Project 2: Making Decisions That are Legal and Ethical

RESOURCES

Contract Formation and Execution

Contract law is a component of civil law that concerns the legal principles governing the exchange of goods or services between individuals or businesses. At its heart, contract law involves how legally enforceable promises are formed and executed.

A promise is a declaration by a legal person (called the promisor) to perform or forbear from performing specified act(s). The recipient of the promise (called the promisee), upon a promise being made, has rights to expect (and often to demand) that the promise be performed. Whether these rights to expect and demand performance are moral or legal rights depends on whether the promise was made in the context of a valid and enforceable contract. Only if the legal requirements of a contract are satisfied, or if other legal remedies are available, will a promise be enforceable in a court of law.

The law of contracts provides a means of distinguishing between types of promises that create moral obligation (e.g., a promise to meet a friend for coffee) and those that also create legal obligation (e.g., a promise to your bank to pay the mortgage acquired on your home).

Within the United States, there are two major sources of domestic contract law: the Uniform Commercial Code (UCC) and the common law. Depending on the subject matter of the contract, such as if the contract involves the purchase of tangible personal property ("goods") or the hiring of an individual for employment ("services"), one will look to specific sources of law to determine whether the legal promise is enforceable.

Contracts for the sale of goods are governed by Article 2 of the UCC. Most contracts that are not for the sale of goods—such as contracts for employment, real property, insurance, and so forth—are governed by the common law, which is generally summarized in the Restatement of Contracts (Restatement).

Once one identifies the applicable source of the contract law—that is, whether the contract is governed by the common law or by the UCC—then, one can determine if the particular promise is valid and enforceable under the applicable rules contained in that source of law. Although the UCC and the common law do overlap, there are many key differences between the two sources of law as regards many areas of contract law, including the formation and performance of a contract, the requirements for breach of a contract, the enforceability of a contract, and the remedies available for the victim of a breach.

The legal enforceability of a particular promise thus hinges on the rules contained in the relevant source of law that are applicable to the subject matter of that particular promise. The promise is, in many ways, the cornerstone of societal order. As stated by distinguished jurist Roscoe Pound, the "social order rests upon the stability and predictability of conduct, of which keeping promises is a large item" (Pound, 1959). Contract law provides the mechanism for determining when a promise is valid and enforceable in a court of law.

References

Pound, R. (1959). Jurisprudence (Vol. 3). Saint Paul, MN: West Publishing Co.

Contract Law

A contract is a legally enforceable promise or an exchange of promises. To be enforceable, the contract must meet certain elements. There must be an offer, acceptance of that offer, and then an intended exchange of value between the parties. These elements demonstrate a meeting of the minds between the parties. That is, the parties have a common understanding of the material terms of the agreement. A contract does not have to be a formal, written document. It can be a verbal agreement or it can arise through the conduct of the parties. Those who make a contract do not have to use the word contract or even recognize that they have made a legally enforceable promise. Each state develops its own contract law. Contract law provides confidence and promotes productivity by making private agreements between individuals legally enforceable. Plainly stated, it helps make buyer and seller willing to do business together.

For example, one individual offers to purchase a widget from another person for $1. The other person agrees. This is an contract, as there is an offer and acceptance of that offer, a planned exchange of value, and a meeting of the minds as to these primary terms of the agreement.

As you can see, a contract does not necessarily have to be formal or in writing. A simple conversation or even actions of two or more individuals can be a contact.

Ask Yourself

· Does it surprise you how easy it is to form a contact? Why or why not? Why do you think it is so easy to form an enforceable contract? Are there any negatives to this? How do you judge whether there is a meeting of the minds between the parties? How do you account for the subjective nature of one person's understanding?

· Mark goes to an antiques auction. A nice painting comes up for auction and Mark love it. The auction provides extensive background on all of the items being offered. The auctioneer begins taking bids and Mark the winning bidder. Has a contract been formed in this situation?

Sources of Contract Law

States create their own contract law. They pass statutes and allow courts to develop common law. In doing so, state legislators and judges rely upon model laws in developing the statutory and common law. These model laws are known as the Restatement of Contracts and the Uniform Commercial Code (UCC). These model laws influence judges who interpret contract law and legislators who draft statutes that resemble (or copy exactly) these model laws. As such, you can study model laws to acquire a broad understanding of how contract law works. You can then look to the specific laws of your state to determine the exact law that applies to a given situation.

· Restatement of Contract—The Restatement of Contracts (Restatement) is a model law that deals primarily with contracts that do not involve the sale of goods or when goods are not the primary subject of the contract. Most state common law generally tracks closely the provisions of the Restatement.

· Article 2 of the Uniform Commercial Code—Article 2 of the UCC governs contracts for the sale of goods. It has been uniformly accepted by nearly every state in the United States. A sale of goods includes any manufactured product, crops, timber, livestock, attachments to land, exchanged currencies, mined minerals, etc. It does not include intellectual property, securities, noncommodity currencies, and un-mined minerals.

To be subject to the provision of the UCC, goods must be the primary purpose of the contract. If services are the primary purpose of the agreement, the incidental inclusion of goods is not covered by the UCC or corresponding state statutes.

Ask Yourself

· What are some of the advantages and disadvantages of model codes of laws? Why do you think states more readily adopt a uniform code of contracts covering the sale of goods, but are less apt to adopt a uniform code covering services?

· Jill approaches an interior designer about designing and purchasing furniture for her home. Jill owns a large mansion. The designer quotes Jill a price of $10,000 for her services and $1 million for all of the furniture. If Jill's state adopts the Restatement of Contracts and UCC, which model law will primarily govern the contract?

Unilateral and Bilateral Contracts

Contracts are divided into unilateral and bilateral agreements based upon the duty of performance and how an offer to contract is accepted.

· bilateral contract—A bilateral contract consists of two promises between individuals that form a contract. Specifically, one party makes a promise to another party that she will do something (or forgo doing something) in exchange for the other party's promise to do something (or promise to forgo doing something). For example, Eric promises to wash Julia's car if she promises to pay him $20. The both activities will occur at some point in the future, so you have two promises of future performance.

· unilateral contract—A unilateral contract is an agreement with only one promise. That is, one party promises a future action if the other party performs whatever is requested of her. The promising party does not want a return promise. As such, a contract is formed or comes into exists once the other party begins to perform the requested services. Suppose Eric tells Julia that he will pay her $20 if she washes his car. Eric does not want a promise to wash the car. Julia can accept Eric's offer by beginning to wash his car. Julia is not obligated to wash the car unless or until she begins doing so. Further Eric is not obligated to pay Julia until she begins washing the car.

The common characteristic between unilateral and bilateral contracts is that it entails a promise of performance and a demand from the offeree. This is critical to the requirement that a contract contain an offer, acceptance, and exchange of value.

Ask Yourself

· Why do you think it is important to distinguish and recognize these two types of contracts? Do you think each type of contract is more applicable in either sales of goods or services? Why or why not?

· Jennifer is looking for someone to paint her house. She sends out an email to several painters in the neighborhood that she has purchased the paint and will pay $3,000 to anyone who paints her house. She also includes some detailed requirements for the painting process and states that project must be completed by the coming weekend. Rob shows up the next morning with all of his equipment and ready to paint. Is there a contract in this situation? Why or why not?

Express, Implied-in-Fact, and Implied-in-Law Contracts

An express contract arises from interactions in which parties actually discuss the agreement and the promised terms. The contract does not have to be formal or in writing, but it requires that the parties express their intentions in an agreement.

For example, one person expressly offers to sell a widget to another person. The other person accepts the offer by saying the she will buy it. The parties have an expressed contract because they have stated an offer, stated an acceptance, and identified consideration. These expressions can be verbal, as in this situation, or written.

An implied-in-fact contract arises from the conduct of the parties, rather than from words. That is, the parties interact in a manner that constitutes a legally enforceable contract. This means that all of the elements of an enforceable contract can be inferred from the actions of the parties.

For example, Ellen asks Albert, an attorney, for professional advice. Ellen knows that Albert is an attorney and charges for his advice. Asking Albert for his professional advice implies a promise from Ellen to pay the going rate for that advice. This is true even though Ellen and Albert did not make an express promise to pay for it.

An implied-in-law contract, or quasicontract, is a contractual relationship ordered by the court. It lacks the mutual asset element of a contract, but the court deems the interactions between parties to be a contract under the law. This court action is generally taken to avoid an unjust result, such as when one party is unjustly enriched at the expense of another. The court will hold that the law implies a duty on the first party to pay the second, even though the elements to find a legally enforceable contract between the two parties are absent.

For example, Bell routinely rakes leave in the neighborhood for extra money. She rakes leaves for lots of houses and sometimes forgets which houses have requested her services. She begins raking James's yard, having forgotten that she never worked out an agreement to do so. James often pays individuals to rake his yard and has plenty of money to do so. At the end of the job, Bell asks James for $20 for her effort. If James refuses to pay the court may hold that it would be unfair for James to receive this value and not pay something for it. As such, the court could hold that an implied-in-law contract to pay for Bell's services.

Ask Yourself

· How do you feel about implied contracts? Should all contracts be required to be expressed? What are some arguments for and against this approach? What do you think is the justification for recognizing implied contracts?

· Kyle agrees to purchase building material from Anna, a new employee of a construction materials company. Anna executes a contract but makes an error when pricing the material. Per the terms of the agreement, Kyle will pay far less than the cost of the material. Kyle realizes this, but he stays quiet. Kyle uses the material before Anna catches the error. She sends Kyle an additional bill to cover the cost of the material, but not profit. Kyle refuses to pay the additional amount. What might a court do in this situation?

Valid, Enforceable, Void, and Voidable Contracts

There are several common characteristics of contracts that dictate whether a contract actually exists and whether it is enforceable in a court of law. The following vocabulary is important for characterizing these aspects of a contract.

· valid and invalid—A contract is valid when all of the elements essential to forming a legal contract are present. Conversely, a contract is invalid (or rather, there is no contract) if any of the essential elements of a contract are missing. The elements to forming a valid contract (offer, acceptance, consideration, and a meeting of the minds) are discussed further below. For example, One person announces that she will sell her cell phone for a reasonable price. Another person quickly says, "I will buy it." In this case there is not a valid contract because there is not enough specificity in the consideration. As such, a critical piece of the contract is missing. While the parties might think they have a contract, if a challenge to the contract arises, a court is likely to hold it to be invalid.

· enforceable and unenforceable contract—An enforceable contract is one that can be enforced in court of law. That is, the law allows for enforcement of the contract. An enforceable contract must always be valid. A valid contract may, however, be unenforceable. That is, even though all of the essential elements of a contract are present, a court will not enforce the contract. An oral contract may be valid, but the court will not enforce it because that specific type of contract is required to be in writing under the state's law. Contracts that are required to be in writing are discussed further below.

· void and voidable contracts—An otherwise valid contract may be void pursuant to the law. That is, state law identifies certain types of contracts that are deemed void from the outset. These include contracts that violate public policy or have an illegal purpose. A voidable contract is an agreement where either one or both parties has the right to make the contract void. That is, the contract is valid and enforceable until one party elects to void it. A contract to purchase illegal drugs, for example, is void. A party to a contract who is below the legal age of mental capacity may void the contract at any point before she reaches the age of mental capacity. Various situations where contracts are deemed valid, enforceable, void, or voidable are discussed further below.

Ask Yourself

· Why do you think there is a distinction between a invalid contract and contract that is unenforceable against a party? Are there any reasons or justifications for treating them as one in the same?

· Gayle arrives at work one morning and says to all of her colleague, "I am tire of my piece of junk car. I would sell it right now for $500." Bert thinks about Gayle's statement and determines that it would be a good buy. After lunch, Bert approaches Gayle and says, "I will buy your car" and extends $500 in cash. Gayle, surprised by Bert's actions, replies that she is not willing to sell her car. If Bert sues Gayle for breach of contract, what will be the likely result?

· What do you think are the justifications for deeming a contract voidable? Can you think of scenarios where you think one party should be allowed to get out of the contract, but not the other party? Can you think of scenarios where both parties should be allowed out of the contract?

· Amy is extremely angry at David. She hires Laura to pour sugar into the gas tank of David's car. Laura loses her nerve and backs out of their agreement? Can Amy enforce her agreement with Laura?

Requirements of a Valid Contract

As previously discussed, a contract is a specific promise to another and also a specific demand of that person. The demand could be a promise of future action (bilateral contract) or immediate performance of an act (unilateral contract). The promise and demand is an offer. Meeting with the offerer's demand is known as acceptance. Both parties must give or exchange something of value with the other. The thing of value is known as consideration. Consideration is the promise to give, or actual giving, of a requested benefit or the incurring of a legal detriment (i.e., doing something one does not have to do.). Both parties must be of a legal age and sound mind, and the purpose of the agreement cannot be illegal or against public policy.

For example, one person offers to sell a product, service, or offers something of value (money, goods, etc.) in exchange for someone else's product, service, or other thing of value. This constitutes a valid offer. The things of value constitute consideration. A second person accepts the offer by either agreeing to the offerer's request to trade things or actually trading those valuables.

Remember that each party must provide something of value to the other. It does not matter how much value or even whether anyone else in the world would consider it valuable.

Ask Yourself

· Why do you think that the law requires an agreement to have all of the elements to be enforceable? Can you think of situations where any of these elements are not present, but you believe the agreement should be enforceable anyway?

Offer to Contract

The following elements must be present to establish a valid offer to contract:

· offerer and offeree—An offer to contract must contains a specific promise from the the person making the promise (offerer) and a specific demand of the individual receiving the offer (offeree). For example, I tell you that I will sell you a product for $5. I am the offerer and you are the offeree. My offer is to transfer ownership of a product and my demand is that you transfer ownership $5.

· intent to make an offer—The offerer must intend to make the offer. Whether there is intent to make an offer is judged from the position of the offeree. If a reasonable person in the position of the offeree would believe the offerer's words or actions constitute an offer, it is an offer. This is an objective, rather than subjective, standard for determining whether the intent to make an offer exists. For example, I shout out loud in frustration that I would sell my piece-of-junk car for a $100. The words look like an offer to sell my car. In reality, I am simply espousing my frustration. I do not have the intent necessary for my statement to constitute an offer and no reasonable person would interpret my statement as truly demonstrating that intent.

· definite terms—An offer to contract must be sufficiently definite. That is, the terms of the offer must be sufficiently specific to allow the offeree to understand and accept the offer. The offeree must understand that she is the intended recipient of the offer and may accept it. Also, the terms of consideration must be stated. There is an exception to this rule for the sale of goods pursuant to the terms of the UCC. Some contracts for the sale of goods can leave open nonquantity terms to be decided at a future time. For example, simply stating that I will sell you an item "for a reasonable price" is not sufficient to constitute a definite offer. Most advertisements, catalogs, and web page price quotes are considered too indefinite to form the basis for a contract. To be sufficiently definite, the advertisement must be specific about the quantity of goods being offered and who is the intended offeree.

Remember, the above elements do not have to be in writing or formal. Further, the parties do not have to realize that their words or actions constitute a valid contract; rather, each element is judged by an objective standard. That is, how would a reasonable person perceive the actions potentially constituting an offer?

Ask Yourself

· How do you feel about the requirement that a contract meet this level of formality? Should it be more or less formal, and why? How do you feel about the fact that individuals can form a contract without fully realizing that their agreement is legally enforceable?

· Ashton is reading looking at the merchandise for sale on Smart Clothes Corp's website. He places an order for a new shirt and goes through the process of setting up an account and attempting to pay. At the end of the process, he gets notification that his purchase is discontinued and cannot be purchased. Ashton is furious and wants to sue Smart Clothes for breach of contract. If he does, what is the likely legal result in this situation?

When Does an Offer to Contract Terminate?

An offer to contract terminates at the following times or under the following conditions:

· specific provision—An offer may include a specific provision detailing how long an offer will stay open and the conditions under which it terminates.

· lapse of time—Unless the offer states otherwise, an offer terminates after a reasonable period of time. A reasonable period of time will vary depending upon the type of contract. An offer to sell bananas will terminate more quickly than an offer to sell cement.

· offeree’s rejection—An offer terminates if the offeree receives the offer and rejects it. Once the offeree rejects the offer, she cannot come back later and accept the offer. Any attempt to do so may constitute a new offer to the original offerer.

· counter offer—If an offeree makes a counter offer or counter proposal in response to an offer, the original offer terminates. This is the case with negotiations. If a party attempts to negotiate new or additional material terms to the offer, the original offer terminates. Attempting to offer ancillary or nonmaterial terms may not terminate the offer.

· revocation by the offerer—Generally, the offerer may revoke an offer at any time before the offeree accepts it. If the offeree has already accepted the offer, a valid contract exists and an attempt to revoke the offer may constitute breach of the contract. There are certain offers, known as "firm offers," that state that the offer cannot be revoked for a certain period. This type of offer is a form of contract in itself.

· destroy subject matter of contract—An offer terminates if, before the offer is accepted, the property that is the subject of the offer is destroyed. If the offer has already been accepted, this could serve to void the contract.

· death or mental incapacity—If the offerer dies or loses mental capacity at any time before an offer is accepted, the offer is revoked. The offer does not become effective again if the offerer regains mental capacity.

· illegality—An offer terminates if the subject of the offer (the activity or product) becomes illegal. If the offer has been accepted, the subject matter becoming illegal will void the contract.

Some of the methods of contract termination are voluntary, while others others are a result of circumstances beyond the control of the parties.

Ask Yourself

· Do any of the common methods by which an offer terminates surprise you? What factors should a court consider when determining whether a "reasonable time" has passed? What factors should the court consider in determining whether an offeree has been rejected? Does the rule regarding counter-offers discourage negotiation? Why or why not?

· Dudley is interested in purchasing an ownership interest in Sarah's business. Sarah sends over a term sheet that places a specific value on her business and offers a specific number of shares. Dudley reviews the sheet and sends back a sign subscription agreement that lists a lower valuation, but agrees to buy a larger number of shares. The total purchase price for all shares would equal the amount indicated in Sarah's term sheet. Sarah writes back and says that she will work with other investors. Dudley is angry and wants to sue for a breach of contract? What is the likely outcome?

Acceptance of an Offer

Acceptance of a contract is the assent of the offeree to the demands contained in the offerer's offer. Acceptance of the contract varies depending upon whether the contract is unilateral or bilateral. An offeree accepts a bilateral contract by making the return promise demanded by the offerer. An offeree accepts a unilateral contact by undertaking the performance demanded by the offerer. The acceptance of an offer must meet a specific standard based upon the type of contract and the governing law. The standards that a specific type of contract must meet are described in the sections below.

Mirror-Image Rule (Reinstatement)

Contracts that are not primarily for the sale of goods may be governed by rules derived from the Restatement of Contracts. The Restatement proposes the "mirror-image rule" for acceptance of an offer. This rule states that the acceptance of an offer must be exactly as demanded by the offerer. That is, the acceptance must "mirror" the offer. If the offeree adds new terms to the acceptance, it is not really an acceptance. Acceptance with different or additional terms constitutes a counteroffer.

For example, I offer to perform a service for you at a given fee. You reply that my prices are too high and that you want a 15 percent discount. You changed the terms of the consideration (the price), which is a material aspect of the offer. As such, you have effectively rejected my offer, as your attempted acceptance was not the mirror image of my offer.

Ask Yourself

· Why do you think about the mirror-image rule? Does it concern you that a minor deviation in an acceptance can effectively reject a contract? Why or why not? What if this was not the intent of the parties at the time of entering into the agreement?

· Kate offers to paint Roger's house for $2,500. Roger attempts to accept the offer by saying, "Great. But, you have to paint the storage shed in the backyard as well." Kate does not respond and decides to take a different painting job. Roger is angry, particularly when he learns that the next closest offer is twice as expensive. He wants to sue Kate for her failure to perform. What is the likely result?

Rule for Sale of Goods (UCC)

The mirror-image rule does not apply to sales of goods under the UCC. The UCC recognizes that a contract is formed if the acceptance of the offer is unequivocal. That is, if it is obvious the parties agree on the primary or material terms of the agreement, an acceptance that changes or adds additional terms is a valid acceptance. The effect of different or additional terms depends on whether the parties are merchants. If either party is not a merchant, any additional or different terms are deemed suggestions for addition and do not become part of the contract. If both parties are merchants, the additional terms become a part of the contract, unless:

· they materially alter the contract,

· acceptance is conditioned on the specific terms of the offer, or

· the offerer specifically rejects the additional or different terms.

For example, I am a merchant and I offer to sell you goods. You respond that you are willing to purchase the goods, but I must provide you with a warranty. I send the goods and you accept them. If you are not a merchant, there is no warranty. That was simply a recommendation to be part of the contract. If you are a merchant, the warranty is a part of the contract. In this example, if we are both merchants, I could have excluded the warranty from the contract be expressly rejecting the warranty. If I sent the goods and you accepted them, you have agreed to the terms of my original offer.

Ask Yourself

· Why do you think the sale of goods employs a different rule than contracts to provide services? Can you think of any reasons for differentiating between the rules that apply to merchants of goods and nonmerchants?

· Darla is purchasing consumer goods from Isaac's business. Darla sends in a purchase order and the payment for the goods. Isaac sends the goods and a receipt that includes a clause stating that any disputes about the goods must be submitted to arbitration. Darla is not happy with the quality of the goods and she asks Isaac to return her money. When Isaac refuses she seeks to sue Isaac. What is the result in this situation?

Silence with Regard to Offer

Failing to reply to an offer is not acceptance in most cases. This is true even if the offer says silence will be considered acceptance. There are, however, exceptions to this rule. If the relationship between the parties is such that it is not expected that the offeree reply, silence by the offeree may constitute acceptance. Another exception would be where the offeree readily understands that silence or a failure to respond means acceptance of the offer. This generally only arises in situations where the offerer and offeree have a history of prior dealings. Lastly, in the case of contracts between merchants under the UCC, silence may constitute acceptance of an offer. In some instances, a merchant is required to expressly reject goods that are delivered; otherwise, her silence constitutes acceptance of the contract.

For example, I offer to paint your house for $100. If you do not respond to my offer, there is no acceptance. If, however, I specifically state that, "If I do not hear anything from you by Friday, I will assume you agree to my offer." You reply, "That sounds good." You now realize that silence become acceptance on Friday. Changing the scenario a bit, you are a contractor and I routinely provide you quotes on houses. You expect me to paint all of your houses. If our routine practice is that I provide a quote and am expected to paint the house if you do not object, silence may be acceptance.

If we are both merchants dealing in expensive bicycles. You make a monthly order with me for the same inventory. One month, I send a shipment of inventory without receiving an order from you. If the goods arrive and you do not reject them for two weeks, your silence constitutes acceptance.

Ask Yourself

· How do you feel about the idea that, in some instances, an individual can accept and offer simply by failing to respond? Are you convinced that the applicable exceptions are justified? Why or why not?

· Eric enters his email address to receive offers from a CD of the month club. The next week, Eric receives a CD in the mail with instructions state that he must return them within 10 days or he incurs an obligation to purchase the CD. What is the likely result?

Mailbox Rule

The mailbox rule is a default rule that applies when the offerer does not place specific requirements on the manner of acceptance. Under this rule, the offeree accepts the offer when it is sent to the offerer. This could include dropping it in the mail or sending it with a courier. This may also include providing notice of acceptance via email or other electronic communication (regardless of whether the offerer actually checks or reads the email). As such, if an offer is made to multiple offerees, the first offeree to accept in any manner (including by dropping the acceptance in the mail) has a binding contract.

For example, You offer to sell me your car for $500. I immediately send you a letter accepting your offer and a $500 check. We have a contract as soon as I drop the letter in the mail.

Ask Yourself

· What do you think about the mailbox rule? Should it be the default rule in contracts? Why or why not?

· Pamela is a musician and writer. She offers to sell her copyright to a popular song to Devon and Mark. Devon drops his acceptance of the offer in the mail on Friday evening. On Saturday morning, Pamela meets with Mark and signs an agreement transferring the copyright to him. What is the likely result in this situation?

Consideration in Contract Formation

Consideration is anything of value. Recall that a valid contract must include an exchange of value between the offerer and offeree. The value should be the inducement or incentive for the other party entering into the agreement. That is, it must be the subject of the bargain between the parties. A promise to make a gift is not binding because the party receiving the gift gives no value in return for the promise. When the existence of consideration is not clear, the court will examine the transaction as a whole to determine if consideration exits and the contract is enforceable.

