 was enacted with the expectation of creating an orderly mechanism to resolve commercial disputes resulting from a “battle of the forms.” The sec- tion has been characterized as “an amphibious tank that was originally designed to fight in the swamps, but was sent to fight in the desert.” [Citation.] Section 2-207 sets forth rules and principles concerning contract formation and the procedures for determining the terms of a con- tract. As to contract formation, under § 2-207, there are essentially three ways by which a contract may be formed. [Citation.]

First, if the parties exchange forms with divergent terms, yet the seller’s invoice does not state that its acceptance is made ‘expressly conditional’ on the buyer’s assent to any additional or different terms in the invoice, a contract is formed [under subsection (1) of § 2-207].

Second, if the seller does make its acceptance ‘expressly conditional’ on the buyer’s assent to any additional or di- vergent terms in the seller’s invoice, the invoice is merely a counteroffer, and a contract is formed [under subsection (1) of § 2-207] only when the buyer expresses its affirmative acceptance of the seller’s counteroffer.

Third, where for any reason the exchange of forms does not result in contract formation (e.g., the buyer “expressly limits acceptance to the terms of [its offer]” under § 2- 207(2)(a), or the buyer does not accept the seller’s counter- offer under the second clause of § 2-207[1]), a contract nonetheless is formed [under subsection (3) of § 2-207] if their subsequent conduct—for instance, the seller ships and the buyer accepts the goods—demonstrates that the parties believed that a binding agreement had been formed.

Bayer correctly concedes that its contract with Mal- den Mills resulted from the parties’ conduct, and, thus, was formed pursuant to subsection (3) of § 2-207. A contract never came into being under subsection (1)

of § 2-207 because (1) paragraph fourteen on the reverse side of Bayer’s invoices expressly conditioned ac- ceptance on Malden Mills’s assent to “additional or dif- ferent” terms, and (2) Malden Mills never expressed “affirmative acceptance” of any of Bayer’s invoices. In addition, the exchange of forms between Malden Mills and Bayer did not result in a contract because Malden Mills, by means of language in paragraph one of its pur- chase orders, expressly limited Bayer’s acceptance to the terms of Malden Mills’s offers. [Citation.]

*** *** Where a contract is formed by the parties’ con-

duct (as opposed to writings), as is the case here, the terms of the contract are determined exclusively by sub- section (3) of § 2-207. [Citation.]. Under subsection (3) of § 2-207, “the terms of the particular contract consist of those terms on which the writings of the parties agree, together with any supplementary terms incorpo- rated under any other provisions of this chapter.” § 2- 207 (3). In this respect, one commentator has aptly referred to subsection (3) of § 2-207 as the “fall-back” rule. [Citation.] Under this rule, the Code accepts “common terms but rejects all the rest.” While this approach “serves to leave many matters uncovered,” terms may be filled by “recourse to usages of trade or course of dealing under [§] 1-205 or, perhaps, the gap filling provisions of [§§] 2-300s.” [Citation.]

*** Thus, the judge correctly concluded, under subsection

(3) of § 2-207, that the arbitration provision in Malden Mills’s purchase orders did not become a term of the parties’ contract. The arbitration provision was not common to both Malden Mills’s purchase orders and Bayer’s invoices. Bayer properly does not argue that any of the gap-filling provisions of [the UCC] apply. Because Bayer concedes that it never previously arbitrated a dis- pute with Malden Mills, we reject Bayer’s claim that the parties’ course of dealing requires us to enforce the arbi- tration provision.

INTERPRETATION In cases in which a con- tract is formed by the parties’ conduct (as opposed to writings), all conflicting written terms are invalid.

ETHICAL QUESTION Is it unethical for Mal- den Mills to try to avoid a term from its own forms? Explain.

CRITICAL THINKING QUESTION Do you agree with how the Code deals with the battle of the forms?

398 Sales Part IV

Manner of Acceptance [19-3c] As is true of contracts under common law, the offeror may specify the manner in which the offer must be accepted. If the offeror does not so specify and the cir- cumstances do not otherwise clearly indicate, an offer to make a sales contract invites acceptance, effective upon dispatch, in any manner and in any medium rea- sonable in the circumstances. (Article 2A.) The Code therefore allows flexibility of response and the ability to keep pace with new modes of communication.

An offer to buy goods for prompt or current ship- ment may be accepted either by a prompt promise to ship or by prompt shipment. Acceptance by perform- ance requires notice within a reasonable time, or the offer may be treated as lapsed. (Article 2A.)

Auctions [19-3d] The Code provides that if an auction sale is advertised or announced in explicit terms to be without reserve, the auctioneer may not withdraw the article put up for sale unless no bid is made within a reasonable time. Unless the sale is advertised as being without reserve, the sale is with reserve, and the auctioneer may with- draw the goods at any time until he announces comple- tion of the sale. Whether with or without reserve, a bidder may retract his bid at any time prior to accep- tance by the auctioneer. Such retraction, however, does not revive any previous bid.

If the auctioneer knowingly receives a bid by or on behalf of the seller and notice has not been given that the seller reserves the right to bid at the auction sale, the bidder to whom the goods are sold can either avoid the sale or take the goods at the price of the last good faith bid.

CISG The CISG does not apply to sales by auctions.

CONSIDERATION [19-4] In several respects, the Code has relaxed the common law requirements regarding consideration. For example, the Code provides that a contract for the sale of goods can be modified without new consideration, provided the modification is made in good faith. (Article 2A.) In addition, any claim of right arising out of an alleged breach of contract can be discharged in whole or in part without consideration by a written waiver or renuncia- tion signed and delivered by the aggrieved party. Under

Revised UCC Article 1, a claim or right arising out of an alleged breach may be discharged in whole or in part without consideration by agreement of the aggrieved party in an authenticated record. Moreover, a firm offer is not revocable for lack of consideration.