Types of Consideration

The amount or value of the consideration present does not matter. It need not be money or goods. Acceptable types of consideration include the following:

· agreement to refrain—An agreement to refrain from doing something that you have the right and ability to do may constitute consideration. For example,  I really want to stand up and sing in the middle of a crowded restaurant. You would be very embarrassed if I do so. You offer me $5 to not stand up and start singing. My refraining from doing this may constitute consideration.

· agreement not to sue—An agreement not to sue the other party may be sufficient consideration when reasonable grounds exist to make a lawsuit possible. For example, you claim that I owe you additional funds under a contract. I disagree and argue that all accounts are settled. You threaten to sue me. I offer to pay you a small sum of money in exchange for your agreement not to bring a legal action against me. Forgoing your right to sue me in exchange for money is a valid exchange of consideration.

· prior consideration—Generally, consideration in a prior agreement is not valid consideration in a new agreement, except in very limited circumstances. The reason is because the individual is already obligated under the old agreement. Trying to promise to do the same thing does not provide a new form of value. Under the UCC, however, a preexisting obligation can constitute valid consideration if the offerer is a purchaser of $500 or more in goods, and she offers to pay more than an additional $500 for the same goods. This exception exists to protect certain business arrangement from failing. For example, we are both merchants. You enter into a contract to purchase goods from me for $5,000. In the pendency of the contract, you realize that I am likely breach the contract. You really do not want to find another seller, so you offer to pay an additional $1,000 for me to perform the contract. May agreement to perform my existing contractual obligation (sell you the goods) is valid consideration - even though it is the consideration for a prior agreement.

Ask Yourself

· How do you feel about the requirement for consideration? Should there be a value requirement for the consideration? Why or why not? What do you think is the purpose or objective behind requiring any form of consideration, regardless of the nature or value?

· Donna is merchant and enters into a contract with Ashley to purchase bricks from me for $10,000. In the pendency of the contract, the cost of bricks rises dramatically. Ashley will lose money by selling the bricks to Donna for $10,000. Donna realizes that Ashley is going to lose money and will likely breach the contract. Donna really needs the bricks and it is most convenient to purchase from Ashley. She offers to pay an additional $1,000 for the bricks. If, after Ashley ships the bricks, Donna decides not to pay the additional $1,000, what is the probable result?

Promissory Estoppel Exception to Consideration Requirement

A doctrine known as promissory estoppel may serve as a substitute for consideration to make an agreement into a valid contract. Promissory estoppel is an equitable doctrine. If the offeree reasonably relies on the offerer's promise to her detriment, the doctrine of promissory estoppel may make the contract valid despite the absence of consideration. The two key elements are (1) that the reliance must be reasonable in light of the situation, and (2) the relying party must suffer a tangible detriment. The court may also consider whether performance causes a hardship on the promising party.

For example, you are having erosion problems in your hard. You cannot afford to pay to have it fixed, so I offer to give you the materials necessary to build a retaining wall. You spend your available money grading out the ground and digging the dirt where the wall will go. After all of this, I back out of my promise. You have now spent your available money and, without installing the wall, made the situation far worse than it was before. A court may deem my promise to be an enforceable contract because you relied to your detriment on my promise.

Ask Yourself

· How do you feel about the idea that a person's reliance on another person's promise can substitute for consideration? How much of a detriment must the relying party suffer before you think a court should enforce the agreement? Should the promise be enforced if it would result in a significant hardship for the promising party?

· Tina says that she will give Sam her car to drive across the country from Georgia to California. Sam relies on Tina's promise by not purchasing a plane ticket. Tina fails to follow through with her promised gift. Sam has to purchase a plane ticket that is dramatically more expensive that it would have been if he had purchased the ticket at the time that Tina made her promise. If Sam wants to sue Tina for breach of contract, what is the likely result?

Other Exceptions to Consideration Requirement

There are two very broad, common exceptions to the requirement that a contract be supported by consideration:

· option contracts—An option contract is an agreement between parties that allows one party a specific period of time to purchase a particular asset at a given price. For example, Mark believes that the price of Apple, Inc., stock is going to rise. He purchases an option contract from Tom that allows him to purchase the Apple stock at the current price at any time within the next 30 days. Tom believes that the price is going to go down, so he is happy to sell the option to Mark.

· firm offers—The UCC recognizes the enforceability of a promise to keep open (not retract or cancel) the offer to purchase or sell a good for a specific period of time. For example, Agnes offers to sell a piece of equipment to Maria. She states that the offer is good for 30 days. Agnes and Maria now have an enforceable agreement for the next 30 days, despite the absence of consideration in the agreement to keep the offer open.

Mental Capacity to Contract

To enter into a contract, a person must have mental capacity sufficient to understand the nature and consequences of her actions. If mental capacity is absent, the contract is voidable by the person lacking capacity. There are three classes of persons commonly understood to lack capacity to be bound by contractual promises:

· minors—A minor is someone below the statutory age of mental capacity within a jurisdiction. Generally, a person must be 18 years old or older to have the requisite mental capacity to contract. As such, a minor who enters into a contract can void the contract at any time prior to reaching the age of majority. The exception to this rule is when the contract involves goods or services necessary for the child's survival. This could include food, water, shelter, etc. In the case of necessities, the child will be obligated to pay the reasonable value of the goods or services received. If the child fails to disaffirm the contract by this time, she thereby ratifies the contract and is bound going forward. For example, Jane is 17 years old. She goes to a local gym and signs up for a year-long membership. This is not a contract for a necessity. Jane will be able to void the contract at any time before she turns 18 years old. She will, however, have to pay the reasonable cost of any value she receives from the gym.

· intoxicated person—An intoxicated person may lack the mental capacity necessary to contract. Generally, this will require extreme intoxication. If the intoxicated person enters into a contract, she must disaffirm the contract within a reasonable time of regaining capacity and learning of the contract. If she fails to do so within a reasonable time, she has ratified the contract and will be bound. For example, Don gets drunk in a bar. He does not know where he is and asks a stranger for a ride home. He offers to give the stranger, Gary, his Rolex watch in exchange for a ride home. Gary takes him home and takes the Rolex. When Don sobers up, he can immediately demand return of the Rolex. He was too intoxicated to appreciate the nature of his actions. As such, he can void the contract. He must act within a reasonable period to void the contract upon becoming sober.

· mentally incompetent person—A mentally incompetent person generally lacks the ability to enter into a contract. If the mental incompetency is temporary, the individual must disaffirm any contract entered into during incapacity within a reasonable time of regaining capacity. If the person is permanently incapacitated, the contract is either void or voidable at the insistence of a legally appointed guardian. For example, Ernie is having psychotic delusions. He goes to a security firm and hires a private security guard. Ernie's legally appointed caretaker will be able to void the contract based upon Ernie's lack of mental competence to enter into the agreement.

Each state may pass additional situations in which it deems an individual mentally incompetent to enter into contractual relations.

Ask Yourself

· How do you feel about the requirement for mental capacity to contract? Do you agree with arbitrarily setting an age at which a person is deemed to have mental capacity? Why or why not? How should a person's level of intoxication be measured to determine whether she has mental capacity to contract?

· Phyllis is in a bar and drinking heavily. She realizes that she cannot drive in her state, so she solicits a ride from Harriet. She does not have any money, so she offers Harriet her new Rolex watch in exchange for a ride. Harriet accepts and drives Phyllis three miles to her home. The next morning Phyllis realizes that she traded a very expensive watch for a three-mile ride. What are Phyllis' options?

Lawful Purpose of a Contract

A contract must have a lawful purpose to be enforceable. That is, the contract cannot violate or cause others to violate the law or public policy. The following scenarios may result in an unenforceable contract:

· crimes and torts—Contracts that require commission of a crime or tort or violate accepted standards are void. If a contract has both legal and illegal provisions, a court will often enforce the legal provisions and refuse to enforce the illegal ones.

· unconscionable contracts—An unconscionable contract is one that is so unfair that it is said to "shock the conscience." Unconscionability is broken down into "substantive unconscionability" and "procedural unconscionability."

· Substantive unconscionability means that the terms of the agreement are so extremely unfair or one-sided in favor of a party that it is unlikely that the other party to the agreement understood its terms.

· Procedural unconscionability refers to the conditions under which the contract was formed. The terms of the contract may indicate that one party was taken advantage of by another party with greater bargaining power. Such a contract may be void as against public policy if the circumstances indicate that a reasonable person would not have entered into the agreement without the existence of an undue hardship. In some situations, the undue hardship must have been brought on by the party unduly benefited by the contract.

· contracts to restrain trade—Contracts that restrain trade may be illegal and thus void. This is true for contracts that create a monopoly, fix prices, and divide up markets. This is generally the area of antitrust law. A court may also find a contract void if it serves to frustrate economic activity in a manner not covered by antitrust law or it intentionally interferes with contractual relations or unfairly competes. An example of a contract that directly prohibits competitive business activity is a "covenants not to compete." This type of contract restricts an individual from carrying on a trade or practice. These contracts are held to be void when they are unduly burdensome in their restrictions regarding the time and geographic locations for doing business. A covenant not to compete that has a limited time frame (3 to 6 months) and a limited jurisdiction (up to 50 miles) is generally enforceable if there is good reason for the restriction.

 States are free to pass statutes or develop common law that protects the public interest. A contract that runs afoul of what is deemed necessary for the public good may also be void.

Ask Yourself

· How do you feel about the requirement that a contract have a lawful purpose? Can you think of any situations where this requirement may cause an unfair result for parties? Should there be a sliding scale for determining enforceability of contracts that violate public policy or are illegal? Why or why not?

· Carter lives in New Orleans, Louisiana. The state is in a state of emergency based upon an approaching hurricane. Carter, along with thousands of other people, attempts to flee the city. The traffic is horrible and folks are running out of gas on the roadway. Carter is low on gas and pulls into a gas station. The gas station is charging $250 per gallon of gas. Carter is outraged, but purchases the gas and continues to flee the city. What are his legal options?

Voidable Contracts: Common Situations

Contracts are commonly voided in the following situations:

· fraud—Fraud involves an intentional misstatement of the material (important) fact that induces one to rely justifiably to his or her injury. If a person is defrauded into entering a contract, the defrauded party may void the contract upon learning of the fraud. Voiding the contract is at the option of the defrauded party, as she may wish to remain in the contract. The party committing fraud may not void the contract. If the defrauded party fails to void the contract upon learning if the fraud, she is deemed to have ratified it and is bound.

· misrepresentation—Misrepresentation is a material misstatement of fact that induces one to rely on the statement. The difference with misrepresentation and fraud is that misrepresentation does not involve the intent to mislead. As in the case a fraud, a party who enters a contract as a result of a material misrepresentation may void the contract upon learning of the false representation. The misrepresenting party may not void the contract. If a party fails to void the contract upon learning of the misrepresentation, she is deemed to ratify the agreement.

· duress—Duress means the use or threat of force to convince a person to act according to one's wishes. If a party enters into a contract due to the physical or economic duress imposed by the other party, the contract is voidable at any time by the party subject to duress.

· undue influence—Undue influence arises when one party unfairly takes advantage of another party by using a position of trust, influence, or confidence. For example, a psychiatrist who enters into a contract with her patient that is not related to medical services may be deemed to have exercised undue influence. The influenced party may have been pressured to enter into the agreement or felt unduly obligated to enter into the agreement for fear of destroying the doctor-client relationship.

· mutual mistake—A mistake by both parties regarding "material" facts or circumstances relevant to the contract may make a contract voidable. In such a situation, either party may void the contract upon learning of the mutual mistake. The standard for whether the mistake of fact is material is whether a reasonable person would have entered into the agreement if the true facts were known. A mutual mistake of law may make a contract voidable if it caused the parties to not have a "meeting of the minds" with regard to the core aspects of the contract. If no meeting of the minds exists, there is never a valid agreement between the parties.

· unilateral mistake—Generally, unilateral mistake by one party to the contract does not make the contract voidable. A unilateral mistake about the basic assumptions of the contract will only make the contract voidable when the nonmistaken party knew or had reason to know of the other party's mistake. In such a case, the effect of enforcing the contract against the mistaken party must be unconscionable and the nonmistaken party would not suffer a substantial hardship by voiding the contract. If the nonmistaken party did not know about the other party's mistake, the standard for voiding the contract is even higher. In such a case, the contract must not yet have been performed or the parties must be easily restored to their pre-performance positions. The mistake must be substantial, and the mistake must directly relate to some computational or clerical error in the construction of the terms of the agreement. No defense exists if the mistaken party knowingly assumed the risk of the mistake; is grossly negligent in making the mistake; violates a legal duty; fails to act within her duty of good faith and fair dealing; or intentionally fails to read the contract.

Ask Yourself

· How do you feel about the idea that both parties may hold the right to void a contract? Is there any justification for holding that the contract is void rather than voidable? Do you agree with the scenario under which a unilateral mistake if voidable? Why or why not?

· Constance enters into an agreement to purchase Gerald's business. The contract contains a calculation for the business's cash on hand at the time of sale to be added to the purchase price. Constance and Gerald did not pick up on the calculation error at the time of signing the agreement. The week prior to closing, Constance's attorney caught the error, which causes a huge increase in the calculated value of the business. Gerald wants to hold Constance to the dramatically increased price, as she signed the contract containing the calculation error. What are Constance's options?

When is a Contract Required to Be in Writing?

Some valid contracts are required to be in writing to be enforceable by a court of law. The requirement that a contract be in writing is generally dependent upon the subject matter of the agreement. A statute requiring that a contract be in writing is known as a "statute of frauds." These statutes are designed to prevent fraud in the formation of contracts. Most statutes do not require that the entire contract be in a formal writing; rather, there must be sufficient writing (in any form) to demonstrate the core aspects of the agreement.

The following types of contract are generally required to be in writing in all jurisdictions:

· sale of an interest in land—Contracts concerning the transfer of an interest in land must be in writing to be enforceable. An "interest in land" includes contracts for mortgages, mining rights, easements, etc. For example, I agree to sell you an easement to cross my land. Our contract must be in writing to be enforceable. Note that a construction agreement is not a transfer of an interest in land.

· collateral promise to pay another's debt—Debt surety or guarantee agreements are required to be in writing to be enforcement. These instruments document when one person promises to repay the debt of another. This includes situations where business owners guarantee the debts of their business. For example, you approach your rich uncle and ask that he loan you money to buy a car. I am your friend and I promise to repay the loan if you are unable to do so. If you default, your uncle may not be able to recover against me because our agreement is not in writing. That is, your uncle and I do not have an enforceable contract.

· duties that cannot be performed within one year—A contract must be in writing to be enforceable if the duties under the contract cannot possibly be performed within one year after its making. The ability to carry out the contract must be impossible to a certainty. For example, you and I enter into an oral contract for services that lasts for twenty months. This is not enforceable, as any service contract or a lease of longer than one year are generally not enforceable.

· sale of goods of $500 or more—Sales of goods fall under the provisions of the UCC. The UCC requires that any contract for the sale of goods for $500 or more must be in writing to be enforceable. Modifications to any such agreement must also be in writing. For example, I verbally agree to sell you a piece of equipment for $750. If I back out of our agreement, you may not be able to enforce our agreement through the courts because the agreement is not in writing.

States may establish other contracts that are required to be in writing to be enforced in that jurisdiction. For example, most states require insurance policies to be written.

Ask Yourself

· Why do you think that certain contracts are required to be in writing to be enforceable while others are not? Can you think of any other types of contract that you believe should be in writing to be enforceable? What is your reasoning?

· Todd enters into a verbal agreement with Ashley to provide lawn serves at her rental property for the next two years. After performing his obligations for one month, he realizes that it is a very difficult property to service and he drastically underbid the job. What are his options?

Statute of Frauds Requirements

To meet the requirements of the statute of frauds, there must be a sufficient writing to demonstrate that a contract exists. The writing can be typed, handwritten, or electronic. The agreement must generally be signed by the party against whom it is being enforced. A signature may be a mark, seal, stamp, electronic signature, or a handwritten agreement. Between merchants, a confirmation regarding the contract by one merchant that is not objected to by the other merchant will be sufficient, even though it is not signed by the other merchant.

Ask Yourself

· Why do you think that the definition of a writing is construed so broadly? Is this broad interpretation justified or does it unduly detriment a party? Why?

· Frank agrees to sell Amy his collector-edition, signed baseball card. Frank writes on the back of the a napkin, "I agree to sell Amy my Mickey Mantle rookie card for $2,000." Will this be a sufficient writing to satisfy the statute of frauds?

Exceptions to Requirement of a Written Contract

Jurisdictions recognize a number of exceptions to the requirement that certain contracts be in writing to be enforceable. Common exceptions to the writing requirement are as follows:

· admission under oath—If a party admits under oath (such as in a deposition or in a court proceeding), the contract may then be deemed enforceable.

· part performance—A court may deem an oral contract enforceable if the parties (or one party) has partly performed the contract. This principle generally applies to oral agreements to sell or transfer real property (land). If the buyer has paid part of the purchase price and taken possession of the land, the court may hold the oral agreement enforceable. This would generally entail a court order to complete the contract performance by signing a deed legally transferring the property.

· promissory estoppel—The equitable doctrine of promissory estoppel applies in situations where one party relies to her detriment on another party's promise. It arises in a situation where a party believes that her exchange of promises with the other party is a legally enforceable contract. That party puts herself in a position where she would suffer a loss if the other party does not perform. For example, Tom promises Jane that he will sell her land to build a house. Jane, relying on the promise, hires individuals to begin grading the land and laying a foundation for the house. Later, Tom refuses to transfer a deed to Jane and claims that the contract is not enforceable because it was not in writing. Jane has spent significant money and time under the belief that the contract was enforceable. As such, a court will probably hold the contract to be enforceable under the doctrine of promissory estoppel.

· rules involving goods—The UCC provides several exceptions to the rule that contracts for the sale of goods for $500 or more be in writing:

· specialty goods—If a manufacturer agrees to manufacture specialty goods for a client, once the manufacturer begins production of the goods, the contract may be enforceable without a written agreement.

· partial or complete performance—If goods have been accepted and payment for the goods has been made, the parties cannot later claim that the contract was unenforceable and demand return of the money or property. This may also be true for partial payment or delivery of a portion or installment of the goods.

· contract between merchants—An oral contract between merchants is enforceable when one party delivers goods and the other party either delivers goods or sends written notice confirming the terms of the agreement and the other party does not object to that notice within 10 days.

The justification for the above exceptions to the statute of frauds is that each situation provides an additional level of proof regarding the existence of a contract. It reduces the need for a writing to prove that the contract exists and its terms.

Ask Yourself

· Why do you think each of these exemptions from the statute of frauds exists? What standard do you think should apply to determining what is "part performance"? How far should anindividual go in relying on a promisor before it exempts the agreement from the statute of frauds? Why do you think these special provisions exist for sales of goods between merchants?

· Chris is a professional musician and celebrity. He walks into Grey's jewelry store and request that Grey make him a custom necklace. Grey agrees, but they do not execute a contract. The necklace is very ornate and will cost about $150,000. It will contain the musician's initials and symbol. When Grey finishes the necklace, Chris decides that he does not want it. What are Grey's options?

Relief from Contractual Obligation

Parties to a contract have duties or obligations thereunder. There are generally three options to relieve these obligations:

· perform—An individual is relieved from her duties under a contract once she has fully or substantially performed those duties. The individual is "discharged" from the contract.

· release from contract—Either party may be released from a contract by the other party. Alternatively, the person may be released if the contract becomes void.

· breach—Once a party to a contract breaches that contract, she and the other party no longer have duties to perform. If the contract is enforceable, the other party then has the ability to enforce the contract against the other party by seeking damages.

Performance of the contract and release eliminate a person's liability under the contract. Breach exposes the breaching party to damages or losses suffered for the breach. None of these options relieve a party form tort liability if her actions with regard to the contract constitute a tort.

Ask Yourself

· Should a party pursue the method of relieve her obligation under a contract that is of greatest advantage to her? Why or why not?

· Katie and Smith enter into a contract. Each has a duty to perform services for the other. Neither party ever takes action to act on the contract. What is the result?

Performance of a Contract

Performance of a contract relieves a person from further duties under the contract. There are three levels of performance:

· complete performance—Complete performance by a party means that the contracting party has fulfilled every duty required by the contract. A completely performing party is entitled to a complete performance by the other party. For example, I enter into a contract to build a house for Ellen. I build the house and complete all of the material and nonmaterial requirements of the contract.

· substantial performance—Substantial performance of a contract means less than complete performance; but, the level of performance is sufficient to avoid a claim of breach of contract. More specifically, it means that a party has performed all material elements of the contract, but there are nonmaterial aspects left uncompleted. The other party may be entitled to seek offset or recovery from the substantially performing the party for the aspects of the contract not completed. For example, I enter into a contract to build a house for Ellen. I build the house, but fail to paint the interior the color described in the contract. This contract is substantially performed and does not give rise to an action for breach. Ellen may, however, recover or offset the cost of painting the walls when paying me.

· breach of contract—Any performance that is not complete or substantial performance is a material breach. This entails performance at a level below what is reasonably acceptable. The materially breaching party cannot sue the other party for performance and is liable for damages to the other party for the breach. For example, I enter into a contract to build a house for Ellen. I distracted by another contract and make material errors in laying the foundation. It causes the house not to meet standards and pass inspection by the building inspector. In this case, I have breached the contract by failing to perform a material duty under the agreement.

Ask Yourself

· How do you feel about the concept of substantial performance? Do you believe that failure to perform certain duties under a contract should not constitute a breach? Why or why not?

· Missy enters into a contract to perform auditing functions for ABC Corp. She does reconciliation of many of the accounts, which takes substantial time. She is satisfied that the books are accurate, so she skips performing many of the key tasks required of external auditors. What is the status of Missy's duties under the contract?

Relief from Performing Duties under a Contract

An individual is relieved from her duty to perform a contract in the following scenarios:

· void contract—If a contract becomes void, both parties are relieved from their duty of performance.

· breach by other party—If the other party materially breaches the contract, the nonbreaching party is relieved from the obligation to further perform the agreement.

· failure of a condition—contract may contain any number of conditions that may materialize (or fail to materialize), which relieve the parties' obligation to perform under the contract.

· impossibility, impracticability, or frustration of purpose—Parties to a contract may be relieved from their obligation to perform if performance becomes impossible, commercially impracticable, or the underlying purpose of the contract is frustrated.

· waiver or release—A party may, per her own volition, sign a waiver or release relieving the other party's obligation to perform.

Any of the above situations may release one or both parties from their duties of performance.

Ask Yourself

· Do you agree that the above situations should relieve an individual from her obligations under a contract? Why or why not?

Conditions Regarding Payment, Delivery, and Tender of Performance

Tendering performance means to offer or attempt to perform the agreement. Often a party's offer or attempt to perform is sufficient to satisfy the condition of performance and obligate the other party's performance. That is, a party cannot avoid her obligation under the contract by failing to accept the other party's tender of performance. One party offering or attempting to perform is a condition to the other party's obligation to perform. Unless a contract states otherwise, the default rules under the UCC and Restatement place conditions on the delivery of services and the delivery of a product by a party to a contract.

The UCC states the buyer tendering payment to the seller of a good is a condition that must be satisfied before the seller has the duty to deliver the good. For example, I offer to purchase an expensive jacket from you. You accept. I must offer to give you the money before you are obligated under the contract to give me the jacket.

The Restatement, in contrast to the UCC, requires that a service provider must tender performance before the other party has a duty to pay for those services. I offer to paint your house for $500. You accept. I must complete my obligation to paint your house before you are obligated to pay me $500. In this case, tendering performance is completing my duty to paint.

In either case, rejecting a party's tender of performance can constitute a breach of contract if the tender of performance conforms to the requirements of the contract.

Ask Yourself

· Why do you think tending performance as a condition is treated differently under the UCC versus the Restatement?

· Herman offers to purchase machinery for his business from Jamie. The party is silent on who must perform first. Herman asks that Jamie ship the goods to his business location so that he can inspect it. If it meets inspection, he will pay for the machinery. Jamie refuses and asks Herman to pay first. If both parties refuse to perform first, who is likely legally liable for breach of contract?

Impossibility, Impracticability, and Supervening Frustration of Purpose

Impossibility of performance, commercial impracticability, and a supervening frustration may excuse a party's duty to perform a contract. Further, it will relieve the party from liability for the nonperformance.

Impossibility of Performance

A party may be excused from her duty to perform under a contract if performance becomes impossible. Events that make a contract impossible include the following:

· Illegality of the subject matter. I enter into a contract with you to sell you cleaning chemicals. The sale of such chemicals becomes illegal. My duty to perform is excused.

· The subject of the contract (property) is destroyed. I enter into a contract to sell you a car. Before I can sell it to you, a branch falls from a large tree and destroys the car. I am excused from my duty to sell an undamaged car.

· One of the parties to the contract dies or becomes physically or mentally disabled.

· Natural forces interrupt the contract. For example, a tornado, earthquake, severe storms, flooding, etc., permanently interrupts a party's ability to perform her contractual obligations.

· Performance would cause substantial risk of physical harm to one party. I enter into an agreement to replace the shingles on our house. Upon inspection, the roof of the house appears to be structurally unsound. Replacing the shingles would put me in an unreasonably dangerous situation. I did not anticipate this danger when entering the contract. As such, my duty to perform is relieved.

Impossibility of performance will only excuse a party's performance if the impossibility is not the fault of the nonperforming party. Further, impossibility will not excuse liability for nonperformance if the contract expressly contemplated the risk of conditions making performance impossible and specifically placed those risks upon the nonperforming party. For example, I enter into a contract to sell you a piece of machinery. In the contract, we expressly state that I must repair any malfunction of the machine that occurs prior to sale. The machinery breaks before the sale date. In this situation, the contract anticipates a risk and places it on me. I must repair the machine prior to sale.

Ask Yourself

· What do you think is the justification for allowing the above situations to excuse a person's duty under a contract? Can you think of any other situations that you believe should excuse a person's duty?

· Derek agrees to sell Artem sheet rock for a construction job. Derek leaves the sheetrock outside and it rains. The sheet rock is ruined. Artem has to purchase sheetrock from another source at a much higher price. If Artem decides to sue Derek, what will be the likely outcome?

Commercial Impracticability

Commercial impracticability arises when performance of a contract by a party has become unfeasibly difficult or costly to perform. The difference between impracticability and impossibility is that impracticability is still physically possible; however, performance will result in a substantial hardship to the performing party. Impracticability will excuse performance where the excused party did not have control over (or was not at fault for) the condition that made performance impracticable. Further, the excused party must not have expressly or impliedly assumed the risk of the duties becoming impracticable. Generally, impracticability is only found in extreme circumstances.

For example, I enter into an agreement with you to sell goods or perform services. The cost of performing the contract spikes because of a government tax, regulatory hurdles, raw material rates, etc. When entering the contract, we did not contemplate the price of goods or the cost of performing services to go up. If performing the contract would result in a serious financial burden to me, I may be able to get out of the contract by claiming that commercial impracticability excuses my performance.

Ask Yourself

· How do you feel about the doctrine of commercial impracticability? How unforeseeable must the intervening event be to make the contract impracticable? How severe must the damage suffered by the performing party be?

· Tom agrees to sell lobsters to Suzie for resale in her restaurant. Tom sets the price at a specific dollar value per pound. Later, the government imposes a large tax on sales of lobsters. If Tom continues to sell at the contract price, he will go out of business. What are Tom's options?

Supervening Frustration of Purpose

Supervening frustration of purpose is when circumstances arise that fundamentally frustrate a party's reason or purpose for entering a contract. The doctrine is similar to impracticability, but it does not relate to a party's hardship; rather it focuses on her expectation and purpose in entering the agreement. For a frustrating circumstance to relieve or excuse an obligation under a contract, the party cannot have assumed the risk of the circumstance (in the contract) or be at fault for the occurrence or the nonoccurrence of the event or circumstance. Further, the occurrence or nonoccurrence must have been a basic assumption on which the contract was made.

For example, John signs up for piano playing lessons from Tara. John suffers a horrible accident that causes him to lose dexterity in his hands. This is a frustration of purpose that was unforeseeable and substantially frustrates the purpose of learning to play the piano. As such, John will be excused from performance of the contract. Suffering an economic loss is not a frustration of purpose.

Ask Yourself

· How do you feel about allowing an unforeseen event relieving a person's duty for performing a contract? How fundamental must the assumption be to the purpose of the contract? To what extent must each party understand this to be the fundamental purpose of the agreement?

· Donald bids for and wins a government contract to construct a dam. The contract is subject to legislative approval. He begins preparing by entering into contracts with Lizzie for the purchase of cement. The cement supplier knows that the cement purchase is in preparation for the dam-building project. The legislator ultimately disapproves the dam project, which causes Donald to lose the contract. What is the possible result?

Waiver and Release

A waiver and a release serve to excuse one or both parties' duty of performance.

When a party intentionally relinquishes a right to enforce the contract. A waiver is generally employed after a party fails to perform. For instance, per our contract, I am supposed to paint your house, but I fail to do so in the allotted time. You grant a waiver excusing my liability for failure to perform.

A release is when one party is relieved from her promise of performance. A release generally occurs before a contracting party has to perform. For example, we sign a contract where you agree to pay me to paint your house by the end of the month. Before my performance is due, I explain that I do not have time to paint your house. You sign a release that frees me of my duty to paint your house.

Waivers and releases are often used synonymously to refer to a single document that simultaneously relieves a party from her duty to perform and excuses a nonperformance or breach.

Ask Yourself

· What do you think is the justification for categorizing a release and waiver differently? Should the content of a release agreement be treated differently than the content of a waiver?

· Pam enters into a contract with Lia to perform consulting services for her business. Pam has a great deal of work and is too busy to perform the contract. She asks Lia to let her out of the contract. What is Pam asking of Lia?

Licenses and Attributions

Business Law: An Introduction, by TheBusinessProfessor.com, Jason M. Gordon & Colleagues has been adapted with permission from Jason M. Gordon. © Business Professor, LLC. 

Contract Modification

In order to modify a contract, first determine whether the contract is governed by Uniform Commercial Code (UCC) or common law. The UCC requires no new consideration for modification of a sales contract made in good faith (UCC Section 2-209(1)). However, under common law, new consideration is required to modify a contract. The following case considers whether a contract was properly modified under common law.

Gross v. Diehl Specialties International, Inc., 776 S.W.2d 879 (Missouri Ct. App. 1989)

The plaintiff appeals from a jury verdict and resultant judgment for defendant in a breach of employment contract case. Plaintiff was employed under a 15-year employment contract originally executed in 1977 between plaintiff and defendant. Defendant, at that time called Dairy Specialties, Inc., was a company in the business of formulating ingredients to produce nondairy products for use by customers allergic to cow’s milk. Plaintiff successfully formulated [Vitamite]...for that usage. Thereafter, on August 24, 1977, plaintiff and defendant corporation entered into an employment contract employing plaintiff as general manager of defendant for 15 years. Compensation was established at $14,400 annually plus cost of living increases. In addition, when 10 percent of defendant’s gross profits exceeded the annual salary, plaintiff would receive an additional amount of compensation equal to the difference between his compensation and 10 percent of the gross profits for such year. On top of that, plaintiff was to receive a royalty for the use of each of his inventions and formulae of 1 percent of the selling price of all of the products produced by defendant using one or more of plaintiff’s inventions or formulae during the term of the agreement. That amount was increased to 2 percent of the selling price following the term of the agreement. The contract further provided that during the term of the agreement the inventions and formulae would be owned equally by plaintiff and defendant and that following the term of the agreement the ownership would revert to plaintiff. During the term of the agreement, defendant had exclusive rights to use of the inventions and formulae and a nonexclusive right of use after the term of agreement.

At the time of the execution of the contract, sales had risen from virtually nothing in 1976 to $750,000 annually from sales of Vitamite and a chocolate-flavored product formulated by plaintiff called Chocolite. [Dairy’s owner] was in declining health and, in 1982, desired to sell his company. At that time, yearly sales were $7.5 million. [Owner] sold the company to the Diehl family enterprises for $3 million. Prior to the sale, Diehl insisted that a new contract between plaintiff and defendant be executed, or Diehl would substantially reduce the amount to be paid for [the company]. A new contract was executed August 24, 1982. It reduced the expressed term of the contract to 10 years, which provided the same expiration date as the prior contract. It maintained the same base salary of $14,400, effective September 1982, thereby eliminating any cost of living increases incurred since the original contract. The 10 percent of gross profit provision remained the same. The new contract provided that plaintiff’s inventions and formulae were exclusively owned by defendant during the term of the contract and after its termination. The 1 percent royalty during the term of the agreement remained the same, but no royalties were provided for after the term of the agreement. No other changes were made in the agreement. Plaintiff received no compensation for executing the new contract. He was not a party to the sale of the company by [Owner] and received nothing tangible from that sale.

After the sale, plaintiff was given the title and responsibilities of president of defendant with additional duties but no additional compensation. In 1983 and 1984, sales declined precipitously, and, in October 1984, plaintiff’s employment with defendant was terminated by defendant. This suit followed...We turn now to the court’s holding that the 1982 agreement was the operative contract. Plaintiff contends this holding is erroneous because consideration for the 1982 agreement does not exist to support it. We agree.

A modification of a contract constitutes the making of a new contract, and such new contract must be supported by consideration. If a contract has not been fully performed at the time of the new agreement, the substitution of a new provision, resulting in a modification of the obligations on both sides, for a provision in the old contract still unperformed is sufficient consideration for the new contract. Although consideration may consist of either a detriment to the promisee or a benefit to the promisor, a promise to carry out an already-existing contractual duty does not constitute consideration. Under the 1982 contract, defendant assumed no detriment it did not already have. The term of the contract expired on the same date under both contracts. Defendant undertook no greater obligations than it already had. Plaintiff, on the other hand, received less than he had under the original contract. His base pay was reduced back to its amount in 1977, despite the provision in the 1977 contract for cost of living adjustments. He lost his equal ownership in his formulae during the term of the agreement and his exclusive ownership after the termination of the agreement. He lost all royalties after termination of the agreement and the right to use and license the formulae subject to defendant’s right to nonexclusive use upon payment of royalties. In exchange for nothing, defendant acquired exclusive ownership of the formulae during and after the agreement, eliminated royalties after the agreement terminated, turned its nonexclusive use after termination into exclusive use and control, and achieved a reduction in plaintiff’s base salary. Defendant did no more than promise to carry out an already-existing contractual duty, without consideration for the 1982 agreement. Defendant asserts that consideration flowed to plaintiff because the purchase of defendant by the Diehls might not have occurred without the agreement, and the purchase provided plaintiff with continued employment and a financially viable employer. However, evidence to support this contention does not exist. Plaintiff had continued employment with the same employer under the 1977 agreement. Nothing in the 1982 agreement provided for any additional financial protection to plaintiff. The essence of defendant’s position is that [the owner] received more from his sale of the company because of the new agreement than he would have without it. We have difficulty converting [the owner’s] windfall into a benefit to plaintiff.

[Remanded to determine how much plaintiff should receive.]

Contract Remedies

The US legal system is a common-law system, a type of system that originated in England after the Norman conquest of 1066 CE. The rulers of England, including William the Conqueror and his progeny, took measures to unify the country. One of the measures they took was to establish king's courts, which sparked the beginning of a body of common law, or generally applicable rules of law, throughout England and, eventually, its colonies. Over time, the common law was brought to America through English colonization, and the system of common law was adopted by the Founding Fathers of the United States.

In medieval English times, one could seek different remedies in different courts. Remedies, broadly construed, are the legal method by which rights are enforced or wrongs redressed. In medieval English times, king's courts resolved disputes by issuing an award of compensation to injured parties, often in the form of land, valuable property, or money. The king's courts eventually became known as courts of law, and the awards of compensation, remedies at law. Remedies at law, today, are mostly issued in the form of monetary amounts called damages, and are awarded through court orders.

It became apparent during the medieval period that there was sometimes no adequate remedy at law available to resolve a dispute, and so, over time, chancery courts, also known as courts of equity, were established. The remedies available in the courts of equity (called remedies in equity or equitable remedies) were non-monetary remedies, including specific performance, rescission, reformation, and injunction.

During the medieval period and still today, equitable remedies are typically available to the injured party only when remedies at law (e.g., monetary damages) are inadequate for resolving a dispute. Over time, and particularly during the nineteenth century, most states in United States adopted rules to combine the traditional courts of law and courts of equity, streamlining the process by making injured parties capable of seeking both monetary and equitable remedies in the same court.

Remedies are available for victims of breach of contract. When one party to a contract does not fulfill his or her legal obligations under the contract ("breaching the contract"), the other party may seek a remedy, or some combination of remedies, to make the injured party whole. Today, in the United States, the remedies available for breach of contract include both remedies at law (damages), and equitable remedies, and in most states, these remedies may be sought simultaneously in the same court. When there is a valid and enforceable contract, monetary and equitable remedies may be available.

Even when there is not a valid and enforceable contract, in some cases, remedies may be sought under other common-law theories, such as promissory estoppel, or pursuant to theories of quasi-contract. The following decision tree explains how contract remedies work in tandem with noncontract remedies.

Contract Remedy Decision Tree

As the decision tree shows, when there is a valid and enforceable contract, then monetary and equitable remedies may be sought. If there is not a valid and enforceable contract, then one should ask if a promise has been made in order to determine the appropriate theory to use. If a promise has been made, then one may seek a remedy under the theory of promissory estoppel. If a promise has not been made, then one may seek a remedy under the theory of quasi-contract. If there might be a contract, but this is not certain, then one may seek relief in the alternative (by requesting the court to determine if there is a contract and, if so, to issue contract remedies; or, if not, to issue noncontract remedies).

Thus, even if no valid and enforceable contract exists, there is still the potential, depending on the circumstances, for the injured party to seek remedies.

Transcript

Resources

· Breach of Contract

Breach of Contract

A party who is not relieved from her duty of performance and fails to perform her obligations under a contract is said to breach the contract. Breach entails a failure to perform material duties in accordance with the agreement. This can include a complete lack of performance, partial performance of the material duties, or performance that fails to meet the demanded standard. A breach by one party relieves the other party's duty of performance.

Ask Yourself

· Should different types of breach be treated differently? Why or why not?

· Joseph enters into a contract with Eric to build a deck on Eric's house. Joseph builds a deck that is weak, flimsy, and drastically varies from the design plans. Under what grounds might Joseph allege breach of contract against Eric?

Remedies

A breach of contract action may result in any number of damages.

Compensatory Damages

Compensatory damages are court-awarded damages to put the plaintiff in the same position as if the contract had been performed. It includes lost profits on the contract and the cost of substitute performance. A party's lost profits from the other party's breach of contract are the expected gains from performance of the contract. This would generally mean the value received minus the costs incurred in performing. This calculation is known as the "expectation damages."

For example, you sign a contract to sell me supplies for my business. You back out of the contract and I have to purchase my supplier from another vendor. The cost to me to purchase the supplies from a new vendor is 15 percent higher than pursuant to our agreement. I have suffered damages of 15 percent of the contract value. Alternatively, if I backed out of the contract and my duties to purchase your supplies, you would have suffered expectation damages equal to the price of the goods minus your cost of supplying them to me.

Consequential Damages

Consequential damages are court-awarded damages arising from unusual losses which the parties knew would result from breach of the contract.

For example, I order cement from you to complete a large contract. I express to you that I intend to use the cement for the large construction contract and that time of deliver and quality of the goods is of utmost importance. You fail to deliver the cement and I am forced to purchase from another vendor. The cement arrives late and causes delays. I incur substantial penalties under the larger contract. Your breach of contract may have cost me compensatory damages equal to the price difference between our contract and the replacement vendor. The consequential damages, however, are the penalties incurred and any lost business as a result of your breach.

Liquidated Damages

Liquidated damages are damages specified in the contract in the event of non-performance by either party. Liquidated damages are appropriate where real damages for breach of contract are likely to be uncertain. In such a case, the parties decide to specify in the contract the damages in the event of breach. Courts will enforce these liquidated damage clauses unless they seem to penalize the defendant instead of merely compensating the plaintiff for uncertain losses.

For example, I sign an agreement to provide you with consulting services. It is difficult to estimate the damage to your business if I fail to adequately perform. In the agreement we indicate that my failure to perform will result in damages of $1,000 to you. This liquidated damages clause is likely enforceable.

Nominal Damages

Nominal damages include a small amount awarded by the court to the plaintiff for a breach of contract, which causes no financial injury to the plaintiff. In a tort action, a court may only award punitive damages if there is some finding of liability of the defendant. The court may not be able to find liability based upon tort theory in the absence of identifiable harm suffered by the plaintiff. If, however, the tort action is accompanied by a contract cause of action for the same conduct, the award of nominal damages for breach of contract may support a finding of punitive damages in the related tort action.

For example, I enter into a contract to provide you with consulting services. I fail to perform and you hire someone else. In this situation, it is difficult to determine if your business incurred any damages. If you sue me, a court may award nominal damages against me indicating that I was legally wrong in failing to perform my contractual duties. A common nominal damages amount is between $1 and $100.

Specific Performance

Specific performance is a court-ordered, equitable remedy available when the subject matter of the contract is unique. A court order for specific performance directs a party to perform her duties under the contract. The court will only apply this remedy when the subject matter of the agreement is truly unique and irreplaceable. Specific performance is not available for service obligations.

For example, you agree to sell me a Picasso painting that you inherited. At the last minute, you back out of the contract. I sue you to force you to sell me the painting. A court may order specific performance of the contract by ordering you to sell me the painting.

Recission

Rescission means to undo a contract and return the parties to the position they were in prior to entering the contract. This generally means returning property sold in the condition it was transferred and a return of the purchase price. This remedy is not available for executed services contracts.

Ask Yourself

· How do you feel about the concept of consequential damages? Is it fair to impose that extent of liability on a party if it is not part of the subject matter of the contract? Why or why not?

· Taylor enters into a contract with Winnie to supply her with reinforced steel. Winnie is going to use the steel in the construction of a new manufacturing facility for her business. Winnie backs out of the contract when she realizes that she can get the steel 10 percent cheaper from a competitor. If Taylor sues Winnie, what are his options for damages?

Efficient Breach

Efficient breach occurs when a party makes a conscious decision to breach a contract after balancing the costs of complying against fulfilling the contractual obligation. This normally arises in situations where a party will incur fewer losses or make more money by breaching the contract than the party would suffer in compensatory or consequential damages if sued.

Ask Yourself

· How do you feel about the concept of efficient breach? Should the decision of whether to breach a contract simply be an economic consideration or is there a moral consideration involved? Should morality or ethics play a role in business transactions? If so, to what extent and why?

· Wendy enters into a contract to sell a piece of equipment to Laura. Before the sale is finalized, Erwin offers to purchase the equipment from Wendy at a much higher price. Wendy evaluates whether to breach the contract with Laura and sell the equipment to Erwin at the higher price. What might Wendy consider in making her decision?

Legal Responsibilities of Agents and Employees

Agency law is a component of civil law and deals with the legal relationship by which one person acts on behalf of another. The agent is the person who acts on behalf of the principal to do something the principal has delegated the agent to do, which the principal him or herself is legally permitted to do.

The creation of an agency relationship gives rise to both rights and duties of the agent and the principal, as well as the potential for liability to each other and to third parties. Principals may be held liable by third parties for the acts of their agents under certain, but not all, circumstances. The potential liabilities a principal has to third parties for the agent's acts often depend on whether the agent is an employee or an independent contractor. Principals face potentially more liabilities to third parties for the acts of their employees than they do for the acts of their independent contractors.

Agency and Liability

Agency law concerns the legal relationship by which one person acts on behalf of another. This resource will examine the agency relationship and the legal duties owed by principal and agent. It will focus on the scope of the agency relationship—particularly in the context of the employer-employee relationship. It will introduce the concept of vicarious liability and provide the elements necessary for a principal to be held liable for the actions of the agent. This topic will include liability for contracts entered into by the agent and torts committed by the agent.

What Is an Agency?

An agency relationship is one in which a party acts on behalf of and with the authority of another party. The principal appoints or authorizes the agent to act on her behalf. Thus, she is responsible for the actions of the agent taken in furtherance of her duties or per the instructions of the principal. The agent will interact with third parties on behalf of the principal. The agency relationship requires an understanding of the relationship between principal and agent, agent and third parties, and the principal and third parties’ roles, responsibilities, and rights.

For example, I hire Betty to negotiate a business deal on my behalf. I am the principal and Betty is my agent for this purpose. Betty will act as my representative in dealing with the third parties to this business deal.

Types of Agents

The principal will lay out the scope of the agency, including the responsibilities and limitations of the agent. Agents generally fall into three categories:

· limited agent—A limited agent has a special purpose and limited authority to act on behalf of the principal. Unless specifically limited by the principal, actions done in furtherance of that purpose are within the scope of the agent’s authority. For example, I hire a real estate agent to represent me in the purchase of a business. She is my limited agent for that purpose. Her authority to act on my behalf is limited to this situation.

· general agent—A general agent has broad authority to act on behalf of the principal. The scope of the agency is not limited to a special purpose. For example, Arthur is my employee. He serves as operations manager. As such, he is my general agent with regard to all aspects of operations falling under his responsibility. His authority to act as my agent is not limited to a specific task; rather, it is pursuant to his responsibilities in his position.

· independent contractor—Agency law considers an independent contractor to be a special form of agent of the principal. The independent contractor is hired to perform a service for the principal but is generally not under the direct control or supervision of the principal. In this way, the agent has very limited ability to represent or act on behalf of the principal outside of the context of the services contract.

Numerous subcategories of agent exist within these broader categories. For instance, an agent coupled with an interest is a type of special agent who earns compensation through performing her agency duties (rather than receiving compensation directly from the principal). A sales agent who receives a commission on sales may be an agent coupled with an interest. This type of agency is subject to contract rules and cannot be terminated without violating the legal rights of the agent or principal.

Other common categorizations of agents include co-agents and subagents. Co-agents are multiple agents who serve a single principal for the same purpose. Subagents are authorized agents of an agent.

Ask Yourself

· Why do you think there is a distinction between a general and limited agent? How should the authority of a limited agent be interpreted? What should be the limits placed upon the authority of the general agent?

· Erin is starting an interior design firm. She hires Ann as a senior designer, and Rachel as a design assistant. She hires Rita to handle her bookkeeping and Patricia to handle her business setup and legal matters. What is the status of each of these individuals (employee, independent contractor, general agent, or limited agent)?

Employee vs. Independent Contractor

An employer hires an employee to work on behalf of the employer as part of or in support of the business’s core functions. The employee generally works exclusively for the business in the functions for which she is hired. The employer exercises extensive control over the nature, time, and manner of work carried out by the employee. As such, the employee is a general agent of the business to the extent of her authority in the position.

An individual working on behalf of an employer does not have to be paid to be considered an employee. An unpaid person may be a “gratuitous employee.” This may be the case when individuals are volunteering for nonprofit ventures or working as part of an internship.

For example, ABC Corp hires me as an internal accountant. I report to ABC Corp from 8 a.m. to 6 p.m. five days per week. I work on any and all accounting functions assigned to me by my supervisor.

An independent contractor is not an employee; rather, she or it is a separate business that is hired to perform services for or on behalf of another person or business. One way of thinking of an independent contractor is that she has her own business that services the employer as a client or customer. The employer does not directly control the manner and method by which an independent contractor carries out her duties. Also, an independent contractor generally has more than one customer or client. As such, the independent contract is only a limited or special agent of the principal employer.

For example, I have my own professional accounting practice. I prepare the tax returns for any business or individual who pays me to do so. I do not have any employees. ABC Corp hires me to prepare its annual tax return. I promise to have the return completed within 1 month. I will invoice ABC Corp for my services. I am not an employee of ABC Corp. I am an independent contractor who is hired to perform a specific function for a limited amount of time. While I have a projected deadline, ABC Corp does not control the nature, time, and manner of the services I perform.

This distinction is important for determining a principal’s liability for the agent’s actions. Generally, absent specific instructions to do a task leading to liability, an employer is not liable for the actions of an independent contractor taken on behalf of the principal.

There are exceptions where an independent contractor may subject an employer to liability for her actions. This is the case when the work performed is inherently dangerous in nature; the tasks performed for the employer are illegal; the work is nondelegable; or the employer ratifies the contractor’s actions. A separate cause of action may exist if the employer was negligent in selecting a contractor to perform the duties. That is, she failed to exercise reasonable care in selecting a particular contractor. This may be the case where past performance demonstrated the contractor was unsuitable for the task.

Ask Yourself

· Why do you think employees have a different agency status from independent contractors? Is there any reason or justification for treating employees and independent contractors similarly for agency purposes?

· Donald drives for Super, a company that provides a network for drivers to pick up and drop off customers who need a ride. The service is very similar to a taxi service. The individuals driving for Super have their own cars and their own insurance. They work whenever they like. The driver logs into an application that notifies her when a Super customer needs a ride. She confirms that they will provide the ride and she is off. The passenger pays Super directly and Super later remits payment to the driver. What factors in this scenario would be used to determine whether Donald is an employee or an independent contractor?

Types of Principals

Principals are categorized based upon whether their identity is disclosed to third parties with whom the agent interacts on their behalf:

· disclosed principal—A disclosed principal’s identity is known to third parties dealing with the agent.

· partially disclosed principal—A partially disclosed principal is known by third-parties to exist, but her exact identity is unknown. This type of relationship exists when there is some benefit to the principal to remain anonymous to third parties interacting with the agent.

· undisclosed principal—The existence of an undisclosed principal is unknown to a third party. The third party believes that she is interacting only with the agent.

These categorizations of principal are important in determining the rights and duties of the principal, agent, and third party.

Ask Yourself

· How do you feel about the ability of an agent to act on behalf of a undisclosed and partially-disclosed principal? Is this fair to a third party? Why or why not?

· Winston is a special agent of ABC Corp hired to negotiate the purchase of intellectual property. He seeks to purchase a premium domain name from Alice. Alice is unaware that Winston wants to buy the domain name for some third party, but does not know that he works for ABC. What type of agent is Winston? How would it affect Winston’s status if Alice found out that he works for ABC? What if she did not know he was buying the domain name for a principal?

Principal-Agent Relationship Requirements

An agency relationship is created in the following manners:

· express agreement—A principal and agent may expressly agree to form an agency relationship. The agreement can be oral or in writing. The principal must simply confer the authority upon the agent to act on her behalf. The subject matter of the agency relationship must be legal. The agency has the express authority granted in the agency agreement and the implied authority to undertake tasks incidental to that objective. If the duties of the agent include executing a contract subject to the statute of frauds, the agency relationship may need to be in writing to be enforceable. An express agency relationship is often created pursuant to a legal document known as a power of attorney. The power of attorney may create a general or special agency relationship.

· implied agency—An agency may be implied from the facts or circumstances surrounding an individual’s actions on behalf of another. If the principal acts in a way that demonstrates an intent for an individual to act on her behalf, this may imply an agency relationship. The parties to an agency relationship do not need to understand the law of agency or understand what it means to be a principal or agent.

· ratification—Ratification is a contract principle. If an individual undertakes actions on behalf of another, these actions may be outside of any express or implied authority. If, however, the principal acknowledges and accepts the agent’s actions, this is known as “ratification” of the agency relationship. The principal ratifies the agent’s actions, after the fact. Agency by ratification is only possible when the principal is fully disclosed.

· by estoppel—If a third-party reasonably relies on an agent’s representation that she has authority to act on behalf of the principal, the principal may be bound by the actions of the agent. Generally, the principal must act or fail to act in a manner that causes a third party to reasonably believe that an agency relationship exists, when in fact there is no agency. Agency by estoppel is based upon principles of fairness. It would be unfair to detriment a third party who reasonably believed that the agent had authority to act on behalf of the principle, and the principal was the source or cause of that belief. Agency by estoppel is only possible with fully-disclosed principals. For example, Bill is James’ agent. James terminates the agency relationship. Nonetheless, unbeknownst to James, Bill continues to transact with third parties on James’ behalf. James fails to notify third parties of Bill’s termination. James may be bound to any agreement entered into by Bill.

· by necessity—Agency by necessity arises when one party makes a decision on behalf of another person who is unable to do so. The decision must be essential in nature and it must be in the interest of the principal in making that decision. As such, the law will impute a de facto agency relationship where no actual agency exists. For example, Bill is hired to deliver Tom’s goods. He drops the goods off at the fulfillment center. The center says that there is no contract in place and intends to reject the goods. Tom is out of country and cannot be reached. The goods will spoil if not accepted. Bill signs the warehousing agreement on Tom’s behalf.

Ask Yourself

· How do you feel about the ability to form an agency relationship without a principal expressly authorizing the agent to act on her behalf? What intent should be required before a court can find that an implied agency exists? What constitutes ratification of an agent’s actions by a principal? When is reliance upon an agent’s representations about her authority reasonable? Should a third party be required to verify an agent’s actual authority? How great must the need be for a court to find an agency by necessity?

· Terrence hires Joe as a general manager of his business. Joe routinely purchases supplies for the business, though this authority is not in his job description. Terrence never gave Joe the authority to enter into these purchase agreements, but he routinely acknowledges Joe’s actions and keeps the purchased goods. When Terrence falls sick, Joe handles all store operations, including signing some major purchase orders that Joe generally signs. These purchases were necessary to continue business operations. One of the purchase orders, however, is for the wrong type of goods. The error potentially costs Terrence’s business thousands of dollars. When Terrence recovers and learns of the purchase order, he is furious and refuses to honor the purchase agreement. What are the arguments for and against Terrence’s liability for Joe’s errant purchase order?

Duties of a Principal?

Generally, a principal owes the following duties to the agent:

· duty to compensate—An agency relationship may be paid or gratuitous. The terms of an agency may be laid out in the agency agreement. If the agency agreement does not indicate the terms of compensation, the principal is obligated to provide the agent with reasonable compensation. For example, default rules in a relationship with a sales agent dictate that the agent will earn a reasonable commission on sales induced or completed.

· duty to reimburse—The principal must reimburse the agent for a reasonable amount expended in carrying out her duties. Reasonable reimbursement includes the cost of travel, meals, lodging, incidental expenses, etc.

· duty to indemnify—Generally, a principal must indemnify an agent for liability incurred in the performance of her duties. This generally arises when the instructions of the principal subject the agent to liability to a third party. If an agent exceeds or acts outside of the scope of her authority, the principal may be relieved from the duty to indemnify. If the principal later ratifies the actions of the agent, she will incur the obligation to indemnify the agent against liability.

Ask Yourself

· How do you feel about the default duties owed by a principal to an agent? Why do you think these are the default standards? Do you believe there should be any other or additional duties of the principal?

· Ethan hires Naomi to serve as his buying agent. The employment agreement is very short and lists only Naomi’s primary responsibilities and compensation. Pursuant to her job description, Naomi will make purchases for the business but will not disclose that she is an agent of the business. One of her business deals goes bad and a client sues her for breach of contract. What are Ethan’s responsibilities in this situation?

Duties of an Agent

Agents generally have the following duties to the principal:

· loyalty—An agent has the duty of loyalty to act for the principal’s advantage and not to act to benefit herself at the principal’s expense. An agent is expected to refrain from undertaking actions personally that would conflict with the purpose of the agency. An employee has a lower duty of loyalty with regard to opportunities that are outside of the employee’s duties or responsibilities to the employer. Generally, this means that an agent may not simultaneously represent the principal and another party to a transaction.

Employees are agents of the employer. If an employee does not have permission, she violates a duty of loyalty by undertaking activities for a third party that are similar to the duties of the employee in the agency relationship. This is seen as competing with the employer. If, however, she performs services unrelated to or not the type of services the employer would seek to provide to the client, she does not a breach a duty by providing those services. This is true even if the employee provides those services to a client of the employer.

For example, I work for ABC Corp as a professional service provider. A potential client comes in to seek the services of ABC Corp. I cannot compete with ABC Corp by trying to convince the client to pay me to serve them personally rather than hire ABC Corp. I also have a side job selling supplies to construction contractors. This is a completely different line of business from ABC Corp. If it does not conflict with ABC Corp’s services, I can offer my supplies for sale to the client without violating my duty of loyalty.

· duty of care—An agent has a duty to exercise due care and diligence when carrying out the responsibilities of the agency. This is often referred to as a duty to not act negligently in carrying out the principal’s affairs. For example, I work for ABC Corp as an accountant. I represent ABC Corp in every action I undertake as part of my employment, such as preparing client taxes. I have a duty to ABC Corp and the client to exercise reasonable care in carrying out my job duties.

· information and disclosure—The agent has a duty to protect all confidential information of the principal, such as trade secrets. Further, the agent has a duty to keep the principal fully informed of all material information acquired as a result of the agency relationship. For example, I am a sale agent for ABC Corp. I receive an offer from a customer to undertake a joint venture with ABC Corp. I have a duty to transmit this information to ABC Corp. I acquired this information as a result of the agency relationship, and it is obviously outside of my unilateral decision-making authority.

· obedience—The agent has a duty to obey the reasonable instructions from the principal. For example, I work for ABC Corp selling insurance. ABC provides me detailed training and instructions on what types of policies to write and the client area that I can serve. I have a duty to obey these instructions as agent of my employer.

· accounting—The agent has a duty to account to the principal for monies handled. Further, the agent may have a duty to account to third parties for whom money is handled. This includes situations where an agent collects too much money from a third party and is still in possession of those funds or when an agent intentionally collects funds that belong to the third party and the principal is undisclosed. For example, I am a financial advisor for ABC Corp. I am responsible for reporting and keeping accurate records regarding all money or value transferred or received in carrying out my job duties. Note that the principal-agent relationship is a fiduciary or trust-based relationship. The agent may have any other duties as established in the agency agreement.

Ask Yourself

· Should the duty of loyalty and care be the same for an agent in every situation? Why or why not? Should these duties vary depending upon whether the agent is a limited or general agent? Why or why not?

· Carol is an employee of Rob’s accounting firm. She is a CPA, but she has been thinking of breaking away from the firm and starting her own practice. One day, a representative from a large corporation walks into the CPA firm and inquires about accounting services. Carol is strongly considering offering her personal services to the representative’s firm? Are there any issues in this situation?

Contractual Obligations

A principal is generally bound to third parties pursuant to the contracts entered into by the agent on behalf of the principal. This means that the principal is responsible for any obligations incurred by the agent that are within her authority. An agent has varying sources of authority when dealing with third parties.

· actual authority—Actual authority is the express authority from the principal allowing the agent to enter into obligations (contracts) on her behalf. It can be specific instructions to do so or generally included in her job duties. The principal is bound to third parties if disclosed, partially disclosed, or undisclosed. For example, Arnold is an employee of ABC Corp. He signs an employee agreement indicating that he will sell products manufactured by ABC Corp directly to retailers. He has express authority to enter into any contracts with retailers for the sale of ABC-manufactured goods.

· implied authority—Implied authority concerns the authority to enter into obligations that a reasonable person would imply from the agent’s position, title, or past course of dealings. If an employee has the title of vice president, it implies a great deal of authority to act on behalf of the business. Further, if an employee entered into a previous contract on behalf of the principal, it may imply that she can enter into similar contracts in the future. This principle can only apply to disclosed and partially disclosed principals. There can never be implied authority to act on behalf of an undisclosed principal. For example, Beth is hired by ABC Corp with the title of Senior Sales Manager. 123 Corp seeks to purchase a shipment of supplies manufactured by ABC Corp. Even if Beth is expressly prohibited in her employment agreement from entering into direct sales agreements, it is reasonable for a retailer to believe that a person with her title has that authority. If a retailer is unaware of Beth’s limitations and Beth signs a sales contract on behalf of ABC Corp, ABC Corp will be bound by the contract. Beth may be liable to ABC Corp, but her title implies this authority to transact with third parties in this manner.

· apparent authority—Apparent authority arises from the reasonable representations of the agent to third parties. That is, when the agent represents that she has authority to enter into a contract on behalf of the principal, her actions will bind the principal if a reasonable person would believe those representations. The 3rd party’s belief must generally result from some action or inaction by the principal. This principle applies to disclosed and partially disclosed principals. There can be no apparent authority if the principal is not disclosed to the third party. For example, Gina works for ABC Corp. She has a generic title of manager. She is limited in her ability to sign purchase agreements on behalf of ABC Corp. She does, however, routinely negotiate the terms of purchase agreements with vendors. She then transmits the purchase agreements to her boss who signs them. The vendor never deals with anyone other than Gina. If Gina decides to start by personally signing the purchase agreement, ABC Corp will likely be bound by the contracts. By signing the agreements, she is representing to vendors that she has authority to do so. It is likely reasonable for vendors to believe that she has this authority, as Gina is the primary point of contact for negotiating the agreements.

· ratification—While an agent may bind the principal to the extent of her authority, the principal is also bound if she ratifies the conduct of the agent that is beyond her express, implied, or apparent authority. That is, if the principal accepts or takes advantage of the agent’s actions, she impliedly ratifies those actions as taken on her behalf. In such a situation, this expands the implied and apparent authority of the agent when undertaking future actions. Ratification can only take place if the principal is disclosed or partially disclosed.

In each of the above situations, a disclosed principal is liable to third parties dealing with the agent. If the agent exceeds her express authority, the third party may still have the ability to back out of the contract. The third party is generally bound by the contract if the principal ratifies the agent’s conduct before the third-party finds out about the lack of authority and withdraws.

Ask Yourself

· How do you feel about the doctrines of implied and apparent authority? Should an agent have the ability to bind an agent in contract when the agent does not have actual authority to do so? Why or why not? Should the standard be different for limited and general agents? Why or why not? Should the onus be on the employer to protect itself by informing third parties of the limited authority of the agent, or should the onus be on the third-parties to verify the authority of the agent? What is your justification for this opinion?

· Kristy is an operations manager for ABC Corp. She has authority to enter into agreements for operational supplies. She does not, however, have authority to enter into sales agreements with retailers of ABC Corp products. In a couple of instances she is called upon to assist in putting together custom sales orders for large retailers. In these situations, Kristy was the primary point of contact with the retailers. 123 Corp learns about ABC Corps products through one of the retailers who previously worked with Kristy. 123 Corp contacts Kristy about putting together a custom sales package. What is Kristy’s authority to deal with 123 Corp.? If Kristy enters into an unauthorized agreement with 123 Corp, under what theory might ABC Corp be bound by the contract? Why?

Agents’ Liability

An agent acting within the scope of her authority is not liable to third parties on obligations entered into on behalf of the principal. Even if the agent exceeds her express authority, her implied authority may bind the principal to the agreement and relieve her from any contractual liability to the third party. The important point is that the agent must act on behalf of the principal and disclose that relationship to the third party. If the agent is acting on behalf of a principal, but fails to disclose her agency status, it may subject her to liability to the third party. In some cases, it may also serve to bind the principal once the agency relationship is determined.

If the agent goes beyond her express authority, she may be liable to the principal for any obligations binding the principal to third parties. That is, the principal may be able to recover damages suffered because of the agent exceeding her authority.

For example, I work for ABC Corp. I enter into an agreement with 123 Corp on behalf of ABC Corp. I am not personally obligated to perform the contract. If I fail to tell 123 Corp that I work for ABC Corp (123 Corp believes that I have my own business), I am liable to 123 Corp if ABC Corp does not perform the contract. ABC Corp is obligated to perform the contract if my entering the contract was in my express, implied, or apparent authority. If I did not have express or implied authority, but 123 Corp realized I was acting on behalf of an agent, ABC Corp may be liable if I had apparent authority. In such a situation, ABC Corp may be able to sue me for any losses suffered.

Ask Yourself

· Should an agent who exceeds her express authority be liable to the principal? Why or why not? Should she be liable to the third-party? Why or why not?

· Practice Question: Agnes is an agent of Emory Corp, a technology company that sells subscriptions to its cloud-based software. Agnes has the general title of manager, but has no express authority in her employment agreement. Agnes routinely negotiates sales agreements with large companies that are clients of Emory Corp. Agnes enters into an agreement with Tech, LLC that is far larger than any deal Agnes previously negotiated. The agreement is very poorly negotiated and it will cause a huge loss for Emory Corp. What is Emory Corp’s obligation? What are Agnes’s potential obligations and liabilities?

Principals’ Liability

An individual is always liable for her own conduct. Whenever an individual is held liable for the actions of another, this is known as vicarious liability. In the context of agency, the agent is acting vicariously for the principal. A principal is responsible for the tortious acts of an agent pursuant to a doctrine known as respondeat superior. More specifically, an agent may create legal liability for the principal for actions taken by the agent “within the scope of the agency.” In such cases, the principal and agent are “jointly and severally” liable for the harm caused by the agent’s conduct. An act is within the scope of the agency if the purpose behind the action taken is to advance the interests of the principal. As such, if any act taken by an employee in an effort to advance the employer’s interest is a tort, the employer may be liable for that conduct.

Generally, intentional torts are generally not considered to be within the scope of an employee’s duties or employment. As such, a principal will not be liable for the intentional torts committed by an employee unless the principal ordered or condoned the tortious conduct. Even if a tort is within the scope of employment, it will not relieve the agent from personal liability for her actions.

For example, I am an employee of a corporation. While carrying out my duties, I act negligently and harm a third party. The third party sues the corporation and me. The corporation will be liable for my negligent act because I was acting within the scope of my job responsibilities when I committed the tort.

Ask Yourself

· How do you feel about a business being held liable for the tortious activity of its agents (employees)? Does it matter if the tort is negligence, intentional, or strict liability? How do you think the court should define “within the scope of employment”?

· Mitchell is an employee of Big Corp. His primary responsibilities are to deliver company goods to retailers. When out driving to a retailer’s location, Mitchell is following to closely and accidentally rear ends Bertha. Bertha sues Mitchell for negligence. What is the likely result for Big Corp?

Frolic and Detour

A “frolic and detour” is a general defense to vicarious tort liability. It states that the principal should not be liable for the tortious acts of the agent when the agent is acting outside the scope of her employment and for the benefit of someone other than the employer. Plainly stated, an employee who is on a frolic or detour is no longer acting for the employer. 

A frolic is when an employee abandons the employer’s business objectives and pursues personal interests. A detour occurs when an employee substantially deviates from an employer’s instructions or rules. Generally, both a frolic and detour must be present to relieve an employer from liability for the agent’s actions.

For example, an employee providing services for her employer at the location of a client is an agent acting within the scope of her employment. If, however, the employee takes the company vehicle and goes on a personal errand that is not authorized, the employee is likely outside the scope of her employment. Suppose while running these errands she gets into an automobile accident that is her fault. The employer would be able to argue that the deviation from her duties as employee was a frolic and detour and relieved her of liability for the employee’s tort.

Ask Yourself

· How do you feel about the doctrine of respondeat superior? Should a principal be held liable for the tortious acts of an agent if committed within the scope of employment? Why or why not? How would you define scope of employment? Does it matter to you if the agent was also acting in her personal interest when committing the tort? In your opinion, how much of a deviation from her job duties must an employee vary in order for it to be considered a frolic and detour? Can you think of any situations in which a frolic or detour should still subject a principal to liability?

· Mitchell is an employee of Big Corp. His primary responsibilities are to deliver company goods to retailers. When out driving to a retailer’s location, Mitchell decides to stop by his house and have lunch. Big Corp has a strict policy against taking work trucks home or using company trucks for any purpose other than delivering Big Corp products to retailers. When backing out of his driveway, Mitchell hits Tom who is out jogging. Tom suffers injuries and sues Mitchell and Big Corp. What will Big Corp have to show to defend the action for Mitchell’s negligence? What facts in this situation may hinder Big Corp’s defense?

Termination of Agency Relationship

The establishment, duration, and termination of the agency relationship is generally governed by the agreement between the principal and agent. In the absence of an express agreement, several default rules apply regarding the point at which the agency relationship terminates. Below are common rules for terminating the agency relationship:

· withdrawal by either party—A principal or agent may withdraw from the relationship at any time. This legal authority is separate from the contractual right to withdraw. While withdrawal terminates the agency relationship, it may lead to liability of the withdrawing party. For example, Daisy hires Jeb as a sales agent for her new product line. Jeb will earn a commission on sales of the product. Jeb studies the product lines, develops a sales plan, and hits the road. Shortly after the relationship begins, Daisy decides to hire Luke and fire Jeb. Daisy’s withdrawal terminates the agency relationship with Jeb. Jeb, however, may have the legal right to seek damages against Daisy for terminating the relationship.

· withdrawal by both parties—The parties can terminate the agency relationship upon mutual consent.

· termination by the principal—Either party may terminate the agency relationship, even if it violates a contractual agreement between the parties. A principal will be subject to a breach of contract action for terminating the agency relationship if the agent’s status is part of an agreement that is supported by consideration and terminating the agency relationship will harm the agent’s rights. This scenario commonly arises in an agency coupled with an interest. An agency relationship is coupled with interest when the agent has a specific interest in the subject matter of the agency, such as a consignment of goods for resale. For example, I enter into a contract with Ernest to package and sell his products on the Internet. In exchange for my effort, I will keep in percentage of the sale value. As such, the agency is coupled with an interest and cannot be revoked without breaching a contract.

· renunciation by the agent—The agent can renounce the business of the principal and terminate her agency status and authority. This may, however, violate a contractual relationship between the parties. For example, I enter into a contract to serve as your agent. I may terminate the agency by renouncing my duties. Unless I have a justification, my actions will likely violate my contractual obligations to you.

· duties of agent complete—If the purpose of the agency ceases to exist, the agency relationship terminates. This often arises when the agent discharges all of her agency obligations. Further, it could arise when the subject matter of the agency no longer exists. For example, You higher me to represent you in the sale of your real estate. The real estate is the subject of an eminent domain action and is taken by the government. The agency relationship terminates when the purpose of my agency is gone.

· death or incapacity—The agency relationship terminates upon the death or incapacity of either party.

· bankruptcy—The agency relationship terminates upon the liquidation or reorganization of either party.

The above situations resulting in termination of the agency relationship are default rules. The parties may reserve any rights or restrictions on terminating the agency relationship within their agreement.

Ask Yourself

· How do you feel about either party’s right to terminate the agency relationship? What should the remedy be if termination of the agency relationship by a party violates a contract between the parties? Should a party have additional rights if she is harmed by the termination of the agency and the other party’s rights are not? Why or why not?

· Earl runs a showroom for baby products. Gayle, the inventor of a new product, consigns a large quantity of goods with Earl. Earl agrees to display the goods and represent them to potential retailers. Earl earns a percentage of all future sales to the retailer as compensation for his services. Can Gayle cancel the agency relationship?

Ethical Business Decision Making

It is reasonable that everyone who asks justice should do justice.

Thomas Jefferson

What Is Ethics?

Ethics has been a topic of discussion and debate starting with the Greek philosophers about 2,500 years ago. We can define ethics simply, but resolving ethical issues is rarely simple. Ethics is the study of good and of how people apply good principles in their behavior. Behavior includes how we treat people we know and, perhaps more importantly, how we treat people we do not know. Our biases and fears can complicate ethical decision making. Our own interests in achieving specific ends can also interfere with our choice of an ethical course of action; the ethical choice may not be the most profitable or socially acceptable.

It might be helpful to discuss what ethics is not. Ethics is not religion, although religion can guide ethical thinking. Ethics is not defined by what is possible (e.g., through scientific discovery or technology), although, as new machines are created, what is possible changes, giving rise to new ethical quandaries. Nor is ethics simply what is commonly practiced. Any one of us could cite a historically common practice that is unethical. In addition, what is common practice today in one place will conflict with what is common practice today in other places.

Ethics is not just how we feel: our instincts may tell us to act one way or another, but this feeling may not lead us to the best behavior. If making a public speech against a new piece of legislature were the only way to behave ethically following the passage of that legislature, would we take this action? Many people, for example, have a gut reaction against public speaking. The law is not an adequate guide either. Looking back at history, we can certainly name unethical laws.

An important outcome of ethical decision making is a standard for behavior. Standards can be informal, as in our behavior on the street, in a store, or with our neighbors. If you see someone drop a $20 bill, what should you do? Standards can also be formal, usually at the institutional level (e.g., at a university, trade organization, or business) or the societal level (city, county, state, national, international). At the societal level, for example, methods and forms of taxation must be determined. What means of taxation are ethical? Are there some that are unethical?

What Is Business Ethics?

Business ethics is ethics concerning behaviors occurring within a business context. The breadth of ethical considerations should be considered when one is formulating a standard of behavior in a business setting. We cannot look only to the law, only to common or prior practice, to religion, or to instinct. We must carefully consider multiple competing factors and, using logic and rational thought, create business standards of behavior that are ethical.

How Does a Business Provide Ethical Standards?

Businesses attempt to provide ethical standards in several ways:

· relying on each individual to make ethical decisions

· stopping at compliance with the law

· simply telling employees and officers to act ethically

And some businesses achieve results by taking a managing values approach—a systematic approach to maintaining the organization's values that doesn't depend on individual interpretation of those values or how to safeguard them.

The first three options are not helpful even when an employee wishes to act ethically; the employee may not understand how to judge what is ethical behavior. Thus, determining if your company is using a managing values approach is the first step. Places to look to make this determination include your organization's mission statement, core values, and ethics code.

Operational Ethics in a Business Setting

But what if these don't help, or worse, they raise ethical issues themselves? Fortunately, there is a set of standard ethics tests that you can apply yourself.

Ethics Tests You Can Apply

The first ethics test you can apply is called the front page test, or viral news test. This is a fairly new test, and it is simple: How would your business feel if the issue were on the front page of a newspaper? Or went viral on the internet?

More traditionally, there are five theoretical tests with which you can judge a business action (Markkula Center for Applied Ethics, n.d.):

· rights—What duty do the actors have to respect the human rights of those affected?

· justice or fairness—Are all parties treated equally or proportionally? If differently, is the basis for treating them differently rational?

· virtues—The good human being is fair, is honest, shows integrity, and shows compassion. Does the action uphold these virtues?

· common good—This test has become more common recently. How does the action benefit everyone in society? Whom does it not benefit? Whom might it harm?

· utilitarianism—Utilitarianism is also called the greatest good principle. Does the overall good outweigh any bad? Sometimes, this conflicts with other tests.

In order to answer the questions above, we must have a clear sense of what is a good? What is a harm? What are legitimate rights? What is the standard of fairness? What is the canon of virtues? What is the common good? These questions have been much debated.

A Method of Determining Ethical Responsibility

There are five questions you can ask to determine whether or not you should act on a given decision:

· What is the severity of the harm?

· What is the certainty of the harm?

· What is the degree of involvement?

· What is the cost of acting?

· What is the certainty of the solution?

Process of Ethical Analysis

Think of ethical analysis as a process that builds on itself. Follow the steps below, knowing that you might circle back and reevaluate your interpretation of the situation as you complete each step.

1. Identify the stakeholders and determine whether some are more important than others.

2. Determine whether all stakeholders have been consulted on the business decision at hand.

3. Describe the possible actions of the stakeholders following the business decision

4. Evaluate each of the possible business decisions in light of the ethical tests.

5. Identify the best possible decision and justify your choice, with reference to the ethical approach on which you have based it.

References

Markkula Center for Applied Ethics. (n.d.). Ethical decision making. Santa Clara University. Retrieved from https://www.scu.edu/ethics/ethics-resources/ethical-decision-making/

Business Ethics in a Nutshell: What is Ethics?

Ethics is the branch of philosophy concerned with the meaning of all aspects of human behavior. Theoretical ethics, sometimes called normative ethics, is about discovering and delineating right from wrong; it is the consideration of how we develop the rules and principles (norms) by which to judge and guide meaningful decision making. Theoretical ethics is supremely intellectual in character, and being a branch of philosophy, is also rational in nature. Theoretical ethics is the rational reflection on what is right, what is wrong, what is just, what is unjust, what is good and what is bad in terms of human behavior.

Business ethics is not chiefly theoretical in character. Though reflective and rational in part, this is only a prelude to the essential task behind business ethics. It is best understood as a branch of ethics called applied ethics: the discipline of applying value to human behavior, relationships and constructs, and the resulting meaning. Business ethics is simply the practice of this discipline within the context of the enterprise of creating wealth (the fundamental role of business).

There are three parts to the discipline of business ethics: personal, professional, and corporate. All three are intricately related, and it is helpful to distinguish between them because each rests on slightly different assumptions and requires a slightly different focus in order to be understood. We are looking at business ethics through a trifocal lens: close up and personal, intermediate and professional, and on the grand scale (using both farsighted and peripheral vision) of the corporation.

In spite of some recent bad press, business executives are first and foremost human beings. Like all persons, they seek meaning for their lives through relationships and enterprise, and they want their lives to amount to something. Since ethics is chiefly the discipline of meaning, the business executive, like all other human beings, is engaged in this discipline all the time, whether cognizant of it or not. Therefore, we should begin by looking at how humans have historically approached the process of making meaningful decisions. Here are four ethical approaches that have stood the test of time.

Personal Ethics: Four Ethical Approaches

From the earliest moments of recorded human consciousness, the ethical discipline has entailed four fundamental approaches, often called ethical decision-making frameworks: utilitarian ethics (outcome based), deontological ethics (duty based), virtue ethics (virtue based), and communitarian ethics (community based). Each has a distinctive point of departure as well as distinctive ways of doing the fundamental ethical task of raising and answering questions of value. It is also important to understand that all four approaches have overlaps as well as common elements, such as the following:

· impartiality—weighting interests equally

· rationality—backed by reasons a rational person would accept

· consistency—standards applied similarly to similar cases

· reversibility—standards that apply no matter who makes the rules

These are in a sense the rules of the ethics game, no matter which school or approach to ethics one identifies with most.

Utilitarian Ethics

The utilitarian approach is perhaps the most familiar and easiest to understand of all approaches to ethics. Most of us are using utilitarian ethics much of the time, especially those of us in business. The utilitarian asks a very important question: "How will my actions affect others?" They then attempt to quantify the impact of their actions based on some least common denominator, such as happiness, pleasure, or wealth. Therefore, utilitarians are also called consequentialists, because they look to the consequences of their actions to determine whether any particular act is justified.

"The greatest good for the greatest number" is the motto of the utilitarian approach. Of course, defining "good" has been no easy task because what some people think of as good, others think of as worthless. When a businessperson does a cost benefit analysis, he or she is practicing utilitarian ethics. In this case, the least common denominator is usually money. Everything from the cost of steel to the worth of a human life must be given a dollar value, and then one just does the math. The Ford Pinto automobile was a product of just such reasoning. Thirty years ago, executives at the Ford Motor Company reasoned the cost of fixing the gas tank problem with their Pinto would cost more than the benefit of saving a few human lives. Several tanks did explode, people died, and the company lost lawsuits when judges and juries refused to accept these executives' moral reasoning.

One of the most familiar uses of outcome-based reasoning is in legislative committees in representative democracies. How many constituents will benefit from a tax credit and how many will be diminished is the question before the revenue committee at tax rectification time. Representative democracies make most decisions based on the utilitarian principle of the greatest good for the greatest number.

Democratic governments are naturally majoritarian, though in constitutional democracies there are some things that cannot be decided by doing the math (adding up the votes). Some questions should never be voted on. The founders of our nation expressed this fundamental concept with three words: certain unalienable rights.

Deontological Ethics

Enter the deontological ethicists. Immanuel Kant is the quintessential deontological (duty-based) ethical theorist. Kant, who lived in eighteenth-century Prussia, was one of the most amazing intellects of all time, writing books on astronomy, philosophy, politics, and ethics. He once said, "Two things fill the mind with ever new and increasing admiration and awe ...the starry heavens above and the moral law within" (Kant, 1788). For Kant there were some ethical verities as eternal as the stars.

Deontological simply means the study (or science) of duty. Kant did not believe that humans could predict future consequences with any substantial degree of certainty. Ethical theory based on a guess about future consequences appalled him. What he did believe was that if we use our facility of reason, we can determine with certainty our ethical duty. As to whether or not doing our duty would make things better or worse (and for whom), Kant was agnostic.

Duty-based ethics is enormously important for (though consistently ignored by) at least two kinds of folks: politicians and business people. It is also the key to a better understanding of our responsibilities as members of teams. Teams (like work groups or political campaign committees) are narrowly focused on achieving very clearly defined goals: winning the election, successfully introducing a new product, or winning a sailboat race. Sometimes a coach or a boss will say, "Look, just do whatever it takes." Ethically, "whatever it takes" implies the ends justify the means. This was Kant's fundamental criticism of the utilitarians.

For Kant, there were some values (duties) that could never be sacrificed to the greater good. He wrote: "So act as to treat humanity, whether in thy own person or in that of any other, in every case as an end withal, never as a means only" (Kant, 1998). Fellow team members, employees, campaign staffs, customers, and partners are always to some extent means to our various goals (ends), but they are also people. And people, Kant believed, cannot be just used, they must also be respected in their own right, whether or not the goal is achieved. He called this absolute respect for persons a categorical imperative.

In any team situation the goal is critical, but treating team members with respect is imperative. Teams fall apart when a team member feels used or abused (treated as less important than the overall goal itself). Great leaders carry the double burden of achieving a worthwhile end without causing those who sacrifice to achieve the goal being treated as merely expendable means. People are never merely a means to an end. We owe that understanding to Immanuel Kant.

It is one thing to understand that there are duties that do not depend on consequences; it is quite another to develop the character to act on those duties. This is where Aristotle (384-322 B.C.) comes in. Aristotle wrote the first systematic treatment of ethics in Western civilization: Nicomachean Ethics.

Virtue Ethics

Today we call his approach to ethics  virtue ethics . For Aristotle and other Greek thinkers, virtue meant the excellence of a thing. The virtue of a knife is to cut; the virtue of a physician is to heal; the virtue of a lawyer is to seek justice. In this sense, ethics becomes the discipline of discovering and practicing virtue. Aristotle begins his thinking about ethics by asking, "What do people desire?" He discovers the usual—wealth, honor, physical and psychological security—but he realizes that these are not ends in themselves; they are means to ends.

The ultimate end for a person, Aristotle taught, must be an end that is self-sufficient, "that which is always desirable in itself and never for the sake of something else" (Arisotle, 1999). This end of ends Aristotle designates with the Greek word eudemonia, usually translated by the English word “happiness.” But happiness does not do Aristotle or his ethics justice. Yes, eudemonia means “happiness,” but really it means so much more. The problem is not with Aristotle's Greek word eudemonia, the problem is in our English word “happiness.”

Happiness in English comes from the ancient word hap, meaning chance, as in happenstance. For Aristotle happiness was not something one acquired by chance. Happiness was the grand work of living; the very practice of being all that you can be. Fulfillment and flourishing are far better words to translate the concept contained in the Greek word eudemonia. For Aristotle, this state of virtue is achieved not by accident but through intent, reason, and practice.

Aristotle thought that one discovers virtue by using the unique gift of human reasoning, that is, through rational contemplation. "The unexamined life is not worth living," said Socrates almost 100 years before Aristotle. Like Aristotle and Aristotle's teacher Plato, Socrates knew that we humans need to engage our brains before we open our mouths or spring into some decisive action. For Aristotle, the focus of that brain work was chiefly about how to balance between the fears and excesses in which the human condition always abounds. Between our fears (deficits) and exuberances (excesses), lies a sweet spot, the golden mean, called virtue.

At times of physical peril—say in a big storm on a small sailboat—a crew member may be immobilized by fear and unable to function, thus putting the lives of everyone on the sailboat in danger. Or the opposite could happen. A devil-may-care attitude in the face of real danger can as easily lead to disaster. Courage is the virtue located at the mean between cowardliness and rashness. Yet, identifying such a virtue and making that virtue part of one's character are two quite different things. Aristotle thus distinguishes between intellectual virtue and practical virtue. Practical virtues are those developed by practice and are a part of a person's character, while intellectual virtue is simply the identification and understanding of a virtue.

Practice is how one learns to deal with fear; practice is how one learns to tell the truth; practice is how one learns to face both personal and professional conflicts. Practice is the genius of Aristotle's contribution to the development of ethics. He showed that virtues do not become a part of our moral muscle fiber because we believe in them, or advocate them. Instead, virtues become characteristics of ourselves by our exercising them. How does one learn to be brave in a storm at sea? "Just do it."

The ultimate goal behind developing characteristics of virtue is eudemonia, a full flourishing of our self, true happiness. Practitioners of the Judeo-Christian tradition tend to think of ethics (or morality) as the business of figuring out how to be good rather than bad. That is not the true end of ethics so far as Aristotle was concerned. The end is a state of fulfillment; the ultimate goal is becoming who you truly are and realizing the potential you were born with—being at your best in every sense.

Just as the virtue of the knife is to cut and the virtue of the boat is to sail, the virtue of the self is to become the best of who it can be. This is eudemonia. Just as the well-trained athlete seeks to be in the zone (the state of perfect performance achieved by practice), Aristotle wrote about the truly virtuous life and the pursuit of eudemonia. Just as a perfectly trimmed sailboat glides through the water, effortlessly in sync with the waves and the wind, the man or woman in a state of eudemonia has achieved the state of earthly fulfillment.

Communitarian Ethics

All three approaches to ethics described above are principally focused on the individual: the singular conscience, rationally reflecting on the meaning of duty or responsibility, and in the case of virtue ethics, the ethical athlete practicing and inculcating the capacity to achieve the state of eudemonia. Communitarian ethics has quite a different point of departure: the community (or team, or group, or company, or culture) within which the individual engages himself or herself is the critical context for ethical decision making.

The communitarian asks the important question, "What are the demands (duties) that the community or communities of which I am a part make on me?" The Scottish ethicists W. D. Ross (himself a student of Aristotle) focused his own ethical reflections on the question of, "Where do ethical duties come from?" His answer was that they come from relationships. We know our duties toward fellow human beings by the nature and quality of our relationships with them. The duties we owe a colleague in the workplace is different from the duties we owe a spouse; those duties are different from the duties we owe our country. The communitarian asks us to look outward and to face up to the duties of being social creatures. We define ourselves and our responsibilities by the company we keep.

Communitarians are quite critical today of the attitude of so many in our society who, while adamant about their individual rights, are negligent of their social duties. The "me generation" has created a need for a new breed of ethicists who insist that, from family and neighborhood to nation and global ecosystem, the communities in which we live require us to accept substantial responsibilities. Environmentalists, neighborhood activists, feminists, and globalists are some of the groups loosely identified today with the communitarian movement.

Amitai Etzioni, in Spirit of Community: Rights, Responsibilities and the Communitarian Agenda described the principles of this somewhat disorganized movement. Etizioni's thesis is that we must pay more attention to common duties as opposed to individual rights. Our neighborhoods, he believes, can again be safe from crime without turning our country into a police state. Our families can once again flourish without forcing women to stay home and not enter the workforce. Our schools can provide, "essential moral education" without indoctrinating young people or violating the First Amendment's prohibition of establishing religion.

The key to this social transformation is the communitarian belief in balancing rights and responsibilities: "Strong rights presume strong responsibilities." Etzioni (1993) states the communitarian agenda: “Correcting the current imbalance between rights and responsibilities requires a four-point agenda: a moratorium on the minting of most, if not all, new rights; reestablishing the link between rights and responsibilities; recognizing that some responsibilities do not entail rights; and, most carefully, adjusting some rights to the changed circumstances.”

Here, if nothing else, is a frontal attack on the libertarian mindset of our age.

Communitarianism is not new, at least if one defines it as an approach to ethics and value referencing significant communities of meaning. Most of the world's great religions are in this sense communitarian. It is from a community of faith that the faithful develop a sense of self and responsibility (or in Confucian thought, the extended family which nurtures this development). Ethics cannot be separated from the ethos of the religious or familial community. The modern communitarian movement may or may not be religiously inclined, yet it is clearly a part of a tradition of ethical approach as old as human association.

In the context of teams, the communitarian approach to ethics has much to commend itself. How much of one's personal agenda is one willing to sacrifice for the overall goal of winning a sailboat race? Under what conditions is one willing to let the values or culture of the team alter one's own ethical inclinations? To what extent do the relationships one has with team members give rise to duties that one is willing to honor? How willing is one to share the credit when the team succeeds? How willing is one to accept blame when the team loses? Under what conditions would one break with the team? If Ross is correct that duties come from relationships, paying attention to such questions about the company we keep may be more than a social obligation; perhaps, our ethical duty.

Other Ethical Approaches

There are two pervasive ethical approaches not treated here: ethical egoism and the divine imperative. Each has a broad and dedicated following and each is deeply problematic to the ethical maturing of any society. Briefly, and with pejorative intent, here is what these extreme, yet interestingly similar approaches assert.

The ethical egoists say that ethics is a matter of doing what feels right to the individual conscience. If one asks, "Why did you do that?" The answer is, "Because I felt like it." The approach is often dressed up with statements about being true to yourself: "let your conscience be your guide", or "do the right thing." But how does one know what is true for the self? How does one develop a conscience? How is one to know that doing what is right (what feels right to you) is the right thing to do?

If nothing else, ethical egoism is a conversation stopper! How does one communicate to colleagues, friends, children or any other human being when the reference point of behavior or ethical judgment is just about how one feels inside? How does a civil society emerge if we civilians cannot deliberate in common, understandable language about our motives, intents, values, or duties? In essence, ethical egoism is the ethics of teenagers rebelling against being answerable to outside authority. To teenagers, to enter the ethical dialogue is to take the radical risk of having one's values and actions challenged.

Apparently, there are many of us who are just not grown up enough to risk that! Better to repeat the mantra: "I did what my conscience dictated."

Just as there is no possible meaningful ethical dialogue with the ethical egoist, nor is there much hope of creative engagement with divine imperialists. For this growing community, ethics is the simple business of doing what God tells one to do. There is therefore no reason or need for discussion. The issue is conversion, not conversation. In a constitutional democracy like ours with a fundamental commitment to "the non-establishment of religion", the divine imperialist is stuck with a difficult dilemma: either to 

make all ethical inquiry personal (that is, no social or political value deliberation), or bring no state into conformity with the revealed will of God. Divine Imperialists do not deliberate. They dictate, simply because there is nothing to deliberate about. God has spoken. It is in the book.

The flaw in the divine imperialists' approach that if God is good, then He must reveal only good laws and rules. This creates two alternatives. The first is that there is a reference for "good" apart from the divine itself. The only other, that God is undependable; that God is arbitrary; surely this is unacceptable. God is not only good, but God wills the good. God's will, then, becomes a reality discoverable even apart from belief in a particular represented manifestation of God. Religion, at its best, should understand that faith confers no special status of ethical insight. Believers, agnostics, and nonbelievers can, and do, contribute to the culture's continuing struggle to understand what is good, what is just, what is true. That is why democracies (as opposed to states founded upon some divine right of kings) survive.

Narrative Ethics

Among the professions, particularly medicine, law, and counseling, narrative has become a powerful tool in developing ethical insights and perspective. To tell a story is to invite participation from the hearer, and it is to also a means of communicating the richness and complexity of human dilemmas. Narrative ethics is simply diagnosis through story. Its benefit over the four traditional ethical approaches is that story invites both ethical engagement and ethical creativity. In business, as in law, a great deal of teaching is done through the use of cases. This is nothing more or less than using the pedagogy of narrative ethics. The narrative invites the hearer into the complexity of issues involved in personal, professional and organizational dilemmas, and provides a road through the complexity to the simplicity on the other side.

Oliver Wendell Holmes, an American jurist who wrote stunningly comprehensible decisions, even in some of the most complex cases imaginable, has a famous quote: "I would not give a fig for simplicity this side of complexity, but I would give my life for the simplicity that lies on the other side of complexity." It is the role of narrative to lead us through the thickets of overwhelming complexity, to the clarity of enriched simplicity.

At all stages of the ethical decision-making process, narrative is a useful tool of analysis for exposing the facts, conflicts, feelings, and values that are the stuff of the human predicament.

International Law

by Robert C. Goodwin

Introduction to Law

There are many definitions of law, each of which focuses on a different aspect of the subject. Black’s Law Dictionary (n.d), for example, defines law in a way that emphasizes it as applicable to people as well as physical phenomena: “That which is laid down, ordained, or established. A rule or method according to which phenomena or actions coexist or follow one another.”

Webster’s Third New International Dictionary (1961) is less broad, focuses on people, adds the enforcement concept, and emphasizes the notion of law as an expression of the customs of the people: “A binding custom or practice of a community. A rule or mode of conduct or action that is prescribed or formally recognized as binding by a supreme controlling authority or is made obligatory by a sanction made, recognized, or enforced by the controlling authority.”

An even more specific definition is, law consists of the entire body of principles that govern conduct, the observance of which can be enforced in courts.

Man-made law is necessary to provide not only rules of conduct but also the machinery and procedures for enforcing right conduct, for punishing wrongful acts, and for settling disputes that arise even when both parties are motivated by good intentions. In its broadest sense, the purpose of law is to provide order, stability, and justice. It is often said that procedure is the heart of the law. There are many instances where the substantive words of the law appear to give someone a right but they are unable to exercise that right for procedural reasons. Something as simple as failing to file a lawsuit within the time limits set by the local court rules can prevent someone from receiving the remedy they thought they had. We should always keep this distinction between right and remedy in mind as we review the various materials in this course.

The Legal System

Each nation has its own legal system. Thus, the institutions that create the laws (such as bureaucracies, courts, legislatures, a king) can differ significantly from country to country. So also will the scope of the substantive rules enacted by these institutions, which define the rights and responsibilities of the citizens of the nation. The rules relating to what constitutes criminal conduct, when a contract is considered to be formed, what activities of private parties are subject to government control, and myriad other substantive regulations of human conduct all differ from country to country. A final aspect of a nation’s legal system consists of the procedural rules that govern enforcement of the substantive ones. As noted, one doesn’t truly have a right without a remedy, and it is the remedy that is defined by procedural law. These rules encompass everything from the rules of evidence to the right to be represented by a lawyer and are a critical component of a legal system.

While it is a fact that each nation has its own legal system, it is also true that legal systems can be grouped into major categories, with the individual nations within a category having similar structures to their legal systems. The two major legal systems in the world are the common law legal system and the civil law legal system.

Civil Law and Common Law

A civil law country is one whose legal system reflects, however remotely, the principles of classical Roman law as codified by the emperor Justinian I in the sixth century. While modern countries that are part of the civil law system have substantive laws that differ greatly from the law at the time of the Romans, the structure of the system and its approach to legal problem solving date from the sixth century. We may be more familiar with the Napoleonic Code of 1804, which often is considered the father of civil law codes, but it too was a direct descendant of Roman law.

Common law, on the other hand, owes its origins to the slow development of royal courts after the Norman Conquest of England in 1066. Gradually, the expansion of royal power at the expense of the local barons resulted in the ascendancy of royal institutions and particularly the royal courts, where citizens perceived the likelihood of justice at the hand of the King’s judges as greater than that of the purely local tribunals, which had existed before the conquest. The term common law owes its origins to the fact that it was the law applied by royal or national courts and hence "common" to the entire country as opposed to the customary law of the local courts.

More important for us than the origins of these two major legal systems are the questions: which countries are influenced by which system, how do the two systems differ, and what do the differences mean for international business, if anything?

Common law is applied in Great Britain and almost all of the countries where Great Britain had a significant influence. Thus, the United States, Canada, Australia, India, and most other former British colonies use the common law system. The civil law system is centered in continental Europe and prevalent in South America and much of Asia, including Japan.

While in recent years the differences between the two major legal systems have narrowed somewhat, with countries identified as common law or civil law borrowing legal approaches from each other and being influenced by the same social movements and cultural changes, there nevertheless are significant differences that should be highlighted. The most fundamental difference rests in the very nature of how law is made.

In the civil law tradition, law is conceived as a rule of conduct expressed in written codes. Nothing is law unless it is written down in such a code. The expression of the law is stated in broad general terms, and a judge, when deciding a case, must find a basis for the decision in the principles expressed in the code. While the judge may refer readily to legal scholars for assistance in doing so, reference to other similar cases handled by other judges would ordinarily not be part of the process. Rather, the civil law judge would apply deductive reasoning—solving the case by deduction from a principle expressed in the code.

Common law focuses heavily on cases. While common law countries have codes (any statute enacted by a legislative body would fit this definition) the law inferred by prior cases (i.e., judicial precedents) is equally as important as the statute. Common law lawyers and judges reason by analogy to prior cases, and if a prior case decided by a higher court is essentially the same in its factual pattern then the case will control the outcome under the principle of stare decisis (i.e., that past decisions are generally binding for the resolution of factually similar cases). Thus, the role of judges is critical, and the common law is often referred to as "judge-made law." One of the facets of common law which often surprises those familiar with the civil law tradition is that there are many areas of the common law where there is no written statute at all—only prior cases. In order to know the state of the law, one has to study the cases first. A good summary of these fundamental differences might be, a common law lawyer looks for a case, a civil law lawyer looks for the principle involved.

In addition to the fundamental difference noted above, there are a number of less general but equally important practical differences. For example, there are no juries in noncriminal cases in civil law countries. In a court case in a civil law country, the judge assumes a far more activist role, and attorneys for each side have an obligation to assist the judge in finding the facts. In contrast, in litigation in a common law country, the judge is a neutral referee, ruling on motions made by the advocates but not generally initiating his own inquiries.

The US Legal System

In order to understand the context of international law, it is important to have a basic understanding of the US legal system. This system is somewhat complex because each state within the United States has its own legislative body, executive branch, and court system. And, of course, the federal government has this structure as well. How these systems overlap and interact with each other is an important issue.

One of the most important aspects of the US federal system is the acceptance by courts in one state of the judicial decisions made in another state. The Constitution itself requires that each state give "full faith and credit" to the judicial determinations of its sister states. Thus, for example, if I bring a successful lawsuit in Maryland against a party who moves to California, I can take that Maryland judgment to the courts of California and ask that the California court convert that judgment into a California judgment, which can then be enforced in that state. Importantly, there is no comparable situation among countries. If I obtain a favorable court ruling from the courts of France against a person who then moves to Brazil before the judgment can be enforced it will be doubtful that I could convince a Brazilian court to adopt the French judgment. There is no international "full faith and credit" clause, although negotiations on an international agreement, which would do just that, are already underway.

One interesting aspect of the differences between federal laws and state laws is that those laws that are of principal interest to us (i.e., those laws that deal with commercial matters) are virtually all state laws. There is no federal law of contracts and no federal law of sales. That does not mean, however, that federal courts are never involved in hearing a case involving a contract dispute. But if and when they do hear such a case they apply state law. Assume, for example, that you have a contract dispute that arises over a contract that was signed in New York and was to be performed in New York. One party brings an action in the federal court sitting in the state of Maryland (we’ll explain how this happens shortly). The federal court in the state of Maryland would apply New York law to the case because (1) it has to apply state law since there is no federal law on contracts, and (2) the jurisdiction with the closest connection with the case is New York and hence, New York law should apply.

We all are familiar with the Supreme Court and its role as the final decision-making body on matters of legal interpretation. The Supreme Court is the highest court in the federal system. Immediately below the Supreme Court are thirteen circuit courts of appeal, which hear appeals from the district courts, the trial-level courts in the federal system. Twelve of these circuit courts of appeal cover geographic areas—the sixth circuit, for example, covers Michigan, Ohio, Kentucky, and Tennessee. The courts have as many as twenty judges and they hear cases in panels of three. The circuit courts do not conduct trials—they only hear appeals and, in the common law system, appeals can only be made as to matters of law as opposed to facts. The trial court and the jury have complete responsibility for determining the facts, and the appellate courts can only hear appeals relating to matters of law.

Federal courts at the trial level (the district courts) and at the appellate level (the circuit courts of appeal) have their basic power, or jurisdiction, defined by the Constitution. Under Article III of the Constitution, specific powers are outlined for the federal courts. Federal courts have jurisdiction with respect to the following:

1. constitutional issues

2. laws and treaties of the United States

3. admiralty

4. ambassadors

5. where the United States government is a party

6. controversies between a state and citizens of another state

7. controversies between citizens of different states (called "diversity jurisdiction")

8. controversies between a citizen of a state and a foreign citizen

Plus, a $75,000 minimum applies to suits involving numbers 8 and 9 above.

Number 8 above is most significant for our purposes. The concept of "diversity jurisdiction" was adopted by the framers of the Constitution in order to provide an alternative to the home field advantage that might otherwise apply if lawsuits involving parties from different states could be heard only in the state courts of one of the parties. The federal courts were seen as providing a more neutral forum for such situations. Thus, because of this provision of the Constitution, a party can either bring a case in a federal court (as a plaintiff) or ask to have it removed to a federal court (as a defendant) so long as the diversity criteria are met. And, as already noted, the federal court would apply state law in its consideration of the case, unless it is a case involving federal law or one of the other categories set forth above.

International Legal Issues

Before considering the issues related to the application of legal rules to international businesses, we should understand the scope of the power of nations to make such rules. In other words, what are the limits of a nation’s law-making authority and where do such limits come from? Can the Parliament in Great Britain issue edicts regulating businesses in Switzerland? What are the principles involved?

We start with the consideration of public international law—that is, the category of international law that defines the relationships between and among nations. It differs from what is usually termed private international law, which really is simply another way of describing the rules that apply to private businesses in an international setting. But our concern now is to analyze public international law and to understand the reach of a nation’s power over its subjects and over the subjects of other nations. Hereafter we’ll drop the word public and simply refer to public international law as international law.

The term international law is used to describe the rules that regulate the conduct of nations. International law differs from the laws of the various nations of the world in two major respects. First, many areas of international law are not definitive—that is, nations (or states) differ as to what the actual rule in question is (although there are many areas where the rules are clear, either by virtue of an international agreement or long usage). Second, for the most part there is no enforcement mechanism associated with international law, so that a nation that ignores the rules, while subject to possible ostracism, is not otherwise at risk of being enjoined, fined, or arrested as would a private citizen or business that violated the law of a nation.

International law is based on the principles of (1) sovereignty and (2) the consent of states. The concept of sovereignty is that a nation is master in its own territory. The International Court of Justice (ICJ) (1948) has defined sovereignty as "the whole body of rights and attributes which a State possesses in its territory, to the exclusion of all other States, and also in its relations with other States. Sovereignty confers rights upon States and imposes obligations on them."

Thus, sovereignty is that concept which allows a state to make rules that are applicable throughout its territory and that govern all people within the state. The concept of sovereignty also conveys the notion that each state is equal to all other states, and the sovereign rights of any particular state are limited by the sovereign rights of other states.

The acceptance of the concept of sovereignty dates from the middle of the seventeenth century at the conclusion of the Thirty Years War, which marked the separation of the powers of the church and the state. As time has passed, nations have begun to recognize specific principles that further define the concept of sovereignty and the notions of territorial integrity and political independence as being inviolable. Since each state is sovereign in its own territory, international law recognizes the basic principle that no state has the right to impose its will on the territory of another state.

Courts in the United States often use the term comity to refer to the deference or respect that is due to the decisions and actions of another country in order to minimize the conflicts that could arise through the assertion of conflicting jurisdiction by different countries.

There are a number of sources of international law. First, there is customary international law, which derives from the practice of nations over a period of time; in other words,something that over time is recognized by states as international law, whether from a sense of obligation or other reason. Second, international conventions and treaties establish rules, which are accepted by the nations that sign them, such as the Law of the Sea Convention. Third, general principles of law recognized by civilized nations can serve as a source for international law. Finally, judicial decisions by international courts such as the ICJ in the Hague, as well as the opinions of legal scholars, can assist in determining the rules of international law.

While international law seems from one perspective to be academic and theoretical, it actually has considerable practical impact in the real world. Consider, for example, if a US citizen were involved in a dispute in Mexico with citizens of Brazil and a Brazilian court ordered him or her to return to Brazil for a trial. Instead, the US citizen heads to Houston, where a representative of Brazil appears in a Houston court and asks the judge to assist in enforcing the Brazilian court order. The first thing the US judge will consider is international law and whether Brazilian courts have the power to order a noncitizen outside their country to return to appear in their courts.

The Permanent Court of International Justice, or the World Court, was created as an international court long before the founding of the United Nations after the Second World War. When the United Nations was created, the court was named the International Court of Justice, and was incorporated as one of the organs of the UN. Article 34 of the UN Statute defining the jurisdiction of the court makes it clear that the court can only hear disputes that arise between nations, not disputes that arise between private parties or between a nation and a private party. And, the court only decides issues which are presented to it by the countries on a voluntary basis. As a general rule, both nations involved in a dispute must agree to have the ICJ hear the dispute in order for the court to have jurisdiction.

In general, international law recognizes, to one extent or another, five bases for the exercise of a nation’s powers to cases involving foreign persons, property, or events. (Voluntary agreement of the parties would be a sixth basis.) The support for and legitimacy of these theories of jurisdiction differ, and they are outlined here in the order of acceptance:

territorial principle—This concept is universally accepted and is the fundamental attribute of sovereignty—that a nation can control events and people within its territory. Each nation is responsible for the conduct of law and the maintenance of good order within its borders, and this principle is an expression of that right and responsibility.

nationality principle—The person committing the offense is a citizen who can be presumed to know his country’s laws wherever he is. By virtue of nationality, a citizen becomes entitled to certain rights and protections from his country (such as a passport, right to vote, etc.) and also has certain obligations. Under this theory of jurisdiction, a nation can exercise its control over its nationals wherever they may be.

protective principle—Jurisdiction can be exercised because of conduct that was injurious to a fundamental national interest.

universality principle—Nations have jurisdiction to try cases where the offense is one that is regarded as a crime by the entire international community. The two most common situations are piracy and war crimes.

passive personality principle—Crimes against citizens (i.e., a nation claiming jurisdiction to try a person for offenses committed abroad that affect nationals of the country), such as crimes against ambassadors and diplomats.

“effects” principle—The "effects" principle refers to the situation where a state assumes jurisdiction on the grounds that the behavior of a party is producing "effects" within its territory. This is the case even though all the conduct complained of takes place in another state. The use of the "effects" test has arisen most often in situations which are described as the exercise of "extraterritorial" jurisdiction by a country. The United States, for example, has been subject to considerable criticism for purporting to control events and exercise jurisdiction over activities that occur outside of its borders, particularly in the antitrust area and in the area of export controls.

Determining the Applicable Law and Forum

We already discussed the jurisdiction of countries and their power to prescribe rules, and we evaluated the various bases upon which such power could be exercised. When we talk of jurisdiction, whether of courts or nations, think of the word as synonymous with the concept of power. What we have learned so far is that there are various standards under international law for determining the reach of the power of nations to assert their authority over people. We observed the territorial principle, the nationality principle, and the effects test as being three of the important ones.

Now we will consider a different aspect of jurisdiction—the jurisdiction of courts— starting with an analysis of the situation in the United States. The concept of jurisdiction is central to the legal system. If you are sued in California, can a California court proceed with the case even though you live in Maryland? The answer depends upon the limits on the jurisdiction of US courts and how those limits are determined. In fact, in every lawsuit, the first criterion that a plaintiff has to include in his pleadings is a presentation of the legal basis as to why the court has jurisdiction over the subject matter of the case and over the defendant.

After considering the concept of jurisdiction we will touch upon what is called "choice of law." Once a court has decided that it has jurisdiction, what law does it apply? The law of the state where the court is located, the law of the state where the plaintiff or defendant resides, or some other law? Like most areas of the law, the legal principles in this area are still developing and, although it is easy enough to state the generally accepted principles, we must always be aware that there are many gray areas in the law.

Finally, we will address the ability of parties to choose their own law and forum (i.e., in which court the matter will be decided).

The Jurisdiction of Courts

Subject Matter Jurisdiction

Before we can determine if a court can exercise power over an individual or a corporation (i.e., exercise personal jurisdiction) we need to know that the court is authorized to deal with the subject matter of the dispute. This is generally not a significant issue because most state courts are courts of general jurisdiction and are empowered by statute to hear all controversies arising under the laws of a particular jurisdiction. The federal courts have more limited subject matter jurisdiction, as we discussed previously, where we reviewed the constitutional provision that delineated the power of federal courts. And, there are a number of "specialized" courts where the issue of subject matter jurisdiction is indeed significant. Take, for example, the bankruptcy courts, which were created to deal exclusively with bankruptcy. If you were to try to bring another type of case in a bankruptcy court, you would not be able to do so, because the court would determine that it did not have subject matter jurisdiction. But, for the most part, determining whether a court has subject matter jurisdiction is not a difficult issue. The same is not true with respect to the issue of personal jurisdiction.

Personal Jurisdiction

By far the more significant jurisdictional issue from our point of view is that of personal jurisdiction—whether a court has the ability to exercise power over a particular individual or corporation. Keep in mind that the answer to this question could be quite important. If a Maryland resident is sued in California and the court there determines that it has personal jurisdiction over him then the defendant must undergo the trouble and expense of defending himself in a court far from home. The principles that we discuss now will be helpful when we evaluate the same problem in the international context.

Statutory Basis

In order for a US court to have jurisdiction over a person, there must first be a specific law that purports to set forth the power of the court over persons. These laws are called long-arm statutes, and every state has its own version of such a law. Generally, these laws grant the courts far-reaching powers. For example, the statute may give the state jurisdiction over persons who commit acts outside the state but which have an effect within the state.

Constitutional Basis

The principal limitation on the exercise of personal jurisdiction by courts in the United States comes not from the state long-arm statutes but rather from the limitations of the Constitution as expressed by the Supreme Court in a series of cases over the years. The Constitutional provision is the due process clause, that is, the portion of the Fourteenth Amendment to the Constitution, which says that no person shall be deprived of life, freedom, or property without due process of law. In American jurisprudence, this clause has come to serve many purposes. Another term for due process might be fundamental fairness, and the essential notion the the Supreme Court has been dealing with in these cases is that the Constitution requires the application of this fundamental fairness.

General Jurisdiction

The analysis of the legal sufficiency of personal jurisdiction is divided into two general categories: general jurisdiction and specific jurisdiction. General jurisdiction is jurisdiction over the person not related to the particular cause of action. In other words, the person’s connection with the particular venue is so significant that she is subject to being sued in that place regardless of whether the particular lawsuit has anything to do with the place of venue. For example, a corporation is always subject to general jurisdiction in the state where it is incorporated. Thus, a Maryland corporation is always subject to being sued in Maryland courts whether a particular claim has anything to do with Maryland or not. Similarly, if a person or a corporation has continuous and systematic activities within a forum state, that state will be considered to have general jurisdiction over that person or corporation. By conducting such continuous and systematic activities in a particular state, the legal theory is that, by regularly doing business in that place, a person has to accept the notion that they can be sued there as well.

Specific Jurisdiction

Specific jurisdiction relates to situations where the particular action that is the subject of the suit arose in the forum where the lawsuit is sought to be brought. In other words, a defendant has caused some damage in a particular place, and the question is whether the defendant can be held to account in that location or whether one must go to the defendant’s home state and sue there. In these situations, the courts have developed a two-part test:

Did the defendant purposefully avail itself of the protections and benefits of the forum state’s laws?

Would the exercise of jurisdiction be reasonable?

When a corporation purposefully avails itself of the privilege of conducting activities within the forum state it has clear notice that it is subject to suit there and can act to alleviate the risk of burdensome litigation by procuring insurance, passing the expected costs on to customers, or, if the risks are too great, severing its connection with the state.

The explosive growth of the internet and electronic commerce have raised many issues related to the law of jurisdiction. If you create a web page that slanders someone in California, are you subject to suit in that state even though you have never been there, and your only connection with the state is that your web page is available there as it is everywhere else? Courts have addressed these questions by applying the traditional principles, adjusted perhaps, but still largely intact.

The Ability of a Court to Refuse to Exercise Jurisdiction

The fact that a particular court has the power under the constitution to hear a case does not necessarily mean that the court is required to hear the case. There is a judicial doctrine called forum non conveniens, which allows a court to determine that, even though it has the power to hear the case, it would be more appropriate for another court to hear it. A good example of the application of this principle is the Bhopal case involving the explosion of a chemical plant in India partially owned by Union Carbide. When the case was brought in New York, that court clearly had jurisdiction over Union Carbide (although not over the Indian joint venture entity) but declined to exercise jurisdiction under the doctrine of forum non conveniens. All the witnesses were in India, the accident occurred there, the evidence was there, etc. Underlining the application of this doctrine, in many cases such as Bhopal where foreign plaintiffs are involved, is a policy view that US courts should avoid becoming the location of choice for all international litigation simply because jury awards are traditionally higher in the United States.

International Contracts

by Robert C. Goodwin

In this paper we will focus on the specific rules relating to certain international contracts as well as the critical question of how we make sure we get paid!

Formation of Contracts

Contracts involve an offer by one party and an acceptance by the other. Both the offer and the acceptance must be definite, unqualified, and unconditional. An advertisement for bids is not itself an offer, but a bid in response to such an advertisement is an offer. An offer may be revoked at any time prior to its acceptance, but that revocation must be communicated to the offeree before acceptance.

Under common law principles, the offer and the acceptance must match (i.e., must be a mirror image of each other) at least as to those aspects that are considered "material." The term material basically means important or significant. In contract law, all the basic terms involving price, quantity, delivery, and warranty are considered material. The provision of the contract dealing with dispute resolution is also material, even though the parties may not pay much attention to that.

In commercial transactions in the United States, the common law principles are less important because all states except Louisiana have enacted Article 2 of the Uniform Commercial Code (UCC). The code is not really "uniform," since it is simply comprised of  proposed text, which is then adopted by each state, in many instances with their own changes to the "uniform" provisions. But the UCC has given the United States a common sales law related to the sale of goods in commercial transactions, even if there are a few minor differences among the states. Article 2 of the UCC applies to contracts for the sale of goods, with goods defined as any tangible personal property. Examples of such tangible personal property include moveable items such as chairs, computers, and clothing. On the question of whether the offer and the acceptance have to match precisely, the UCC differs from the common law mirror image rule. Under the UCC, depending on if the parties are involved are merchants, the additional terms of an acceptance either fall out of the contract or may become a part of it.  If both parties are merchants (e.g., people who regularly deal in these types of goods), then the additional terms may become a part of the contract. If the parties are not both merchants, then they fall out of the contract, and do not become a part of it.

Breach of Contract and Remedies

There is a breach of contract whenever one or both parties fail to comply with the terms of contract without legal excuse. The remedies for breach include the following:

· The injured party can bring an action for damages.

· In some instance the injured party may cancel the contract.

· In some instances the injured party may bring a suit to obtain "specific performance." This means requesting the court to order the breaching party to do what he or she had promised to do in the contract instead of simply having the court award monetary damages. Specific performance is more common in civil law countries than common law countries, where the courts prefer monetary damages, and is used even in common law countries almost exclusively for goods ( particularly unique items), but almost never to compel a person to perform a personal service obligation of a contract.

The simple rule governing the appropriate damages in a contract case is that the injured party has a right to recover a sum of money that will place him in the same position as he would have been in if the contract had been performed. But this rule can become complex quite easily and it doesn’t take account of the critical area of consequential damages.

Damages can be divided into three classifications:

1. compensatory damages, which compensate for the loss;

2. punitive damages, which are common in other areas of the law but not favored in contract law

3. consequential damages.

The notion of consequential damages is that a contract violation can have additional consequences beyond simply the failure to honor the particular contract obligation. Suppose your failure to deliver a part on time as required by your contract causes a machine to shut down, resulting in millions of dollars of damages. Are you responsible for the cost of the part, or for the millions of dollars of damages?

U.N. Convention on Contracts for the International Sale of Goods (CISG)

The U.N. Convention on Contracts for the International Sale of Goods (CISG) was an effort to create a new international law of sales to apply to international sales transactions. The convention entered into force between the United States and other signatories as of January 1, 1988. As an international agreement, it has the status of law in those countries that have adopted it, and most major trading nations are signatories.

Basic Principles

Unless the parties to an international sales contract identify a specific legal regime that will apply to the contract, the CISG will be applied to the interpretation of the contract, so long as both of the parties to the contract have their places of business in a contracting state. Thus, if an international sales contract between a US company and an Italian company (Italy has signed the CISG) did not provide for the application of particular law, both a US court and an Italian court would be bound to apply the rules of the CISG to the interpretation of the contract. Had the contract said that the law of a particular US state would apply, then that choice would be honored by the courts as well. The parties could always specifically identify the rules of the CISG as applicable to the contract. But the important point is that the convention is the default legal regime in contracts between parties whose places of business are in countries that have signed the Convention. If the parties to a contract do not want the CISG to apply to their contract, they will need to specify another law that will apply.

Another important point to remember about the convention, is that it applies to sales only, not to other types of contracts. Of course, clarification is needed when you have more than one type of activity covered by a contract. Many international sales contracts, for example, cover service of equipment. Under the CISG, if the sales aspect of a contract is the "preponderant part of the obligations," then the convention will apply to the entire contract. Even with respect to sales transactions, the convention expressly excludes from its coverage consumer sales, securities transactions, and the sales of ships, aircraft, and electricity. Note that the exclusion for consumer sales is not the same as excluding consumer goods from coverage.

Fortunately, the rules of the CISG are not dramatically different from common law contract principles or statutes such as the UCC. But there are differences. The CISG applies the mirror image rule on offer and acceptance: if the acceptance doesn’t match the offer (in all material respects) then you have a rejection and a counteroffer. While the common law would also apply this rule, most sales transaction in the United States between merchants are governed by the UCC, which would reach a different conclusion, allowing a contract to be formed even if the offer and the acceptance did not match. For example, a projected buyer accepts an offer to sell a vehicle for $20,000 but adds a provision for a warranty. In this example, the added material becomes a proposal for a separate agreement, but the underlying contract remains in place. Another notable difference is that the UCC requires that contracts for sale of goods be in writing, while the CISG has no such requirement.

Remedies

The discussion above focuses on the basic principles relating to the CISG and the specific rules in that convention relating to contract formation. Now we are going to consider the rules of the CISG relating to remedies, covering such things as contract frustration or the impossibility of performance and the question of proper measure of damages.

Article 79 of the CISG is the "force majeure" provision that covers situations where a party is unable to perform their contractual obligations due to impediment beyond their control. The first section of Article 79 provides: "A party is not liable for a failure to perform any of his obligations if he proves that the failure was due to an impediment beyond his control and that he could not reasonably be expected to have taken the impediment into account at the time of the conclusion of the contract or to have avoided or overcome its consequences." Article 79 also provides that the exemption has effect for the period during which the impediment exists (CISG, 1988). In other words, if you are prevented from delivering goods by a force majeure event, you will still have to deliver them when the event that prevented delivery is over.

As a practical matter, sellers in international contracts will likely want a provision in the contract that is broader than Article 79. For example, Article 79 would require a seller to acquire parts elsewhere if his usual supplier were unable to supply them, since the exclusion in Article 79 does not apply if the consequences of the problem can be overcome. In the real world, a seller would want a force majeure provision that contained a list of those circumstances constituting excusable delay, including failure on the part of a normal supplier to supply needed parts.

With respect to damages, the CISG states the standard principle that "damages for breach of contract by one party consist of a sum equal to the loss, including loss of profit, suffered by the other party as a consequence of the breach. Such damages may not exceed the loss which the party in breach foresaw or ought to have foreseen at the time of the conclusion of the contract, in the light of the facts and matters of which he then knew or ought to have known, as a possible consequence of the breach of contract" (CISG, 1988).

Thus, the CISG specifically recognizes consequential damages, and this fact should cause those who draft contracts to add a provision that effectively overrides it. The better course of wisdom is to provide that no consequential damages will be available for breach of the contract. Since the CISG recognizes freedom of contract, one can override any of its provisions through the drafting of appropriate contract provisions.

There is also significant disagreement across contracting states over whether a “loss” under the CISG includes attorneys’ fees, making attorneys’ fees recoverable as a loss in some contracting countries, but not currently in the United States. One drafting a CISG contract would be prudent to include an express provision authorizing the recovery of attorney’s fees for victims of breaches of contracts, to ensure their recoverability. The UCC generally also only allows for the recovery of attorneys’ fees for sales contracts if there is an express contractual provision permitting their recovery.

Letters of Credit

As you know, the most important element of international sales transactions involves the fundamental question of how one gets paid. After all, if both the buyer and the seller are in the same country, and the buyer refuses to pay after receiving the goods, at least the seller has recourse to courts, which can assert jurisdiction over the deadbeat buyer. Assuming the seller is able to prove his case, he can get a judgment that can be enforced. But what does a seller do when the buyer is in another country? We have already seen how difficult it is to get judgments enforced in a country other than the country where it was issued. Arbitration awards are better, but they still involve considerable expense to pursue an international arbitration. If the transaction itself is not that large (possibly less than half a million dollars or so), the cost of enforcing the contract may be too high, even with a good arbitration clause.

Letters of credit (L/C) are designed to solve this problem and to help encourage international trade. (Click to see an example of a letter of credit.) By their nature, they are designed more to help sellers than buyers. In addition to letters of credit, there is another mechanism that uses banks and documents in a similar way, called payment on a collection basis, the most common of which is documents against payment (D/P). Both L/C and D/P transactions are referred to as documentary transactions because they rely principally on documents as the basis on which payment is made.

While a documentary transaction involves a number of documents, there are two documents that are important to understand.

A bill of lading (B/L) is issued by the carrier and is both a receipt and a contract for carriage. (Click to see an example of a bill of lading.) In a typical ocean shipment, the captain of the vessel is responsible for checking what has been loaded on the ship, noting whether there is any obvious damage, and issuing a B/L to the shipper, (i.e., the person who is shipping the goods). The B/L is a negotiable document, meaning it can be sold or exchanged for value. To understand conceptually what a B/L is, think about a claim check for a coat that you check at a concert. The claim check represents the goods and it can be transferred from one person to another. In effect, whoever possesses the claim check possesses the goods and can use the claim check to obtain them. In a documentary international trade transaction, the B/L serves the same purpose and is transferred from one party to another until it eventually is obtained by the buyer, who can use it to claim the goods. If the buyer doesn’t have the B/L, the carrier cannot release the goods to him. There are different kinds of B/Ls, but for use in a documentary transaction, the B/L must be indicated as being "clean" (no damage or defects noted by the captain), "negotiable" (able to be transferred for value), and "blank endorsed" (just like endorsing a check so that whoever has the check can cash it). The same basic principles of the nature of the document are applicable to air waybills as well.

The second important document is the draft, which is a negotiable instrument containing an order to pay. It is like a check in reverse where the person preparing the draft “orders” the recipient of the draft to pay. The draft is the executing document in a documentary transaction and must be included.

The basic rules relating to L/Cs are contained in a document by the International Chamber of Commerce referred to as the Uniform Customs and Practice for Documentary Credits (UCP). The UCP is not a rule promulgated by a governmental organization but rather was developed by a private international organization, the International Chamber of Commerce (ICC). The UCP creates a set of contractual rules that apply to documentary credits. Uniformity is obtained because all documentary credits state that the credit is subject to the rules set forth in the UCP. In using the credit, the user accepts the rules as set out in the UCP. The rules are comprehensive and cover most, if not all, of the types of circumstances that can arise in a documentary credit transaction (ICC, 2006).

Within the United States, however, for domestic transactions, L/Cs are governed primarily by UCC Article 5.

From a legal perspective, a commercial letter of credit is a contractual agreement between a bank, known as the issuing bank, on behalf of one of its customers (the buyer), authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary (the seller). This agreement is independent from the underlying contract between buyer and seller other than the fact that the dollar amounts will be the same as set out in the underlying contract of sale. A third contract exists between the issuing bank and its customer (the buyer), whereby the buyer either pays for the credit in advance or has sufficient credit with the bank to have the credit opened. The issuing bank, on the request of its customer, opens the L/C and agrees that it will make payments in accordance with the schedule in the L/C so long as the documentation presented exactly matches the documentation as described in the L/C. If the documentation does not match exactly the bank will not honor the L/C.

It is this requirement for “exact compliance” which raises the most issues in disputes over payments under L/Cs. So long as the goods are as described and both the buyer and seller are happy with the transaction, the process of correcting L/Cs to cure any discrepancies is simple and relatively common. But if there is a serious problem, such as a significant change in the market value of the goods as compared with the contract amount, then a discrepancy in the documentation can give a reluctant buyer (through his bank) a way to avoid the deal. Hence, great care needs to be taken to ensure the terms in the L/C and in the documentation match exactly.

Introduction to Alternative Dispute Resolution

Alternative dispute resolution (ADR) refers to the methods that individuals use to resolve disputes without resorting to civil litigation (i.e., without going through a trial). ADR includes any method or procedure for achieving this purpose; however, there are two commonly recognized processes: arbitration and mediation. Employing these resolution methods may be mandatory or voluntary. Further, these methods may not be exclusive. That is, the parties may employ mediation, arbitration, and litigation, all within the realm of a single dispute. There are unique procedures and general legal principles applicable to each of these processes.

Alternative Dispute Resolution

Settlement of a Legal Dispute

Settlement means that the parties to a legal dispute work out their differences and enter into an agreement to resolve the situation. The benefit of a settlement is that the parties maintain control over the outcome of the dispute. The parties are not subjected to a ruling, judgment, or award of a third- party decision maker. Businesses often settle legal disputes to avoid the high cost of litigation, maintain privacy, and to preserve the professional relationship with the other party. Also, juries tend to show favor to individual plaintiffs to the detriment of businesses. Individuals, on the other hand, settle disputes to avoid the long, tenuous litigation process and to make certain of some level of recovery. Achieving a settlement is a core objective of mediation, which is discussed in a separate section.

Ask Yourself

· Can you think of any other benefits of privately settling a matter, as opposed to pursuing litigation? Can you think of any situations where the above benefits of settlement are undesirable? Hint: Think about situations where you want to get your message or reason for dispute out to the public.

Alternative Dispute Resolution

Alternative dispute resolution (ADR), as the name implies, is an alternative to resorting to litigation to resolve a legal dispute between parties. The most common forms of ADR are mediation and arbitration.

Since ADR is an alternative to litigation, disputing parties do not have to begin a lawsuit prior to using any form of ADR. Also, filling a lawsuit does not preclude the use of ADR in conjunction with the litigation. Some courts, such a family court, often encourage or require parties to undertake some form of ADR prior to moving forward with litigation.

Advantages of ADR 

The effective use of ADR offers several distinct advantages:

· costs—ADR may reduce the costs associated with litigation for the disputing parties. This is probably the most common reason for including an ADR clause in a contract or agreeing separately to submit a dispute to ADR.

· no jury—Businesses generally prefer ADR to litigation because it avoids allowing a jury to decide a dispute. ADR, unlike a jury trial, generally involves the use of one or more knowledgeable professionals to either decide or assist in resolving the dispute. This is far more practical than letting a random group of jurors resolve the issue.

· privacy—Another reason to use ADR is that it is a private process; whereas, litigation and court records are open to the public. Individuals concerned with public knowledge of the dispute harming the company's brand or reputation strongly prefer the use of ADR to resolve disputes.

· business relationship—ADR can preserve the ongoing business relationship between the parties, where litigation often destroys the relationship.

Ask Yourself

· Can you think of any other benefits to ADR over litigation? Should businesses include ADR clauses in all contracts? Should individuals dealing with businesses agree to an ADR clause or should they attempt to eliminate ADR clauses? Why?

· Ryan runs a consulting business. All of his clients enter into an agreement to mediate any disputes arising under the agreement. If the mediation does not work, the client agrees to submit the dispute to arbitration. What are the advantages to the business of pursuing all available ADR methods rather than pursuing litigation?

Mediation 

Mediation is the process by which parties to a legal dispute employ a third party, called a mediator, to assist in resolving the dispute. The mediator is an unbiased and disinterested third party. She generally has undergone special training in dispute resolution and possesses in-depth knowledge of the subject matter of the dispute. In most instances, a mediator is a licensed attorney who has mediator training.

This is important, as the mediator should understand the legal principles that will apply to the dispute and be able to explain those legal principles to the parties. The mediator can honestly communicate with each party the process and possible results if the parties cannot resolve the dispute and decide to move forward with litigation. Mutual understanding of the parties is import in resolution of the dispute.

The mediator is not a decision maker; rather, she is a facilitator helping to bring the parties together toward a negotiated settlement. As such, she cannot deliver a binding decision on a matter. The parties must ultimately agree or refuse to settle the dispute.

Advantages and Disadvantages of Mediation?

There are numerous advantages and a few disadvantages to mediating a dispute:

· control—Recall that mediation allows the parties to retain control over the dispute. They are free to refuse to negotiate, and they are not required to find a resolution to the dispute. The voluntary nature of negotiation in the mediation process allows the parties to decide to pursue litigation or some other form of ADR. The level of control retained by the parties can also be seen as a disadvantage. Neither party can be certain that the mediation will result in a settlement. This lack of certainty can frustrate the parties with the process.

· costs—There is significant cost savings associated with mediation. While the parties generally share the responsibility of paying the mediator, it avoids court fees, some legal fees, and other expenses associated with going to trial. Further, the cost of mediation is generally far lower than the cost of other ADR approaches, such as arbitration. The cost disadvantage of mediation is that it can still be expensive and not result in a resolution. A simple negotiation between the parties can resolve a dispute for free; but, employing counsel to represent the parties at mediation and employing the mediator can cost significant money. Generally, the mediator takes a small percentage of the total settlement amount between the parties.

· privacy—As with other types of ADR, mediation is a private process. The parties do not have to disclose the dispute or any of the facts of the situation to the rest of the world. Litigation, on the other hand, is generally a public affair. Unless the court orders otherwise, anyone can attend a public trial and can access the court records. This includes access to all allegations, testimony, and the evidence presented in the case. The disadvantage to privacy generally concerns the expectations of the aggrieved party. In many cases, the injured party seeks compensation for the harm or loss to make certain that the alleged wrong is not repeated. Negotiating a settlement of the dispute outside of the public's knowledge does less to prevent a party from repeating the allegedly illegal conduct. This is particularly true when that party's conduct is intentional.

· relationships—Disputes between parties can destroy their on-going relationship. Being able to work out a mutually agreeable settlement of the dispute can serve to preserve the relationship. This is important for businesses that depend upon each other as future business partners (such as in supplier-purchaser relationships). Litigation generally destroys the business relationship, as the process is highly competitive and confrontational. The negative aspect of mediation is that relationships can still be strained without any resolution to guide the relationship going forward. A judicial determination that one party's conduct is not legal establishes precedent to guide the future conduct of a business. A negotiated settlement does not always achieve this same effect.

The above-mentioned advantages and disadvantages of mediation are general examples. There may be any number of party or case-specific benefits or detriments to mediation.

Ask Yourself

· Can you think of any other benefits to pursuing mediation over litigation? Why do you think mediators are often successful in negotiating a settlement between parties? Do you think businesses generally see litigation as a favorable or unfavorable option? Why?

· Mark and Sam are in a business relationship. They are now in a dispute over the quality of the last shipment of goods. While they generally get along well, they are unable to reach a resolution on this dispute. Mark and Sam are considering submitting their dispute to a mediator. What are the advantages of pursuing mediation?

How do Parties Initiate Mediation?

Mediation can be either mandatory or voluntary. General principles applicable to each are described below.

Mandatory Mediation 

Mandatory mediation is initiated pursuant to a court order or pursuant to the law (statute or regulation). For example, it is common for jurisdictions or courts to mandate that the parties to a family dispute, such as a divorce, work with a government sanctioned mediator prior to initiating litigation. Remember, mediation does not involve a decision maker. Mandatory mediation, therefore, simply requires that the parties begin the process. The parties are not forced to negotiate or arrive at a settlement. The hope is that requiring the parties to take part in mediation will help them to voluntarily work out the legal dispute without having to resort to litigation.

Voluntary Mediation 

Voluntary mediation is initiated pursuant to agreement among the parties. The parties may establish this agreement before a legal dispute arises or afterward. Pre- dispute mediation agreements are generally part of a separate contract between the parties. That is, the parties enter into any form of contract. A clause in the contract dictates that any legal dispute between the parties must be submitted to mediation before pursuing litigation or another dispute resolution method. A post-dispute mediation agreement generally arises pursuant to a separate agreement between the parties to employ a mediator to resolve the dispute. That is, the parties seeking to resolve a legal dispute recognize the value of pursuing mediation and voluntarily enlist the services of a mediator.

People often confuse mandatory and voluntary mediation by assuming that mediation is mandatory because there is a mediation clause in a contract. Even though a contract contains a mediation clause, it was still a voluntary decision to enter into that contract. As such, this is voluntary mediation. Mandatory mediation only arises pursuant to law or judicial procedure.

Ask Yourself

· Why do you think some jurisdictions, either through statute or court procedure, impose mandatory mediation? Do you think mandatory mediation is effective when the parties always retain the ability to refuse a settlement or resolution of the dispute?

· Jonathan enters into a service contract with Melinda. Soon after entering into the agreement, the relationship begins to sour. Now Jonathan and Melinda do not want to continue doing business together and they have a dispute over the amount owed under the contract for services. The parties are considering undertaking mediation in an attempt to resolve the dispute. How would Jonathan and Melinda go about submitting their dispute to mediation?

Mediation Procedures 

The voluntary mediation process is far less rigid than that of mandatory mediation. Involuntary mediation is somewhat of an informal process. The mediator may employ any number of techniques to help the parties arrive at a negotiated settlement. Mandatory mediation procedure may be subject to law or court order. The most common format for carrying out voluntary or mandatory mediation of a legal dispute with or between businesses is as follows:

· delivery of evidence—Each party provides the mediator with all of the facts and evidence surrounding the dispute. The mediator will set a date for the mediation.

· introductions—At the mediation, the mediator will introduce everyone, give an overview of the mediation process, and summarize the dispute at hand.

· initial statements—The mediator will often allow the parties to give an initial statement directed to the mediator and the other party. This serves a couple of purposes. First, it appeases the parties to allow them to voice their opinion on the matter. Second, it allows the parties to state a summary of their belief and facts in a persuasive manner.

· private sessions—Following the initial statements, the mediator will generally break the parties out into private sessions or caucuses. This means that the parties are placed in separate rooms, while the mediator moves back and forth between the rooms to negotiate the position of each party. These private sessions are optional at the mediator's discretion, though, they prove to be very effective in getting the parties to exchange dialogue or enter into negotiations. They tend to break down the competitive spirit that is present when the parties are together. The mediator is in the position to play devil's advocate and help each party understand the logic and legality of the other party's argument. Importantly, the mediator explains the likely results at trial if the parties proceed to litigation. This can be the strongest tool of the mediator in opening the parties up to negotiation.

· formalization of agreement—If the mediator is successful, she will assist the parties in negotiating a resolution to the dispute. Once a consensus is reached, counsel for one party is then directed to draft a legal contract memorializing the terms of the settlement. The parties sign the contract to settle the dispute. They are legally obligated act in accordance with the terms of the contract.

Involuntary mediation may follow the same or similar steps, but the process is more closely dictated by court procedure, statute, or regulation.

Ask Yourself

· Do you think it is important to give a mediator autonomy in carrying out the mediation process? Why or why not? Can you see any disadvantages to employing the process outlined above? Can you think of any techniques that could help the disputing parties arrive at a negotiated settlement?

· How and why do mediators use the isolation of the parties and conducting private sessions to help them reach a resolution of their dispute?

Challenging the Mediation Agreement 

A successful mediation results in a negotiated settlement between the parties. This is a formal contract that memorializes the agreed-upon resolution of the legal dispute. Once the parties enter into this agreement, it takes the place of the underlying dispute. The parties can no longer pursue litigation for the underlying dispute without breaching this contract. If, after the settlement agreement is signed, the parties wish to dispute the agreement, they must bring a contract action in court attacking the validity of the agreement. In this situation, however, the suing party is not suing regarding the underlying dispute but is arguing that the settlement agreement is not valid based upon some contract law principle. If the party is successful in rescinding (doing away with) the mediation agreement, the parties would be free to litigate the underlying dispute or pursue other forms of ADR.

Ask Yourself

· Should parties be able to revisit the subject of the mediation even if the mediation resulted in a settlement agreement? What are the arguments for and against disregarding the settlement agreement?

· Venus and Maria submit their dispute to mediation. After several hours, they reach a resolution of their dispute and sign a settlement agreement. The next morning, Venus regrets having signed the settlement agreement. She thinks that the hours of mediation unduly pressured her into reaching an agreement. What are Venus's options for pursuing litigation of the original dispute?

Arbitration 

Arbitration is a form of ADR in which the parties choose to forgo litigation and solve their problems through a third-party decision maker, known as an arbitrator. The key characteristic of arbitration is that the parties are hiring one or more unrelated and unbiased third parties to decide the legal dispute. Basically, the arbitrator acts as judge and jury in deciding the dispute. Unlike in mediation, the arbitrators are decision makers. Arbitration yields a final resolution of the dispute in the form of an arbitrator's award. The award generally consists of monetary damages, but may include equitable remedies as necessary. Parties may generally enforce an arbitrator's award similarly to a judgment.

It may surprise you to know that popular reality court television shows are actually arbitrations, as opposed to trials. The proceeding is made to look like a trial proceeding, with the arbitrator acting like (and even taking the title of) a judge.

Ask Yourself

· How does the core principle behind arbitration compare to that of mediation? Hint: Think about the role of a decision maker versus that of a facilitator.

Advantages and Disadvantages of Arbitration?

There are numerous advantages and a few disadvantages of arbitration:

· expertise—Arbitrators are generally chosen based upon their expertise in the subject matter of the dispute. This is a key advantage over litigation, which generally involves the use of jurors as fact-finders. The jurors will lack the subject-matter knowledge of professional arbitrators chosen by the parties. Some argue that this fact makes it less likely that jurors will arrive at a fair and just result.

· resolution—Similar to litigation, in arbitration the parties lose control of the dispute resolution process. The benefit of this situation is that the arbitrators will decide the dispute and issue an award. This may give the parties comfort in knowing that the legal dispute will be resolved.

· costs—There may be significant cost savings associated with arbitrating rather than litigating a dispute. While the parties generally share the responsibility of paying the arbitrators, it avoids many of the court fees, legal fees, and other expenses associated with going to trial. The primary point of savings is the lack of formality in the discovery process. Generally, the arbitrators control the proceeding and request from the parties whatever evidence they require in deciding the dispute.

· privacy—As with other types of ADR, arbitration is a private process. The parties do not have to disclose the dispute or any of the facts of the situation to the rest of the world. Privacy in arbitration offers the same advantages and disadvantages as mediation.

· relationships—Arbitration can have the effect of preserving ongoing business relationships. The parties may feel comfortable that the dispute is not decided arbitrarily, as experts are reviewing the facts and deciding the case. In this way, the parties are less likely to feel that they were treated unfairly by the system.

The above aspects of arbitration may be seen by a party as an advantage or disadvantage. For example, a party may hope to sway jurors by appealing to their emotions. This is not as easy when dealing with expert arbitrators who are more likely to apply the law without regard to personal emotions. Further, arbitration will lead to a decision on the dispute. One party may see this finality as a benefit, while other parties may want to retain the ability to continue negotiating a settlement.

Ask Yourself

· Do you think businesses generally prefer arbitration to litigation? Why or why not? Do you think individuals in a dispute with a business generally prefer litigation or arbitration? Why or why not?

· Bernie and Hillary do business together. Unable to reach a compromise in a dispute, they decide to submit their issue to arbitration. What advantages does arbitration offer to Hillary and Bernie?

How do Parties Initiate Arbitration?

Arbitration can be either voluntary or mandatory.

Voluntary Arbitration

Voluntary arbitration, as the name indicates, means that the parties voluntarily agree to submit a dispute (or any dispute) to arbitration. This is also known as arbitration at common law. This is normally done through a formal, written agreement entered into between the parties. Voluntary arbitration generally takes two forms:

· predispute arbitration—A contract between parties may contain an arbitration clause. These agreements require that any dispute over the contract will be arbitrated. For example, assume you enter into a contract to purchase a vehicle. The contract contains a clause stating that any legal disputes about the contract will be arbitrated. This is a predispute arbitration clause.

· postdispute arbitration—The parties may enter into an agreement after the dispute arises to resolve a dispute through arbitration. Even if the contract has an arbitration provision that makes arbitration of any disputes mandatory, it is still voluntary arbitration. The reason is because the parties voluntarily entered into the contract. Continuing the above example between you and the car salesman, suppose the agreement does not contain an arbitration clause. If a dispute arises, you and the car salesman may enter into an agreement to submit the dispute to arbitration rather than litigate it.

Mandatory Arbitration

Certain state and federal laws require parties to arbitrate specific types of disputes. When a statute or court requires the parties to arbitrate a matter, this is known as mandatory arbitration. This is common in some very technical areas of law, such as alleged violations of rules put forward by the Financial Industry Regulatory Authority (FINRA). The requirement to arbitrate may be tied either to the type of dispute or the amount in controversy in the dispute. When the law requires arbitration, there is also a procedure in place for the identification and hiring of certified arbitrators.

Ask Yourself

· How do you feel about laws requiring that individuals arbitrate their dispute? Does this have any constitutional implications (such as the right to due process under the law)?

· Carlos has a dispute with his employer. He believes that he has been discriminated against in the promotion selection process. In his employment contract, there is a clause requiring arbitration of any dispute under the agreement. Also, a state employment law requires arbitration of any employee-employer, discrimination disputes. In this situation, is the arbitration between the parties voluntary or mandatory?

Arbitration Procedures

The rules and procedures applicable to an arbitration depend on the jurisdiction. Some jurisdictions rely upon common law to supply the rules applicable to arbitrations. In these jurisdictions, judges often draw heavily upon model laws or other influential sources in the development of the law. Historically, common law arbitration jurisdictions have far less developed procedural rules. Notably, these jurisdictions vary in the degree to which they support the arbitration process. Other jurisdictions pass statutes controlling the arbitration process. In such jurisdictions, the general procedure for carrying out an arbitration proceeding is as follows:

· subject matter of the arbitration—The dispute may be a question of fact, law, or a mixed question of fact and law. There is a great deal of controversy surrounding what issues the arbitrator has the ability to decide. The arbitration agreement should be clear about the extent of the arbitrator's authority. The arbitrator exceeding her authority is the most common grounds for challenging arbitration awards.

· choosing arbitrators—In voluntary arbitrations, the parties choose the arbitrator to decide the dispute. In most cases, arbitration involves three arbitrators, which allows for a majority vote on the matter. There are numerous methods the parties can employ in selecting arbitrators. In some cases, an arbitration agreement will outline the procedure. Mandatory arbitration may identify or provide a limited pool of certified arbitrators. Otherwise, the parties have latitude in choose an arbitrator. Most jurisdictions do not require that arbitrators have any special training. Each party may select one arbitrator and those arbitrators select the third arbitrator. The parties will seek to select experts with experience in the particular industry and with knowledge of the customs and practices.

· submit to arbitration—Arbitration begins by the parties "submitting" their dispute to the arbitrators. Submission is simply the act of contacting the arbitrators and providing them with the dispute information and setting up a time to have an arbitration proceeding. Submitting a dispute to arbitration authorizes arbitrators to make a decision that binds the parties and resolves their dispute. In mandatory arbitrations, many jurisdictions require that the parties submit the matter to arbitration within six months of the dispute arising.

· agreement with arbitrator—In voluntary arbitration, the parties must enter into an agreement with the arbitrators to resolve the dispute. The terms of the arbitration agreement and the dispute are passed on to the arbitrator. The parties may propose the rules governing the arbitration. In most cases, however, the arbitrator will agree to arbitrate the matter based upon model arbitration procedural rules. Mandatory arbitration may have formalized documents or procedures for this purpose. Many arbitrations employee the rules provided in the Federal Arbitration Act.

· arbitration proceeding—The arbitration procedure follows a semi-formal format with the arbitrators controlling the process. Often the arbitrators will orchestrate the arbitration similarly to a trial. The judicial rules of evidence and procedure do not apply, so the arbitrators have a great deal of latitude. They look beyond strictly legal criteria to other factors that bear on the proper resolution of a dispute. They can look at such factors as the state of the law, fairness, productivity, consequences on morale, and whether tensions will be heightened or diminished. Of note, they can generally request any evidence from the parties that is necessary to arrive at a decision. The arbitrator will often follow a form of model arbitration rules in holding the proceeding. Mandatory arbitrations will always follow the procedure proscribed by the law or court mandating arbitration.

· award—arbitrators do not issue a judgment, as in civil trials. Rather, they decide the matter and hand down an award in favor of one party or the other. The arbitration agreement and the rules employed by the arbitrators may limit the amount or type of award the arbitrators can issue. Generally, the arbitrators do not need to set forth findings of fact, conclusions of law, or reasons for the award. The arbitrators may, however, be required to elaborate on their reasoning if required by statute or arbitration agreement. If so, the arbitrators generally provide the reasoning for their decision in the form of an opinion letter. This opinion letter becomes part of the award. Regardless of the reasoning, parties are generally bound by the arbitrator's decision.

· enforcement—Courts will generally enforce arbitration awards either through contract law or through recordation and recognition as a judgment. Enforcement of arbitration awards is discussed in greater detail in a separate section.

Ask Yourself

· What differences do you see between the arbitration and mediation process? What differences do you see between the arbitration and litigation process? Do you think it is wise for businesses to include arbitration clauses in contracts? Is it wise for individuals?

· You work for ABC, Inc. ABC is involved in arbitration of a major business dispute. Your boss wants you to attend the arbitration and provide evidence to the arbitrators. Concerned that you perform well, you begin researching the arbitration process. In a short memo, explain the process for carrying out an arbitration.

Rules to Arbitration

The rules governing an arbitration vary depending upon whether the arbitration is voluntary or mandatory. In a voluntary arbitration, the parties may agree upon the rules to govern the proceeding. It is rare that the parties will specifically state all of the governing provisions; rather, the agreement to arbitrate will agree that statutory provisions or a set of model rules will govern the arbitration proceeding.

The Revised Uniform Arbitration Act of 2000 is a model law commonly employed in voluntary arbitrations.

In a mandatory arbitration, state law or court order dictates the rules governing the arbitration. Notably, in 1925, Congress passed the Federal Arbitration Act (FAA) to encourage the use of arbitration to resolve conflicts. The FAA provides the process and procedure for carrying out the arbitration. The FAA applies when the dispute is subject to mandatory federal arbitration or when there is an voluntary arbitration agreement and the dispute involves federal law. Of course, the parties to voluntary arbitration may agree to a different set of laws, but applying FAA standards may affect a party's ability to enforce the arbitrator's award through the court system. Importantly, the FAA requires that where the parties have agreed to arbitrate, they must do so in lieu of going to court.

Ask Yourself

· Why do you think Congress found it necessary to establish uniform Federal Arbitration Procedures? How do you feel about a federal law attempting to control the state court procedure for recognizing and enforcing arbitration agreements?

· Pam and Lisa enter into a contract with an arbitration clause covering any disputes. When a dispute arises, Pam and Lisa decide to submit the matter to arbitration. If the contract does not indicate, what rules apply to the arbitration process?

Challenging the Arbitration Award

An arbitration is a nonjudicial process. As such, there is no appeal available. There is, however, a limited ability to challenge an arbitration award in an Art. III court. The standard for challenging an arbitration award differs for voluntary and mandatory arbitrations.

Challenging Voluntary Arbitration 

In the case of voluntary arbitrations parties may challenge an arbitration award based upon the arbitrator exceeding her authority or based upon a contractual defense to the validity of the arbitration agreement. That is, the court will not disturb an arbitrator's award based upon an error in the application of law or determination of a fact. The challenging party must file a legal action attacking the validity of the arbitration agreement or the authority of the arbitrator. For example, the arbitrator may have issued an award that affected property that was not subject to the original contract.

In general, arbitration clauses are liberally interpreted when a party contests the scope of the clause. If the scope is debatable or reasonably in doubt, the clause is construed in favor of arbitration. In summary, the fact that the arbitrator made an erroneous ruling or reached erroneous findings of fact are not grounds for setting aside the award. Of course, an error of law may render the award void when it requires the parties to commit a crime or otherwise to violate a positive mandate of the law. In any event, judicial review of the arbitration award may correct fraudulent or arbitrary actions by an arbitrator.

Ask Yourself

· Why do you think courts, when reviewing a challenge to an arbitration award, refuse to revisit the facts or procedures of the arbitration? Do you believe they should revisit the facts and procedures?

· Brad and Angela agree to arbitrate their contract dispute. At the end of the arbitration, Angela is not happy with the award handed down by the arbitrators. What are her options for challenging the arbitration award.

Challenging Mandatory Arbitration 

Mandatory arbitration effectively cuts off the parties' access to a trial court. Many courts have held that mandatory arbitration statutes that close the courts to litigants are void as against public policy and are unconstitutional. The arguments against enforcing mandatory arbitration statutes include the following:

· They deprive one of property and liberty of contract without due process of law.

· They violate the litigant's Seventh Amendment right to a jury trial and or state's constitutional access to courts.

· They result in the unconstitutional delegation of legislative or judicial power in violation of state constitutional separation of powers provisions.

Mandatory arbitration is generally deemed constitutional if fair procedures are provided by the legislature and ultimate judicial review is available. As such, statutorily mandated arbitration requires a higher level of access to judicial review of the awards by the court. If a party can reject the arbitrator's award and seek de novo judicial review, mandatory arbitration is generally considered constitutional. The right to reject the award and to proceed to trial is the sole remedy of the parties. If a party rejects an arbitrator's award and challenges the case at trial, the court may impose sanctions on the party who fails to improve its position. Also, failing to attend the arbitration could forfeit the right of a party to reject the award and proceed to trial.

Ask Yourself

· What is your opinion with regard to the above-mentioned arguments against mandatory arbitration? Do you think that allowing a party to refuse an arbitrator's award makes mandatory arbitration constitutional? Why or why not?

· Brad and Angela have a dispute that is subject to a state law requiring mandatory arbitration. At the end of the arbitration, Angela is not happy with the award handed down by the arbitrators. What are her options for challenging the arbitration?

Review Under the Federal Arbitration Act 

In cases involving federal matters, the Federal Administration Act controls the procedures. The procedures of the FAA are binding upon both state and federal courts when called upon to review an arbitration. Once an award is entered by an arbitrator or arbitration panel, it must be "confirmed" in a court of law. Per the FAA, awards must be confirmed within one year. A losing party must object and challenge the award within three months.

As a federal law, the FAA trumps state statutes that conflict with its provisions. For example, the FAA trumps state laws that allow for challenge of arbitration awards in a manner that differs from the provisions of the FAA.

Ask Yourself

· Do you think that the provisions of the FAA requiring a court to confirm an arbitration award make the arbitration process more fair? Why or why not? Do these provisions help to ensure the mandatory arbitration statute observes Constitutional rights? Why or why not?

· Erica is a party to an arbitration under the Federal Arbitration Act. She receives an award from the arbitrators. What is the process for enforcing the arbitration award?

Arbitration Award Enforcement

The method of enforcing an arbitration award will vary depending upon the jurisdiction. In a common- law arbitration jurisdiction, a

party must generally initiate a legal action to enforce an arbitration award as a contract. Most statutory- arbitration jurisdictions establish a process for enforcing arbitration awards. This may include seeking court recognition and approval of the award. Many jurisdictions require arbitration awards be registered with the court system to receive judicial assistance in enforcement. Generally, the holder of the award will file the award with the Clerk of Court's office. The clerk will prepare a certification of judgment order for a judge's signature. Once a judge signs and certifies the order, it may be enforced in the same manner is a judgment. Once confirmed, the award is then reduced to an enforceable judgment, which may be enforced by the winning party in court, like any other judgment.

Under the FAA, state courts are encouraged to enforce arbitration agreements. Arbitration agreements "shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract."

Ask Yourself

· What do you think about the process for enforcing an arbitration award? Should it be easier or require more effort to enforce? Should the courts get involved at all?

· Josh receives an arbitration award in an arbitration governed by the Federal Arbitration Act. What process can Josh follow to enforce his arbitration award?

 

International Dispute Resolution

by Robert C. Goodwin

Applicability of Foreign Law

It is important for those of us interested in international business to understand the nature of legal responsibilities when conducting business in foreign countries and the power of countries to impose rules that will influence business activities in another country. It would be useful for you to be familiar with a few basic concepts in this area.  First, each country has a sovereign right to define the legal rules for activities within its territory, and the principles of international law are supposed to respect that sovereignty.

There are several areas where this simple statement runs into problems. One is where a country is undertaking actions that violate international law, such as allowing genocide. Another is where one country (state A) attempts to regulate activity that occurs in a foreign country (state B) because the activity has a direct effect in state A.  The best example of this situation is US antitrust laws. If UK companies conspire in London to fix prices on goods exported to the United States, the United States will attempt to sue these UK companies in spite of the fact that their actions might have been legal in the UK.  

But, aside from these exceptions, the general rule that each country has the right to set its own legal rules for activities within its borders still holds pretty well. The corollary to this rule is that foreign companies are bound to obey the laws of the country where they are doing business. For the most part this rule does not create conflict between the laws of the home country (e.g., the United States) and the host country because countries usually do not give their laws extraterritorial application. Thus, the United States does not typically attempt to regulate the activities of US-owned companies that are operating in foreign countries.  

There are, however, a few instances where the United States does regulate the activities of US entities operating abroad, and these types of situations are increasing. But if there is no conflict with the local law then there might not be a problem. For example, bribery, a common problem in international business, is outlawed in all countries. Therefore, an American company has no legal problem in complying with the US Foreign Corrupt Practices Act, which prohibits bribery, even though it is a case of US law affecting activities taking place inside a foreign country. Another tricky area is employment discrimination; the US Congress has made prohibitions on discrimination applicable not only to US corporations abroad but also to subsidiaries controlled by US corporations, unless compliance with the US antidiscrimination law would cause a violation of the law of the country that the workplace is located in.

Where a conflict does exist between US law and local law, there often is an ad hoc solution negotiated between the countries. Keep in mind that the US company operating abroad is clearly subject to local law. A subsidiary established in country B is a country B company, not a US company, even though it may be 100 percent owned by a US company. A GM subsidiary in China is a Chinese company and must follow Chinese rules regarding its board of directors, etc. Fundamentally, though, there is no good international system for solving conflicts involving the legal rules of different countries. Suppose that you are a US company with subsidiaries in Japan and China, and suppliers in China fail to honor some contract commitments. If the goods were supposed to be delivered to Japan, does Japanese law apply? If a Japanese court ruled on the dispute would a Chinese court honor the decision? These are difficult questions and arbitration can be useful in such situations.  

Choice of Law

Once we know what court will hear a case, we do not necessarily know what law will be applied by that court. While courts in some countries prefer only to apply their own law to any case which is heard in their court, in the United States that is often not true. If a court in Maryland hears a case about a contract entered into between a Maryland corporation and a California corporation which was negotiated in California and performed in California, then the Maryland court will apply California law to the case. The short answer is that, absent a choice by the parties, a US court applies the law of the state that has the most significant relationship to the transaction and the parties.

Ability of Parties to Select the Forum

What if the parties themselves want to decide in advance that a particular forum will be the location for any possible lawsuits? Can they do that? The short answer is yes, in the United States, but maybe not so readily in other jurisdictions. (Read the 1972 US Supreme Court case of M/S Bremen v. Zapata Offshore Co., 407 U.S. 1.)

Recognition and Enforcement of Foreign Judgments

In the United States there is a provision in the US Constitution that requires each state to give full faith and credit to the judicial decisions of any of the other sister states. But internationally there is no similar structure, and the extent to which each country will recognize the judgments of other nations depends upon the law of the country that is asked to enforce a foreign judgment. This type of enforcement is in stark contrast to arbitration, where there is an international agreement whereby countries promise to enforce arbitral awards made in other countries. We will discuss arbitration more in the section below

Many business people might be surprised to discover that if they were to be sued in a foreign country they could be at serious risk of having any judgment that might be rendered in that country brought here to the United States and enforced against them. The United States, unlike many countries, is willing to accept judgments issued by the courts of other nations provided that certain standards have been met. Courts will apply the following tests to determine whether the foreign judgment should be accepted and enforced:

1. Did the foreign court have jurisdiction over the person and subject matter? The question of whether the foreign court had jurisdiction is evaluated using US standards of jurisdiction, not the standards as expressed in the law of the foreign country. This takes us back to the standard reflected in US court decisions that there be minimum contacts between the defendant in the dispute and the jurisdiction or that a company has purposefully availed itself of the privilege of doing business in the jurisdiction. Also, a reasonableness overlay is part of the analysis. That is, the assertion of jurisdiction must be reasonable under the circumstances of the case.

2. Was the defendant given adequate notice? Here adequate can refer to lead time as well as the language of the notice.

3. Was the judgment rendered under a system that provides impartial tribunals or procedures compatible with the requirements of due process of law?

4. Was there fraud in obtaining the judgment? If fraud existed, of course, the US court will not enforce the judgment.

5. Is enforcement of the foreign judgment consistent with US public policy?

6. Does the judgment conflict with another final judgment or is it contrary to an agreement between the parties providing for arbitration or some other alternate dispute settlement mechanism? The foregoing principles are contained both in court decisions and in a uniform law that has been adopted by some states, called the Foreign-Country Money Judgements Recognition Act

International Dispute Resolution

by Robert C. Goodwin, Collegiate Professor, University of Maryland Global Campus

Applicability of Foreign Law

It is important for those of us interested in international business to understand the nature of legal responsibilities when conducting business in foreign countries and the power of countries to impose rules that will influence business activities in another country. It would be useful for you to be familiar with a few basic concepts in this area.  First, each country has a sovereign right to define the legal rules for activities within its territory, and the principles of international law are supposed to respect that sovereignty.

There are several areas where this simple statement runs into problems. One is where a country is undertaking actions that violate international law, such as allowing genocide. Another is where one country (state A) attempts to regulate activity that occurs in a foreign country (state B) because the activity has a direct effect in state A.  The best example of this situation is US antitrust laws. If UK companies conspire in London to fix prices on goods exported to the United States, the United States will attempt to sue these UK companies in spite of the fact that their actions might have been legal in the UK.  

But, aside from these exceptions, the general rule that each country has the right to set its own legal rules for activities within its borders still holds pretty well. The corollary to this rule is that foreign companies are bound to obey the laws of the country where they are doing business. For the most part this rule does not create conflict between the laws of the home country (e.g., the United States) and the host country because countries usually do not give their laws extraterritorial application. Thus, the United States does not typically attempt to regulate the activities of US-owned companies that are operating in foreign countries.  

There are, however, a few instances where the United States does regulate the activities of US entities operating abroad, and these types of situations are increasing. But if there is no conflict with the local law then there might not be a problem. For example, bribery, a common problem in international business, is outlawed in all countries. Therefore, an American company has no legal problem in complying with the US Foreign Corrupt Practices Act, which prohibits bribery, even though it is a case of US law affecting activities taking place inside a foreign country. Another tricky area is employment discrimination; the US Congress has made prohibitions on discrimination applicable not only to US corporations abroad but also to subsidiaries controlled by US corporations, unless compliance with the US antidiscrimination law would cause a violation of the law of the country that the workplace is located in.

Where a conflict does exist between US law and local law, there often is an ad hoc solution negotiated between the countries. Keep in mind that the US company operating abroad is clearly subject to local law. A subsidiary established in country B is a country B company, not a US company, even though it may be 100 percent owned by a US company. A GM subsidiary in China is a Chinese company and must follow Chinese rules regarding its board of directors, etc. Fundamentally, though, there is no good international system for solving conflicts involving the legal rules of different countries. Suppose that you are a US company with subsidiaries in Japan and China, and suppliers in China fail to honor some contract commitments. If the goods were supposed to be delivered to Japan, does Japanese law apply? If a Japanese court ruled on the dispute would a Chinese court honor the decision? These are difficult questions and arbitration can be useful in such situations.  

Choice of Law

Once we know what court will hear a case, we do not necessarily know what law will be applied by that court. While courts in some countries prefer only to apply their own law to any case which is heard in their court, in the United States that is often not true. If a court in Maryland hears a case about a contract entered into between a Maryland corporation and a California corporation which was negotiated in California and performed in California, then the Maryland court will apply California law to the case. The short answer is that, absent a choice by the parties, a US court applies the law of the state that has the most significant relationship to the transaction and the parties.

Ability of Parties to Select the Forum

What if the parties themselves want to decide in advance that a particular forum will be the location for any possible lawsuits? Can they do that? The short answer is yes, in the United States, but maybe not so readily in other jurisdictions. (Read the 1972 US Supreme Court case of M/S Bremen v. Zapata Offshore Co., 407 U.S. 1.)

Recognition and Enforcement of Foreign Judgments

In the United States there is a provision in the US Constitution that requires each state to give full faith and credit to the judicial decisions of any of the other sister states. But internationally there is no similar structure, and the extent to which each country will recognize the judgments of other nations depends upon the law of the country that is asked to enforce a foreign judgment. This type of enforcement is in stark contrast to arbitration, where there is an international agreement whereby countries promise to enforce arbitral awards made in other countries. We will discuss arbitration more in the section below

Many business people might be surprised to discover that if they were to be sued in a foreign country they could be at serious risk of having any judgment that might be rendered in that country brought here to the United States and enforced against them. The United States, unlike many countries, is willing to accept judgments issued by the courts of other nations provided that certain standards have been met. Courts will apply the following tests to determine whether the foreign judgment should be accepted and enforced:

1. Did the foreign court have jurisdiction over the person and subject matter? The question of whether the foreign court had jurisdiction is evaluated using US standards of jurisdiction, not the standards as expressed in the law of the foreign country. This takes us back to the standard reflected in US court decisions that there be minimum contacts between the defendant in the dispute and the jurisdiction or that a company has purposefully availed itself of the privilege of doing business in the jurisdiction. Also, a reasonableness overlay is part of the analysis. That is, the assertion of jurisdiction must be reasonable under the circumstances of the case.

2. Was the defendant given adequate notice? Here adequate can refer to lead time as well as the language of the notice.

3. Was the judgment rendered under a system that provides impartial tribunals or procedures compatible with the requirements of due process of law?

4. Was there fraud in obtaining the judgment? If fraud existed, of course, the US court will not enforce the judgment.

5. Is enforcement of the foreign judgment consistent with US public policy?

6. Does the judgment conflict with another final judgment or is it contrary to an agreement between the parties providing for arbitration or some other alternate dispute settlement mechanism? The foregoing principles are contained both in court decisions and in a uniform law that has been adopted by some states, called the Foreign-Country Money Judgements Recognition Act

Arbitration

Arbitration is a nonjudicial proceeding designed to settle disputes. Our focus here is arbitration of disputes between two private parties to a contract, not the arbitration of disputes between a private party and a government. Many people confuse arbitration with mediation. They are not the same at all. In mediation, a neutral third party tries to bring the two disputing parties together. A mediator serves as a facilitator and the parties themselves eventually reach an agreement. Arbitration, on the other hand, involves the neutral third party (or parties) acting as a decision maker in the same way that a judge does. Each party presents its point of view to the arbitrator, who then makes a decision that the parties have agreed in advance they will honor.

There is no requirement as to how an arbitration will proceed—it is dictated by whatever is in the contract between the parties. There are several organizations that provide arbitration services and that have rules detailing how they conduct arbitrations, what procedures are applied, etc. The International Chamber of Commerce (ICC) in Paris, for example, is a popular center for arbitration, and many people draft contracts with an arbitration clause providing that arbitration will be conducted in accordance with the rules of the ICC. The American Arbitration Association (AAA) also provides arbitration services pursuant to its rules. Generally, in addition to specifying the rules that will apply, parties to the contract should specify the location of the arbitration, the language of arbitration, and the number of arbitrators. Sometimes one arbitrator will make more sense than three. Keep in mind that arbitrators must be paid, so there may be an advantage from a cost perspective for having a single arbitrator.

Arbitration has a number of advantages, including efficiency and confidentiality. But the most important benefit is enforceability. Under the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (usually referred to as the New York Convention), most of the world’s trading nations have agreed to have their courts enforce arbitral awards issued in foreign nations. There are limited circumstances where a nation could refuse to enforce a foreign arbitral award. These are set forth in Article V of the Convention.

Review the text of the Convention on the Recognition and Enforcement of Foreign Arbitral Awards. Search for Article V in the pdf using the "Ctrl F" search function.

Important Takeaways for Your International Contracts

In terms of the important issues to keep in mind related to dispute resolution in contracts, with a particular focus on international contracts, the following major issues are important:

1. US courts now have a strong bias for allowing the parties to determine their own dispute resolution approach and are reluctant to allow a party to bypass a contractual commitment to resolve disputes through arbitration. This view is bolstered by the US Arbitration Act, which contains limited bases for overturning an arbitral award in the United States.

2. Internationally, those nations that have signed the Convention on the Enforcement of Arbitral Awards (called the New York Convention) have also agreed to enforce arbitral awards and to allow them to be overturned by their courts in only very limited circumstances, similar to the circumstances set forth in the US Arbitration Act.

3. There is a major difference between enforcement of arbitral awards and court judgments. In the United States, courts are liberal in enforcing judicial awards made by the courts of other countries. However, other countries do not follow the US practice. Thus, as a businessperson, you might win a lawsuit but not be able to enforce the award in another country. However, if you win an arbitration your chances of enforcing it are far greater because of the New York Convention, which obligates those countries that have signed it to enforce arbitral awards. As a businessperson doing business internationally, you will more likely than not want to include an arbitration clause in your contracts.

4. Note that many US lawyers like to put into contracts that both parties agree that the courts of New York or some other state will be used to settle disputes. But if you are doing business with a foreign company that doesn't have any assets in the US, what good does it do you to have a US judgment? Courts overseas won't honor the judgment and there are no assets in the United States to execute against. You would be better off with an arbitral award that can be enforced overseas, so long as the country has signed the New York Convention.

5. For sales contracts, use letters of credit to ensure that you receive payment. The true advantage of a letter of credit is that it involves a bank in the process so the seller is not relying on the buyer to pay the invoice, but rather on the bank.

Arbitration is a nonjudicial proceeding designed to settle disputes. Our focus here is arbitration of disputes between two private parties to a contract, not the arbitration of disputes between a private party and a government. Many people confuse arbitration with mediation. They are not the same at all. In mediation, a neutral third party tries to bring the two disputing parties together. A mediator serves as a facilitator and the parties themselves eventually reach an agreement. Arbitration, on the other hand, involves the neutral third party (or parties) acting as a decision maker in the same way that a judge does. Each party presents its point of view to the arbitrator, who then makes a decision that the parties have agreed in advance they will honor.

There is no requirement as to how an arbitration will proceed—it is dictated by whatever is in the contract between the parties. There are several organizations that provide arbitration services and that have rules detailing how they conduct arbitrations, what procedures are applied, etc. The International Chamber of Commerce (ICC) in Paris, for example, is a popular center for arbitration, and many people draft contracts with an arbitration clause providing that arbitration will be conducted in accordance with the rules of the ICC. The American Arbitration Association (AAA) also provides arbitration services pursuant to its rules. Generally, in addition to specifying the rules that will apply, parties to the contract should specify the location of the arbitration, the language of arbitration, and the number of arbitrators. Sometimes one arbitrator will make more sense than three. Keep in mind that arbitrators must be paid, so there may be an advantage from a cost perspective for having a single arbitrator.

Arbitration has a number of advantages, including efficiency and confidentiality. But the most important benefit is enforceability. Under the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (usually referred to as the New York Convention), most of the world’s trading nations have agreed to have their courts enforce arbitral awards issued in foreign nations. There are limited circumstances where a nation could refuse to enforce a foreign arbitral award. These are set forth in Article V of the Convention.

Review the text of the Convention on the Recognition and Enforcement of Foreign Arbitral Awards. Search for Article V in the pdf using the "Ctrl F" search function.

Important Takeaways for Your International Contracts

In terms of the important issues to keep in mind related to dispute resolution in contracts, with a particular focus on international contracts, the following major issues are important:

1. US courts now have a strong bias for allowing the parties to determine their own dispute resolution approach and are reluctant to allow a party to bypass a contractual commitment to resolve disputes through arbitration. This view is bolstered by the US Arbitration Act, which contains limited bases for overturning an arbitral award in the United States.

2. Internationally, those nations that have signed the Convention on the Enforcement of Arbitral Awards (called the New York Convention) have also agreed to enforce arbitral awards and to allow them to be overturned by their courts in only very limited circumstances, similar to the circumstances set forth in the US Arbitration Act.

3. There is a major difference between enforcement of arbitral awards and court judgments. In the United States, courts are liberal in enforcing judicial awards made by the courts of other countries. However, other countries do not follow the US practice. Thus, as a businessperson, you might win a lawsuit but not be able to enforce the award in another country. However, if you win an arbitration your chances of enforcing it are far greater because of the New York Convention, which obligates those countries that have signed it to enforce arbitral awards. As a businessperson doing business internationally, you will more likely than not want to include an arbitration clause in your contracts.

4. Note that many US lawyers like to put into contracts that both parties agree that the courts of New York or some other state will be used to settle disputes. But if you are doing business with a foreign company that doesn't have any assets in the US, what good does it do you to have a US judgment? Courts overseas won't honor the judgment and there are no assets in the United States to execute against. You would be better off with an arbitral award that can be enforced overseas, so long as the country has signed the New York Convention.

5. For sales contracts, use letters of credit to ensure that you receive payment. The true advantage of a letter of credit is that it involves a bank in the process so the seller is not relying on the buyer to pay the invoice, but rather on the bank.